9 1 Chapter Eight Accounting for LongTerm Operational

9 - 1 Chapter Eight Accounting for Long-Term Operational Assets Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 2 Chapter 8 Long-Term Operational Assets Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 3 Classification of Operational Assets Operational assets are used by a business to generate revenue. l Tangible operational assets have physical substance. l – Property, Plant, and Equipment – Sometimes called plant assets or fixed assets. We depreciate these assets over their useful life. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 4 Classification of Operational Assets l Tangible operational assets have physical substance. – Land – Has an infinite life and is not subject to depreciation. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 5 Classification of Operational Assets l Tangible operational assets have physical substance. – Natural Resources – Mineral deposits, oil and gas reserves, timber stands, coal mines, and stone quarries are some examples of natural resources. We deplete these assets over their useful life. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

8 -6 Cost of Long-Term Assets Buildings • Purchase price • Sales taxes • Title search and transfer document costs • Realtor’s and attorney’s fees • Remodeling costs Land Equipment • Purchase price (less discounts) • Sales taxes • Title search and transfer • Sales taxes document costs • Delivery costs • Realtor’s and attorney’s fees • Installation costs • Costs to adapt to intended use • Costs of removal of old buildings • Grading costs Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 7 Classification of Operational Assets l Intangible operational assets lack physical substance and confer specific use rights on the owner. p Patents Burger Queen Franchise p Copyrights p Franchises p Licenses p Trademarks Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 8 Basket Purchases of Assets When land 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. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 9 Basket Purchases of Assets Example: On March 1, Arco Co. purchased land 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 = ? Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 10 Basket Purchases of Assets Fair Market Values: Appraised Values Building Land $ 90, 000 $ 30, 000 Total market value $120, 000 Allocation of cost: Total Cost Building Land Mc. Graw-Hill/Irwin * $100, 000 = © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 11 Basket Purchases of Assets Fair Market Values: Building Land Total market value Allocation of cost: Building Land Mc. Graw-Hill/Irwin Appraised Values Percent $ 90, 000 75% $ 30, 000 25% $120, 000 Total Cost * $100, 000 = © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 12 Basket Purchases of Assets Fair Market Values: Appraised Values Building Land Total market value Allocation of cost: Building Land Mc. Graw-Hill/Irwin Percent $ 90, 000 75% $ 30, 000 25% $120, 000 100% Total Cost * $100, 000 = © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 13 Basket Purchases of Assets Fair Market Values: Appraised Values Percent Building Land $ 90, 000 $ 30, 000 75% 25% Total market value $120, 000 100% Allocation of cost: Total Cost Building Land Mc. Graw-Hill/Irwin 75% * $100, 000 = 25% * $100, 000 = © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 14 Basket Purchases of Assets Fair Market Values: Appraised Values Building Land $ 90, 000 $ 30, 000 Total market value $120, 000 Allocation of cost: Total Cost Building Land Mc. Graw-Hill/Irwin Allocated Cost 75% * $100, 000 = $75, 000 25% * $100, 000 = $25, 000 © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 15 Basket Purchases of Assets General Journal entry: Building Land Cash $ 75, 000 $ 25, 000 $100, 000 Allocation of cost: Total Cost Building Land Mc. Graw-Hill/Irwin Allocated Cost 75% * $100, 000 = $75, 000 25% * $100, 000 = $25, 000 © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 16 Depreciation You’ve purchased an asset that will be used to benefit more than one year of operations. When you buy the asset you do NOT “expense” it. You postpone (defer) the recognition of the expense until you have used the asset over a period of time. Recognizing an expenditure by spreading it over several years, allocating a part of the expense to each of several periods during which the asset is used, is called depreciation. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

Depreciation l l The portion of the cost of an asset allocated to any one accounting period is called-DEPRECIATION EXPENSE Depreciation of an asset is an allocation process--spreading the cost of an asset that benefits more than one accounting period over the estimated useful life of the asset. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

Example of Depreciation: l Mc. Graw-Hill/Irwin ABC Sports Bar Co. bought equipment for $55, 000. The asset is expected to last five years and have a $10, 000 salvage value at the end of its useful life. How will the purchase and use of the asset affect the financial statements? © The Mc. Graw-Hill Companies, Inc. , 2015

l We want to allocate the cost of the asset to the income statement as an expense during the time period we use the asset. Why? To comply with the MATCHING principle. Expenses incurred must be “matched” to the same time period the revenues (from using this equipment) are recorded. If we depreciate the asset using the STRAIGHT LINE method, we will divide the cost of the asset (minus any estimated salvage value) by the useful life: (55, 000 -10, 000)/5 yrs. = $9, 000 depreciation expense each year. l Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

