Plant Assets and Intangibles

Plant Assets and Intangibles
Chapter 7 Chapter 7 addresses Plant Assets and Intangibles. ©2008 Pearson Prentice Hall. All rights reserved.

Categories of Long-Lived Assets
Plant assets Tangible Include land, buildings and equipment Intangible assets Carry special rights without physical substance Include patents, copyrights and trademarks Long-lived assets are placed into two categories: plant assets and intangible assets. So far, we have focused on current assets–assets that are converted to cash or used within one year. Long-lived assets are expected to be used for more than one year. Some plant assets, like buildings can last over 50 years. Plant asset are tangible; you can touch them. Common plant assets are land, buildings, equipment, furniture, and vehicles. Intangible assets represent special rights or legal benefits. They do not have physical substance; you can’t touch them. Common intangibles are patents, copyrights and trademarks. ©2008 Pearson Prentice Hall. All rights reserved.

Plant Asset Terminology
Asset Accounts Related Expense Account (Balance Sheet) (Income Statement) Plant Assets Land None Buildings & Equipment Depreciation Furniture & Fixtures Land Improvements Natural Resources Depletion Intangibles Amortization This table shows common accounts within plant assets. The assets appear on the balance sheet, usually in their own section. Natural resources are categorized within plant assets. All plant assets, except land, are depreciated. This results in an expense on the income statements. Intangible assets are amortized, and this expense also appears on the income statement. ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 1 Determine the cost of a plant asset
Learning Objective 1 shows us how to determine the cost of a plant asset. ©2008 Pearson Prentice Hall. All rights reserved.

renovation for intended use Insurance in transit, sales
Cost of a Plant Asset Sum of all the costs incurred to bring the asset to its intended use Land Purchase price, commissions, survey & legal costs, removal of old buildings Land Improvements Fencing, paving, security systems, lighting The cost of a plant asset includes more than its purchase price. All necessary costs to get the asset ready for use become part of its cost. For land, this includes commissions to real estate agents, surveying and legal costs. In addition, removal of old buildings (razing) and clearing the land are included. Land improvements are items placed on the land. Land improvements include fencing, paving, driveways, security systems and outdoor lighting. The cost of buildings also includes real estate commissions (like land). Then, there are any taxes necessary to purchase the building, and any repairs or renovations made to get the building ready for its intended use. Machinery and equipment costs include any shipping and insurance while in transit, and any installation and test runs of the machinery. Sales tax is not an expense, but rather a cost of purchasing the machine. Buildings Purchase price, commissions, sales & other taxes, repairs & renovation for intended use Machinery & Equipment Purchase price, Insurance in transit, sales taxes, installation ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved.
Lump-Sum Purchases Companies purchase several assets in a group for one price Cost is allocated to individual assets by on their market values Sometimes a company will purchase a group of plant asset for one set price. For example, land, a building and land improvements are all purchased together. For accounting purposes, the assets must be separated into the appropriate accounts. The purchase price is allocated based on the fair values of the individual assets. ©2008 Pearson Prentice Hall. All rights reserved.

Capital Expenditure vs. Immediate Expense
Increase capacity or extend life Examples: Major overhaul Building additions Immediate Expense Maintain or restore to working order Examples: Minor repairs Painting After a company has purchased a plant asset, it will incur other costs related to it. The company must decide if the cost is a capital expenditure that becomes part of the cost of the asset, or if it is an expense. If the cost increases the capacity or extends the life of the asset, it should be capitalized. If the cost is just to maintain normal working order of the asset, it should be expensed. Practically speaking, companies often set a dollar amount, say $1000, to help make this decision. If it is under the dollar amount, the item is expensed. If it is above, it is capitalized. NOTE: Most companies set a dollar amount to decide if an expenditure should be capitalized or expensed ©2008 Pearson Prentice Hall. All rights reserved.

Measuring Depreciation on Plant Assets
Plant assets wear out or grow obsolete over time The cost of a plant asset is allocated to an expense over its life Matches expense of using the asset to the revenues the asset helped produce Land has an unlimited life and is the only plant asset not depreciation Plant assets (except land) wear out over time or become obsolete. Because of this, companies allocate the cost of the plant asset to expense over its useful life. The matching principle is demonstrated with this process. The expense of using the asset is matched to the revenues it helps produce. ©2008 Pearson Prentice Hall. All rights reserved.

