1 Chapter 10: Long-lived assets Learning Objectives 1.What measurement base is used for long- lived assets? 2.What kinds of costs are capitalized and

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Chapter 10: Long-lived assets

Learning Objectives1. What measurement base is used for long-

lived assets?

2. What kinds of costs are capitalized and how joint costs are allocated among assets?

3. What does asset “impairment” mean and how is it recorded?

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Learning Objectives (contd.)

4. How analysts can adjust for different depreciation assumptions and improve comparisons across companies?

5. How GAAP measurement rules complicate ROA trend analysis and comparisons across companies?

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Asset

• An asset is something that generates future economic benefits and is under the exclusive control of a single entity.

• Examples: Cash, Accounts receivables, investments, inventories, property, plant and equipment, intangible assets.

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Assets Actively Used in OperationsAssets Actively Used in Operations

Tangible ( Fixed) Assets

Property, Plant, Equipment ( PPE)& Natural Resources

Tangible ( Fixed) Assets

Property, Plant, Equipment ( PPE)& Natural Resources

Intangible Assets

No PhysicalSubstance

Intangible Assets

No PhysicalSubstance

Long-Lived Assets

Expected to Benefit Future PeriodsExpected to Benefit Future Periods

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Property, Plane and Equipment PPE are acquired for use in

continuing operations over the life of the asset to generate revenue.

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PPE (contd.) PPE are classified into two categories:

Land (the cost is NOT subject to depreciation)

Depreciable assets: buildings, equipment, motor vehicles, land improvement. Matching principle is applied for the

periodical allocation of the cost of PPE to expenses ( this process is referred to as depreciation).

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Control Over PPE A fixed asset ledger card should be prepared

and maintained for each individual PPE asset purchased. Include all the pertinent information relating to

the asset and its use. These data enable the management to

establish and maintain control over each individual asset.

It also assists in accounting for all transaction relating to PPE assets.

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1. What costs to capitalize?

Overview of Accounting for PPE

Acquisition

2. Depreciation

3. Post acquisition expenditures

4. Retirement

Use Disposal

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Costs include in the initial cost

Identify the various costs included in the initial cost of property, plant, and equipment.

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Costs to be CapitalizedGeneral Rule

The initial cost of an operational asset includes the purchase price and all

expenditures necessary to bring the asset to its desired condition and location for use.

General RuleThe initial cost of an operational asset

includes the purchase price and all expenditures necessary to bring the asset to

its desired condition and location for use.

•PPE are acquired either by cash purchase or by incurring a liability. •If a liability is incurred, the interest charges cannot be included in the cost of the asset except for self-constructed assets.•

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Net purchase price Taxes Transportation costs Installation costs Modification to building necessary to

install equipment Testing and trial runs

Net purchase price Taxes Transportation costs Installation costs Modification to building necessary to

install equipment Testing and trial runs

Costs to be Capitalized- Equipment

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Land: Purchase price Commissions Legal fees Closing fees Clearing fees Title search &

transfer fees Net razing cost of

an old building

Land: Purchase price Commissions Legal fees Closing fees Clearing fees Title search &

transfer fees Net razing cost of

an old building

Costs to be Capitalized – Land and Land Improvements

Land Improvements (depreciable):

DrivewaysParking lotsFencingLandscapingPrivate roads

Land Improvements (depreciable):

DrivewaysParking lotsFencingLandscapingPrivate roads

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Building Purchase price or

contract priceCost of remodelingArchitectural feeBuilding permitsSurveying cost before constructionInterest capitalized7 excavation cost before construction

Building Purchase price or

contract priceCost of remodelingArchitectural feeBuilding permitsSurveying cost before constructionInterest capitalized7 excavation cost before construction

Costs to be Capitalized- Building and Nature Resources

Natural Resources Purchase price,

exploration and development costs of: Timber Mineral deposits Oil and gas reserves

Natural Resources Purchase price,

exploration and development costs of: Timber Mineral deposits Oil and gas reserves

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Capitalization example:Initial costs

All costs are capitalized.

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Lump-Sum Purchases

Cost allocation for Lump-Sum Purchases.

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Several assets are acquired for a single, lump-sum price that may be lower than the

sum of the individual asset prices.

Several assets are acquired for a single, lump-sum price that may be lower than the

sum of the individual asset prices.

Lump-Sum Purchases

Asset 2Asset 1 Asset 3

Allocation of the lump-sumprice is based on relative

market value of the individual assets.

