Chapter 8 Operating Assets Property Plant Equipment and

Chapter 8 Operating Assets: Property, Plant, & Equipment, and Intangibles Financial Accounting: The Impact on Decision Makers 6 e by Gary A. Porter and Curtis L. Norton Copyright © 2009 South-Western, a part of Cengage Learning.

Nike, Inc. Property, Plant, and Equipment (in millions) Land Buildings 842. 6 Machinery and equipment 1, 661. 7 At Leasehold improvements 626. 7 Cost Construction in progress 81. 4 $ 3, 408. 3 Less accumulated depreciation Property, plant, and equipment (net) $ 1, 657. 7 $ 195. 9 (1, 750. 6) Book Value LO 1

Acquisition Cost of PP&E v. All costs necessary to acquire asset and prepare for intended use Examples: Purchase price Purchase Price. Taxes paid at time of purchase Transportation charges + Taxes Installation costs LO 2

Group Asset Purchases Allocate cost of lump-sum purchase based on fair market values Fair Market Value Building = $90, 000 Land = $30, 000 Cost Allocated Cost 75% X $100, 000 = $75, 000 25% X $100, 000 = $25, 000 % of Market Value LO 3

Capitalization of Interest v. Interest can be included as part of the cost of an asset if: • company constructs asset over time, and • borrows money to finance construction 5

Depreciation of PP&E Match costs of assets With periods benefited via Straight-Line Units of Production Accelerated Methods LO 5

Straight-Line Method v. Allocates cost of asset evenly over its useful life $9, 000 3 -year life $3, 000 Year 1 $3, 000 Year 2 $3, 000 Year 3

Units-of-Production Method v. Allocate asset cost based on number of units produced over its useful life Depreciation = $ per unit

Double-Declining-Balance Method v. Double the straight-line rate on a declining balance (book value) v. Accelerated method—higher amount of depreciation in early years Straight-line Rate

Depreciation Example On January 1, 2008, Exer. Co purchases a machine for $20, 000. The life of the machine is estimated at five years, after which it is expected to be sold for $2, 000.

Depreciation Example Calculate Exer. Co’s depreciation of the machine for 2008 - 2012 using the, units-of-production and double-decliningbalance depreciation methods. $20, 000 cost - $2, 000 residual value = $18, 000 to be depreciated

Straight-Line Depreciation = Cost - Residual Value Life $18, 000 5 -year life $3, 600 2008 $3, 600 2009 = $20, 000 - $2, 000 5 years = $3, 600/year $3, 600 2010 $3, 600 2011 $3, 600 2012

Units-of-Production Depreciation v. Exer. Co’s estimated machine production: 2008 2009 2010 2011 2012 Total 3, 600 units 3, 600 units 18, 000 units

Units-of-Production Depreciation = Cost - Residual Value per unit Life in Units = $20, 000 - $2, 000 18, 000 = $ 1. 00 per unit

Units-of-Production Depreciation v Exer. Co’s depreciation in 2008: 4, 000 units x $1/unit = $ 4, 000

Double-Declining-Balance Depreciation DDB rate = (100% / useful life) x 2 = (100% / 5 years) x 2 = 40% Initially ignore residual value

Double-Declining-Balance Depreciation 2008 Depreciation = Beginning book value x rate = $20, 000 x 40% = $8, 000 Year 2008 Rate 40% Beginning Ending Book Value Depreciation Book Value $20, 000 $8, 000 $12, 000

Double-Declining-Balance Depreciation 2008 Depreciation = Beginning Book Value × Rate = $12, 000 × 40% = $4, 800 Year Rate 2008 40% 2009 40% Beginning Book Value $20, 000 $12, 000 Depreciation $8, 000 $4, 800 Ending Book Value $12, 000 $ 7, 200

Double Declining-Balance Depreciation Year 2008 2009 2010 2011 2012 Rate 40% 40% 40% Beginning Ending Book Value Depreciation Book Value $20, 000 $8, 000 $12, 000 4, 800 7, 200 2, 880 4, 320 1, 728 2, 592 592 2, 000 $18, 000 Final year’s depreciation = amount needed to equate book value with salvage value = Residual Value