Depreciation Depreciation is NOT: a process of valuation based on market value decline a method of setting aside cash to replace assets It’s important to remember that depreciation is not a process of valuation. It does not correspond to the decrease in market value that occurs. It also does not set aside funds to purchase new plant assets. ©2008 Pearson Prentice Hall. All rights reserved.

How to Measure Depreciation
Three items needed Cost of the plant asset Estimated useful life How long the company expects to use the asset Estimated residual value Expected cash value of asset at the end of its life Can be zero The expense to record the “using up” of plant assets is called depreciation. Three amounts are needed to compute depreciation. (1) The cost of the plant asset that includes the purchase price, plus all the other necessary costs to get the asset ready for use. (2) The company must estimate a useful life for the asset. This is based on how long the company expects to use the asset in the business. (3) A residual value must also be estimated. This is the expected cash value of the asset and the end of its useful life. Some companies assign a residual value of zero. The asset’s depreciable cost (how much will be allocated to expense) equal the cost less the residual value. Depreciable Cost = Asset’s cost – Estimated residual value ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 2 Account for depreciation
Learning Objective 2 discusses accounting for depreciation. ©2008 Pearson Prentice Hall. All rights reserved.

Depreciation Methods Straight-line (S/L) Units-of-production (UOP) Double-declining-balance (DDB) The three most common methods of depreciation are straight-line, units-of-production and double-declining-balance. ©2008 Pearson Prentice Hall. All rights reserved.

Straight-Line Depreciation
An equal amount of depreciation assigned to each period Cost – residual = Depreciation expense Useful life in years JOURNAL Date Accounts Debit Credit 12-31 Depreciation Expense $$,$$$ Accumulated Depreciation Straight-line is the easiest method. It results an equal amount of depreciation each period. The depreciable cost (cost – residual) is divided by the useful life in years. Remember, the entry to record depreciation is the same regardless of the method. Depreciation expense is debited and will appear on the income statement. Accumulated depreciation, a contra-asset, is credited and will appear on the balance sheet. It will be deducted from the cost of the plant asset to determine its book value. Contra-asset ©2008 Pearson Prentice Hall. All rights reserved.

Impact of Depreciation
Each year: Accumulated Depreciation increases Book value decreases At the end of the asset’s life: Book value = Cost minus accumulated depreciation The word “accumulated” means that this account will grow each year as depreciation is added to it over the life of the plant asset. Since accumulated depreciation is subtracted from the cost of the asset, as it increases, the book value decreases. At the end of the asset’s useful life, the book value will equal its residual. Book value = residual value ©2008 Pearson Prentice Hall. All rights reserved.

Units-of-Production Depreciation per unit is computed Depreciation per unit is multiplied by production for the period Cost – residual = Depreciation expense per unit Useful life, in units Units-of-production is similar to straight line depreciation. Cost less residual is divided by the useful life. Only with this method, the life is expressed in units, not years. The result is depreciation expense per unit. Units can be measured in any input or output of an asset. For example, for a vehicle, a company could use miles driven or for a copy machine, number of copies made. The depreciation per unit is then multiplied by the units produced during the year. This method results in varying amounts of depreciation each period, depending on the use of the asset. Depreciation expense per unit x units produced during the period ©2008 Pearson Prentice Hall. All rights reserved.

Double-Declining-Balance
An accelerated method Larger expense amounts early in asset’s life 2 x Book value = Depreciation expense Useful life Double-declining-balance is an accelerated method. This means that early in the asset’s life, large depreciation amounts are expensed. Later in the life of the asset, the amounts are smaller. This formula does not use residual value until towards the end of the asset’s life. First, the DDB rate is computed. This is found by dividing two by the useful life. This is often referred to as twice-the-straight-line rate. It usually expressed as a percent. The DDB rate is multiplied by the book value of the asset (not cost minus residual). In the first year, the book value will equal the asset’s cost. However, each year as accumulated increases, book value decreases, and thus, so does depreciation expense. You need to be careful with this method not to depreciate below residual. The formula is not set up to “stop” when depreciable cost equals residual value. In the last year, or earlier in some cases, the depreciation expense is “forced” so that ending book value equals residual. DDB rate (%) x (Cost – Accumulated Depreciation) Accumulated Depreciation increases each year Book value decreases each year ©2008 Pearson Prentice Hall. All rights reserved.

