Ch09 Fundamental Of Financial Accounting By Edmonds (4th Edition)

Fundamental Financial Accounting Concepts Fourth Edition by Edmonds, McNair, Milam, Olds PowerPoint® presentation by J. Lawrence Bergin

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Chapter 9 Long-Term Operational Assets

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Classification of Operational Assets ●

Operational assets are used by a business to generate revenue.

●

Tangible operational assets have physical substance. – Land, buildings, fixtures, and equipment – Natural resources

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Long-term Operational Assets... ●

●

Long-term assets will be used more than one year. Tangible operational assets are reported on the balance sheet in a classification called Property, Plant, and Equipment.

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Classification of Operational Assets ●

Intangible operational assets lack physical substance and confer specific use rights on the owner. ❐ Patents ❐ Copyrights ❐ Franchises ❐ Licenses ❐ Trademarks

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Burger Queen Franchise

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Measuring and Recording Acquisition Cost

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Purchased operational assets are recorded at cost, an amount that includes all normal and reasonable expenditures necessary to get the asset in place and ready for its intended use. Invoice price ❐ Sales taxes ❐ Transportation costs ❐ Installation costs ❐ Renovation and repair cost incurred prior to use. ❐

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Measuring Acquisition Cost ●

Acquisition cost is the net cash equivalent amount paid for the asset.

●

Financing charges are excluded from the acquisition cost but should be reported as interest expense.

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Measuring Acquisition Cost ●

The cost of land includes: – Acquisition price – Real estate commissions – Title search and transfer fees – Title insurance premiums – Delinquent taxes – Surveying fees

●

Land is not depreciated.

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Basket Purchases of Assets When land and building are purchased together, the land cost and the building cost are placed in separate accounts. The total cost of the purchase is separated on the basis of relative market values.

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Basket Purchases of Assets Example: On March 1, Arco Co. purchased land and building for $100,000 cash. The appraised value of the building was $90,000 and the land was appraised at $30,000. How much of the $100,000 purchase price will be allocated to each account? Land = ? Building = ?

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Basket Purchases of Assets Fair Market Values: Building Land

$ 90,000 $ 30,000

Total market value

$120,000

Allocation of cost: Building Land McGraw-Hill/Irwin

* $100,000 = * $100,000 = © The McGraw-Hill Companies, Inc., 2003

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Basket Purchases of Assets Fair Market Values: Fraction Building Land

$ 90,000 $ 30,000

Total market value

$120,000

Allocation of cost: Building Land McGraw-Hill/Irwin

* $100,000 = * $100,000 = © The McGraw-Hill Companies, Inc., 2003

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Basket Purchases of Assets Fair Market Values: Building Land

Fraction $ 90,000 9/12 $ 30,000 3/12

Total market value

$120,000 12/12

Allocation of cost: Building Land McGraw-Hill/Irwin

* $100,000 = * $100,000 = © The McGraw-Hill Companies, Inc., 2003

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Basket Purchases of Assets Fair Market Values: Building Land

Fraction $ 90,000 9/12 $ 30,000 3/12

Total market value

$120,000 12/12

Allocation of cost: Building Land McGraw-Hill/Irwin

9/12 * $100,000 = 3/12 * $100,000 = © The McGraw-Hill Companies, Inc., 2003

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Basket Purchases of Assets Fair Market Values: Building Land

$ 90,000 $ 30,000

Total market value

$120,000

Allocation of cost: Building Land McGraw-Hill/Irwin

9/12 * $100,000 = $75,000 3/12 * $100,000 = $25,000 © The McGraw-Hill Companies, Inc., 2003

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Basket Purchases of Assets General Journal entry: Building Land Cash

$ 75,000 $ 25,000 $100,000

Allocation of cost: Building Land McGraw-Hill/Irwin

9/12 * $100,000 = $75,000 3/12 * $100,000 = $25,000 © The McGraw-Hill Companies, Inc., 2003

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Nature of Depreciation, Depletion, and Amortization The matching principle requires that part of the acquisition cost be expensed in periods when the future revenues are earned. Cost of asset on Balance Sheet [capitalize]

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...as the asset is used.....

Expense on Income Statement [expense]

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Terminology: Write-off….amortize ●

●

Amortization:

Depreciation: – Property, plant, equipment

– Intangible assets

franchise ●

Depletion: –Natural resources

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Depreciation Methods ❐

For Financial Accounting (books) ❐ Straight-line ❐ Production method

❐ (Double) Declining balance ❐For Tax Returns ❐ Modified Accelerated Cost Recovery System (MACRS)

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Straight-Line Method Depreciation Expense per Year

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=

Cost - Residual Value Life in Years

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Straight-Line Method: Example On January 1, 2004, equipment was purchased for $55,000 cash. The equipment has an estimated useful life of 5 years and an estimated residual value of $10,000. What is the annual straight-line depreciation expense?

