Copyright 2003 Prentice Hall Publishing1 Chapter 5 Acquisitions: Purchase and Use of Business Assets

Copyright 2003 Prentice Hall Publishing2 Classification of Operational Assets l Operational assets are used by a business to generate revenue. l Tangible operational assets have physical substance. n Land, buildings, fixtures, and equipment n Natural resources

Copyright 2003 Prentice Hall Publishing3 Long-term Operational Assets... l Long-term assets will be used more than one year. l Tangible operational assets are reported on the balance sheet in a classification called Property, Plant, and Equipment.

Copyright 2003 Prentice Hall Publishing4 Classification of Operational Assets Classification of Operational Assets l Intangible operational assets lack physical substance and confer specific use rights on the owner. p Patents p Copyrights p Franchises p Licenses p Trademarks

Copyright 2003 Prentice Hall Publishing5 Purchased operational assets are recorded at cost, an amount that includes all normal and reasonable expenditures necessary to get the asset in place and ready for its intended use. Invoice price p Sales taxes p Transportation costs p Installation costs p Renovation and repair cost incurred prior to use. Measuring and Recording Acquisition Cost

Copyright 2003 Prentice Hall Publishing6 l Acquisition cost is the net cash equivalent amount paid for the asset. l Financing charges are excluded from the acquisition cost but should be reported as interest expense. Measuring Acquisition Cost

Copyright 2003 Prentice Hall Publishing7 l The cost of land includes: n Acquisition price n Real estate commissions n Title search and transfer fees n Title insurance premiums n Delinquent taxes n Surveying fees l Land is not depreciated. Measuring Acquisition Cost

Copyright 2003 Prentice Hall Publishing8 When land and building are purchased together, the land cost and the building cost are placed in separate accounts. The total cost of the purchase is separated on the basis of relative market values. Basket Purchase of Acquisitions

Copyright 2003 Prentice Hall Publishing9 Example: On March 1, Arco Co. purchased land and building for $200,000 cash. The appraised value of the building was $172,500, and the land was appraised at $57,500. How much of the $200,000 purchase price will be allocated to each account? Basket Purchase of Acquisitions

Copyright 2003 Prentice Hall Publishing10 Fair Market Values: Building$ 172,500 Land$ 57,500 Total market value$ 230,000 Allocation of cost: Building* $200,000 = Land* $200,000 = Basket Purchase of Acquisitions

Copyright 2003 Prentice Hall Publishing11 Fair Market Values: Building$ 172,500 Land$ 57,500 Total market value$ 230,000 Allocation of cost: Building172,500/230,000* $200,000 = Land 57,500/230,000 * $200,000 = Basket Purchase of Acquisitions

Copyright 2003 Prentice Hall Publishing12 Fair Market Values: Building$ 172,500 Land$ 57,500 Total market value$ 230,000 Allocation of cost: Building.75* $200,000 = 150,000 Land.25 * $200,000 = 50,000 Basket Purchase of Acquisitions

Copyright 2003 Prentice Hall Publishing13 Nature of Depreciation, Depletion, and Amortization The matching principle requires that part of the acquisition cost be expensed in periods when the future revenues are earned. Cost of asset on Balance Sheet...as the asset is used..... Expense on Income Statement [capitalize] [expense]

Copyright 2003 Prentice Hall Publishing14 Terminology: Write-off….amortize l Amortization: n Intangible assets l Depreciation: n Property, plant, equipment franchise l Depletion: –Natural resources The most general term for writing off an asset is amortization amortization. However, specific terms are used for certain assets:

Copyright 2003 Prentice Hall Publishing15 Depreciation Methods p Straight-line p Production method p (Double) Declining balance

Copyright 2003 Prentice Hall Publishing16 Cost - Residual Value Life in Years Depreciation Expense per Year = Straight-Line Method

Copyright 2003 Prentice Hall Publishing17 On January 1, 2003, equipment was purchased for $55,000 cash. The equipment has an estimated useful life of 5 years and an estimated residual value of $10,000. What is the annual straight- line depreciation expense? Straight-Line Method: Example

Copyright 2003 Prentice Hall Publishing18 Depreciation Expense per Year = Depreciation Expense per Year = Cost - Residual Value Life in Years Depreciation Expense per Year = Straight-Line Method: Example

