(BQ) Part 2 book Financial accounting has contents: Investments in property, plant, and equipment and in intangible assets, long term debt financing, equity financing, investments in debt and equity securities, the statement of cash flows, introduction to financial statement analysis,...and other contents.
Trang 1Investing and Financing Activities
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Investments in Property, Plant, and Equipment and in Intangible Assets Long-Term Debt Financing
Equity Financing
Investments in Debt and Equity Securities
© DUNCAN SMITH/PHOTODISC GREEN/GETTY IMAGES INC.
Trang 2Investments in Property, Plant, and Equipment and in Intangible Assets
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© AP PHOTO/SARA D DAVIS
Trang 3Identify the two major categories of
long-term operating assets: property, plant,
and equipment and intangible assets.
A company needs an infrastructure of long-term
operating assets in order to produce and distribute
its products and services In addition to property,
plant, and equipment, long-term operating assets
also include intangible items such as patents and
licenses.
Understand the factors important in
de-ciding whether to acquire a long-term
operating asset A company should purchase a
long-term operating asset if the future cash flows
expected to be generated by the asset are “large”
in comparison to the cost to purchase the asset.
Record the acquisition of property, plant,
and equipment through a simple
purchase as well as through a lease, by
self-construction, and as part of the
pur-chase of several assets at once The recorded
cost of property, plant, or equipment includes all
costs needed to purchase the asset and prepare it
for its intended use Assets can be acquired through
purchase, leasing, exchange, self-construction, or
through the purchase of an entire company.
Compute straight-line and
units-of-production depreciation expense for plant
and equipment Depreciation is the process of
systematically allocating the cost of a long-term
as-set over the service life of that asas-set If that service
life is measured in years, then a reasonable way to
allocate the cost is equally over the years; this is
called straight-line depreciation.
Account for repairs and improvements
of property, plant, and equipment.
Postacquisition costs that increase an asset’s
capacity or extend its life are called improvements
and are capitalized meaning that they are added
to the cost of the asset Routine maintenance costs
are called repairs and are expensed.
Identify whether a long-term operating
asset has suffered a decline in value and
record the decline When a long-term
operat-ing asset suffers a significant decline in value (as
indicated by a decline in the cash flows expected
to be generated by the asset), it is said to be
impaired When an asset is impaired, its recorded
value is reduced and an impairment loss is
recognized Increases in asset values are not
recognized in the financial statements.
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L E A R N I N G O B J E C T I V E S
After studying this chapter, you should be able to:
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E X P A N D E D
material
Record the discarding and selling of
prop-erty, plant, and equipment Upon the
dis-posal of a long-term operating asset, a gain or loss
is recognized if the disposal proceeds are more or less, respectively, than the remaining book value of the asset.
Account for the acquisition and tion of intangible assets and understand the special difficulties associated with ac-
amortiza-counting for intangibles Because the
tradi-tional accounting model is designed for manufacturing and retail companies, many intangi- ble assets go unrecorded Intangible assets are recorded only when they are purchased, either indi- vidually or as part of a set of assets Goodwill is the excess of the purchase price over the fair value of the net identifiable assets in a business acquisition.
Use the fixed asset turnover ratio as a measure of how efficiently a company is using its property, plant, and equipment.
The fixed asset turnover ratio is computed as sales divided by the amount of property, plant, and equipment (fixed assets) This ratio can be used as
a general measure of how efficiently a company is using its property, plant, and equipment.
Compute declining-balance and the-years’-digits depreciation expense for
sum-of-plant and equipment Many long-term
operat-ing assets wear out proportionately more in the early years of their lives For these assets, more de- preciation is recorded in the early years; this is called accelerated depreciation Two mathematical techniques used to generate this accelerated pat- tern are declining-balance depreciation and sum-of- the-years’-digits depreciation.
Account for changes in depreciation
esti-mates and methods Depreciation expense
in-volves making estimates relating to pattern of use, estimated useful life, and salvage value Changes
in estimated salvage value or useful life and changes in depreciation method are reflected in the computation of depreciation expense for the current and future periods The undepreciated book value is allocated over the remaining life based on the revised estimates or method.
Trang 4Thomas Edison received $300,000 in investment
funds in 1878 in order to start his Edison
Electric Light Company Today, General
Electric is the direct descendant of Edison’s
company and, with a market value of $354 billion
(as of May 2006), is the second most valuable
company in the world (behind ExxonMobil)
General Electric has been a fixture in corporate
America since the late 1800s and is the only one
of the 12 companies in the original Dow Jones
Industrial Average that is still included among the
30 companies making up the Dow today.1
The stated purpose of the creation of theEdison Electric Light Company was the de-
velopment of an economically practical
elec-tric light bulb After a year of experimentation,
Thomas Edison discovered that carbonized
bamboo would provide a long-lasting light
fila-ment that was also easy to produce Edison
quickly found that delivering electric light to
people’s homes required more than a light bulb,
however So, he developed an entire electricity
generation and distribution system, inventing
new pieces of equipment when he couldn’t find
what he needed The first public electric light
system was built in London, followed soon
af-ter by the Pearl Street Station system in New
York City in 1882 In 1892, Edison’s company
merged with the Thomson-Houston Electric
Company [developer of alternating-current
From the beginning, General Electric’sstrength has been research In addition to im-proving the design of the light bulb (includingthe development in the early 1900s of gas-filled,tungsten-filament bulbs that are the model forbulbs still used today), GE was also instrumen-tal in developing almost every familiar householdappliance—the iron, washing machine, refrigera-tor, range, air conditioner, dishwasher, and more
In addition, GE research scientists helped ate FM radio, aircraft jet engines, and nuclear-power reactors
cre-Today, General Electric operates in a verse array of businesses, ranging from train lo-comotives to medical CT scanners to consumerfinancing to the NBC television network To sup-port its broad array of businesses, GeneralElectric maintains a vast quantity of long-termassets that cost almost $112 billion to acquire
di-In 2005 alone, GE spent an additional $14.4billion in acquiring long-term operating assetsand received $6.0 billion for disposing of oldassets Its long-term assets include $3.3 billion
in rail cars, $32.9 billion in aircraft, $15.6 lion in buildings, $25.8 billion in machinery, and
bil-$81.7 billion in “intangible” assets
1 This description is based on General Electric Company History at http://ge.com/en/company/companyinfo/
at_ a_glance/hist_leader.htm; General Electric Company, International Directory of Company Histories, vol 12
In Chapters 6 through 8, operating activities
of a business and the assets and liabilities arising from those operations were dis- cussed In this and the next three chapters, in-
vesting and financing activities are covered In
this chapter, investments in long-term assets
that are used in the business, such as buildings,
property, land, and equipment, are discussed.
In Chapter 10, long-term debt financing is covered.
In Chapter 11, equity ing is discussed Once you understand debt and equity securities, as discussed in Chapters 10 and 11, you will understand how these
financ-same securities can be purchased as ments Therefore, in Chapter 12, investments in stocks and bonds (securities) of other compa- nies are discussed Exhibit 1 illustrates the time line of important business issues associated with long-term operating assets and shows the financial statement impact of the items that will
invest-be covered in this chapter.
The two primary categories of long-term assets discussed in this chapter are (1) property, plant, and equipment and (2) intangible assets Because property, plant, and equipment and intangible assets are essential to a business in carrying out its operating activities, they are some- times called long-term operating assets Unlike inventories, these long-term operating assets are
long-term operating
assets
Assets expected to be
held and used over the
course of several years to
facilitate operating
activities
Trang 5Investments in Property, Plant, and Equipment and in Intangible Assets Chapter 9 391
chapter, long-term operating assets often prise a significant portion of the total assets of
com-a compcom-any.
not acquired for resale to customers but
are held and used by a business to generate
revenues As illustrated by the numbers given
for General Electric at the beginning of the
S E T T
ESTIMATE and RECOGNIZE
No J/E Long-term asset
Debt (or cash)
F/S
Impact
LT asset Debt
*Increase or decrease would depend on whether the sale resulted in a gain or a loss.
Exp Asset (net)
Exp Asset (net)
Asset (cash) R/E * Asset (LT asset)
Impairment Loss Equipment (net)
Cash Loss (or Gain) Equipment (net) Expense
Accumulated Depreciation (or the asset)
possible acquisition
of long-term
operating assets
long-term operating assets
periodic depreciation and amortization
asset value for possible declines
of assets
EXHIBIT 1 Time Line of Business Issues Involved with Long-Term Operating Assets
Nature of Long-Term Operating Assets
Businesses make money by selling products and services A company needs an frastructure of long-term operating assets in order to profitably produce and dis-tribute these products and services For example, General Electricneeds factories
in-in which to manufacture the locomotives and light bulbs that it sells GE alsoneeds patents on its unique technology to protect its competitive edge in the mar-ketplace A factory is an example of a long-term operating asset that is classified asproperty, plant, and equipment A patent is an example of an intangible asset
Property, plant, and equipmentrefers to tangible, long-lived assets acquired foruse in business operations This category includes land, buildings, machinery, equip-ment, and furniture Intangible assetsare long-lived assets that are used in the oper-ation of a business but do not have physical substance (see page 392 for definition)
In most cases, they provide their owners with competitive advantages over otherfirms Typical intangible assets are patents, licenses, franchises, and goodwill
The following section outlines the process used in deciding whether to quire a long-term operating asset The subsequent sections discuss the account-ing issues that arise when a long-term operating asset is acquired: accounting forthe acquisition of the asset, recording periodic depreciation, accounting for newcosts and changes in asset value, and properly removing the asset from the booksupon disposition
ac-Identify the two
major categories of
long-term operating
assets: property,
plant, and equipment
and intangible assets.
1
property, plant, and
equipment
Tangible, long-lived assets
acquired for use in
busi-ness operations; include
land, buildings, machinery,
equipment, and furniture
Trang 6Long-lived assets without
physical substance that
are used in business,
such as licenses, patents,
franchises, and goodwill
Deciding Whether to Acquire a Long-Term Operating Asset
As mentioned in the previous section, long-term operating assets are acquired
to be used over the course of several years The decision to acquire a long-termasset depends on whether the future cash flows generated by the asset are ex-pected to be large enough to justify the asset cost The process of evaluating along-term project is called capital budgeting This process is briefly introducedhere and is covered in more detail in Chapter 22 in the management accounting
section of Accounting: Concepts and Applications.
Assume that Yosef Manufacturing makes joysticks and other computer game cessories Yosef is considering expanding its operations by buying an additionalproduction facility The cost of the new factory is $100 million Yosef expects to
ac-be able to sell the joysticks and other items made in the factory for $80 millionper year At that level of production, the annual cost of operating the factory(wages, insurance, materials, maintenance, etc.) is expected to total $65 million.The factory is expected to remain in operation for 20 years Should Yosef buythe new factory for $100 million?
