Long-Lived Assets. 1. How the matching principle underlies the methods used to account for long-lived assets.

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1 CHAPTER 9 Long-Lived Assets SYNOPSIS In this chapter, the author discusses (1) accounting for the acquisition, use, and disposal of long-lived assets, and (2) management's incentives for selecting accounting procedures associated with long-lived assets. The specific issues discussed in accounting for long-lived assets include the costs to capitalize when the asset is acquired, the treatment of postacquisition costs, cost allocation, and the disposal of long-lived assets. The discussion of cost allocation focuses on the alternative depreciation methods for fixed assets and the activity method for natural resources. The author also discusses intangible assets, deferred costs, and international financial reporting standards as they relate to property, plant and equipment. The ethics vignette considers a case where management's methods of accounting for long-lived assets may be within the guidelines of GAAP but still leave the statement reader with vague and insufficient information. The Internet research exercise examines the FASB's recent financial accounting standard for asset impairments. The following key points are emphasized in Chapter 9: 1. How the matching principle underlies the methods used to account for long-lived assets. 2. Major questions that are addressed when accounting for long-lived assets and how the financial statements are affected. 3. Major economic consequences associated with the methods used to account for long-lived assets. 4. Costs that should be included in the capitalized cost of a long-lived asset. 5. Accounting treatment of postacquisition expenditures. 6. How the cost of a long-lived asset is allocated over its useful life and the alternative allocation methods. 7. Disposition of long-lived assets. 8. The increasing importance of fair market value and issues that must be addressed when using fair market value as a basis for long-lived assets. TEXT/LECTURE OUTLINE Long-lived assets. I. Assets used in the operations of a business (not for resale) that provide benefits to the company extending beyond the current operating period. Long-lived assets include the following: A. Land.

2 B. Fixed assets (i.e., buildings, machinery, and equipment). C. Natural resource costs. D. Intangible assets. E. Deferred costs. II. The relative size of long-lived assets. III. Long-lived asset accounting: general issues and financial statement effects. A. Three basic questions when accounting for long-lived assets. 1. What dollar amount should be included in the capitalized cost of the long-lived asset? 2. Over what time period should the cost be amortized? 3. At what rate should the cost be amortized? B. An overview of long-lived asset accounting acquisition, use, and disposal. IV. Acquisition: what costs to capitalize? A. As a general rule, all costs necessary to get the asset in a serviceable and usable condition and location should be capitalized. The allowable costs of capitalization vary across long-lived assets. B. The capitalized cost of land should include: 1. Purchase price of the land, including closing costs (such as title, legal, and recording fees). 2. Costs incurred to prepare the land for its intended use such as razing old buildings, grading, filling, and so forth. Any proceeds received from preparing the land for its intended use (such as the sale of scrap from a demolished old building) reduce the capitalized cost of land. 3. Permanent land improvements such as landscaping, sewers, drainage systems, and so forth. C. Lump sum purchases. 1. As a general rule, allocate the purchase price to the assets based on their relative fair market values. This method requires that the fair market value of each asset acquired be known. 2. Because fair market values are somewhat subjective, using fair market values to allocate the purchase price among the individual assets acquired gives

3 management discretion about how much to report for each asset. This discretion, in turn, can affect the timing of expense recognition and certain key ratios. D. Construction of long-lived assets. V. Post-acquisition expenditures: betterments or maintenance? A. Betterments costs incurred to improve an asset. 1. To be considered a betterment, an expenditure must provide one of the following: a) An increase in the asset's useful life. b) An improvement in the quality of the asset's output. c) An increase in the quantity of the asset's output. d) A reduction in the costs associated with operating the asset. 2. Betterments should be capitalized as part of the long-lived asset and amortized over the asset's remaining useful life. B. Maintenance expenditures costs incurred to repair or maintain an asset's current level of productivity. Maintenance expenditures are considered period expenses. VI. Cost allocation: amortizing capitalized costs. A. The purpose of cost allocation is to match the costs of long-lived assets against the benefits the assets helped generate. B. Amortization terms. 1. Depreciation the amortization of fixed assets. 2. Depletion the amortization of natural resource costs. 3. Amortization the allocation of intangible assets and deferred costs. C. Steps in the allocation process. 1. Determine over what period of time the long-lived asset will help generate benefits. This step requires the company to estimate the asset's useful life. Estimating an asset's useful life is very subjective and is complicated by technological advances. 2. Determine the dollar amount of the asset's capitalized cost that the company expects to consume over the asset's estimated useful life. a) This step requires the company to estimate the asset's salvage value. Estimating an asset's salvage value is extremely difficult. In practice,

