Chapter 12 Investments in Operating Assets Financial Accounting

Chapter 12 Investments in Operating Assets Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 1

Financial Statement Items Covered Balance Sheet Long-term Assets Property, Plant, & Equipment Accumulated Depreciation Intangible Assets Income Statement Depreciation Expense Amortization Expense Loss on Impairment Financial Accounting, 7 e Stice/Stice, 2006 © Thomson Statement of Cash Flows Operating Asset depreciation (indirect method) Financing Cash paid (received) to purchase (from sale of) long-term assets Cash paid to acquire another company 2

What are Long-Term Operating Assets? Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 3

Long-Term Operating Assets Long-term operating assets are – not held for resale to customers – are used by a business to generate revenues Long-term operating assets include – Property, plant, and equipment – Intangible assets Diamond Chapter 11 4

Property, Plant, and Equipment “PP&E” – Tangible, long-lived assets – Acquired for use in business operations • Land • Buildings • Machinery • Equipment • Furniture Diamond Chapter 11 5

Intangible Assets Long-lived assets – Used to facilitate the operation of a business – Do not have physical substance • Patents • Trademarks • Licenses • Franchises • Goodwill Diamond Chapter 11 6

Long-Term Asset Issues Evaluate Acquire Estimate and Recognize possible acquisition of long-term operating assets periodic depreciation Diamond Chapter 4 Monitor Dispose asset value for possible decline of the asset 7

Deciding Whether to Acquire a Long-Term Operating Asset Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 8

Capital Budgeting The process of evaluating a long-term project that may include purchasing property, plant, and equipment Common capital budgeting models: – Payback period – Accounting rate of return – Net present value Diamond Chapter 11 9

Payback Period The time it takes for a company to recover its original investment in cash Diamond Chapter 11 10

Accounting Rate of Return Projects are approved if their rate of return exceeds some predetermined rate Diamond Chapter 11 11

Net Present Value Utilizes the concept of the time value of money A project is undertaken only if the present value of the cash inflows from the project exceeds the present value of the cash outflow Diamond Chapter 11 12

Acquisition of Plant, Property, & Equipment Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 13

Acquisition of PP&E The cost of PP&E includes any costs necessary to bring the asset to the condition and location for its intended use Diamond Chapter 11 14

Items Included in PP&E Acquisition Cost Land Purchase price, commissions, legal fees, escrow fees, surveying fees, clearing and grading costs Land Improvements (e. g. , landscaping, paving, fencing) Cost of improvements, including expenditures for materials, labor and overhead Buildings Purchase price, commissions, reconditioning costs Equipment Purchase price, taxes, freight, insurance, installation, and any expenditures incurred in preparing the asset for its intended use Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 15

Acquisition for Cash Purchase price $15, 000 Discount* (300) Net Price $14, 700 6% sales tax on purchase price $900 Freight charges 850 Installation costs 150 1, 900 Total Acquisition Cost $16, 600 *terms 2/10, n/30; payment made within discount period Diamond Chapter 11 16

Subsequent Expenditures Normal repairs and maintenance are expensed in the current period Expenditures which extend the useful life or increase the productive capacity are capitalized – Asset book value is increased – Annual depreciation is revised Diamond Chapter 11 17

Acquisition Through Leasing A lease is a contract whereby • one party (lessee) • is granted the right to use property • owned by another party (lessor) • for a specified period of time for a specified cost Diamond Chapter 11 18

Lease Types Operating lease - equivalent to a rental – Lease payments charged to expense Capital lease – equivalent to a purchase – The asset acquired is recorded in property, plant and equipment Ú The leased asset is depreciated over the lease period – A lease liability is shown in the liability section of the balance sheet Diamond Chapter 11 19

Acquisition by Exchange The acquisition price of the asset is equal to fair market value of noncash consideration plus any cash given To record the purchase of land in exchange for 10, 000 shares of stock when market price of the stock was $78 per share Diamond Chapter 11 20

Acquisition Through Donation The asset is recorded at its fair market value at time it is received To record the receipt of land through donation. Diamond Chapter 11 21

Acquisition With a Basket Purchase Fixed assets purchased for a lump sum need to be recorded separately The total purchase price must be allocated among individual assets received in proportion to their appraised values Diamond Chapter 11 22

Example: Acquisition With a Basket Purchase Fair Value of Assets: Land 300, 000 Building 900, 000 Price Paid $1, 000 Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 23