To summarize the information in the preceding paragraph, Yosef must decidewhether to pay $100 million for a factory that will generate a net profit of $15 million($80 million $65 million) per year for 20 years At first glance, you might think that thedecision is obvious because the factory costs only $100 million but will generate $300million in profit ($15 million 20 years) during its 20-year life But this analysis ignoresthe important fact that dollars received in the future are not worth as much as dollarsreceived right now For example, if you can invest your money and earn 10%, receiving
$1 today is the same as receiving $6.73 20 years from now because the $1 received
to-day could be invested and would grow to $6.73 in 20 years This important cept is called the time value of moneyand is essential to properly evaluatingwhether to acquire any long-term asset
con-Using the time value of money calculations that will be explained in detail inChapter 10, it can be shown that receiving the future cash flows from the fac-tory of $15 million per year for 20 years is the same as receiving $128 million inone lump sum right now, if the prevailing interest rate is 10% Thus, the decision
to acquire the factory boils down to the following comparison: Should we pay $100 lion to buy a factory now if the factory will generate future cash flows that are worth theequivalent of $128 million now? The decision is yes, because the $128 million value ofthe expected cash inflows is greater than the $100 million cost of the factory On theother hand, if the factory were expected to generate only $10 million per year, then, us-ing the computations that will be explained in Chapter 10, it can be calculated that the
time value of money
The concept that a dollar
received now is worth
more than a dollar
received in the future
Trang 7value of the cash flows would be only $85 million, and the factory should not be chased for $100 million.
pur-The important concept to remember here is that long-term operating assets havevalue because they are expected to help a company generate cash flows in the future Ifevents occur that change the expectation concerning those future cash flows, then thevalue of the asset changes For example, if consumer demand for computer joysticks dries
up, the value of a factory built to produce joysticks can plunge overnight even thoughthe factory itself is still as productive as it ever was Accounting for this type of decline
in the value of a long-term operating asset is discussed later in the chapter
Investments in Property, Plant, and Equipment and in Intangible Assets Chapter 9 393
R E M E M B E R T H I S
• Long-term operating assets have value because they help companies generatefuture cash flows
• The decision to acquire a long-term operating asset involves comparing the cost
of the asset to the value of the expected cash inflows, after adjusting for thetime value of money
• An asset’s value can decline or disappear if events cause a decrease in the pected future cash flows generated by the asset
ex-Accounting for Acquisition of Property, Plant, and Equipment
Like all other assets, property, plant, and equipment are initially recorded atcost The cost of an asset includes not only the purchase price but also any othercosts incurred in acquiring the asset and getting it ready for its intended use.Examples of these other costs include shipping, installation, and sales taxes Theitems that should be included in the acquisition cost of various types of property,plant, and equipment are outlined in Exhibit 2
Property, plant, and equipment are usually acquired by purchase In somecases, assets are acquired by leasing but are accounted for as assets in much the sameway as purchased assets Plant and equipment can also be constructed by a businessfor its own use Also, a company can in one transaction purchase several different assets
or even another entire company The accounting for each of these types of acquisition isexplained below and on the following pages
EXHIBIT 2 Items Included in the Acquisition Cost of Property,
Plant, and Equipment
Land Purchase price, commissions, legal fees, escrow fees,
surveying fees, clearing and grading costs.
Land improvements Cost of improvements, including expenditures for (e.g., landscaping, paving, fencing) materials, labor, and overhead.
Buildings Purchase price, commissions, reconditioning costs Equipment Purchase price, taxes, freight, insurance, installation, and
any expenditures incurred in preparing the asset for its intended use, e.g., reconditioning and testing costs.
Trang 8Assets Acquired by Purchase
A company can purchase an asset by paying cash, incurring a liability, exchanging anotherasset, or by a combination of these methods If a single asset is purchased for cash, theaccounting is relatively simple To illustrate, we assume that Wheeler Resorts, Inc., pur-chases a new delivery truck for $15,096 (purchase price, $15,000, less 2% discount forpaying cash, plus sales tax of $396) The entry to record this purchase is:
In this instance, cash was paid for a single asset, the truck An alternative would be
to borrow part of the purchase price If the company had borrowed $12,000 of the
$15,096 from a bank, the entry would have been:
The $12,000 represents the principal of the note; it does not include anyinterest charged by the lending institution (The interest is recognized later as in-terest expense.)
When one long-term operating asset is acquired in exchange for another, thecost of the new asset is usually set equal to the market value of the asset given
up in exchange
Assets Acquired by Leasing
Leasesare often short-term rental agreements in which one party, the lessee, isgranted the right to use property owned by another party, the lessor For ex-ample, as a student, you may decide to lease (rent) an apartment to live in whileyou are attending college The owner of the apartment (lessor) will probably re-quire you to sign a lease specifying the terms of the arrangement The lease statesthe period of time in which you will live in the apartment, the amount of rentyou will pay, and when each rent payment is due When the lease expires, youwill either sign a new lease or move out of the apartment, which would then berented to someone else
Companies enter into similar types of lease arrangements For example,Wheeler Resorts might decide to lease a building because it needs additional of-fice space Assume Wheeler signs a two-year lease requiring monthly rental pay-ments of $1,000 When the lease expires, Wheeler will either move out of thebuilding or negotiate a new lease with the owner Accounting for this type ofrental agreement, called an operating lease, is straightforward When rent ispaid each month, Wheeler records the following journal entry:
Some lease agreements, however, are not so simple Suppose Wheeler has decided
to expand its operations and wants to acquire a hotel in the Phoenix, Arizona, area
Rent (or Lease) Expense 1,000 Cash 1,000
To record monthly rent of office building.
Delivery Truck 15,096 Cash 3,096 Notes Payable 12,000
Purchased a delivery truck for $15,096; paid $3,096 cash and issued a note for $12,000 to Chemical Bank.
Delivery Truck 15,096 Cash 15,096
Purchased a delivery truck for $15,096 ($15,000 – $300 cash discount $396 sales tax).
lease
A contract that specifies
the terms under which the
owner of an asset (the
lessor) agrees to transfer
the right to use the asset
to another party
(the lessee)
lessee
The party that is granted
the right to use property
under the terms of a
lease
lessor
The owner of property
that is leased (rented) to
another party
operating lease
A simple rental
agreement
Trang 9Wheeler’s alternatives are to buy land and build anew hotel, purchase an existing hotel, or lease ahotel Assume Wheeler locates a desirable piece ofland, and the owner of the land agrees to build ahotel and lease the property to Wheeler The leaseagreement is noncancelable and requires Wheeler tomake annual lease payments of $100,000 for 20 years.
At the end of 20 years, Wheeler will become theowner of the property Clearly, this is not a simplerental agreement, even though the transaction iscalled a lease by the parties involved In reality, thistransaction is a purchase of the property with thepayments being spread over 20 years The result isthe same as if Wheeler had borrowed money on a 20-year mortgage and purchased the property.Generally accepted accounting principles require that the recording of a transactionreflect its true economic nature, not its form Instead of recognizing the individual leasepayments as an expense as was done with the operating lease, Wheeler records theproperty as an asset and also records a liability reflecting the obligation to the lessor Theamount to be recorded is the cash amount that Wheeler would have to pay right now
in order to completely pay off the obligation to make the future lease payments Thisamount is called the present value of the lease payments (in the Wheeler example, thepresent value of 20 annual payments of $100,000) and takes into account the time value
of money As mentioned earlier, the time value concept will be explained in more detail
in Chapter 10
Continuing the example, assume that, at the beginning of the lease term, the presentvalue of the future lease payments is $851,360 Wheeler makes the following journal en-try to record the lease:
This type of lease is called a capital leasebecause the lessee records talizes) the leased asset the same as if the asset had been acquired in an outrightpurchase The asset is reported with Property, Plant, and Equipment on thelessee’s balance sheet The lessee (Wheeler Resorts) also shows the lease liabil-ity on the balance sheet as a long-term liability
(capi-When annual lease payments are made, Wheeler will not record the payment as rentexpense Instead, the payment will be recorded as a reduction in the lease liability, withpart of each payment being interest on the outstanding obligation The difference be-tween the total lease payments (20 years $100,000, or $2 million) and the “cost” orpresent value of the property is the amount of interest that will be paid over the term ofthe lease To illustrate, assume that the first payment is made one year after the lease termbegins and includes interest of $85,136 and a $14,864 reduction in the liability The pay-ment is recorded as follows:
Leased Property 851,360 Lease Liability 851,360
To record hotel acquired under a 20-year noncancelable lease.
Investments in Property, Plant, and Equipment and in Intangible Assets Chapter 9 395
A college student (lessee) often rents an apartment while attending college The apartment owner (lessor) will require the student to sign a lease stating the terms of the arrangement.
capital lease
A leasing transaction that
is recorded as a purchase
by the lessee
Trang 10Accounting for payments on capital leases is discussed in more detail in Chapter 10.
Classifying Leases As illustrated, an operating lease is accounted for as asimple rental, whereas a capital lease is accounted for as a purchase of the leased as-set Because the accounting treatment of a lease can have a major impact on the finan-cial statements, the accounting profession has established criteria for determiningwhether a lease should be classified as an operating or a capital lease If a lease isnoncancelable and meets any one of the following four criteria, it is recorded as a capitallease:
1 The lease transfers ownership of the leased asset to the lessee by the end of thelease term (as in the Wheeler Resorts example)
2 The lease contains an option allowing the lessee to purchase the asset at the end ofthe lease term at a bargain price, essentially guaranteeing that ownership will even-tually transfer to the lessee
3 The lease term is equal to 75% or more of the estimated economic life of the asset,meaning that the lessee will use the asset for most of its economic life
4 The present value of the lease payments at the beginning of the lease is 90% ormore of the fair market value of the leased asset Meeting this criterion means that,
in agreeing to make the lease payments, the lessee is agreeing to pay almost asmuch as the cash price to purchase the asset outright
If just one of the above criteria is met, then the lease agreement is classified as a ital lease and is accounted for by the lessee as a debt-financed purchase A lease that doesnot meet any of the capital lease criteria is considered an operating lease Keep in mindthat these two types of leases are not alternatives for the same transaction If the terms
cap-of the lease agreement meet any one cap-of the capital lease criteria, the lease must be counted for as a capital lease
ac-The accounting for leases has been a thorn in the side of accounting standard-settersfor at least 50 years From the beginning, the crucial issue has been how to require com-panies to report leased assets and lease liabilities in the balance sheet when a lease con-stitutes an effective transfer of ownership The four lease criteria outlined above wereissued by the FASB in 1976, with the thought that the rigidity and strictness of the crite-ria would result in most leases being reported on lessee companies’ balance sheets as cap-
ital leases In practice, U.S companies havetaken these four criteria as a challenge andhave carefully crafted their lease agreements
so that none of the criteria is satisfied, lowing the leases to continue to be ac-counted for as operating leases
al-One of the largest leasing companies inthe United States is a subsidiary of General Electric called GE Capital Services GECapital Services leases industrial equipment,aircraft, factory buildings, rail cars, shippingcontainers, computers, medical equipment,and more In 2005, the total original cost ofassets leased by GE Capital Services to othercompanies was $72.4 billion
Lease Liability 14,864 Interest Expense 85,136 Cash 100,000
To record annual lease payment under capital lease.