Effect on the financial statements: Purchase of asset: _Balance Sheet u Increases assets (eg. Equip); may decrease “cash” asset (thus, no effect on net assets) or may increase a liability _Income Statement _Statement of Changes in Stockholders’ Equity _Statement of Cash Flows Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

Effect on the financial statements: Purchase of asset: _Balance Sheet u Increases assets; may decrease an asset (cash) or increase a liability (payable) if we haven’t paid yet. _Income Statement u No effect _Statement of Changes in Stockholders’ Equity _Statement of Cash Flows Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

Effect on the financial statements: Purchase of asset: _Balance Sheet u Increases assets; may decrease an asset (cash) or increase a liability (payable) if we haven’t paid yet. _Income Statement u No effect _Statement of Changes in Stockholders’ Equity u No effect _Statement of Cash Flows Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

Effect on the financial statements: Purchase of asset: _Balance Sheet u Increases assets; may decrease an asset (cash) or increase a liability (payable) if we haven’t paid yet. _Income Statement u No effect _Statement of Changes in Stockholders’ Equity u No effect _Statement of Cash Flows u Depends on whether or not the asset was purchased for cash. If cash is paid it is an Investing Activity cash flow. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

Use of the asset: l Balance Sheet u l Reduces the net value of the asset by increasing a contra-asset account called accumulated depreciation Income Statement Accumulated Depreciation is a Permanent (Asset) Account. It l Statement of Changes in Stockholders’ Equity accumulates the depreciation expense year of the asset’s l Statement of each Cash Flows useful life. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

Use of the asset: l Balance Sheet u l Reduces the net value of the asset by increasing a contra-asset called accumulated depreciation Income Statement u Increase in depreciation expense reduces Net Income l Statement of Changes in Stockholders’ Equity l Statement of Cash Flows Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

Use of the asset: l Balance Sheet u l Income Statement u l Increase in depreciation expense reduces Net Income Statement of Changes in Stockholders’ Equity u l Reduces the net value of the asset by increasing a contra-asset called accumulated depreciation Since the Net Income decreased, the remaining Retained Earnings will decrease causing total Stockholders’ Equity to decrease. Statement of Cash Flows Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

Use of the asset: l Balance Sheet u l Income Statement u l Increase in depreciation expense reduces Net Income Statement of Changes in Stockholders’ Equity u l Reduces the net value of the asset by increasing a contra-asset called accumulated depreciation Since the Net Income decreased, the remaining Retained Earnings will decrease causing total Stockholders’ Equity to decrease. Statement of Cash Flows u No cash involved. Depreciation is an adjusting entry. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

8 -28 Depreciation Methods 1. Straight-line method - the same amount is depreciated each accounting period. 2. Units-of-Production – produces varying amounts of depreciation in different accounting periods depending upon the number of units produced. 3. Double-declining-balance – produces more depreciation expense in the early years of an asset’s life, with a declining amount of expense in later years. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

Example of Balance Sheet Net Asset Balance Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 30 Straight-Line Method Depreciation Expense per Year Mc. Graw-Hill/Irwin = Cost - Salvage Value Life in Years © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 31 Straight-Line Method: Example On January 1, 2013, equipment was purchased for $55, 000 cash. The equipment has an estimated useful life of 5 years and an estimated Salvage value of $10, 000. What is the annual straight-line depreciation expense? Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