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Straight-Line Method: Example Depreciation Expense per Year

=

Depreciation Expense per Year

=

Depreciation Expense per Year

=

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Cost - Residual Value Life in Years

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Straight-Line Method: Example Depreciation Expense per Year

=

Depreciation Expense per Year

=

Depreciation Expense per Year

=

McGraw-Hill/Irwin

Cost - Residual Value Life in Years 55,000 - 10,000 5

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Straight-Line Method: Example Depreciation Expense per Year Depreciation Expense per Year Depreciation Expense per Year

McGraw-Hill/Irwin

=

=

=

Cost - Residual Value Life in Years 55,000 - 10,000 5 9,000

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Straight-Line Method: Example Calculate depreciation expense for the second year of the asset’s life.

9,000 Depreciation expense is the same amount each year of the asset’s life using the straight-line method. McGraw-Hill/Irwin

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Units-of-Production Method Step 1: Depreciation Rate

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=

Cost - Residual Value Estimated units of useful life

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Units-of-Production Method Step 1: Depreciation Rate

=

Cost - Residual Value Estimated units of useful life

=

Number of Depreciation × Units Produced Rate for the Year

Step 2: Depreciation Expense

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Example of Units of Production Method Given the same information [asset cost $55,000, has a residual value of $10,000, has a useful life of five years] plus the fact that the asset is estimated to have a total productive capacity of 100,000 units during the useful life: If 22,000 units were produced this year, what is the amount of depreciation expense?

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Example of Production Method Step 1: $ Depreciation = Rate

=

$

= $. Per unit

Step 2: Dep. rate x units produced Depreciation = $ x = $ Expense

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Example of Production Method Step 1: Cost - salvage value $45,000 Depreciation = = $.45 = Rate Productive output 100,000 Per unit

Step 2: Dep. rate x units produced Depreciation = $ .45/unit x 22,000 = Expense

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$9,900

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Example of Production Method If 15,000 units are produced during the second year of the asset’s life, what is the amount of depreciation expense? $ ● What is the Accumulated Depreciation at the end of the second year? $ ● What is the 12/31/05 Equip. Book Value? ●

$

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Example of Production Method If 15,000 units are produced during the second year of the asset’s life, what is the amount of depreciation expense? $0.45 x 15,000 = $6,750 ● What is the Accumulated Depreciation at the end of the second year? $9,900 + $6,750 = $16,650 ● What is the 12/31/05 Equip. Book Value? ●

$55,000 cost - $16,650 Accum. Dep. = $38,350

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Accelerated Depreciation ●

Accelerated depreciation methods result in more depreciation expense in the early years of an asset’s useful life and less depreciation expense in later years of the an asset’s useful life.

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Double-Declining Balance Method ●

Declining-balance depreciation is based on the straight-line rate multiplied by an acceleration factor. – For example, when the acceleration factor is 200 percent, the method is referred to as double-declining balance depreciation.

●

Declining-balance depreciation computations ignore residual value.

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Double-Declining Balance Method Annual Depreciation is calculated with the following formula: Book Value × (2 × Straight-Line Rate)

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Double-Declining-Balance Method Annual Depreciation is calculated with the following formula: Book Value × (2 × Straight-Line Rate)

Book Value ×

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(

100% 2 × Useful Life in Years

)

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Double-Declining-Balance Example Using the same information from our earlier example [asset cost $55,000, residual value is $10,000, and useful life is 5 years]: Calculate the depreciation expense for the first two years of the asset’s life.

