FINANCIAL ACCOUNTING a user perspective Sixth Canadian Edition Prepared by: Lynn de Grace C.A. Chapter 8 Capital Assets— Tangible and Intangible 1

Capital Assets— Recognition A capital asset  Has value in use Used to generate future revenue through sales of products or services Cash received over several future periods  Used until replaced with a new asset Can have residual (or resale) value John Wiley & Sons Canada, Ltd. ©2011 2

Valuation of Capital Assets Alternative 1 – Historical cost  Original cost of the asset  Expensed (amortized) over the useful life  Gain or loss on sale Recognized only when sold Difference between the proceeds of the sale and the net book value  Net book value (or carrying value) Original cost less amortization Also called the amortized cost of the asset John Wiley & Sons Canada, Ltd. ©2011 3

4 Valuation of Capital Assets Alternative 2: Market Value—Replacement Cost  Amount that would be needed to acquire an equivalent asset  Unrealized gains and losses are recognized as the replacement value of the asset changes  Amortization would need to be adjusted each time the replacement value changes John Wiley & Sons Canada, Ltd. ©2011

5 Valuation of Capital Assets Alternative 3: Market Value—NRV  Amount that would be received by converting the asset to cash  Unrealized gains and losses are recognized as NRV changes  Amortization is adjusted each time NRV is adjusted  When the asset is sold or disposed of, the gain or loss will be small John Wiley & Sons Canada, Ltd. ©2011

Valuation of Capital Assets Canadian practice:  Use historical cost (original acquisition cost). Meets objectives: reliable, verifiable, objective  Amortize cost over the period of use  Market value changes are not recognized until the asset is disposed of.  IFRS : Companies may opt to use NRV to value capital assets Unrealized gains and losses are reported directly in shareholders’ equity as a revaluation reserve. John Wiley & Sons Canada, Ltd. ©2011 6

Capitalizable Costs  Costs to acquire and prepare the asset for use Purchase price (less any discounts) Transportation costs Preparation, installation and set-up costs Direct taxes Interest costs (on self-constructed assets) Legal costs associated with the purchase John Wiley & Sons Canada, Ltd. ©2011 7

Basket Purchases  Several assets acquired in one transaction  Price paid is divided between the assets on the basis of their relative fair values at the time of acquisition John Wiley & Sons Canada, Ltd. ©2011 8

Basket Purchases John Wiley & Sons Canada, Ltd. © Timberland Example AssetFair Values% of fair value Purchase Price Allocation Land$ 250,000 25% $220,000 Timber 750,000 75% 660,000 $1,000, %$ 880,000

Interest Capitalization  Companies often borrow money to finance A capital asset The construction of a capital asset  IFRS - Interest paid on borrowed money may be capitalized for assets constructed or acquired over time. John Wiley & Sons Canada, Ltd. ©

Amortization Concepts  Systematic and rational method of 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  Respects the matching concept John Wiley & Sons Canada, Ltd. ©

Amortization Methods  Straight-line method  Production method  Accelerated or declining-balance method  Decelerated or compound interest method John Wiley & Sons Canada, Ltd. ©

Straight-Line Method  Allocates the cost evenly over the life of the asset  Estimates needed for: Useful life Residual value  Advantage is simplicity John Wiley & Sons Canada, Ltd. ©

Straight-Line Method  EXAMPLE – Data/Assumptions: Original cost $50,000 Estimated Residual value $5,000 Useful life 5 years John Wiley & Sons Canada, Ltd. ©

Straight-Line Method John Wiley & Sons Canada, Ltd. © Amortization Expense = Original Cost - Estimated Residual Value Estimated Useful Life = = $50,000 - $5,000 5 years $9,000 per year

Straight-Line Method YearBeg. Book Value Amortization Expense Ending Book Value 1$50,000$9,000$41, ,0009,00032, ,00023, ,00014, ,0005,000 $45,000 John Wiley & Sons Canada, Ltd. © Amortization Schedule

Units of 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 John Wiley & Sons Canada, Ltd. ©

