Chapter 9 Investments in Property, Plant, and Equipment and in Intangible Assets Albrecht, Stice, Stice, Swain COPYRIGHT 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. 1
Long-Term Assets Property, plant, and equipment Tangible assets acquired for the use in business operations. Land, buildings, and equipment. Intangible Assets Assets without physical substance that are used in business. Licenses, patents, franchises, and goodwill. 2
Capital Budgeting Capital budgeting Planning for investment in long-term assets. Long-term assets have value because they help companies generate future cash flows. Involves comparing the cost of the asset to the value of the expected cash flows, after adjusting for the time value of money. Time value of money The concept that a dollar today is worth more than a dollar received in the future. 3
Asset Acquisition Include purchase price. Include costs incurred to acquire the asset and getting it ready for its intended use. Sales tax, shipping, installation, and other costs. Fork Lift........................ 12,500 Cash........................ 3,500 Notes Payable................ 9,000 Purchased a fork lift for $12,000 and paid $500 for shipping; paid $3,500 cash and issued a note for $9,000 to the bank. 4
Leases Lease A contract that specifies the terms under which the owner of an asset (the lessor) agrees to transfer the right to use the asset to another party (the lessee). What terms should be included in a lease? Term Payment amount Due dates 5
Match Lease Terms Capital Lease Lessor Operating Lease Lessee The party that is granted the right to use the property under the terms of a lease. The owner of property that is leased (rented) to another party. A simple rental agreement. A leasing transaction that is recorded as a purchase by the lessee. 6
Classifying Leases A lease is classified as a capital lease if it is non-cancelable and meets one of the following criteria: 1. Lease transfers ownership of the asset. 2. Lease contains a bargain purchase option. 3. Lease term is equal to 75% or more of the estimated life of the asset. 4. Present value of the lease payments is equal to 90% or more of the fair market value of the asset. 7
Operating Lease Dahl & Sons, Attorneys at Law, leases a building with monthly rental payments of $1,000. Make the appropriate entry if rent is paid in cash the first month. Rent (or Lease) Expense..........1,000 Cash........................ 1,000 To record monthly rent of storage building. 8
Capital Lease Dahl & Sons enters into a non-cancelable lease agreement that requires lease payments of $100,000 a year for 20 years. At the end of 20 years, Dahl & Sons will own the property. The present value of the lease payments at a 10% discount rate is $851,360. Make the appropriate entries. Leased Property................ 851,360 Lease Liability................ 851,360 To record commercial building acquired under a 20-year non-cancelable lease. Lease Liability.................. 14,864 Interest Expense................ 85,136 Cash........................ 100,000 To record annual payment under capital lease. 9
Assets Acquired by Self Construction Self-constructed assets Recorded at cost. Include all expenditures incurred to build the asset and make it ready for its intended use. Costs include: Materials used to build the asset. The construction labor. Capitalized interest. Some reasonable share of the general company overhead. 10
Basket Purchases When two or more assets are acquired at a single price, the prices are allocated on the relative fair market value method. In this example, Dahl and Sons purchased land and a building at a total cost of $3,600,000. Prepare the entry to record the purchase. Asset FMV % of Total Value Cost Land $1,000,000 25% 0.25 x $3,600,000 = $ 900,000 Building 3,000,000 75 0.75 x $3,600,000 = 2,700,000 Total $4,000,000 100 % $3,600,000 Land........................... 900,000 Building........................ 2,700,000 Cash........................ 3,600,000 To record building and land acquired for $3,600,000. 11
Depreciation Depreciation The process of cost allocation that assigns the original cost of plant and equipment to the periods benefited. Book value The assets original cost less any accumulated depreciation. Salvage value The amount expected to be received when the asset is sold at the end of its useful life. 12
Straight-Line Depreciation Costs assigned equally to all periods benefited. Annual Depreciation Expense = Cost - Salvage value Estimated useful life (years) $5,500 = $24,000 - $2,000 4 years Depreciation Expense................. 5,500 Accumulated Depreciation........... 5,500 To record annual depreciation for truck. 13
Units-of-Production Depreciation Assigning depreciation according to what has been used during the year. Per Unit Depreciation = Cost - Salvage value Estimated life in units Depreciation Expense = Per unit depreciation x Units produced $4,400 = ($24,000 - $2,000) 60,000 miles x 12,000 miles Depreciation Expense................. 4,400 Accumulated Depreciation........... 4,400 To record annual depreciation for truck. 14
Partial-Year Depreciation Straight-line method Calculate depreciation expense for the year. Distribute it evenly over the number of months the asset is held during the year. Units-of-production method The same as normal because it is based off of the actual usage. 15
Repairing and Improving Assets Ordinary expenditures Typically benefit only the period in which they are made. (i.e. repairs, maintenance, and minor improvements.) Expense when incurred. Capital expenditures Significant in amount and benefit more than the current period. Increase the productive life or capacity of the asset. (i.e. engine overhaul, components added.) Capitalize and add to asset value. Depreciated over the remaining life of the asset. 16
Impairments Impairment A decline in the value of a long-term operating asset. Sum of Future Cash Flows from Asset Is Sum of Future Cash Flows Less than the Book Value? Book Value of Asset YES NO IMPAIRMENT Recognize Loss and Record Asset at FAIR VALUE. NO IMPAIRMENT Continue to Recognize Asset at BOOK VALUE. 17
Impairments Journal entry reduces property value as listed on balance sheet and clears out the accumulated depreciation. Accumulated Depreciation............. 4,000 Loss on Impairment of Equipment...... 1,000 Building.......................... 5,000 To record impairment of building. Increases in asset values can never be recognized according to GAAP. 18
Discarding and Selling Long- Term Assets An asset s cost and accumulated depreciation must be removed from the accounting records. Assets can be: Discarded (scrapped) Sold Exchanged 19
Discarding Property, Plant, and Equipment Dahl & Sons purchased an advance copier system for $15,000. It has a 5-year life, no salvage value, and is depreciated on a straight-line basis. If Frank pays $300 to have the copier removed, what is the appropriate entry? Accumulated Depreciation, Conveyor... 15,000 Loss on Disposal of Conveyor......... 300 Conveyor........................ 15,000 Cash............................ 300 Scrapped $15,000 copier and paid $300 disposal costs. 20
Selling Property, Plant, and Equipment Dahl & Sons purchased an advanced copier system for $15,000. It has a 5-year life, no salvage value, and is depreciated on a straight-line basis. If the copier is sold for $600 after only four years of service, Dahl & Sons will experience a loss of $2,400. Make the appropriate entry. Cash............................... 600 Accumulated Depreciation, Conveyor... 12,000 Loss on Sale of Conveyor............. 2,400 Conveyor......................... 15,000 Sold $15,000 copier at a loss of $2,400. Losses are incurred when the asset is sold for less than the book value and gains are recorded when the asset is sold for 21 more than the book value.
