1. FINANCIAL ACCOUNTING a user perspective Sixth Canadian Edition Prepared by: Lynn de Grace C.A. Chapter 8 Capital Assets— Tangible and Intangible 1

2. Capital Assets— Recognition A capital asset  Has value in use Used to generate future revenue through sales of products or services Cash received over several future periods  Used until replaced with a new asset Can have residual (or resale) value John Wiley & Sons Canada, Ltd. ©2011 2

3. Valuation of Capital Assets Alternative 1 – Historical cost  Original cost of the asset  Expensed (amortized) over the useful life  Gain or loss on sale Recognized only when sold Difference between the proceeds of the sale and the net book value  Net book value (or carrying value) Original cost less amortization Also called the amortized cost of the asset John Wiley & Sons Canada, Ltd. ©2011 3

4. 4 Valuation of Capital Assets Alternative 2: Market Value—Replacement Cost  Amount that would be needed to acquire an equivalent asset  Unrealized gains and losses are recognized as the replacement value of the asset changes  Amortization would need to be adjusted each time the replacement value changes John Wiley & Sons Canada, Ltd. ©2011

5. 5 Valuation of Capital Assets Alternative 3: Market Value—NRV  Amount that would be received by converting the asset to cash  Unrealized gains and losses are recognized as NRV changes  Amortization is adjusted each time NRV is adjusted  When the asset is sold or disposed of, the gain or loss will be small John Wiley & Sons Canada, Ltd. ©2011

6. Valuation of Capital Assets Canadian practice:  Use historical cost (original acquisition cost). Meets objectives: reliable, verifiable, objective  Amortize cost over the period of use  Market value changes are not recognized until the asset is disposed of.  IFRS : Companies may opt to use NRV to value capital assets Unrealized gains and losses are reported directly in shareholders’ equity as a revaluation reserve. John Wiley & Sons Canada, Ltd. ©2011 6

7. Capitalizable Costs  Costs to acquire and prepare the asset for use Purchase price (less any discounts) Transportation costs Preparation, installation and set-up costs Direct taxes Interest costs (on self-constructed assets) Legal costs associated with the purchase John Wiley & Sons Canada, Ltd. ©2011 7

8. Basket Purchases  Several assets acquired in one transaction  Price paid is divided between the assets on the basis of their relative fair values at the time of acquisition John Wiley & Sons Canada, Ltd. ©2011 8

9. Basket Purchases John Wiley & Sons Canada, Ltd. ©2011 9 Timberland Example AssetFair Values% of fair value Purchase Price Allocation Land$ 250,000 25% $220,000 Timber 750,000 75% 660,000 $1,000,000 100%$ 880,000

10. Interest Capitalization  Companies often borrow money to finance A capital asset The construction of a capital asset  IFRS - Interest paid on borrowed money may be capitalized for assets constructed or acquired over time. John Wiley & Sons Canada, Ltd. ©2011 10

11. Amortization Concepts  Systematic and rational method of allocating the cost of capital assets to the periods in which the benefits from the assets are received (the useful life)  Does not refer to the value of the asset  Respects the matching concept John Wiley & Sons Canada, Ltd. ©2011 11

12. Amortization Methods  Straight-line method  Production method  Accelerated or declining-balance method  Decelerated or compound interest method John Wiley & Sons Canada, Ltd. ©2011 12

13. Straight-Line Method  Allocates the cost evenly over the life of the asset  Estimates needed for: Useful life Residual value  Advantage is simplicity John Wiley & Sons Canada, Ltd. ©2011 13

14. Straight-Line Method  EXAMPLE – Data/Assumptions: Original cost $50,000 Estimated Residual value $5,000 Useful life 5 years John Wiley & Sons Canada, Ltd. ©2011 14

15. Straight-Line Method John Wiley & Sons Canada, Ltd. ©2011 15 Amortization Expense = Original Cost - Estimated Residual Value Estimated Useful Life = = $50,000 - $5,000 5 years $9,000 per year

16. Straight-Line Method YearBeg. Book Value Amortization Expense Ending Book Value 1$50,000$9,000$41,000 241,0009,00032,000 3 9,00023,000 4 9,00014,000 5 9,0005,000 $45,000 John Wiley & Sons Canada, Ltd. ©2011 16 Amortization Schedule

17. Units of Production Method  Assumptions Benefits derived are related to the output or use of an asset  Requires that the useful life can be expressed as units of output John Wiley & Sons Canada, Ltd. ©2011 17

