Reporting and Interpreting Property, Plant and Equipment; Natural Resources; and Intangibles Chapter 8 McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

Slide 2 McGraw-Hill/Irwin Tangible Physical Substance Intangible No Physical Substance Expected to Benefit Future Periods Actively Used in Operations Classifying Long-Lived Assets Land Assets subject to depreciation  Buildings and equipment  Furniture and fixtures Natural resource assets subject to depletion  Mineral deposits and timber Examples Value represented by rights that produce benefits Definite life Patents Copyrights Franchises Indefinite life Trademarks Goodwill Examples

Slide 3 McGraw-Hill/Irwin Measuring and Recording Acquisition Cost Acquisition cost includes the purchase price and all expenditures needed to prepare the asset for its intended use. Acquisition cost does not include financing charges and cash discounts. Acquisition cost includes the purchase price and all expenditures needed to prepare the asset for its intended use. Acquisition cost does not include financing charges and cash discounts.

Slide 4 McGraw-Hill/Irwin Depreciation is a cost allocation process that systematically and rationally matches acquisition costs of operational assets with periods benefited by their use. Cost Allocation (Unused) Balance Sheet (Used) Income Statement Expense Depreciation Concepts Acquisition Cost Depreciation Expense Income Statement Balance Sheet Accumulated Depreciation Depreciation for the current year Total of depreciation to date on an asset

Slide 5 McGraw-Hill/Irwin Depreciation Concepts The calculation of depreciation requires three amounts for each asset:  Acquisition cost.  Estimated useful life.  Estimated residual value. The calculation of depreciation requires three amounts for each asset:  Acquisition cost.  Estimated useful life.  Estimated residual value. Alternative depreciation methods:  Straight-line  Units-of-production  Accelerated Method: Declining balance Alternative depreciation methods:  Straight-line  Units-of-production  Accelerated Method: Declining balance

Slide 6 McGraw-Hill/Irwin Straight-Line Method Cost - Residual Value Life in Years Depreciation Expense per Year Depreciation Expense per Year == At the beginning of the year, Southwest purchased ground equipment for $62,500 cash. The equipment has an estimated useful life of 3 years and an estimated residual value of $2,500. Depreciation Expense per Year = Depreciation Expense per Year = $20,000 $62,500 - $2,500 3 years

Slide 7 McGraw-Hill/Irwin Residual Value SL More companies use the straight-line method of depreciation in their financial reports than all other methods combined. Straight-Line Method

Slide 8 McGraw-Hill/Irwin Units-of-Production Method Depreciation Rate = Cost - Residual Value Life in Units of Production Step 1: Step 2: Depreciation Expense = Depreciation Rate × Number of Units Produced for the Year At the beginning of the year, Southwest purchased ground equipment for $62,500 cash. The equipment has a 100,000 mile useful life and an estimated residual value of $2,500. If the equipment is used 30,000 miles in the first year, what is the amount of depreciation expense?

Slide 9 McGraw-Hill/Irwin Units-of-Production Method $62,500 - $2, ,000 miles = $.60 per mile Depreciation Rate = Step 1: Step 2: $.60 per mile × 30,000 miles = $18,000 Depreciation Expense = Residual Value

Slide 10 McGraw-Hill/Irwin Accelerated Depreciation Depreciation Repair Expense Early Years High Low Later Years Low High Accelerated depreciation matches higher depreciation expense with higher revenues in the early years of an asset’s useful life when the asset is more efficient.

Slide 11 McGraw-Hill/Irwin Declining-Balance Method Annual Depreciation expense Net Book Value () Useful Life in Years 2 = × Cost – Accumulated Depreciation Declining balance rate of 2 is double-declining- balance (DDB) rate. Annual computation ignores residual value. At the beginning of the year, Southwest purchased equipment for $62,500 cash. The equipment has an estimated useful life of 3 years and an estimated residual value of $2,500. Calculate the depreciation expense for the first two years.

Slide 12 McGraw-Hill/Irwin Annual Depreciation expense Net Book Value () Useful Life in Years 2 = × () $62,500 × 3 years 2 = $41,667 () ($62,500 – $41,667) × 3 years 2 = $13,889 Declining-Balance Method Year 1 Depreciation: Year 2 Depreciation:

Slide 13 McGraw-Hill/Irwin () ($62,500 – $55,556) × 3 years 2 = $4,629 Below residual value Declining-Balance Method

Slide 14 McGraw-Hill/Irwin Depreciation expense is limited to the amount that reduces book value to the estimated residual value. Declining-Balance Method

Slide 15 McGraw-Hill/Irwin Repairs, Maintenance, and Additions

Slide 16 McGraw-Hill/Irwin Repairs, Maintenance, and Additions To solve this problem, many companies have policies regarding the expensing of all expenditures below a certain amount according to the materiality constraint.

