Long-Term Investments in Productive Assets Chapter 12 Robinson, Munter, Grant

Robinson, Munter & Grant Chapter 122 Learning Objectives Identify long-term productive assets Expensing vs. capitalizing Asset costs Research and development costs Operating and capital leases Disclosures related to long-term productive assets

Robinson, Munter & Grant Chapter 123 Issues for Long-term Assets Depreciation of Property, Plant and Equipment –Straight-line –Accelerated –Units of production Deplete natural resources Amortize intangible assets

Robinson, Munter & Grant Chapter 124 Long-lived Productive Assets Asset-related expenditures are capitalized –Result in a probable future economic benefit –Expenses are deferred –Reduces the volatility of ROA and ROE Period costs – those not related to assets – are expensed as incurred –Expense appears on the income statement immediately

Robinson, Munter & Grant Chapter 125 Cost of P, P & E Includes all costs necessary to bring the asset to the condition and location of its intended use Invoice price, net of discounts Freight-in and installation Taxes Interest charges, in some cases

Robinson, Munter & Grant Chapter 126 Asset Cost Capitalized Interest – US GAAP Qualifying assets are constructed or otherwise produced for an enterprise’s own use Discrete projects, not routine inventory Cost that would have been avoided if asset-related expenditures had not been made Cannot exceed total interest cost International standards state a preference for expensing

Robinson, Munter & Grant Chapter 127 Depreciation A systematic process of cost allocation Does not reflect changes in market value Time based methods –Ratable: uniform expense over time –Accelerated: greater expense in early years Activity based method

Robinson, Munter & Grant Chapter 128 Depreciation Time based methods Ratable: –Straight-line Accelerated: –Sum of the Years’ Digits –Double Declining Balance –Greater expense in early years Calculations demonstrated in Chapter 2

Robinson, Munter & Grant Chapter 129 Depreciation Review From Chapter 2 Straight-line depreciation Most common method Annual expense = (Cost – salvage value) ÷ Life A 4-year asset costing $450,000 with a $50,000 SV Annual depreciation = $100,000 Total depreciation = $400,000

Robinson, Munter & Grant Chapter 1210 Depreciation Review From Chapter 2 Sum of the years’ digits Annual expense = (Cost – SV) * (Years remaining/Sum of the years’ digits) Year 1 = ($450,000-$50,000)*(4/10) = $160,000 Year 2 = ($450,000-$50,000)*(3/10) = $120,000 Year 3 = ($450,000-$50,000)*(2/10) = $ 80,000 Year 4 = ($450,000-$50,000)*(1/10) = $ 40,000 Total depreciation expense = $400,000

Robinson, Munter & Grant Chapter 1211 Depreciation Review From Chapter 2 Declining balance Determine straight-line rate (1/Useful life) Determine acceleration factor (150%, 175%, 200%) Depreciation rate = (SL rate * acceleration factor) Depreciation expense = Cost – Accumulated depreciation * Depreciation rate Return to previous data, use acceleration factor of 150% Year 1 = ($450,000)*(.375) = $ 168,750 Year 2 = ($450,000-$168,750)*(.375) = $ 105,469… Discontinue depreciation when Net book value = SV Total depreciation expense = $400,000

Robinson, Munter & Grant Chapter 1212 Analyses from Disclosure Information Estimate percent of life used –Accumulated depreciation/Depreciable property Estimate useful life –Depreciable property/Depreciation expense –Better when companies use straight-line When an accelerated form of depreciation is used, Net income and Profit margin will be lower in the early years of the asset’s life

Robinson, Munter & Grant Chapter 1213 Identifiable Intangible Assets Contract based –Agreements, contracts, leases, rights Legal-based –Patents, copyrights, franchises, trademarks Separable –Lists, databases, processes, R & D

Robinson, Munter & Grant Chapter 1214 Identifiable Intangible Assets Postacquisition – The US Model Amortize according to the pattern of benefit No maximum useful life has been established If asset has an indefinite useful life, it is not amortized –Test for impairment (at least) annually –Compare fair value to carrying amount

