Bus 78008 Long Lived Assets

7/31/2019 Bus 78008 Long Lived Assets

1/72

BUS780

Chapter 8

Long-Lived Tangible andIntangible Assets: The Source of

Operating Capacity


2/72

Long-Lived Tangible and Intangible Assets2

Long-L ve perat onaAssets

Long-lived operational assets include:

Tangible Assets: land, buildings, factory

plants, computers, machinery, etc. Intangible assets: patents, copyrights,

franchises, goodwill, organization costs, tradenames, trademarks, etc.

Natural Resources: oil and gas reserves,timber, mineral deposits.


3/72


Tangible Assets: Property,Plant and Equipment (PPE)

Tangible assets are productive assetsderiving their value from the use of them inoperations.

Tangible assets are:Assets used in operations (not for

resale).Long-term in Nature (Economic Life >

one year).Possess physical substance.$ must be material.


4/72


Intangible Assets

Assets --

a. with future economic benefits,b. no physical substance,

c. with high degree of uncertaintyconcerning the future benefit.


5/72


6/72


ect ves o t e apter(Contd.)

4. To learn the accounting treatment forasset impairment of long-lived assets.

5. To understand the accounting treatmentfor the disposition of long-lived assets.

i li


7/72Long-Lived Tangible and Intangible Assets

7

1. Expense Vs. CapitalizeExpenditures

s When an expenditure occurs, accountantshave to decide whether the expenditureshould be debited into an expenseaccount (expense) or to an asset account(capitalize).

s

If the expenditure is expensed, it becomesa period expense and will be deductedfrom the income of the current year.


8/72


9/72Long-Lived Tangible and Intangible Assets

9

Expense Vs. CapitalizeExpenditures (contd.)

s The Impact of expenditure capitalization:

x a. The expenditure will be recognized asan asset and will not reduce currentyears income.

x b. the cost allocation of the asset over thelife of the asset (i.e., depreciationexpense) will reduce future yearsincome.


10/72


Examples- WorldCom

WorldCom Inc. consistently met WallStreet's targets for earnings during 2000and the first three quarters of 2001. But the

company now says it improperlycapitalized $3.8 billion dollars of expensesto inflate profits, in what could be the

largest accounting fraud ever.(Wall Street Journal, 8/5/2002)


11/72


Improper Capitalization WorldCom (Contd.)

s According to Stickney and Weil (2006), theimpact of the improper capitalization of coststhat WorldCom paid to other carriers of the

telecommunication lines results in anincrease of earnings by $53.1 billion and$17.1 billion in 2000 and 2001, respectively.

s

The restated earnings of WorldComindicated a net loss of $48.9 billion and$15.6 billion for 2000 and 2001, respectively.


12/72

i li i


13/72


Improper Capitalization-Global Crossing (contd.)

"This is just another example of GlobalCrossing's methods of meeting its numbers,," said Paul Murphy, his attorney at O'Neill

Lysaght & Sun. Global Crossing also used swaptransactions (i.e., trading same amounts of

telecom capacity with another telecom corp.and recorded the trade as revenue and thecosts as capital expenditures).


14/72

A ti S d l


15/72


Accounting Scandals Delphi (WSJ, 3/7/2005)

According to Delphi, the company usedseveral improper accounting methodsduring this time. In some cases, itprematurely recognized revenue fortechnology contracts and rebates whenit should have spread them over the life

of the contract.

A ti S d l


16/72


Accounting Scandals Delphi (Cont.)

Other times it improperly capitalizedexpenses over time, rather thanrecognizing them immediately. It alsoboosted cash flow from operations andpretax earnings by claiming it soldassets and inventory that it had actually

agreed to buy back later.


