Accounting Chapter 7

Fixed Asset Turnover Ratio

Fixed Asset Turnover Ratio = Net Sales / Average Fixed Assets; the more efficient a company uses its fixed assets, the higher the ratio will be

Accumulated Depreciation

represents the total amount of depreciation expense that has been recorded for an asset since the asset was acquire; reported on the balance sheet as a contra-asset

Property, Plant, & Equipment

-Land: The site of a manufacturing facility or office building used in operations (not subject to depreciation because it has an unlimited life and service potential) -Land Improvements: Structural additions or improvements to land (such as driveways, parking lots, fences, landscaping, lighting) -Buildings: Structures used in operations (factory, office, warehouse) -Equipment: Assets used in operations (machinery, furniture, automobiles)

Natural Resources

-Unlike fixed assets, natural resources are physically consumed as they are used by a company -Natural resources can generally be replaced or restored only by an act of nature. (Timberlands are renewed by replanting and growth, but coal deposits and most mineral deposits are not subject to renewal.) -As a natural resource is removed from the earth, the cost of the natural resource is allocated to each unit of natural resource removed. This process of allocating the cost of the natural resource to each period in which the resource is used is called depletion

To measure depreciation you must know...

-cost of the fixed asset -useful life (or expected life) of the fixed asset -residual value (salvage value) of the fixed asset

Straight-Line Method

allocates an equal amount of an asset's cost to depreciation expense for each year of the asset's useful life; is appropriate to apply this method to those assets for which an equal amount of service potential is considered to be used each period; Straight-Line Depreciation = (Cost - Residual Value) ÷ Expected Useful Life

Organizational Costs

costs related to legal fees, stock issuance, accounting fees, and promotional fees. Occur during the formation of a new company; current accounting standards treat organizational costs as an expense in the period the cost is incurred

Declining Balance Depreciation

is an accelerated depreciation method that produces a declining amount of depreciation expense each period by multiplying the declining book value of an asset by a constant depreciation rate; Declining Balance Depreciation Expense = Declining Balance Rate X Book Value

Cost

is any expenditure necessary to acquire the asset and to prepare the asset for use

Involuntary Disposal

occurs when assets are lost or destroyed through theft, acts of nature, or by accident.

Voluntary Disposal

occurs when the company determines that the asset is no longer useful and sells or retires it. If a retirement, no cash is received.

Disposal of Fixed Assets

An entry to record depreciation expense up to the date of disposal. An entry to: Remove the asset's book value (credit the cost of the asset and debit the related accumulated depreciation). Record a gain or loss on disposal of the asset, which is computed as the difference between the proceeds from the sale and the book value of the asset. If the cash proceeds are greater than the book value, a gain (credit difference) is recorded. If the cash proceeds are less than the book value, a loss (debit difference) is recorded

Revenue Expenditures

expenditures that do not increase the future economic benefits of the asset; are expensed in the same period the expenditure is made; these expenditures maintain the level of benefits provided by the asset, relate only to the current period, occur frequently, and typically involve relatively small dollar amounts; ex. ordinary repair and maintenance of an asset

Capital Expenditures

extend the life of the asset, expand the productive capacity, increase efficiency, or improve the quality of the product; because these expenditures provide benefits to the company in both current and future periods, capital expenditures are added to an asset account and are subject to depreciation; typically involve relatively large dollar amounts; ex. extraordinary repairs, additions, remodeling, improvements

Differences between Straight-Line and Declining Balance Method

1) The straight-line method multiplies a depreciation rate by the depreciable cost of the asset. However, the declining balance method multiplies a depreciation rate by the book value of the asset. Because the book value declines as depreciation expense is recorded, this produces a declining pattern of depreciation expense over time. 2) The straight-line method records an equal amount of depreciation expense each period of the asset's life. It is likely that the computation of depreciation expense under the declining balance method would cause the asset's book value to fall below its residual value. Typically, a lower amount of depreciation expense (relative to what is calculated under the declining balance method) must be recorded in the last year of the asset's life so that depreciation stops once the residual value is reached.

