ACCT 100 Chapter 9 Plant Assets, Natural Resources, and Intangible Assets

2 Plant Assets, Natural Resources and Intangible Assets n Plant Assets: - Assets used in operations (not for resale) - Long-term in nature (Eco. Life > one year) - Possess physical substance - $ must be material  Natural Resources: Including timber, oil, gas and mineral deposits. Requiring cutting, pumping or mining to extract these resources in operations.

Plant Assets, Natural Resources and Intangible Assets (Contd.)  Intangible Assets: long-lived assets with no physical substance but have value based on rights from these assets (i.e., patents, copyrights, trademarks, trade names franchises, leaseholds and goodwill). 3

4 Topics of Plant Assets (i.e., Property, Plant, and Equipment or PPE) A. 1)Valuation of PPE. 2)Determination of acquisition costs of land, building and equipment. B. Payments: Lump-sum purchase C. Depreciation of PPE D. Disposition of PPE: exchange, discard, and sell for cash. E. Costs occurred subsequent to acquisition (i.e., replacement, repair, etc.)

5 Topics of Intangible Assets n Valuation n Amortization

6 A.1 PPE Valuation (APB Opinion No. 6)  At acquisition, PPE is recorded at the acquisition cost.  At the end of period, PPE is also reported at cost.  Acquisition cost includes the purchase price and any costs necessary to bring the asset to the location and condition for its intended use (i.e., applicable taxes, purchase commissions, etc.).

7 PPE Valuation (contd.) u PPE (except for land) is subject to depreciation. u Both cost and accumulated depreciation are reported on the balance sheet statement. u Depreciation is a process of cost allocation, not a process of asset valuation.

8 A.2 Determination of Acquisition Cost u Cost of Land u Cost of Buildings u Cost of Equipment

9 A. Determination of Acquisition Cost Cost of Land (held for operation, not for resale) n Any cost occurred before the land is ready for its intended use should be capitalized as cost of land.

10 A. Determination of Acquisition Cost Cost of Land (contd.) Cost of land includes: 1. Purchase price. 2. Title fee. 3. Closing fee. 4. Clearing fee. 5. Back property taxes (unpaid by previous owner). 6. Net razing cost of an old building.

11 A. Determination of Acquisition Cost Cost of Land (contd.) n Land improvements with limited life (i.e., parking lot, fences, drive ways, etc.) would be debited to land improvement account and subject to depreciation.

12 A. Determination of Acquisition Cost Cost of Buildings Cost of Buildings includes: 1. contract price(including material, labor, etc), 2. cost of remodeling, 3. architects’ fees, 4. building permits, 5. survey cost before construction, 6. interest cost (for self-constructed building),and 7. excavation cost before construction. * Cost of strike or accidents should be expensed.

13 A. Determination of Acquisition Cost Cost of Equipment n Any cost occurred to acquire and to bring the asset to the location and condition for its intended use.

14 A. Determination of Acquisition Cost Cost of Equipment (contd.) n Cost of Equipment includes: 1. purchase price, 2. freight-in, 3. insurance in transit, and 4. foundation cost, installation cost, cost of test runs and assembling cost. n Not including:Cash discount lost, unnecessary storage cost and hauling charges from storage for delivery of machine.

15 Capitalizing the Cost of Interest n Capitalize the interest on funds borrowed for construction. The capitalized interest should not exceed the actual interest cost. n The capitalized interest = interest rate  average accumulated expenditures on the construction project.

16 Example n The Greenway borrowed $2,000,000 on a one-year, 12% note payable to construct a factory on 1/5/98. Assume the average accumulated expenditures on this project during 1998 are $1,200,000. The company should capitalize $1,200,000 x 12% = $144,000. The actual interest cost of 1998 on the borrowing is $2,000,000 x 12% = $240,000.

17 Example (contd.) n The journal entry to record the interest expense and capitalized interest for 1998 is: Interest Exp.96,000 Factory144,000 Cash240,000 Capitalized interest cost

18 B. Lump Sum Purchase n Acquisition costs would be allocated proportionately to the market value of the individual asset purchased.

19 B. Lump Sum Purchase (contd.) n A building and land were purchased at $100,000. The market value of building and land was $30,000 and $90,000, respectively. n J.E. Building25,000 1 Land75,000 2 Cash100, ,000/(30,000+90,000)=25%, 25%x100,000 = 25, ,000/(30,000+90,000)=75%, 75%x100,000 = 75,000

20 C. Depreciation of P.P.E & Depletion of Nature Resources n The allocation of a plant asset’s cost to expense over the life of the asset is called depreciation.

21 C. Depreciation of P.P.E & Depletion of Nature Resources (contd.) (For Financial Reporting Purposes) 1. Time-Based Methods: depreciation based on the passage of time.