Allocation of the lump-sumprice is based on relative

market value of the individual assets.

Must separate costs because many assets have different depreciable lives, and some (land) are not depreciated.

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For financial reporting and tax purposes, the allocation is guided by their relative market value.

Tax versus financial reporting incentives The allocation of costs between land and buildings affects

the amount of income that will be reported in future periods.

$100

$500

• Higher depreciation

• Lower net income

• Lower taxes

Land Building

Allocation 1:

$500

$100

• Lower depreciation

• Higher net income

• Higher taxesLand Building

Allocation 2:

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On May 13, we purchase land and building for $200,000 cash. The appraised value of

the building is $162,500, and the land is appraised at $87,500.

How much of the $200,000 purchase price will be charged to the building account?

On May 13, we purchase land and building for $200,000 cash. The appraised value of

the building is $162,500, and the land is appraised at $87,500.

How much of the $200,000 purchase price will be charged to the building account?

Lump-Sum Purchases

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Appraised % of Purchase AssignedAsset Value Value Price Cost

(a) (b)* (c) (b × c)Land 87,500$ 35% 200,000$ 70,000$ Building 162,500 65% 200,000 130,000 Total 250,000$ 200,000$

* $87,500÷$250,000 = 35%

The building will be apportioned $130,000of the total purchase price of $200,000.

The building will be apportioned $130,000of the total purchase price of $200,000.

Lump-Sum Purchases

Prepare the journal entry to record the purchase.Prepare the journal entry to record the purchase.

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Lump-Sum Purchases

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Exercise – Joint costsTotal cost of $260,000 ($10,000 cash, $250,000

credit). Individual fair value is determined as if purchased separately.

Asset (Fair value / Total FV) x Total Cost = CostBldg. (100,000 / 325,000) x 260,000 = $ 80,000Equip. (185,000 / 325,000) x 260,000 = 148,000Land ( 40,000 / 325,000) x 260,000 = 32,000Total 325,000 $260,000Journal entry:

Building 80,000Equipment 148,000Land 32,000

Cash 10,000Mort. Payable 250,000

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Self-Constructed Asset

Identify the items included in the cost of a self-constructed asset and determine the amount of

capitalized interest.

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Self-Constructed Assets Costs

Cost of self-constructed assets includes:1. direct materials,

2. direct labor,

3. factory overhead (variable overhead and fixed overhead).

When self-constructing an asset, two accounting issues must be addressed:

Overhead allocation to the self-constructed asset.

Proper treatment of interest incurred during construction.

Cost of self-constructed assets includes:1. direct materials,

2. direct labor,

3. factory overhead (variable overhead and fixed overhead).

When self-constructing an asset, two accounting issues must be addressed:

Overhead allocation to the self-constructed asset.

Proper treatment of interest incurred during construction.

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Under certain conditions, avoidable interest incurred on qualifying assets is

capitalized.

Under certain conditions, avoidable interest incurred on qualifying assets is

capitalized.

Interest that could have been avoided if the asset

were not constructed and the money used to

retire debt.

Interest that could have been avoided if the asset

were not constructed and the money used to

retire debt.

An asset constructed:

For a company’s own use.

As a discrete project for sale or lease.

An asset constructed:

For a company’s own use.

As a discrete project for sale or lease.

Interest Capitalization

GAAP limits the amount of interest capitalized to the lower of (1) Actual Interest or (2) Avoidable interest.

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Capitalization of interest begins when construction begins interest is incurred, and qualifying expenditures for assets

consturtion are incurred.

Capitalization ends when . . . The asset is substantially complete and

ready for its intended use, or when interest costs no longer are being

incurred.

Capitalization of interest begins when construction begins interest is incurred, and qualifying expenditures for assets

consturtion are incurred.

Capitalization ends when . . . The asset is substantially complete and

ready for its intended use, or when interest costs no longer are being

incurred.

Interest Capitalization

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Interest is capitalized based on Weighted Average Accumulated Expenditures

(WAAE).

Interest is capitalized based on Weighted Average Accumulated Expenditures

(WAAE).

Qualifying expenditures include labor, material

and overhead incurred on the construction project

during accounting period.

Qualifying expenditures include labor, material

and overhead incurred on the construction project

during accounting period.

Qualifying expenditures

weighted for the number of months outstanding during

the current accounting period.

Qualifying expenditures

weighted for the number of months outstanding during

the current accounting period.

