Chapter 7

Common Mistake

Some students mistakenly depreciate land because it's part of property, plant, and equipment. Land is property, but it is not depreciated because its service life never ends.

Key Point

Straight-line, declining-balance, and activity-based depreciation are all acceptable depreciation methods for financial reporting. Most companies use straight-line depreciation for financial reporting and an accelerated method called MACRS for tax reporting.

Return on Assets

net income/average total assets

Three Methods of Asset Disposal

-Sale: can result in either a gain or a loss -Retirement: occurs when a long-term asset is no longer useful but cannot be sold -Exchange: occurs when two companies trade assets

Which of the following is an exclusive right to manufacture a product or to use a process?

A patent is an exclusive right to manufacture a product or to use a process. The U.S. Patent and Trademark Office grants this right for a period of 20 years.

Key Point

Amortization is a process, similar to depreciation, in which we allocate the cost of intangible assets over their estimated service lives. Intangible assets with an indefinite useful life (goodwill and most trademarks) are not amortized.

How much depreciation should be recorded in the first year for a delivery truck purchased on April 1 with a cost of $30,000, an expected life of five years, and an estimated residual value of $5,000? Assume the straight-line method is used.

Annual depreciation would be: $5,000 = ($30,000 − $5,000) ÷ 5 years Therefore, depreciation from April 1 through December 31 (9 months) in the first year would be: $3,750 = $5,000 × 9/12

Common Mistake

Be careful not to combine the delivery truck ($40,000) and accumulated depreciation ($21,000) and credit the $19,000 difference to the Equipment account. Instead, remove the delivery truck and accumulated depreciation from the accounting records separately. Otherwise, the Equipment and the Accumulated Depreciation accounts will incorrectly have a remaining balance after the asset has been sold.

Key Point

Depreciation refers to the allocation of the asset's original cost to an expense during the periods benefited. Depreciation does not refer to the change in value or selling price.

Key Point

If we dispose of an asset for more than its book value, we record a gain. If we dispose of an asset for less than its book value, we record a loss.

Two-Step Impairment Process

Impairment: Estimated future cash flows (future benefits) generated for a long-term asset fall below its book value.

Straight-Line Depreciation

Method that allocates an equal portion of the depreciable cost of plant asset (cost minus salvage) to each accounting period in its useful life.

An impairment loss is recorded when:

Record an impairment loss only when book value exceeds estimated future cash flows.

Property, Plant, and Equipment

Recorded at: The original cost of the asset + All expenditures necessary to get the asset ready for use

Common Mistake

Students sometimes mistake accounting depreciation as recording the decrease in value of an asset. Depreciation in accounting is not a valuation process. Rather, depreciation in accounting is an allocation of an asset's cost to expense over time.

Key Point

Tangible assets such as land, land improvements, buildings, equipment, and natural resources are recorded at cost plus all costs necessary to get the asset ready for its intended use.

If an asset is sold at the end of its first year of use, which depreciation method would result in the highest amount of gain (or lowest amount of loss) assuming the asset is used fairly evenly over its life?

The double-declining-balance would result in the most depreciation in the first year and therefore the lowest book value. A low book value results in the highest amount of gain (or lowest amount of loss). Assuming that the asset is used uniformly, approximately the same amount of depreciation would be recorded each year of the asset's life under the straight-line method or activity-based method.

Papa's Pizza has the following items for the past year: Net sales are $24,128, net income is $2,223, total assets at the beginning of year are $14,898, and total assets at the end of year are $15,465. What is the profit margin?

The profit margin is computed by taking net income and dividing by net sales. Net income of $2,223 divided by net sales of $24,128 results in a profit margin of 9.2%.

A company makes a basket purchase of land, buildings, and equipment with estimated fair values of $70,000, $150,000, and $30,000, respectively. The purchase price is $210,000. How much should be recorded to the Land account?

The purchase price of $210,000 is allocated to the separate accounts for Land, Buildings, and Equipment based on their relative fair values. The total fair value of the three assets is $250,000. Land's relative fair value is $70,000/$250,000 (or 28%). Therefore, the land would be recorded for $210,000 × 28% = $58,800.

How much depreciation should be recorded for the first year for a delivery truck with a cost of $30,000, an expected life of six years, and an estimated residual value of $6,000? Assume the double-declining-balance method is used.

The straight-line rate for a six-year asset is 1/6. This rate would be doubled to 2/6 (or 33.33%). Depreciation the first year (rounded): $10,000 = $30,000 × 33.33%.

Which of the following costs would be expensed?

Tune-ups are necessary to maintain the truck and are regularly required. The cost of a tune-up should be expensed. All of the other items benefit future periods and should be capitalized.

Key Point

We capitalize (record as an asset) expenditures that benefit future periods. We expense items that benefit only the current period.

Which of the following intangible assets would not be subject to amortization?

We do not amortize intangible assets with indefinite lives (unknown or not determinable). So if a trademark has an indefinite life, we would not amortize it.

Common Mistake

When using the declining-balance method, mistakes are commonly made in the first and last year of the calculation. In the first year, students sometimes calculate depreciation incorrectly as cost minus residual value times the depreciation rate. The correct way in the first year is to simply multiply cost times the depreciation rate. In the final year, some students incorrectly calculate depreciation expense in the same manner as in earlier years, multiplying book value by the depreciation rate. However, under the declining-balance method, depreciation expense in the final year is the amount necessary to reduce book value down to residual value.