Depreciation and Income Taxes

A company can choose between the three depreciation methods discussed earlier as it prepares its financial statements, but the depreciation method used in preparing its tax return does not need to be the same; tax depreciation rules are designated to stimulate investment in operating assets and, therefore, are not guided by the matching concept

Book Value

Cost - Accumulated Depreciation = Book Value

Depreciation for Partial Years

If the asset is purchased during the accounting period, the matching principle requires that depreciation be recorded only for the portion of the year that the asset was used to generate revenue

Recording Intangible Assets

recorded at cost; For internally developed intangible assets, the cost of developing the asset is expensed as incurred and normally recorded as research and development (R&D) expense; the cost of an intangible asset with a finite life, is allocated to accounting periods over the life of the asset to reflect the decline in service potential. This process is referred to as amortization. If intangibles have indefinite lives, they are instead reviewed at least annually for impairment;

Residual Value

the amount of cash or trade-in consideration that the company expects to receive when an asset is retired from service

Operating Assets

the long-lived assets that are used by the company in the normal course of operations; are not sold to customers; used to generate revenue

Revise Depreciation Expense

Step 1: Obtain the book value of the asset at the date of the revision of depreciation Step 2: Compute depreciation expense using the revised amounts for book value, useful life, and/or residual value

Useful Life

is the period of time over which the company anticipates deriving benefit from the use of the asset

Depreciation Methods

standardized calculations required to determine periodic depreciation expense; -striaght-line -declining balance -units-of-production

The decline of service potential of an Operating Asset is called...

-Depreciation for property, plant, and equipment assets -Amortization for intangible assets -Depletion for natural resources

Impairment

-Is a permanent decline in the future benefit or service potential of an asset - Impairment may be due to numerous factors, including too little depreciation expense being recorded in previous years or obsolescence of the asset. -A company is required to review an asset for impairment if events or circumstances lead the company to believe that an asset may be impaired. -Consistent with the principle of conservatism, if a fixed asset is impaired, a company should reduce the asset's book value to its fair value in the year the impairment occurs

Operating Costs are recorded...

1) At acquisition, they are recorded at its cost, illusion the cost of acquiring the asset and the cost of preparing the asset for use (historical cost principle) 2) As the service potential of an operating asset declines, the cost of the asset is allocated as an expense among the accounting periods in which the asset is used and benefits are received (the matching principle)

Depletion

1) Depletion Rate = (Cost - Residual Value) ÷ Recoverable Units 2) Depletion = Depletion Rate X Units Recovered

3 Categories of Operating Assets

1) Property, plant, and equipment also known as fixed assets or plant assets. They include land, buildings, machines, equipment, and automobiles. 2) Intangible assets do not have physical substance. They include patents, copyrights, trademarks, licenses, franchises, and goodwill. 3) Natural resources are naturally occurring materials. They include timberlands and deposits such as coal, oil, and gravel.

Average Age of Fixed Assets

Average Age of Fixed Assets = Accumulated Depreciation / Depreciation Expense; Investors are also concerned with the condition of a company's fixed assets. Typically, older assets tend to be less efficient.

Units-of-Production Method

When the decline in an asset's service potential is proportional to the usage of the asset and asset usage can be measured; usage is typically gauged by a measure of productive capacity such as miles, hours, or production; Depreciation Cost per Unit = (Cost - Residual Value) ÷ Expected Usage of the Asset then Units-of-Production Depreciation Expense = Depreciation Cost per Unit X Actual Usage of the Asset

Depreciation

allocating, in a systematic and rational manner, the cost of a tangible fixed asset (other than land) to expense over the asset's useful life; matching principle; recorded each period as DEPRECIATION EXPENSE on the income statement

Cost of a Fixed Asset

an expenditure necessary to acquire the asset and to prepare the asset for use; expenditures that are included as part of the cost are said to be CAPITALIZED, expenditures that are not included as part of the cost of the asset are EXPENSED immediately

Expenditures after Acquisition

companies incur costs over the life of the asset that range from ordinary repairs and maintenance to major overhauls, additions, and improvements; companies must decide whether these expenditures should be capitalized (added to an asset account) or expensed (reported in total on the income statement

Intangible Operating Assets

like tangible assets, represent future economic benefit to the company, but unlike tangible assets, they lack physical substance; Patents, copyrights, trademarks, leaseholds, organization costs, franchises, and goodwill are all examples of intangible assets;The economic benefits associated with most intangible assets are in the form of legal rights and privileges conferred on the owner of the asset.