Interest Capitalization= Average Accumulated Expenditures x interest rate

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If the qualifying asset is financed

through a specific new borrowing . . .

If the qualifying asset is financed

through a specific new borrowing . . .

. . . use the specific rate of the new

borrowing as the capitalization rate.

. . . use the specific rate of the new

borrowing as the capitalization rate.

If there is no specific new borrowing, and

the company has other debt . . .

If there is no specific new borrowing, and

the company has other debt . . .

. . . use the weighted average cost of other

debt as the capitalization rate.

. . . use the weighted average cost of other

debt as the capitalization rate.

Interest Rate used in Interest Capitalization

Operational Assets: Acquisition 29

Example - Interest Capitalization for Self-Constructed Assets Capitalization period: 1/2/x2 to 6/30/x3

Specific construction debt: $1,500,000 at 11% annual int. rate. This debt was borrowed on 9/30/x1 to finance the project.

Other debt during the construction period:

1. $4,000,000 at 12% annual int. rate.

2. $8,000,000 at 15% annual int. rate.

These loans have been outstanding since 1/1/x2.


Example (contd.) Weighted Average Interest Rate (of other debt):

Total interest = 480,000 +1,200,000 = 14%Total Principle 12,000,000

or 12% x 4,000,000 +15% x 8,000,000 = 14% 12,000,000 12,000,000

Expenditures on the construction during 20x2 and 20x3 were as follows: 1/2/x2 $800,000 7/1/x2 $1,000,000

10/1/x2 $600,0003/1/x3 $900,0006/1/x3 $1,800,000


Example (contd.) The amount of interest to be capitalized for 20x2:

Computing the Weighted-Average Accumulated Expenditures (WAAE):

1/2/x2 $800,000 x 12/12 = $800,000 7/1/x2 1,000,000 x 6/12 = 500,00010/1/x2 600,000 x 3/12 = 150,000 2,400,000 $1,450,000

Capitalized Interest (Avoidable Interest) for 20x2:$1,450,000 x 11% x 12/12= $159,5001

1.$1,450,000 < $1,500,000 11% int. loan borrowed specifically to finance the project


Example (contd.) Actual interest incurred in 20x2:

$1,500,000 x11% + $4,000,000 x 12% + $8,000,000 x 15% = $1,845,000.

Interest exp. = actual int. - capitalized int.

= $1,845,000 - 159,500

= $1,685,500


Example (contd.)

Journal entry to record the construction costs and interest expense for 20x2:

Building 2,559,5001

Interest Expense 1,685,500

Cash 4,245,000

1.construction costs of 20x2 plus the capitalized interest of 20x2 (2,400,000+159,500=2,559,500).


Example (contd.) The amount of interest to be capitalized for 20x3:

WAAE of 20x3:

1/1/x3 $2,559,500 x 6/6 =$2,559,5003/1/x3 900,000 x 4/6 = 600,0006/1/x3 1,800,000 x 1/6 = 300,000

$3,459,500 Capitalized interest for 20x3:

WAAE Int. Rate $1,500,000 x 11% x 6/12= $ 82,500 1,959,5001 x 14% x 6/12= 137,165 219,6651. 3,459,500-1,500,000


Example (contd.) Actual interest incurred in 20x3:

Same as in x2 = $1,845,000.

Int. exp. Of x3 = 1,845,000-219,665= 1,625,335

Journal entry to record the construction costs and int. exp. for x3:

Building 2,919,6651

Interest Exp. 1,625,335

Cash 4,545,000

1.$900,000 + 1,800,000 + 219,665 = 2,919,665 (costs of 20x3 plus the capitalized interest)


Example (contd.) Reporting:

Income Statement (for the year ended 12/31/x2) Other Revenues & Expenses:

Interest Expenses $1,845,000 Less: Capitalized Int. (159,500)

$ 1,685,500 Notes:Accounting Policy Capitalized interest: during 20X2, total interest

expense was $1,845,000 of which $159,500 was capitalized and $1,685,500 was charged to expense.

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Interest capitalization can distort trends

The income decline becomes larger once the distortion is removed.

Income will be even lower without capitalizing interest.

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Depreciation Methods

Depreciation Methods:( a) Straight-line method

( b) Double-declining balance ( c) Sum-of-the-years’ digits

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Depreciation method recap:Basic concepts The costs of productive assets must be apportioned to

the periods in which they provide benefits (matching principle).