One of the most interesting accounting
manipulations involving the four lease criteria
relates to the 90% threshold for the present
value of the minimum lease payments By
hiring an insurance company to guarantee a
portion of the lease payments, a lessee is able
to exclude these payments from the present
value computations, lowering the present value
below the 90% threshold
F Y I
Trang 11Assets Acquired by Self-Construction
Sometimes buildings or equipment are constructed by a company for its own use Thismay be done to save on construction costs, to utilize idle facilities or idle workers, or tomeet a special set of technical specifications Self-constructed assets, like purchased as-sets, are recorded at cost, including all expenditures incurred to build the asset and make
it ready for its intended use These costs include the materials used to build the asset, theconstruction labor, and some reasonable share of the general company overhead (elec-tricity, insurance, supervisors’ salaries, etc.) during the time of construction
Another cost that is included in the cost of a self-constructed asset is the interest costassociated with money borrowed to finance the construction project Just as the cost torent a crane to be used to construct a building would be included in the cost of the build-ing, the cost to “rent” money to finance the construction project should also be included
in the building cost Interest that is recorded as part of the cost of a constructed asset is called capitalized interest The amount of interest thatshould be capitalized is that amount that could have been saved if the moneyused on the construction project had instead been used to repay loans
The following illustration demonstrates the computation of the cost of a constructed asset Wheeler Resorts decided to construct a new hotel using itsown workers The construction project lasted from January 1 to December 31, 2009.Building materials costs for the project were $4,500,000 Total labor costs attributable tothe project were $2,500,000 Total company overhead (costs other than materials and la-bor) for the year was $10,000,000; of this amount, it is determined that 15% can be rea-sonably assigned as part of the cost of the construction project A construction loan wasnegotiated with Wheeler’s bank; during the year, Wheeler was able to borrow from thebank to pay for materials, labor, etc The total amount of interest paid on this construc-tion loan during the year was $500,000 The total cost of the self-constructed hotel is com-puted as follows:
self-Materials $4,500,000 Labor 2,500,000 Overhead allocation ($10,000,000 0.15) 1,500,000 Capitalized interest 500,000 Total hotel cost $9,000,000
The new hotel would be reported inWheeler’s balance sheet at a total cost of
$9,000,000 As with other long-term ating assets, self-constructed assets are re-ported at the total cost necessary to getthem ready for their intended use
oper-The amount of capitalized interestreported by several large U.S companies,relative to their total interest expense, is displayed in Exhibit 3 As you can see, GeneralElectric capitalized only an insignificant amount of its $15.187 billion in interest dur-ing 2005 On the other hand, ExxonMobil capitalized almost one-half of its interestduring 2005
Acquisition of Several Assets at Once
Abasket purchaseoccurs when two or more assets are acquired together at asingle price A typical basket purchase is the purchase of a building along withthe land on which the building sits Because there are differences in the ac-counting for land and buildings, the purchase price must be allocated betweenthe two assets on some reasonable basis The relative fair market values of the
Investments in Property, Plant, and Equipment and in Intangible Assets Chapter 9 397
capitalized interest
Interest that is recorded
as part of the cost of a
self-constructed asset
basket purchase
The purchase of two or
more assets acquired
to-gether at a single price
What is the difference between capitalized
interest and regular interest?
S T O P & T H I N K
Trang 12assets are usually used to determine the respective costs to be assigned to the land andthe building.
To illustrate, we will assume that Wheeler Resorts purchases a 40,000-square-footbuilding on 2.6 acres of land for $3,600,000 How much of the total cost should beassigned to the land and how much to the building? If an appraisal indicates that thefair market values of the land and the building are $1,000,000 and $3,000,000, respec-tively, the resulting allocated costs would be $900,000 and $2,700,000, calculated asfollows:
Land $1,000,000 25% 0.25 $3,600,000 $ 900,000 Building 3,000,000 75 0.75 $3,600,000 2,700,000 Total $4,000,000 100% $3,600,000
In this case, the fair market value of the land is $1,000,000, or 25% of the total ket value of the land and building Therefore, 25% of the actual cost, or $900,000, is al-located to the land, and 75% of the actual cost, or $2,700,000, is allocated to the building.The journal entry to record this basket purchase is:
mar-If part of the purchase price is financed by a bank, an additional credit to Notes Payable
or Mortgage Payable would be included in the entry
Sometimes one company will buy all the assets of another company For example, inits 2006 annual report, Wal-Martdiscloses that, in December 2005, it purchased Sonae Distribuicao Brasil S.A.(a retail operation in Southern Brazil) for $720 million in cash.The purchase of an entire company raises a number of accounting issues The first, al-ready discussed above, is how to allocate the purchase price to the various assets ac-quired In general, all acquired assets are recorded on the books of the acquiring company
at their fair values as of the acquisition date
Land 900,000 Building 2,700,000 Cash 3,600,000
Purchased 2.6 acres of land and a 40,000-square-foot building.
Capitalized Interest
$ 0 45 434 5 77
Interest Expense**
$15,187 15,768 496 356 597
Capitalized, as a Percentage
of Total Interest
0.0%
0.3 46.7 1.4 11.4
General Electric*
General Motors ExxonMobil McDonald's Disney
Note: Numbers are for 2005 and are in millions of dollars.
*Once again, GE reports it capitalized only an “insignificant” amount.
**These amounts come from the income statement, and are net of capitalized interest, which explains the high percentage for ExxonMobil.
Company
EXHIBIT 3 Magnitude of Capitalized Interest for Several Large U.S Companies
Trang 13The second major accounting issue associated with the purchase of an entirecompany is the recording of goodwill Goodwill represents all the special com-petitive advantages enjoyed by a company, such as a trained staff, good credit rat-ing, reputation for superior products and services, and an established network ofsuppliers and customers These factors allow an established business to earnmore profits than would a new business, even though the new business mighthave the same type of building, the same equipment, and the same type of pro-duction processes.
When one company purchases another established business, the excess ofthe purchase price over the value of the identifiable net assets is assumed to rep-resent the purchase of goodwill The accounting for goodwill is illustrated later
in the chapter
Investments in Property, Plant, and Equipment and in Intangible Assets Chapter 9 399
goodwill
An intangible asset that
exists when a business is
valued at more than the
fair market value of its net
assets, usually due
to strategic location,
reputation, good customer
relations, or similar factors;
equal to the excess of the
purchase price over the
fair market value of the net
• Operating lease—accounted for as a rental; nothing on the balance sheet
• Capital lease—accounted for as a purchase; asset and liability on thebalance sheet
• Self-construction cost Materials, labor, reasonable overhead, and interest
• When two or more assets are acquired for a single price in a basket purchase,the relative fair market values are used to determine the respective costs
Calculating and Recording Depreciation Expense
The second element in accounting for plant and equipment is the allocation of
an asset’s cost over its useful life The matching principle requires that this cost
be assigned to expense in the periods benefited from the use of the asset Theallocation procedure is called depreciation, and the allocated amount, recorded
in a period-ending adjusting entry, is an expense that is deducted from revenues
in order to determine income It should be noted that the asset “plant” normallyrefers to buildings only; land is recorded as a separate asset and is not depreciatedbecause it is usually assumed to have an unlimited useful life
Accounting for depreciation is often confusing because students tend tothink that depreciation expense reflects the decline in an asset’s value The con-cept of depreciation is nothing more than a systematic write-off of the originalcost of an asset The undepreciated cost is referred to as book value, which rep-resents that portion of the original cost not yet assigned to the income statement
as an expense A company never claims that an asset’s recorded book value isequal to its market value In fact, market values of assets could increase at thesame time that depreciation expense is being recorded
To calculate depreciation expense for an asset, you need to know (1) its inal cost, (2) its estimated useful life, and (3) its estimated salvage, or residual,value.Salvage valueis the amount expected to be received when the asset issold at the end of its useful life (see page 400 for definition) When an asset ispurchased, its actual life and salvage value are obviously unknown They must be
The process of cost
allocation that assigns the
original cost of plant and
equipment to the periods
benefited
book value
For a long-term operating
asset, the asset’s original
cost less any accumulated
depreciation
Trang 14estimated as realistically as is feasible, usually on the basis of experience withsimilar assets In some cases, an asset will have little or no salvage value If thesalvage value is not significant, it is usually ignored in computing depreciation.Several methods can be used for depreciating the costs of assets for financialreporting In the main part of this chapter, we describe two: straight-line andunits-of-production In the expanded material section of this chapter, we describetwo more depreciation methods: sum-of-the-years’-digits and declining-balance.Thestraight-line depreciation methodassumes that an asset will benefitall periods equally and that the cost of the asset should be assigned on a uniformbasis for all accounting periods If an asset’s benefits are thought to be related toits productive output (miles driven in an automobile, for example), the units-of- production methodis usually appropriate.
To illustrate straight-line and units-of-production depreciation methods, weassume that Wheeler Resorts purchased a van on January 1 for transporting ho-tel guests to and from the airport The following facts apply:
Acquisition cost $24,000 Estimated salvage value $2,000 Estimated life:
In years 4 years
In miles driven 60,000 miles
Straight-Line Method of Depreciation
The straight-line depreciation method is the simplest depreciation method It assumes that
an asset’s cost should be assigned equally to all periods benefited The formula for lating annual straight-line depreciation is:
calcu- Annual depreciation expenseWith this formula, the annual depreciation expense for the van is calculated as:
$5,500 depreciation expense per year
When the depreciation expense for an asset has been calculated, a schedule showingthe annual depreciation expense, the total accumulated depreciation, and the asset’s bookvalue (undepreciated cost) for each year can be prepared The depreciation schedule forthe van (using straight-line depreciation) is shown in Exhibit 4
asset is sold at the end
of its useful life
straight-line
depreciation method
The depreciation method
in which the cost of an
asset is allocated equally
over the periods of an
as-set’s estimated useful life
units-of-production
method
The depreciation method
in which the cost of an
asset is allocated to each
period on the basis of the
productive output or use
of the asset during the
Trang 15The entry to record straight-line depreciation each year is:
Depreciation Expense is reported onthe income statement Accumulated Depre-ciation is a contra-asset account that is offsetagainst the cost of the asset on the balancesheet Book value is equal to the asset ac-count balance, which retains the originalcost of the asset as a debit balance, minusthe credit balance in the accumulateddepreciation account
At the end of the first year, the tion cost, accumulated depreciation, andbook value of the van are presented on the balance sheet as follows:
acquisi-Property, Plant, and Equipment:
Hotel van $24,000 Less: Accumulated depreciation 5,500 Book value $18,500
Similar information is provided in the annual reports of all companies with property,plant, and equipment For example, General Electricreported the following in the notes
to its 2005 financial statements:
Original Cost (in millions)
GE
Land and improvements $ 1,366 $ 1,562 Buildings, structures, and related equipment 10,044 9,617 Machinery and equipment 25,811 25,811 Leasehold costs and manufacturing plant under construction 2,157 2,157
$ 72,355 $ 66,725
$111,733 $105,872
Accumulated Depreciation and Amortization
Accumulated Depreciation, Hotel Van 5,500
To record annual depreciation for the hotel van.
