Intermediate Accounting

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1 Intermediate Accounting Thomas H. Beechy Schulich School of Business, York University Joan E. D. Conrod Faculty of Management, Dalhousie University PowerPoint slides by: Bruce W. MacLean, Faculty of Management, Dalhousie University

2 Introduction The emphasis in this chapter is on tangible capital assets such as buildings, equipment, furniture, and vehicles. Purchased intangible assets, including purchased goodwill, subscription lists, trademarks rights, and franchise rights. Assets are defined as elements that have the capacity to contribute directly or indirectly to future net cash flows of the entity by helping to generate revenue. Capital assets involve risk for an entity: money has been invested in these assets, and they ll only generate a return over time sometimes lengthy periods of time. Capital assets often constitute the largest single asset category for corporations, and a major source of the business risk that stakeholders assume.

3 Definition Of Capital Assets Capital assets can be defined as the identifiable long-lived assets that have been acquired for use in the revenue producing activities of the enterprise. There are five important aspects of this definition: they are assets in the general meaning of the term and the enterprise has the rights to their productive use; the assets are long-lived, that is, they last more than one year; they have been acquired by purchase or donation; they are separately identifiable, even if they have been acquired in a basket purchase of several (or many) assets, such as in a business combination; and they are used in generating revenue, but they are not themselves sold to generate revenue.

4 Valuation Of Capital Assets Capital assets are normally recorded at cost. Cost is usually the fair value at the date of purchase. As time passes, the fair value of the asset will change as the price for a comparable asset changes in the market, due to changes in technology and supply and demand forces. Also, the asset itself becomes used; consumed in operations. Historical cost financial statements do not attempt to reflect the current value of capital assets, just the sacrifice made to acquire them. Cost is the amount of consideration given up to acquire, construct, develop, or better a capital asset [including] all costs directly attributable to the acquisition, construction, development or betterment of the capital asset including installing it in the location and in the condition necessary for its intended use. [CICA ]

5 EXHIBIT 10-1 Buildings Common capitalization practices Buildings, purchased Buildings, self constructed purchase price legal fees, closing costs cost of modifications, if any Buildings, constructed architectural fees payments to contractors cost of permits excavation costs legal fees, closing costs direct construction costs excavation costs reasonable apportionment of overhead legal costs, permits, etc. interest on specific construction loans

6 EXHIBIT 10-1 Machinery and Equipment Common capitalization practices invoice cost, net of discounts, whether taken or not taxes, freight and duty special platforms, foundations, other required installation costs costs of building modifications necessary for specific installation

7 EXHIBIT 10-1 Common capitalization practices Industrial Design Registrations (i.e., a five-year renewable registration of the shape, pattern, or ornamentation of a manufactured item) acquisition and registration cost, as per patents, above successful defence costs, as per patents, above

8 EXHIBIT 10-1 Common capitalization practices Copyrights acquisition and registration cost, as per patents, above successful defence costs, as per patents, above Trademarks and Trade Names legal and other necessary documentation costs to register the patent, if self-developed acquisition cost, as per patents, above successful defence costs, per patents, above

9 EXHIBIT 10-1 Common capitalization practices Franchise Rights initial franchise fees, not related to annual volumes legal fees, closing costs Leasehold Improvements (alterations, improvements or refurbishing of leased space) invoice, installation costs

10 EXHIBIT 10-1 Common capitalization practices Organization Costs legal, accounting, promotional, and clerical activities associated with creating a new company Share Issuance Costs printing share certificates and related items, professional fees, commissions paid for selling capital stock, and the costs of filing with securities commissions

11 Exhibit 2 Vita Life Company (Click below to expand) EXHIBIT 10-2 Example of Cost Classification: Vita-Life Company Vita-Life Company recently acquired several plant assets and began construction on a building. The costs incurred by Vita-Life are classified into the indicated accounts. Account Debited Cost Incurred Equipment Land Invoice price of equipment $50,000 3% cash discount not taken on equipment purchase -1,500 4% sales tax on equipment 2,000 Building under Construction* Land Improvmts. Current Period Expense Insurance and freight costs on equipment purchase 600 Cost of land parcel $100,000 Commission and title insurance on land purchase 7,000 Setup, testing, and practice runs on equipment 2,000 Cost to train employees on equipment 500 Interest on debt incurred to purchase equipment 1200 Cost to remove structures from land 30,000 Proceeds on materials salvaged from structures removed -2,000 Excavation of foundation $3,500 Surveying and grading 12,000 Concrete and labour for foundation 26,000 Property tax paid four months after acquisition of land 550 Asphalt for parking lot $11,000 Fencing for property 6,000 Asset ending account balance $53,100 $147,000 $29,500 $17,000 * Reclassified to building account on completion. ** Finance expense.