Depreciation is not intended to track the asset’s declining market value but to allocate the cost over its economic life.

Depreciation

Amortization

Depletion

• Buildings• Equipment

• Intangibles

• Mineral deposits• Wasting assets

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Depreciation method recap :(a) Straight-line method example

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Depreciation method recap : (b) Double-declining balance example

Switch to straight-line method

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Depreciation method recap : (c) Sum-of-the-years’ digits example

= n(n+1)/2

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Compare depreciation methods:Alternative patterns

Compare Alternative depreciation methods

(a)

(b)

(a) Annual depreciation charges

(b) Net book value (carrying value)

Total depreciation expenses will be the same

Ending book values will be the same

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Depreciation:Methods used in financial reports

Straight-line is the most popular depreciation method for financial reporting purposes.

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On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of 5 years and estimated residual value of $5,000.

What is the annual straight-line depreciation?

On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of 5 years and estimated residual value of $5,000.

What is the annual straight-line depreciation?

Straight-Line

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Straight-Line

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Accumulated Accumulated UndepreciatedDepreciation Depreciation Depreciation Balance

Year (debit) (credit) Balance (book value)50,000$

1 9,000$ 9,000$ 9,000$ 41,000 2 9,000 9,000 18,000 32,000 3 9,000 9,000 27,000 23,000 4 9,000 9,000 36,000 14,000 5 9,000 9,000 45,000 5,000

45,000$ 45,000$

Residual ValueResidual Value

Note that at the end of the asset’s useful life, BV = Residual Value

Note that at the end of the asset’s useful life, BV = Residual Value

Straight-Line

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2

SYD depreciation is computed as follows:

Accelerated Methods : Sum-of-the-Years’ Digits (SYD)

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On January 1, we purchased equipment for $50,000 cash. The equipment has a service life of 5 years and an estimated

residual value of $5,000.

Using SYD to compute depreciation for the first two years.

On January 1, we purchased equipment for $50,000 cash. The equipment has a service life of 5 years and an estimated


Using SYD to compute depreciation for the first two years.

Sum-of-the-Years’-Digits (SYD)

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2

Use this in your computation of SYD Depreciation for Years 1 & 2.

Use this in your computation of SYD Depreciation for Years 1 & 2.

Sum-of-the-Years’ Digits (SYD)

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Accumulated UndepreciatedDepreciation Depreciation Balance

Fraction (debit) Balance (book value)50,000$

5/15 15,000$ 15,000$ 35,000 4/15 12,000 27,000 23,000 3/15 9,000 36,000 14,000 2/15 6,000 42,000 8,000 1/15 3,000 45,000 5,000

45,000$


Fraction (debit) Balance (book value)50,000$

5/15 15,000$ 15,000$ 35,000 4/15 12,000 27,000 23,000 3/15 9,000 36,000 14,000 2/15 6,000 42,000 8,000 1/15 3,000 45,000 5,000

45,000$ Residual ValueResidual Value


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Declining-Balance (DB) Methods

DB depreciation

Based on the straight-line rate multiplied by an acceleration factor.

Computations initially ignore residual value.

DB depreciation

Based on the straight-line rate multiplied by an acceleration factor.

Computations initially ignore residual value.

Stop depreciating when:

BV=Residual Value

Stop depreciating when:

BV=Residual Value

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DDB depreciation is computed as follows:

Note that the Book Value will get lower each time

depreciation is computed!

Note that the Book Value will get lower each time

depreciation is computed!

Double-Declining-Balance (DDB)

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On January 1, we purchase equipment for $50,000 cash. The equipment has a service life of 5 years and an estimated


What is depreciation forthe first two years using

double-declining-balance?

On January 1, we purchase equipment for $50,000 cash. The equipment has a service life of 5 years and an estimated


What is depreciation forthe first two years using

double-declining-balance?


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Year (debit) Balance (book value)50,000$

1 20,000$ 20,000$ 30,000 2 12,000 32,000 18,000 3 7,200 39,200 10,800 4 4,320 43,520 6,480 5 1,480 45,000 5,000

45,000$


Year (debit) Balance (book value)50,000$

1 20,000$ 20,000$ 30,000 2 12,000 32,000 18,000 3 7,200 39,200 10,800 4 4,320 43,520 6,480 5 1,480 45,000 5,000

45,000$


We usually have to force depreciation in thelatter years to an amount that brings BV = Residual Value.