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Double-Declining-Balance Example Book Value ×

(

100% 2 × Useful Life in Years

)

First year’s depreciation:

Second year’s depreciation:

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Double-Declining-Balance Example Book Value ×

(

100% 2 × Useful Life in Years

)

First year’s depreciation expense:

55,000 * [2 * 1.00/5] = 55,000 * .40 = $22,000 Second year’s depreciation expense:

(Cost - Accum. Dep) x .40 ($55,000 - $22,000) x .40 = $13,200 D.Exp. McGraw-Hill/Irwin

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Double-Declining-Balance Example Book Value ×

(

100% 2 × Useful Life in Years

)

What is the ACCUMULATED depreciation after Yr. 2? Dep. Exp, Yr. 1 + Dep. Exp. Yr. 2 = Accumulated Dep. At end of yr. 2

$22,000 + $13,200 = $35,200 Accum.Dep. Third year’s depreciation expense:

(Cost - Accum. Dep) x .40 ($55,000 - $35,200) x .40 = $ 7,920 D.Exp. McGraw-Hill/Irwin

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Comparison of Depreciation Methods Straight-line Production* Double-Declining Bal. Before comparing these methods, let’s look at a problem in the later years of lifeDep. whenAccum. using Double-declining balance. Dep. Accum. Dep. Accum. Since we cannot off theDep. $10,000 salvage total Year Exp. Dep.writeExp. Exp. value,Dep.

1 2

depreciation of $45,000 ($55,000 Cost - $10,000 Sal. Val.) must be 9000 over 9000 9900 9900 The 22,000 22,000 written-off the life of the asset. DDB formula would result in too much Dep. Exp. in year 4. Here’s why…. 9000 18000 6750 16650 13,200 35,200 40%x (Cost - Accum. Dep. @ Yr. 3 end)

($55,00043,120) = $4,752 D.Exp. 7,920 3 = .40x 9000 27000 11250 27900

4 5

But, after Year 3 there is only $1,880 9000 43,120) 36000left11250 39150to ($45,000to depreciate accumulate $45,000 of depreciation.

9000 45000

5850 45000

43,120

1,8801

45,000

01

45,000

*Units produced were Yr 1= 22,000; Yr 2=15,000; Yrs 3&4=25,000 each; Solution: Depreciate the final $1,880 Yr. 5=13,000. [1 In yr. 4, didn’t use DDB formula. Wrote-off last 1,880.] in Yr. 4 and $0 Dep. Exp in Yr. 5. McGraw-Hill/Irwin

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Comparison of Depreciation Methods Straight-line Production* Double-Declining Bal. Dep. Accum. Dep. Accum. Dep. Accum. Year Exp. Dep. Exp. Dep. Exp. Dep. 1

9000

9000

2

9000 18000

9900

9900

22,000

22,000

6750 16650

13,200

35,200

3

9000 27000 11250 27900

7,920

43,120

4

9000 36000 11250 39150

1,8801

45,000

5

9000 45000

01

45,000

5850 45000

*Units produced were Yr 1= 22,000; Yr 2=15,000; Yrs 3&4=25,000 each; Yr. 5=13,000. [1 In yr. 4, didn’t use DDB formula. Wrote-off last 1,880.]

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Comparison of Depreciation Methods ●

The total amount of depreciation recorded over the useful life of an asset is the same regardless of the method used.

●

Depreciation expense recorded in any one period will vary according to method used.

●

The straight-line method is used for financial accounting purposes (“the books”) by about 95 percent of companies because it is easy to use and to explain to financial statement users.

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Horizontal Model Transactions Depreciation and Disposal

1. Jan. 1, 2004, the owner invested $70,000 cash to start the business. 2. Jan. 1, 2004 the Co. purchased equipment paying $55,000 cash. 3. During 2004 the Co. earned $30,000 of cash revenue. 4. Dec. 31, ‘04 adjustment for straight-line depreciation was recorded. (Estimated life = 5 years with $10,000 residual value.) 4B. Calculate the balances at the end of 2004 which will be carried over to begin 2005. 5. Dec. 31, ‘05 adjustment for straight-line depreciation was recorded. 5B. Calculate the 2005 ending balances to carry over to start 2006. Sept. 1, 2006 the equipment was sold for $26,000 cash. 6. Update the depreciation accounts to the disposal date. 7. Record the disposal, including any gain or loss. McGraw-Hill/Irwin

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Horizontal Model Transaction Analysis Balance Sheet Assets = Liab.+ Equity Cash + Equip.- Acc.D.= A/P + C.C.+ R.E.

McGraw-Hill/Irwin

Income Statement Rev./ Exp. Gains - Loss= N.I.

Cashflow Statem’t OA,IA,FA

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Horizontal Model Transaction Analysis Balance Sheet Assets = Liab.+ Equity Cash + Equip.- Acc.D.= A/P + C.C.+ R.E. 1 70,000 2 (55,000) 55,000

3 30,000 4 + 9000 B 45,000 55,000 9000

McGraw-Hill/Irwin

70,000

Income Statement Rev./ Exp. Gains - Loss= N.I.

