Chapter 9 Fixed Assets and Intangible Assets Financial

Chapter 9 Fixed Assets and Intangible Assets Financial and Managerial Accounting 8 th Edition Warren Reeve Fess Power. Point Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University © Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electroni presentation is used with the permission of NVTech Inc.

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Objectives 1. Define fixed assets and describe the accounting for their cost. After studying this 2. Compute depreciation, using the following chapter, youmethod, should units-ofmethods: straight-line be able production method, andto: declining-balance method. 3. Classify fixed asset costs as either capital expenditures or revenue expenditures. 4. Journalize entries for the disposal of fixed assets. 5. Define a lease and summarize the accounting rules related to the leasing of fixed assets.

Objectives 6. Describe internal controls over fixed assets. 7. Compute depletion and journalize the entry for depletion. 8. Describe the accounting for intangible assets, such as patents, copyrights, and goodwill. 9. Describe how depreciation expense is reported in an income statement, and prepare a balance sheet that includes fixed assets and intangible assets. 10. Compute and interpret the ratio of fixed assets to long-term debt.

Nature of Fixed Assets Fixed assets are long term or relatively permanent assets Fixed assets are tangible assets because they exist physically. They are owned and used by the business and are not held for sale as part of normal operations.

Classifying Costs Is the purchased item long-lived? Yes No Is the asset used in a productive purpose? Yes Fixed Assets Expense No Investment

Land • • • Purchase price Sales taxes Permits from government agencies Broker’s commissions Title fees Surveying fees

Land • Purchase price • Delinquent real estate taxes • Sales taxes Razing or removing • Permits • from government agencies unwanted buildings, less the salvage • Broker’s commissions • Grading and leveling • Title fees • Paving a public street • Surveying fees bordering the land

Buildings ü Architects’ fees ü Engineers’ fees ü Insurance costs incurred during construction ü Interest on money borrowed to finance construction ü Walkways to and around the building

Buildings ü Sales taxes ü Repairs (purchase of existing building) ü Reconditioning (purchase of an existing building) ü Modifying for use ü Permits from governmental agencies

Land Improvements • • • Trees and shrubs Fences Parking areas Outdoor lighting Concrete sewers and drainage Paved parking areas

Machinery and Equipment • • Sales taxes Freight Installation Repairs (purchase of used equipment) • Reconditioning (purchase of used equipment)

Machinery and Equipment • Insurance while in transit • Assembly • Modifying for use • Testing for use • Permits from governmental agencies

Cost of Acquiring Fixed Assets Excludes: § § § Vandalism Mistakes in installation Uninsured theft Damage during unpacking and installing Fines for not obtaining proper permits from government agencies

Nature of Depreciation All fixed assets except land lose their capacity to provide services. This loss of productive capacity is recognized as Depreciation Expense. Physical depreciation occurs from wear and tear while in use and from the action of the weather. Functional depreciation occurs when a fixed asset is longer able to provide services at the level for which it was intended, e. g. , personal computer.

Depreciation Expense Factors Initial Cost - Residual Value = Depreciable Cost Useful Life 1 2 3 4 5 Periodic Depreciation Expense

Use of Depreciation Methods Other Units-of-Production Declining 4% Balance 8% 5% 83% Straight-Line Source: Accounting Trends & Techniques, 56 th. ed. , American Institute of Certified Public Accountants, New York, 2002.

Facts Original Cost. . . …………. . $24, 000 Estimated Life in years…. . 5 years Estimated Life in hours…. . 10, 000 Estimated Residual Value. . . $2, 000

Straight-Line Method Cost – estimated residual value Estimated life = Annual depreciation

Straight-Line Method $24, 000 – $2, 000 5 years = $4, 400 annual depreciation

Straight-Line Rate $24, 000 – $2, 000 5 years = $4, 400 = 18. 3% $24, 000

Straight-Line Method The straight-line method is widely used by firms because it is simple and it provides a reasonable transfer of cost to periodic expenses if the asset is used about the same from period to period.

Straight-Line Method Year 1 2 3 4 5 Cost Accum. Depr. at Beginning of Year $24, 000 24, 000 Book Value at Beginning of Year $24, 000 $ 4, 400 19, 600 8, 800 15, 200 13, 200 10, 800 17, 600 6, 400 Depr. Expense for Year Book Value at End of Year $4, 400 $19, 600 4, 400 15, 200 4, 400 10, 800 4, 400 6, 400 4, 400 2, 000 Cost ($24, 000) – Residual Value ($2, 000) Estimated Useful Life (5 years) Annual = Depreciation Expense ($4, 400)

Units-of-Production Method Cost – estimated residual value Estimated life in units, hours, etc. = Depreciation per unit, hour, etc.