Straight-Line Cost – residual = Depreciation expense Useful life in years = $3,000 annual depreciation expense Exercise 7-19 first calculates the straight-line depreciation of an asset at $3,000 per year. $15,000 - $3,000 4 years ©2008 Pearson Prentice Hall. All rights reserved.

Units-of-Production Cost – residual = Depreciation expense per mile Useful life, in miles $15,000 - $3,000 = $0.12 depreciation per mile 100,000 miles Year Miles Depreciation 1 34,000 $0.12 $ ,080 2 28,000 $ ,360 3 18,000 $ ,160 Next, Exercise 7-19 calculates the units-of-production method, showing depreciation of $.12 per mile. ©2008 Pearson Prentice Hall. All rights reserved.

E7-19 Double-Declining-Balance Yr Beginning Book Value DDB rate Depr.
How is the DDB rate computed? Yr Beginning Book Value DDB rate Depr. Exp. Accum. Depr. Ending Book Value 1 $ ,000 50% $ 7,500 $ 7,500 $ ,500 2 $ ,500 $ 3,750 $ 11,250 $ ,750 3 $ ,750 ** $ $ 12,000 $ ,000 Finally, Exercise 7-19 first calculates depreciation using the double-declining-balance method, showing a depreciation expense of $7,500 (first year). Why wasn’t the DDB rate used in year three? How was the $750 computed? ©2008 Pearson Prentice Hall. All rights reserved.

Which method reflects usage
Which method would provide larger expense amounts in year one? Yr S/L UOP DDB 1 $3,000 $4,080 $7,500 2 $3,360 $3,750 3 $2,160 $ 750 Now, we compare the results of the three methods of depreciation. Which method would be easiest for companies to use? Which method reflects usage of the asset? ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 3 Select the best depreciation method 5-22
Learning Objective 3 shows us how to select the most appropriate depreciation method. 5-22 ©2008 Pearson Prentice Hall. All rights reserved. ©2009 Prentice Hall 22

Depreciation for Tax Purposes
Most companies use straight-line for external reporting Most companies use accelerated depreciation for tax purposes Modified Accelerated Cost Recovery System (MACRS) Larger deductions early in assets’ lives helps reduce taxes and increase cash flow Most companies use straight-line depreciation for external reporting. It provides an equal amount each year. However, companies can choose different methods for tax purposes than they do for accounting purposes. The IRS, to encourage investment in long-term assets, developed a special accelerated depreciation method abbreviated MACRS. It is similar to the DDB method. This allows greater tax deductions early in assets’ lives and reduces taxable income. Therefore, cash that would have been used to pay taxes can now be used for other purposes. ©2008 Pearson Prentice Hall. All rights reserved.

Partial Year Depreciation
Companies purchase plant assets when needed–not just at beginning of year To compute depreciation for a partial year 1. Compute depreciation for a full year 2. Multiply by fraction of the year the asset is owned Not applicable to units-of-production Life is not based on years If an asset was purchased May 1, what fraction would be used? Companies don’t usually purchase all their plant asset on January 1. While this would make depreciation calculations easier, it is not a practical way to do business. To compute depreciation for a partial year, determine depreciation for a full year and then multiply by a fraction–the numerator is the number of months the asset was used during the year (purchase date to end of year); the numerator is 12 for the months in a year. This does not apply to UOP because the life is not expressed in years, but in units. ©2008 Pearson Prentice Hall. All rights reserved.

Changing Useful Life of Asset
A company may change useful based on new information or experience Called a change in estimate Depreciation formula needs to be revised Book value at time of change New knowledge may come to the attention of management that causes the estimated life of an asset to be revised. In accounting, this is an example of a change in estimate. When this occurs, the deprecation formula needs to be revised. The book value at the time of the change is computed (cost less accumulated deprecation up to the date of the change) is divided by the remaining useful life (from that day forward). Remaining useful life ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 4 Analyze the effect of a plant asset disposal
Learning Objective 4 analyzes the effect of plant asset disposal. ©2008 Pearson Prentice Hall. All rights reserved.