Cashflow Statem’t OA,IA,FA 70,000 FA (55,000) IA

30000 30,000 30,000 30,000 OA (9000) 9,000 (9000) 70,000 21000 Closed out 45,000 B

© The McGraw-Hill Companies, Inc., 2003

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What’s the result? - End of Year 1 How much depreciation expense is on the 2004 income Statement?

$ How much Accumulated Deprec. is on the 12/31/04 Bal. Sheet?

$ What is the equipment’s Book Value (or Carrying Value) at the end of 2004?

Equip, cost

$

Less: Accum.Dep. Equip, (net BV) $

McGraw-Hill/Irwin

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Horizontal Model Transaction Analysis Balance Sheet Assets = Liab.+ Equity Cash + Equip.- Acc.D.= A/P + C.C.+ R.E. 1 70,000 2 (55,000) 55,000

3 30,000 4 + 9000 B 45,000 55,000 9000

McGraw-Hill/Irwin

70,000

Income Statement Rev./ Exp. Gains - Loss= N.I.

Cashflow Statem’t OA,IA,FA 70,000 FA (55,000) IA

30000 30,000 30,000 30,000 OA (9000) 9,000 (9000) 70,000 21000 Closed out 45,000 B

© The McGraw-Hill Companies, Inc., 2003

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What’s the result? - End of Year 1 How much depreciation expense is on the 2004 income Statement?

$9,000 How much Accumulated Deprec. is on the 12/31/04 Bal. Sheet?

$9,000 What is the equipment’s Book Value (or Carrying Value) at the end of 2004?

$55,000 9,000 Less: Accum.Dep. Equip, (net BV) $46,000 Equip, cost

McGraw-Hill/Irwin

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Horizontal Model Transactions Depreciation and Disposal

1. Jan. 1, 2004, the owner invested $70,000 cash to start the business. 2. Jan. 1, 2004 the Co. purchased equipment paying $55,000 cash. 3. During 2004 the Co. earned $30,000 of cash revenue. 4. Dec. 31, 2004 adjustment for depreciation was recorded. (Estimated life = 5 years with $10,000 residual value.) 4B. Calculate the balances at the end of 2004 which will be carried over to begin 2005. 5. Dec. 31, 2005 adjustment for depreciation was recorded. 5B. Calculate the 2005 ending balances to carry over to start 2006. Sept. 1, 2006 the equipment was sold for $26,000 cash. 6. Update the depreciation accounts to the disposal date. 7. Record the disposal, including any gain or loss. McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

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Horizontal Model Transaction Analysis Balance Sheet Assets = Liab.+ Equity Cash + Equip.- Acc.D.= A/P + C.C.+ R.E. 1 70,000 2 (55,000) 55,000

3 30,000 4 + 9000 B 45,000 55,000 9000 5 9000 B 45,000 55,000 18,000

McGraw-Hill/Irwin

70,000

Income Statement Rev./ Exp. Gains - Loss= N.I.

Cashflow Statem’t OA,IA,FA 70,000 FA (55,000) IA

30000 30,000 30,000 30,000 OA (9000) 9,000 (9000) 70,000 21000 Closed out 45,000 B (9000) 9,000 (9000) 70,000 12,000 Closed out 45,000 B

© The McGraw-Hill Companies, Inc., 2003

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What’s the result? - End of Year 2 How much depreciation expense is on the 2005 income Statement?

$ How much Accumulated Deprec. is on the 12/31/05 Bal. Sheet?

$ What is the equipment’s Book Value (or Carrying Value) at the end of 2005?

Equip, cost

$

Less: Accum.Dep. Equip, (net BV) $

McGraw-Hill/Irwin

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Horizontal Model Transaction Analysis Balance Sheet Assets = Liab.+ Equity Cash + Equip.- Acc.D.= A/P + C.C.+ R.E. 1 70,000 2 (55,000) 55,000

3 30,000 4 + 9000 B 45,000 55,000 9000 5 9000 B 45,000 55,000 18,000

McGraw-Hill/Irwin

70,000

Income Statement Rev./ Exp. Gains - Loss= N.I.

Cashflow Statem’t OA,IA,FA 70,000 FA (55,000) IA

30000 30,000 30,000 30,000 OA (9000) 9,000 (9000) 70,000 21000 Closed out 45,000 B (9000) 9,000 (9000) 70,00012,000 Closed out 45,000 B

© The McGraw-Hill Companies, Inc., 2003

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What’s the result? - End of Year 2 How much depreciation expense is on the 2005 income Statement?

