Chapter 9 Long Term Operating Assets May 2010 ©Kimberly Lyons 1

Long Term Operating Assets Purchased, produced, or leased for long term use by the business May be tangible or intangible Capitalized cost may include any cost incurred to get the asset and get it ready for its intended use Purchase price, tax, title, license, delivery, installation, setup, testing, improvements, clearing, grading, landscaping, etc. May 2010©Kimberly Lyons 2

Tangible vs. Intangible Tangible long-term assets might include Property, plant, and equipment Buildings, equipment, machinery, furniture, etc. Land Land improvements Intangible long-term assets might include Patents Trademarks Copyrights Franchise agreements Customer lists Goodwill May 2010©Kimberly Lyons 3

Basket Purchase Putnam Company purchases Land, a building, and equipment for $500,000 cash. If the fair market values of the assets are: FMV Land$200,000 FMV Building 250,000 FMV Equipment 150,000 Total FMV$600,000 What amount will Putnam record for each of the assets? May 2010©Kimberly Lyons 4

Relative Fair Market Value The historical cost principle states that assets should be recorded at cost, which is value given in an exchange In this case the value given is $500,000 while the value received is $600,000 We will use the fair market values of the assets to help divide up the cost Land $200,000/$600,000 = 33% (rounded) Building $250,000/$600,000 = 42% (rounded) Equipment $150,000/$600,000 = 25% May 2010©Kimberly Lyons 5

Relative Fair Market Value Continued Use the percentage of each assets market value relative to total market value to divide up the cost: Land 33% x $500,000 = $165,000 Building42% x $500,000 = $210,000 Equipment25% x $500,000 = $125,000 Record the assets as follows: Land165,000 Building210,000 Equipment125,000 Cash500,000 May 2010©Kimberly Lyons 6

Leased Assets Leases are short-term rental agreements for use of property The lessor is the property owner The lessee uses the property in exchange for rent payments There are two types of lease accounting, depending on the nature of the contract Operating leases Capital leases May 2010©Kimberly Lyons 7

Operating Lease An operating lease is a simple rental agreement where the lessee makes rental payments to the lessor in exchange for use of the asset The only evidence of an operating lease is the payment Rent (lease) expenseXXX CashXXX May 2010©Kimberly Lyons 8

Capital Lease Certain rental agreements are more complex, or may be a purchase structured to look like a lease If the lease is non-cancellable and any one of the following four criteria is met, it will be treated as a capital lease 1.Title will transfer at the end of the lease term, or 2.The lease contains a bargain purchase option, or 3.The lease term 75% of the assets economic life, or 4.The present value of lease payments 90% of the assets fair market value May 2010©Kimberly Lyons 9

Capital Lease Example Dental Co. enters into a lease agreement with Drillers Inc. on 1/1/2009 for the use of special equipment. The lease is non-cancellable and calls for the equipment to be returned to the lessor at the end of the 5 year term. The equipment has a useful life of 6 years. The present value of lease payments is $100,000 and the fair market value of the equipment is $105,000. There is no bargain purchase option. Dental will make payments of $26,380 at the end of each year for five years. Is this an operating lease or a capital lease? May 2010©Kimberly Lyons 10

Capital Lease Continued Evaluate the terms of the lease It is non-cancellable and: Title transfer? No Bargain purchase option? No Lease life relative to asset life? 5/6 = 83% Yes Present value of lease payments to FMV? $100,000/$105,000 = 95% Yes This lease will be recorded as a capital lease May 2010©Kimberly Lyons 11

Capital Lease Continued At the inception of the lease on 1/1/2009 Dental will record the leased asset and related lease liability for an amount equal to the present value of lease payments 1/1Leased equipment100,000 Lease liability 100,000 May 2010©Kimberly Lyons 12

Capital Lease Continued The first payment of $26,380 is made on 12/31/2009, and it includes $10,000 of interest 12/31 Interest expense10,000 Lease liability16,380 Cash 26,380 Each payment will include interest at an amount equal to the interest rate x the outstanding liability The remainder of the payment goes toward reducing the liability May 2010©Kimberly Lyons 13

Depreciation The systematic allocation of an assets cost to expense over the assets useful life Methods include: Straight line (SL) Units of production (Units) Sum-of-the-years digits (SYD) Double declining balance (DDB) Modified Accelerated Cost Recovery (MACRS) May 2010©Kimberly Lyons 14

Straight Line Depreciation Straight line depreciation allocates an equal mount of depreciable cost to expense each period A machine is purchased at the beginning of the year at a cost of $100,000, has a useful life of 10 years or 1,000,000 units and an $8,000 salvage value at the end of its useful life Annual depreciation expense: (Cost – Salvage)/Useful life in years (100,000 – 8,000)/10 years = $9,200/year Record at December 31 st : 12/31 Depreciation expense9,200 Accumulated depreciation9,200 May 2010©Kimberly Lyons 15

Accumulated Depreciation Accumulated depreciation is a contra-asset Reported in the balance sheet net to the machine Machine$100,000 Less: Accumulated Depreciation (9,200) Net Book Value$ 90,800 As a balance sheet account, the balance of accumulated depreciation will carry over from period to period and accumulate As accumulated depreciation increases, the assets net book value decreases An asset cannot be depreciated below its salvage value or zero if there is no salvage May 2010©Kimberly Lyons 16

