Accounting for Long-Term Assets Chapter 8 Accounting for Long-Term Assets In this chapter we will study the acquisition and depreciation of productive assets used in a business.

Plant Assets Tangible in Nature Actively Used in Operations Expected to Benefit Future Periods Previously, we discussed assets and liabilities that arise from the day to day operating activities of an entity. In this chapter, and the ones that follow we discuss assets and liabilities that arise from the investing activities of an entity. This chapter discusses the purchase of assets for investment, and the next chapter discusses liabilities that result from these purchases. LONG LIVED ASSETS A long-lived asset is an asset that is held over the course of several years in order to facilitate operating activities. A long-term asset is different from inventory because unlike inventory, a long-term asset is not acquired for resale to customers, but are used to generate future revenues. In this chapter you will be introduced to the basic types of long-lived assets and learn how they are presented on the financial statements. Businesses need equipment in order to meet their objectives, whether it is desks, computers, tables or a building. Equipment of this sort is known as Property, Plant and Equipment. Property, Plant and Equipment- Tangible, long-lived assets acquired for use in operations. Called Property, Plant, & Equipment

Plant Assets C 1 As you can see, not all companies have a high percentage of plant assets. McDonald’s, the fast food franchiser, has buildings and equipment in almost all cities in this country and major cities abroad. We would expect a company like McDonald’s to have substantial investments in property, plant, and equipment. Contrast McDonald’s with the online giant eBay. There is no need for eBay to have plant assets in many major cities. The company is basically an online service run from a central location. We do not mean to imply that eBay has no plant assets, but rather that its plant assets are concentrated in a central location and made up largely of computer equipment.

Intangible Assets Intangible Assets P6 Noncurrent assets without physical substance. Often provide exclusive rights or privileges. Intangible Assets Tangible Assets- Assets that have physical substance which include the examples listed above. Having physical substance means that they can be seen and touched. Intangible Assets- a long-lived asset that lacks physical substance. Examples on intangible assets are copyrights, goodwill, and anything of the sort that provides a future benefit but does not have a physical substance. An intangible asset generally is what gives one firm a competitive advantage over another firm. Useful life is often difficult to determine. Usually acquired for operational use.

Decline in asset value over its useful life Plant Assets C 1 Decline in asset value over its useful life When accounting for a long-term asset, it is not acceptable to simply record an expense for the cost of the asset and record the outflow of cash. Like all other assets, when purchasing or acquiring a fixed asset they are recorded at the historical (initial cost), including any costs to acquire the asset and get it ready for use. There are two basic steps in accounting for assets: Record the initial purchase, which will place the asset on the balance sheet (as property, plant and equipment), at cost and record the payable or outflow of cash. This is done on the date of purchase. At the end of each accounting period (year), an adjusting entry must be made to recognize the expense attributable to that period a/k/a depreciation expense. In order to comply with the matching principle, the expense of the asset is recognized over the estimated useful life of the asset or period in which it will be of use and aid in the generation of revenue, as opposed to taking an expense at the time the asset is purchased. This concept is called DEPRECIATION! A similar thing also happens to intangible assets, works in the same way, but we refer to it using a different term. Disposal 4. Record disposal. Acquisition 1. Compute cost. Use 2. Allocate cost to periods benefited. 3. Account for subsequent expenditures.

All expenditures needed to prepare the asset for its intended use Cost Determination P1 Purchase price All expenditures needed to prepare the asset for its intended use Acquisition Cost The cost of a plant asset includes the purchase price as well as all costs necessary to get the asset in place and ready for its intended use. We record the purchase price net of any cash discounts available. Finance charges are not included in the cost of an asset. If we elect to finance the purchase over a period of time, the interest cost is charged as an expense when incurred. Finance charges are INTEREST as a result of using credit to purchase. Acquisition cost excludes financing charges and cash discounts.

Land Land is not depreciable. Title insurance premiums Purchase price Delinquent taxes Real estate commissions Surveying fees Land is not a depreciable plant asset. In addition to the purchase price, there are many costs generally incurred in connection with the acquisition. Many of these costs are related to obtaining legal title to the land. Why is land an exception to the rule, and not treated as other long term assets and not depreciable?? Title search and transfer fees Land is not depreciable.