Straight-Line Method: Example On January 1, 2013, equipment was purchased for $55, 000 cash. The equipment has an estimated useful life of 5 years and an estimated Salvage value of $10, 000. Mc. Graw-Hill/Irwin 8 -32 © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 33 Straight-Line Method: Example Depreciation Expense per Year Mc. Graw-Hill/Irwin = = = Cost - Salvage Value Life in Years 55, 000 - 10, 000 5 9, 000 © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 34 Straight-Line Method: Example The company use the equipment to generate $30, 000 revenue for the period Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 35 Units-of-Production Method Step 1: Depreciation Rate = Cost - Salvage Value Estimated units of useful life Depreciation Rate = Depreciation charge per each unit produced Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 36 Units-of-Production Method Step 1: Depreciation Rate = Cost - Salvage Value Estimated units of useful life = Number of Depreciation × Units Produced Rate for the Year Step 2: Depreciation Expense Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 37 Example of Units of Production Method Given the same information [asset cost $55, 000, has a salvage 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? Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 38 Example of Production Method Step 1: Depreciation = Cost - salvage value = $45, 000 = $. 45 Rate Productive output 100, 000 Per unit Step 2: Dep. rate x units produced Depreciation = $. 45/unit x 22, 000 = Expense Mc. Graw-Hill/Irwin $9, 900 © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 39 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 l What is the Accumulated Depreciation at the end of the second year? $9, 900 + $6, 750 = $16, 650 l What is the 12/31/05 Equip. Book Value? l $55, 000 cost - $16, 650 Accum. Dep. = $38, 350 Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 40 Accelerated Depreciation l 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. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 41 Double-Declining Balance Method l 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. l Declining-balance depreciation computations ignore salvage value. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 42 Double-Declining Balance Method Annual Depreciation is calculated with the following formula: Book Value × (2 × Straight-Line Rate) Straight-Line: $55, 000 – 10, 000 1 5 x 2 = 2 or 5 Mc. Graw-Hill/Irwin x 1 5 yrs 40% © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 43 Double-Declining-Balance Example Using the same information from our earlier example [asset cost $55, 000, Salvage value is $10, 000, and useful life is 5 years]: Calculate the depreciation expense for the asset’s life. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 44 Double-Declining-Balance Example Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 45 Double-Declining-Balance Example Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 46 Double-Declining-Balance Example Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 47 Comparison of Depreciation Methods Straight-line Production* Double-Declining Bal. Dep. Accum. Year Exp. Dep. 1 9000 2 9000 18000 9900 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. ] Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 48 Comparison of Depreciation Methods l The total amount of depreciation recorded over the useful life of an asset is the same regardless of the method used. l Depreciation expense recorded in any one period will vary according to method used. l 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. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 49 Disposal of Operational Assets Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 50 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 Mc. Graw-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 OA (9000) 9, 000 (9000) 70, 000 21000 Closed out 45, 000 B © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 51 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 Mc. Graw-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 OA (9000) 9, 000 (9000) 70, 000 21000 Closed out 45, 000 B © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 52 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 Mc. Graw-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 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 Mc. Graw-Hill Companies, Inc. , 2015

9 - 53 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 Mc. Graw-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 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 Mc. Graw-Hill Companies, Inc. , 2015

9 - 54 Horizontal Model Transaction Analysis Balance Sheet Income Statement Cashflow Assets = Liab. + Equity Rev. / Exp. Statem’t Cash + Equip. - Acc. D. = A/P + C. C. + R. E. Gains - Loss= N. I. OA, IA, FA 1 70, 000 FA 2 (55, 000) 55, 000 (55, 000) IA 3 30, 000 4 + 9000 B 45, 000 55, 000 9000 5 9000 B 45, 000 55, 000 18, 000 6 6, 000 Mc. Graw-Hill/Irwin 30000 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) 6, 000 (6000) © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 55 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). Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 56 Gain or Loss on Disposal? How do we know if there is a Loss or Gain on the disposal? l 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 e s as Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 57 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) Mc. Graw-Hill/Irwin $26, 000 31, 000 $ (5, 000) © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 58 Horizontal Model Transaction Analysis Balance Sheet Assets = Liab. + Equity Cash + Equip. - Acc. D. = A/P + C. C. + R. E. 1 70, 000 FA 2 (55, 000) 55, 000 (55, 000) IA 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) Mc. Graw-Hill/Irwin Income Statement Cashflow Rev. / Exp. Statem’t Gains - Loss= N. I. OA, IA, FA 30000 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) 6, 000 (6000) (5000) 5, 000 (5000) 26, 000 IA © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 59 Journalize the Disposal Cash $26, 000 Accumulated Depreciation (to remove) 24, 000 Loss on Disposal of 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). Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 60 Horizontal Model Transaction Analysis Balance Sheet Income Statement Cashflow Assets = Liab. + Equity Rev. / Exp. Statem’t Cash + Equip. - Acc. D. = A/P + C. C. + R. E. Gains - Loss= N. I. OA, IA, FA 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 6 6, 000 7 26, 000 (55, 000) (24, 000) B 71, 000 0 0 Mc. Graw-Hill/Irwin 70, 000 FA (55, 000) IA 30000 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) 6, 000 (6000) (5000) 5, 000 (5000) 26, 000 IA 70, 000 1, 000 Closed out 71, 000 B © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 61 What’s the result? - For Year 3 How much depreciation expense is on the 2015 Income Statement? $6, 000 How much Gain or Loss is on the 2015 Income Statement? $5, 000 Loss on Disposal How much Accumulated Deprec. is on the 12/31/15 Bal. Sheet? $0 (We don’t have the equipment anymore. ) What is the equipment’s Book Value (or Carrying Value) at the end of 2015? $0 Mc. Graw-Hill/Irwin (We don’t have the equipment anymore. ) © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 62 Depreciation and Federal Income Tax l Most corporations use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes. (Could use straight-line depreciation. ) l MACRS provides for rapid write-off of an asset’s cost in order to stimulate investment in modern facilities. l MACRS uses half-year convention and assumes no Salvage value. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 63 Depreciation and Federal Income Tax MACRS example Same purchase recorded previously: On Jan. 1, 2013 equipment costing $55, 000 was purchased. Estimated life = 5 yrs. Estimated Salvage 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. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 64 IRS yr. 1 2 3 4 5 6 Depreciation and Federal Income Tax MACRS example Table % 20. 00 32. 00 19. 20 11. 52 5. 76 Equipm’t Depreciation Deduction Cost x $55, 000 = $11, 000 x 55, 000 = 17, 600 x 55, 000 = 10, 560 x 55, 000 = 6, 336 x 55, 000 = 3, 168 100% $55, 000 = 100% Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

