1. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA CHAPTER 8 REPORTING AND INTERPRETING PROPERTY, PLANT, AND EQUIPMENT; INTANGIBLES; AND NATURAL RESOURCES McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. UNDERSTANDING THE BUSINESS Insufficient capacity results in lost sales. Costly excess capacity reduces profits. 8-2 How much is enough?

3. Tangible Physical Substance Intangible No Physical Substance Expected to Benefit Future Periods Actively Used in Operations CLASSIFYING LONG-LIVED ASSETS 8-3

4. Tangible Physical Substance Intangible No Physical Substance CLASSIFYING LONG-LIVED ASSETS Land Assets subject to depreciation  Buildings and equipment  Furniture and fixtures Natural resource assets subject to depletion  Mineral deposits and timber  Definite life  Patents  Copyrights  Franchises  Indefinite life  Trademarks  Goodwill 8-4

5. FIXED ASSET TURNOVER Fixed Asset Turnover Net Sales (or Operating Revenues) Average Net Fixed Assets = This ratio measures the sales dollars generated by each dollar of fixed assets used. During 2011, Southwest Airlines had $15,658 of operating revenues. End-of-year fixed assets were $12,127 and beginning-of-year fixed assets were $10,578. (All numbers in millions.) Fixed Asset Turnover $15,658 ($10,578 + $12,127) ÷ 2 == 1.38 8-5

6. 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. Buildings Purchase price Renovation and repair costs Legal and realty fees Title fees Buildings Purchase price Renovation and repair costs Legal and realty fees Title fees 8-6

7. MEASURING AND RECORDING ACQUISITION COST Equipment Purchase price Installation costs Modification to building necessary to install equipment Transportation costs Equipment Purchase price Installation costs Modification to building necessary to install equipment Transportation costs Land Purchase price Real estate commissions Title insurance premiums Delinquent taxes Surveying fees Title search and transfer fees Land Purchase price Real estate commissions Title insurance premiums Delinquent taxes Surveying fees Title search and transfer fees Land is not depreciated 8-7

8. MEASURING AND RECORDING ACQUISITION COST On January 1, Southwest Airlines purchased aircraft for $75,000,000 cash. Acquisition for Cash On January 14, Southwest Airlines purchased aircraft for $1,000,000 cash and a $74,000,000 note payable. Acquisition for Debt 8-8

9. ACQUISITION FOR NONCASH CONSIDERATION Record at the current market value of the consideration given, or the current market value of the asset acquired, whichever is more clearly evident. On July 7, Southwest gave Boeing 1,000,000 shares of $1.00 par value common stock with a market value of $50 per share plus $25,000,000 in cash for aircraft. 8-9

10. ACQUISITION BY CONSTRUCTION Asset cost includes: All materials and labor traceable to the construction. A reasonable amount of overhead. Interest on debt incurred during the construction. 8-10

11. REPAIRS, MAINTENANCE, AND IMPROVEMENTS 8-11

12. REPAIRS, MAINTENANCE, AND IMPROVEMENTS To aid with the capitalize/expense decision, many companies record all expenditures below a certain dollar amount as expenses. 8-12

13. Depreciation is the process of allocating the cost of buildings and equipment over their productive lives using a systematic and rational method. Cost Allocation (Unused) Balance Sheet (Used) Income Statement Expense DEPRECIATION CONCEPTS Acquisition Cost Depreciation Expense Income Statement Balance Sheet Accumulated Depreciation Depreciation for the current year Total depreciation to date on an asset 8-13

14. DEPRECIATION CONCEPTS An adjusting journal entry is needed at the end of each period to reflect the use of buildings and equipment for the period: 8-14

15. DEPRECIATION CONCEPTS The calculation of depreciation requires three amounts for each asset:  Acquisition cost.  Estimated useful life.  Estimated residual value. The calculation of depreciation requires three amounts for each asset:  Acquisition cost.  Estimated useful life.  Estimated residual value. 8-15

16. STRAIGHT-LINE METHOD Cost - Residual Value Useful Life in Years Depreciation Expense per Year Depreciation Expense per Year == At the beginning of the year, Southwest purchased ground equipment for $62,500 cash. The equipment has an estimated useful life of 3 years and an estimated residual value of $2,500. Depreciation Expense per Year = Depreciation Expense per Year = $20,000 $62,500 - $2,500 3 years 8-16

17. Residual Value SL More companies use the straight-line method of depreciation in their financial reports than all other methods combined. STRAIGHT-LINE METHOD 8-17

18. UNITS-OF-PRODUCTION METHOD Depreciation Rate = Cost - Residual Value Life in Units of Production Step 1: Step 2: Depreciation Expense = Depreciation Rate × Number of Units Produced for the Year At the beginning of the year, Southwest purchased ground equipment for $62,500 cash. The equipment has an estimated useful life of 100,000 miles and an estimated residual value of $2,500. If the equipment is used 30,000 miles in the first year, what is the amount of depreciation expense? 8-18