Disposal of Plant Assets
When a company is finished using an asset, the asset can be: Discarded Sold Exchanged Before accounting for the disposal: Depreciation is updated Final book value is determined When an company is finished using a plant asset, it can discard the asset, sell it for cash or exchange it for another asset. Before the disposal is recorded, depreciation must be updated and a final book value is determined. ©2008 Pearson Prentice Hall. All rights reserved.

Discarding Plant Asset
Accumulated depreciation and cost of asset removed from records Loss recorded (unless asset is fully depreciated and no residual value) JOURNAL Date Accounts Debit Credit Accumulated depreciation Loss on disposal of plant asset Plant asset (equipment, bldg) If a company discards an asset (throws away and receives nothing), it will incur a loss. The only exception to this would be if the asset was fully depreciated and had a residual value of zero. The plant asset account and its related accumulated depreciation must be removed from the records, because the company no longer has the asset. Accumulated is debited for its balance and the plant asset account is credited for its cost. A loss is debited for the difference, which in this case, will equal the asset’s book value. The loss is an income statement account that will reduce net income. ©2008 Pearson Prentice Hall. All rights reserved.

How is book value computed?
Selling a Plant Asset If cash received > Book value GAIN Income Statement account Similar to revenue; increases net income LOSS If cash received < Book value Income Statement account Similar to an expense; decreases net income When an asset is sold for cash, the company can incur a gain or a loss. If the cash received for the asset is greater than the book value, a gain will be recorded. A gain is similar to a revenue. It is reported on the income statement and increases net income. If the cash received is less than the book value, then a loss is recorded. The following slide shows the journal entries to record sales of plant assets in both situations. How is book value computed? Book value = _________________________ ©2008 Pearson Prentice Hall. All rights reserved.

Record loss on sale of equipment Record gain on sale of equipment
JOURNAL Date Accounts Debit Credit Cash Accumulated Depreciation Loss on sale of equipment Equipment Record loss on sale of equipment Gain on sale of equipment Record gain on sale of equipment Like the disposal entry, the plant asset account and its related accumulated depreciation are removed from the records. However, with a sale, a debit to cash will be recorded. Gains are on the credit side and losses on the debit. The gain or loss will equal the difference between the cash received and the book value of the asset. ©2008 Pearson Prentice Hall. All rights reserved.

Book value at time of sale: Cost $ 8,700 Accumulated depreciation 2004 ($8,700 x 2/5) $ 3,480 2005 ($ ) x 2/5 $ 2,088 January - September x 9 /12 $1,566 $5,046 Book value September 30 $3,654 Cash received $2,500 Loss on sale $1,154 Exercise 7-23 shows how to record the loss on the sale of an asset. ©2008 Pearson Prentice Hall. All rights reserved.

Record loss on sale of equipment
JOURNAL Date Accounts Debit Credit Cash $2,500 Accumulated Depreciation $5,046 Loss on sale of equipment $1,154 Equipment $8,700 Record loss on sale of equipment Exercise 7-23 continues with the journal entry to record this loss. ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 5 Account for natural resources and depletion
Learning Objective 5 discusses accounting for natural resources and depletion. Account for natural resources and depletion ©2008 Pearson Prentice Hall. All rights reserved.

Natural Resources Come from the earth Oil, minerals, coal and timber Depletion records the expense related to extracting the natural resource Similar to units-of-production depreciation JOURNAL Date Accounts Debit Credit 12-31 Depletion Expense $$,$$$ Accumulated Depletion Natural resources are extracted from the land—for example, oil, coal, timber and mineral ore. The process of allocating the cost of a natural resource to an expense is called depletion. The method to compute the amount is very similar to the units-of-production depreciation method. The journal entry is similar as well. Just substitute the word “depletion” for “depreciation”. ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 6 Account for intangible assets and amortization
Learning Objective 6 shows how to account for intangible assets and amortization. Account for intangible assets and amortization ©2008 Pearson Prentice Hall. All rights reserved.

Intangible Assets Represent special rights and benefits Have no physical form Very valuable in today’s information-driven society Examples include patents and copyrights Intangible assets are special rights and benefits. They have no physical form; you can’t touch them. In today’s information-driven society, intangibles can be a company’s largest asset. Examples include patents, copyrights, customer lists, exclusive contracts and many others. ©2008 Pearson Prentice Hall. All rights reserved.