Revising Estimates of Salvage Value or of Useful Life 9 - 65 l l l 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. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 66 Revising Estimates of Salvage Value or of Useful Life - Example On Jan. 1, 2013 the Goodview Co. purchased Equipment costing $55, 000. It was estimated to last 5 years and have a $10, 000 Salvage value. Straight-line depreciation ($9, 000) has been used. On Jan. 1, 2015 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, 2015? Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 67 Revising Estimates of Salvage Value or of Useful Life - Example The equipment has already been depreciated two years (‘ 08 and ‘ 09) at $9, 000 per year. So, Accumulated Depreciation has an $18, 000 balance at the beginning of 2015. Original Cost Less: Accum. Dep. $55, 000 18, 000 = Book value, Jan. 1, ‘ 2015 37, 000 Less: Revised Salvage Value -5, 000 = Remainder to be depreciated 32, 000 Divided by Remaining life 4 yrs. = New annual Depreciation expense $ 8, 000 Mc. Graw-Hill/Irwin Starting in 2015 © The Mc. Graw-Hill Companies, Inc. , 2015

Continuing Expenditures for Plant Assets Costs That Are Expensed The cost of routine maintenance and minor repairs that are incurred to keep an asset in good working order are expensed as incurred. Assume the company spent $500 cash for routine maintenance on machinery. Mc. Graw-Hill/Irwin 8 -68 © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 69 Continuing Expenditures for Plant Assets l l Mc. Graw-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 (1) improve the quality or (2) extend the life of an asset are capitalized. © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 70 Accounting for capital expenditures: Extraordinary Repairs Ex: Overhaul l 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. Mc. Graw-Hill/Irwin Betterments Ex: Attach snowplow to truck owned for 2 years. l 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 Mc. Graw-Hill Companies, Inc. , 2015