Copyright 2003 Prentice Hall Publishing19 Depreciation Expense per Year = Depreciation Expense per Year = Cost - Residual Value Life in Years Depreciation Expense per Year = 55, ,000 5 Straight-Line Method: Example

Copyright 2003 Prentice Hall Publishing20 Depreciation Expense per Year = Depreciation Expense per Year = Cost - Residual Value Life in Years Depreciation Expense per Year = 55, , ,000 Straight-Line Method: Example

Copyright 2003 Prentice Hall Publishing21 Calculate depreciation expense for the fourth year of the asset’s life. $9000 Depreciation expense is the same amount each year of the asset’s life using the straight-line method. Straight-Line Method: Example

Copyright 2003 Prentice Hall Publishing22 Units-of-Production Method Step 1:Depreciation Rate Rate= Cost - Residual Value Cost - Residual Value Estimated units of useful life

Copyright 2003 Prentice Hall Publishing23 Units-of-Production Method Depreciation Rate Rate= Cost - Residual Value Cost - Residual Value Estimated units of useful life Step 1: Step 2: Depreciation Expense = Depreciation Rate × Number of Units Produced for the Year

Copyright 2003 Prentice Hall Publishing24 Given the same information [asset cost $55,000, a residual value of $10,000, and a useful life of five years] plus the asset is estimated to have a total productive capacity of 100,000 units during the useful life: If 22,000 units were produced this year, what is the amount of depreciation expense? Units of Production Method: Example

Copyright 2003 Prentice Hall Publishing25 Step 1: Step 2: Depreciation Expense = Depreciation Rate Rate = = Cost - salvage value Productive output 45, ,000 Production Method: Example

Copyright 2003 Prentice Hall Publishing26 Step 1: Step 2: Depreciation Expense = $.45/unit* 22,000 = 9,900 Depreciation Rate Rate = = Cost - salvage value Productive output 45, ,000 Dep. rate * units produced Production Method: Example

Copyright 2003 Prentice Hall Publishing27 l If 15,000 units are produced during the second year of the asset’s life, what is the amount of depreciation expense?.45 * = Production Method: Example

Copyright 2003 Prentice Hall Publishing28 l Accelerated depreciation methods result in more depreciation expense in the early years of an asset’s useful life and less depreciation expense in later years of the an asset’s useful life. Accelerated Depreciation

Copyright 2003 Prentice Hall Publishing29 Double-Declining Balance Method l Declining-balance depreciation is based on the straight-line rate multiplied by an acceleration factor. n For example, when the acceleration factor is 200 percent, the method is referred to as double-declining balance depreciation. l Declining-balance depreciation computations ignore residual value, although the asset can’t be depreciated below the residual value.

Copyright 2003 Prentice Hall Publishing30 The annual depreciation amount is calculated with the following formula: Book Value × (2 × Straight-Line Rate) First, calculate a rate by dividing 2 by the number of years of useful life. = Double-Declining Balance Method

Copyright 2003 Prentice Hall Publishing31 Annual depreciation expense is calculated with the following formula: () Book Value × Useful Life in Years 2 Double-Declining Balance Method

Copyright 2003 Prentice Hall Publishing32 Using the same information from our earlier example [asset cost $55,000, residual value is $10,000, and useful life is 5 years]: Calculate the depreciation expense for the first two years of the asset’s life. Double-Declining-Balance Example

Copyright 2003 Prentice Hall Publishing33 First year’s depreciation: Second year’s depreciation: Rate = 2/5 = 40% Double-Declining Balance Method

Copyright 2003 Prentice Hall Publishing34 Double-Declining-Balance Example First year’s depreciation: 55,000 *.40 = 22,000 Rate = 2/5 = 40%

Copyright 2003 Prentice Hall Publishing35 Double-Declining-Balance Example First year’s depreciation: Second year’s depreciation: 55,000 *.40 = 22,000 33,000 *.40 = 13,200 Rate = 2/5 = 40%

Copyright 2003 Prentice Hall Publishing36 l The total amount of depreciation recorded over the useful life of an asset is the same regardless of the method used. l Depreciation expense recorded in any one period will vary according to method used. l The straight-line method is used by about 95 percent of companies because it is easy to use and to explain. Comparison of Methods

Copyright 2003 Prentice Hall Publishing37 l Most corporations use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes. l MACRS provides for rapid write-off of an asset’s cost in order to stimulate investment in modern facilities. Depreciation and Federal Income Tax

Copyright 2003 Prentice Hall Publishing38 Revising Estimates of Salvage Value or of Useful Life l When an estimate is revised, no changes are made to amounts reported in the past. l The new estimates are incorporated into the present and future calculations only. l Depreciation amounts are revised using the book value and the estimated useful life and salvage value at beginning of the year of the revision.