Acquisition of an Entire Company All acquired assets are recorded on the books of the acquiring company at their fair values as of the acquisition date The excess of the purchase price over the fair value of the identifiable assets represents goodwill Diamond Chapter 11 24

Acquisition Through Self-Construction Self-constructed assets are recorded at cost, including all expenditures necessary to build the asset and make it ready for its intended use Diamond Chapter 11 25

Acquisition Through Self-Construction Costs include: – Materials and labor used directly in construction – A reasonable share of general overhead – If interest is included it is called capitalized interest Interest should be included equal to the amount that could have been saved if the money used on the construction had instead been used to repay loans Diamond Chapter 11 26

Acquisition of Intangible Assets Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 27

Intangible Assets • Long-term • Nonmonetary • Generate revenues – Grant a right to use of a product, process, name, image, customer list, or business practice • Uncertainty about future benefits greater than that of tangible assets • Specifically identifiable – Except goodwill Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 28

Patent An exclusive right to use, manufacture, process, or sell a product granted by the U. S. Patent Office. Patents have a legal life of 17 years, but their economic life may be shorter Diamond Chapter 11 29

Copyright The exclusive right of the creator or heirs to reproduce and/or sell an artistic or published work. Granted by the U. S. government for a period of 50 years after the death of the creator. Amortized over the shorter of its economic life or legal life. Diamond Chapter 11 30

Trademark and Trade Names A symbol or name that allows the holder to use it to identify or name a specific product or service. A legal registration system allows for an indefinite number of 20 -year renewals Diamond Chapter 11 31

Franchise An exclusive right to use a formula, design, technique, or territory. Diamond Chapter 11 32

Goodwill The ability of a company to earn above-normal income. Recorded goodwill is the excess amount paid to acquire a company, over and above the fair market value of the company’s identifiable assets. Diamond Chapter 11 33

Accounting for Goodwill A business combination occurs when one company buys all of the assets of another company The combination is accounted for using the purchase method (as if one company is buying the other) Diamond Chapter 11 34

Purchase Method The identifiable assets and liabilities are recorded at their fair values – The excess of the purchase price over the fair value of the identifiable net assets is recorded as goodwill • Goodwill represents the company’s reputation, superior business practices, and market position • Goodwill is only recorded when it is purchased Diamond Chapter 11 35

Determining Goodwill Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 36

Depreciation and Amortization Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 37

Depreciation: What it Is. . . and Isn’t IS • The systematic allocation of an asset’s cost to the periods of benefit Financial Accounting, 7 e Stice/Stice, 2006 © Thomson IS NOT • Accumulation of a cash fund for asset replacement • A determination of an asset’s current value 38

Depreciation Causes of depreciation: – Physical deterioration • Due to use, passage of time, and exposure to the elements – Obsolescence • Outdated, outmoded, or inadequate Diamond Chapter 11 39

Depreciation Factors Residual value (salvage value) – An estimate of the asset’s worth at the time of its disposal Depreciable cost – The original cost minus the residual value Estimated useful life – A measure of the service potential in terms of years or units produced Diamond Chapter 11 40

Depreciation Methods Straight-line – Allocates an equal amount of asset cost per year Units-of-production – Allocates cost based on the productive output of the asset Declining balance – An accelerated method which allocates more cost to depreciation in the early years than the later years Diamond Chapter 11 41

Depreciation Methods Illustrated Assume the following information: üEquipment purchase date January 1, 2006 üAcquisition cost $40, 000 üEstimated residual value $4, 000 üDepreciable cost $36, 000 üEstimated useful life 5 years Diamond Chapter 11 42

Straight-Line Depreciation Diamond Chapter 11 43

Straight-Line Method An equal amount of depreciation expense is allocated to each period Diamond Chapter 11 44

Declining-Balance Method Annual depreciation is determined by applying a fixed percentage to the remaining book value at the beginning of each year ‘rate’ is the multiple of straight-line (double is 2 times the straight-line rate) Diamond Chapter 11 45

Declining-Balance Method 2010’s expense is adjusted so that ending book value is not less than established residual value Diamond Chapter 11 46

Declining-Balance Method Accelerated methods allocate a greater portion of cost to the earlier years of the asset’s life Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 47

Comparison of Straight-line and Double-Declining Balance Both methods allocate a depreciable cost of $36, 000 over a fiveyear period Diamond Chapter 11 48

Selecting a Depreciation Method for Financial Reporting Purposes Management may choose any GAAP-based method for financial reporting Theoretically, best to use a method that reflects the pattern of the asset’s revenues or benefits – The straight-line method is appropriate for assets whose benefits diminish on a fairly uniform basis – The double-declining-balance method is appropriate for assets that give up a greater portion of their benefits in the early years Most companies use the straight-line method due to its simplicity Diamond Chapter 11 49

