4/10/2012. Long-Lived Assets and Depreciation. Overview of Long-lived Assets. Learning Objectives (LO) Learning Objectives (LO)

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1 Learning Objectives (LO) CHAPTER Long-Lived Assets and Depreciation 8 After studying this chapter, you should be able to 1. Distinguish a company s expenses from expenditures that it should capitalize 2. Measure the acquisition cost of tangible assets such as land, buildings, and equipment 3. Compute depreciation for buildings and equipment using various depreciation methods 4. Recalculate depreciation in response to a change in estimated useful life or residual value 5. Differentiate financial statement depreciation from income tax depreciation 6. Explain the effect of depreciation on cash flow 1of 35 2of 40 Learning Objectives (LO) After studying this chapter, you should be able to 7. Account for expenditures after acquisition 8. Compute gains and losses on disposal of fixed assets and consider the impact of these gains and losses on the statement of cash flows 9. Determine the balance sheet valuation of tangible assets for companies who use the revaluation method allowed under IFRS 10. Account for the impairment of tangible assets 11. Account for intangible assets, including impairment 12. Explain the reporting for goodwill 13. Interpret depletion of natural resources Overview of Long-lived Assets Long-lived assets (LLA) Used over a period longer than an operating cycle As a percentage of total assets, vary considerably depending on the industry Divisible into tangible and intangible categories Tangible assets - physical (can see and touch) Land Natural resources Buildings Equipment 3of 40 4of 40 Overview of Long-lived Assets Intangible assets Lack physical substance Contractual or legal rights or economic benefits Patents Trademarks Copyrights Amortize spreading the LLA s cost over the periods it contributes to the production of revenue Depreciate buildings, equipment (but not land) Deplete natural resources Amortize intangible assets 5of 40 LO 1 Contrasting Long-lived Asset Expenditures with Expenses Expenditures what is paid for an item Expensed Within an operating cycle or year Not consumed - current asset Consumed - deducted as an expense ( expensed ) expensed) Capitalize Beyond an operating cycle or year, expenditure is placed on the balance sheet (capitalized) Cost is then amortized over its useful life Exceptions Land and other items where cost-benefit considerations suggest expensing is justified 6of 40 1

2 LO 1 Contrasting Long-lived Asset Expenditures with Expenses Capitalize or Expense? judgment required Expensing all this year lowers this year s net income (and has no affect on future years net income) Capitalizing this year then amortizing some of its cost lowers this years expenses (in comparison to expensing) thus improving this year s net income. In future years, more expenses means lower net income In the long-run, same end results are achieved What is in the best interests of stakeholders (management, investors) WorldCom example in text What did they do? LO 2 - Tangible Assets Acquisition Cost LLA asset costs that are capitalized include (besides the purchase price itself $100 ) all necessary costs to get the asset into a usable condition Land survey, legal/title l/titl fees, taxes, demolition Buildings legal/title fees, taxes Equipment - taxes ($5), transportation ($3), installation ($4), testing ($1), essential repairs ($2) to get it into an operating condition ASSET 115 CASH 115 7of 40 8of 40 LO 2 - Tangible Assets Acquisition Cost Nonmonetary exchange Fair market value Fair market value = what could sell/buy the asses for from an independent third party Fair market value of the consideration given up or received, whichever is more clearly determinable Basket Purchase more than one asset for a single price. E.g. For $1M, can buy Land ($480,000) and building ($720,000) (appraised value) Building 600,000 (480/1200) x $1m) Land 400,000 (720/1200 x $1m) Cash 1,000,000 LO 2 - Tangible Assets Acquisition Cost Subsequent to Acquisition - The market value: Declines Write the value of the asset down (impairment if considered permanent), or Leave at historical cost less depreciation, i.e., Book Value U.S. required and IFRS permitted Increases Revalue to fair market value (IFRS permitted) Precluded by U.S. GAAP 9of of 40 Matching recording expenses in the period in which they help produce revenue Buildings and Equipment Typically last many years Thus contributing to revenue for many years Thus their cost is capitalized when purchased And amortized over many years Accumulated Depreciation = the cumulative amount of Depreciation Expense recorded over the life of the asset Information needed to determine depreciation Acquisition (capitalized) cost what was debited to the asset account Salvage (terminal, residual) value what is expected to be received at the time the asset is disposed of Depreciable value = amount to be allocated to each year of usage Useful life = shorter of the asset s Physical life expected time it will wear out Economic life when it is no longer economically feasible to operate 11 of of 40 2