We usually have to force depreciation in thelatter years to an amount that brings BV = Residual Value.

2,592

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Reporting Fixed assets –Carrying value

Define and measure carrying value

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Measuring the carrying amount:Carrying value = Original Purchase Price – Accumulated Depreciation There are two ways that long-lived assets could be

measured on balance sheets:

Expected benefit approach:

$$• Discounted present

value

• Net realizable value

Estimated value in an output market where the asset is sold

Economic sacrifice approach:

$$• Historical cost

• Replacement cost

Estimated value in an input market where the asset is purchased

GAAP uses historical cost because the numbers are reliable and verifiable.

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Measuring the carrying amount Assume a truck originally costing $100,000, is two years old, has a remaining life of 8 years, is

being depreciated on a straight-line basis, and is expected to have no salvage value.

Historical cost less accumulated depreciation is the carrying value reported on balance sheets:

$100,000 – {(100,000/10) *2} = $80,000 ( Carrying amount)

Carrying value = Cost – Accumulated Depreciation

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Assets held for sale When firms actively try to sell assets they own, the

asset groups should be classified on the balance sheet as “held for sale”.

When assets are held for sale, they are reported at the lower of book value or fair market value minus costs to sell.

$2,500,000$2,350,000

$46,000

$2,304,000

Book value Fair value Expected cost to sell

So, these assets would be shown on the balance sheet at $2,304,000.

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International perspective

In the U.K., companies are permitted to revalue land and buildings.

Suppose a building that originally cost ₤20 million and has an accumulated depreciation balance of ₤10 million is appraised at ₤35 million. The entry to write-up the building is:

And the new book value becomes:

DR Building £15,000,000DR Accumulated depreciation 10,000,000 CR Revaluation reserve £ 25,000,000

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Post-acquisition Expenditures

Identify the post-acquisition expenditures need to be capitalized or expensed.

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Post-acquisition Expenditures: Capitalize or Expense? GAAP capitalizes costs (i.e., record the

cost in an asset account) incurred after the asset has been placed in use as long as the expenditure: Extends the asset’s useful life Increases its productive capacity

(e.g. attainable production units) Increases its production efficiency

(e.g., fewer raw materials) Increases the asset’s other economic

benefits

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Post-acquisition Expenditures: Capitalize or Expense?

If there is no increase in economic benefits (or future service potential), the expenditure is charged to income as an expense.

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Post-acquisition Expenditures: Subsequent costs In January 2008 (three years later), Winger spent an

additional $8,000 on the machine:

$2,000

$6,000

Ordinary repairs and maintenance

Install new component

Expense to income statement: record as repair expenses.

Capitalize to balance sheet : Adding values into the asset accounts.

Increases the economic benefit (future service potential) of the machine.

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Expenditures Subsequent to Acquisition

Maintenance and ordinary

repairs.

Maintenance and ordinary

repairs.

Additions.Additions.

Improvements (betterments),

replacements, and extraordinary repairs.

Improvements (betterments),

replacements, and extraordinary repairs.

Rearrangements and other

adjustments.

Rearrangements and other

adjustments.

Normally we debit an expense account for amounts spent on:

Normally we debit the asset account for amounts spent on:

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Case Study: Impact of WorldCom’s Misapplication of Asset Capitalization Rules

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Asset Impairment

What asset “impairment” means and how it is recorded.

Operational Assets: Utilization and Disposition

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Asset Impairmentsa

Unlike inventory which is reported at LCM, PPE and Intangibles are reported at cost except for impairments.

An impairment occurs when the book value of an asset is not fully recoverable.

a. Based on SFAS No. 144: Accounting for the Impairment or Disposal of Long-Lived Assets and SFAS No. 142: Goodwill and Other Intangible Assets

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Impairment of Value

Accounting treatment differs.Accounting treatment differs.

Operational assetsto be held and usedOperational assetsto be held and used

Operational assetsheld to be sold

Operational assetsheld to be sold

Tangible andintangible with finiteuseful lives

Tangible andintangible with finiteuseful lives

Intangiblewith

indefiniteuseful lives

Intangiblewith

indefiniteuseful lives

GoodwillGoodwill

Operational Assets: Utilization and Disposition 72

Operational Assets Held for Use – a. Tangible Assets and Finite-Life Intangibles SFAS No. 144 (effective 2002) requires

test for impairment only when events or changes in circumstances indicate that the book value of this asset (or asset group) may not recoverable.