Units-of-Production Method $24, 000 – $2, 000 10, 000 hours = Depreciation = $2. 20 per perunit, hour, etc.

Units-of-Production Method The units-of-production method is more appropriate than the straight-line method when the amount of use of a fixed asset varies from year to year.

Declining-Balance Method Step 1 Ignoring residual value, determine the straight-line rate $24, 000 – $2, 000 5 years $4, 800 $24, 000 = $4, 800 = 20%

Declining-Balance Method There’s a shortcut. Simply divide one by the number of years (1 ÷ 5 =. 20).

Declining-Balance Method Step 2 Double the straight-line rate. . 20 x 2 =. 40 For the first year, the cost of the asset is multiplied by 40 percent. After the first year, the declining book value of the asset is multiplied 40 percent.

Declining-Balance Method Step 3 Build a table.

Declining-Balance Method Year 1 Book Value Beginning of Year Rate $24, 000 40% Annual Deprec. $9, 600 $24, 000 x. 40 Accum. Deprec. Year-End Book Value Year-End

Declining-Balance Method Year 1 Book Value Beginning of Year Rate $24, 000 40% Annual Deprec. Accum. Deprec. Year-End $9, 600 Book Value Year-End $14, 400

Declining-Balance Method Year 1 2 Book Value Beginning of Year Rate $24, 000 14, 400 Annual Deprec. 40% Accum. Deprec. Year-End $9, 600 5, 760 $14, 400 x. 40 $9, 600 Book Value Year-End $14, 400

Declining-Balance Method Year 1 2 Book Value Beginning of Year Rate $24, 000 14, 400 40% Annual Deprec. Accum. Deprec. Year-End $9, 600 5, 760 $9, 600 15, 360 Book Value Year-End $14, 400 8, 640

Declining-Balance Method Year 1 2 3 Book Value Beginning of Year Rate $24, 000 14, 400 8, 640 40% 40% Annual Deprec. Accum. Deprec. Year-End $9, 600 5, 760 3, 456 $9, 600 15, 360 18, 816 Book Value Year-End $14, 400 8, 640 5, 184

Declining-Balance Method Year 1 2 3 4 Book Value Beginning of Year Rate $24, 000 14, 400 8, 640 5, 184 40% 40% Annual Deprec. Accum. Deprec. Year-End $9, 600 5, 760 3, 456 2, 074 $9, 600 15, 360 18, 816 20, 890 Book Value Year-End $14, 400 8, 640 5, 184 3, 110

Declining-Balance Method Year 1 2 3 4 5 Book Value Beginning of Year Rate $24, 000 STOP! 14, 400 8, 640 5, 184 3, 110 40% 40% 40% Annual Deprec. Accum. Deprec. Year-End $9, 600 5, 760 3, 456 2, 074 1, 244 $9, 600 15, 360 18, 816 20, 890 22, 134 Book Value Year-End $14, 400 8, 640 5, 184 3, 110 1, 866

Declining-Balance Method Year 1 2 3 4 5 If we use this approach in Year 5, we will Book Value Accum. end the year with. Annual a book value of $1, 866. Beginning Deprec. Book Value of Year Rate Deprec. value Year-End Remember, the residual at the end of Year 5 is expected to be $2, 000, so we must $24, 000 40% $9, 600 $14, 400 modify our approach. 14, 400 40% 5, 760 15, 360 8, 640 5, 184 3, 110 40% 40% 3, 456 2, 074 1, 244 18, 816 20, 890 22, 134 5, 184 3, 110 1, 866

Declining-Balance Method Year 1 2 3 4 5 Book Value Beginning of Year Rate $24, 000 14, 400 8, 640 5, 184 3, 110 40% 40% --- Annual Deprec. Accum. Deprec. Year-End $9, 600 5, 760 3, 456 2, 074 1, 110 $3, 110 – $2, 000 $9, 600 15, 360 18, 816 20, 890 Book Value Year-End $14, 400 8, 640 5, 184 3, 110

Declining-Balance Method Year 1 2 3 4 5 Book Value Beginning of Year Rate $24, 000 14, 400 8, 640 5, 184 3, 110 40% 40% --- Annual Deprec. Accum. Deprec. Year-End $9, 600 5, 760 3, 456 2, 074 1, 110 $9, 600 15, 360 18, 816 20, 890 22, 000 Book Value Year-End $14, 400 8, 640 5, 184 3, 110 2, 000 Desired ending book value

Comparing Straight-Line With the Declining-Balance Method Depreciation ($) 5, 000 Straight-Line Method Declining-Balance Method 4, 000 3, 000 2, 000 1 2 3 1, 000 Life (years) 4 1 2 3 Life (years) 4

Revising Depreciation Estimates A machine purchased for Annual $130, 000 was originally Depreciation estimated to have a useful $130, 000 – $10, 000 life of 30 years and a 30 years residual value of $10, 000. The asset has been $4, 000 per year depreciated for ten years using the straightline method.

