FINANCIAL ACCOUNTING A USER PERSPECTIVE Hoskin Fizzell Davidson Second Canadian Edition

Capital Assets Chapter Eight

Capital Asset Recognition Capital assets –Used to generate revenue over several periods in the future –Used until replaced with a new asset –Can have residual (or resale) value

Capital Asset Valuation Historical cost –Original cost of the asset –Expensed (amortized) over the period used

Capital Asset Valuation Gain or loss on sale –Recognized only when sold –Difference between proceeds of the sale and the net book value Net book value (or carrying value) –Original cost less amortization

Capital Asset Valuation Market value –Replacement cost Amount that would be needed to acquire an equivalent asset –Net realizable value Amount that could be received by converting the asset to cash

Capital Asset Valuation Canadian practice –Uses historical cost –Amortized over the period of use Maximum of 40 years –Market value changes generally not recognized

Capitalizable Costs Costs to acquire and prepare the asset for use –Purchase price (less any discounts) –Installation costs –Transportation costs –Legal costs –Direct taxes

Basket Purchases Several assets acquires in one transaction Price paid is divided between the assets on the basis of their relative fair values at the time of acquisition

Basket Purchases Timberland Example

Interest Capitalization Companies often borrow money to finance a capital asset Interest paid on borrowed money –Capitalized when it is included in the capital asset account rather than being expensed

Amortization (or Depreciation) Method for 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 Follows the matching concept

Amortization Methods Straight-line method Accelerated or diminishing balance method Decelerated method Unit of production method

Amortization Methods DollarsDollars Asset Carrying Value

Amortization Methods DollarsDollars Amortization Expense

Straight-Line Method Allocates the cost evenly over the life of the asset Estimates needed for –Useful life –Residual value

Straight-Line Method Assumptions: –Original Cost$10,000 –Estimated Residual Value $1,000 Useful Life5 years

Straight-Line Method Amortization Expense = Original CostResidual Value Useful Life - = = $10,000 5 years $1,000 $1,800 per year -

Straight-Line Method Amortization Schedule

Accelerated Methods Amortization –Multiply the carrying value of the asset by a fixed percentage Carrying value decreases each year Amortization expenses decreases each year

Accelerated 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 computations Serves as a constraint

Double Declining Balance Method Assumptions: –Original Cost$10,000 –Estimated Residual Value $1,000 Useful Life5 years –200% Declining Balance Method

Double Declining Balance Method Calculation: DB rate = DB% x SL rate = 200% x 1/n = 200% x 1/5 = 40%

Double Declining Balance Method Amortization Schedule

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

Production Method Assumptions: –Original Cost$10,000 –Estimated Residual Value $1,000 –Estimated Usage

Production Method Amortization Expense per Unit = CostResidual Value Estimated Total Units of Output - = = $10,000 20,000 units $1,000 $0.45 per unit -

Production Methods Amortization Schedule

Recording Amortization Expense All amortization methods: SE-Amortization expenseXX XA-Accumulated amortizationXX

Corporate Income Taxes Revenue Canada –Amortization expense is allowed to be deducted to calculate accounting income –Capital cost allowance (CCA) instead must be used to calculate taxable income

Corporate Income Taxes May result in a temporary difference between Accounting income and taxable income Result is a future tax asset or liability (formerly referred to as deferred tax)

Capital Cost Allowance (CCA) Capital assets are grouped into classes and assigned a maximum rate –Vehicles: Class 10: rate 30% –Equipment: Class 8: rate 20%

Capital Cost Allowance (CCA) Companies may deduct any part of the undepreciated capital costs (UCC) in the class up to the stated maximum Exception: –Year of acquisition: 50% of normal amount

Capital Cost Allowance (CCA) Central Corp. purchases new equipment (Class 8) at a cost of $20,000 CCA Year 1: 50% x $20,000 x 20% = $2,000 Year 2: 20% x ($20,000-$2,000)= $3,600 Year 3: 20% x ($20,000-$2,000-$3,600) = $2,880

Capital Cost Allowance (CCA) Journal entry: SE-Tax expense11,460 A-Future tax asset* 90 L-Income taxes payable11,550 *(Future tax liability if a credit balance)

Changes in Amortization Estimates and Methods Estimates of useful life and residual value may change over time Amortization may change as a result

Changes in Amortization Estimates and Methods Straight-Line Method Assumptions –Original Cost$10,000 –Residual Value $1,000 –Useful Life 5 years Changes in Year 4 (Estimations) Remaining Useful Life3 years Residual Value$ 400

Changes in Amortization Estimates and Methods Amortization Expense = Remaining Book Value Residual Value Useful Life - = = $4,600 3 years $400 $1,400 per year -

Changes in Amortization Estimates and Methods Amortization Schedule

Sale of Capital Assets Original cost and accumulated amortization removed from accounts Gain or loss: difference between cash received and book value A-Cash1,200 XA-Accumulated amortization9,000 A-Property, plant and equipment10,000 SE-Gain on sale of PP&E 200

Disposal of Capital Assets If assets are disposed of and no cash is received XA-Accumulated amortization9,000 SE-Loss on disposal of PP&E1,000 A-Property, plant and equipment10,000

Writedown of Capital Assets If future recoverable amount of a capital asset declines below its carrying value SE-Loss due to damage to asset1,000 XA-Accumulated amortization1,000

Natural Resources Capitalizing the costs implies that they have future value Example: oil exploration Exploration costs choices –Full costing method –Successful efforts method

Intangible Assets Intangible assets have probable future value but no physical form Guidelines: –If developed internally, expense as incurred –If purchased, can be capitalized

Intangible Assets Estimate useful life and residual value (if any) Use straight-line method to amortize SE-Amortization expenseXX A-PatentsXX

Intangible Assets Advertising –Generally expensed as incurred Patents, Trademarks, Copyrights –Legal life is the maximum for amortizing Goodwill –Capitalize and amortize if purchased

Return on Assets ROA = Net income + [Interest expense x (1-Tax rate)] Average total assets = Net income before interest Average total assets