Investments in Property, Plant, and Equipment and in Intangible Assets Chapter 9 401
A comparison of the amounts of cost and
accumulated depreciation reveals how old the
plant and equipment is relative to its total
expected life
F Y I
Trang 16Using this information, one can calculate that the property, plant, and equipment used byGeneral Electric had been used for 58% ($22,874/$39,378) of its useful life as of the end
of 2005 Similarly, the buildings and equipment used by GE Capital Services had beenused for 44% ($2,431/$5,547) of its life, and the equipment leased by GE Capital Services
to others had been used for 28% ($18,900/$66,808) of its useful life
Units-of-Production Method of Depreciation
The units-of-production depreciation method allocates an asset’s cost on the basis of userather than time This method is used primarily when a company expects that asset us-age will vary significantly from year to year If the asset’s usage pattern is uniform fromyear to year, the units-of-production method will produce the same depreciation pattern
as the straight-line method Assets with varying usage patterns for which this method ofdepreciation may be appropriate include automobiles and other vehicles whose life is es-timated in terms of number of miles driven It is also used for certain machines whose life
is estimated in terms of number of units produced or number of hours of operating life.The formula for calculating the units-of-production depreciation for the year is:
Current year’s depreciation expense
To illustrate, we again consider Wheeler Resorts’ van, which has an expected life of60,000 miles With the units-of-production method, if the van is driven 12,000 miles dur-ing the first year, the depreciation expense for that year is calculated as follows:
12,000 miles $4,400 depreciation expenseThe entry to record units-of-production depreciation at the end of the first year of thevan’s life is:
The depreciation schedule for the four years is shown in Exhibit 5 This exhibit sumes that 18,000 miles were driven the second year, 21,000 the third year, and 9,000the fourth year
as-Note that part of the formulas for straight-line and units-of-production depreciation
is the same In both cases, cost salvage value is divided by the asset’s useful life Withstraight-line, life is measured in years; with units-of-production, life is in miles or hours
Depreciation Expense 4,400 Accumulated Depreciation, Hotel Van 4,400
To record depreciation for the first year of the hotel van’s life.
$24,000 $2,000
60,000 miles
Number of units produced, hours used, or miles driven during the year
Cost Salvage value
Total estimated life inunits, hours, or miles
EXHIBIT 5 Depreciation Schedule with Units-of-Production
Trang 17With units-of-production, the depreciation per mile or hour must then be multiplied bythe usage for the year to determine depreciation expense.
What if the van lasts longer than four years or is driven for more than 60,000 miles?Once the $22,000 difference between cost and salvage value has been recorded as de-preciation expense, there is no further expense to record Thus, any additional years ormiles are “free” in the sense that no depreciation expense will be recognized in connec-tion with them However, as other vans are purchased in the future, the initial estimates
of their useful lives will be adjusted to reflect the experience with previous vans.What if the van lasts less than four years or is driven fewer than 60,000 miles? Thistopic is covered later in the chapter in connection with the accounting for the disposal
of property, plant, and equipment
A Comparison of Depreciation Methods
The amount of depreciation expense will vary according to the depreciation method used
by a company Exhibit 6 compares the annual depreciation expense for Wheeler Resorts’van under the straight-line and units-of-production depreciation methods As this sched-ule makes clear, the total amount of depreciation is the same regardless of which method
is used
Straight-line is by far the most commonly used depreciation method because it is thesimplest to apply and makes intuitive sense For example, in the notes to its 2006 finan-cial statements (see Appendix A), Wal-Mart discloses that it depreciates its property,plant, and equipment using the straight-line method over useful lives ranging from 3 to
50 years
Partial-Year Depreciation Calculations
Thus far, depreciation expense has been calculated on the basis of a full year Businessespurchase assets at all times during the year, however, so partial-year depreciation calcu-lations are often required To compute depreciation expense for less than a full year, firstcalculate the depreciation expense for the year and then distribute it evenly over the num-ber of months the asset is held during the year
To illustrate, assume that Wheeler Resorts purchased its $24,000 van on July 1 instead
of January 1 The depreciation calculations for the first one and one-half years, usingstraight-line depreciation, are shown in Exhibit 7 The units-of-production method hasbeen omitted from the exhibit; midyear purchases do not complicate the calculations withthis method because it involves number of miles driven, hours flown, and so on, ratherthan time periods
In practice, many companies simplify their depreciation computations by taking a fullyear of depreciation in the year an asset is purchased and none in the year the asset isInvestments in Property, Plant, and Equipment and in Intangible Assets Chapter 9 403
EXHIBIT 6 Comparison of Depreciation Expense Using Different
Trang 18sold This is allowed because depreciation is based on estimates, and in the longrun, the difference in the amounts is usually immaterial.
Units-of-Production Method with Natural Resources
Another common use for the units-of-production method is with natural sources.Natural resources include such assets as oil wells, timber tracts, coalmines, and gravel deposits Like all other assets, newly purchased or developednatural resources are recorded at cost This cost must be written off as the assetsare extracted or otherwise depleted This process of writing off the cost of nat-ural resources is called depletionand involves the calculation of a depletion ratefor each unit of the natural resource Conceptually, depletion is exactly the same
re-as depreciation; with plant and equipment, the accounting process is called preciation, whereas with natural resources it is called depletion
de-To illustrate, assume that Power-T Company purchases a coal mine for $1,200,000cash The entry to record the purchase is:
If the mine contains an estimated 200,000 tons of coal deposits (based on a gist’s estimate), the depletion expense for each ton of coal extracted and sold will be $6($1,200,000/200,000 tons) Here, the unit of production is the extraction of one ton ofcoal If 12,000 tons of coal are mined and sold in the current year, the depletion entry is:
geolo-After the first year’s depletion expense has been recorded, the coal mine is shown onthe balance sheet as follows:
Coal mine $1,200,000 Less: Accumulated depletion 72,000 Book value $1,128,000
But how do you determine the number of tons of coal in a mine? Because mostnatural resources cannot be counted, the amount of the resource owned is an estimate.The depletion calculation is therefore likely to be revised as new information becomesavailable When an estimate is changed, a new depletion rate per unit is calculated andused to compute depletion during the remaining life of the natural resource or until an-other new estimate is made Coverage of accounting for changes in estimates is included
in the expanded material section of this chapter
Depletion Expense 72,000 Accumulated Depletion, Coal Mine 72,000
To record depletion for the year: 12,000 tons at $6 per ton.
Coal Mine 1,200,000 Cash 1,200,000
Purchased a coal mine for $1,200,000.
EXHIBIT 7 Partial-Year Depreciation
Straight-line $5,500 $2,750 ($5,500 1 ⁄ 2 ) $5,500
natural resources
Assets that are physically
consumed or waste away,
such as oil, minerals,
gravel, and timber
depletion
The process of cost
allocation that assigns the
original cost of a natural
resource to the periods
benefited
Trang 19Investments in Property, Plant, and Equipment and in Intangible Assets Chapter 9 405
• Straight-line depreciation expense (Cost Salvage value) Estimated useful life
• Units-of-production depreciation expense [(Cost Salvage value) Estimated life in units] Units produced
• Depreciation for natural resources is called depletion and is similar to production depreciation
units-of-Repairing and Improving Property, Plant, and Equipment
Sometime during its useful life, an asset will probably need to be repaired orimproved The accounting issue associated with these postacquisition expendi-tures is whether they should be immediately recognized as an expense or beadded to the cost of the asset (capitalized) Remember from the discussion inChapter 8 that an expenditure should be capitalized if it is expected to have anidentifiable benefit in future periods
Two types of expenditures can be made on existing assets The first is ordinaryexpenditures for repairs, maintenance, and minor improvements For example,
a truck requires oil changes and periodic maintenance Because these types of ditures typically benefit only the period in which they are made, they are expenses of thecurrent period
expen-The second type is an expenditure that lengthens an asset’s useful life, increases itscapacity, or changes its use These expenditures are capitalized; that is, they are added tothe asset’s cost instead of being expensed in the current period For example, overhaul-ing the engine of a delivery truck involves a major expenditure to extend the useful life
of the truck To qualify for capitalization, an expenditure should meet three criteria: (1) itmust be significant in amount; (2) it should benefit the company over several periods, notjust during the current one; and (3) it should increase the productive life or capacity ofthe asset
To illustrate the differences in accounting for capital and ordinary expenditures,assume that Wheeler Resorts also purchases a delivery truck for $42,000 This truckhas an estimated useful life of eight years and a salvage value of $2,000 The straight-line depreciation is $5,000 per year [($42,000 – $2,000)/8 years] If the companyspends $1,500 each year for normal maintenance, its annual recording of these expendi-tures is:
This entry has no effect on either the recorded cost or the depreciation expense ofthe truck Now suppose that at the end of the sixth year of the truck’s useful life, Wheelerspends $8,000 to overhaul the engine This expenditure will increase the truck’s remaining
Repairs and Maintenance Expense 1,500 Cash 1,500
Spent $1,500 for maintenance of delivery truck.
Account for repairs
and improvements of
property, plant, and
Trang 20The journal entry to record the $8,000 capitalized expenditure is:
Another example of a capital expenditure is the cost of land improvements Certainimprovements are considered permanent, such as moving earth to change the land con-tour Such an expenditure would be capitalized as part of the land account Other ex-penditures may have a limited life, such as those incurred in building a road, a sidewalk,
or a fence These expenditures would be capitalized in a separate land improvements count and be depreciated over their useful lives
ac-It is often difficult to determine whether a given expenditure should be capitalized
or expensed The two procedures produce a different net income, however, so it is tremely important that such expenditures be properly classified When in doubt, acceptedpractice is to record an expenditure as an expense to ensure that the asset is not reported
ex-at an amount thex-at exceeds its future benefit
Delivery Truck 8,000 Cash 8,000
Spent $8,000 to overhaul the engine of the $42,000 truck.