$ 9,000 How much Accumulated Deprec. is on the 12/31/05 Bal. Sheet?

$18,000 What is the equipment’s Book Value (or Carrying Value) at the end of 2005?

$55,000 Less: Accum.Dep. 18,000 Equip, cost

Equip, (net BV)

$37,000 McGraw-Hill/Irwin

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Disposal of Operational Assets

McGraw-Hill/Irwin

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Horizontal Model Transactions Depreciation and Disposal

1. Jan. 1, 2004, the owner invested $70,000 cash to start the business. 2. Jan. 1, 2004 the Co. purchased equipment paying $55,000 cash. 3. During 2004 the Co. earned $30,000 of cash revenue. 4. Dec. 31, 2004 adjustment for depreciation was recorded. (Estimated life = 5 years with $10,000 residual value.) 4B. Calculate the balances at the end of 2004 which will be carried over to begin 2005. 5. Dec. 31, 2005 adjustment for depreciation was recorded. 5B. Calculate the 2005 ending balances to carry over to start 2006. Sept. 1, 2006 the equipment was sold for $26,000 cash. 6. Update the depreciation accounts to the disposal date. 7. Record the disposal, including any gain or loss. McGraw-Hill/Irwin

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Disposal of Operational Assets ●

Voluntary disposal refers to situations where a business gives up ownership of an asset by: – Sale – Trade-in – Retirement

●

Involuntary disposal results because of a casualty such as a fire or an accident.

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Disposal of Operational Assets

1. Update the depreciation on the asset to the date of disposal. (Jan.1-Sept 1 = 8 mo.)

McGraw-Hill/Irwin

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Horizontal Model Transaction Analysis Balance Sheet Assets = Liab.+ Equity Cash + Equip.- Acc.D. = A/P + C.C.+ R.E. OA,IA,FA 1 70,000 70,000 2 (55,000) 55,000 3 30,000 30000 4 + 9000 (9000) B 45,000 55,000 9000 70,000 21000 5 9000 (9000) B 45,000 55,000 18,000 70,00012,000 6

6,000

McGraw-Hill/Irwin

(6000)

Income Statement Cashflow Rev./ Exp. Statem’t Gains - Loss= N.I. 70,000 FA (55,000) IA

30,000

30,000 30,000 OA 9,000 (9000) Closed out 45,000 B 9,000 (9000) Closed out 45,000 B 6,000 (6000)

© The McGraw-Hill Companies, Inc., 2003

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Disposal of Operational Assets

1. Update the depreciation on the asset to the date of disposal. 2. Record the disposal by . . . – Removing the asset cost (credit). – Removing the Accumulated Depreciation (debit). – Recording cash received (debit) or cash paid (credit). – Recording a loss (debit) or gain (credit).

McGraw-Hill/Irwin

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Gain or Loss on Disposal? How do we know if there is a Loss or Gain on the disposal? ●

Compare cash received for the asset with the asset’s book value (BV). – If cash greater than BV, record a gain (credit). – If cash less than BV, record a loss (debit). – If cash equals BV, no gain or loss. le

sa r t fo

se s a

McGraw-Hill/Irwin

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Disposal of Operational Assets How do we know if there is a Loss or Gain on the disposal?

Compare cash received for the asset with the asset’s book value (BV). Cash received Equipment, cost $ Less: Accum. Dep. Equip, Book Value Gain (Loss)

McGraw-Hill/Irwin

$

r o f t

le a s

se s a

$ © The McGraw-Hill Companies, Inc., 2003

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Disposal of Operational Assets How do we know if there is a Loss or Gain on the disposal?

Compare cash received for the asset with the asset’s book value (BV). - 5000 .

Cash received Equipment, cost $55,000 Less: Accum. Dep. 24,000 Equip, Book Value Gain (Loss)

McGraw-Hill/Irwin

$26,000

31,000 $ (5,000) © The McGraw-Hill Companies, Inc., 2003

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Horizontal Model Transaction Analysis Balance Sheet Assets = Liab.+ Equity Cash + Equip.- Acc.D.= A/P + C.C.+ R.E. 1 70,000

70,000

70,000 FA

2 (55,000) 55,000

3 30,000 4 + 9000 B 45,000 55,000 9000 5 9000 B 45,000 55,000 18,000 6 6,000 7 26,000 (55,000) (24,000) IA

McGraw-Hill/Irwin

Income Statement Cashflow Rev./ Exp. Statem’t Gains - Loss= N.I. OA,IA,FA (55,000) IA

30000 30,000 30,000 30,000 OA (9000) 9,000 (9000) 70,000 21000 Closed out 45,000 B (9000) 9,000 (9000) 70,00012,000 Closed out 45,000 B (6000) (5000)

6,000 (6000) 5,000 (5000) 26,000

© The McGraw-Hill Companies, Inc., 2003

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Journalize the Disposal Cash

$

Accumulated Depreciation (to remove) Loss on Disposal of Equipment Equipment (original cost)

What if there had been a GAIN on disposal? The GAIN would be a CREDIT in the journal entry above (and there would be more cash).

