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Chapter 9: Long-Lived Assets and Cost Allocation 2
Capitalize vs Expense Revenue Expenditures Merely maintain a given level of services Should be Expensed Debit Expense Capital Expenditures Provide future benefits (useful life > 1 year) Should be Capitalized Debit Asset 3
Overview of Accounting for Property, Plant, and Equipment 4
1. Acquisition - What Costs to General Rule: Capitalize? Capitalize (add to an asset account) the costs to acquire the asset and to prepare it for its intended use. Dr. Asset (purchase price, sales tax, delivery, installation, etc) Cr. Cash, Notes Payable, etc 5
Land Has indefinite life and therefore is not depreciated Historical Cost includes: Purchase price, Closing costs, Cost to get ready for intended use (Note: Sale of salvaged materials reduces cost) Land Improvements Have definite life and therefore are depreciated Fences, walls, parking lots, driveways Buildings Have definite life and therefore are depreciated Proportionate share of purchase price, or construction cost, Closing Cost, Architect & Attorney fees Machinery, Equipment, Furniture & Fixtures Purchase price (net of cash discounts), Freight & handling, Insurance while in transit, Installation
Direct Materials & Labor Variable Overhead Apply Fixed Overhead Self Constructed Assets What to Capitalize? Interest During Construction, if constructed for company s own use by someone else and progress payments &/or deposit are required
2. Depreciation (Cost Allocation) Depreciation is a method of cost allocation. it is used to allocate the capitalized cost of PP&E over the years benefited (matching) Note: depreciation will decrease the carrying value of the asset, but it is not a valuation technique (i.e., book value is not market value) 8
2. Depreciation (Cost Allocation) Useful Life Salvage Value Depreciation methods (1) Activity (units-of-production) (2) Straight-line (3) Double-declining balance (4) 150 percent declining balance (5) Sum-of-the-years digits (6) MACRS (income tax depreciation) Under IFRS, depreciation accounting is very similar to US GAAP. 9
Class Example Given the following information regarding an automobile purchased by the company on January 2, 2008: Cost to acquire = $10,000 Estimated life = 4 years Estimated miles = 100,000 miles Salvage value = $2,000 Calculate depreciation expense for the first two years under each of the following methods. 10
(1) Units-of-Production (Activity) Assume that the car was driven 20,000 miles in the year 2008, and 30,000 miles in 2009. Annual depreciation = Cost - Salvage Value x Current Activity Total expected activity For 2008= 10,000-2,000 x 20,000 = $1,600 100,000 miles For 2009 = 10,000-2,000 x 30,000 = $2,400 100,000 miles 11
(2) Straight-Line Annual depreciation = Cost - Salvage Estimated Life = $10,000 - $2,000 = $2,000 per year 4 years 12
(3) Double-Declining Balance DDB is an accelerated depreciation technique. It generates more expense in the early years and less in the later years. Annual depreciation = % (Cost - A/D) where A/D is the accumulated depreciation for all prior years, and the percentage is double the straight line rate, or 2 x 1/Estimate life. In the example, the % = 2 x 1/4 = 2/4 = 50%. Depreciation expense (D.E.)for: 2008 = 50% x (10,000-0) = $5,000 2009 = 50% x(10,000-5,000) = $2,500 13
(4) 150% Declining Balance 150%DB is another accelerated depreciation technique. It also generates more expense in the early years and less in the later years. Annual depreciation = % (Cost - A/D) where A/D is the accumulated depreciation for all prior years, and the percentage is 1.5 times the straight line rate, or 1.5 x 1/Estimate life. In the example, the % = 1.5 x 1/4 = 37.5%. Depreciation expense (D.E.)for: 2008 = 37.5% x (10,000-0) = $3,750 2009 = 37.5% x(10,000-3,750) = $2,344 14
(5) Sum-of-the-years Digits SYD is another accelerated technique that calculates more expense in early years and less in later years. Annual depreciation = Fraction x (Cost-Salvage) where the fraction is calculated as follows: Numerator = declining years (highest first) Denominator = sum of the years digits In the class example, the denominator is 4+3+2+1 = 10 D.E. for 2008 =4/10(10,000-2,000) = $3,200 D.E. for 2009 = 3/10(10,000-2,000) = $2,400 15
(6) MACRS MACRS (modified accelerated cost recovery system) is a technique developed by the IRS for tax reporting. It utilizes combinations of DDB, 150%DB, and SL to calculate a table of percentages that can be applied to any depreciable asset. Additionally, the IRS assumes no salvage value, and a half year in the first and last year of depreciation (some limitations on fourth quarter purchases). 16
Change in Estimate The change in estimate affects only the current and future years; we do not go back and change the previous years that have already been posted. To calculate the new depreciation expense, first find out how much depreciation has been posted (the Accumulated Depreciation to date). Then use the following formula (to modify the straight-line depreciation rate): Remaining Book Value - New Est. Salvage Remaining Estimated Life 17
Class Problem: Problem 9-7 (a)book Value at 1/1/06: First: annual depr. expense = (180-30)/10 = 15/yr. Then Accumulated Depr. to 1/1/11: 15 x 5 yrs = $75,000 So BV = 180,000-75,000 = 105,000 18
Class Problem: Problem 9-7 (b) Estimate for 2011, assuming revised useful life: BV - SV = 105,000-30,000 = $9,375 per yr. Remaining life 10-5 +3 Journal entry: Depreciation Expense 9,375 Accum. Depreciation 9,375 19