Straight-line vs. DDB Depreciation 2008 2009 2010 2011 2012 20

Reasons for Choosing Straight-Line Depreciation Simplicity Reporting to stockholders Comparability Bonus plans

Reasons for Choosing Accelerated Methods v. Technological rate of change and competitiveness v. Minimize taxable income v. Comparability

Changes in Depreciation Estimates v. Recompute depreciation schedule using new estimates v. Record prospectively (i. e. , change should affect current and future years only) LO 6

Change in Estimate Example: $20, 000 machine originally expected to be depreciated over 5 years. After 2 years, useful life is increased to 7 years. $3, 600 planned $3, 600 2008 2009 2010 Depreciation revise estimate 2011 2012

Change in Estimate Example: v$12, 800 remaining book value allocated prospect over remaining life $3, 600 $2, 160 $2, 160 2008 2009 2010 2011 2012 2013 2014 revise estimate Depreciation

Capital vs. Revenue Expenditures v. Capital Expenditure • Treat as asset addition to be depreciated over a period of time v. Revenue Expenditure • Expense immediately Balance Sheet Income Statement LO 7

Capital vs. Revenue Expenditures Category Normal maintenance Minor repair Major repair Addition Example Asset or Expense Repainting Expense Replace spark plugs Expense Replace a vehicle’s engine Asset* Add a wing to a building Asset *if life or productivity is enhanced 27

Capital Expenditures Example: A $20, 000 machine purchased on January 1, 2008 is originally expected to be depreciated over 5 years. After 2 years, an overhaul of the machine is made at a cost of $3, 000. Machine life is increased by 3 years. $3, 600 planned $3, 600 2008 2009 2010 replace engine 2011 2012

Capital Expenditures Example: v$12, 800 remaining book value + $3, 000 capital expenditure depreciated prospectively over remaining life $3, 600 $2, 300 $2, 300 2008 2009 2010 replace engine 2011 2012 2013 2014

Disposal of Operating Assets v Record depreciation up to date of disposal v Compute gain or loss on disposal Proceeds > Book Value = Gain Proceeds < Book Value = Loss LO 8

Disposal of Operating Assets Example: v. Sell truck (cost $20, 000; accumulated depreciation $9, 000) for $12, 400 Sale price Less book value: Asset cost $20, 000 Less: accumulated depreciation 9, 000 Gain on sale $ ( 11, 000) $ 1, 400

Intangible Assets v. Long-term assets with no physical properties Patents Copyrights Trademarks Goodwill LO 9

Intangible Assets v Includes cost to acquire and prepare for intended use Purchase Price + Acquisition Cost (i. e. , legal fees, registration fees, etc. ) +

Nike, Inc. Partial Balance Sheet (in millions) 2006 Amortized Intangible Assets: Patents $ 23. 6 Trademarks 34. 6 e l b i g n a t Other 5. 8 In s t e s As $ 64. 0 Unamortized intangible assets: Trademarks Total $341. 5 $405. 5 34

Research & Development v. Must be expensed in period incurred v. Difficult to identify future benefits

Amortization of Intangibles v. Normally recorded using straight-line method v. Reported net of accumulated amortization v. Amortized over legal or useful life, whichever is shorter LO 10

Amortization of Intangibles Example: Nike developed a patent for $10, 000. The patent’s legal life is 20 years, but its anticipated useful life is 5 years.

Amortization of Intangibles Journal entry: Patent Amortization Expense 2, 000 Accumulated Amortization—Patent 2, 000 To record amortization of patent for one year. Nike’s annual amortization: Patent approval costs Divided by: Lesser of legal or useful life Annual amortization $10, 000 5 years $ 2, 000

Long-term Assets and the Statement of Cash Flows Operating Activities Net income xxx Depreciation and amortization Gain on sale of asset Loss on sale of asset + Investing Activities Purchase of asset Sale of asset + Financing Activities + - LO 11

Analyzing Long-term Assets Average Life = Property, Plant, & Equipment Depreciation Expense What is the average depreciable period (or life) of the company’s assets? LO 12

Analyzing Long-term Assets Average Age = Accumulated Depreciation Expense Are assets old or new?

Analyzing Long-term Assets Asset Turnover = Net Sales Average Total Assets How productive are the company’s assets?

End of Chapter 8