McGraw-Hill/Irwin

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Journalize the Disposal Cash

$26,000

Accumulated Depreciation (to remove) 24,000 Loss on Disposal of Equipment Equipment (original cost)

5,000 55,000

What if there had been a GAIN on disposal? The GAIN would be a CREDIT in the journal entry above (and there would be more cash).

McGraw-Hill/Irwin

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Horizontal Model Transaction Analysis Balance Sheet Assets = Liab.+ Equity Cash + Equip.- Acc.D. = A/P + C.C.+ R.E. OA,IA,FA 1 70,000 70,000 2 (55,000) 55,000 3 30,000 30000 4 + 9000 (9000) B 45,000 55,000 9000 70,000 21000 5 9000 (9000) B 45,000 55,000 18,000 70,00012,000 6 6,000 (6000) 7 26,000 (55,000) (24,000) B 71,000

McGraw-Hill/Irwin

0

0

(5000) 70,000 1,000

Income Statement Cashflow Rev./ Exp. Statem’t Gains - Loss= N.I. 70,000 FA (55,000) IA

30,000

30,000 30,000 OA 9,000 (9000) Closed out 45,000 B 9,000 (9000) Closed out 45,000 B 6,000 (6000) 5,000 (5000) 26,000 IA Closed out

71,000 B

© The McGraw-Hill Companies, Inc., 2003

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What’s the result? - For Year 3 How much depreciation expense is on the 2006 Income Statement?

$6,000 How much Gain or Loss is on the 2006 Income Statement?

$5,000 Loss on Disposal How much Accumulated Deprec. is on the 12/31/06 Bal. Sheet?

$0

(We don’t have the equipment anymore.)

What is the equipment’s Book Value (or Carrying Value) at the end of 2006?

$0 McGraw-Hill/Irwin

(We don’t have the equipment anymore.)

© The McGraw-Hill Companies, Inc., 2003

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What’s the result? - For Year 3 How much depreciation expense is on the 2006 Income Statement?

$ How much Gain or Loss is on the 2006 Income Statement?

$ How much Accumulated Deprec. is on the 12/31/06 Bal. Sheet?

$ What is the equipment’s Book Value (or Carrying Value) at the end of 2006?

$ McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

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Depreciation and Federal Income Tax ●

Most corporations use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes. (Could use straight-line depreciation.)

●

MACRS provides for rapid write-off of an asset’s cost in order to stimulate investment in modern facilities.

●

MACRS uses half-year convention and assumes no residual value.

McGraw-Hill/Irwin

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Depreciation and Federal Income Tax MACRS example

Same purchase recorded previously: On Jan. 1, 2004 equipment costing $55,000 was purchased. Estimated life = 5 yrs. Estimated residual value = $10,000. Calculate the depreciation tax deduction assuming the equipment is classified as “5 year property.” Note: See tax tables in your text for 5-Yr. and 7-Yr. properties. McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

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Depreciation and Federal Income Tax MACRS example

IRS yr. 1 2 3 4 5 6

Table % 20.00 32.00 19.20 11.52 11.52 5.76

McGraw-Hill/Irwin

Equipm’t Depreciation Cost Deduction x$ = $ x = x = x = x = x =

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Depreciation and Federal Income Tax MACRS example

IRS yr. 1 2 3 4 5 6

Table % 20.00 32.00 19.20 11.52 11.52 5.76

McGraw-Hill/Irwin

Equipm’t Depreciation Cost Deduction x $55,000 = $11,000 x 55,000 = 17,600 x 55,000 = 10,560 x 55,000 = 6,336 x 55,000 = 6,336 x 55,000 = 3,168 $55,000 © The McGraw-Hill Companies, Inc., 2003

Revising Estimates of Salvage Value or of Useful Life

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●

●

●

When an estimate is revised, no changes are made to amounts reported in the past. The new estimates are incorporated into the present and future calculations only. Depreciation amounts are revised using the book value, estimated useful life and salvage value at beginning of the year of the revision.

