# Adjustments for Useful Life LO3 Changes in Estimates Additional Improvement Expenditures Significant Declines in Asset Market Values Adjustments for fixed.

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Adjustments for Useful Life LO3 Changes in Estimates Additional Improvement Expenditures Significant Declines in Asset Market Values Adjustments for fixed assets can arise from:

Changes in Depreciation Estimates Assume Thomas Supply purchases a machine for \$90,000 on 1/1/2010, with a 10 year useful life and \$10,000 salvage value. Using straight-line, Thomas records \$8,000 depreciation expense. Assets=Liabilities+Equity -8,000

Changes in Depreciation Estimates Year 5: Thomas estimates that the machine will last only 8 years and have a salvage value of \$6,000. The prospective revision (current and future) will not correct the first 4 years. Calculate net book value at the time of estimate revision (or unexpired cost): Cost of the asset, January 1, 2010\$90,000 Less: Accumulated depreciation for four years\$32,000 Net book value on January 1, 2014\$58,000 Step 1 Step 2 Calculate depreciable cost for future depreciation: Net book value on January 1, 2014\$58,000 Less: Estimated salvage value \$6,000 Remaining depreciable cost\$52,000 Step 3 Calculate revised depreciation expense: \$52,000 ÷ 4 remaining years = \$13,000 annual depreciation

Expenditures After Acquisition The accounting treatment for expenditures made during the useful life of a fixed asset depends on whether they are classified as capital or revenue expenditures. A capital expenditure increases the expected useful life or productivity of the asset. A revenue expenditure maintains the expected useful life or productivity of the asset.

Capital Expenditure A company purchases a fixed asset for \$50,000 on 1/1/2010, with a 5-year life and no salvage. During the fifth and final year of the asset’s life, the company incurs \$8,000 for upgrades that extend the asset’s life for 2 years. General Journal Year fiveFixed Asset\$8,000 Cash\$8,000 (To record upgrade to asset) Assets=Liabilities+Equity +8,000 -8,000

Change in Depreciation Due to Capital Expenditure Calculate net book value after capital expenditure: Cost of the asset, January 1, 2010\$50,000 Less: Accumulated depreciation for four years\$40,000 Net book value on January 1, 2014\$10,000 Plus: Upgrades made in 2014\$ 8,000 Updated Net Book Value for 2014\$18,000 Step 1 Step 2 Calculate depreciable expense: Updated book value for 2014\$18,000 Less: Estimated salvage value\$ 0 Remaining depreciable cost\$18,000 Divided by remaining useful life÷ 3 Annual depreciation expense\$ 6,000

Revenue Expenditure A company purchases a fixed asset for \$50,000 on 1/1/2010, with a 5-year life and no salvage. During the fifth and final year of the asset’s life, the company incurs \$1,000 in ordinary maintenance. General Journal Year fiveMaintenance Expense\$1,000 Cash\$1,000 (To record normal maintenance) Assets=Liabilities+Equity -1,000

Potential Fraud Issue While these expenditure classifications seem rather unimportant, many corporate frauds have misclassified costs as assets on the balance sheet rather than as expenses.

Asset Impairment When a fixed asset’s market value falls materially below its net book value and the decline in value is deemed to be permanent, the asset is considered impaired. Under GAAP, companies apply conservatism by writing these assets down from their book values to their market values. Assume a machine losses value equal to \$100,000: General Journal Loss on Impairment\$100,000 Fixed Asset\$100,000 (To record permanent impairment asset) Assets=Liabilities+Equity -100,000 Included in Other Income in the Income Statement

Disposal of Fixed Assets The accounting for the disposal of a fixed asset consists of the following three steps: LO4 1. Update depreciation on the asset. 2. Calculate gain or loss on the disposal. 3. Record the disposal.

Rule for Calculating the Gain or Loss on Disposal If Proceeds from Sale > Net Book Value, then Gain on Disposal If Proceeds from Sale < Net Book Value, then Loss on Disposal

Evaluating Management of Fixed Assets Three issues are important when managing fixed assets: LO5 1. How productive are the company’s fixed assets in generating revenues? 2. What is the condition of the company’s fixed assets? 3. How are cash flows affected by the purchase of fixed assets?

