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CHAPTER 10 Capital assets (fixed assets) are: Long-lived Used in the operations of a business Not intended for sale to customers. Capital assets have.

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Presentation on theme: "CHAPTER 10 Capital assets (fixed assets) are: Long-lived Used in the operations of a business Not intended for sale to customers. Capital assets have."— Presentation transcript:

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2 CHAPTER 10

3 Capital assets (fixed assets) are: Long-lived Used in the operations of a business Not intended for sale to customers. Capital assets have two classes: 1. Tangible (can touch it) 2. Intangible (can’t touch it) CAPITAL ASSETS

4 TANGIBLE CAPITAL ASSETS Tangible capital assets include: property, plant and equipment like: Land + land improvements Buildings + improvements Equipment + freight + installation natural resources such as mineral deposits, oil and gas reserves, and timber

5 INTANGIBLE CAPITAL ASSETS What are they? Patents, copyrights, sports contracts, and trademarks, goodwill Intangible capital assets provide future benefits through the special rights and privileges they possess. © 

6 Capital assets are recorded at cost (cost principle). Cost consists of all expenditures necessary to 1. Acquire the asset and 2. Make it ready for its intended use. These costs include purchase price, freight costs, and installation costs. So, how do you come up with a cost figure?... DETERMINING THE COST OF CAPITAL ASSETS

7 Funny you should ask… Cost is measured by cash paid, or by the cash equivalent price when other assets are used instead. The cash equivalent price is equal to the fair market value of 1. the asset given up or 2. the asset received, whichever is more clearly determinable. MEASUREMENT OF CAPITAL ASSET COST Achtung !

8 The cost of land can include: 1. Purchase price 2. Closing costs such as title and legal fees 3. Accrued property taxes and other liens on the land assumed by the purchaser 4. Land improvements like: 1. Parking lots 2. Fencing 3. Landscaping 4. Lighting LANDLAND

9 The cost of buildings includes all necessary expenditures relating to purchase or construction. When purchased: Purchase price and closing costs. When making building ready for its intended use: Expenditures for remodelling, replacing or repairing the roof, floors, wiring, and plumbing, etc.. When constructed, cost consists of: Contract price, architects’ fees, building permits, interest payments during construction, and excavation costs. BUILDINGSBUILDINGS

10 The cost of equipment consists of: 1. Cash purchase price, 2. Freight charges, duties or tariffs 3. Insurance against loss during transit, 4. As well as all costs to assemble, install, and test it. EQUIPMENTEQUIPMENT

11 During an asset’s life, its usefulness may decline because of usage or obsolescence. Amortization is the process of allocating to expense the cost of a capital asset over its useful life. Amortization is designed to match expenses with revenues in accordance with the matching principle. Recognition of amortization does not result in the accumulation of cash for the replacement of the asset, nor the use of cash, although an expense is recognized. Land is the only capital asset that is not amortized. WHY AMORTIZATION? (Depreciation - Review) WHY AMORTIZATION? (Depreciation - Review) Achtung !

12 AMORTIZATION METHODS Three methods of recognizing amortization are: 1. Straight-line, 2. Declining-balance (includes CCA), and 3. Units of activity. Each method is acceptable under GAAPs. Management selects the method that is appropriate for their company, it should be applied consistently.

13 1. STRAIGHT-LINE METHOD Historical CostSalvage Value Useful Life (in years) Annual Rate of Amortization

14 1. STRAIGHT-LINE METHOD

15 DECLINING-BALANCE METHOD Based on a declining book value (cost less accumulated amortization). The amortization rate remains constant, but the net book value declines each year. Book Value (at beginning of year) Declining balance rate Amortization Expense (for the year)

16 If you aren’t given a rate for declining balance, use the following formula: DECLINING-BALANCE (cont.) 100%. Useful Life Rate = NEW! Example: Business buys $10,000 piece of equipment with a salvage value of $1,000 is expected to last for 10 years. However, management feels that the DECLINING BALANCE METHOD is best for amortizing this asset. 100%. 10 years = 10%