Categories of Intangibles
Finite lives that can be measured Amortized using the straight-line method Intangible asset is reduced by amortization No Accumulated Amortization account Indefinite Lives Not amortized Tested annually for loss in value Intangibles are placed into two categories based on their lives. Those intangibles that have lives that can be measured are amortized.= Amortization is like depreciation; it allocates the cost of the intangible over its life–usually using the straight-line method. One difference from depreciation, however, is that there is no “accumulated amortization” account. Instead, the asset is reduced directly. The other category of intangibles is those with indefinite lives. These assets are not amortized. Instead, they are tested annually for any loss in value. ©2008 Pearson Prentice Hall. All rights reserved.

Specific Intangibles Patents Copyrights Trademarks & Trade Names
Federal grants that give holder exclusive right to produce and sell an invention for 20 years Copyrights Exclusive right to sell a book, music, file or other work of art; lasts for the life of the author + 70 years Trademarks & Trade Names Distinctive identification of product or service; a logo or catch phrase Franchises & Licenses Right to sell a product or service with specific Conditions, such as chain restaurants Here, we describe some common intangibles. Patents are purchased from the federal government and grant the exclusive right to produce and sell an invention for 20 years. Often companies assign a shorter life because other companies “infringe” upon the patent. It usually takes litigation to solve this issue. Copyrights are the exclusive right to a literary or artistic work. The original copyright is purchased from the government, but then the holder can sell to others. The life of a patent is the author’s life plus 70 years. Unique symbols or sayings that identify a company’s product or service are trademarks and trade names. Think of the brand name Coca-Cola or the Nike “swoosh”. Franchises give the owner the right to sell a product or service with specific conditions. The holder pays the corporation a fee to use the business name and sell its product and services. Many chain restaurants, like Burger King, are set up in this manner. ©2008 Pearson Prentice Hall. All rights reserved.

Goodwill Very specific meaning in accounting Only recorded when an entire business is purchased Purchase price exceeds fair value of net assets of business Represents earning power of purchased business Not amortized Goodwill is a term used in many different ways. In accounting, the meaning is very specific. A company can only record goodwill as an intangible asset if it purchasing another company, and the purchase price is greater than the fair value of the company’s net assets. Theoretically, if a company is willing to buy another company for more than its worth, it must represent superior earnings power that the acquired company holds. Goodwill is an example of an asset that has an indefinite life, and therefore, it is not amortized. ©2008 Pearson Prentice Hall. All rights reserved.

Purchase price of MySpace $18 Fair value of net assets Current assets $10 Long-term assets $15 Total liabilities ($24) $1 Goodwill $17 Exercise 7-27 shows the calculation for goodwill. ©2008 Pearson Prentice Hall. All rights reserved.

JOURNAL Date Accounts Debit Credit Current assets $10 Long-term assets $15 Goodwill $17 Total liabilities $24 Cash $18 Exercise 7-27 continues with the journal entry for the goodwill calculation. ©2008 Pearson Prentice Hall. All rights reserved.

Research & Development Costs
Not an intangible asset Required to be expensed as incurred No guarantee expenditures will result in a successful project One might think that companies that spend large sums on research and development would record an intangible asset. However, since many of these projects are unsuccessful, they are required to be recorded as an expense. ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 7 Learning Objective 7 discusses how to report plant asset transactions on the statement of cash flows. Report plant asset transactions on the statement of cash flows ©2008 Pearson Prentice Hall. All rights reserved.

Plant Assets and Cash Flow Statement
Operating section Depreciation, amortization and depletion are noncash expense Added back to net income to determine operating cash flows Investing section Purchases of plant assets and intangibles result in an outflow of cash Sales results in inflow of cash Plant asset transactions appear on many places on the Cash Flow Statement. In the operating section, depreciation, amortization and depletion expense are added back to net income. These are non-cash expenses and, when added to net income, help determine cash provided by operating activities. Purchases and sales of plant assets appear in the investing section. If plant assets are purchased with cash, it is shown as an investing outflow. The cash proceeds received from selling plant asset is shown as an inflow. ©2008 Pearson Prentice Hall. All rights reserved.

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