Units of Production A machine is purchased at the beginning of the year at a cost of $100,000, has a useful life of 10 years or 1,000,000 units and an $8,000 salvage value at the end of its useful life. It produces 110,000 units in year 1 and 106,000 units in year 2. Annual depreciation expense for the first two years (Cost – Salvage)/Useful life in units = Cost per unit Cost per unit x units produced = depreciation expense ($100,000 – 8,000)/1,000,000u = $0.092/unit Year 1: $0.092 x 110,000u = $10,120 depreciation expense Year 2: $0.092 x 106,000u = $9,752 depreciation expense May 2010©Kimberly Lyons 17

Sum-of-the-Years Digits A machine is purchased at the beginning of the year at a cost of $100,000, has a useful life of 10 years or 1,000,000 units and an $8,000 salvage value at the end of its useful life SYD is an accelerated depreciation method where depreciable cost is expensed at a rate of the declining useful life to the sum of the years digits Annual depreciation expense for the first two years (Cost – salvage) x (remaining life/SYD) SYD = = 55 SYD = n(n+1)/2 = (10 x 11)/2 = 55 Year 1: ($100,000 – 8,000) x (10/55) = $16,727 Year 2: ($100,000 – 8,000) x (9/55) = $15,055 May 2010©Kimberly Lyons 18

Double Declining Balance This is the most accelerated method, depreciating Book value (the declining balance) at two times the straight- line rate Book value = Cost – accumulated depreciation As accumulated depreciation increases, book value decreases Salvage value is not incorporated in the initial calculation, that would reduce the depreciation expense May 2010©Kimberly Lyons 19

Double Declining Balance Continued A machine is purchased at the beginning of the year at a cost of $100,000, has a useful life of 10 years or 1,000,000 units and an $8,000 salvage value at the end of its useful life Annual depreciation expense for the first three years 2 x 1/SL x (cost – accumulated depreciation) Year 1: 2 x 1/10 ($100,000 – 0) = $20,000 Year 2: 2 x 1/10 ($100,000 – 20,000) = $16,000 Year 3: 2 x 1/10 ($100,000 – 36,000) = $12,800 Be careful not to depreciate below salvage This means total accumulated depreciation cannot exceed $92,000 May 2010©Kimberly Lyons 20

Recording Partial Years Depreciation The year of acquisition and disposal usually require partial years allocation Purchases and sales of long-term assets typically do not occur on January 1 All methods except units-of-production will require proration Units of production is based on production, not time Some companies apply a first and last year convention or assumption to simplify One half year in the first and last year regardless of the date of purchase A full year in the first year and none in the last regardless of the date of purchase Watch the dates May 2010©Kimberly Lyons 21

Asset Disposal Disposing of long-term assets for more (less) less than book value creates gains (losses) To record a disposal Depreciation must be recorded and up-to-date Remove the cost of the asset from the books Remove all related accumulated depreciation Record cash or assets received upon disposal Debit difference = loss Credit difference = gain If cash received = book value, no gain or loss May 2010©Kimberly Lyons 22

Asset Disposal Continued A machine is purchased at the beginning of the year at a cost of $100,000, has a useful life of 10 years or 1,000,000 units and an $8,000 salvage value at the end of its useful life After recording the third year of depreciation (straight-line) the asset is sold for $75,000 Accumulated depreciation (100,000 – 8,000)/10 x 3 = $27,600 Record the disposal Cash 75,000 Accumulated depreciation27,600 Machine100,000 Gain on sale 2,600 May 2010©Kimberly Lyons 23

Asset Impairment An impairment represents a decline in the value of a long-term asset The value of a long-term asset depends on the future cash flows (benefit) it will generate When an asset is considered impaired Future cash flows < book value The loss of value equals Fair market value – book value May 2010©Kimberly Lyons 24

Recording an Impairment Dalton Inc. has a piece of equipment with the following information Original cost$400,000 Accumulated depreciation$130,000 Expected future cash flows$200,000 Fair market value$190,000 Is the asset impaired? How much is the impairment? Record the impairment May 2010©Kimberly Lyons 25

Recording an Impairment Continued Is the asset impaired? Future cash flows < book value? $200,000 - $270,000 = (70,000) Yes How much is the impairment? Book value – fair market value $270,000 - $190,000 = $80,000 Loss Record the impairment Accumulated depreciation130,000 Loss on impairment 80,000 Equipment 210,000 May 2010©Kimberly Lyons 26

Recording an Impairment Continued Debiting accumulated depreciation removes it from the books Debiting the loss records it Crediting the asset for the difference between recorded cost and fair market value reduces recorded cost to fair market value If future estimates of cash flows show an increase in value, this increase is not recorded May 2010©Kimberly Lyons 27

Review for Exam Identify different categories of long-term assets Record a basket purchase Distinguish between an operating lease and a capital lease Record the journal entries for both types of lease Calculate and record depreciation using SL, Units, SYD, DDB Calculate book value Calculate a gain or loss on disposal and record the disposal Calculate and record an asset impairment May 2010©Kimberly Lyons 28