18. Units of Production Method Year 1 4,000 units Year 2 5,000 units Year 3 6,000 units Year 4 4,500 units Year 5 3,000 units 22,500 units John Wiley & Sons Canada, Ltd. ©2011 18  Data/Assumptions: Original cost $50,000 Estimated Residual value $5,000 Usage:

19. Units of Production Method John Wiley & Sons Canada, Ltd. ©2011 19 Amortization Expense per Unit = Cost - Residual Value Estimated Total Units of Output = = $50,000 - $5,000 22,500 units $2.00 per unit

20. Units of Production Method YearCost per Unit Units Produced Amortization Expense Ending NBV 1$2.00$4,000$8,000$42,000 22.005,00010,00032,000 32.006,00012,00020,000 42.004,5009,00011,000 52.003,0006,0005,000 $45,000 John Wiley & Sons Canada, Ltd. ©2011 20 Amortization Schedule

21. Accelerated Depreciation Methods  Amortization Multiply the carrying value of the asset by a fixed percentage  Carrying value decreases each year  Amortization expense decreases each year John Wiley & Sons Canada, Ltd. ©2011 21

22. Accelerated Depreciation Methods  Percentage rates Lower when asset has longer life  Double-declining-balance method Percentage is double the straight-line rate Residual value Not used for calculations Serves as a constraint  Formula (Cost – Accumulated Amortization at beginning of period) X Amortization % = Amortization Expense John Wiley & Sons Canada, Ltd. ©2011 22

23. Double Declining Balance Method  Data: Original cost $50,000 Estimated Residual value $5,000 Estimated Useful life 5 years John Wiley & Sons Canada, Ltd. ©2011 23 Rate Calculation: DDB rate = DB% x SL rate= 2 x 1/n yrs = 2 x 1/5yrs = 40%

24. Double-Declining- Balance Method YearBeginning NBV Amortization Expense Ending NBV 1$50,000$20,000$30,000 230,00012,00018,000 3 7,20010,800 4 4,3206,480 5 1,4805,000 John Wiley & Sons Canada, Ltd. ©2011 24 Amortization Schedule

25. Recording Amortization Expense  The same journal entry is used for all amortization methods: Amortization expense (SE) XX Accumulated amortization (XA) XX  Use of a contra-asset account—more informative than reducing the asset directly. John Wiley & Sons Canada, Ltd. ©2011 25

26. Corporate Income Taxes  Canada Revenue Agency (CRA) Amortization expense is allowed to be deducted to calculate accounting income Capital cost allowance (CCA) instead must be used to calculate taxable income John Wiley & Sons Canada, Ltd. ©2011 26

27. Corporate Income Taxes  Must add back amortization expense to net income and deduct CCA instead.  Results in a temporary difference between accounting income and taxable income  Result is a future income tax liability or asset (Amortization Expense – CCA) x Tax Rate = Future Income Tax Asset/Liability John Wiley & Sons Canada, Ltd. ©2011 27

28. Capital Cost Allowance (CCA)  Capital assets are grouped into classes and assigned a maximum rate  Example: Vehicles: Class 10 - rate 30 % Equipment: Class 8 - rate 20 %  Most classes are declining balance John Wiley & Sons Canada, Ltd. ©2011 28

29. Capital Cost Allowance (CCA)  Company purchases new equipment (Class 8) costing $50,000  CCA calculation: John Wiley & Sons Canada, Ltd. ©2011 29 YearRateUCC (Cost-Accumulated CCA) CCA 120%x50,000 x 50%=5,000 220%x(50,000 - 5,000)=9,000 320%x(50,000 - 14,000)=7,200 420%x(50,000 - 21,200)=5,760

30. 30 Future Income Taxes John Wiley & Sons Canada, Ltd. ©2011 Accounting Income Taxable Income Revenues$100,000 Amortization(9,000)— CCA—(5,000) Other Expenses(66,000) Income Before Tax25,00029,000 Taxes at 40%$10,000$11,600

31. Future Income Taxes  Journal entry: Income Tax expense (SE)10,000 Future tax asset (A) 1,600 Income taxes payable (L) 11,600 *(Future tax liability if a credit balance) John Wiley & Sons Canada, Ltd. ©2011 31

32. Changes in Depreciation Estimates  Example: Data/assumptions Original cost $50,000 Estimated Residual value $5,000 Useful life 5 years Straight-line amortization$9,000 NBV at end of year 3$23,000 John Wiley & Sons Canada, Ltd. ©2011 32  Estimates of useful life and residual value may change over time - amortization may change as a result.