Horizontal and Vertical Analyses A good place to start in the analyses of fixed assets is with performance of horizontal and vertical analyses. Horizontal Analysis Vertical Analysis Fixed assetsCY Fixed assets – PY Fixed assets PY Fixed Assets Fixed assets Total Assets Depreciation Expense CY Depreciation – PY Depreciation PY Depreciation Depreciation Expense Total Sales [A1] Key Formula[A1]

Horizontal Example Let’s look at McDonald’s 2008 & 2007 analyses. HorizontalAnalyses 20082007Change% Change Property & Equip, net (in millions) 20,254.520,984.720,254.5 – 20,984.7 (20,254.5 – 20,984.7) 20,984.7 ↓↓ \$(730.2)(3.5)% 20082007ChangePercentage Change Depreciation Expense (in millions) 1,161.61,145.01,161.6 – 1,145.0 (1,161.6 – 1,145.0) 1,145.0 ↓↓ \$16.61.5%

Vertical Example Let’s look at McDonald’s 2008 & 2007 analyses. VerticalAnalysis 2008200720082007 Property & Equip, net 20,254.520,984.720,254.5 28,461.5 20,984.7 29,391.7 Total Assets28,461.529,391.7↓↓ 71.2%71.4% 2008200720082007 Depreciation Expense 1,161.61,145.01,161.6 23,522.4 1,145.0 22,786.6 Total Revenues23,522.422,786.6↓↓ 4.9%5.0%

Fixed Asset Turnover Ratio How do you find out if the company is using fixed assets productively to generate revenues? Total Revenues Average Net Book Value of Fixed Assets Where average Net Book Value =Beginning Net Book Value + Ending Net Book Value 2 The fixed asset turnover ratio compares total revenues during a period to the average net book value of fixed assets for the period.

Fixed Asset Turnover Example 20082007 Total Revenues 23,522.4 (20,254.5 + 20,984.7)/2 → 1.14 Net Book Value of Fixed Assets 20,254.520,984.7 McDonald’s 2008 fixed asset turnover ratio is calculated as follows.

Average Life of Fixed Assets

Average Age of Fixed Assets

Acquiring Fixed Assets – Cash Flow Effects LO6 Determining fixed assets’ effects on cash flow is another important issue. McDonald’s 2008 Capital Expenditures from the Statement of Cash Flows 2008 2007 2006 Property and equipment expenditures (\$2,135.7)(\$1,946.6)(\$1,741.9) A negative number indicates investment in operating activities.

Intangible Assets LO7 An intangible asset is a resource that is used in operations for more than one year but has no physical substance. Examples include: Patent Trademark Copyright Franchise Goodwill

Recording Goodwill Goodwill is created when one company buys another company and pays more than the value of the net assets of the purchased company. Suppose that Buyer Company purchases Seller Company for \$8 million when the value of Seller Company’s net assets is \$6 million. How will we record this?

Recording Goodwill General Journal Net Assets of Seller Company\$6,000,000 Goodwill\$2,000,000 Cash (To record the purchase of Seller) \$8,000,000 Assets=Liabilities+Equity +6,000,000 +2,000,000 -8,000,000 The premium paid for GOODWILL is usually due to the acquired company’s customers, its reputation, its employees, its market share, or its research.

Amortizing Intangible Assets Suppose that a company possesses a \$60,000 patent that has the maximum legal life of 20 years. The company believes that the patent will be useful for only 12 years and will then be worthless. How do we record amortization? \$60,000 ÷ 12 = \$5,000 per year General Journal End of yearAmortization Expense\$5,000 Patent\$5,000 Assets=Liabilities+Equity -5,000

Remember Amortization applies only to intangibles with limited lives, like patents. Assets with indefinite lives (i.e., trademarks and goodwill) are instead examined periodically to check for impairment.

End of Chapter 8