Revising Depreciation Estimates Equipment 130, 000 Book value = $90, 000 Before revising Accumulated Depreciation 4, 000 4, 000 4, 000 40, 000

Revising Depreciation Estimates During the eleventh year, it is estimated that the remaining useful life is 25 years (rather than 20) and that the revised estimated residual value is $5, 000. Book value – revised residual value Revised estimated remaining life $3, 400 revised $90, 000 – $5, 000 = annual depreciation 25 years

Capital and Revenue Expenditures made to acquire new plant assets are known as capital expenditures.

Capital and Revenue Expenditures to repair or maintain plant assets that do not extend the life or enhance the value are known as revenue expenditures.

Capital and Revenue Expenditures EXPENDITURE Increases operating useful life efficiency or adds No (extraordinary to capacity? repairs)? Yes Capital Expenditure (Debit fixed asset account) Revenue Expenditure (Debit expense No account for ordinary maintenance and repairs) Yes Capital Expenditure (Debit accumulated depreciation account)

Capital and Revenue Expenditures LIABILITIES CAPITAL EXPENDITURES 1. Initial cost 2. Additions 3. Betterments 4. Extraordinary repairs ASSETS OWNER’S EQUITY net income EXPENSES REVENUES

Capital and Revenue Expenditures LIABILITIES ASSETS OWNER’S EQUITY net income REVENUE EXPENDITURES Normal and ordinary repairs and maintenance EXPENSES REVENUES

Accounting for Fixed Asset Disposals When fixed assets lose their usefulness they may be disposed of in one of the following ways: 1. discarded, 2. sold, or 3. traded (exchanged) for similar assets. Required entries will vary with type of disposition and circumstances, but the following entries will always be necessary: An asset account must be credited to remove the asset from the ledger, and the related Accumulated Depreciation account must be debited to remove it’s balance from the ledger.

Discarding Fixed Assets A piece of equipment acquired at a cost of $25, 000 is fully depreciated. On February 14, the equipment is discarded.

Discarding Fixed Assets Feb. 14 Accumulated Depr. —Equipment To write off fully depreciated equipment. 25 000 00

Discarding Fixed Assets Equipment costing $6, 000 is depreciated at an annual straight-line rate of 10%. After the adjusting entry, Accumulated Depreciation— Equipment had a $4, 750 balance. The equipment was discarded on March 24. Mar. 24 Depreciation Expense. —Equipment 150 00 Accum. Depreciation—Equipment To record current depreciation on equipment discarded. 150 00 $600 x 3/12

Discarding Fixed Assets Equipment costing $6, 000 is depreciated at an annual straight-line rate of 10%. After the adjusting entry, Accumulated Depreciation—Equipment had a $4, 750 balance. The equipment was discarded on March 24. Mar. 24 Accumulated Depr. —Equipment 4 900 00 Loss on Disposal of Fixed Asset 1 100 00 Equipment To write off equipment discarded. 6 000 00

Sale of Fixed Assets When fixed assets are sold, the owner may break even, sustain a loss, or realize a gain. 1. If the sale price is equal to book value, there will be no gain or loss. 2. If the sale price is less than book value, there will be a loss equal to the difference. 3. If the sale price is more than book value, there will be a gain equal to the difference. Gain or loss will be reported in the income statement as Other Income or Other Loss.

Sale of Fixed Assets Equipment costing $10, 000 is depreciated at an annual straight-line rate of 10%. The equipment is sold for cash on October 12. Accumulated Depreciation (last adjusted December 31) has a balance of $7, 000. Oct. 12 Depreciation Expense—Equipment 750 00 Accumulated Depr. —Equipment To record current depreciation on equipment sold. 750 00 $10, 000 x ¾ x 10%

Sale of Fixed Assets Assumption 1: The equipment is sold for $2, 250, so there is no gain or loss. Oct. 12 Cash 2 250 00 Accumulated Depr. —Equipment Sold equipment. 7 750 00 10 00