4 many managers simply assign a salvage value of zero to assets because of the difficulty in estimating a reasonable salvage value. b) The dollar amount of the asset's capitalized cost that the company expects to consume over the asset's estimated useful life is called the asset's depreciation base (for fixed assets). The depreciation base equals the capitalized cost of the asset less its estimated salvage value. 3. Select a cost allocation method. a) The choice of cost allocation methods does not affect the dollar amount amortized over a long-lived asset's estimated useful life. The dollar amount that is amortized over the asset's life is always its depreciation base. b) A cost allocation method determines the rate at which an asset's capitalized cost will be amortized to future periods. That is, the total amount amortized over an asset's life is the same across allocation methods, but the timing of the allocations will differ. D. Cost allocation (depreciation) methods. 1. Straight-line method. a) Allocates an equal amount of the depreciation base to each period. b) Depreciation expense equals: (Capitalized cost minus Salvage value) Estimated life in years. 2. Double-declining-balance method. a) Allocates larger amounts of an asset's depreciation base to the earlier periods of the asset's life than to the later periods. b) Salvage value is not used to calculate depreciation expense, but the asset's book value cannot be reduced below its salvage value. c) Depreciation expense = (Book value x 2) N, where N = the entire estimated useful life. 3. Activity method (units-of-production). a) Allocates an equal amount of the cost to each unit of output. This method is most commonly used to deplete natural resource costs. b) Expense = [(Capitalized cost Salvage value) Estimated life in units of production] x Number of units produced. E. Economic effects of cost allocation methods. 1. Cost allocation methods and the matching principle. 2. How does management choose an acceptable cost allocation method?

5 3. Depreciation methods for income tax purposes. VII. Disposal: retirements, sales, and trade-ins. A. General rules for accounting for the disposal of fixed assets. 1. Depreciate the asset up to the date of disposal. 2. Remove the cost and related accumulated depreciation (for fixed assets) from the books. 3. Record the receipt or payment of cash (or other assets) involved in the disposal. 4. Recognize any gains or losses on the disposal. Gains and losses are computed as the difference between the disposed asset's book value and the net value of assets received. B. Methods to dispose of fixed assets. 1. Retirement; discontinue using the long-lived asset. 2. Sale; exchange a long-lived asset for cash or a receivable. 3. Trade-in; an exchange for dissimilar assets. VIII. Intangible assets. a) Exchanging a long-lived asset (and often cash) for a different type of long-lived asset. b) It is often difficult to determine the value of the new asset, which, in turn, affects the magnitude of any gains or losses on the transaction. (1) As a general rule, value the new asset at the fair market value of the assets given up or at the fair market value of the assets received, whichever is clearly more evident and objectively determined. (2) Accounting for trade-ins is governed by APB No. 29, "Accounting for Nonmonetary Transactions." A. Assets characterized by rights, privileges, and benefits of possession rather than by physical existence. B. Intangible assets and deferred costs should be amortized, in certain instances, over the shorter of the asset's legal life or the asset's useful life. C. The preferred method to amortize intangible assets is the straight-line method. D. Types of intangible assets.

6 1. Copyrights exclusive rights over musical or artistic works. The legal life is the life of the creator plus an additional 50 years. 2. Patents provide the holder exclusive rights to use, manufacture, or sell a product or process. The legal life is 10 years. 3. Trademarks (or trade name) a word, phrase, or symbol that identifies an enterprise or product. The legal life is 20 years but the exclusive right can be renewed indefinitely. 4. Computer software development costs. 5. Goodwill The nature of goodwill and the methods used to account for it are discussed in Chapter 8. E. Organizational costs - costs incurred prior to the start of a company's operations that are necessary to allow the company to begin operations. Such costs typically include legal and accounting services, licenses, underwriting fees, titles, and so forth. F. Research and development costs. 1. Governed by SFAS No. 2, "Accounting for Research and Development Costs." 2. Conceptually, some R&D costs provide future benefits and would be capitalized as an asset and amortized as the R&D provides benefits. However, given the difficulty of matching specific expenditures with associated benefits, the FASB mandated that all R&D costs should be treated as period costs. IX. IFRS vs. US GAAP: revaluations to fair market value. X. ROE exercise XI. Review problem XII. Ethics in the real world. XIII. Internet research exercise. LECTURE TIPS 1. Students often have difficulty in deciding which costs should be capitalized as part of a long-lived asset (such as the cost of demolishing an old building on land just acquired) and which costs should be expensed. It should be stressed that for some costs, a great deal of judgment is involved. However, if the cost is necessary to get the asset into a useable condition, the cost should be capitalized. End-of-chapter exercise 9 3 and problem 9 1 are helpful in addressing which costs to capitalize.