33. Changes in Amortization Estimates John Wiley & Sons Canada, Ltd. ©2011 Amortization Expense = Remaining Book Value – Residual Value Useful Life = = $23,000 – $2,000 3 years $7000 per year for years 4, 5, and 6 Change in year 4 Residual value $2,000 Remaining useful life 3 years 33

34. Write-down of Capital Assets Net Recoverable Amount  The total of all the future cash flows related to the asset, without discounting them to present values.  If an asset’s carrying value exceeds its net recoverable amount, the carrying value must be written down and the difference recognized as an impairment loss.  Under both historical cost and net realizable value, an asset cannot be valued at more than the amount that can be recovered from it. John Wiley & Sons Canada, Ltd. ©2011 34

35. Write-down of Capital Assets  If future recoverable amount of a capital asset declines below its carrying value Loss due to damage to equipment (SE) 3,000 Accumulated depreciation (XA) 3,000 John Wiley & Sons Canada, Ltd. ©2011 35

36. Sale of Capital Assets  Original cost and accumulated amortization removed from accounts  Gain or loss: difference between cash received and book value of asset Cash (A) 6,000 Accumulated amortization (XA) 45,000 Equipment (A) 50,000 Gain on sale of equipment (SE) 1,000 John Wiley & Sons Canada, Ltd. ©2011 36

37. Disposal of Capital Assets  If assets are disposed of and no cash is received: Accumulated amortization (XA)45,000 Loss on disposal of equipment (SE) 5,000 Equipment (A)50,000 John Wiley & Sons Canada, Ltd. ©2011 37

38. Capital Asset Disclosures John Wiley & Sons Canada, Ltd. ©2011 38

39. Natural Resources  Capitalizing the costs as assets implies that they have future value  Example: oil exploration  Exploration costs methods Full costing method – capitalizes the costs of all explorations, both successful and unsuccessful, as long as the expected revenues from all the explorations are estimated to exceed the total costs.  Successful efforts method – capitalizes only the cost of successful explorations and expenses any unsuccessful exploration costs.  Amortization of natural resources is called depletion John Wiley & Sons Canada, Ltd. ©2011 39

40. Intangible Assets  Intangible assets have probable future value but may not have physical form  Guidelines: If developed internally, expense costs as incurred If purchased, acquisition costs can be capitalized John Wiley & Sons Canada, Ltd. ©2011 40

41. Intangible Assets - Amortization  Estimate useful life and residual value (if any)  Straight-line method is most commonly used  Accumulated amortization account rarely used Amortization expense (SE)XX Patents (A) XX John Wiley & Sons Canada, Ltd. ©2011 41

42. Intangible Assets  Advertising Generally expensed as incurred Difficult to justify future benefits  Patents, Trademarks, Copyrights Legal life is the maximum for amortizing Useful, or economic life, is generally used for calculating amortization  Goodwill Capitalize if purchased but not amortized Annual evaluation to determine if value is impaired—if so, write-down is required John Wiley & Sons Canada, Ltd. ©2011 42

43. 43 Return on Assets  Widely used to assess how well management has used the assets to operate income  Interest expense is added back to income to equate interest with dividends  Interest expense is adjusted to reflect the fact that it is tax- deductible John Wiley & Sons Canada, Ltd. ©2011 43 What does “tax deductible” mean?

44. ROA = Net income + [Interest expense - Tax savings of Interest Expense)] Average total assets = Income before Interest expense Average total assets Return on Assets John Wiley & Sons Canada, Ltd. ©2011 = Net Income + [Interest Expense X (1 – Tax Rate)] Average total assets

45. 45 Statement Analysis Considerations  Choice of amortization method affects both the value of asset on balance sheet and the amount of expense on the income statement;  Many valuable assets are not recorded on the balance sheet because they are internally developed, e.g., customer lists, intellectual property, human resources;  Establishing the market values for some assets might be relevant if the company has to replace them;  Soft assets, such as development costs, may require skepticism. John Wiley & Sons Canada, Ltd. ©2011 What is a “soft asset” ?

46. Copyright © 2011 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his / her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. 46 Copyright