ACCOUNTING PRINCIPLES Third Canadian Edition Prepared by: Keri Norrie, Camosun College

LONG-LIVED ASSETS CHAPTER 9

Long-lived assets are used in the operations of a business and are not intended for sale to customers. Long-lived assets are subdivided into two classes: 1. Tangible (with physical substance) 2. Intangible (without physical substance) LONG-LIVED ASSETS

Tangible assets include: Property, plant and equipment –Land –Land improvements –Buildings –Equipment Natural resources such as mineral deposits, oil and gas reserves, and timber. TANGIBLE ASSETS

Property, plant, and equipment are recorded at cost in accordance with the 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. DETERMINING THE COST OF PROPERTY, PLANT, AND EQUIPMENT

Cost is measured by the cash paid in a cash transaction or by the cash equivalent price when non-cash assets are used in payment. The cash equivalent price is equal to the fair market value of the asset given up or the fair market value of the asset received, whichever is more clearly determinable. MEASUREMENT OF COST

The cost of Land includes: 1.purchase price, 2.closing costs such as title and legal fees. All necessary costs incurred in making land ready for its intended use are debited to the Land account. LAND

The cost of land improvements includes all expenditures necessary to make the improvements ready for their intended use, such as: 1. parking lots 2. fencing 3. landscaping 4. lighting Lighting Parking Lot LAND IMPROVEMENTS

The cost of buildings includes all necessary expenditures relating to the purchase or construction of a building. When a building is purchased, such costs include the purchase price and closing costs. Costs to make the building ready for its intended use consist of expenditures for remodelling and replacing or repairing the roof, floors, wiring, and plumbing. When a new building is constructed, cost consists of the contract price plus payments for architects’ fees, building permits, interest payments during construction, and excavation costs. BUILDINGS

The cost of equipment consists of the cash purchase price, freight charges, and insurance paid by the purchaser during transit. Cost includes all expenditures required in assembling, installing, and testing the unit. EQUIPMENT

BASKET PURCHASE Allocate cost of a group of assets in proportion to relative fair market values.

Amortization is the process of allocating to expense the cost of a long-lived asset over its useful (service) life in a rational and systematic manner. Cost allocation is designed to provide for the proper matching of expenses with revenues in accordance with the matching principle. During an asset’s life, its usefulness may decline because of wear and tear or obsolescence. Recognition of amortization does not result in the accumulation of cash for the replacement of the asset. Long-lived assets with indefinite lives (e.g., land) are not amortized. However, they are written down for impairment losses (when market value is permanently less than the asset’s book value). AMORTIZATION

FACTORS IN CALCULATING AMORTIZATION (Illustration 9-3)

AMORTIZATION METHODS Three methods of recognizing amortization are: 1. Straight-line, 2. Declining-balance, and 3. Units of activity. Each method is acceptable under generally accepted accounting principles. Management selects the method that is appropriate for their company. Once a method is chosen, it should be applied consistently.

STRAIGHT-LINE METHOD Illustration 9-5

STRAIGHT-LINE METHOD (Illustration 9-7) Amortization is constant for each year of the asset's useful life.

DECLINING-BALANCE METHOD The calculation of periodic amortization is based on a declining net book value (cost less accumulated amortization) of the asset. The amortization rate remains constant from year to year, but the net book value to which the rate is applied declines each year. Net Book Value (at beginning of year) Straight-line Rate (x declining balance rate multiplier, if any) Amortization Expense x=

DECLINING-BALANCE METHOD Illustration 9-9 Accelerated methods result in more amortization in early years and less in later years.

UNITS-OF-ACTIVITY METHOD To use the units-of-activity method, 1. the total units of activity for the entire useful life are estimated, 2. the amount is divided into amortizable cost to calculate the amortization cost per unit, and 3. the amortization cost per unit is then applied to the units of activity during the year to calculate the annual amortization. Amortizable Cost Total Estimated Units of Activity Amortizable Cost per Unit = ÷ Units of Activity during the Year Amortization Expense x = Amortizable Cost per Unit

UNITS-OF-ACTIVITY METHOD Illustration 9-11 Useful life is expressed in terms of total units of production or activity expected from the asset.

If annual amortization is inadequate or excessive, a change in the periodic amount 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. REVISING PERIODIC AMORTIZATION Revised amortization expense = Net book value at time of revision – revised residual value Remaining useful life

Ordinary repairs are expenditures to maintain the operating efficiency and expected productive life of the long-lived asset. They are debited to Repairs Expense as incurred and are often referred to as operating expenditures. Additions and improvements are costs incurred to increase the operating efficiency, productive capacity, or expected useful life of the long-lived asset. 1. Expenditures are usually material in amount and occur infrequently during the period of ownership. 2. Since additions and improvements increase the company’s investment in productive facilities, they are debits to the long-lived asset affected, and are referred to as capital expenditures. EXPENDITURES DURING USEFUL LIFE

Property, plant, and equipment may be disposed of by a) retirement b) sale, or c) exchange DISPOSALS OF PROPERTY, PLANT, AND EQUIPMENT