For the purpose of this test, assets are grouped at the lowest level in which the cash flows of each group are independent.


The Accounting Treatment for Impairment (for Held for Use Tangible and finite-Life Intangibles)

Steps:

1. Conduct the Recoverability Test.

2. Compute the Impaired Amount.

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Asset impairment:The impairment loss is the difference between the fair value of the asset and the carrying amount of the assetAccording to SFAS No. 144 Guidelines: Step 1: If the events or changes in circumstances

raised the possibility that certain long-lived assets may be impaired, go to step 2.

Step 2: Estimate the future undiscounted net cash flows expected from the use and disposal of the asset.

If the future undiscounted net cash flows are less than the carrying amount of the asset, the impaired asset must be written down.


Step 1: Conduct the Recoverability Test Compare the book value (BV) of the

asset with the undiscounted expected future cash flows (EFCF) of the asset (asset group).

If BV > Undiscounted EFCF, the impairment has occurred and the impaired amount should be written off.


Step 2: Compute The Impaired Amount

Impaired amount

= Book value - fair value

(if the fair value is available) or

Impaired amount

= Book value – estimated fair value1

(if fair value is not available)1. discounted present value of the future cash flows of the asset can be the estimated fair value

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Asset impairment:SFAS No. 144 guidelines

• Market value, price of similar assets, or PV of future net cash inflows.

Recoverable value

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Asset impairment: An Example

Solomon Corporation manufactures a variety of consumer electronics products. The growing popularity of DVD players is expected to reduce the demand for Solomon’s videocassettes. The videocassettes are produced on an assembly line consisting of five special purpose assets with a carrying amount (net book value) of $2,000,000. Solomon’s management believes that this change in the business climate threatens the recoverability of these assets’ carrying amount. Assume the current fair value of the entire assembly line is $1,000,000.

Impairment possible?

Undiscounted net cash flows expected

Are cash flows lowerthan carrying amount?

Impairment loss

a.

b.

c.

d.

Yes!

$1,500,000

The difference between the fair vale of the asset and the carrying amount of the asset.

2,000,000-1,000,000=1,000,000

Yes!

Expected net operating cash flows:

2005 $800,0002006 400,0002007 200,000Expected salvage value 100,000

Total undiscounted cash flows $1,500,000

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Disposition or retirement of long-lived assets

Disposition or retirement of long-lived assets.

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Suppose the asset in Exhibit 10.9 is sold at the end year 2 for $5,000 when its book value is $3,780. The entry to record this disposition is:

Dispositions of individual assets take place frequently, so gains and losses do not qualify for extraordinary item treatment.

Both original cost and accumulated depreciation must be removed from the balance sheet.

Disposition or retirement of long-lived assets

DR Cash $5,000

DR Accumulated depreciation 6,720

CR Long-lived assets $10,500

CR Gain on sale of assets 1,220

10-81

Obligations arising from retiring long-lived assets (SFAS No. 143)

Kali records the asset retirement obligation when the asset is placed into service:

This results in additional depreciation expense:

DR Drilling rig (asset retirement cost) $8,167,000

CR ARO liability $8,167,000

DR Depreciation expense $1,633,400

CR Accumulated depreciation-drilling rig $1,633,400

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Intangible Assets

Identify the various costs included in the initial cost of intangible assets.

10-83

Intangible assets:Overview

Intangible assets convey future benefits to their owners.

Examples of Intangible assets: Patents, Copyrights, Trademarks, Franchises and goodwill.

Characteristics of Intangible assets: Lack physical substance. Future benefits less certain than tangible assets. Owner with exclusive rights.

TrademarkPatent

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Costs to be Capitalized Intangible Assets

The accounting for acquired intangible assets is straight-forward: The asset is first recorded at the arm’s length

transaction price. Then amortized (think “depreciation”) over its

expected useful life. Difficult financial reporting issues arise when

the intangible asset is developed internally instead of being purchased.

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An exclusive right recognized by law and granted by the US Patent Office for 20 years.

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. R& D costs that lead to an

internally developed patentare expensed in the periodincurred.

An exclusive right recognized by law and granted by the US Patent Office for 20 years.

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. R& D costs that lead to an

internally developed patentare expensed in the periodincurred.

Patents

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Genetech, Inc. has developed a new device. Research and development costs totaled

$30,000. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal

registration fees.

What is Genetech’s patent cost?

Genetech, Inc. has developed a new device. Research and development costs totaled

$30,000. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal

registration fees.