22 C. Depreciation of P.P.E & Depletion of Nature Resources (contd.) 1. Time-Based Methods: a. Straight-Line: cost is allocated evenly through out the life of the P.P.E. (assets) b. Sum-of-the-Years’-Digits (SYD): cost is allocated more heavily in the early years of life of the P.P.E. c. Declining-Balance:same as S-Y-D. (b. and c. are called the accelerated depreciation methods.)

23 C. Depreciation of P.P.E & Depletion of Nature Resources (contd.) 2. Activity-Based Method : depreciation is based on the usage of assets. Depreciation bases -- hours of usage or production units. Method: Unit-of-Production Method

24 Depreciation (For Financial Reporting Purposes) 1a. Straight-Line Method: cost is allocated evenly through the life of the P.P.E.

25 Example 1 n Machine costing $10,000 was purchased on 1/1/98. The estimated residual value of the machine is $2,000 and the estimated life of the machine is 4 years. n Depreciation Expense per year: ($10, ,000)/ 4 = $2,000 or 8,000 x 25% = $2,000 12/31/98 Depreciation Expense2,000 Accumulated Depreciation2,000

26 Example 2 (partial year depreciation) n Using the information in example 1, except that the machine was purchased on 3/11/98 rather than 1/1/98. n Depreciation Expense of 1998 ==> [($10,000-2,000)/4] x (10/12) = $1,667

27 Example 2 (contd.) - Presentation (Book Value (Carrying Value) = Cost - Acc. Depr) B/S (1998) P.P.E. Machine $10,000 Acc. Depr. (1,667) Net B/V 8,333 B/S (1999) P.P.E Machine $10,000 Acc. Depr. (3,667) Net $6,337 B/S (2000) P.P.E Machine $10,000 Acc. Depr. (5,667) Net $ 4,333 B/S (2001) P.P.E Machine $10,000 Acc. Depr. (7,667) Net 2,333

28 1b. Sum-of-the-year’s-Digits Method (SYD) n Same example as Example 1 on page 25, except using the SYD method: YearDepreciation Expense 1998$8,000 x 4/10 = 3, ,000 x 3/10 = 2, ,000 x 2/10 = 1, ,000 x 1/10 = 800

29 1c. Declining-Balance Method n Depreciation Exp.=constant Rate  book value* at the beginning of the period u Residual value is not considered in the computation. u Assets cannot be depreciated below the residual value (i.e., book value cannot be smaller than the residual value). u The constant rate is expressed as a function of a straight-line annual depreciation rate. * Book value = Cost - Acc. Depreciation.

30 Example

31 Double Declining- Balance Method n (the constant rate is twice of the S-L Depr. Rate) Depr. Exp. = constant rate  book value at beginning of the period.

32 Example 1 n Example 1: Machine costing $10,000 purchased on 1/1/98, with residual value $2,000 and life 4 years.

33 Example 1 (contd.) Straight-Line Depr. Rate=1/4=25% Double Declining-Balance Depr. Rate =2  25%=50% * Assets cannot be depreciated below the residual value.

34 A Comparison of Depreciation Methods 1. Straight-Line Method 2. S-Y-D Method 3. Declining-Balance Method Year Depreciation Expense 1 2 3

35 Changes in Depreciation Estimate n Accounting treatment: no retroactive effect and make no adjustment for the past misstatement. Spread the remaining undepreciated balance (i.e., the book value) less the revised (new) residual value over the revised (new) estimate of the remaining life of the assets.

36 Example: (S-L Depr. Method) Machine costing $10,000 acquired on 1/1/98.Estimates on 1/1/981/1/00 Residual value$2,000$1,000 Life4 years5 years

37 1. (10,000-2,000)/4 = $2, (6,000-1,000)/(5-2) = Example: (contd.)

38 2. Activity-Based Method: n Units-of-Production Method: depreciation based on the usage of the asset.

39 Example: n Machine costing $10,000, with estimated residual value $2,000 and estimated service hours, 8,000 hours. Depreciation expense per hour = ($10,000-2,000)/8,000 hours = $1 per hour During 1998, the machine was used for 1,000 hours, the depreciation expense of 1998: $1 * 1,000 = $1,000 12/31/98 Depreciation Expense1,000 Accumulated Depreciation1,000

40 Tax Depreciation n Methods in different periods: 1.GAAP depreciation methods (i.e., S-L, SYD or DDB): apply to assets acquired before 1981; cannot be depreciated to below the residual value. IRS published tables with estimated lives for depreciable assets. 2. ACRS: Accelerated Cost Recovery System applies to assets purchased between Modified ACRS: MACRS applies to assets purchased in 1987 or later.