Choosing a Depreciation Method for Tax Purposes IRS Code stipulates depreciation method and techniques – Method depends on the statutory “class life” category – Current recovery periods range from 3 to 20 years for personal property Diamond Chapter 11 50

IRS Depreciation Recovery Periods and Lives

Choosing a Depreciation Method for Tax Purposes Salvage value is ignored for tax purposes The half-year convention is used – Property is depreciated for half the taxable year in which it is placed in service, regardless of when use actually begins Deferred tax liability arises – Accelerated depreciation for tax purpose vs straight-line depreciation for financial purpose – Earlier years have higher tax deductions – Later years have higher taxable income Diamond Chapter 11 52

Depreciation and Cash Flow Depreciation is not a source of cash; it is a noncash expense Depreciation indirectly affects cash flow – depreciation reduces taxable income – results in lower income taxes being paid Diamond Chapter 11 53

Changes in Estimated Useful Lives Later events may require changes in estimates of economic life and residual value – A change in estimate is not an error correction – A change in estimate is reflected by spreading the remaining depreciable cost over the remaining useful life of the asset Diamond Chapter 11 54

Amortization of Intangible Assets Finite life intangibles: – Amortize over the economic useful life or legal life, whichever is shorter – Not to exceed 40 years – Direct subtraction from the asset account Indefinite life intangibles: – No amortization Diamond Chapter 11 55

Impairment of Asset Value Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 56

Impairment of Asset Value Occurs when an event happens after the purchase of an asset that reduces its value – Recognized in the financial statements as a reduction in the value of the asset on the balance sheet and a loss on the income statement Diamond Chapter 11 57

Recording Decreases in the Value of PP&E A two-step process to identify impairments and record decreases in the value of PP&E Identify: An impairment loss exists if the sum of estimated future cash flows from the asset is less than its book value Record: An impairment is measured as the difference between the book value of the asset and the fair value Diamond Chapter 11 58

Impairment of Intangible Assets Intangibles must be evaluated to determine if – Their estimated useful life has changed – The intangible has become impaired Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 59

Recording Increases in the Value of PP&E U. S. GAAP – The principle of conservatism controls – Increases in the value of PP&E are not allowed under current U. S. GAAP – Gains are recognized in income only when assets are sold IAS GAAP – Upward revaluation permitted Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 60

Disposal of Long-Term Assets Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 61

Disposal of Long-Term Assets Disposal of long-term assets can occur through retirement, sale, or trade-in of operating assets In each case, depreciation must be recorded up to the date of the disposal and any gain or loss recognized Diamond Chapter 11 62

Retirement Occurs when an operating asset is removed from service and is disposed of without the company receiving any proceeds An difference between the cost and balance in the accumulated depreciation account results in a loss on retirement Diamond Chapter 11 63

Sale A gain occurs if the cash or other assets received are greater than the book value at the time of sale A loss occurs if the consideration received is less than the book value at the time of sale Gains/Losses are reported in “Other” section of the Income Statement Diamond Chapter 11 64

Sale: Two Examples When the disposal is recorded in the accounting records, both the original cost of the truck and the accumulated depreciation on the truck are removed from the books. Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 65

Trade-In Trade-in allowance > book value of the asset given up a gain is realized Trade-in allowance < book value of the asset given up a loss is realized Diamond Chapter 11 66

Measuring PP&E Efficiency Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 67

Fixed Asset (PPE)Turnover Used to evaluate the appropriateness of the level of a company’s PP&E Can be interpreted as the number of dollars in sales generated by each dollar of fixed assets Diamond Chapter 11 68

Fixed Asset Turnover Dangers 1. The ratios for two companies in different industries cannot be compared 2. The reported amount of PP&E can be a poor indicator of fair value 3. Sales generated by leased assets are included in the numerator, but the leased assets are not included in the denominator; upward bias in the ratio Diamond Chapter 11 69

In Summary. . . • Long-term assets provide the infrastructure for production and distribution • Capital budgeting models include the payback period, accounting rate of return, and net present value analysis • Patents, franchises, licenses, and goodwill are intangible assets. • Straight-line and declining balance are common depreciation methods • Recognizing impairment for PPE is a two-step process • Gain (loss) on asset disposal occurs if proceeds received are greater (less) than the asset’s book value at date of sale Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 70