Adjustments for Useful Life LO3 Changes in Estimates Additional Improvement Expenditures Significant...

Adjustments for Useful LifeLO3

Changes in Estimates

Additional Improvemen

t Expenditures

Significant Declines in

Asset Market Values

Adjustments for fixed assets can arise from:

Changes in Depreciation EstimatesAssume Thomas Supply purchases a machine for $90,000 on

1/1/2010, with a 10 year useful life and $10,000 salvage value. Using straight-line, Thomas records $8,000

depreciation expense.

GENERAL J OURNAL

Date Description Debit Credit 2010 Dec

31

Depreciation Expense

8,000

Accumulated Depreciation-Truck

8,000

Assets = Liabilities + Equity-8,000 -8,000

Changes in Depreciation EstimatesYear 5: Thomas estimates that the machine will last only 8 years and have a salvage value of $6,000. The prospective revision (current and future) will not correct the first 4 years.

Calculate net book value at the time of estimate revision (or unexpired cost):Cost of the asset, January 1, 2010 $90,000Less: Accumulated depreciation for four years $32,000Net book value on January 1, 2014 $58,000

Step 1

Step 2

Calculate depreciable cost for future depreciation:Net book value on January 1, 2014 $58,000Less: Estimated salvage value $6,000Remaining depreciable cost $52,000

Step 3 Calculate revised depreciation expense: $52,000 ÷ 4 remaining years = $13,000 annual depreciation

Expenditures After AcquisitionThe accounting treatment for expenditures made during the useful life of a fixed asset depends on whether they are classified as capital or revenue expenditures.

• A capital expenditure increases the expected useful life or productivity of the asset.

• A revenue expenditure maintains the expected useful life or productivity of the asset.

Capital Expenditure• A company purchases a fixed asset for

$50,000 on 1/1/2010, with a 5-year life and no salvage. During the fifth and final year of the asset’s life, the company incurs $8,000 for upgrades that extend the asset’s life for 2 years.

General JournalYear five Fixed Asset $8,000

Cash $8,000(To record upgrade to asset)

Assets = Liabilities + Equity+8,000-8,000

Change in Depreciation Due to Capital ExpenditureCalculate net book value after capital expenditure:Cost of the asset, January 1, 2010 $50,000Less: Accumulated depreciation for four years $40,000Net book value on January 1, 2014 $10,000Plus: Upgrades made in 2014 $ 8,000Updated Net Book Value for 2014 $18,000

Step 1

Step 2

Calculate depreciable expense:Updated book value for 2014 $18,000Less: Estimated salvage value $ 0Remaining depreciable cost $18,000Divided by remaining useful life ÷ 3Annual depreciation expense $ 6,000

Revenue Expenditure• A company purchases a fixed asset for

$50,000 on 1/1/2010, with a 5-year life and no salvage. During the fifth and final year of the asset’s life, the company incurs $1,000 in ordinary maintenance.

General JournalYear five Maintenance Expense $1,000

Cash $1,000(To record normal

maintenance)

Assets = Liabilities + Equity-1,000 -1,000

Potential Fraud Issue

Asset ImpairmentWhen a fixed asset’s market value falls materially

below its net book value and the decline in value is deemed to be permanent, the asset is considered

impaired. Under GAAP, companies apply conservatism by writing these assets down from their

book values to their market values.

Assume a machine losses value equal to $100,000:

General JournalLoss on Impairment $100,000

Fixed Asset $100,000(To record permanent impairment asset)

Assets = Liabilities + Equity-100,000 -100,000

Included in Other Income in the Income Statement

Disposal of Fixed Assets

• The accounting for the disposal of a fixed asset consists of the following three steps:

LO4

1. Update depreciation on the asset.

2. Calculate gain or loss on the disposal.

3. Record the disposal.

Rule for Calculating the Gain or Loss on Disposal

If Proceeds from Sale > Net Book Value, then Gain on Disposal

If Proceeds from Sale < Net Book Value, then Loss on Disposal

Evaluating Management of Fixed Assets

Three issues are important when managing fixed assets:

LO5

1. How productive are the company’s fixed assets in generating revenues?

2. What is the condition of the company’s fixed assets?

3. How are cash flows affected by the purchase of fixed assets?

Horizontal and Vertical Analyses

A good place to start in the analyses of fixed assets is with performance of horizontal and

vertical analyses.

Horizontal AnalysisHorizontal Analysis Vertical Vertical AnalysisAnalysis

Fixed assets CY Fixed assets – PY Fixed assetsPY Fixed Assets

Fixed assetsTotal Assets

Depreciation Expense

CY Depreciation – PY DepreciationPY Depreciation

Depreciation ExpenseTotal Sales

 [A1]Key Formula

Horizontal ExampleLet’s look at McDonald’s 2008 & 2007 analyses.

Vertical ExampleLet’s look at McDonald’s 2008 & 2007 analyses.

Fixed Asset Turnover RatioHow do you find out if the company is

using fixed assets productively to generate revenues?

Total RevenuesAverage Net Book Value of Fixed

AssetsWhere average Net Book Value = Beginning Net Book Value + Ending

Net Book Value2

The fixed asset turnover ratio compares total revenues during a period to the average net

book value of fixed assets for the period.

Fixed Asset Turnover ExampleMcDonald’s 2008 fixed asset turnover

ratio is calculated as follows.

Average Life of Fixed Assets

Average Age of Fixed Assets

Acquiring Fixed Assets – Cash Flow Effects

LO6

Determining fixed assets’ effects on cash flow is another important issue.

McDonald’s 2008 Capital Expenditures from the Statement of Cash Flows

2008 2007 2006Property and equipment expenditures($2,135.7) ($1,946.6) ($1,741.9)

A negative number indicates investment

in operating activities.

Intangible AssetsLO7

An intangible asset is a

resource that is used in

operations for more than one year but has no

physical substance.  

Examples include:•Patent•Trademark•Copyright•Franchise•Goodwill

Recording Goodwill

Goodwill is created when one company

buys another company and pays more than the value of the net

assets of the purchased company.

Suppose that Buyer Company purchases Seller Company for $8 million when the

value of Seller Company’s net

assets is $6 million. How will we record this?

Recording GoodwillGeneral Journal

Net Assets of Seller Company $6,000,000

Goodwill $2,000,000

Cash(To record the purchase of Seller)

$8,000,000

Assets = Liabilities + Equity+6,000,000+2,000,000-8,000,000

The premium paid for GOODWILL is usually due to the acquired company’s customers, its reputation, its

employees, its market share, or its research.

Amortizing Intangible AssetsSuppose that a company possesses a $60,000 patent that has the maximum legal life of 20 years. The company believes that the patent

will be useful for only 12 years and will then be worthless. How do we record amortization?

$60,000 ÷ 12 = $5,000 per year

General JournalEnd of year Amortization Expense $5,000

Patent $5,000

Assets = Liabilities + Equity-5,000 -5,000

Remember

End of Chapter 8