Less salvage value 2,000 Accumulated depreciation
Cost to be allocated (depreciable amount) $40,000 (prior to overhaul) 30,000 Original life of asset 8 years Remaining book value $12,000 Original depreciation per year ($40,000/8) $5,000 Capital expenditure (overhaul) 8,000
Accumulated depreciation prior to overhaul $30,000 Less salvage value 2,000
New depreciable amount $18,000
New annual depreciation ($18,000/4) $ 4,500
2 provide benefits for more than one period, and
3 increase the productive life or capacity of an asset
• Ordinary expenditures, such as repairs, merely maintain an asset’s productivecapacity at the level originally projected and are expenses of the currentperiod
life from two to four years, but will not change its estimated salvage value The depreciationfor the last four years will be $4,500 per year, calculated as shown below
Trang 21Recording Impairments of Asset Value
As mentioned earlier, the value of a long-term asset depends on the future cashflows expected to be generated by that asset Occasionally, events occur afterthe purchase of an asset that significantly reduce its value For example, a de-cline in the consumer demand for high-priced athletic shoes can cause the value
of a shoe-manufacturing plant to plummet Accountants call this impairment.When an asset is impaired, the event should be recognized in the financial state-ments, both as a reduction in the reported value of the asset in the balance sheetand as a loss in the income statement Of course, the value of long-term assets canalso increase after the purchase date In the United States, these increases are notrecorded, as explained more fully later in this section
Recording Decreases in the Value of Property, Plant, and Equipment
According to U.S accounting rules, the value of an asset is impaired when the sum of timated future cash flows from that asset is less than the book value of the asset Thiscomputation ignores the time value of money As illustrated in the example below, this
es-is a strange impairment threshold—a more reasonable test would be to compare the bookvalue to the fair value of the asset
Once it has been determined that an asset is impaired, the amount of the impairment
is measured as the difference between the book value of the asset and the fair value Tosummarize, the existence of an impairment loss is determined using the sum of the esti-mated future cash flows from the asset, ignoring the time value of money The amount ofthe impairment loss is measured using the fair value of the asset, which does incorporatethe time value of money The practical result of this two-step process is that an impair-ment loss is not recorded unless it is quite certain that the asset has suffered a permanentdecline in value
To illustrate, assume that Wheeler Resorts purchased a fitness center building fiveyears ago for $600,000 The building has been depreciated using the straight-line methodwith a 20-year useful life and no residual value Wheeler estimates that the building has aremaining useful life of 15 years, that net cash inflow from the building will be $25,000per year, and that the fair value of the building is $230,000
Annual depreciation for the building has been $30,000 ($600,000 20 years) Thecurrent book value of the building is computed as follows:
Original cost $600,000 Accumulated depreciation ($30,000 5 years) 150,000 Book value $450,000
The book value of $450,000 is compared with the $375,000 ($25,000 15 years)sum of future cash flows (ignoring the time value of money) to determine whether thebuilding is impaired The sum of future cash flows is only $375,000, which is less thanthe $450,000 book value, so an impairment loss should be recognized The loss is equal
to the $220,000 ($450,000 – $230,000) difference between the book value of the ing and its fair value The impairment loss would be recorded as follows:
build-Accumulated Depreciation, Building 150,000 Loss on Impairment of Building 220,000 Building ($600,000 $230,000) 370,000
Recognized $220,000 impairment loss on building.
Identify whether a
long-term operating
asset has suffered a
decline in value and
record the decline.
6
impairment
A decline in the value of a
long-term operating asset
Investments in Property, Plant, and Equipment and in Intangible Assets Chapter 9 407
Trang 22This journal entry basically records the set as if it were being acquired brand new atits fair value of $230,000 The existing accu-mulated depreciation balance is wiped clean,and the new recorded value of the asset is itsfair value of $230,000 ($600,000 $370,000).After an impairment loss is recognized, norestoration of the loss is allowed even if thefair value of the asset later recovers.
as-The odd nature of the impairment test can be seen if the facts in the Wheeler ple are changed slightly Assume that net cash inflow from the building will be $35,000per year and that the fair value of the building is $330,000 With these numbers, no im-pairment loss is recognized, even though the fair value of $330,000 is less than the bookvalue of $450,000, because the sum of future cash flows of $525,000 ($35,000 15 years)exceeds the book value Thus, in this case the asset would still be recorded at its bookvalue of $450,000, even though its fair value is actually less As mentioned above, the prac-tical impact of the two-step impairment test is that no impairment losses are recorded un-less the future cash flow calculations offer very strong evidence of a permanent decline
exam-in asset value The impairment test is summarized exam-in Exhibit 8
AOL Time Warnerset a world record when it recorded an impairment loss in 2002
of $99.737 billion Over half of that amount related to a write-off of goodwill associatedwith the 2000 merger of AOL andTime Warner This record write-off resulted in AOLTime Warner reporting a net loss for the year of $98.7 billion
Recording Increases in the Value of Property, Plant, and Equipment
Under U.S accounting standards, increases in the value of property, plant, and equipmentare not recognized Gains from increases in asset value are recorded only if and when theasset is sold Thus, in the Wheeler example discussed above, if the fair value of the build-ing rises to $800,000, the building would still be reported in the financial statements atits depreciated book value of $450,000 This is an example of the conservative bias thatoften exists in the accounting rules: losses are recognized when they occur, but the recog-nition of gains is deferred until the asset is sold
Do you think businesses would prefer an
impairment test involving only the comparison
of the book value of an asset to its fair value?
Sum of Future Cash Flows
Less than Book Value?
Trang 23Although increases in the value of property, plant, and equipment are not recognized inthe United States, accounting rules in other countries do allow for their recognition For ex-ample, companies in Great Britain often report their long-term operating assets at their fairvalues Because this upward revaluation of property, plant, and equipment is allowable un-der international accounting standards, it will be interesting to watch over the next decade
or so to see whether sentiment grows to allow this practice in the United States as well.Investments in Property, Plant, and Equipment and in Intangible Assets Chapter 9 409
R E M E M B E R T H I S
• When an asset’s value declines after it is purchased, it is said to be impaired
• Recording an impairment loss is a two-step process
1 Compare the recorded book value of the asset to the sum of future cashflows expected to be generated by the asset
2 If the book value is higher, recognize a loss in an amount equal to thedifference between the book value of the asset and its FAIR value
• According to U.S accounting rules, increases in the value of property, plant,and equipment are not recognized
Disposal of Property, Plant, and Equipment
Plant and equipment eventually become worthless or are sold When a companyremoves one of these assets from service, it has to eliminate the asset’s cost andaccumulated depreciation from the accounting records There are basically threeways to dispose of an asset: (1) discard or scrap it, (2) sell it, or (3) exchange itfor another asset
Discarding Property, Plant, and Equipment
When an asset becomes worthless and must be scrapped, its cost and its accumulateddepreciation balance should be removed from the accounting records If the asset’s to-tal cost has been depreciated, there is no loss on the disposal If, on the other hand, thecost is not completely depreciated, the undepreciated cost represents a loss on disposal
To illustrate, we assume that Wheeler Resorts, Inc., purchases a computer for $15,000.The computer has a five-year life and no estimated salvage value and is depreciated on astraight-line basis If the computer is scrapped after five full years, the entry to record thedisposal is as follows:
If Wheeler must pay $300 to have the computer dismantled and removed, the entry
to record the disposal is:
Accumulated Depreciation, Computer 15,000 Loss on Disposal of Computer 300 Computer 15,000 Cash 300
Scrapped $15,000 computer and paid disposal costs of $300.
Accumulated Depreciation, Computer 15,000 Computer 15,000
Trang 24If the computer had been scrapped after only four years of service (and after $12,000
of the original cost has been depreciated), there would have been a loss on disposal of
$3,300 (including the disposal cost), and the entry would have been:
Don’t think of the losses recognized above as “bad” or gains as “good.” A loss on posal simply means that, given the information we now have, it appears that we didn’trecord enough depreciation expense in previous years As a result, the book value of theasset is higher than the amount we can get on disposal Similarly, a gain means that toomuch depreciation expense was recognized in prior years, making the book value of theasset lower than its actual disposal value
dis-Selling Property, Plant, and Equipment
A second way of disposing of property, plant, and equipment is to sell it If the sales price
of the asset exceeds its book value (the original cost less accumulated depreciation), there
is a gain on the sale Conversely, if the sales price is less than the book value, there is a loss
To illustrate, we refer again to Wheeler’s $15,000 computer If the computer is soldfor $600 after five full years of service, assuming no disposal costs, the entry to recordthe sale is:
Because the asset was fully depreciated, its book value was zero and the $600 cashreceived represents a gain If the computer had been sold for $600 after only four years
of service, there would have been a loss of $2,400 on the sale, and the entry to recordthe sale would have been:
The $2,400 loss is the difference between the sales price of $600 and the book value
of $3,000 ($15,000 – $12,000) The amount of a gain or loss is thus a function of two tors: (1) the amount of cash received from the sale, and (2) the book value of the asset
fac-at the dfac-ate of sale The book value can vary from the market price of the asset for tworeasons: (1) the accounting for the asset is not intended to show market value in the fi-nancial statements, and (2) it is difficult to estimate salvage value and useful life at the out-set of an asset’s life
Exchanging Property, Plant, and Equipment
A third way of disposing of property, plant, and equipment is to exchange it for anotherasset Such exchanges occur regularly with cars, trucks, machines, and other types of
Cash 600 Accumulated Depreciation, Computer 12,000 Loss on Sale of Computer 2,400 Computer 15,000
Sold $15,000 computer at a loss of $2,400.
Cash 600 Accumulated Depreciation, Computer 15,000 Computer 15,000 Gain on Sale of Computer 600
Sold $15,000 computer at a gain of $600.
Accumulated Depreciation, Computer 12,000 Loss on Disposal of Computer 3,300 Computer 15,000 Cash 300
Scrapped $15,000 computer and paid disposal costs of $300.
Trang 25large equipment When dissimilar assets are exchanged, such as a truck for a computer,the transaction is accounted for exactly as outlined previously: the acquired asset isrecorded in the books at its fair market value, and a gain or loss may be recognized de-pending on the difference between this market value and the book value of the asset thatwas disposed of Accounting for exchanges of similar assets can be more complicated andtherefore is not discussed in this text For a full treatment of the accounting for the ex-change of similar assets, see an intermediate accounting text.