17 DECLINING-BALANCE METHOD

18 UNITS-OF-ACTIVITY METHOD EXAMPLE (assume the following): Mine of 1,000,000 m 3 of ore Cost of finding, dropping a shaft and preparing for use: $50,000,000 This year we harvested 75,000 m 3 of ore. Total Cost of Resource – Salvage Value Total Units Available Amortization Cost per Unit XUnits Used Amortization Cost this Period

19 UNITS-OF-ACTIVITY METHOD

20 If annual amortization is inadequate or excessive, a change should be made. When a change is made, 1. There is no correction of previously recorded amortization expense, and 2. Amortization expense for current and future years is revised using the normal formulas. When asset is bought/sold part way through a year, that year’s amortization must be prorated. REVISING AMORTIZATION Change in Amounts or Speed REVISING AMORTIZATION Change in Amounts or Speed

21 REVISING AMORTIZATION Change in Method REVISING AMORTIZATION Change in Method If you decide to change the amortization method, a prior period adjustment must be made When you change any accounting policy you: 1. Do NOT revise prior years’ financial stmts 2. Calculate the total change for all prior years and charge it directly to the Capital account 3. Record this year’s amortization using the new method. Why would it be done this way?

22 C.C.A. Capital Cost Allowance CCA is the government’s method of calculating amortization for tax purposes. CCA is exactly like the Declining Balance method. However, CCA only allows you to recognize ½ a year’s amortization in the year of disposal AND purchase. CCA rates are specific, and are the maximum allowable rates for a year. See page 472 for a schedule of CCA rates for asset classes.

23 C.C.A. and Income Taxes Must report using GAAPs Most firms use straight-line (it’s easy) But taxes are determined using tax law (CCA). This creates a discrepancy. Observe

24 C.C.A. and Income Taxes The discrepancy is charged to an account called Deferred Income Tax Most people (especially politicians) think that this account represents legitimate tax that corporations have somehow evaded paying. Not the case. It arises from the discrepancy between CCA for tax purposes, and amortization using GAAPs. DateParticularsDebitCredit April 30 Income Tax Expense 25,000 Deferred Income Taxes5,000 Cash 20,000

25 Ordinary repairs are expenditures to maintain the operating efficiency and expected productive life of the capital asset. Expenditures are usually immaterial in amount and occur infrequently. They are operating expenses and are debited to Repairs Expense. Additions and improvements are costs incurred to increase operating efficiency, productive capacity, or expected useful life of the capital asset. They increase a company’s investment in productive facilities, so They are capital expenditures and are debited to the capital asset. EXPENDITURES DURING USEFUL LIFE Achtung !

26 CAPITAL ASSET DISPOSALS (Example: equipment costing $5,000 with $1,100 of amortization was sold for $4,000 on September 30 th ) 1 Amortization for the fraction of the year to the date of disposal must be recorded DateParticularsDebitCredit Sept 30 Amortization Expense 100 Accumulated Amortization (assumed) 100 To record 9 months of depreciation on disposed asset.

27 CAPITAL ASSET DISPOSALS 2 Remove the value of all accounts associated with that asset, and record receipt of cash. DateParticularsDebitCredit Sept 30 Cash 4000 Equipment 5000 To record gain on the sale of buffing equipment. Gain on sale of equipment 200 Accumulated amortization 1200 Gain or loss equals = Selling Price – Book Value $200 = ($4,000 - $3,800) Historical Cost – Accumulated Amortization ($5,000 – $1,200) = $3,800

28 Alternatively, you can combine all three steps into one journal entry. The only difference here is that Accumulated Amortization will not include the value of the last write-off (step 1). CAPITAL ASSET DISPOSALS (cont.) DateParticularsDebitCredit Sept 30 Cash 4000 Equipment 5000 Gain on sale of equipment 200 Amortization expense 100 Accumulated amortization 1100 $1,200

29 Natural resources (wasting assets), consist of standing timber and underground deposits of oil, gas, and minerals. They have two distinguishing characteristics: 1. They are physically extracted in operations. 2. They are replaceable only by an act of nature. NATURAL RESOURCES

30 The acquisition cost of a natural resource is the cash or cash equivalent price necessary to acquire the resource and prepare it for its intended use. If the resource is already discovered, cost is the price paid for the property. NATURAL RESOURCES Acquisition Cost