12 Determining The Cost Of Capital Assets Lump-Sum Purchase Of Several Assets Several assets are acquired for a single lump-sum price: to encourage sale (lump sum less than individual prices). the assets are attached, for example, land and building. This type of acquisition, called a basket, group, or lump-sum purchase The portions of the lump-sum price directly attributable to particular assets in the group are assigned in full to those assets. Land appraisal costs are assigned only to the land account. Allocation of the remaining lump-sum price to each asset is necessary. Under the cost principle, the sum of the individual asset account balances at acquisition is limited to the lump-sum price.

13 Donated Assets Governments, shareholders, and other parties occasionally donate assets and services to corporations. For example, municipalities donate land and buildings to induce a company to locate in a particular area. Shareholders may donate original paintings to adorn the corporate boardroom. Current practice in Canada is to record the (DEBIT) asset at its fair value (CREDIT) a shareholders equity contributed capital account (owners' equity). Depreciation based on the market value of the donated asset is matched against future revenue presumably generated by the assets. The expected cost of complying with restrictions imposed by the donor should be estimated and deducted from the market value of the asset.

14 Government Assistance Assets are often acquired with monetary assistance from various levels of governments. This may be in the form of a specific government grant, which may require the firm to maintain certain employment levels or pollution control levels. If the conditions of the assistance are not met, the firm may be required to refund the amounts received to the granting agency. Governments may give a money grant to a firm. Very commonly, government assistance takes the form of an investment tax credit, which reduces the amount of tax otherwise payable based on a set percentage of eligible capital expenditures for a period.

15 Self-Constructed Assets Companies sometimes construct plant assets for their own use. For example, suppose a utility employs its personnel to extend transmission lines and construct pipelines. All costs directly associated with the construction are capitalized to the constructed asset. These costs include incremental material, labour, and overhead costs. Overhead includes general costs not directly related to production, such as utility costs, maintenance on equipment, and supervision.

16 Intangible Assets Intangible assets are similar to tangible capital assets in that their cost is capitalized, and they are later subject to systematic and rational amortization. Legal fees are a major component of cost, as it can be a long and expensive process to register some of these intangibles. It s interesting to note that legal fees for successful defense of these assets are to be capitalized.these lawsuits clearly establish property rights over the intangible asset. Conversely, unsuccessful lawsuits result in cost recognition and usually mean that any remaining balance in the intangible asset account must be written off the asset isn t worth anything if it can t be defended!

17 Share Issue Costs Expenditures associated with issuing capital stock are called share issuance costs. Such costs include printing share certificates and related items, professional fees, commissions paid for selling capital stock, and the costs of filing with securities commissions. Share issuance costs, as opposed to organizational costs, are often accounted for as an offset to the issuance price of the capital stock to which they relate, or as a reduction to retained earnings. Sometimes, though, they appear as an intangible asset, although they aren t used in production or operations and are more technically a deferred charge. Fortunately, they re rarely material in amount.

18 Disposals Of Capital Assets The disposal of capital assets may be voluntary, as a result of a sale, exchange, or abandonment, or involuntary, as a result of a casualty such as a fire, storm, or by government action, such as expropriation.

19 Disposal By Donation Corporations occasionally donate assets to other organizations. Computer manufacturers donate computing equipment to universities, for example. In this event, the donor recognizes a contribution expense equal to the market value of the donated asset, since market value represents the sacrifice made by shareholders. If the assets donated are capital assets, then a gain or loss equal to the difference between book value and market value is recorded on donation. Normally, an expense and a payable are recognized when an unconditional promise to donate the asset is made; recognition need not be delayed until the asset has been physically transferred.

20 Exchanges Of Non-Monetary Assets Capital assets are often exchanged for other non-monetary assets. Remember that monetary assets are those whose value is fixed in terms of dollars, like cash and receivables. Non-monetary assets, such as inventory and capital assets, do not have a value fixed in terms of dollars. Valuation of the acquired asset is the substantive issue in non-monetary asset exchanges. This valuation determines whether a gain or loss is recognized. Nonmonetary transactions are:...exchanges of non-monetary assets, liabilities or services for other non-monetary assets, liabilities or services with little or no monetary consideration involved. [CICA ]

21 Exchange Of Similar Non-Monetary Assets It often happens that one non-monetary asset is exchanged for a similar asset, and a small (e.g., less than 10%) cash amount is included to even things up. The CICA Handbook defines similar assets as:...assets of the same general type, which perform the same function and are employed in the same line of business. [CICA ] If similar assets are exchanged, should a gain or loss be recognized? Has anything, in fact, changed? Remember that capital assets are meant to generate wealth over a period of years, recapturing their capital cost and providing returns to shareholders through operations. If a firm has an apartment building, and swaps it for a similar apartment building and a little bit of cash, are shareholders really in a different position?