Slide 17 McGraw-Hill/Irwin Disposal of Property, Plant, and Equipment  Journalize disposal by: Writing off accumulated depreciation (debit). Writing off the asset cost (credit). Recording cash received (debit) or paid (credit). Recording a gain (credit) or loss (debit).  Update depreciation to the date of disposal.

Slide 18 McGraw-Hill/Irwin If Cash > BV, record a gain (credit). If Cash < BV, record a loss (debit). If Cash = BV, no gain or loss. If Cash > BV, record a gain (credit). If Cash < BV, record a loss (debit). If Cash = BV, no gain or loss. Disposal of Property, Plant, and Equipment Southwest Airlines sold flight equipment for $5,000,000 cash at the end of its 17th year of use. The flight equipment originally cost $20,000,000, and was depreciated using the straight-line method with zero residual value and a useful life of 20 years.

Slide 19 McGraw-Hill/Irwin Prepare the journal entry to record Southwest’s sale of the equipment at the end of the 17th year. Disposal of Property, Plant, and Equipment

Slide 20 McGraw-Hill/Irwin Fixed Asset Turnover Net Sales (or Operating Revenues) Average Net Fixed Assets = This ratio measures the sales dollars generated by each dollar of fixed assets used. During 2011, Southwest Airlines had $15,658 of operating revenues. End-of- year fixed assets were $12,127 and beginning-of-year fixed assets were $10,578. (All numbers in millions.) Fixed Asset Turnover $15,658 ($10,578 + $12,127) ÷ 2 ==

Slide 21 McGraw-Hill/Irwin Acquisition and Depletion of Natural Resources Examples: oil, coal, gold Extracted from the natural environment. A noncurrent asset presented at cost less accumulated depletion. Total cost of asset is the cost of acquisition, exploration, and development. Total cost is allocated over periods benefited by means of depletion. Depletion is like units-of-production depreciation.

Slide 22 McGraw-Hill/Irwin The unit depletion rate is calculated as follows: Estimated Recoverable Units Acquisition and Residual Development Cost Value – Depletion cost Inventory for sale Unsold Inventory Cost of goods sold Depletion cost for a period is: UNIT DEPLETION RATE NUMBER OF UNITS EXTRACTED IN PERIOD × Acquisition and Depletion of Natural Resources

Slide 23 McGraw-Hill/Irwin Acquisition and Amortization of Intangible Assets Noncurrent assets without physical substance. Useful life is often difficult to determine. Usually acquired for operational use. Often provide exclusive rights or privileges. Intangible Assets: -Patents -Trademarks -Copyrights -Franchises -Licenses Record at current cash equivalent cost, including purchase price, legal fees, and filing fees.

Slide 24 McGraw-Hill/Irwin Occurs when one company buys another company. The amount by which the purchase price exceeds the fair market value of net assets acquired. Only purchased goodwill is an intangible asset. Goodwill Acquisition and Amortization of Intangible Assets Goodwill is not amortized. Its value must be reviewed at least annually for possible impairment, and the book value is reduced to fair value if impaired.

Slide 25 McGraw-Hill/Irwin Definite Life Amortize over shorter of economic life or legal life, subject to rules specified by GAAP. Use straight-line method. Definite Life Amortize over shorter of economic life or legal life, subject to rules specified by GAAP. Use straight-line method. Indefinite Life Not amortized. Tested at least annually for possible impairment, and book value is reduced to fair value if impaired. Indefinite Life Not amortized. Tested at least annually for possible impairment, and book value is reduced to fair value if impaired. Amortization is a cost allocation process similar to depreciation and depletion. Acquisition and Amortization of Intangible Assets

Slide 26 McGraw-Hill/Irwin Measuring Asset Impairment Impairment is the loss of a significant portion of the utility of an asset through... Casualty. Obsolescence. Lack of demand for the asset’s services. Recognize a loss when an asset suffers a permanent impairment. Determination of Asset Impairment Compare Net Book Value to Estimated Future Cash Flows: If FCF>NBV, do nothing If FCF<NBV, asset is impaired Record Impairment: Asset Impairment Loss XXX Asset XXX XXX=Difference between NBV and Fair (Market) Value Determination of Asset Impairment Compare Net Book Value to Estimated Future Cash Flows: If FCF>NBV, do nothing If FCF<NBV, asset is impaired Record Impairment: Asset Impairment Loss XXX Asset XXX XXX=Difference between NBV and Fair (Market) Value

Slide 27 McGraw-Hill/Irwin TAX REPORTING Most public companies maintain two sets of accounting records reflecting the same transactions, but accounted for using two different sets of measurement rules. One set is prepared under GAAP for reporting to stockholders. The other set is prepared to determine the company’s tax obligation under the Internal Revenue Code (IRC). The two sets of rules differ because the objectives of GAAP and the IRC differ

© 2008 The McGraw-Hill Companies, Inc. End of Chapter 8