31 NATURAL RESOURCES Amortization The units-of-activity method is generally used to calculate amortization

32 ILLUSTRATION STATEMENT PRESENTATION OF AMORTIZATION Accumulated Amortization, a contra asset account, is deducted from the cost of the natural resource in the balance sheet as follows:

33 Intangible assets cannot be touched. They are rights, privileges, and competitive advantages that result from the ownership of long-lived assets that do not possess physical substance. INTANGIBLE ASSETS

34 Do Problems: P10-2A, and 7A

35 TYPES OF INTANGIBLE ASSETS Patents Copyrights Trademarks and Trade Names Franchises and Licenses Goodwill Research and Development Costs

36 Copyrights are granted by the federal government giving the owner the exclusive right to reproduce and sell artistic or published work Copyrights extend for the life of the creator plus 50 years COPYRIGHTS

37 TRADE MARKS/NAMES Word, phrase, jingle or symbol that distinguishes or identifies a particular enterprise or product If indefinite life, do not amortize. Test for impairment

38 PATENTS Exclusive right to manufacture, sell or control granted for 20 years Legal costs of protecting a patent in an infringement suit are added to the Patent account and amortized over the remaining life of the patent

39 FRANCHISES Contractual agreement under which the franchiser grants the franchisee the right To sell certain products To render specific services or to use certain trademarks or trade names, usually within a designated geographic area Annual fees are not capitalized, but are expensed.

40 LICENSES Operating rights permit the enterprise to use public property in performing its service (i.e. the use of airwaves for radio or TV broadcasting) Annual fees are NOT capitalized, but expensed.

41 GOODWILL Goodwill represents favourable attributes that relate to a business enterprise Recorded only in an exchange transaction that involves the purchase of an entire business Goodwill = (Price paid – Equity in Business) Goodwill is not written off as it has an unlimited useful life. It must be tested regularly for impairment. Impairment is when fair market value for an assets drops below the book value. HUGE Achtung !

42 GOODWILL How does goodwill arise? Cash Other Assets Goodwill Liabilities Equity 100,000 Firm A Firm BFirm AB 300, , , , , ,000 75, ,000 50, , , , , ,000 50,000 25, ,000 How? 275, ,000 cash + 25,000 goodwill = 200,000 How? 100,000 cash -75,000 Equity acquired = 25,000 goodwill

43 Two steps: ONE: If FMV > Book Value = no impairment TWO: If not, then Goodwill is impaired. Things to consider in determining FMV: Significant adverse change in legal or business climate Adverse action by a regulator Unanticipated competition Loss of a key personnel More-likely-than-not expectation that a significant portion of a reporting unit will be sold or disposed of Impairment of a significant asset group within a reporting unit Recognition of a goodwill impairment loss by a subsidiary GOODWILL

44 Research costs–record as an expense when incurred Development costs–capitalize if associated with an identifiable, feasible product. Otherwise, expense RESEARCH AND DEVELOPMENT COSTS What does identifiable and feasible mean?

45 In general, accounting for intangible assets is the same as for capital assets. Intangible assets are: 1. Recorded at cost; 2. Written off over useful life in a rational and systematic manner; 3. At disposal, book value is eliminated and gain or loss, if any, is recorded. ACCOUNTING FOR INTANGIBLE ASSETS

46 Amortizable intangible assets: Have defined lives Allocate cost to expense over the shorter of Useful (economic) life, or Legal life Straight-line method of amortization is used Unamortizable Intangible assets: Have indefinite useful lives, Do not amortize, and Must be tested for impairment (when fair market value for an assets drops below the net book value). AMORTIZATION

47 Capital Assets are often combined on the Balance Sheet. If so, there should be full disclosure in the notes to the financial statements, which means disclose: Balances in each major asset class, Accumulated amortization of each major class, (or of assets in total), Amortization methods used should be described, and Amount of amortization expense for the period disclosed as well. FINANCIAL STATEMENT PRESENTATION

48 ASSET TURNOVER RATIO The ratio that shows how efficiently a company uses its assets to generate sales is the asset turnover ratio. Net Average Assets Sales Total Assets Turnover  =

49 RETURN ON ASSETS The ratio that shows the profitability of assets used in the earnings process is the return on assets. Net Average Return on IncomeTotal Assets Assets  =


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