Robinson, Munter & Grant Chapter 1215 Identifiable Intangible Assets Postacquisition – The International Model Amortize all intangible assets 20-year maximum useful life –Sometimes longer Impairments are recorded as necessary Revaluation (increases) are rare –Gain is a component of “other comprehensive income”

Robinson, Munter & Grant Chapter 1216 Goodwill Arises as part of business combinations When fair value identifiable assets acquired < price paid US standards require impairment testing and do not allow amortization International standards require amortization over a maximum of 20 years

Robinson, Munter & Grant Chapter 1217 Research and Development Research – aimed discovery of new knowledge with the hope of developing or improving a product, process or service. Development – translation of research into plan, design or improvement of product or process. Does not include costs incurred after development has been completed.

Robinson, Munter & Grant Chapter 1218 Research and Development U.S. Standard R&D costs are expensed as incurred. R&D includes: –Materials, equipment, facilities, personnel… If an expenditure-related item has an alternative future use, the cost is capitalized. –Depreciation may be a component of R&D while the asset is used in R&D activities

Robinson, Munter & Grant Chapter 1219 Research and Development International Standard Research phase: planned investigation Cost are expensed as incurred Most R&D costs are expensed before reaching the development phase

Robinson, Munter & Grant Chapter 1220 Research and Development International Standard Development phase: application of research findings Capitalize if –Intangible asset is complete (specific criteria must be met), and –Expenditures can be reliably measured

Robinson, Munter & Grant Chapter 1221 Research and Development International Standard Capitalize if: –Technical feasibility of completing the asset has occurred –Intend to complete the intangible asset –Entity has ability to use/sell the asset –R&D will result in probably future economic benefit –Entity has resources to complete and sell/use asset

Robinson, Munter & Grant Chapter 1222 Software Development Costs SOP 98-1 Accounting for the Costs of Computer Software Developed or Obtained for Internal Use Determine three sequential phases of development and implementation processes Categorize costs by phase Capitalize and amortize, or expense costs

Robinson, Munter & Grant Chapter 1223 Software Development Costs SOP 98-1 Preliminary project: costs are expensed –Conceptual work, consideration of alternatives Application development: capitalize costs –Coding, installation, testing Postimplementation and operation: expensed –Training and maintenance

Robinson, Munter & Grant Chapter 1224 Software Development Costs SFAS 86 Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed All costs incurred prior to the point where the technological feasibility has been established are R&D –Costs of planning, coding, testing US and international standards are similar

Robinson, Munter & Grant Chapter 1225 Advantages of Leases 1.Property financing at 100% 2.Advantageous financing arrangements 3.Flexible 4.Protection against obsolescence 5.Off-balance-sheet financing 6.Guarantees to the lessor

Robinson, Munter & Grant Chapter 1226 Capital Leases 1.Transfer ownership? 2.Contains a bargain purchase option? 3.Lease term ≥ 75% life of leased property? 4.PV of minimum lease payments ≥ 90% fair value of leased property? If “Yes” to any question, it is a capital lease.

Robinson, Munter & Grant Chapter 1227 Lessee Accounting Capital lease –Asset (and depreciation) –Liability (and interest expense) –PV of minimum lease payments Operating lease –Rent expense –No asset or liability related to leased asset

Robinson, Munter & Grant Chapter 1228 Lease Disclosures Required by US and international standards Disclose total lease payments to be made in the future Segregate amounts –Each of the next five years, individually –Total amount due thereafter

Robinson, Munter & Grant Chapter 1229 Conversion Adjustments To reflect a purchase: (Income statement, Balance sheet) Add back the lease payments Subtract depreciation on the additions to equipment Subtract interest expense on the additions to liabilities

Robinson, Munter & Grant Chapter 1230 Summary Long-term non-financial assets –Cost –Depreciation Goodwill Research and development Leases