Chapter

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Long-Lived Non-monetary

Assets andTheir

Amortization

7

1-2

Nature of Long-Lived Assets

• Benefits obtained from expenditures on goods or services are either– Obtained in current period (expenses) or– Expected to be obtained in future periods

(capitalized).

• Capital assets provide benefits to future periods.• Amortization is the process of matching costs

incurred for capital assets with revenues obtained from their use.

1-3

Types of Long-Lived Assets

Tangible asset Asset with physical substance Property, plant, and equipment = fixed asset.

Intangible asset Intellectual property. No physical substance

Examples are patent rights, copyrights

1-4

Amortization

View capital asset as bundle of services. Similar to prepaid expenses, cost is

expensed as company benefits from services.

1-5

Types of Long-lived Assets & Amortization

Tangible Assets Land - no depreciation Plant and equipment - depreciation. Natural resources - depletion

Intangible Assets Limited life Intangible assets – amortization Indefinite life Intangible assets – no amortization,

impairment tests Deferred charges – amortization Research & development – not capitalized

1-6

Asset versus expense

Expenditures: either expensed or capitalized. Small items may be expensed (materiality).

Capitalize large purchases of small items. Replacement items charged as an expense.

Repairs and maintenance are expensed. Betterments are capitalized.

Makes the asset better than when purchased.

Replacements: assets or expenses depending on how the asset unit is defined.

1-7

What is included in cost?

All expenditures necessary to make asset ready for its intended use.

Self constructed assets: All construction costs (materials, direct labor,

overhead). Capital asset acquired for other than cash:

Record at fair market value (FMV) of consideration given or received.

Basket purchase: Allocate cost based on FMV of acquired assets.

1-8

Depreciation

Gradual conversion of cost into expense. Depreciation is a cost consumed by an

entity during an accounting period.

• Systematic allocation of original cost of an asset to periods in which asset provides benefit to the entity.

1-9

Definitions

• Deterioration = physical process of wearing out.• Obsolescence = loss of usefulness because of

change in technology or tastes.• Physical life = time until asset wears out.• Service life = shorter of either time until asset

becomes obsolete or time until asset wears out.• Book value = net book value = original cost -

accumulated depreciation to date.

1-10

Judgments required

Service life of asset. Residual value at the end of its service life.

Net cost = original cost - residual value.

Method of depreciation used to allocate cost over useful life of asset.

1-11

Depreciation methods

Straight line method: (original cost - residual value) /service life

Accelerated methods: Declining balance methods. Sum of the years’ or years’ digits methods.

1-12

Declining Balance Method

Depreciation = book value * depreciation rate. Double declining balance method = book

value * 2 * straight line rate. Straight line rate = 1/(life of asset in years).

1-13

Years digits method

Depreciation for first year = (cost - residual value) * n / SYD. SYD = n(n+1)/2 where n is estimated years of

useful life.

Depreciation for second year = (cost - residual value) * (n - 1) / SYD.

1-14

Units of production method

Depreciation = (cost / estimated units of production over life of asset) * units produced in period

1-15

Depreciation Accounting

• Acquire an asset for $1,000 and depreciate straight line over 5 years.

• Each year’s depreciation:

• Depreciation expense 200

• Accumulated depreciation 200

1-16

Depreciation Miscellany

Theoretically: selection that results in best matching. Changes in estimated life:

Not unusual. Affect future, not past depreciation.

Fully depreciated assets on BS until disposal. Half year convention: record a half year’s depreciation in

year of acquisition and disposition. Disclosure: amount of depreciation expensed in year, &

original cost, & accumulated depreciation by category.

1-17

Plant and Equipment: Disposal

• Sale of building:– Remove cost and accumulated depreciation.

• Reminder: book value = cost - accumulated depreciation.

– Gain or (loss) = Selling price of asset - book value.

• Gain or loss in current period income statement.

• Cost = market value at time of purchase.

1-18

Impaired Assets

Impaired if remaining benefits, as measured by sum of future cash flows generated by use of asset, is less than its book value.

If entity expects to hold asset: Write asset down to fair value

If entity expects to sell asset: Write asset down to lower of cost or fair value less

cost of disposal.

1-19

Exchange and Trade-Ins

Trade is for a similar asset if asset received is of same general type or performing same function. Otherwise, it is dissimilar.