Investments in Property, Plant, and Equipment and in Intangible Assets Chapter 9 411
Accounting for Intangible Assets
Intangible assets are rights and privileges that are long-lived, are not held for sale, have no physical substance, and usually provide their owner with compet-itive advantages over other firms Familiar examples are patents, franchises,licenses, and goodwill
re-The importance of intangible assets can be illustrated by considering General Electric As mentioned in Chapter 2, if the balance sheet were perfect, theamount of owners’ equity would be equal to the market value of the company
On December 31, 2005, GE’s reported equity was equal to $109.354 billion Theactual market value of GE on December 31, 2005, was $367 billion The reason forthe large difference between the recorded value and the actual value is that a tradi-tional balance sheet excludes many important intangible economic assets.Examples of GE’s important intangible economic assets are its track record of suc-cessful products and its entrenched market position in the many industries inwhich it operates These intangible factors are by far the most valuable assetsowned by GE, but they fall outside the traditional accounting process
As with many accounting issues, accounting for intangibles involves a off between relevance and reliability Information concerning intangible assets isrelevant, but to meet the standard for recognition in the financial statements, therecorded amount for the intangible must also be reliable The most important distinction
trade-in trade-intangible assets for accounttrade-ing purposes is between those trade-intangible assets that are trade-ternally generated and those that are externally purchased This distinction is importantbecause the transfer of externally-purchased intangible assets in an arm’s-length markettransaction provides reliable evidence that the intangibles have probable future economicbenefit Such reliable evidence does not exist for most internally-generated intangibles.Accordingly, as discussed in Chapter 8, most costs associated with generating and main-taining internally-generated intangibles are expensed as incurred
in-Keep in mind, however, that an intangible asset that is internally generated (andtherefore not recorded as an asset on a company’s books) is still valued by the stock mar-ket As an illustration, consider Exhibit 9, which lists the 10 most valuable brands in the
Account for the
An exclusive right granted
for 20 years by the
federal government to
manufacture and sell an
invention
Trang 26world in 2005 Each of these brands represents a valuable economic asset that has beeninternally generated For example, the $67.5 billion Coca-Cola brand name has been cre-ated over the years by The Coca-Cola Companythrough successful business operationsand relentless marketing But because the valuation of this asset is not deemed sufficientlyreliable to meet the standard for financial statement recognition, it is not included in TheCoca-Cola Company’s balance sheet However, as explained below, if another companywere to buy The Coca-Cola Company, an important part of recording the transactionwould be allocating the total purchase price to the various economic assets acquired, in-cluding previously unrecorded intangible assets.
In the future, financial reporting will move toward providing more information aboutinternally-generated intangibles Whether this will involve actual valuation and recogni-tion of these intangibles in the financial statements, or simply more extensive note dis-closure, remains to be seen
A short description of some of the common types of intangible assets is given below
Trademark A trademark is a distinctive name, symbol, or slogan that distinguishes aproduct or service from similar products or services Well-known examples include Coke,Windows, Yahoo!, and the Nike Swoosh As shown in Exhibit 9 above, it was estimated
in 2005 that the value of the Coca-Cola trademark was in excess of $67 billion Becausethe Coca-Cola trademark is an internally-generated intangible asset, it is not reported inThe Coca-Cola Company’s balance sheet However, the company has purchased othertrademarks (such as Minute Maid), with a total cost of $2.3 billion; these are reported inThe Coca-Cola Company’s balance sheet
Franchises Franchise operations have become so common in everyday life that we ten don’t realize we are dealing with them In fact, these days it is difficult to find a non-franchise business in a typical shopping mall When a business obtains a franchise, the
of-recorded cost of the franchise includes any sum paid specifically for the franchiseright as well as legal fees and other costs incurred in obtaining it Although thevalue of a franchise at the time of its acquisition may be substantially in excess
of its cost, the amount recorded should be limited to actual outlays For ple, approximately 60% of McDonald’s locations are operated under franchiseagreements A McDonald’s franchisee must contribute an initial cash amount of
exam-$200,000, which is used to buy some of the equipment and signs and also to paythe initial franchise fee The value of a McDonald’s franchise alone is much more
Source: http://www.interbrand.com.
EXHIBIT 9 Ten Most Valuable Brands in the World for 2005
franchise
An entity that has been
licensed to sell the
product of a manufacturer
or to offer a particular
service in a given area
Trang 27than $200,000, but the franchisee wouldonly record a franchise asset in his or her fi-nancial statements equal to the cost (notvalue) of the franchise However, if a fran-chise right is included when one companypurchases another company, presumablythe entire value is included in the purchaseprice, and the fair value attributable to the franchise right is recorded as an intangible as-set in the acquirer’s books.
Goodwill Goodwill is the business contacts, reputation, functioning systems, staff maraderie, and industry experience that make a business much more than just a collec-tion of assets As mentioned above, if these factors are the result of a contractual right orare associated with intangibles that can be bought and sold separately, then the value ofthe factor should be reported as a separate intangible asset In essence, goodwill is a resid-ual number, the value of all of the synergies of a functioning business that cannot bespecifically identified with any other intangible factor Goodwill is recognized only when
ca-it is purchased as part of the acquisca-ition of another company In other words, a company’sown goodwill, its homegrown goodwill, is not recognized Goodwill will be discussedmore in depth later in the chapter Exhibit 10 provides a summary of a number of intan-gible assets and how they are valued
Estimating the Fair Value of an Intangible The most difficult part of recording
an amount for an intangible asset is not in identifying the asset but instead is in ing a fair value of the asset The objective in estimating the fair value is to duplicate the
estimat-Investments in Property, Plant, and Equipment and in Intangible Assets Chapter 9 413
The original Coca-Cola bottling franchise sold
for $1
F Y I
EXHIBIT 10 Acquisition Costs of Goodwill and Other Intangible Assets
Patent An exclusive right granted by a national government COST:Purchase price, filing and registry
that enables an inventor to control the manufacture, fees, cost of subsequent litigation to protect sale, or use of an invention In the United States, right Does not include internal research and legal life is 20 years from patent application date development costs.
Trademark An exclusive right granted by a national COST:Same as Patent.
government that permits the use of distinctive symbols, labels, and designs, e.g., McDonald’s golden arches, Nike’s Swoosh, Apple’s computer name and logo Legal life is virtually unlimited.
Copyright An exclusive right granted by a national government COST:Same as Patent.
that permits an author to sell, license, or control his/her work In the United States, copyrights expire
50 years after the death of the author.
Franchise agreement An exclusive right or privilege received by a COST:Expenditures made to purchase the
business or individual to perform certain functions franchise Legal fees and other costs
or sell certain products or services incurred in obtaining the franchise.
Acquired customer list A list or database containing customer information COST:Purchase price when acquired from
such as name, address, past purchases, and so forth another company Costs to internally develop Companies that originally develop such a list often a customer list are expensed as incurred sell or lease it to other companies, unless prohibited
by customer confidentiality agreements.
Goodwill Miscellaneous intangible resources, factors, and COST: Portion of purchase price that
conditions that allow a company to earn above-normal exceeds the sum of the current market value income with its identifiable net assets Goodwill is for all identifiable net assets, both tangible recorded only when a business entity is acquired and intangible.
by a purchase.
Trang 28price at which the intangible asset would change hands in an arm’s-length market action If there is a market for similar intangibles assets, then the best estimate of fair value
trans-is made with reference to these observable market prices
To illustrate the accounting for the purchase of an intangible patent, assume thatWheeler Resorts, Inc., acquires, for $200,000, a patent granted seven years earlier toanother firm The entry to record the purchase of the patent is:
The one exception to valuing purchased intangibles at market value involves will, which arises when an entire business is purchased Goodwill is best thought of as aresidual amount, the amount of the purchase price of a business that is left over after allother tangible and intangible assets have been identified As such, goodwill is that intan-gible something that makes the whole company worth more than its individual parts Ingeneral, goodwill represents all the special advantages, not otherwise separately identifi-able, enjoyed by an enterprise, such as a high credit standing, reputation for superiorproducts and services, experience with development and distribution processes, favorablegovernment relations, and so forth These factors allow a business to earn above-normalincome with the identifiable assets, tangible and intangible, employed in the business
good-To illustrate the accounting for goodwill, assume that, in order to cater to the cinal needs of its guests, Wheeler Resorts purchases Valley Drug Store for $400,000 Atthe time of purchase, the recorded assets and liabilities of Valley Drug have the followingfair market values:
medi-Inventory $220,000 Long-term operating assets 110,000 Other assets (prepaid expenses, etc.) 10,000 Liabilities (20,000) Total net assets $320,000
Note that Wheeler Resorts records these items at their fair market values on the datepurchased, just as it does when purchasing individual assets
Because Wheeler was willing to pay $400,000 for Valley Drug, there must have beenother favorable, intangible factors worth approximately $80,000 These factors are calledgoodwill, and the entry to record the purchase of the drug store is:
Amortization of Intangible Assets
Like tangible assets, intangible assets are recorded at their historical costs Unlike gible assets, the costs associated with intangible assets are not always allocated as ex-penses over time The periodic allocation to expense of an intangible asset’s cost iscalled amortization Conceptually, depreciation (with plant and equipment), de-pletion (with natural resources), and amortization (with intangible assets) are exactlythe same thing Straight-line amortization is generally used for intangible assets
tan-Inventory 220,000 Long-term Operating Assets 110,000 Other Assets 10,000 Goodwill 80,000 Liabilities 20,000 Cash 400,000
Purchased Valley Drug Store for $400,000.
Patent 200,000 Cash 200,000
Purchased patent for $200,000.
amortization
The process of cost
allocation that assigns
the original cost of an
intangible asset to the
periods benefited
Trang 29In accounting for an intangible asset after its acquisition, a determination first must
be made as to whether the intangible asset has a finite life If no economic, legal, or tractual factors cause the intangible to have a finite life, then its life is said to be indefi-nite, and the asset is not to be amortized until its life is determined to be finite Anindefinite life is one that extends beyond the foreseeable horizon An example of an in-tangible asset that has an indefinite life is a broadcast license which includes an extensionoption that can be renewed indefinitely If an intangible asset is determined to have a fi-nite life, then the asset is to be amortized over its estimated life; the useful life estimateshould be reviewed periodically
con-To illustrate the amortization of an intangible asset, let us continue with the patentexample with Wheeler Resorts, Inc., used earlier Recall that the patent, with a legal life
of 20 years, was purchased from another company after seven years Because seven years
of its 20-year legal life have already elapsed, the patent now has a legal life of only
13 years, although it may have a shorter useful life If its useful life is assumed to be eightyears, one-eighth of the $200,000 cost should be amortized each year for the next eightyears The entry each year to record the patent amortization expense is:
Notice that in the above entry, the patent account was credited Alternatively, a asset account, such as Accumulated Amortization, could have been credited In practice,however, crediting the intangible asset account directly is more common This is differentfrom the normal practice of crediting Accumulated Depreciation for buildings or equipment.Many intangible assets that used to be amortized are no longer amortized For example,goodwill used to be amortized over a 40-year period Goodwill is now no longer amortized
contra-Impairment of Intangible Assets
While many intangible assets are not amortized, all intangible assets must be evaluatedevery year to determine if (1) their estimated useful life has changed and (2) the intangi-ble asset has become impaired Previously in this chapter the issue of asset impairmentwas discussed with regard to tangible assets While the specifics of the various impair-ment tests associated with the different kinds of intangible assets are beyond the scope
of this textbook, suffice it to say that when evaluating whether or not an intangible assethas become impaired, the objective is to ensure that the intangible assets recorded on thebooks of a company are not overstated If an intangible asset is determined to be impaired,
an impairment loss is recorded on the income statement and the intangible asset is reduced
on the books of the company
Amortization Expense, Patent 25,000
Patent 25,000
To amortize one-eighth of the cost of the patent.