3 Symbols Amounts for Illustration C = total acquisition cost December 31, 20X2 $41,000 R = estimated residual value $1,000 n = estimated useful life (in years or miles) 4 years 200,000 miles D = amount of depreciation Various Straight-line depreciation Spreads the depreciable value evenly over the useful life of an asset Most popular method for financial reporting purposes Depreciation expense = (C R) / n = ($41,000 1,000) / 4 = $10,000 per year Depreciation Expense 10,000 Accumulated Depreciation 10, of of 40 Units of Production - If physical wear and tear determines the useful life, depreciation may be based on units of service (e.g. miles) or units of production Depreciation expense = (C R) / n = ($41,000 1,000) / 200,000 = $.20/mile = 65,000 miles (yr 1) x $.20 = $13,000 Depreciation Expense 13,000 Accumulated Depreciation 13,000 Double-declining-balance (DDB) method is an accelerated method Straight line rate of depreciation = ¼ year = 25% per year Double the straight line rate = 25% x 2 = 50% Book value at the begin. of the year = Acquisition cost less Accumulated Depreciation Year Depreciation Expense 1.50 ($41,000 zero Accum. Depr.) = $20,500 > $10, ($41,000 $20,500) = $10, ($42,000 $20,500 $10,250) = $5, ($41,000 $20,500 $10,250 $5,125) = $2,563 < $10,000» $38, of of 40 In comparison to straight line depreciation expense, DDB records more in the earlier years; less in the later years Over the asset s s life, the same amount is depreciated, regardless of method Depreciable asset is never depreciated below its estimated salvage (terminal, residual) value Note that the $41,000 asset is only depreciated to $38,438 in this example, Thus to fully depreciate this asset, a plug number is needed to increase accumulated depreciation to $40,000. Never depreciate an asset below its salvage value. 17 of of 40 3

4 LO 4 - Changes in Estimated Useful Life or Residual Value Asset s useful life and residual value estimated when acquired If material changes to those estimates become known, must use the new estimate to revise the depreciation schedule Revisions are applied to the period in which they are determined and future periods, i.e., not applied retroactively LO 4 - Changes in Estimated Useful Life or Residual Value Example Cost = $41,000 Residual value = $1000 Life = 4 years Beginning of year 4, life changes to 2 full years Revised Depreciation Expense for next 2 years $41,000 ($10,000 x 3 years) = $11,000 $11,000 $1000 residual value = $10,000 to be depreciated $10,000 / 2 years = $5000 each for next 2 years 19 of of 40 LO 5 - Contrasting Income Tax and Shareholder Reporting LO 6 - Depreciation and Cash Flow Tax reporting - prepared according to IRS rules Assets divided into property classes Each class has prescribed lives and permissible depreciation methods Modified Accelerated Cost Recovery System (MACRS) prescribes zero salvage value and allows use of DDB (more deprecation/lower taxable income) Financial reporting prepared per FASB/SEC rules Straight-line depreciation is the most used method Matches portions of the asset s cost to the periods of revenue generation Cash Flow Operating repairs Investing - acquired, sold, or bettered Depreciation expense Allocates investing expenditures to periods Operating cash flows - Statement of Cash Flows Indirect method explains why net income is different than operating cash flows. Since depreciation expense was deducted from net income but is not a cash flow, it is removed by adding it back to net income, causing some to believe it increases cash from operations. 21 of of 40 LO 7 - Expenditures After Acquisition Definitions Maintenance - Sustain LLA original performance level Repairs Restore LLA to original performance level Improvements (betterments) improve LLA s life, quantity/quality of output or reduce operating costs U.S. GAAP Maintenance and repair expenditures - expensed Improvements If immaterial or cost/benefit applies expensed If material capitalize (revise depreciation schedules) Example Original cost - $41,000 Accumulated Depreciation at time of sale $20,000 Book Value at time of Sale - $21,000 Sale at book value (all are Asset accounts) Cash 21,000 Accumulated Depreciation 20,000 Equipment 41, of of 40 4