Units of Production Method Year 1 4,000 units Year 2 5,000 units Year 3 6,000 units Year 4 4,500 units Year 5 3,000 units 22,500 units John Wiley & Sons Canada, Ltd. ©  Data/Assumptions: Original cost $50,000 Estimated Residual value $5,000 Usage:

Units of Production Method John Wiley & Sons Canada, Ltd. © Amortization Expense per Unit = Cost - Residual Value Estimated Total Units of Output = = $50,000 - $5,000 22,500 units $2.00 per unit

Units of Production Method YearCost per Unit Units Produced Amortization Expense Ending NBV 1$2.00$4,000$8,000$42, ,00010,00032, ,00012,00020, ,5009,00011, ,0006,0005,000 $45,000 John Wiley & Sons Canada, Ltd. © Amortization Schedule

Accelerated Depreciation Methods  Amortization Multiply the carrying value of the asset by a fixed percentage  Carrying value decreases each year  Amortization expense decreases each year John Wiley & Sons Canada, Ltd. ©

Accelerated Depreciation 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 calculations Serves as a constraint  Formula (Cost – Accumulated Amortization at beginning of period) X Amortization % = Amortization Expense John Wiley & Sons Canada, Ltd. ©

Double Declining Balance Method  Data: Original cost $50,000 Estimated Residual value $5,000 Estimated Useful life 5 years John Wiley & Sons Canada, Ltd. © Rate Calculation: DDB rate = DB% x SL rate= 2 x 1/n yrs = 2 x 1/5yrs = 40%

Double-Declining- Balance Method YearBeginning NBV Amortization Expense Ending NBV 1$50,000$20,000$30, ,00012,00018, ,20010, ,3206, ,4805,000 John Wiley & Sons Canada, Ltd. © Amortization Schedule

Recording Amortization Expense  The same journal entry is used for all amortization methods: Amortization expense (SE) XX Accumulated amortization (XA) XX  Use of a contra-asset account—more informative than reducing the asset directly. John Wiley & Sons Canada, Ltd. ©

Corporate Income Taxes  Canada Revenue Agency (CRA) Amortization expense is allowed to be deducted to calculate accounting income Capital cost allowance (CCA) instead must be used to calculate taxable income John Wiley & Sons Canada, Ltd. ©

Corporate Income Taxes  Must add back amortization expense to net income and deduct CCA instead.  Results in a temporary difference between accounting income and taxable income  Result is a future income tax liability or asset (Amortization Expense – CCA) x Tax Rate = Future Income Tax Asset/Liability John Wiley & Sons Canada, Ltd. ©

Capital Cost Allowance (CCA)  Capital assets are grouped into classes and assigned a maximum rate  Example: Vehicles: Class 10 - rate 30 % Equipment: Class 8 - rate 20 %  Most classes are declining balance John Wiley & Sons Canada, Ltd. ©

Capital Cost Allowance (CCA)  Company purchases new equipment (Class 8) costing $50,000  CCA calculation: John Wiley & Sons Canada, Ltd. © YearRateUCC (Cost-Accumulated CCA) CCA 120%x50,000 x 50%=5, %x(50, ,000)=9, %x(50, ,000)=7, %x(50, ,200)=5,760

30 Future Income Taxes John Wiley & Sons Canada, Ltd. ©2011 Accounting Income Taxable Income Revenues$100,000 Amortization(9,000)— CCA—(5,000) Other Expenses(66,000) Income Before Tax25,00029,000 Taxes at 40%$10,000$11,600

Future Income Taxes  Journal entry: Income Tax expense (SE)10,000 Future tax asset (A) 1,600 Income taxes payable (L) 11,600 *(Future tax liability if a credit balance) John Wiley & Sons Canada, Ltd. ©

Changes in Depreciation Estimates  Example: Data/assumptions Original cost $50,000 Estimated Residual value $5,000 Useful life 5 years Straight-line amortization$9,000 NBV at end of year 3$23,000 John Wiley & Sons Canada, Ltd. ©  Estimates of useful life and residual value may change over time - amortization may change as a result.