Sale of Fixed Assets Assumption 2: The equipment is sold for $1, 000, so there is a loss of $1, 250. Oct. 12 Cash 1 000 00 Accumulated Depr. —Equipment 7 750 00 Loss on Disposal of Fixed Assets 1 250 00 Equipment Sold equipment. 10 00

Sale of Fixed Assets Assumption 2: The equipment is sold for $2, 800, so there is a gain of $550. Oct. 12 Cash 2 800 00 Accumulated Depr. —Equipment Gain on Disposal of Fixed Assets Sold equipment. 7 750 00 10 00 550 00

Exchanges of Similar Fixed Assets 1. 2. 3. 4. 5. 6. Trade-in Allowance (TIA) – amount allowed for old equipment toward the purchase price of similar new assets. Boot – balance owed on new equipment after trade-in allowance has been deducted. TIA > Book Value = Gain on Trade TIA < Book Value = Loss on Trade Gains are never recognized (not recorded). Losses must be recognized (recorded).

Exchanges of Similar Fixed Assets List price of new equipment acquired Cost of old equipment traded in Accum. depreciation at date of exchange Book value at date of exchange $5, 000 $4, 000 3, 200 $ 800 CASE ONE (GAIN): Trade-in allowance, $1, 100 Cash paid, $3, 900 ($5, 000 – $1, 100) Gains are not TIA > Book Value = Gain recognized for $1, 100 – $800 = $300 financial reporting. Boot + Book = Cost of New Equipment $3, 900 + $800 = $4, 700

Exchanges of Similar Fixed Assets On June 19, equipment exchanged at a gain of $300. June 19 Accumulated Depr. —Equipment (new equipment) 3 200 00 4 700 00 Equipment (old equipment) 4 000 00 Cash 3 900 00

Exchanges of Similar Fixed Assets List price of new equipment acquired Cost of old equipment traded in Accum. depreciation at date of exchange Book value at date of exchange $10, 000 $7, 000 4, 600 $2, 400 CASE TWO (LOSS): Trade-in allowance, $2, 000 Cash paid, $8, 000 ($10, 000 – $2, 000) TIA<Book Value = Losses are $2, 000 – $2, 400 = $400 recognized for financial reporting.

Exchanges of Similar Fixed Assets On September 7, equipment exchanged at a loss of $400. Sept. 7 Accumulated Depr. —Equipment (new equipment) Loss on Disposal of Fixed Assets 4 600 00 10 00 400 00 Equipment (old equipment) 7 000 00 Cash 8 000 00

Natural Resources and Depletion is the process of transferring the cost of natural resources to an expense account.

Natural Resources and Depletion A business paid $400, 000 for the mining rights to a mineral deposit estimated at 1, 000 tons of ore. The depletion rate is $0. 40 per ton ($400, 000 ÷ 1, 000 tons).

Natural Resources and Depletion During the current year, 90, 000 tons are mined. The periodic depletion is $36, 000 (90, 000 tons x $0. 40). Adjusting Entry Dec. 31 Depletion Expense Accumulated Depletion 36 000 00

Intangible Assets and Amortization is the periodic cost expiration of intangible assets which do not have physical attributes and are not held for sale (patents, copyrights, and goodwill). Date Dec. 31 Description Debit Credit Amortization Expense 20, 000 Patents 20, 000 Paid $100, 000 for patent rights. The patent life is 11 years and was issued 6 years prior to purchase. 11 years – 6 years = 5 -year life ($100, 000 / 5 years) = $20, 000 per year

74 Discovery Mining Co. Partial Balance Sheet December 31, 2006 Accum. Book Property, plant, and equipment: Cost Land $ 30, 000 Buildings Factory equipment Office equipment 679, 000 Mineral deposits: 110, 000 650, 000 120, 000 $910, 000 Cost 950, 000 Total property, plant, and equipment Goodwill Value $ 30, 000 Alaska deposit Wyoming deposit Intangible assets: Patents Depr. $ $ 26, 000 84, 000 192, 000 458, 000 13, 000 107, 000 $231, 000 Accum. Book Depr. Value $1, 200, 000$ 800, 000 $400, 000 750, 000 200, 000 550, 000 $1, 950, 000 $1, 629, 000 75, 000 50, 000 $

Ratio of Fixed Assets to Long-Term Liabilities Procter & Gamble Fixed assets (net) Long-term debt Ratio of fixed assets to long-term liabilities (in millions) 2002 2001 $13, 349 $11, 201 $13, 095 $9, 792 1. 2 Use: To indicate the margin of safety to long-term creditors 1. 3

Chapter 9 The End