Land Improvements P1 Parking lots, driveways, fences, walks, shrubs, and lighting systems. Depreciate over useful life of improvements. Land improvements are depreciated over their useful life. Land improvements include parking lots, driveways, fences, sidewalks, landscaping, and any outdoor lighting systems.

Cost of purchase or construction Buildings P1 Cost of purchase or construction Title fees Brokerage fees Attorney fees Whether we purchase or construct a building, the cost should include the purchase price plus any attorney fees or title fees. If we construct the building, the cost will include all the necessary construction costs as well as the costs we have just mentioned. Taxes

Machinery and Equipment Purchase price Taxes Transportation charges Machinery and equipment is recorded at its purchase price less any available cash discount. The company may have to pay delivery charges on the truck; these costs are included in the cost of the truck. If we need to install any special parts to make the machinery or equipment ready for its intended use, we will include these costs in the price of the assets. Installing, assembling, and testing Insurance while in transit

Depreciation C2 Depreciation is the process of allocating the cost of a plant asset to expense in the accounting periods benefiting from its use. Acquisition Cost (Unused) Balance Sheet (Used) Income Statement Expense Cost Allocation The allocation that assigns the cost of the asset to the periods benefited by the asset is called depreciation. Many get confused by this concept because students think that depreciation reflects a decline of an assets value, but it is actually nothing more than a write off of the original cost. We’re moving the asset off of the balance sheet as used, to the income expense, so we have an expense for the purchase of the asset every year over its life. The unused portion of the asset’s cost appears on the balance sheet. We allocate a portion of the cost to expense on the income statement each accounting period. Let’s look at some very common methods of calculating depreciation expense.

Factors in Computing Depreciation The calculation of depreciation requires three amounts for each asset: Book Value. Salvage Value. Useful Life. Book Value- the assets original cost less any accumulated depreciation (depreciation expense that has occurred for this asset over prior years). In other words, book value is the portion of the cost not yet assigned to income statement expense. Salvage Value- what you expect to get for the asset when disposed at the end of its useful life. Ex. You buy a car, and you expect that after 5 years you can sell it to somebody else for $5,000. Useful Life- The Length of time that the asset can be productively used within operations.

Straight-line Units-of-production Depreciation Methods C 2 When we record depreciation, we are recording an expense for the value of the asset consumed and removing that portion of the asset off the balance sheet. The journal entry to record depreciation is as follows: Depreciation Expense…………………..xxx Accumulated Depreciation………….xxx To record depreciation on asset for period. Depreciation expense is a conventional operating expense, so it is shown on an income statement. Accumulated Depreciation is called a contra asset, meaning it appears on the balance sheet and is used to reduce the value of the asset to its new book value (has a credit balance). e.g. Harry Company Balance Sheet 12/31/2000 Assets: Property, Plant and Equipment: Truck…………………….25,000 Less: Accum. Deprec……(5,000) 20,000 In this case, the assets book value would be 20,000; the historical cost of 25,000 less the accumulated depreciation of 5,000.

Cost - Salvage Value Useful life in periods Straight-Line Method P2 Cost - Salvage Value Useful life in periods Depreciation Expense for Period = On January 1, 2007, equipment was purchased for $50,000 cash. The equipment has an estimated useful life of 5 years and an estimated residual value of $5,000. Depreciation expense for any given period is determined by taking the asset’s cost less its estimated salvage value and dividing this amount by the asset’s estimated useful life. If we calculate annual depreciation, we would express the useful life in years. Or we may want to calculate monthly depreciation. We will see how to do this on a later slide. Here is our specific depreciation example. On January 1, 2007, a company purchased equipment for fifty thousand dollars. The estimated useful life is five years and the estimated salvage value is five thousand dollars. Can you calculate the amount of annual depreciation?

Cost - Salvage Value Useful life in periods Straight-Line Method P2 Cost - Salvage Value Useful life in periods Depreciation Expense for Period = $9,000 Depreciation Expense per Year = $50,000 - $5,000 5 years This calculation was relatively easy. Did you get the annual depreciation of nine thousand dollars? Now let’s make the journal entry on December 31, to record depreciation expense for the year. The proper adjusting journal entry is to debit, or increase, depreciation expense and credit, or increase, the contra account, accumulated depreciation dash equipment for nine thousand dollars. Now let’s look at depreciation for this asset for its five-year life.