17/72


rea men o xpen ureswith Potential Long-TermBenefit Acquired Externally

Tangible Intangible

Land, Building Patent (a) (Merck, expl. 6)

Equipment (asset) Copyright (a)

Goodwill (a)

Trade name (a)

Proved technologies (a)

In-Process technologies (e)a = asset; e = expense (Merck, expl. 9 on p370)(source: figure 8.3 of textbook)


18/72


rea men o xpen ureswith Potential Long-TermBenefit Acquired Internally

Tangible Intangible

Self-Constructed Research and Develop-

Land, Building ment (e)(Merck, example 7)

Equipment (asset) Software Development cost:

Pre-tech. Feasibility (e)

Post-tech. Feasibility (a)

(Microsoft, expl. 8 on p370)a = asset; e = expense(source: figure 8.3 of textbook)

t P t P t


19/72


. ost o Property, P antand Equipment

s At acquisition, PPE is recorded at theacquisition cost. At the end of period,

PPE is also reported at cost.s Acquisition cost includes the purchase

price and any costs necessary to bringthe asset to the location and conditionfor its intended use.


20/72


Cost of PPE (contd.)

s PPE (except for land) is subject todepreciation.

s

Depreciation is a process of costallocation, not a process of assetvaluation.

s

If the acquisition cost or the self-constructed cost is greater than the marketvalue at time of delivery, Lower of cost ormarket is applied (see Wal-Mart, expl. 5 onp370).


21/72


Determination ofAcquisition Cost

x Cost of Land

x Cost of Buildings

x Cost of Equipment

x Cost of Self-Constructed Assets

Cost of Land


22/72


Cost of Land(held for operation, not for

resale)s Any cost occurred before the land isready for its intended use should be

capitalized as cost of land.


23/72


Cost of Land (contd.)

s Cost of land includes:1. Purchase price.2. Title search fee.

3. Closing fee.4. Clearing fee.5. Back property taxes (unpaid by previous

owner).

6. Net razing cost of an old building.7. Land improvements with unlimited

(permanent in nature) life.(landscaping, pavements, street lights,etc.)

8. Assessment by city for drainage project.


24/72


25/72


Cost of Equipment

s Any cost occurred to acquire and tobring the equipment to the location and

condition for its intended use.

ost o Equ pment


26/72


ost o Equ pment(contd.)

s Cost of Equipment includes:1. purchase price,2. freight-in,

3. insurance in transit, and4. foundation cost, installation cost, cost of

test runs and assembling cost.

s Not including: Cash discount lost,unnecessary storage cost and haulingcharges from storage for delivery ofequipment.

Examp e 1 on p 7 o


27/72


Examp e 1 on p 7 othe textbook

s General Motors incurs the following costs insearching and acquiring the land andbuilding:

1. Purchase price of land and building, $1,000,000.

2. Fees paid to lawyers related to the purchase,$10,000.

3. Transfer taxes paid to the city, $2,000.

4. Salaries earned by management personnelduring the search for the site and thenegotiation of its purchase, $8,000.


28/72


Example (contd.)

5. Operating expenditures for companyautomobiles used during the search, $75.

6. Depreciation charges for company automobilesused during the search, $65.

7. Fees paid to engineer for a repot on thestructural soundness of the building, $15,000.

8. Uninsured costs to repair automobiles damagedin an car accident during the search, $3,000.

9. Profits lost on sales the company failed to makebecause, during the search, management paidinsufficient attention to a potential newcustomer, $20,000.


29/72


Example (contd.)

s What is the cost of land and Building?x Cost of both land and building: items 1 to

6

x Cost of building: item 7x Items 8 and 9 ?

s Cost of both land and building should be

allocated to cost of land and cost ofbuilding, respectively, based on the relativemarket value of land and building.

Cost Allocation of a Lump


30/72


Cost Allocation of a LumpSum Purchase An

ExamplesA building and land were purchased at$100,000. The market value of buildingand land was $30,000 and $90,000,

respectively.Building 25,0001

Land 75,000

2

Cash 100,0001. 30,000/(30,000+90,000)=25%,

25%x100,000 = 25,000

2. 90,000/(30,000+90,000)=75%,


31/72


Cost of Self-Constructed(S-C) Assetss Cost of self-constructed assets includes:

1. direct materials,

2. direct labor,3. factory overhead (variable overhead

and fixed overhead).

Interest osts Dur ng


32/72


Interest osts Dur ngConstruction

s Background of SFAS No. 34 (effective in1979)

s Only capitalize the interest on fundsborrowed for construction.