What is Genetech’s patent cost?

Torch’s cost for the new patent is $3,000. The $30,000 R & D cost is expensed as

incurred.

Torch’s cost for the new patent is $3,000. The $30,000 R & D cost is expensed as

incurred.

Patents

87

A form of protection given by law to authors of literary, musical, artistic, and similar works.

Copyright owners have exclusive rights to print, reprint, copy, sell or distribute, perform and record the work.

Generally, the legal life of a copyright is the life of the author plus 70 years.

A form of protection given by law to authors of literary, musical, artistic, and similar works.

Copyright owners have exclusive rights to print, reprint, copy, sell or distribute, perform and record the work.

Generally, the legal life of a copyright is the life of the author plus 70 years.

Copyrights

88

A symbol, design, or logo associated with a business.

If internally developed, trademarks have no recorded asset cost.

If purchased, a trademark is recorded at cost.

Registered with U.S. Patent Office and renewable indefinitely in 10-year periods.

A symbol, design, or logo associated with a business.

If internally developed, trademarks have no recorded asset cost.

If purchased, a trademark is recorded at cost.

Registered with U.S. Patent Office and renewable indefinitely in 10-year periods.

Trademarks

89

A franchise is a contractual agreement under which the franchiser grants the franchisee the right to sell certain products or service or to use certain tradenames or trademarks

A license is a contractual agreement between a governmental body (i.e., city, state, etc.) and a private enterprise to use public prope

A franchise is a contractual agreement under which the franchiser grants the franchisee the right to sell certain products or service or to use certain tradenames or trademarks

A license is a contractual agreement between a governmental body (i.e., city, state, etc.) and a private enterprise to use public prope

Franchises and License

90

Occurs when onecompany buys

another company.

The amount by which thepurchase price exceeds the fair

market value of net assets acquired.

Only purchased goodwill is an

intangible asset.

Goodwill

Goodwill

91

Eddy Company paid $1,000,000 to purchase all of James Company’s assets and assumed James Company’s liabilities of $200,000. James Company’s assets were appraised at a fair value of $900,000.

Eddy Company paid $1,000,000 to purchase all of James Company’s assets and assumed James Company’s liabilities of $200,000. James Company’s assets were appraised at a fair value of $900,000.

Goodwill

92

What amount of goodwill should be recorded on Eddy Company books?

a. $100,000

b. $200,000

c. $300,000

d. $400,000

What amount of goodwill should be recorded on Eddy Company books?

a. $100,000

b. $200,000

c. $300,000

d. $400,000

Goodwill

10-93

Intangible assets:Research and development (R&D) Recoverability of R&D expenditures (i.e., the

future benefit) is highly uncertain at the start of a project.

So, SFAS No. 2 requires virtually all R&D expenditures to be expensed as incurred.

The FASB justified expensing all R&D for three reasons:1. The future benefits are highly uncertain and difficult to predict.

2. A causal relationship between current R&D and future revenue (the benefit) has not been demonstrated.

3. Whatever benefits may arise cannot be objectively measured.

94

Research Planned search or critical investigation aimed at discovery of

new knowledge . . .Development

The translation of research findings or other knowledge into a plan or design . . .

Research Planned search or critical investigation aimed at discovery of

new knowledge . . .Development

The translation of research findings or other knowledge into a plan or design . . .

Research and Development (R&D)

Accounting Treatment for R&D costs: R&D costs incurred under contract for other

companies are expensed against revenue from the contract.

Operational assets used in R&D should be capitalized if they have alternative future uses.

Accounting Treatment for R&D costs: R&D costs incurred under contract for other

companies are expensed against revenue from the contract.

Operational assets used in R&D should be capitalized if they have alternative future uses.

10-95

Intangible assets:Software development

SFAS No. 86 extends the accounting treatment for R&D to internal expenditures for software development.

Development expenditures $$

Development expenditures $$

Software project time line

Technological feasibility establishedExpensed as incurred

Capitalized and amortized

Befor After

10-96

Intangible assets:Purchased in-process R&D

When one firm buys another firm, the total purchase price must be apportioned among the individual assets acquired.

Managers have a strong incentive to allocate a large portion of the purchase price to purchased in-process R&D.

$500

$200

$250

In-process R&D (no alternative future use)

Other in-process R&D

Tangible assets

Immediately written off

Price paid for company

Allocation of purchase price

$950

97

Software Development CostsSFAS No. 86

All costs incurred to establish the technological feasibility of a computer software product are treated as R&D and expensed as incurred.