Activity-Based Depreciation

depreciable cost/total units expected to be produced ex. depreciable cost / miles or hours

Long-Term Assets

tangible and intangible

how are depreciation methods related

total depreciation is the sam eunder all 3 methods

Tax Depreciation

•Accelerated methods reduce taxable income more in the earlier years of an asset's life •Most companies use: qStraight-line for financial reporting qAccelerated for tax reporting - called MACRS

Amortization of Intangible Assets

•Allocating the cost of most tangible assets to expense is called qDepreciation •Allocating the cost of intangible assets to expense is called qAmortization •Most intangible assets have a finite useful life that can be estimated. •Most companies use straight-line amortization for intangibles.

Materiality

•An item is said to be material if it is large enough to influence a decision. •When an expenditure is not material, the item is typically recorded as an expense regardless of its expected period of benefit. •Companies generally have policies regarding amounts that are not material. They will expense all costs under a certain dollar amount, say $1,000, regardless of whether future benefits are increased.

Buildings

•Buildings: administrative offices, retail stores, manufacturing facilities, and storage warehouses •Costs of getting a building ready for use include items such as: qRealtor commissions and legal fees qRemodeling costs •Unique accounting issues arise when a firm constructs a building rather than purchasing it (capitalize interest cost).

Depreciation

•Dictionary definition qDecrease in value of an asset •Accounting definition qAllocation of an asset's cost to expense over time

Equipment

•Equipment: machinery used in manufacturing, computers and other office equipment, vehicles, furniture, and fixtures •The cost of equipment might include sales tax, shipping, assembly, and any other costs to prepare the asset for use •Recurring costs such as annual property insurance and annual property taxes on vehicles are expensed as incurred

Copyrights

•Exclusive right of protection given to the creator of a published work •Granted for the life of the creator plus 70 years •Allows holder to pursue legal action against anyone who attempts to infringe the copyright •Accounting is virtually identical to that of patents

Patents

•Exclusive right to manufacture a product or to use a process •Granted for a period of 20 years •When purchased: qCapitalize the purchase price plus legal and filing fees •When developed internally: qCapitalize legal and filing fees only (Research and Development costs are expensed as incurred)

Goodwill

•Goodwill is the portion of the purchase price that exceeds the fair value of identifiable net assets •Recorded only when one company acquires another company •Net assets = assets acquired less liabilities assumed •Most companies also create goodwill to some extent through advertising, employee training, and other efforts. However, as it does for other internally generated intangibles, a company must expense costs incurred in the internal generation of goodwill.

Depreciation Methods

•In determining how much of an asset's cost to allocate to each year, a company should choose a depreciation method that corresponds to the pattern of benefits received from using the asset. • •Three common methods: qStraight-line qDeclining-balance qActivity-based

Intangible Assets

•Intangible assets: patents, copyrights, trademarks, franchises, and goodwill •Lack physical substance but can be very valuable •Existence often based on legal contract •Acquired in two ways: qPurchased qDeveloped internally

Land Improvements

•Land improvements are amounts spent to improve the land •Examples: qParking lots, sidewalks, driveways, landscaping, lighting systems, fences, and sprinklers •Land improvements have limited useful lives and are recorded separately from the Land account.

Land

•Land includes the cost of the land and all expenditures necessary to get the land ready for its intended use •Costs to get the land ready for use include items such as: qReal estate commissions and fees qBack property taxes or other obligations qClearing, filling, and leveling the land qCash received from selling salvaged building materials reduces the cost of land

Franchises

•Local outlets that pay for the exclusive right to use the franchisor's name and to sell its products within a specified geographical area •The franchisee records the initial fee as an intangible asset •Additional periodic payments to the franchisor are usually expensed as incurred

Natural Resources

•Natural resources: oil, natural gas, timber, and salt •Distinguished from other assets by the fact that they are physically used up, or depleted •Recorded at cost plus all other costs necessary to get the natural resource ready for its intended use

Basket Purchases

•Purchase of more than one asset at the same time for one purchase price qExample: purchase land, building, and equipment together for $900,000 •Because we need to record land, building, and equipment in separate accounts we must allocate the total purchase price based on the relative fair values of the individual assets

Expenditures After Acquisition

•Repairs and maintenance •Additions •Improvements •Litigation costs For all expenditures after acquisition:

Factors Used in Calculating Depreciation

•Service life (or useful life)—The estimated use the company expects to receive from the asset before disposing of it. •Residual value (or salvage value)—The amount the company expects to receive from selling the asset at the end of its service life. •Depreciation method—The pattern in which the asset's depreciable cost (original cost minus residual value) is allocated over time.

Trademarks

•Word, slogan, or symbol that distinctively identifies a company, product, or service •Renewable for an indefinite number of 10-year periods •Capitalize legal, registration, and design fees qAdvertising costs expensed as incurred

Intangible assets developed internally

•expense in the income statement most of the costs for internally developed intangible assets in the period we incur those costs. qDifficult to determine portion of the expense that benefits future periods.

Purchased intangibles

•record at their original cost plus all other costs necessary to get the asset ready for use. qSimilar to reporting purchased property, plant, and equipment.

Tangible assets

••Land ••Land improvements ••Buildings ••Equipment ••Natural resources

Intangible assets

••Patents ••Trademarks ••Copyrights ••Franchises ••Goodwill