7 2. The straight-line method is usually easily understood. However, the double-decliningbalance (DDB) method often poses more problems to students. The primary problems are (1) computing the appropriate multiplication factor to multiply against the asset's book value, and (2) depreciating the asset below its salvage value. End-of-chapter exercises 9 9 and 9 10 can be used to illustrate the computations for each method. 3. Distinguishing between betterment and maintenance expenditures is also a difficult area. It should be pointed out that even practicing accountants face this problem because a great deal of judgment is involved in classifying postacquisition costs. End-of-chapter exercise 9 4 provides several situations to illustrate the concepts involved. 4. Distinguishing between depreciation expense and accumulated depreciation sometimes poses difficulty. It should be stressed that depreciation expense represents the cost of the fixed asset allocated to expenses for a particular accounting period; accumulated depreciation represents the total depreciation expense taken on a fixed asset since that fixed asset was acquired. Recording the entries in end-of-chapter exercise 9 10 in T- accounts will help the student distinguish between the two. ANSWERS TO IN-TEXT DISCUSSION QUESTIONS 386. The importance of fixed asset accounting to the financial statements of the companies mentioned would be ranked in the order the companies were named: Chevron, Yahoo, and the Goldman Sachs. A natural resources company such as Chevron is highly capital intensive, with large investments in property, plant, and equipment. An Internet company such as Yahoo has electronic equipment, as opposed to extensive properties or heavy equipment. Banks such as the Goldman Sachs have large financial assets on their balance sheets which far outweigh fixed assets By choosing to depreciate their aircraft over a longer useful life, United spreads the cost of the aircraft over a greater number of reporting periods. This would serve to decrease depreciation expense and increase reported income compared to Delta, which is using a shorter useful life for its aircraft. There would be no effect on the statement of cash flows because depreciation is a non-cash expense By extending the depreciation lives of its aircraft, American Airlines chose to spread the cost of the aircraft over a greater number of reporting periods. This would serve to decrease depreciation expense and increase reported income. There would be no effect on the statement of cash flows because depreciation is a non-cash expense Zimmer s investments in property, plant and equipment would be reflected as negative cash flows in the investing section of the statement of cash flows. These assets are accounted for as long term assets on the balance sheet and will be subject to depreciation over their useful lives The fair market value of each identifiable current and noncurrent asset, and of each liability, would first be determined. Monetary assets (cash, securities, receivables) would be valued at face value, net realizable value, present value, or quoted market prices. Liabilities would be valued at face value or present value. The value of nonmonetary assets (inventories, land, buildings, equipment, and identifiable intangible assets) would

8 be determined using replacement costs, comparable sales values, or the present value of estimated future cash flows. The fair market value of identifiable net assets as determined in the preceding paragraph would be deducted from the purchase price. The excess of the purchase price over net assets would be assigned to goodwill. In the case of Kellogg s purchase of Worthington Foods, goodwill of $194 was arrived at by subtracting net assets of $156 million (assets valued at $218 million, minus liabilities valued at $62 million), from the purchase price of $350 million. The valuations required in this process are inherently subjective and offer opportunities to either maximize or minimize future income. For instance, valuations which give lower values to identifiable net assets, result in a higher value assigned to goodwill, which is not amortized against future income. Within identifiable net assets, a higher value assigned to assets such as land result in greater future income because land is not depreciated. Conversely, a higher value assigned to inventory results in a larger cost of goods sold in the next period, thus reducing income The interest costs of the funds borrowed by AT&T that related to the period of time during which the facilities were under construction would have been capitalized as part of the cost of those facilities. This is because these costs were incurred in the process of getting the facilities into operating condition. The interest expense that applied to the post construction period would have been treated as an operating expense in the year incurred By capitalizing costs that should have been expensed, WorldCom understated its expenses and overstated net income for the period during which this fraud took place. Net income in future periods would have been reduced through depreciation, had the fraud not been discovered Renewals and improvements are betterments and are capitalized because they improve the asset by extending its useful life, improve the quantity or quality of its output, or reduce the cost of operating the asset. Repairs are considered part of maintenance and are expensed as incurred, because they do not improve the asset or extend its useful life The accounting expert is referring to estimates of salvage value, the dollar amount that can be recovered when a long-lived asset is sold, traded, or scrapped. Salvage value reduces the depreciable cost of an asset, thus reducing the amount of depreciation expense recognized in each period subsequent to acquisition of the asset. The expert is warning financial statement users interested in reported income that income may be overstated to the extent that salvage values are overstated and depreciation understated. The warning recognizes management s discretion and incentive to make optimistic assumptions of salvage values The ranges of useful lives vary for these two broad categories of assets because buildings generally last a lot longer than machinery or equipment. The broad ranges of lives used by management gives them a certain amount of flexibility in managing earnings by choosing useful lives that extend or compress the time period during which newly acquired assets are to be depreciated. The extent to which the choice of useful life