3. Postacquisition Expenditures: Betterments or Maintenance? Betterments: Increase asset s useful life Improve quality of asset s output Increase quantity of asset s output Reduce asset s operating costs Maintenance maintain existing productivity or useful life Accounting treatment Betterments are capitalized Maintenance expenditures are expensed 20
4. Disposal: Retirement, Sale or Trade-In Retirement : Dr. Loss (if not fully depreciated) Dr. Acc Dep Cr. Asset Sale: Dr. Cash Dr. Acc Dep Cr. Asset Dr. Loss if BV > Cash or Cr. Gain if BV < Cash Trade-ins (for dissimilar assets): asset received should be valued at the fair market value of assets given up, or the fair market value of the asset received, whichever is more evident and objectively determined 21
4. Disposal - continued Using earlier example (cost = $10,000, salvage = $2,000). After 4 years straight-line, $8,000 would be in A/D. 1. Assume the asset is retired (no cash received) Loss on retirement 2,000 Accumulated Depr. 8,000 Automobiles 10,000 2. Assume the asset is sold for $3,000: Cash 3,000 Accumulated Depr. 8,000 Automobiles 10,000 Gain on sale 1,000 22
Class Exercise: Exercise 9-15 First calculate depreciation: DDB % = 1/5 x 2 = 2/5 = 40% Depr. Book Date % Cost - A/D Expense Value 1/1/09 25,000 12/31/09 40% (25,000-0) = 10,000 15,000 12/31/10 40% (25,000-10,000) = 6,000 9,000 12/31/11 40% (25,000-16,000) = 3,600 5,400 12/31/12 400* 5,000=SV 12/31/13-0- 5,000 *formula will exceed salvage value limit in 2012; just depreciate $400, to salvage of $5,000. 23
Exercise 9-15, continued (a) JE to scrap after 3 years, at 12/31/11, assumes that no cash is received: Dr. Loss on Disposal 5,400 Dr. Acc Dep 19,600 Cr. Equipment 25,000 (b) JE to scrap after 5 years, assumes that no cash is received: Dr. Loss on Disposal 5,000 Dr. Acc Dep 20,000 Cr. Equipment 25,000 24
Exercise 9-15, continued (c) JE to sell for $8,000 after 3 years: Dr. Cash 8,000 Dr. Acc Dep 19,600 Cr. Equipment 25,000 Cr. Gain 2,600 (d) JE if, after 5 years, the equipment and $28,000 traded for a dissimilar asset with a fair market value of $30,000: Dr. Asset (new) 30,000 Dr. Acc Dep 20,000 Dr. Loss 3,000 Cr. Equipment (old) 25,000 Cr. Cash 28,000 25
B. Intangible Assets Intangible assets are characterized by (1) lack of physical evidence, and (2) high uncertainty about future benefits. Cost is amortized over useful life (or legal life, if less), but not to exceed 40 years. Exception is Goodwill, which is no longer amortized. Under IFRS, revaluing intangibles is an option, but not a requirement. Under US GAAP, revaluation is not an option. 26
(1) Patents (20 year legal life) A company may capitalize the following the cost of acquiring an externally developed patent. filing fees for internally or externally developed patents. the legal fees for acquiring and successfully defending a patent (internal or external). A company cannot capitalize the following: legal fees for unsuccessfully defending a patent. Most research and development costs for an internally developed patent. 27
Research and Development Costs (for internally developed patents) Prior to 1974, most companies capitalized research and development costs, then amortized the cost to future periods. The FASB stated in SFAS 2 that, because future benefits were uncertain, companies should expense all R&D costs, unless they were related to tangible assets (like buildings and equipment) that had multi-year lives. Companies complied with the standard, but for several years many companies actually reduced their R&D activities, because of concern for excess expense on the income statement. 28
Other Intangible Assets (2) Copyrights granted for the life of the creator plus 70 years. capitalization rules similar to patents: costs of internally developed copyright material cannot be capitalized. (3) Trademarks and Trade Names granted for 10 year periods, but indefinite renewals. some of design costs may be capitalized. (4) Organization Costs costs related to the creation of a company including underwriting fees, legal and accounting, licenses, titles, etc. treatment similar to R&D costs; even though there may be some future benefit, costs are expensed in the period incurred. 29
Other Intangible Assets - continued (5) Software Development Costs (SFAS 86) Capitalize the costs of developing software for sale or lease. Expense software development costs if for internal use. (6) Goodwill (also discussed in Chapter 8) Recognized when one company purchases another company. Causes include reputation, good customer relations, superior product development, etc. To calculate: Purchase price paid for the company versus the fair market value of the net assets acquired = Goodwill (the excess amount paid) No longer amortized, instead subjected to an impairment test 30
IFRS vs. US GAAP: Revaluations to Fair Market Value One very important way in which IFRS differs from US GAAP involves the use of fair market value as a basis for valuation on the balance sheet. Under US GAAP, long-lived assets must be accounted for at original cost less accumulated depreciation. Under IFRS, companies can either follow the US GAAP method or they can periodically revalue their long-lived assets to fair market value. In essence, US GAAP tends to follow a conservative lower-of-cost-or-market valuation principle, whereas IFRS allows managers the option to more closely follow a pure market valuation principle. 31
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