Changes in Amortization Estimates John Wiley & Sons Canada, Ltd. ©2011 Amortization Expense = Remaining Book Value – Residual Value Useful Life = = $23,000 – $2,000 3 years $7000 per year for years 4, 5, and 6 Change in year 4 Residual value $2,000 Remaining useful life 3 years 33

Write-down of Capital Assets Net Recoverable Amount  The total of all the future cash flows related to the asset, without discounting them to present values.  If an asset’s carrying value exceeds its net recoverable amount, the carrying value must be written down and the difference recognized as an impairment loss.  Under both historical cost and net realizable value, an asset cannot be valued at more than the amount that can be recovered from it. John Wiley & Sons Canada, Ltd. ©

Write-down of Capital Assets  If future recoverable amount of a capital asset declines below its carrying value Loss due to damage to equipment (SE) 3,000 Accumulated depreciation (XA) 3,000 John Wiley & Sons Canada, Ltd. ©

Sale of Capital Assets  Original cost and accumulated amortization removed from accounts  Gain or loss: difference between cash received and book value of asset Cash (A) 6,000 Accumulated amortization (XA) 45,000 Equipment (A) 50,000 Gain on sale of equipment (SE) 1,000 John Wiley & Sons Canada, Ltd. ©

Disposal of Capital Assets  If assets are disposed of and no cash is received: Accumulated amortization (XA)45,000 Loss on disposal of equipment (SE) 5,000 Equipment (A)50,000 John Wiley & Sons Canada, Ltd. ©

Capital Asset Disclosures John Wiley & Sons Canada, Ltd. ©

Natural Resources  Capitalizing the costs as assets implies that they have future value  Example: oil exploration  Exploration costs methods Full costing method – capitalizes the costs of all explorations, both successful and unsuccessful, as long as the expected revenues from all the explorations are estimated to exceed the total costs.  Successful efforts method – capitalizes only the cost of successful explorations and expenses any unsuccessful exploration costs.  Amortization of natural resources is called depletion John Wiley & Sons Canada, Ltd. ©

Intangible Assets  Intangible assets have probable future value but may not have physical form  Guidelines: If developed internally, expense costs as incurred If purchased, acquisition costs can be capitalized John Wiley & Sons Canada, Ltd. ©

Intangible Assets - Amortization  Estimate useful life and residual value (if any)  Straight-line method is most commonly used  Accumulated amortization account rarely used Amortization expense (SE)XX Patents (A) XX John Wiley & Sons Canada, Ltd. ©

Intangible Assets  Advertising Generally expensed as incurred Difficult to justify future benefits  Patents, Trademarks, Copyrights Legal life is the maximum for amortizing Useful, or economic life, is generally used for calculating amortization  Goodwill Capitalize if purchased but not amortized Annual evaluation to determine if value is impaired—if so, write-down is required John Wiley & Sons Canada, Ltd. ©

43 Return on Assets  Widely used to assess how well management has used the assets to operate income  Interest expense is added back to income to equate interest with dividends  Interest expense is adjusted to reflect the fact that it is tax- deductible John Wiley & Sons Canada, Ltd. © What does “tax deductible” mean?

ROA = Net income + [Interest expense - Tax savings of Interest Expense)] Average total assets = Income before Interest expense Average total assets Return on Assets John Wiley & Sons Canada, Ltd. ©2011 = Net Income + [Interest Expense X (1 – Tax Rate)] Average total assets

45 Statement Analysis Considerations  Choice of amortization method affects both the value of asset on balance sheet and the amount of expense on the income statement;  Many valuable assets are not recorded on the balance sheet because they are internally developed, e.g., customer lists, intellectual property, human resources;  Establishing the market values for some assets might be relevant if the company has to replace them;  Soft assets, such as development costs, may require skepticism. John Wiley & Sons Canada, Ltd. ©2011 What is a “soft asset” ?

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