Copyright 2003 Prentice Hall Publishing39 Continuing Expenditures for Plant Assets l Expenditures made to keep an asset in good working order are expensed in the period in which they are incurred. l Substantial costs spent to improve the quality or extend the life of an asset are capitalized.

Copyright 2003 Prentice Hall Publishing40 l Extend the life? n viewed as canceling some of the previous depreciation n journal entry to reduce (debit) accumulated depreciation n new depreciation amount will be calculated l Improve the quality? n viewed as an additional cost of the equipment n journal entry to increase (debit) the cost of the asset n new depreciation amount will be calculated Accounting for Capital Expenditures

Copyright 2003 Prentice Hall Publishing41 l Voluntary disposal refers to situations where a business gives up ownership of an asset by: n Sale n Trade-in n Retirement l Involuntary disposal results because of a casualty such as a fire or an accident. Disposal of Operational Assets

Copyright 2003 Prentice Hall Publishing42 1.Update the depreciation on the asset to the date of disposal. 2. Compare the book value of the asset to the cash proceeds from the disposal. If the proceeds > book value, there is a gain on the disposal. If the book value > proceeds, then there is a loss on the sale. 3. Gains and losses go on the income statement. Disposal of Operational Assets

Copyright 2003 Prentice Hall Publishing43 l Truck which was purchased for $10,000 and with accumulated depreciation of $8,000 was sold for $3,000. Asset Disposal: Example

Copyright 2003 Prentice Hall Publishing44 l Compare the Book Value (10,000- 8,000) to the cash proceeds (3,000). l The difference is a gain or loss on the sale. l Here it is a gain: Proceeds of $3,000 > BV of $2,000 l Gain of $1,000 goes to the income statement.

Copyright 2003 Prentice Hall Publishing45 l Truck which was purchased for $10,000 and with accumulated depreciation of $8,000 was sold for $1,000. Asset Disposal: Example

Copyright 2003 Prentice Hall Publishing46 l Compare the Book Value (10,000-8,000) to the cash proceeds (1,000). l The difference is a gain or loss on the sale. l Here it is a loss: Book value of $2,000 > Proceeds of $1,000 l Loss on disposal of $1,000 goes to the income statement.

Copyright 2003 Prentice Hall Publishing47 Compare cash received for the asset with the asset’s book value (BV). n If cash greater than BV, record a gain. n If cash less than BV, record a loss. n If cash equals BV, no gain or loss. asset for sale Disposal of Operational Assets

Copyright 2003 Prentice Hall Publishing48 l Assets supplied by nature n Examples: gold, oil, and coal l Presented on balance sheet as non-current assets at cost less depletion to date. l Depletion is just like “units of production” depreciation. Natural Resources

Copyright 2003 Prentice Hall Publishing49 l Total cost of the asset is the cost of acquisition, exploration and development. l Total cost is apportioned by means of depletion over periods in which resulting revenues are earned. Natural Resources

Copyright 2003 Prentice Hall Publishing50 A depletion rate is calculated using the units-of-production method. Depletion Cost Per Unit Is Calculated As Follows: Total Cost of Natural Resource Estimated Number of Available Units of Natural Resource Natural Resources

Copyright 2003 Prentice Hall Publishing51 l Noncurrent assets without physical substance that confer certain rights and privileges on the owner of the asset. n Examples: patents, copyrights, franchises and licenses, leaseholds, leasehold improvements, trademarks, and goodwill. l Purchased intangible assets are recorded at cost. Intangible Assets

Copyright 2003 Prentice Hall Publishing52 l Purchased intangible assets are amortized over the shorter of their economic life or legal life, subject to a maximum of 40 years. l Normally the straight-line method is used and the asset is reported in the balance sheet at book value without a related accumulated amortization account. Intangible Assets

Copyright 2003 Prentice Hall Publishing53 l A patent is an exclusive right granted by federal government to sell or manufacture an invention. l A patent is amortized over the shorter of its useful life or 17-year legal life. Intangible Assets: Patents