Straight-Line Method Salvage Value Depreciation Rate = Notice that depreciation expense is the same amount in each of the five years. If we plot this amount on a graph, it would be a straight-line. That is how we got the name of the method. Accumulated depreciation increases by nine thousand dollars each year. The cost of the asset (fifty thousand dollars) less accumulated depreciation at the end of any year is called book value. Book value decreases by nine thousand dollars each year. The book value is equal to the estimated salvage value at the end of the asset’s useful life. We want this to be true regardless of the method we use. It’s easy to calculate the rate of depreciation -- just divide one hundred percent by the useful life. In this case the rate of depreciation is twenty percent. If we multiply the asset’s cost less it’s salvage value of forty five thousand dollars times twenty percent, we get the annual depreciation of nine thousand dollars. Salvage Value Depreciation Rate = (100% ÷ 5 years) = 20% per year

For the year ended December 31 Depreciation Expense reported on the Income Statement. P2 $9,000 $7,000 Depreciation Expense $5,000 $3,000 $1,000 $0 2007 2008 2009 2010 2011 For the year ended December 31 Book Value reported on the Balance Sheet. For the year ended December 31 Book Value In this graph of each year’s depreciation expense, you can clearly see the straight-line nature of the method. Now we have a graph of the asset’s book value at the end of each year. Once again, we have a straight-line that slopes down and to the left.

Units-of-Production Method Depreciation Per Unit = Cost - Salvage Value Total Units of Production Step 1: Step 2: Depreciation Expense = Per Unit × Number of Units Produced in the Period Units of Production Depreciation Expense is computed in two phases: Depreciation Per Unit = Cost-Salvage Value/ Total Estimated Units to be produced Depreciation Expense = Depreciation Per unit (answer from step 1) x Number of units produced in year.

Units-of-Production Method On December 31, 2007, equipment was purchased for $50,000 cash. The equipment is expected to produce 100,000 units during its useful life and has an estimated salvage value of $5,000. If 22,000 units were produced in 2008, what is the amount of depreciation expense? At the end of December 2007, the company purchased equipment that had a cost of fifty thousand dollars and estimated salvage value of five thousand dollars. The equipment is expected to produce one hundred thousand units during its useful life. During 2008, the equipment was used to produce twenty-two thousand units. Let’s follow our two-step method of calculating depreciation expense for 2008.

Units-of-Production Method Step 1: Depreciation Per Unit = $50,000 - $5,000 100,000 units = $.45 per unit Step 2: Depreciation Expense = $.45 per unit × 22,000 units = $9,900 First we calculate the depreciation expense per unit of production of forty-five cents per unit. During 2008, the company produced twenty-two thousand units, so we determine depreciation expense of ninety nine hundred dollars. Just multiply the twenty-two thousand units time the forty five cents per unit depreciation charge. Let’s look at a table of depreciation expense for this equipment over its five year life. Remember that we need to know the units produced in each year.

Units-of-Production Method In the second column we show the units produced in each of the five years. In 2010, no units were produced, so there is no depreciation. The depreciation expense amounts are all determined by multiplying the units produced by forty-five cents per unit. Finally, notice that the book value is equal to the estimated salvage value of five thousand dollars at the end of the asset’s estimated useful life. Now let’s move on to the declining balance method. No depreciation expense if the equipment is idle.

Depreciation for Tax Reporting Most corporations use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes. MACRS depreciation provides for rapid write-off of an asset’s cost in order to stimulate new investment. When filing a tax return most corporations use the modified accelerated cost recovery system developed by the Internal Revenue Service. Because the title of the method is so long most accountants refer to the tax method as MACRS. MACRS is an accelerated depreciation method. It was designed to permit companies to quickly write-off the cost of plant assets and thereby stimulate investment in new plant assets.

Reporting Depreciation Total accumulated depreciation is subtracted for the total cost of property, plant, and equipment.

Additional Expenditures After a plant asset is purchased, the company may incur additional expenditures on that asset. These expenditures may be for repairs and maintenance, overhauls, upgrading the asset, and similar expenditures. One way to handle these types of expenditures is to treat them as a Capital Expenditure and charge the amount to a balance sheet account like the asset or accumulated depreciation. In some cases, the expenditures may be treated as Revenue Expenditures and charged to current period income as an expense. For each expenditure subsequent to acquisition of a plant asset we must decide if the expenditure is to be treated as a Capital or Revenue expenditure. If the amounts involved are not material, most companies expense the item.