9 - 71 Extraordinary Expenditure Extend Useful Life Overhaul Engine Eqpt Cost Accum Deprec Net Book Value Mc. Graw-Hill/Irwin Improve Quality Original Cost Add Attachment 10, 000 4, 000 6, 000 © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 72 Extraordinary Expenditure Extend Useful Life Eqpt Cost Accum Deprec Net Book Value Mc. Graw-Hill/Irwin Improve Quality Overhaul Engine Original Cost 10, 000 2, 000 8, 000 = +2, 000 Add Attachment 4, 000 6, 000 © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 73 Extraordinary Expenditure Extend Useful Life Eqpt Cost Accum Deprec Net Book Value Mc. Graw-Hill/Irwin Improve Quality Overhaul Engine Original Cost 10, 000 +2, 000 = 12, 000 8, 000 = +2, 000 4, 000 6, 000 Add Attachment 4, 000 8, 000 © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 74 Natural Resources l Assets supplied by nature – Examples: gold, oil, and coal l Presented on balance sheet as current assets at cost minus depletion to date. all non- l Total cost of the asset is the cost of acquisition, exploration and development. l Cost is “written-off” as “Depletion Expense” over periods that related revenues are earned. (Usually, units-of-production method. ) Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 75 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 Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 76 Natural Resources Martin Mining Company paid $10, 000 cash to purchase land that is expected to yield 5, 000 tons of coal. After all coal is extracted the land is not expected to have any salvage value. During 2006, the company extracted and sold 500, 000 tons of coal. $10, 000 – $0 5, 000 tons Mc. Graw-Hill/Irwin = $2. 00 per ton extracted and sold © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 77 Natural Resources Martin Mining Company paid $10, 000 cash to purchase land that is expected to yield 5, 000 tons of coal. After all coal is extracted the land is not expected to have any salvage value. During 2006, the company extracted and sold 500, 000 tons of coal. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 78 Intangible Assets l Noncurrent assets without physical substance that confer certain rights and privileges on the owner of the asset. – Examples: patents, copyrights, franchises and licenses, leasehold improvements, trademarks, and goodwill. l Purchased intangible assets are recorded at cost. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 79 Two Categories of Intangible Assets l 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. l 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? Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 80 Intangible Assets with IDENTIFIABLE Useful Lives l Amortize (write-off) over the shorter of their useful life or legal life. l 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. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 81 Intangible Assets: Patents l A patent is an exclusive right granted by the federal government to sell or manufacture an invention. l A patent is amortized over the shorter of its useful life or 17 -year legal life. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 82 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) Patent Cash Mc. Graw-Hill/Irwin 20, 000 Amortization Expense 5, 000 20000 Patent 5000 © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 84 Intangible Assets: Goodwill l Goodwill is the added value of a business that is attributable to favorable factors such as a good reputation, location, and superior products. l 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). l Goodwill has an INDEFINITE useful life, so it must be tested for IMPAIRMENT each year. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 85 Intangible Assets with INDEFINITE Useful Lives l 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). l 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. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 86 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: Eq. , net Liab. -A/P 200 Assets: 1000 C. Cap. 500 Cash 2000 Ret. Earn 300 Eq. , net 7000 T. Assets 1000 T. L&Eq. 1000 T. Assets 9000 Liab. -A/P 1000 C. Cap. 3000 Ret. Earn 5000 T. L&Eq. 9000 An appraiser says the Fair Market Value of Rushford’s assets is $1, 300. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 87 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 Mc. Graw-Hill/Irwin $ 400 © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 88 Let’s Take a Quick Look at a Chapter 11 Stockholders’ Equity For Corporations Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 89 Corporations l A corporation is a popular form of business because. . . ÊIt is simple for individuals to purchase small amounts of stock. ËIt allows for an easy transfer of ownership through established markets, like the New York Stock Exchange. ÌIt provides stockholders with limited liability. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 90 Corporations l Because a corporation is a separate legal entity, it can. . . – Own assets. – Incur liabilities. – Sue and be sued. – Enter into contracts independent of the stockholder owners. l Many Americans own stock through a mutual fund or pension program. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 91 Ownership of a Corporation l Owners of common stock generally receive the following rights: – Voting (in person or by proxy). – Distributions of profits (in the form of Dividends). – Distributions of assets in a liquidation. – Offers to purchase shares of a new stock issue (pro rata basis). Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 92 Creating a Corporation State laws govern the creation of corporations. l An application for a charter (or articles of incorporation) must include the corporation’s name and purpose, kinds and amounts of capital (common) stock authorized, and other detailed information. l Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 93 Creating a Corporation Once the state issues a charter, the stockholders elect a board of directors. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 94 Authorized, Issued, and Outstanding Capital Stock Authorized Shares The maximum number of shares of capital stock that can be sold to the public is called the authorized number of shares. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 95 Authorized, Issued, and Outstanding Capital Stock Authorized Shares Issued Unissued shares have been sold. Mc. Graw-Hill/Irwin never been sold. © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 96 Authorized, Issued, and Outstanding Capital Stock owned by stockholders. Authorized Shares Issued Shares Mc. Graw-Hill/Irwin Outstanding Shares Unissued Shares © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 97 Authorized, Issued, and Outstanding Capital Stock owned by stockholders. Authorized Shares Issued Shares Outstanding Shares Treasury Shares Mc. Graw-Hill/Irwin Unissued Shares reacquired by the corporation. © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 98 Common Stock Basic voting stock of the corporation l Ranks after preferred stock for dividend and liquidation distribution. l Dividend rates are determined by the board of directors based on the corporation’s profitability and other factors. l Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015

9 - 99 Chapter 8 (and a little 11) The End Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2015