Interest osts Dur ng


33/72


Interest osts Dur ngConstruction (contd.)

s Interest can only be capitalized forqualifying assets which must meet thefollowing criteria:

1. Assets are constructed for firms ownuse or constructed as discrete projectsfor sale or lease to others (i.e., ships,

real estate developments).2. Capitalization will make a difference on

the earnings per share.


34/72


35/72


capitalization for self-constructed asset

The labor, material and overhead totaled$2,400,000 for the construction of abuilding in 2006. In addition, during

20X6, total interest expense was$1,845,000 of which $159,500 wascapitalized as the cost of the self-

constructed building and $1,685,500 wascharged to expense.


36/72


Example (contd.)

Journal entry to record the constructioncosts and interest expense for 20x6 is:

Building 2,559,500Interest Expense 1,685,500

Cash 4,245,000


37/72


Example (contd.)

Reporting:Income Statement

(for the year ended 12/31/x6)Other Revenues & Expenses:

Interest Expenses $1,845,000Less: Capitalized Int. (159,500)$ 1,685,500

Notes:Accounting PolicyCapitalized interest: during 20X6, total interest

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

Acqu s t on ost or


38/72


Acqu s t on ost orIntangibles

Acquisition cost plus any other costs thatare necessary to make the intangibleassets ready for the intended uses (i.e.,purchase price, legal fees,)

x If intangible assets are developed

internally, all the R&D costs areexpensed.


39/72


.Lived Assets Over the Lifeof the Assets A firm consumes the services of long-lived

assets to generate revenue, the cost of theseassets should be expensed over time to match

the revenue generated (in compliance with thematching principle).

The process of allocating the depreciable cost

(cost the salvage value) of assets over theestimated economic life is called depreciation(amortization) for tangible (intangible) assets.

i d h if


40/72


Lived Assets Over the Lifeof the Assets (contd.) For intangible assets, the salvage value is

zero. For tangible assets, the salvage value

could be either positive, zero or evennegative (i.e., dismantling a nuclear power

plant).

Deprec at on an


41/72


Deprec at on anEarnings Quality

The estimation of service life and salvagevalue is at the discretion of managers (seethe case of Waste Management on p378).

The choice of depreciation method is alsoat the discretion of mangers.

Earnings would be affected when different

depreciation methods or differentestimates were used.

Depreciation Methods


42/72


Depreciation Methods(For Financial Reporting

Purposes)1. Time-based methods (time-based)a. Straight-Line.b. Sum-of-the-Years-Digits (SYD).

c. Declining-Balance.2. Activity-based method (activity-based)

x

Unit-of-Production.Note: SYD and Declining balance methods areaccelerated depreciation Methods.


43/72


Straight-Line Method

s Cost is allocated evenly through the life of theP.P.E.

s Example 1:Machine costing $10,000 was

purchased on 1/1/x1. The estimated residualvalue of the machine is $2,000 and theestimated life of the machine is 4 years.

Depreciation Expense per year:($10,000 - 2,000)/ 4 = $2,000

12/31/x1 Depreciation Expenses 2,000Accumulated Depreciation 2,000


44/72


Straight-Line Method(contd.)

s Example 2 (partial year depreciation): Using theinformation in example 1, except that the machinewas purchased on 3/11/x1 rather than 1/1/x1.

Depreciation Expense of year x1 ==>[($10,000-2,000)/4] x (10/12) = $1,667

Year Depr. Exp Acc. Depr.x1 1667 (10 months) 1,667

x2 2000 (12 months) 3,667x3 2000 (12 months) 5,667x4 2000 12 months) 7,667x5 333 (2 months) 8,000

um-o -t e-Years-D g ts


45/72


um-o -t e-Years -D g ts(SYD)

s Example :Machine costing $10,000 waspurchased on 1/1/x1 with an estimated residualvalue of $2,000 and an estimated life of 4years.