41 MACRS n MACRS was enacted by Congress in the Tax Reform Act of Assets are classified in 8 property classes instead of 5 classes as in ACRS. In addition, a specified GAAP depreciation method is used in computing the depreciation expense for all classes.

42 MACRS (Continued) n Depreciation methods: MACRS Property Class Double-Declining Balance 3,5,7 or 10-year property 150% declining Balance 15 or 20-year property straight-line 27.5 or 31.5-year property

43 D. Disposal of Plant Assets n Example A: Selling for cash Cost of an equipment = $20,000 Accumulated Depreciation (should be updated) = $12,000 Sold for cash = $9,000 n Journal Entry: Cash9,000 Acc. Depr.12,000 Equipment20,000 Gain on Sale of equipment1,000

44 D. Disposal of Plant Assets (contd.) n Example B: Disposal of an equipment Information as above except the equipment is being disposed off. n Journal Entry: Loss on Disposal of Equip.8000 Accum. Depr.12,000 Equipment20,000

45 Exchanging of Assets n Example C: AMY company trades in an old machine for a new machine. The cost of the old machine is $15,000 with an accumulated depreciation of $9,000. Thus, the book value of the old machine is $6,000. The market value of the old machine is 7,000. The market value of the new machine is $10,000. How much cash would Amy pay for this exchange ?Cash Paid = $10,000- 7,000 = $3,000

46 Exchanging of Assets (contd.) J. E. Machine (new)$10,000 Accum. Depr.9,000 Machine (old)15,000 Cash3,000 gain on disposal of assets 1,000* * Market value of old asset – book value of old = 7,000-6,000 =1,000

47 E. Capital Expenditures Versus Revenue Expenditures 1. Costs subsequent to Acquisition 2. Types of costs occurred subsequent to acquisition.

48 1. Costs Subsequent to Acquisition n Basic Principle for capitalization of these costs: Capitalize the cost if it can: a. extend the life of the existing asset, or b. increase the service quality of the existing asset, or c. increase the productivity of the existing asset (including the reduction of unit cost). Otherwise, expense the cost.

49 2. Types of costs occurred subsequent to acquisition: a. Additions b. Improvements, Replacements c. Rearrangement and Reinstallation d. Repairs e. Maintenance

50 Accounting for Natural Resources and Depletion Example for natural resources: petroleum, natural gas, timber, etc. Cost allocation of natural resources is called depletion. Method of depletion: units-of-production (units- of-activity) Journal Entry Depletion Exp. xxx Accumulated Depletionxxx

51 Accounting for Intangible Assets n Intangible Assets are long-lived assets with no physical substance but have value based on rights from these assets (i.e., patents, copyrights, trademarks, franchises, leaseholds and goodwill). The cost allocation of these assets is called amotization. Journal Entry Amortization Exp.XXX PatentsXXX

52 Amortization of Intangibles  Intangibles with indefinite lives are not subject to amortization but impairment tests (i.e., goodwill, trademark, etc.)  Intangibles with definite lives should be amortized over the shorter of their legal or useful lives (i.e., patents, copyrights, etc.).  Franchises and licenses are amortized over the contractual lives.  All research and development costs are expensed.

53 1. Patents: n Granted by the U.S. Patent office for a period of 20 years. The patent will give the holder the exclusive right to produce, use and sell a product or process without interference or infringement by others.

54 2. Copyrights: n A federally granted right to authors, sculptors, painters, and other artists for their creations. n A copyright is granted for the life of the creator plus 70 years. n Copyright gives the creators and heirs an exclusive right to reproduce and sell the artistic work or published work.

55 3. Trademarks & Trade Names: n A word, a phrase, or a symbol that distinguishes a product or an enterprise from another (i.e., company names, XEROX,...).  Life: register at the US Patent Office for 10 years life. The registration can be renewed every 10 years for unlimited times.

56 4. Leaseholds n By signing a contract, the leasee is acquiring an exclusive right to use the property. n Leasehold Improvements: Improvements made to the leased property.

57 5. Franchises & Licenses: n A franchise is a contractual agreement between a franchisor and a franchisee. n In the agreement, the franchisor (i.e., the holder of patents, formulas, trade names, etc.) grants the franchisee the right to sell certain products or service or to use certain trade names or trademarks.

58 Franchises & Licenses (contd.): n A license is a contractual agreement between a governmental body (i.e., city, state, etc.) and a private enterprise. n The license allows a private enterprise to use public property to provide services.

59 6. Computer Software Costs: n Expense all developing (R&D) costs if for internal use. n Expense most of the costs if the software is to be sold.

60 7. Goodwill (not subject to amortization ): n Cannot be separated from the business. n Can only be recognized if the whole business is purchased. n Goodwill equals the excess of the purchase price over the market value of the net assets acquired (i.e., (market value of assets -- market value of liabilities) of the acquired company).