McGraw-Hill/Irwin

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Revising Estimates of Salvage Value or of Useful Life - Example

On Jan. 1, 2004 the Goodview Co. purchased Equipment costing $55,000. It was estimated to last 5 years and have a $10,000 residual value. Straight-line depreciation ($9,000) has been used. On Jan. 1, 2006 management determined that the equipment would last 4 years from this date, but would only be worth $5,000 at the end of that time. How much depreciation expense should be recorded each year starting on Dec. 31, 2006?

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

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Revising Estimates of Salvage Value or of Useful Life - Example

The equipment has already been depreciated two years (‘04 and ‘05) at $9,000 per year. So, Accumulated Depreciation has an $18,000 balance at the beginning of 2006. Original Cost

$

Less: Accum. Dep. = Book value, Jan. 1, ‘2006 Less: Revised Residual Value = Remainder to be depreciated Divided by Remaining life

Starting in 2006

= New annual Depreciation expense $ McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

9- 77

Revising Estimates of Salvage Value or of Useful Life - Example

The equipment has already been depreciated two years (‘04 and ‘05) at $9,000 per year. So, Accumulated Depreciation has an $18,000 balance at the beginning of 2006. Original Cost

$55,000

Less: Accum. Dep.

18,000

= Book value, Jan. 1, ‘2006

37,000

Less: Revised Residual Value

5,000

= Remainder to be depreciated

32,000

Divided by Remaining life yrs.

4

Starting in 2006

= New annual Depreciation expense $ 8,000 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

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Continuing Expenditures for Plant Assets ●

●

McGraw-Hill/Irwin

Expenditures made to keep an asset in good working order are expensed in the period in which they are incurred. (normally expected repairs & maintenance) Substantial costs spent to improve the quality or extend the life of an asset are capitalized. © The McGraw-Hill Companies, Inc., 2003

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Accounting for capital expenditures: Extraordinary Repairs Ex: Overhaul ● Extend the life? – viewed as canceling some of the previous depreciation – journal entry to reduce (debit) accumulated depreciation – new depreciation amount will be calculated using the revision approach.

McGraw-Hill/Irwin

Betterments Ex: Attach snowplow to truck owned for 2 years. ● Improve the quality?

– viewed as an additional cost of the equipment – journal entry to increase (debit) the cost of the asset – new depreciation amount will be calculated using the revision approach.

© The McGraw-Hill Companies, Inc., 2003

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Natural Resources

●

Assets supplied by nature

– Examples: gold, oil, and coal ●

Presented on balance sheet as non-current assets at cost minus all depletion to date.

●

Total cost of the asset is the cost of acquisition, exploration and development.

●

Cost is “written-off” as “Depletion Expense” over periods that related revenues are earned. (Usually, units-of-production method.)

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

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Natural Resources A depletion rate is calculated using the units-of-production method. Depletion Cost Per Unit Is Calculated As Follows: Total Cost of Natural Resource Estimated Number of Available Units of Natural Resource

McGraw-Hill/Irwin

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Intangible Assets ●

Noncurrent assets without physical substance that confer certain rights and privileges on the owner of the asset. – Examples: patents, copyrights, franchises and licenses, leaseholds, leasehold improvements, trademarks, and goodwill.

●

Purchased intangible assets are recorded at cost.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

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Two Categories of Intangible Assets ●

Intangible assets with IDENTIFIABLE useful lives. – e.g. Patents and Copyrights They have a legal life, BUT they MAY become obsolete or worthless before their legal live is over.

●

Intangible assets with INDEFINITE useful lives. – e.g. Goodwill, Franchise, Trademark How long will the “name” of a restaurant keep attracting customers if new owners don’t serve good food and provide good service?

McGraw-Hill/Irwin

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Intangible Assets with IDENTIFIABLE Useful Lives

●

Amortize (write-off) over the shorter of their useful life or legal life.

●

Normally the straight-line method is used and the asset is reported on the balance sheet at book value without a related accumulated amortization account.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

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Intangible Assets: Patents ●

A patent is an exclusive right granted by the federal government to sell or manufacture an invention.

●

A patent is amortized over the shorter of its useful life or 17-year legal life.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

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Intangible Assets with IDENTIFIABLE Useful Lives

Example: (1) A patent is purchased from a company for $20,000. (2) When purchased, there were 15 years remaining of the 17 year legal life, but management estimates that new technology will make this patent obsolete in 4 years. ($20,000/4=$5,000) INCOME STATEMENT EQUITY Accts Com. Ret. + Patent = Pay. + Stk. + Earn. =

Cash BB 1

30,000 (20,000)

2 EB

+

22,000

10,000 + 15,000 =

Cash McGraw-Hill/Irwin

- Exp. =

8,000

OA,IA,FA $ amt

30,000 bal.

