© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Chapter 8 Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Business Background How much is enough? Insufficient capacity results in lost sales. Costly excess capacity reduces profits.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Classification of Long-Term Assets Tangible Physical Substance Intangible No Physical Substance Expected to Benefit Future Periods Actively Used in Operations

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Classification of Long-Lived Assets Tangible Physical Substance Intangible No Physical Substance Expected to Benefit Future Periods Actively Used in Operations Land Assets subject to amortization Buildings and equipment Furniture and fixtures Natural resource assets subject to depletion Mineral deposits and timber Examples

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Classification of Long-Lived Assets Tangible Physical Substance Intangible No Physical Substance Expected to Benefit Future Periods Actively Used in Operations Value represented by rights that produce benefits Patents Copyrights Trademarks Franchises Goodwill Subject to amortization Examples

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson 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.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson  Purchase price  Architectural fees  Cost of permits  Excavation costs  Construction costs  Purchase price  Architectural fees  Cost of permits  Excavation costs  Construction costs Acquisition Cost Buildings

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson  Purchase price  Installation costs  Modification to building necessary to install equipment  Transportation costs  Purchase price  Installation costs  Modification to building necessary to install equipment  Transportation costs Acquisition Cost Equipment

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson  Purchase price  Real estate commissions  Title insurance premiums  Delinquent taxes  Surveying fees  Title search and transfer fees  Purchase price  Real estate commissions  Title insurance premiums  Delinquent taxes  Surveying fees  Title search and transfer fees Land is not amortizable. Acquisition Cost Land

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Acquisition for Cash On June 1, WestJet Air Lines purchased aircraft for $60,500,000 cash.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Acquisition for Cash On June 1, WestJet Air Lines purchased aircraft for $60,500,000 cash.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Acquisition for Debt On June 14, WestJet Air Lines purchased aircraft for $1,500,000 cash and a $59,000,000 note payable.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Acquisition for Debt On June 14, WestJet Air Lines purchased aircraft for $1,500,000 cash and a $59,000,000 note payable.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Record at the current market value of the consideration given, or the current market value of the asset acquired, whichever is more clearly evident. Acquisition for Noncash Consideration

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Acquisition for Noncash Consideration On July 7, WestJet purchased a $60,500,000 aircraft for $10,500,000 cash plus 2,000,000 common shares of a market value of $25 each.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Acquisition for Noncash Consideration On July 7, WestJet purchased a $60,500,000 aircraft for $10,500,000 cash plus 2,000,000 common shares at a market value of $25 each.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Acquisition by Construction Asset cost includes: All materials and labour traceable to the construction. A reasonable amount of overhead. Interest on debt incurred during the construction.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson The total cost of a combined purchase of land and building is separated on the basis of their relative market values. Acquisition as a Basket Purchase

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson On January 1, WestJet purchased land and building for $300,000 cash. The appraised values are building, $189,000, and land, $126,000. How much of the $300,000 purchase price will be charged to the building and land accounts? Continue Acquisition as a Basket Purchase

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Acquisition as a Basket Purchase

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Prepare the journal entry to record the purchase of land and building. Acquisition as a Basket Purchase

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Acquisition as a Basket Purchase

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Repairs, Maintenance, and Additions

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Capital and Revenue Expenditures Many companies have policies expensing all expenditures below a certain amount according to the materiality constraint.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Amortization 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 Amortization Acquisition Cost

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Amortization Amortization Expense Income Statement Balance Sheet Accumulated Amortization Amortization for the current year Total of amortization to date on an asset

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Book value = Market value Book Values Selected Items from WestJet’s 2001 Notes to the Balance Sheet /

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson The calculation of amortization requires three amounts for each asset:  Acquisition cost.  Estimated useful life.  Estimated residual value. The calculation of amortization requires three amounts for each asset:  Acquisition cost.  Estimated useful life.  Estimated residual value. Amortization Concepts

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Alternative Amortization Methods  Straight-line  Units-of-production  Accelerated Method: Declining balance  Straight-line  Units-of-production  Accelerated Method: Declining balance