Subsequent costs to obtain product masters are to be capitalized as an intangible asset.

All costs incurred to establish the technological feasibility of a computer software product are treated as R&D and expensed as incurred.

Subsequent costs to obtain product masters are to be capitalized as an intangible asset.

“Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed”

98

Start ofR&D

Activity

TechnologicalFeasibility

Date ofProductRelease

Sale of Product

CostsExpensed

as R&DCosts

CapitalizedOperating

Costs

Software Development CostsSFAS No. 86

Software project time line

10-99

Intangible assets:Accounting in the United Kingdom Marketing and advertising expenditures are

treated as period costs. R&D accounting also similar to U.S. GAAP.

However, UK accounting rules allow companies to write long-lived assets up to a new higher carrying value when market value exceeds historical cost.

One firm decided to put a balance sheet value of $1.2 billion on its 60 trademarks (called “brands” in the UK).

100

Learning Objective

How analysts can adjust for different depreciation assumptions and improve

comparisons across companies

101

Depreciation Disclosures Depreciation. Balances of major classes of depreciable

assets. Accumulated depreciation by asset or in

total. General description of

depreciation methods used.

Depreciation. Balances of major classes of depreciable

assets. Accumulated depreciation by asset or in

total. General description of

depreciation methods used.

102

Financial analysis:Depreciation differences

103

When a company uses straight-line depreciation, the ratio of average gross PP&E divided by depreciation expense is a rough approximation of estimated useful life:

Financial analysis:Finding average useful life

104

Financial analysis:Average useful life at Wal-Mart and Costco

Using Costco’s estimated service life, Wal-mart’s depreciations expense would be:

$52.1

19 years$2.7 =

Compared to $3.1 billion reported depreciation expense

10-105

Wal-Mart and Costco Example (contd.) Therefore, had Wal-Mart used Costco’s

deprecation life, its earnings will be reduced by $400 million.

This adjustment process relies on many assumptions (i.e., both companies assets are similar and have similar lives and residual value, etc.)

If the assumptions are incorrect, this method will not result in correct adjustment.

106

Learning Objective

Learning ObjectiveLearning

How GAAP measurement rules complicate trend analysis and comparisons across companies

107

Financial analysis and fixed assets:ROA distortion example

Assume: No new capital

expenditures. Prices rise at 3% per year -

operating CF increases.

0%

5%

10%

15%

20%

25%

2005 2006 2007 2008 2009

Return on assets

ROA chart shows improving performance.

108

Financial analysis and fixed assetsWhy ROA appears to increase

Constant amount

each year

Increases 3% each year

Asset base declines

each year

109

Financial analysis and fixed assets:Rizzo Corporation

Assume: Long-lived asset age of

4.5 years. Capital expenditures

replace 10% of long-lived assets each year.

Prices rise at 3% per year.

0%

5%

10%

15%

20%

25%

2005 2006 2007 2008 2009

Return on assets

Same as CHEN

ROA no longer increases over time.

110

Financial analysis and fixed assetsWhy Rizzo’s ROA is flat

Capital expenditures

cause the increase

10-111

ROA distortion Example (contd.) Therefore, firms whose assets are

continually being replaced (i.e., Rizzo) cannot be easily compared to firms with aging assets such as Chen.

However, most firms do regularly replace some assets.

Therefore, when assets are regularly replaced, the average age of long-lived assets remains fairly constant from year to year.

10-112

ROA distortion Example (contd.) One of the reasons causing the distortion

on ROA analysis is the historical cost basis on depreciation of long-lived assets and the reporting of these assets on financial statements.

Within the same industry comparison of ROA is usually meaningful due to competition often leads firms to have similar investments and operating strategies (i.e., similar % increase in capital expenditures).

113

Summary The need for reliable and verifiable numbers causes

long-lived assets to be measured using historical cost. The balance sheet amounts for intangible assets often

differ from their real value. Changes in the amount of capitalized interest from one

period to another can distort earnings trends. When comparing return on assets (ROA) ratios across

firms, remember that ROA drifts upward as assets age.

Depreciation differences can complicate comparisons across firms. Footnote details can be used to improve these comparisons.

Documents

1 Chapter 10: Long-lived assets Learning Objectives 1.What measurement base is used for long- lived assets? 2.What kinds of costs are capitalized and