20,000

(20,000) IA

(5,000)

Patent

Rev.

Net Inc.

CASHFLOW STATEMENT

(5,000) - + 22,000 + 3,000

20,000

5,000

(5,000)

- - 5,000 = (5,000)

10,000 bal.

Amortization Expense 5,000 20000

Patent

5000 © The McGraw-Hill Companies, Inc., 2003

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Intangible Assets with INDEFINITE Useful Lives

●

Must be tested for IMPAIRMENT each year. If the fair market value of the intangible asset is less than its book value, the value has been IMPAIRED (reduced).

●

To reduce the intangible asset to its new lower fair value an IMPAIRMENT LOSS is recorded and reported on the Income Statement. The intangible asset is reduced by the same amount.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

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Intangible Assets: Goodwill ●

Goodwill is the added value of a business that is attributable to favorable factors such as a good reputation, location, and superior products.

●

Goodwill must be PURCHASED by acquiring an existing business at a cost that is higher than the Fair Market Value of its physical assets (minus any liabilities assumed by the buying company).

●

Goodwill has an INDEFINITE useful life, so it must be tested for IMPAIRMENT each year.

McGraw-Hill/Irwin

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Intangible Assets: Goodwill (Example) Winona Co. purchased Rushford Co. by paying $1,500 cash for all of its assets, but also agreeing to assume its liabilities. Individual company balance sheets before purchase: Rushford Co. Winona Co. Assets: 1000 Eq.,net

Liab.-A/P 200 Assets:

Liab.-A/P

1000 C.Cap. 500 Cash 2000 C.Cap. 3000 Ret.Earn 300 Eq.,net 7000 Ret.Earn 5000 T. Assets 1000 T. L&Eq.1000 T.Assets 9000 T. L&Eq. 9000 An appraiser says the Fair Market Value of Rushford’s assets is $1,300. McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

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Intangible Assets: Goodwill (example) Calculation of Goodwill Cash Paid

$

+ Liab. Assumed = Total cost - FMV of Assets Acquired = Goodwill purchased

McGraw-Hill/Irwin

$

© The McGraw-Hill Companies, Inc., 2003

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Intangible Assets: Goodwill (example) Calculation of Goodwill Cash Paid + Liab. Assumed

$1,500 200

= Total cost

1,700

- FMV of Assets Acquired

1,300

= Goodwill purchased

McGraw-Hill/Irwin

$ 400

© The McGraw-Hill Companies, Inc., 2003

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Horizontal Model Transaction Analysis Record the Goodwill related transactions in the Horizontal Model of the Winona Company, the purchasing company. 1. Purchase of the Rushford Company. 3. After one year, many of the former Rushford customers have taken their business elsewhere. As a result management concluded Goodwill has been impaired by $100. Balance Sheet Assets = Liab.+ Equity Cash + Equip.+Gdwill = A/P.+ C.C.+ R.E. B

2,000

7,000

McGraw-Hill/Irwin

0

1,000 3,000 5,000

Income Statement Rev./ Exp. Gains - Loss= N.I.

Cashflow Statem’t OA,IA,FA 2,000 bal

© The McGraw-Hill Companies, Inc., 2003

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Horizontal Model Transaction Analysis Record the Goodwill related transactions in the Horizontal Model of the Winona Company, the purchasing company. 1. Purchase of the Rushford Company. 3. After one year, many of the former Rushford customers have taken their business elsewhere. As a result management concluded Goodwill has been impaired by $100. Balance Sheet Income Statement Cashflow Assets = Liab.+ Equity Rev./ Exp. Statem’t Cash + Equip.+Gdwill = A/P.+ C.C.+ R.E. Gains - Loss= N.I. B OA,IA,FA 2,000 7,000 0 1,000 3,000 5,000 2,000 bal 1 (1,500) 1,300 400 200 (1,500) IA 2 (100) (100) 100 (100) B 500 8,300 300 1,200 3,000 4,900 0 100 (100) 500bal Equipment Goodwill Acct. Pay. Cash

McGraw-Hill/Irwin

1300 400 200 1500

Impairment Loss 100 Goodwill 100 © The McGraw-Hill Companies, Inc., 2003

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Chapter 9

The End McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003