Amortization for the fraction of the year to the date of disposal must be recorded Amortization expensexxx Accumulated amortization xxx Calculate net book value Net book value = Cost – accumulated amortization 1 2

Compare net book value to sale proceeds Proceeds > Net book value = gain (cr.) Proceeds < Net book value = loss (dr.) Record disposition, removing cost of asset and accumulated amortization, and record proceeds (if any) and gain or loss on disposition (if any) 3 4 Cashxxx Accumulated amortizationxxx Property, plant or equipment accountxxx Gain on disposalxxx DISPOSALS OF PROPERTY, PLANT, AND EQUIPMENT

EXCHANGES OF PROPERTY, PLANT, AND EQUIPMENT (Monetary Exchanges of Assets) Monetary exchanges of assets occur when either: 1. the assets exchanged are dissimilar, or 2. a significant amount of cash (more than 10% of the total consideration) is involved in the exchange of similar assets. To illustrate, assume a delivery truck (cost $100,000; accumulated amortization $75,000) with a fair market value of $30,000 is exchanged for new office furniture.

How is it accounted for? The exchange is viewed as a sale of the old asset (the delivery truck) and a purchase of the new asset (the office furniture). The delivery truck is viewed as being sold for proceeds equivalent to its fair market value ($30,000). The new office furniture is recorded at the cash equivalent price paid which = the fair market value of the asset given up ($30,000 for the truck) plus any cash paid (or less any cash received) which is none in this illustration. The gain or loss is the difference between the net book value ($25,000) and the fair market value of the asset given up ($30,000). Office Furniture30,000 Accumulated Amortization75,000 Delivery Truck 100,000 Gain on disposal 5,000 Office Furniture30,000 Accumulated Amortization75,000 Delivery Truck 100,000 Gain on disposal 5,000 EXCHANGES OF PROPERTY, PLANT, AND EQUIPMENT (Monetary Exchanges of Assets)

Exchanges of non-monetary or similar assets involves assets of the same type, where the new asset performs the same function as the old asset. Since, in effect, the new asset is simply a substitute or swap of the old asset, it is recorded at the net book value of the old asset given up plus any cash paid (or less any cash received). EXCHANGES OF PROPERTY, PLANT, AND EQUIPMENT (Monetary Exchanges of Assets)

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

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. Future removal and site restoration cleanup costs can significantly increase the cost of a natural resource. ACQUISITION COST

AMORTIZATION The units-of-activity method is generally used to calculate amortization, because periodic amortization generally is a function of the units extracted during the year. Unlike property, plant, and equipment, the amortization for natural resources is debited to inventory since it is a cost of extracting a saleable product. When the product is sold, then its cost is expensed to cost of goods sold.

FORMULA TO CALCULATE AMORTIZATION EXPENSE (Illustration 9-15) Amortizable Cost = (Cost – Residual Value) Total Estimated Units Amortizable Cost per Unit Amortizable Cost per Unit Number of Units Extracted and Sold Amortization Expense ÷ x = =

Intangible assets are rights, privileges, and competitive advantages that result from the ownership of long-lived assets that do not possess physical substance. Accounting for intangible assets parallels the accounting for tangible assets: Intangible assets are recorded at cost. If it has a limited life, its amortizable cost is amortized over its useful or legal life, whichever is shorter often using the straight-line method. If it has an indefinite life, it is not amortized. However, it is tested and written down for impairment losses (when market value is permanently less than the asset’s book value). At disposal, net book value is eliminated and a gain or loss, if any, is recorded. INTANGIBLE ASSETS

INTANGIBLE ASSETS WITH LIMITED LIVES (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.

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. INTANGIBLE ASSETS WITH LIMITED LIVES (COPYRIGHTS)

Research costs—record as an expense when incurred. Development costs—capitalize if associated with an identifiable, feasible product. Otherwise, expense. INTANGIBLE ASSETS WITH LIMITED LIVES (Research And Development Costs)

INTANGIBLE ASSETS WITH INDEFINITE LIVES (Trade Marks/Names) Word, phrase, jingle or symbol that distinguishes or identifies a particular enterprise or product. If trademark continues to be marketable, its life can be indefinite.

INTANGIBLE ASSETS WITH INDEFINITE LIVES (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; –If indefinite life, do not amortize. Test for impairment.

Goodwill represents favourable attributes that relate to a business enterprise. Record only in an exchange transaction that involves the purchase of an entire business. Goodwill equals the excess of cost over the fair market value of the net assets (assets less liabilities) acquired. Goodwill is not written off as it has an unlimited useful life. It must be tested regularly for impairment. INTANGIBLE ASSETS WITH INDEFINITE LIVES ( Goodwill )

In the balance sheet, property, plant and equipment and natural resources are often combined under the heading Property, Plant and Equipment. Intangible assets are often listed separately. There should be disclosure of the balances in the major classes of assets and accumulated amortization of major classes of assets or of assets in total. The amortization methods used should be described and the amount of amortization expense for the period disclosed. FINANCIAL STATEMENT PRESENTATION

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

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

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