9 will impact current year net income is usually minor unless there was a relatively large dollar amount of new asset acquisitions An analyst comparing PepsiCo to Coca-Cola would want to factor in the differences in the useful lives assigned to assets being depreciated. The change in depreciation schedules is a way to make earnings look better when they have not improved at all. The depreciation is not relevant to cash flow, and PepsiCo s response to any comments about the change in their depreciation schedule could be deflected by focusing on cash flow. PepsiCo might also state that the adjustment to the depreciation schedules was necessary to reflect the reality that their assets are being used for longer periods of time If they had $4.3 billion in fixtures and equipment, none of which were fully depreciated, and they used an average life of 9 years, the annual depreciation expense (straight line method) for these fixtures would be approximately $4.3 billion divided by 9, or $478 million. This, of course, is a very rough estimate because it assumes an average life of 9 years which could be significantly different than the true weighted average life of the assets being depreciated Conforming to industry practice makes it easier to compare HP s financial statements to those of their competitors. Straight-line would do a better job of matching costs with revenues than accelerated methods if assets being depreciated made equal contributions to revenues during each year of their useful lives If everything about each company was exactly the same except for the method each used for depreciation, reported income would differ, as would related balance sheet amounts. Accordingly, financial statement ratios used as performance measures for each company would differ. Analysts must consider these differences when making comparisons within the industry, either qualitatively, or by attempting to make computational adjustments to make each company comparable. When such differences exist, analysts may wish to focus more on performance measures not dependent on the amount of depreciation, such as cash flow from operations, or earnings before interest, taxes, depreciation and amortization (EBITDA) The activity (units-of-production) method would be used for oil and gas producing assets, which has the effect of assigning more costs to expense in proportion to the asset s level of activity. This method achieves the best application of the matching principle, because the more active an asset is, the more revenue it should produce. This is particularly true in the case of natural resources like oil and gas. The straight-line method would be used for other property, plant, and equipment. The benefits from those assets are less directly related to activity, and more likely constant across time, so an even amount of expense each year is appropriate. The 25 and 45 year lives assigned to refining and pipeline assets probably reflect with some degree of accuracy the actual useful lives of these types of assets Delta could choose between straight-line or accelerated depreciation methods. Straightline depreciation, particularly in earlier years, would result in higher reported net income and higher shareholders equity and total assets, compared to results using accelerated methods. Therefore, performance measures based on net income, and liabilities to equity or assets ratios, would appear more favorable using straight-line, and debt covenants would less likely be violated.

10 405. By using accelerated instead of straight-line depreciation FedEx saves taxes of 37.6% of the excess of accelerated depreciation over straight-line ($3.9 billion $1.8 billion) x 37.6%, or $.8 billion The IRS took the position that the work on the jet engines should be treated as betterments rather than as routine maintenance. If FedEx has a tax rate of 37.3%, treating these costs as expenses increases FedEx s cash flow (by way of reduced income tax payments) by 37.3% of the amount of the expenditures in question There would have been a one time gain recorded on the sale of these assets. This stream of income would not be expected to recur and, if material, would be reflected in the income statement as a gain form the disposal of a segment of the business, rather than as part of operating income The journal entry recorded by Honeywell would have been: DR CR Cash and investment securities (+A) $435 Loss on disposal of assets (+E, -SE) $124 Assets (-A) $ Customer relationships is a sub-category of goodwill and is one of the biggest reasons for paying more for the acquired company than the sum of the fair market value of its tangible assets. Because the goodwill was developed internally by Holsum, rather than purchased, it was not an asset on Holsum s balance sheet. However, when Flowers Foods acquires this goodwill in the acquisition and pays for it, Flowers has an asset to reflect on its balance sheet.