Depr. **BookValueYear*Depr. Base Fraction Expense at the end

x1 $8,000 4/10 $3,200 6,800x2 $8,000 3/10 $2,400 4,400x3 $8,000 2/10 $1,600 2,800x4 $8,000 1/10 $800 2,000

* Depr. Base= Cost - Residual Value

Dec n ng-Ba ance


46/72


Dec n ng-Ba anceMethod

s Depreciation Exp.= constant rate bookvalue at the beginning of the period

xResidual value is not considered in thecomputation.

xAssets cannot be depreciated below theresidual value.

xThe constant rate is expressed as afunction of a straight-line annualdepreciation rate.

Do ble Declining


47/72


Double Declining-Balance Methods Example : Machine costing $10,000

purchased on 1/1/x1, with a residualvalue of $2,000 and an estimated life of4 years. A double declining-balancemethod is used to depreciate themachine. Thus, the constant rate is

twice of the S-L Depr. Rate (2 x 25% =50%).

Double Declining Balance Method


48/72


Double Declining-Balance Method

Example (contd.)Book Value

of Assetat Beg. of Constant Depr. Book Value

Year the Year Rate Exp. At the End

x1 $10,000 50% $5,000 $5,000x2 $5,000 50% 2,500 2,500x3 $2,500 50% 500* 2,000*

x4 2,000 50% 0 2,000*Assets cannot be depreciated below the residual value.

A C i f


49/72


A Comparison ofDepreciation Methods

Assuming expected life = 4 years

1. Straight-Line Method2. S-Y-D Method

3. Declining-Balance Method

Ye

ar

Depreciation

Expense1

23

Income Tax Depreciation:


50/72


Income Tax Depreciation:MACRSsModified Accelerated Cost Recovery System

(MACRS) is used to compute taxdepreciation expense for assets purchasedin or after 1987.

s MACRS was enacted by Congress in the TaxReform Act of 1986. Assets are classified in8 property classes.

s A specified GAAP depreciation method isused in computing the depreciation expensefor all classes (i.e., for a 3-year life PPE,DDB is used).


51/72


52/72


Rate (Contd.)

Re-covery 3-year 5-year 7-year10-year 15-year 20-yearYear (200% DB) (200% DB) (200% DB)(200% DB) (150% DB) (150% DB)10 6.55 5.90 4.461

11 3.28 5.91 4.46212 5.90 4.46113 5.91 4.46214 5.90 4.46115 5.91 4.462

16 2.95 4.46117 4.46218 4.46119 4.46220 4.461

21 2.23152

Amort zat on o


53/72


Amort zat on oIntangibles

s Amortization: a cost allocation ofintangibles with finite lives (i.e., patents,copyrights) over the estimated life of

intangibles.s Current Practice: to amortize over the

shorter of the legal or useful life, not to

exceed 40 yearss No amortization fortrade names,

trademarks and goodwill.

Amortization Method


54/72


Amortization Method

s Straight-line method (unless thecompany can prove other methods aremore appropriate)

s Residual value is, in general, zero andpartial year amortization applied

s Journal entry for amortization:

Amortization Expense xxxIntangible Asset xxx(i.e., patents).

A Summary of


55/72


A Summary ofAmortization ofIntangibles

Intangible Assets

1. Patents

2. Copyrights

3. Trade Names &Trademarks

4. Franchises orLicenses5. Organization

Costs6. Goodwill

Legal Life

20

Life of creator

+ 70 years

Unlimited

ContractualagreementsUnlimited

Unlimited

Amortization

The shorter of useful orlegal life

The shorter of useful or

legal life not to exceed 40yearsNone

Same as copyright

5 - 10 years

None

Impact of New Information on


56/72


Impact of New Information onLong-Lived Assets-Changes InDepreciation Estimate

s Accounting treatment: no retroactiveeffect and make no adjustment for the

past years misstatement. Spread theremaining undercoated balance (i.e., thebook value) less the revised (new)

residual value over the revised (new)estimate of the remaining life of theassets.

Examp e: -L Depr.


57/72


Examp e: L Depr.Method)

s Machine costing $10,000 acquired on1/1/x1. Revised

Estimates Estimateson 1/1/x1 on 1/1/x3

Residual value $2,000 $1,000

Life 4 years 5 years

Example: (Contd )


58/72


Example: (Contd.)

