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Chapter 12 Investments in Operating Assets. 2 Financial Accounting, 7e Stice/Stice, 2006 © Thomson...
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Transcript of Chapter 12 Investments in Operating Assets. 2 Financial Accounting, 7e Stice/Stice, 2006 © Thomson...
2Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Financial Statement Items Covered
Balance SheetIncome
StatementStatement of Cash Flows
Long-term AssetsProperty, Plant, &
EquipmentAccumulated
DepreciationIntangible Assets
Depreciation ExpenseAmortization ExpenseLoss on Impairment
OperatingAsset depreciation
(indirect method)
FinancingCash paid
(received) to purchase (from sale of) long-term assets
Cash paid to acquire another company
4Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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
5Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Property, Plant, and Equipment
“PP&E”– Tangible, long-lived assets– Acquired for use in business operations
•Land•Buildings•Machinery•Equipment•Furniture
6Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Long-lived assets– Used to facilitate the operation of a
business– Do not have physical substance
•Patents•Trademarks•Licenses•Franchises•Goodwill
Intangible Assets
7Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Long-Term Asset Issues
Evaluate AcquireEstimate
andRecognize
Monitor Dispose
possible acquisition of
long-term operating
assets
long-term operating assets
periodic depreciation
asset value for possible decline
of the asset
9Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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
10Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Payback Period
The time it takes for a company to recover its original investment in cash Initial Investment
Payback Period = Annual Cash Inflow
11Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Accounting Rate of Return
Projects are approved if their rate of return exceeds some predetermined rate
Annual Accounting IncomeAccounting Rate = of Return Initial Investment
12Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Net Present Value
Utilizes the concept of the time value of moneyA project is undertaken only if the present value of the cash inflows from the project exceeds the present value of the cash outflow
14Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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
15Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Items Included in PP&EAcquisition 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
16Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Acquisition for Cash
Purchase price $15,000Discount* (300)Net Price $14,7006% sales tax on purchase price $900Freight charges 850Installation costs 150 1,900Total Acquisition Cost $16,600
*terms 2/10, n/30; payment made within discount period
17Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Subsequent Expenditures
Normal repairs and maintenance are expensed in the current periodExpenditures which extend the useful life or increase the productive capacity are capitalized
– Asset book value is increased– Annual depreciation is revised
18Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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
19Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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 The leased asset is depreciated over the
lease period– A lease liability is shown in the liability
section of the balance sheet
20Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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
Land 780,000 Capital Stock 780,000
21Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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.
Land 500,000 Gain - Donated Asset 500,000
22Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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
23Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Example:Acquisition With a Basket
PurchaseFair Value of Assets:
Land
300,000Building
900,000Price Paid
$1,000,000
Appraised Value
Relative Percentage Allocation
Land 300,000 25.0% 250,000 Building 900,000 75.0% 750,000
1,200,000 100.0% 1,000,000
24Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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 dateThe excess of the purchase price over the fair value of the identifiable assets represents goodwill
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Self-constructed assets are recorded at cost, including all expenditures necessary to build the asset and make it ready for its intended use
Acquisition ThroughSelf-Construction
26Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Acquisition ThroughSelf-Construction
Costs include:– Materials and labor used directly in
construction– A reasonable share of general overhead– If interest is included it is called capitalized
interestInterest 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
28Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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
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
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.
Trademark andTrade 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
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.
34Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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)
35Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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
Purchase Method
36Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Determining Goodwill
Purchase price paid 1,300,000 Net assets, book value (750,000)
550,000 Adjust net assets to fair value:
Inventory 50,000 Plant, Property, & Equip 150,000 Patent 100,000 300,000
Goodwill 250,000
Book Value Fair Value DifferenceAssets:
Cash 50,000 50,000 - Accounts Receivable 250,000 250,000 - Inventory 400,000 450,000 50,000 Plant, Property, & Equip 350,000 500,000 150,000 Patent - 100,000 100,000
LiabilitiesAccounts Payable (100,000) (100,000) - Long-term debt (200,000) (200,000) -
Net Assets 750,000 1,050,000
38Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Depreciation:What it Is ... and Isn’t
IS NOT• Accumulation of
a cash fund for asset replacement
• A determination of an asset’s current value
IS• The systematic
allocation of an asset’s cost to the periods of benefit
39Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Depreciation
Causes of depreciation:– Physical deterioration
•Due to use, passage of time, and exposure to the elements
– Obsolescence•Outdated, outmoded, or inadequate
40Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Residual value (salvage value)– An estimate of the asset’s worth at
the time of its disposalDepreciable cost
– The original cost minus the residual value
Estimated useful life– A measure of the service potential
in terms of years or units produced
Depreciation Factors
41Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Depreciation Methods
Straight-line– Allocates an equal amount of asset
cost per yearUnits-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
42Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Depreciation Methods Illustrated
Assume the following information:Equipment purchase date January 1, 2006Acquisition cost $40,000Estimated residual value $4,000Depreciable cost $36,000Estimated useful life 5 years
43Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Straight-Line Depreciation
Cost - Residual Value = Annual Depreciation
Useful Life
$40,000 - $4,000 = $7,200
5 years
Year Depreciation Accum Dep Book Value
2006 7,200 7,200 32,800 2007 7,200 14,400 25,600 2008 7,200 21,600 18,400 2009 7,200 28,800 11,200 2010 7,200 36,000 4,000
44Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Straight-Line Method
An equal amount of depreciation expense is allocated to each period
Straight-line Depreciation
$0
$5,000
$10,000
$15,000
$20,000
$25,000
$30,000
$35,000
1 2 3 4 5
Year
Annual Depreciation End of Year Book Value
45Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Declining-Balance Method
Annual depreciation is determined by applying a fixed percentage to the remaining book value at the beginning of each year
1 rate = percentage rate
life
1 2 = 40%
5
‘rate’ is the multiple of straight-line(double is 2 times the straight-line rate)
46Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Declining-Balance Method
40% remaining book value40% (cost - accum dep)Year 1: 40% ($40,000 - 0) = $16,000Year 2: 40% ($40,000 - $16,000) = $9,600
YearBeginning
Book Value Depreciation Accum Dep
Ending Book Value
2006 40,000 16,000 16,000 24,000 2007 24,000 9,600 25,600 14,400 2008 14,400 5,760 31,360 8,640 2009 8,640 3,456 34,816 5,184 2010 5,184 1,184 36,000 4,000
2010’s expense is adjusted so that ending book value is not less than established residual value
47Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Declining-Balance Method
Double Declining-Balance Depreciation
$0
$5,000
$10,000
$15,000
$20,000
$25,000
$30,000
1 2 3 4 5
Year
Annual Depreciation End of Year Book Value
Accelerated methods allocate a greater portion of cost to the earlier years of the asset’s life
48Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Both methods allocate a depreciable cost of $36,000 over a five-year period
Comparison of Straight-line and Double-Declining
Balance
$0
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
$14,000
$16,000
$18,000
1 2 3 4 5
YearStraight-Line Method Declining Balance Method
49Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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
50Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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
IRS DepreciationRecovery Periods and Lives
Cost Recovery
Period (Yrs) Method
4 years or less 34 to < 10 years 510 to < 16 years 716 to < 20 years 1020 to < 25 years 1525 years or more 20
Real Propertyresidential rental 27.5nonresidential 39
Personal Property
200% DB
150% DB
straight-line
52Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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
53Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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
54Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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
55Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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
57Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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
58Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Recording Decreasesin 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
59Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Impairment of Intangible Assets
Intangibles must be evaluated to determine if
– Their estimated useful life has changed
– The intangible has become impaired
60Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Recording Increasesin 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
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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
63Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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
64Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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
Sale
65Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Sale: Two Examples
Cash received 7,000 4,000 Book Value of Truck
Cost 35,000 35,000 Accum Dep 30,000 5,000 30,000 5,000
Gain (Loss) on Sale 2,000 (1,000)
Case 1 Case 2
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.
66Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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
68Financial Accounting, 7e Stice/Stice, 2006 © Thomson
Used to evaluate the appropriateness of the level of a company’s PP&E
Fixed Asset (PPE)Turnover
SalesFixed Asset Turnover =
Average PP&E
Can be interpreted as the number of dollars in sales generated by each dollar of fixed assets
69Financial Accounting, 7e Stice/Stice, 2006 © Thomson
The ratios for two companies in different industries cannot be compared
The reported amount of PP&E can be a poor indicator of fair value
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
Fixed Asset Turnover Dangers
70Financial Accounting, 7e Stice/Stice, 2006 © Thomson
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