Investments in Property, Plant, and Equipment and in Intangible Assets Chapter 9 415
R E M E M B E R T H I S
• Intangible assets are long-term rights and privileges that have no physical
sub-stance but provide competitive advantages to owners Common intangible assetsare patents, franchises, licenses, and goodwill
• Intangible assets are only recognized in the financial statements if they have
been purchased through an arm’s-length transaction
• The cost of recorded intangible assets is expensed as follows:
• Certain intangible assets are amortized over the economic life of the asset
• Many intangible assets are not amortized because their economic lives are notlimited
• All intangible assets, including goodwill, must be analyzed to determine if pairment has occurred If it has, then an impairment loss is recognized
Trang 30im-Measuring Property, Plant, and Equipment Efficiency
In this section we discuss the fixed asset turnover ratio, which uses financialstatement data to give a rough indication of how efficiently a company is utiliz-ing its property, plant, and equipment to generate sales We also illustrate thatthe fixed asset turnover ratio must be interpreted carefully because, as with mostother financial ratios, acceptable values for this ratio differ significantly from oneindustry to the next
Evaluating the Level of Property, Plant, and Equipment
Fixed asset turnovercan be used to evaluate the appropriateness of the level
of a company’s property, plant, and equipment Fixed asset turnover is computed
as sales divided by average property, plant, and equipment (fixed assets) and isinterpreted as the number of dollars in sales generated by each dollar of fixed as-sets This ratio is also often called PP&E turnover The computation of the fixedasset turnover for General Electricis given below All financial statement num-bers are in millions
Sales $148,019 $133,417 Property, plant, and equipment
Beginning of year $ 63,103 $ 53,388 End of year 67,528 63,103 Average fixed assets $ 65,316 $ 58,246 Fixed asset turnover 2.27 times 2.29 times
The fixed asset turnover calculations suggest that GE used its fixed assets to generatesales a little less efficiently in 2005 than in 2004 In 2005, each dollar of fixed assets gen-erated $2.27 in sales, down from $2.29 in 2004
Industry Differences in Fixed Asset Turnover
As with all ratios, the fixed asset turnover ratio must be used carefully to ensure that roneous conclusions are not made For example, fixed asset turnover ratio values for twocompanies in different industries cannot be meaningfully compared This point can be il-lustrated using the fact that General Electric is composed of two primary parts—GeneralElectric, the manufacturing company, and GE Capital Services, the financial services firm.The fixed asset turnover ratio computed earlier was for both these parts combined.Because GE Capital Services does not use property, plant, and equipment for manufac-turing but instead leases the assets to other companies in order to earn financial revenue,one would expect its fixed asset turnover ratio to be quite unlike that for a manufactur-ing firm In fact, as shown below, the fixed asset turnover ratio for the manufacturing seg-ments of General Electric was 5.44 in 2005, over double the ratio value for the company
is using its property,
plant, and equipment.
9
fixed asset turnover
The number of dollars in
sales generated by each
dollar of fixed assets;
computed as sales
divided by property, plant,
and equipment
Trang 31Fixed Asset Turnover Ratio General Electric—Manufacturing Segments Only
Sales $90,430 $82,214 Property, plant, and equipment
Beginning of year $16,756 $14,566 End of year 16,504 16,756 Average fixed assets $16,630 $15,661 Fixed asset turnover 5.44 times 5.25 times
EM | Investments in Property, Plant, and Equipment and in Intangible Assets Chapter 9 417
by each dollar of fixed assets
• Standard values for this ratio differ significantly from industry to industry
Two topics related to operational assets that are traditionally covered in introductoryaccounting classes were not covered in the main part of this chapter These two topicsrelate to depreciation—accelerated depreciation methods and changes in depreciationestimates
E X P A N D E D
material
Accelerated Depreciation Methods
Earlier in the chapter, straight-line and units-of-production depreciation methodswere discussed Both of these methods allocate the cost of an asset evenly overits life With straight-line depreciation, each time period during the asset’s usefullife is assigned an equal amount of depreciation With units-of-production depre-ciation, each mile driven, hour used, or other measurement of useful life is as-signed an equal amount of depreciation Sometimes, a depreciation method thatdoes not assign costs equally over the life of the asset is preferred For example,
if most of an asset’s benefits will be realized in the earlier periods of the asset’s life,the method used should assign more depreciation to the earlier years and less to thelater years Examples of these “accelerated” depreciation methods are the declining-balance and the sum-of-the-years’-digits methods These methods are merely ways ofassigning more of an asset’s depreciation to earlier periods and less to later periods
To illustrate these depreciation methods, we will again use the Wheeler Resorts ample from earlier in the chapter Assume again that Wheeler Resorts purchased a van fortransporting hotel guests to and from the airport The following facts apply:
ex-Acquisition cost $24,000 Estimated salvage value $2,000 Estimated life:
Trang 32Declining-Balance Method of Depreciation
Thedeclining-balance depreciation methodprovides for higher depreciationcharges in the earlier years of an asset’s life than does the straight-line method.The declining-balance method involves multiplying a fixed rate, or percentage, by
a decreasing book value This rate is a multiple of the straight-line rate Typically,
it is twice the line rate, but it also can be 175, 150, or 125% of the line rate Our depreciation of Wheeler’s hotel van will illustrate the declining-balance method using a fixed rate equal to twice the straight-line rate This method
straight-is often referred to as the double-declining-balance depreciation method
Declining-balance depreciation differs from the other depreciation methods
in two respects: (1) the initial computation ignores the asset’s salvage value, and(2) a constant depreciation rate is multiplied by a decreasing book value The sal-vage value is not ignored completely because the depreciation taken during theasset’s life cannot reduce the asset’s book value below the estimated salvage value.The double-declining-balance (DDB) rate is twice the straight-line rate, computed asfollows:
2 DDB rateThis rate is multiplied times the book value at the beginning of each year (cost accu-mulated depreciation) to compute the annual depreciation expense for the year If the150% declining balance were being used instead, the 2 in the rate formula would be re-placed by 1.5 and so on for any other percentages
To illustrate, the depreciation calculation for the van using the 200% (or double)declining-balance method is:
Straight-line rate 4 years 1/4 25%
Double the straight-line rate 25% 2 50%
Annual depreciation 50% undepreciated cost (book value)Based on this information, the formula for double-declining-balance depreciation can
be expressed as (straight-line rate 2) (cost accumulated depreciation) currentyear’s depreciation expense The double-declining-balance depreciation for the fouryears is shown in Exhibit 11 As you reviewthis exhibit, note that the book value of thevan at the end of year 4 is $2,000, its salvagevalue
1 Estimated life (years)
constant depreciation rate
(such as double the
straight-line percentage,
in the case of
double-declining-balance)
With declining-balance depreciation, the asset
is not depreciated below its salvage value,
though this figure is ignored in the initial
End of year 1 $24,000 0.50 $12,000 $12,000 12,000 End of year 2 12,000 0.50 6,000 18,000 6,000 End of year 3 6,000 0.50 3,000 21,000 3,000
$22,000
Trang 33If Wheeler had applied the declining-balance method to depreciate the hotel van onthe basis of 150% of the straight-line rate, the fixed rate would have been 37.5%, com-puted as follows: 25% 1.50 37.5% Using the 37.5% fixed rate, the annual deprecia-tion of the hotel van would have been as follows:
First year: $24,000 37.5% $9,000 Second year: $24,000 $9,000 $15,000 37.5% $5,625 Third year: $15,000 $5,625 $9,375 37.5% $3,516 Fourth year: $9,375 $3,516 $5,859 $2,000 salvage value $3,859Since a total book value of $5,859 remains at the end of year 3, the remaining bookvalue less the estimated salvage value is expensed in year 4
Depreciation for Income Tax Purposes Net income reported on the financialstatements prepared for stockholders, creditors, and other external users often differsfrom taxable income reported on income tax returns The most common cause of differ-ences between financial reporting and tax returns is the computation of depreciation.Depreciation for income tax purposes must be computed in accordance with federalincome tax law, which specifies rules to be applied in computing tax depreciation forvarious categories of assets Income tax rules are designed to achieve economic objectives,such as stimulating investment in productive assets
The income tax depreciation system in the United States is called the ModifiedAccelerated Cost Recovery System (MACRS) MACRS is based on declining-balance de-preciation and is designed to allow taxpayers to quickly deduct the cost of assets ac-quired Allowing this accelerated depreciation deduction for income tax purposes givescompanies tax benefits for investing in new productive assets Presumably, this will spurinvestment, create jobs, and make voters more likely to reelect their representatives
Sum-of-the-Years’-Digits Method of Depreciation
Like the declining-balance method, the sum-of-the-years’-digits (SYD) ciation methodprovides for a proportionately higher depreciation expense inthe early years of an asset’s life It is therefore appropriate for assets that providegreater benefits in their earlier years (such as trucks, machinery, and equipment)
depre-as opposed to depre-assets that benefit all years equally (depre-as buildings do) The formulafor calculating SYD is:
(Cost Salvage value) Depreciation expenseThe numerator is the number of years of estimated life remaining at the beginning ofthe current year The van, with a four-year life, would have four years remaining at thebeginning of the first year, three at the beginning of the second, and so on The denom-inator is the sum of the years of the asset’s life The sum of the years’ digits for the van
is 10 (4 3 2 1) In other words, the numerator decreases by one year each year,whereas the denominator remains the same for each year’s calculation of depreciation.Also note that the asset’s cost is reduced by the salvage value in computing the annualdepreciation expense as is done for the straight-line method but not for the declining-balance method
The depreciation on the van for the first two years is:
First year: 4/10 ($24,000 $2,000) $8,800 Second year: 3/10 ($24,000 $2,000) $6,600The depreciation schedule for four years is shown in Exhibit 12
Number of years of life remaining at beginning of year Sum-of-the-years’-digits
EM | Investments in Property, Plant, and Equipment and in Intangible Assets Chapter 9 419
which a constant balance
(cost minus salvage value)
is multiplied by a declining
depreciation rate
Trang 34The entry to record the sum-of-the-years’-digits depreciation for the first year is:
Subsequent years’ depreciation entries would show depreciation expense of $6,600,
$4,400, and $2,200
When an asset has a long life, the computation of the denominator (the years’-digits) can become quite involved There is, however, a simple formula for deter-mining the denominator It is:
sum-of-the-where n is the life (in years) of the asset
Given that the van has a useful life of four years, the formula works as follows:
10
As you can see, the answer is the same
as if you had added the years’ digits (4 3
2 1) If an asset has a 10-year life, thesum of the years’ digits is:
55The depreciation fraction in year 1 would be 10/55, in year 2, 9/55, and so on
A Comparison of Depreciation Methods
Now that you have been introduced to the four most common depreciationmethods, we can compare them both graphically and by using the Wheeler Resorts vanexample Exhibit 13 compares the straight-line, sum-of-the-years’-digits, and declining-balance depreciation methods with regard to the relative amount of depreciation ex-pense incurred in each year for an asset that has a five-year life The units-of-productionmethod is not illustrated because there would not be a standard pattern of cost allocation.Exhibit 14 shows the results for the Wheeler Resorts’ van for all four depreciationmethods
To record the first year’s depreciation for the hotel van.