Year Depr. Exp Acc. Depr Book Value

x1 $2,0001 2,000 8,000

x2 $2,0002

4,000 6,000x3 $1,667 5,666.7 4,333.3

x4 $1,667 7,333.4 2,666.6

x5 $1,667 9,000.1 1,000

1. (10,000-2,000)/4 = $2,0002. (6,000-1,000)/(5-2) =1666.7

New Information -Additional


59/72


New Information AdditionalCosts Subsequent toAcquisitions Basic principle for capitalization of these

costs:Capitalize the cost if it can:

a. extend the life of the existing asset, orb. increase the service quality of the

existing asset, or

c. increase the productivity of the existingasset (including the reduction of unitcost).

Otherwise, expense the cost.

os s u sequen o


60/72


os s u sequen oAcquisition

(contd.)s Types of costs occurred subsequentto acquisition:

a. Additionsb. Improvements, Replacements

c. Rearrangement and Reinstallation

d. Repairs

e. Maintenance

4. Impa rment o Long-


61/72


4. Impa rment o LongLived Assets

s PPE and Intangibles are reported at costexcept for impairments.

s An impairment occurs when the book value(cost accumulated depreciation) of anasset is not fully recoverable.

Operational Assets Held for


62/72


Ope a o a sse s e d oUse Tangible Assets and Finite-LifeIntangibles (Patents, etc)

s GAAP requires test for impairment onlywhen events or changes incircumstances indicate that the bookvalue of this asset may not recoverable.

The Accounting Treatment


63/72


gfor Impairment(for Held for UseTangible and finite-Life Intangibles)

Steps:

1. Conduct the Recoverability Test.

2. Compute the Impaired Amount.


64/72

tep : ompute T e


65/72


tep : ompute T eImpaired Amount

s Impaired amount= Book value - fair value(if the fair value is available) or

s Impaired amount= Book value estimated fair value1

(if fair value is not available)

1. discounted present value of the future cash flowsof the asset can be the estimated fair value

Wr te t e Impa re


66/72


Wr te t e Impa reAmount

s Recognition of Impairment Loss:

Loss on Impairment1 $$$$$

Accumulated Depre. $$$$$

1. Reported as part of income from continuingoperations, not extraordinary losses.

Impairment (contd )


67/72

Long-Lived Tangible and Intangible Assets 67

Impairment (contd.)

s After the write off, the fair value (or theestimated fair value if fair value is notavailable) becomes the new cost base

for depreciation.s No restoration of impaired loss is

allowed for tangibles and finite-lifeintangibles assets held for use.

Impairment (contd )


68/72


Impairment (contd.)

s Disclosure Requirements of impairmentloss:

1. A description of the impaired asset or asset

group.2. The facts and circumstances leading to the

impairment.

3.The amount of the loss.4.The method used to determined the fair

value.

Impairment: Assets Held


69/72


Impairment: Assets Heldto Be UsedAsset Type When to Test Impair. TestTangible andIntangible withfinite life

Events indicateBV notrecoverable

Two-Step:

1. BV > EFCF

2. BV - FV

Intangible(indefinite, excludinggoodwill)

Goodwill

Annually or moreoften

Annually or moreoften

One-Step:

BV FV

1.BV (reporting unit) >FV

2. BV of goodwill implied FV

. ,Plant and Equipment- Sold


70/72


Plant and Equipment- Soldfor Cash

sExample:

A building costing $300,000 withaccumulated depreciation of $200,000 was

sold for $70,000. The journal entry torecord the transaction is:Cash 70,000

Accu. Depre. 200,000Loss 30,000

Building 300,000


71/72

,and Equipment Exchange of


72/72

and Equipment Exchange ofAssets

Cost of old asset =$20,000Book value of old asset = 6,000Fair value of old asset = 4,000Fair value of new asset = 9,000

New Asset 9,000

Acc. Depr. 14,000

Loss onDisposal of ass. 2,000

Old ass. 20,000Cash 5 000

Documents

Bus 78008 Long Lived Assets