MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski Hassell
MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell Electronic presentation adaptation by Dr. Barbara L. Hassell & Dr. Harold O. Wilson
Chapter 6
Investment Decisions: (Investments in Productive Assets) • Topics – Property, plant and equipment – Natural resources – Intangible assets
General Rule of Recording the Acquisition of Productive Assets • Record the asset at either the FMV of what is received or the FMV of what is given up, whichever is more clearly determinable. • If unclear, emphasize the asset received. Exception to general rule: Exchanges of similar assets.
Productive Assets May Be Acquired By • Paying cash • Issuing debt (e. g. , notes payable, leases) • Issuing equity (e. g. , common stock, preferred stock) • By donation (e. g. , from a governmental entity) • By self-construction
Property, plant & equipment PPEq defined: Assets that have the four characteristics of being [TURN]. . . • tangible, • used in the operations of the business, • relatively long-lived, and • not intended for resale.
Self-Construction • Interest incurred normally is expensed in the period incurred. Exception to the general rule: Interest incurred on self-constructed assets is capitalized as part of the cost of the asset.
Acquisition of Natural Resources (assets subject to depletion) • Acquisition costs (capitalized) • Exploration costs – two methods – Successful efforts (capitalize costs related only to successful completion) – Full costing (capitalize costs related to all exploration)
• Development costs – Tangible: Capitalized as part of the asset (e. g. , equipment) – Intangible: Capitalized as part of the natural resource • Estimated reclamation (restoration) costs (to be incurred at end of project) are part of depletion base.
Intangible Assets • Specifically identifiable – Patents – Copyrights – Trademarks and tradenames – Franchises – Organization costs • Unidentifiable – Goodwill See anything?
Research and Development • Expensed as incurred! Note: R&D is viewed as an asset (capitalized) if related to services performed under contract for which reimbursement will be realized.
Expenditures After Acquisition I wonder what they’ll debit? • Revenue Expenditures – Expensed (e. g. , normal maintenance, etc. ) by definition. • Capital Expenditures – Capitalized (e. g. , additions, betterments, etc. ) by definition.
Cost Allocation Processes • Depreciation (applies to long-lived tangible assets): The estimated cost of the utility extracted from property, plant & equipment assets. • Depletion (applies to natural resources): The cost of natural resource units removed (e. g. , mined) from the source of such natural resources, for consumption or resale.
Observations. . . Amortization is a term ordinarily applied to a “writing-off” of some defined intangible asset, similar to depreciation when used as a verb. Depreciation accounting is the process of systematically allocating depreciation [expense] to time frames.
Cost Allocation Methods • Straight-line (SL) technique – Uniform allocation to defined time frames. • Declining-balance technique – Double (200%) declining balance (DDB) – 150% declining balance (1. 5 DB) • Units-of-output technique – Uniform allocation to defined units (of the estimated output of the asset over its life)
Cost Allocation Processes and Methods • Depreciable assets – Straight line is predominant method (*) • Natural resources – Units-of-output is predominant method • Intangible assets – Straight line is predominant method (*) Note: The unit-of-output, e. g. , flight hours, may be used on airplane motors, etc.
Straight-Line Allocation Method (Allocation Is Same Amount Each Period) Annual allocation = (Cost – Estimated Salvage) (1/n) Alternatively, (Cost – Estimated Salvage) n where, n = estimated useful life
Example: Cost = $2, 000 Estimated Salvage = $100, 000 Estimated Useful Life = 8 years Annual Allocation = ($2, 000 - $100, 000) 8 = $237, 500 for uniform Depreciation Expense! ……. .
Declining-Balance Allocation Methods (Allocation Declines Each Period) Annual Allocation = (Beginning of the year book value) (1 n) (declining balance percentage)
Example: Cost = $2, 000 Estimated Salvage = $100, 000 Estimated Useful Life = 8 years Use Double-Declining Balance Year 1 Allocation to depreciation expense = $2, 000 (1 8) 200% = $500, 000 Year 2 Allocation to depreciation expense = ($2, 000 - $500, 000) (1 8) 200% = $375, 000
FAQ? Why is estimated salvage value irrelevant in the last example, where DDB depreciation was applied? Because, the book value will always be above zero; thus, accountants tend to assume that the balance at the end of the asset’s useful life will be close to salvage value--an estimate anyway!
Units-of-Output Allocation Method (Allocation Varies Each Period Depending upon Output) Annual Allocation = (Cost – Estimated Salvage) (Current Year’s Output) Estimated Total Output
Example: Cost = $2, 000 Estimated Salvage = $100, 000 Estimated Useful Life = 8 years Total Estimated Output Over Life of Asset = 750, 000 units Current Year Output = 80, 000 units Current Year Allocation = ($2, 000 - $100, 000) ´ (80, 000 750, 000) = $202, 667
Impairment of Asset Value • “Impairment” is assessed if management believes that the FMV of the asset has permanently and materially declined below book value. • Impairment is deemed to have occurred if the gross undiscounted future cash flows from the asset’s use is less than the asset’s current book value.
• If impairment is deemed to have occurred, the asset is written down to its recoverable value, which is measured as either. . . – net realizable value, if asset is to be sold, or – present value of gross future cash flows, if asset is to be used. • An impairment loss is recognized, equal to book value minus recoverable value.
Impairment Examples Facts: Book Value = $2, 000 cost - $750, 000 accumulated depreciation = $1, 250, 000
Example 1: Total gross future cash flows from use of asset = $2, 500, 000 Present value of future cash flows = $900, 000 Net Realizable Value = $1, 100, 000 Solution: No impairment loss; book value is less than total gross (undiscounted) cash flows
Example 2: Total gross future cash flows from use of asset = $900, 000 Present value of future cash flows = $700, 000 Net realizable value = $600, 000 Solution: The asset is considered impaired because book value of $1, 250, 000 is greater than total gross (undiscounted) cash flows of $900, 000
Financial Statement Effects: The asset is written down to $600, 000 if the asset is to be sold, and an impairment loss of $650, 000 ($1, 250, 000 book value - $600, 000 net realizable value) is recognized. The asset is written down to $700, 000 if the asset is to be used, and an impairment loss of $550, 000 ($1, 250, 000 book value – $700, 000 present value) is recognized.
Capital Budgeting GO! NO GO!
To invest or not to invest in a capital asset? • Basic decision variables: IRR (internal rate of return) and NPV (net present value) analyses as criteria for a “GO” decision: • IRR: Higher IRR projects are preferred; the IRR of a proposed project must exceed the firm’s after-tax cost of capital ! • NPV: Higher NPV projects are preferred; the NPV of a proposed project must be positive for acceptance!
Capital Budgeting Example • Facts: Assume that for a $1, 000 cash investment, a company would receive $180, 000 net cash inflows to be received at the end of each of the next 8 years; the terminal value is $0. Assume 7% is the company’s after-tax cost of the capital. • Should the project be accepted? – Use IRR and NPV to answer the question.
Solution: The project is worth considering. It has a positive NPV, and the IRR is greater than the after-tax cost of capital. The project should be compared to other projects demanding approximately the same capital commitments when management decides which project to fund.
IRR = 8. 9%, which exceeds 7% n=8 Collections (ordinary annuity) = $180, 000 PV = $1, 000 Termination payoff = $0 i=?
NPV = $1, 070, 833 - $1, 000 = $74, 833 POSITIVE! n=8 i = 7% Collections (ordinary annuity) = $180, 000 Termination payoff = $0 PVn = $1, 070, 833
End of Chapter 6
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