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson At the beginning of the year, WestJet purchased an aircraft $45,000,000 cash. The equipment has an estimated useful life of 25 years and an estimated residual value of $1,400,000. Cost - Residual Value Life in Years Amortization Expense per Year = Straight-Line Method SL

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Amortization Expense per Year = Amortization Expense per Year = $1,744 $45,000 - $1, years Straight-Line Method (in thousands of dollars) Cost - Residual Value Life in Years Amortization Expense per Year = SL

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Residual ValueResidual Value Straight-Line Method (in thousands of dollars) SL Most companies (about 90 percent) use the straight-line method to amortize some or all of their assets for financial reporting.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Units-of-Production Method Amortization Rate = Cost - Residual Value Estimated Total Production Step 1: Step 2: Amortization Expense = Amortization Rate × Actual Annual Production

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Units-of-Production Method (in thousands of dollars) At the beginning of the year, WestJet purchased an aircraft for $45,000 cash. The aircraft has 86,500 fight hours of useful life and an estimated residual value of $1,400. If the aircraft is used for 3,460 flight hours in the first year, what is the amount of amortization expense? At the beginning of the year, WestJet purchased an aircraft for $45,000 cash. The aircraft has 86,500 fight hours of useful life and an estimated residual value of $1,400. If the aircraft is used for 3,460 flight hours in the first year, what is the amount of amortization expense?

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Step 1: Step 2: Amortization Expense = $504 x 3,460 hours = $1,744 Units-of-Production Method (in thousands of dollars) Amortization Rate = $45,000 - $1,400 86,500 hours = $504 per hour

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Units-of-Production Method (in thousands of dollars)

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Accelerated Amortization AmortizationRepair Expense Early YearsHighLow Later YearsLowHigh Accelerated amortization matches higher amortization expense with higher revenues in the early years of an asset’s useful life when the asset is more efficient.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Double-Declining-Balance Method Annual Amortization expense Net Book Value () Useful Life in Years 2 = × Cost – Accumulated Amortization Declining balance rate of 2 is double-declining-balance (DDB) rate. Annual computation ignores residual value.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson At the beginning of the year, WestJet purchased an aircraft for $45,000 cash. The aircraft has an estimated useful life of 25 years and an estimated residual value of $1,400. Calculate the amortization expense for the first two years. Double-Declining-Balance Method (in thousands of dollars)

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Double-Declining-Balance Method Annual Amortization expense Net Book Value () Useful Life in Years 2 = ×

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Annual Amortization expense Net Book Value () Useful Life in Years 2 = × Year 1 Amortization: () $45,000 × 25 years 2 = $3,600 () ($45,000 – $3,600) × 25 years 2 = $3,312 Double-Declining-Balance Method in $ thousands Year 2 Amortization:

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson () ($45,000 – $6,912) × 25 years 2 = $3,047 Double-Declining-Balance Method (in thousands of dollars)

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson For tax purposes, most corporations use the Capital Cost Allowance (CCA). CCA provides for rapid write-off of an asset’s cost in order to stimulate new investments. For tax purposes, most corporations use the Capital Cost Allowance (CCA). CCA provides for rapid write-off of an asset’s cost in order to stimulate new investments. Amortization and Federal Income Tax

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Amortization Methods in Other Countries Many countries, including Australia, Brazil, England, and Mexico, use other methods such as amortization based on the current cost of assets.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Changes in Amortization Estimates So amortization is an estimate. Estimated residual value Estimated useful life Over the life of an asset, new information may come to light indicating that the original estimates were inaccurate.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson If our estimates change, amortization is: Changes in Amortization Estimates Book value at date of change Residual value at date of change Remaining useful life at date of change –

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Changes in Amortization Estimates After owning aircraft costing $45,000,000 for five years, WestJet revised estimates of residual value and useful life: What is the new annual amortization?

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Changes in Amortization Estimates

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Focus on Cash Flows Amortization expense does not require a cash outflow. Because amortization is tax deductible, it reduces the cash outflow related to taxes (often called a tax shield).

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Voluntary disposals: Sale Trade-in Retirement Involuntary disposals: Fire Accident Disposal of Property, Plant, and Equipment

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Disposal of Property, Plant, and Equipment  Update amortization to the date of disposal.  Journalize disposal by: Writing off accumulated amortization (debit). Writing off the asset cost (credit). Recording cash received (debit) or paid (credit). Recording a gain (credit) or loss (debit).