22 Fair Market Value Determination Where do fair value quotations come from? Sometimes there are quoted cash prices from suppliers of new and used assets. When a quoted cash price is unavailable, a company can invite bids for the asset to be exchanged. The highest bid for the asset in question is used as the market value. However, this approach is not always appreciated by the companies who invest time and energy submitting quotes, only to discover that the asset wasn t really to be sold! A less reliable but commonly used alternative is published information on the average price of specific used assets, such as the Kelley Blue Book Auto Market Report for automobiles. Appraisal is another commonly used approach, but appraisals are notoriously subjective. In the absence of a reasonably determinable market value for either asset, the valuation of the acquired asset is based on the book value of the asset transferred, adjusted for any cash paid or received.

23 Post-Acquisition Expenditures After acquisition, many costs related to capital assets are incurred. Examples include repairs, maintenance, betterments, and replacements. Expenditures that increase the original useful life or productivity of an asset (the quantity or quality of service) above the original level estimated at acquisition are capitalized. A capitalized post-acquisition expenditure is depreciated over the number of periods benefited, which can be less than the remaining useful life of the original asset. Significant post-acquisition expenditures fall into four major categories: Maintenance and ordinary repairs. Betterments. Additions. Rearrangements and other adjustments.

24 Maintenance And Ordinary Repairs Maintenance expenditures include lubrication, cleaning, adjustment, and painting, incurred on a continuous basis to keep plant assets in usable condition. Ordinary repair costs include outlays for parts, labour, and related supplies that are necessary to keep assets in operating condition but neither add materially to the use value of assets nor prolong their useful life significantly. Ordinary repairs usually involve relatively small expenditures. Most expenditures made on capital assets are repairs, and expensing is the norm. Keep this in mind as a rule of thumb - capitalization may look too tempting at times!

25 Betterments A betterment is the cost incurred to enhance the service potential of a capital asset. It often involves the replacement of a major component of a capital asset with a significantly improved component. The asset should be able to deliver enhanced cash flows to the firm (better), either through more revenue (higher quality output, more service hours per day, or a longer life) or through reduced operating costs. Then, the betterment has status as an asset and capitalization is warranted. Otherwise, the expenditure is a repair. Repairs are the norm, betterments are the exception. Betterments may be replacements or renewals. A replacement is the substitution of a major component of a plant asset with one of comparable quality. Renewals involve large expenditures, are not recurring in nature, and usually increase the utility or the service life of the asset beyond the original estimate.

26 Additions Additions are extensions, enlargements, or expansions of an existing asset. Additions represent capital expenditures and are recorded in the capital asset accounts at cost. Related work on the existing structure, such as shoring up the foundation for the addition or cutting an entranceway through an existing wall, is a part of the cost of the addition and is capitalized. If the addition is an integral part of the older asset, its cost (less any estimated residual value) is normally depreciated over the shorter of its own service life or the remaining life of the original asset. If the addition is not an integral part, it is depreciated over its own useful life. Many firms retrofit production facilities with pollution control equipment to comply with laws and court orders. When the cost of antipollution devices exceeds the cost of the polluting assets, the devices are capitalized separately and depreciated as plant additions.

27 Presentation And Disclosure The AcSB recommends disclosure of the cost of each major category of capital assets and the related accumulated amortization [CICA ]. This segregation by major category is important, as the various categories of capital assets are associated with different levels of business risk and may have dissimilar useful lives and amortization policies. Typically, capital assets are shown as one net amount on the balance sheet, or perhaps two net amounts, one for tangible assets and one for intangibles. The required breakdown is usually shown in the notes.

28 Cash Flow Statement Investments in capital assets are shown as investing activities on the cash flow statement, provided that the acquisition is for cash. If a capital asset is acquired in a non-cash transaction, the investment may be reported in the notes to the financial statements if the transaction was substantial, but it would not be reported as part of the cash flow statement because no cash was involved. If cash was only part of the consideration to acquire a capital asset, then only the cash portion will be shown.

29 International Perspective Accounting for acquisition costs of tangible capital assets is similar around the world. In general, accounting practice in all countries is to capitalize the initial cost of the asset and any expenses necessary to prepare it for use. There is substantial variation in practice relating to intangible assets, however. The U.S.A., Australia, and Germany prohibit the capitalization of any research and development costs, while Spain and Switzerland permit capitalization of all types of such costs. The capitalization of other self-generated intangibles, such as patents and trademarks, is forbidden in Austria, France, Germany, Sweden, and Switzerland; it is required in Spain and by the International Accounting Standards; and it is allowed in many other countries. Goodwill is also subject to widely varying practice. Recognition of purchased goodwill is usually permitted, but is required only in Canada, Spain, Sweden, and U.S.A. Recognition of self-generated goodwill is generally forbidden, as it is in Canada.

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