McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 16

Recording and Evaluating Capital Resource Activities: Investing

Operational investments

• Plant assets

• Natural resources

• Intangible assets

Because of the importance of operational investments, it is vital that we understand not only what these assets represent but also how companies record and report their acquisition, use and disposal

Plant Assets

• Often referred to as property, plant and equipment (PPE)

• The three steps to consider when describing the accounting process 1. acquisition 2. use 3. disposal

Acquisition

• Understand the difference between capital and revenue expenditures

• A capital expenditure creates the expectation of future benefit that apply beyond the current accounting period.---capitalize or add to the cost of the plant asset rather than expensing it immediately

• Revenue expenditure (expenses) provide benefit exclusively during the current accounting period ---- Annual repairs, maintenance, utility bills, taxes, day to day

operations

Assets

• Represent economic resources with expected future benefits become expenses as they are used up during construction ---all normal necessary costs incurred provide future benefits

• Capital expenditures include labor and material directly associated with construction --- permits, architects fees, taxes Also, indirect costs – wages paid to security guards,

insurance payments, interest on borrowed money. Once completed, it becomes revenue expenditures

allocation

• Page 451 example of allocation

Depreciation

• Expenses associated with using PPE is called depreciation—it reduces the company’s assets and owners equity that is used to generate revenue

• Depreciation Expense 200,000 Accumulated Depreciation 200,000

Equipment at cost 1,000,000

Less: accumulated depreciation (600,000)Equipment, Net $400,000

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What is the Cost of Property, Plant, and Equipment?• PPE is recorded as the total amount

required to obtain and get the asset ready for its intended use

• Last more than one accounting period• Purchase price• Sales Tax• Costs incurred to obtain (freight, etc.)• Cost incurred to setup (installation, etc.)

• Land, building, and equipment

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What are the Factors Affecting Depreciation Calculations?• Cost• Useful life---period of time over which a

business expects to obtain economic benefits or total number of units (total miles) Limited due to physical wear and tear or

obsolescence ---changing technology• Salvage value—residual value or fair

market value• Depreciation method—cost minus the

salvage value equals the depreciable value

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How is Depreciation Expense Calculated Using the Different Methods?• Straight-line

(Cost – salvage value)/Useful life (time) = annual depreciation expense

• Units-of-production (Cost – salvage value)/Useful life (units) =

depreciation rate Depreciation rate * annual usage = annual

depreciation expense Actual usage-benefit is tied to its use. More

accurate—match the amt of expense recognized with actual rates of usage.

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Depreciation Expense Calculated Using the Different Methods Continued

• Double-declining balance 2 * straight-line rate = DDB rate

DDB * carrying value = annual depreciation expense

Based on a constant percentage of declining balance. The multiplication of a constant rate by this declining balance yields the greatest amount of depreciation in the assets first year of use and a declining amount in each subsequent year.

Depreciation ceases when you reach salvage value

Exercise 1

• Exercise 1a) Buildingb) Supplies or supplies expensec) Investment in landd) Office equipmente) Maintenance expense

Exercise 2

a) Capital expenditureb) Revenue expenditurec) Capital expenditured) Capital expendituree) Revenue expenditure

Exercise 5

a) (59,000 – 5,000)/6 = 9,000 per yearb) (59,000 – 5,000)/45,000 = 1.20 per hour

1.20 * 8,000 hours = 9,600 year 11.20 * 7,500 hours = 9,000 year 2

c) SL rate 1/6 * 2 = 33.33% doubled straight line rate

59,000 * 33.33% = 19,665 year 159,000 – 19,665* 33.33%=13,110 year 2

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What if the Company Doesn’t Purchase (or sell) the Asset at the Beginning (or end) of the Year?

• Units-of-production Multiple the depreciation rate by the actual

usage• Straight-line or double-declining balance

Use the mid-year convention or count the time that the asset was in use

Midyear Convention

• Companies making numerous plant asset purchases and disposals spread out evenly during the course of the fiscal year frequently use the midyear convention, which reflects depreciation expense for each asset

• as if it were purchased or disposed of exactly halfway through the company’s fiscal year.

Illustration --- page 457

• PCs to Go, with a December 31 year-end, purchases its delivery truck in April 2010 and expects to dispose of it five years later in April 2015. Straight – line depreciation for each fiscal year of use would be as follows:

• Refer to page 457

Revision of Estimates

• A company originally assigns a useful life of seven years to a computer and, one year after the date of the purchase, realizes that it will have to replace the computer after a total of three year.

• When it becomes clear that they need to make an adjustment– do the following---

Revision of estimates

• Assume that on January 1, 2010, a company purchases and begins to use office equipment costing $12,000, with an expected useful life of 10 years and a salvage value of $2,000. Assuming the business uses the straight-line method of depreciation for the asset, accumulated depreciation at December 31, 2012, would be $3,000

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What is the Process Involved in Asset Disposals?• Record depreciation to date of disposal• Remove the cost of the asset (CR) and the

accumulated depreciation (DR) from the records

• Record the assets received (DR) if applicable

• Record the cash paid (CR) if applicable• Record the loss incurred (DR) if applicable• Record the gain (CR) if applicable

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How Can a Company Dispose of an Asset Before its Useful Life is Over?• Discard---it is necessary to record a loss at

the date of the disposal Discard equipment that cost 50,000 with a

40,000 of accumulated depreciation at the date of the last balance sheet. Must pay $1,000 to have it removed.

Assets = Liabilities + Owner’s Equity2,000 = 2,000Depreciation expense 2,000

Accumulated Depreciation 2,000

Problem continued

• After the entry is posted, the accumulated depreciation account will have a $42,000 credit balance (previous balance of $40,000 plus $2,000. Second, we must recognize the removal of the equipment (book value = $8,000) and cash:

• Assets = Liabilities + Owners Equity• (8,000) = (9,000)• (1,000)

Journal Entry

• Accumulated Depreciation 42,000• Loss on Disposal 9,000

Equipment 50,000 Cash 1,000

Sell

• SellMust be sold for equal, less than, or

greater than.Recall when more net assets are received

than are given up, a gain results. A loss results when fewer net assets are received than are given up.

Example

Cost of Asset $80,000Accumulated depreciation (60,000)through date of saleCarrying Value at date of sale $20,000

Assets = Liabilities + Owner’s Equity+20,000-20,000Selling for the same amount of net assets

Journal Entry

Cash 20,000Accum Dep 60,000

Equipment 80,000

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Exchange (Trade-In) Example

• We have a computer that originally cost $6,000 and has accumulated depreciation of $4,500. We will trade-in this computer for a new computer with a list price of $10,000. The computer company will give us a trade-in allowance of $2,000.

• Book value = $6,000 - $4,500 = $1,500.• Cash payment required = $10,000 - $2,000

= $8,000

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Trade-in Example Continued

• Computer received = $10,000Less assets given up = $9,500Gain = $500

• Entry:Computer (new) 10,000Accumulated depreciation 4,500

Computer (old) 6,000Cash 8,000

Gain 500

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What are Depletion and Amortization?• Depletion

The cost of a natural resource is allocated to expense

Typically, units-of-production method used• Amortization

The cost of an intangible asset is allocated to expense

Typically, straight-line method is used