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson 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

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson WestJet Airlines sold an aircraft for $1,600,000 cash at the end of its year The flight equipment originally cost $2,600,000 and had accumulated amortization of $595,000. Disposal of Property, Plant, and Equipment

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Disposal of Property, Plant, and Equipment Prepare the journal entry to record WestJet’s sale of the aircraft.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Fixed Asset Turnover Net Sales Revenue Average Net Fixed Assets = This ratio measures a company’s ability to generate sales given an investment in fixed assets.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Natural Resources Examples: oil, coal, gold Extracted from the natural environment. A noncurrent asset presented at cost less accumulated depletion.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Natural Resources Depletion is like amortization. Total cost of asset is the cost of acquisition, exploration, and development. Total cost is allocated over periods benefited by means of depletion.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Depletion of Natural Resources Depletion is calculated using the units-of-production method. Unit depletion rate is calculated as follows: Estimated Recoverable Units Acquisition and Residual Development Cost Value –

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Total depletion cost for a period is: UNIT DEPLETION RATE NUMBER OF UNITS EXTRACTED IN PERIOD × Depletion of Natural Resources Total depletion cost Inventory for sale Unsold Inventory Cost of goods sold

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Specialized plant assets may be required to extract the natural resource. These assets are recorded in a separate account and amortized. Natural Resources

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson 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

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Trademarks Patents Copyrights Franchises Leaseholds Record at current cash equivalent cost, including purchase price, legal fees, and filing fees. Intangible Assets

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Amortize over shorter of economic life or legal life, subject to rules specified by GAAP. Use straight-line method. Research and development costs are normally expensed as incurred. Amortize over shorter of economic life or legal life, subject to rules specified by GAAP. Use straight-line method. Research and development costs are normally expensed as incurred. Intangible Assets

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson 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. Intangible Assets Goodwill Goodwill

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Intangible Assets Goodwill Eddy Company paid $1,000,000 to purchase all of James Company’s assets and assumed liabilities of $200,000. The acquired assets were appraised at a fair value of $900,000.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson What amount of goodwill should be recorded on Eddy Company books? a.$100,000 b.$200,000 c.$300,000 d.$400,000 What amount of goodwill should be recorded on Eddy Company books? a.$100,000 b.$200,000 c.$300,000 d.$400,000 Intangible Assets Goodwill

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson What amount of goodwill should be recorded on Eddy Company books? a.$100,000 b.$200,000 c.$300,000 d.$400,000 What amount of goodwill should be recorded on Eddy Company books? a.$100,000 b.$200,000 c.$300,000 d.$400,000 Intangible Assets Goodwill

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson A symbol, design, or logo associated with a business. Purchased trademarks are recorded at cost. Internally developed trademarks have no recorded asset cost. Intangible Assets Trademarks

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Intangible Assets Patents Exclusive right granted by federal government to sell or manufacture an invention. Cost is purchase price plus legal cost to defend. Amortize cost over the shorter of useful life or 20 years.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Intangible Assets Copyrights Exclusive right granted by the federal government to protect artistic or intellectual properties. Amortize cost over the period benefited. Legal life is life of creator plus 50 years.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Legally protected right to sell products or provide services purchased by franchisee from franchisor. Purchase price is an intangible asset which is amortized over the life of the franchise. Intangible Assets Franchises

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Intangible Assets Leaseholds A lease is a contract to use property granted by a lessor to a lessee. Rights granted under the lease are called a leasehold. A leasehold is recorded only if advance payment is involved. Otherwise periodic payments are treated as rent expense. A lease is a contract to use property granted by a lessor to a lessee. Rights granted under the lease are called a leasehold. A leasehold is recorded only if advance payment is involved. Otherwise periodic payments are treated as rent expense.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Long-term alterations made by lessee to leased property. Intangible Assets Leasehold Improvements Leasehold improvements are recorded at cost and amortized over their useful life.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson 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. A loss should be recognized when an asset suffers a permanent impairment.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson This computer is about to become fully amortized! End of Chapter 8