If exchange is for a similar asset, value of asset received is recorded at additional amount paid + book value of old asset. No gain or loss is recorded.

If exchange is between dissimilar assets, record asset received at fair value and recognize gain or loss on disposal of old asset.

1-20

Group Depreciation

• Treats all similar assets as a “pool” or group rather than calculating for each item separately (unit or item depreciation).

• No gain or loss recognized when an individual item is disposed.– Credit asset account for original cost.– Debit cash for amount of proceeds.– Debit accumulated depreciation for difference.

1-21

Accumulated Depreciation

• Does not represent accumulation of any tangible thing.

• Sum of original cost that has been expensed.

• Funding purchase of new asset is usually unrelated to depreciation.

1-22

Modified accelerated cost recovery system (MACRS)

• Tax code allows rapidly accelerated depreciation for tax purposes to encourage investment in capital assets.

• Ignores estimated residual values.• Combination of declining balance method, half-

year convention, and switch to straight-line depreciation for latter portion of recovery period.

• IRS provides a table to look up percentage to multiply against original cost.

• Lowers taxes to encourage investment.

1-23

Investment tax credit (ITC)

Tax credit as a percent of cost of capital assets.

Encourages investment. Flow through method: reduces taxes in

acquisition year. Deferral method: reduces original cost of

asset. Currently not in tax code.

1-24

Natural Resources

Measure cost same as other assets. Oil exploration costs:

Full cost method: All costs of exploration allocated to and capitalized

as the value of reserves discovered during the year.

Successful efforts method: Only capitalize costs involved with successful

efforts (oil reserves that are discovered).

Both allowed under GAAP.

1-25

Depletion

Amortizing costs of natural resources. Units of production method ordinarily used.

Depletion for a period = (Cost of reserve / estimated units, say barrels) * number of barrels extracted during period.

Accretion = increase in value arising from natural growth (e.g. timber, agricultural products)

Not recognized in accounts until sold. Costs incurred are capitalized.

1-26

Internally Developed or Acquired

Internally developed are expensed as incurred.

Acquired are capitalized.

1-27

Categories of Intangibles

• Intangible assets with limited lives.

• Intangible assets with indefinite lives.

• Goodwill.

1-28

Intangible AssetsLimited Useful Life

• Examples: patents and copyrights.• If purchased, recorded at cost.

– Amortized over useful life.– Useful life can equal or be shorter than legal life. Amortization should reflect the pattern in which the

economic benefits are consumed. Straight line if pattern cannot be determined.

• If developed internally, expense as incurred.

1-29

Intangibles with Indefinite Useful Lives

• Example: renewable broadcast license.• Considered indefinite if no legal, regulatory,

contractual, competitive or other limiting factors.• Not amortized.• Tested for impairment.• If determined to be impaired, it is written down to

realizable value and charged against income.

1-30

Goodwill

• When one company buys another.• Goodwill = Purchase price of company – fair

value of net assets.– Net assets include tangible assets and recognized

intangible assets net of liabilities assumed by the purchaser.

• Recorded as an asset upon acquisition.• Not amortized.• Annual impairment test.• Any write down is charged against income.

1-31

Leasehold improvements

Improvements made to leased property. Revert to owner at end of lease. Amortized over the shorter of useful life or

length of lease. If renewal is likely, amortize through

renewed period.

1-32

Deferred Charges

Start-up Costs in pre-operating period. Expense or Capitalize and amortize over a short period

(rarely more than 5 years).

1-33

Research & development (R&D) costs

Costs incurred to: Develop new knowledge, products or improve

goods, processes, or services. GAAP:

Expense since future benefits uncertain. Argument for capitalizing:

Matching concept. Argument for immediate expensing:

Conservatism, objectivity.

1-34

Other R&D

R&D for customer under contract: Inventory until sold.

Software development: Costs are expensed until technological feasibility

of product has been established. Costs after feasibility established until product is

available for release to customer are capitalized. Amount of amortization for year is the greater of:

Straight line or ratio of year’s revenues to total anticipated revenues

1-35

Analysis of Non-monetary Assets

• To estimate:– Average age of depreciable assets =

(accumulated depreciation)/(annual depreciation expense)

– An asset’s depreciation period in years = (Original cost)/(annual depreciation expense)

– Annual expenditure for a particular type of intangible asset = annual amortization expense + increase in asset’s balance or – a decrease in balance