Accounting for Intangibles Intangibles Rights and privileges that are: Long-lived. Not held for resale. Have no physical substance. Providing owner with competitive advantage over other firms. Amortization Periodic allocation to expense of an intangible asset s cost. Conceptually, the same as depreciation. Intangible assets generally use straight-line amortization. 22
Types of Intangibles Patent An exclusive right granted for 17 years by the U.S. Federal Government to manufacture and sell an invention. Franchise An entity that has been licensed to sell the product of a manufacturer or to offer a particular service in a given area. License The right to perform certain activities, generally granted by a government agency. 23
Recognizing Intangible Assets Intangible assets are only recognized in the financial statements if they have been purchased. Amortize over the economic life of the intangible asset. Intangible assets with indefinite lives are not amortized. Intangible assets must be analyzed to determine if impairment has occurred. 24
Goodwill Goodwill An intangible asset that exists when a business is valued at more than the fair market value of its net assets, usually due to: Strategic location Reputation Good customer relations Equal to the excess of the purchase price over the fair market value of the net assets purchased. 25
Accounting for Goodwill Dahl & Sons purchased Clark & Associates for $1,200,000. At the time, the following market values existed for Clark s assets and liabilities: Inventory $750,000 Long-term operating assets 220,000 Other assets 25,000 Liabilities (18,000) Total Net Assets $977,000 Inventory...................... 750,000 Long-Term Operating Assets.... 220,000 Other Assets.................. 25,000 Goodwill..................... 223,000 Liabilities.................. 18,000 Cash...................... 1,200,000 Purchased Clark & Associates for $1,200,000. 26
Measuring the Management of Long-Term Assets Fixed Asset Turnover The amount of dollars in sales generated by each dollar of fixed assets. Sales Average PP&E Standard values for this ratio differ from industry to industry. 27
Accelerated Depreciation Methods Declining-balance method An asset s book value is multiplied by a constant depreciation rate. This is double the straight-line percentage in the case of double-declining balance (DDB). Sum-of-the-years -digits method A constant balance (cost minus salvage value) is multiplied by a declining depreciation rate calculated based off of the sum of the years. 28
Double-Declining-Balance Double- Book Value Depreciation X 2 = Declining Asset s Life Expense Balance in Years Book Value = Cost Accumulated Depreciation Dahl & Sons purchased a truck for $12,000. The truck has a salvage value of $2,000 and a useful life of 4 years. Compute depreciation using the DDB depreciation method for the first 2 years. Year 1 Year 2 ($12,000 0) 4 X 2 = ($12,000 $6,000) 4 X 2 = $6,000 $3,000 29
Sum-of-Years -Digits Method Sum-of- the-year s- Digits (Cost Salvage Value) Current Year / (4+3+2+1) Sum of the years of the asset s life Dahl & Sons purchased a truck for $12,000. The truck has a salvage value of $2,000 and a useful life of 4 years. Compute depreciation using the SYD depreciation method for the first 2 years. Year 1 Year 2 ($12,000 $2,000) 4/(4+3+2+1) = ($12,000 $2,000) 3/(4+3+2+1) = $4,000 $3,000 30
Change in Depreciation Estimates and Methods Depreciation is only an estimate. Changes in estimates of useful life and salvage value may occur. Changes in method can also occur. When there is a change in estimate, past periods depreciation amounts remain the same. 31
Change in Estimates Dahl & Sons purchased a truck for $24,000 with a $2,000 salvage value and a 4-year useful life. After 3 years, better information reveals the truck has a 6-year useful life and a $3,000 salvage value. Calculate a new depreciation expense for the next three years. Formula Calculation Total Depreciation Annual depreciation Cost - Salvage value = Depreciation $24,000 - $2,000 = $5,500 $16,500 for first 3 years Estimated useful life expense 4 Years Book value after 3 years Cost - Accumulated = Book Value $24,000 - $16,500 = $7,500 depreciation to date Annual depreciation for last 3 years (based on new Book - Salvage value = Depreciation $7,500 - $3,000 = $1,500 4,500 total life of 6 years and new Remaining useful life expense 3 years 32 salvage value of $3,000) $21,000