19. UNITS-OF-PRODUCTION METHOD $62,500 - $2,500 100,000 miles = $.60 per mile Depreciation Rate = Step 1: Step 2: $.60 per mile × 30,000 miles = $18,000 Depreciation Expense = Residual Value 8-19

20. ACCELERATED DEPRECIATION Depreciation Repair Expense Early Years High Low Later Years Low High Accelerated depreciation matches higher depreciation expense with higher revenues in the early years of an asset’s useful life when the asset is more efficient. 8-20

21. DECLINING-BALANCE METHOD Annual Depreciation expense Net Book Value () Useful Life in Years 2 = × Cost – Accumulated Depreciation Declining balance rate of 2 is double-declining- balance (DDB) rate. Annual computation ignores residual value. At the beginning of the year, Southwest purchased equipment for $62,500 cash. The equipment has an estimated useful life of 3 years and an estimated residual value of $2,500. Calculate the depreciation expense for the first two years. 8-21

22. Annual Depreciation expense Net Book Value () Useful Life in Years 2 = × () $62,500 × 3 years 2 = $41,667 () ($62,500 – $41,667) × 3 years 2 = $13,889 DECLINING-BALANCE METHOD Year 1 Depreciation: Year 2 Depreciation: 8-22

23. () ($62,500 – $55,556) × 3 years 2 = $4,629 Below residual value DECLINING-BALANCE METHOD 8-23

24. DECLINING-BALANCE METHOD 8-24 Depreciation expense is limited to the amount that reduces book value to the estimated residual value.

25. INTERNATIONAL PERSPECTIVE COMPONENT ALLOCATION Under IFRS, the cost of an individual asset’s components is allocated among each significant component and then depreciated separately over that component’s useful life. 8-25

26. TAX REPORTING Most public companies maintain two sets of accounting records reflecting the same transactions, but accounted for using two different sets of measurement rules. One set is prepared under GAAP for reporting to stockholders. The other set is prepared to determine the company’s tax obligation under the Internal Revenue Code (IRC). The two sets of rules differ because the objectives of GAAP and the IRC differ. 8-26

27. MEASURING 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. Recognize a loss when an asset suffers a permanent impairment. 8-27

28. Disposal of Property, Plant and Equipment Voluntary disposals: Sale Trade-in Retirement Involuntary disposals: Fire Accident DISPOSAL OF PROPERTY, PLANT AND EQUIPMENT 8-28

29.  Journalize disposal by: Writing off accumulated depreciation (debit). Writing off the asset cost (credit). Recording cash received (debit) or paid (credit). Recording a gain (credit) or loss (debit).  Update depreciation to the date of disposal. DISPOSAL OF PROPERTY, PLANT AND EQUIPMENT 8-29

30. If Cash > BV, record a gain (credit). If Cash < BV, record a loss (debit). If Cash = BV, no gain or loss. 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 Southwest Airlines sold flight equipment for $11,000,000 cash at the end of its 17th year of use. The flight equipment originally cost $30,000,000, and was depreciated using the straight-line method with zero residual value and a useful life of 25 years. Let’s answer the following questions. 8-30

31. The amount of depreciation expense recorded at the end of the 17th year to bring depreciation up to date is: a.$0. b.$1,200,000. c.$1,500,000. d.$2,000,000. The amount of depreciation expense recorded at the end of the 17th year to bring depreciation up to date is: a.$0. b.$1,200,000. c.$1,500,000. d.$2,000,000. Annual Depreciation: ($30,000,000 – $0) ÷ 25 Years. = $1,200,000 DISPOSAL OF PROPERTY, PLANT AND EQUIPMENT 8-31

32. After updating the depreciation, the equipment’s book value at the end of the 17th year is: a.$9,600,000. b.$20,400,000. c.$12,800,000. d.$6,600,000. After updating the depreciation, the equipment’s book value at the end of the 17th year is: a.$9,600,000. b.$20,400,000. c.$12,800,000. d.$6,600,000. Accumulated Depreciation = (17yrs. × $1,200,000) = $20,400,000 BV = Cost – Accumulated Depreciation BV = $30,000,000 – $20,400,000 = $9,600,000 DISPOSAL OF PROPERTY, PLANT AND EQUIPMENT 8-32

33. The equipment’s sale resulted in: a.a gain of $1,400,000. b.a gain of $6,200,000. c.a gain of $3,800,000. d.a loss of $1,700,000. The equipment’s sale resulted in: a.a gain of $1,400,000. b.a gain of $6,200,000. c.a gain of $3,800,000. d.a loss of $1,700,000. Gain = Cash Received – Book Value Gain = $11,000,000 – $9,600,000 = $1,400,000 DISPOSAL OF PROPERTY, PLANT AND EQUIPMENT 8-33

34. Prepare the journal entry to record Southwest’s sale of the equipment at the end of the 17th year. DISPOSAL OF PROPERTY, PLANT AND EQUIPMENT 8-34

35. ACQUISITION AND AMORTIZATION OF 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 Only purchased intangibles are recorded, and they are normally recorded at current cash equivalent cost, including purchase price, legal fees, and filing fees. 8-35