5 Sale for more than its book value (41,000 20,000 = 21,000) Cash 25,000 Accumulated Depreciation 20,000 Equipment 41,000 Gain 4,000 Sale for less than its book value (41,000 20,000 = 21,000) Cash 14,000 Accumulated Depreciation 20,000 Loss 7,000 Equipment 41,000 Companies include gains and losses in a variety of locations on the income statement Some companies list other income with sales revenue at the top of the income statement, thus combining usual and frequent inflows with unusual and/or infrequent inflows Other companies report it after operating income viewing it as not being a part of usual and frequent (central) operations 25 of of 40 LLA sales and the Cash Flow Statement Investing activities if sold for cash Disclose in notes if for other than cash and considered significant Indirect method of presenting operating cash flows Net income includes investing gains and losses To remove them from net income Subtract gains Add losses Direct method - ignore since they are investing flows LO 9 Revaluation Method under IFRS Revaluation Prohibited by U.S. GAAP Optional under IFRS Revalued assets are not depreciated Once started, t must continue to do so Must be done for all assets in the same class Concept-Report assets at fair market value (FMV) Amount the asset could be exchanged between willing knowledgeable parties in an arm s length transaction Determined usually from appraisals 27 of of 40 LO 9 Revaluation Method under IFRS Concept continued Original cost 10,000 + Revaluation gain year 1* +1,000* Fair market Value end of year 1 11,000 Revaluation loss year 2* 2,000* Fair market Value end of year 2 9,000 * Gains and losses typically posted to single account that is reported on the Income statement (rarely volatility of net income) Owners equity (part of Comprehensive Income) Circumstances leading to Impairment when any of the following become apparent (i.e., not automatically on an annual basis) Significant decline in asset s fair market value Significant change in the way the asset is used Change in legal/business environment Obsolescence or physical damage Forecast of continuing losses if usage continues Other factors 29 of of 40 5

6 Process of determining impairment 1. Recoverability test Compare undiscounted expected cash flows from operations and sale to the book value Cash flows > book value = no impairment Cash flows < book value, go to step 2 2. Compute the impairment loss as Active market: Book value fair market value Inactive market: Book value discounted cash flows (see Appendix A to Chapter 9) Recording the loss Loss on Impairment 45,000 * Accumulated Depreciation 45,000 Book value ($150,000) less FMV of asset ($105,000) Reporting the loss U.S. GAAP: part of Income from Continuing Operations Separate line if material Combined with other items if immaterial 31 of of 40 Assets held for resale can be written up following an impairment loss only to the net book value at the time of the impairment Intangible assets Not physical in nature Rights or claims to expected benefits that are often from contract rights Patents - exclusive right to produce/sell a product or use a process for up to 20 years Copyrights exclusive rights to reproduce and sell a book, musical composition, film, or similar creative item for the life of the creator plus 70 years Accounting for intangible assets depends on whether the asset Was acquired externally or developed internally Has a finite or infinite life 33 of of 40 Trademarks - distinctive identifications of a manufactured product or a service, taking the form of a name, sign, slogan, logo, or emblem Franchises/licenses - legal contracts that grant the buyer the right to sell a product or service in accordance with specified conditions Leasehold - right to use a fixed asset for a specified period of time beyond one year Leasehold improvements - lessee spends money to improve leased property Improvements = become part of the leased property and are classified as fixed assets U.S. GAAP: If intangible asset is developed inhouse expense all costs, i.e. they are not capitalized then amortized Know what is expended; do not know its future value, i.e. Research and development For software, expense till technological feasibility is established; from then to production, capitalize all expenditures 35 of of 40 6

7 U.S. GAAP - Purchased rights from elsewhere capitalized Infinite lives not amortized; subject to impairment Finite lives - amortized over the shorter of useful or legal life IFRS Impairment of tangible asset same as U.S. GAAP Impairment of intangible infinite-life assets Must be looked at annually No recoverability test is required Impairment loss = book value fair value 37 of 40 LO 12 - Goodwill Goodwill Arises only when one company buys another Is the excess of the cost of the acquired company over the sum of the fair market value of its identifiable individual assets less the liabilities Is not separately identifiable intangible asset that could be sold to another company as with other intangible assets Goodwill is discussed in more detail in Chapter of 40 Example LO 12 - Goodwill Assets 100 < Fair market value of assets received Goodwill? Liabilities 60 < Fair market value of liabilities assumed Cash 50 < Cash paid to buy the other company Goodwill is then subject to impairment testing with some special twists See Chapter 11 for more details LO 13 - Depletion of Natural Resources Natural resources - LLA such as minerals, oil, and timber (wasting assets) Depletion expense is the amount of the acquisition cost of natural resources allocated to this period Depletion is measured on a units-of-production basis Annual depletion may be recorded as A direct reduction of the asset (credit the asset) Or by using an Accumulated Depletion (contraasset) account 39 of of 40 7