EXHIBIT 12 Depreciation Schedule with Sum-of-the-Years’-Digits
Depreciation
Annual
General Electricis one of the few large
companies that continues to use the
sum-of-the-years’-digits method of depreciation
F Y I
Trang 35EM | Investments in Property, Plant, and Equipment and in Intangible Assets Chapter 9 421
Declining-balancemethod
EXHIBIT 13 Comparison of Depreciation Methods
EXHIBIT 14 Comparison of Depreciation Expense Using Different
Depreciation Methods
• The declining-balance method involves multiplying the asset’s declining bookvalue by a fixed rate that is a multiple of the straight-line rate
• Sum-of-the-years’-digits depreciation is computed by multiplying (cost salvagevalue) by a declining ratio based on the number of years in the asset’s
estimated life
Trang 36Changes in Depreciation Estimates and Methods
As mentioned earlier in the chapter, useful lives and salvage values are only timates In addition, the various depreciation methods are simply alternativeways for estimating the pattern of usage of an asset over time Wheeler Resorts’van, for example, was assumed to have a useful life of four years and a salvagevalue of $2,000 In reality, the van’s life and salvage value may be different fromthe original estimates If, after three years, Wheeler realizes that the van will lastanother three years and that the salvage value will be $3,000 instead of $2,000, theaccountant would need to calculate a new depreciation expense for the remainingthree years Using straight-line depreciation, the calculations would be as follows:
es-Account for changes
in depreciation
estimates and
Total
Annual depreciation for the
Book value after three years Book value $24,000 $16,500 $7,500
Annual depreciation for last
three years (based on new
expense
Book value Salvage value Remaining useful life
Cost Accumulated depreciation to date
$24,000 $2,000
4 years
Depreciation expense
Cost Salvage value Estimated useful life
The example shows that a change inthe estimate of useful life or salvage valuedoes not require a modification of the de-preciation expense already taken New in-formation affects depreciation only in futureyears Exhibit 15 shows the revised depre-ciation expense Similar calculations, al-though more complex, would apply if eitherthe sum-of-the-years’-digits or the declining-balance depreciation method had been
To illustrate the uncertainty about depreciation
life estimates, consider that Boeing 727
airplanes are lasting a lot longer than initially
expected The first Boeing 727 was delivered
in 1963; the last was built in 1984 As of
January 2001, almost 1,300 of the 1,831
727s delivered were still in service
F Y I
EXHIBIT 15 Depreciation Schedule When There Is a Change in
Estimate
Annual
Trang 37R E V I E W O F
L E A R N I N G O B J E C T I V E S
Identify the two major categories of long-term operating assets: property, plant, and equipment and intangible assets.
Property, Plant, and Equipment Land, buildings, machines Intangible Assets Patents, licenses, goodwill
Understand the factors important in deciding whether to acquire a term operating asset.
long-• Long-term operating assets have value because they help companies generate future cashflows An asset’s value can decline or disappear if events cause a decrease in the expectedfuture cash flows generated by the asset
• The decision to acquire a long-term operating asset (called capital budgeting) involves paring the cost of the asset to the value of the expected cash inflows, after adjusting for thetime value of money
com-Record the acquisition of property, plant, and equipment through a simple purchase as well as through a lease, by self-construction, and as part of the purchase of several assets at once.
Ways to Acquire Property, Plant, and Equipment Things to Remember
Simple Purchase Include all costs to purchase the asset and get it ready for its intended use Leasing • Operating lease—accounted for as a rental; nothing on the balance sheet.
• Capital lease—accounted for as a purchase; asset and liability on the balance sheet.
Self Construction Include the cost of materials, labor, reasonable overhead, and interest Basket Purchase Allocate the basket purchase price based on relative fair values.
1 2 3
EM | EOC | Investments in Property, Plant, and Equipment and in Intangible Assets Chapter 9 423
used Had the company changed from the straight-line method to another method, theprocedures used would be the same The book value on the date the change is madewould be used and the assumptions associated with the new depreciation method would
be applied to this book value
• The change is reflected in future years’ depreciation, as follows:
• Change in life—The remaining book value (less old salvage value) is cated over the new life
allo-• Change in salvage value—The remaining book value, less the new salvagevalue, is allocated over the old life
• Change in method—The remaining book value, less the old salvage value, isallocated over the remaining life using the new method
Trang 38Compute straight-line and units-of-production depreciation expense for plant and equipment.
Straight-Line Depreciation (Cost – Salvage value) Estimated useful life
Units-of-Production Depreciation [(Cost – Salvage value) Estimated life in units]
Units produced Depletion Same as units-of-production depreciation
Account for repairs and improvements of property, plant, and equipment.
Record an expenditure as an asset The expenditure is:
(that is, capitalize it) when– • significant in amount,
• provides benefits for more than one period, and
• increases the productive life or capacity of an asset.
Record an expenditure as an The expenditure merely maintains an asset’s productive capacity at expense when– the level originally projected.
Identify whether a long-term operating asset has suffered a decline in value and record the decline.
• Recording an impairment loss is a two-step process
(1) Compare the recorded book value of the asset to the sum of future cash flows expected
to be generated by the asset
(2) If the book value is higher, recognize a loss in an amount equal to the difference betweenthe book value of the asset and its FAIR value
• According to U.S accounting rules, increases in the value of property, plant, and equipmentare not recognized
Record the discarding and selling of property, plant, and equipment.
• If a scrapped asset has not been fully depreciated, a loss equal to the undepreciated cost orbook value is recognized
• When an asset is sold, there is a gain if the sales price exceeds the book value and a loss ifthe sales price is less than the book value
Account for the acquisition and amortization of intangible assets and stand the special difficulties associated with accounting for intangibles.
under-• Intangible assets are only recognized in the financial statements if they have been purchasedthrough an arm’s-length transaction
• The cost of recorded intangible assets is expensed as follows:
• Certain intangible assets are amortized over the economic life of the asset
• Many intangible assets are not amortized because their economic lives are not limited
• All intangible assets, including goodwill, must be analyzed to determine if impairment hasoccurred If it has, then an impairment loss is recognized
Use the fixed asset turnover ratio as a measure of how efficiently a company
is using its property, plant, and equipment.
• Fixed asset turnover is computed as sales divided by average property, plant, and
equipment and is interpreted as the number of dollars in sales generated by each dollar offixed assets
• Standard values for this ratio differ significantly from industry to industry
Trang 39Compute declining-balance and sum-of-the years’-digits depreciation pense for plant and equipment.
ex-• The declining-balance method involves multiplying the asset’s declining book value by a fixedrate that is a multiple of the straight-line rate
• Sum-of-the-years’-digits depreciation is computed by multiplying (cost –salvage value) by adeclining ratio based on the number of years in the asset’s estimated life
Account for changes in depreciation estimates and methods.
• A change in depreciation estimate is reflected in future years’ depreciation, as follows:
• Change in life—The remaining book value (less old salvage value) is allocated over thenew life
• Change in salvage value—The remaining book value, less the new salvage value, is allocatedover the old life
• Change in method—The remaining book value, less the old salvage value, is allocated overthe remaining life using the new method
0 q
EOC | Investments in Property, Plant, and Equipment and in Intangible Assets Chapter 9 425
lessee, 394lessor, 394long-term operatingassets, 390
natural resources, 404operating lease, 394patent, 411
property, plant, andequipment, 391salvage value, 400straight-line depreciationmethod, 400
time value of money, 392
units-of-productionmethod, 400
declining-balance ciation method, 418sum-of-the-years’-digits(SYD) depreciationmethod, 419
depre-K E Y T E R M S & C O N C E P T S
E X P A N D E D
material
R E V I E W P R O B L E M S
Property, Plant, and Equipment
Swift Motor Lines is a trucking company that hauls crude oil in the Rocky Mountain states
It currently has 20 trucks The following information relates to a single truck:
a Date truck was purchased, July 1, 2006
b Cost of truck:
c Estimated useful life of truck, 120,000 miles
d Estimated salvage value of truck, $27,000
e 2008 expenditures on truck:
(1) $6,000 on new tires and regular maintenance
(2) On January 1, spent $44,000 to completely rework the truck’s engine; increased thetotal life to 200,000 miles but left expected salvage value unchanged
Truck $125,000 Paint job 3,000 Sales tax 7,000
(continued)
Trang 40f Miles driven:
Required:
Record journal entries to account for the following (Use the units-of-production tion method.)
deprecia-1 The purchase of the truck
2 The expenditures on the truck during 2008
3 Depreciation expense for:
The cost of the truck includes both the amount paid for it and all costs incurred to get
it in working condition In this case, the cost includes both the paint job and the salestax Thus, the entry to record the purchase is:
Truck 135,000 Cash 135,000
Purchased truck for cash.
Recorded major overhaul to truck’s engine.
3 Depreciation Expense
The formula for units-of-production depreciation on the truck is:
Depreciation expenseJournal entries and calculations are as follows:
a 2006:
Depreciation Expense 9,900 Accumulated Depreciation, Truck 9,900
Recorded depreciation expense for 2006.
11,000 miles $9,900 or $0.90 per mile 11,000 miles
$135,000 $27,000 120,000 miles
Number of miles driven in any year
Cost Salvage value Total miles expected to be driven