36. ACQUISITION AND AMORTIZATION OF INTANGIBLE ASSETS Definite Life Amortize over shorter of economic life or legal life. Use straight-line method. Definite Life Amortize over shorter of economic life or legal life. Use straight-line method. Indefinite Life Not amortized. Tested at least annually for possible impairment, and book value is reduced to fair value if impaired. Indefinite Life Not amortized. Tested at least annually for possible impairment, and book value is reduced to fair value if impaired. Amortization is a cost allocation process similar to depreciation and depletion. 8-36

37. 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. Goodwill ACQUISITION AND AMORTIZATION OF INTANGIBLE ASSETS Goodwill is not amortized. Its value must be reviewed at least annually for possible impairment, and the book value is reduced to fair value if impaired. 8-37

38. Arpec Company paid $2,000,000 to purchase all of Utek Company’s assets and assumed liabilities of $400,000. The acquired assets were appraised at a fair value of $1,800,000. What amount of goodwill should be recorded on Arpec Company books? a.$200,000 b.$400,000 c.$600,000 d.$800,000 What amount of goodwill should be recorded on Arpec Company books? a.$200,000 b.$400,000 c.$600,000 d.$800,000 ACQUISITION AND AMORTIZATION OF INTANGIBLE ASSETS 8-38

39. ACQUISITION AND AMORTIZATION OF INTANGIBLE ASSETS Copyrights The exclusive right to publish, use, and sell a literary, musical, or artistic work. Legal life is life of creator plus 70 years. Amortize cost over the period benefited. Copyrights The exclusive right to publish, use, and sell a literary, musical, or artistic work. Legal life is life of creator plus 70 years. Amortize cost over the period benefited. 8-39 Trademarks A symbol, design, or logo associated with a business. An exclusive legal right to use a name, image, or slogan. Trademarks are almost always internally developed, have indefinite life, and are not amortized. Trademarks A symbol, design, or logo associated with a business. An exclusive legal right to use a name, image, or slogan. Trademarks are almost always internally developed, have indefinite life, and are not amortized.

40. ACQUISITION AND AMORTIZATION OF INTANGIBLE ASSETS Patents Exclusive right granted by the 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. Research and development costs that might result in a patent are normally expensed as incurred. Technology A category of intangible assets that includes a company’s website and any computer programs written by its employees. 8-40

41. Franchises Legally protected right purchased by a franchisee to sell products or provide services for a specified period and purpose. Purchase price is an intangible asset that is amortized. Franchises Legally protected right purchased by a franchisee to sell products or provide services for a specified period and purpose. Purchase price is an intangible asset that is amortized. ACQUISITION AND AMORTIZATION OF INTANGIBLE ASSETS Licenses and Operating Rights Limited permissions to use a product or service according to specific terms and conditions. You may be using computer software that is made available to you through a campus licensing agreement. Licenses and Operating Rights Limited permissions to use a product or service according to specific terms and conditions. You may be using computer software that is made available to you through a campus licensing agreement. 8-41

42. RESEARCH AND DEVELOPMENT EXPENSE Research and development expenses are not intangible assets under U.S. GAAP. The cost to development an intangible asset internally is normally recorded as research and development expense. 8-42

43. INTERNATIONAL PERSPECTIVE DIFFERENCES IN ACCOUNTING FOR TANGIBLE AND INTANGIBLE ASSETS 8-43

44. ACQUISITION AND DEPLETION OF NATURAL RESOURCES Examples: oil, coal, gold Extracted from the natural environment. A noncurrent asset presented at cost less accumulated depletion. Total cost of asset is the cost of acquisition, exploration, and development. Total cost is allocated over periods benefited by means of depletion. Depletion is like units-of-production depreciation. 8-44

45. The unit depletion rate is calculated as follows: Estimated Recoverable Units Acquisition and Residual Development Cost Value – Depletion cost Inventory for sale Unsold Inventory Cost of goods sold Depletion cost for a period is: UNIT DEPLETION RATE NUMBER OF UNITS EXTRACTED IN PERIOD × ACQUISITION AND DEPLETION OF NATURAL RESOURCES 8-45

46. FOCUS ON CASH FLOWS 8-46

47. CHAPTER SUPPLEMENT: CHANGES IN DEPRECIATION ESTIMATES Depreciation Expense is based on... ESTIMATED useful life ESTIMATED residual value If the estimates change, the book value less any residual value at the date of change is depreciated over the remaining useful life. Southwest purchased an aircraft for $60,000,000. The aircraft is depreciated using the straight-line method with a useful life of 20 years and an estimated residual value of $3,000,000. In year 5, Southwest changed the estimated useful life to 25 years and lowered the residual value to $2,400,000. Calculate depreciation expense for the fifth year using the straight-line method. 8-47

48. CHAPTER SUPPLEMENT: CHANGES IN DEPRECIATION ESTIMATES 8-48

49. END OF CHAPTER 8 8-49