ACCTG 211_Reimers Chap 4

Basket Purchase

Buying a building with the land it occupies is an example of a "basket purchase" b/c two assets are acquired for a single price

Depreciable Base

Cost (acquisition cost) - salvage value

Modified Accelerated Cost Recovery System (MACRS)

-used to calc deduction for tax returns -Allowed for tax purposes but not GAAP -Goal is to give companies incentive to invest in new PPE. If asset can be written off quickly (large deprec deductions over a small number of years) tax benefit from depreciation deductions leaves the company more cash to invest in new assets -More depreciation means less net income to be taxed -When depreciation expense is larger, the amount of taxes a company must pay is smaller -Smaller tax bill = less cash paid to IRS & company's net cash flow for the year will be greater -However, over the life on an asset total depreciation expense is the same, but the difference btw the methods is reflected in the way the total depreciation is allocated to the years the asset is used >The reason a company wants to use an accelerated method like MACRS for tax purposes is so that the largest deductions are taken as soon as possible. Saving tax dollars this year is preferred to saving them next year, b/c it is cash the company can use to buy assets that can increase production and therefore profits

Depreciation Methods (3)

1. Activity or Units of Production 2. Double-Declining Balance 3. Straight-Line

Safeguarding Assets (Business Controls)

1. Physical Controls to safeguard assets, may be as simple as a lock on a warehouse door, a video camera in a retail store, or security guard. companies must be sure that only appropriate people have access to the assets 2. Complete and reliable record keeping for the assets is also part of safeguarding assets (the ppl who are responsible for record keeping for long-term assets, such as cash/inventory, should be diff than ppl who have physical custody of them) 3. Monitoring: another control to safeguard assets. This means that someone needs to make sure the other controls--physical controls, segregation of duties, and any other policies and procedures related to protecting assets--are operating properly. Often, firms have internal auditors--their own employees-- who perform this function as part of their job responsibility 4. Intangible assets present special risk to a Firm (Google attempting to digitize books in lib's of major universities has brought new concerns over copyright laws) Value of these intangible assets on a firm's balance sheet and the potential cost of defending these rights can amount to significant sums of money. Technology and ethics have collided, resulting in many questions about he legal and ethical dimensions of current copyright laws

Calculating Gain/Loss

2 methods: Ex. selling equipment purchased 7 yrs ago, that had estimated useful life of 10 years. Asset cost $25,000, using straight-line w/ salvage value = 0. Depreciation expense was $2,500 yearly, now 7 yrs later, ur selling asset for $8,000. Is there gain or loss? First, Calculate book value on date sold: Book value = Cost - accumulated depreciation Book value = $25,000 - (7yrs x 2500 per year) Book value = $25,00 - 17,500 = 7,500 Then, subtract the book value from the cash proceeds to calculate the gain/loss on sale $8,000 - $7,500 = $500 *Another way to calculate the gain or loss on the sale of an asset is to record the three amounts you know.. 1. Record the receipt of cash (Debit Cash sale) 2. Remove the asset and its accumulated depreciation to date (Credit asset, Debit Acc. Depreciation) 3. Balance the transaction in the accounting equation with a gain or loss (Credit retained earnings, or debit expenses)

Business Risk

A firm risks losing long-term assets due to theft (not problem w/ larger assets such as factories but w/ smaller, mobile, fixed assets, like cars or computers) -even large assets risk damage due to vandalism, hurricanes, or terrorist activities -One of the major functions of any company's internal control system is to safeguard all assets from theft and damage--whether intentional or unintentional

Copyrights

A form of legal protection for authors of "original works of authorship," provided by U.S law -Copyright protection extends beyond written works to musical and artistic works and is available to both published and unpublished works According to the 1976 Copyright Act, owner of copyright can: a. copy the work b. use the work to prepare related material c. distribute copies of the work to the public by sale, rental, or lending d. perform the work publicly, in the case of literary, musical, dramatic, and choreographic works e. perform the work publicly by means of a digital audio transmission, in the case of sound recording -All costs to obtain and defend copyrights are part of the cost of the asset

Impairment

A permanent reduction in the fair market value of an asset below its book value -Such changes include 1. a downturn in the economy that causes a significant decrease in the market value of a long-lived asset 2. A change in how the company uses an asset 3. A change in the business climate that could affect the asset's value

Patents

A property right that the U.S government grants to an inventor "to exclude others from making, using, offering for sale, or selling the invention throughout the United States or importing the invention into the United States for a specified period of time" -As with copyrights, costs to defend patents are capitalized as part of the cost of the asset -Patents are amortized using straight-line amortization over their useful life or legal life, whichever is shorter -Most patents have a legal life of 20 years

Return on Assets (ROA)

A ratio that measures how well a company is using its assets to generate revenue -ROA is an overall measure of a company's profitability -A company's return is what the company is getting back -We want to measure that return as a percentage of assets -SO return on assets is literally RETURN--net income-- divided by assets ROA = (net income + interest expense) / average total assets -B/c interest expense is part of what has been earned to pay creditors, it is added back to the numerator [net income = return to owners, interest expense = return to creditors >>Using a ratio such as ROA gives financial statement users a way to standardize net income across companies

Trademarks

A symbol, word, phrase, or logo that legally distinguishes one company's product from any others -In many cases, trademarks are not amortized because their useful lives are indefinite -Registering a trademark with the U.S. Patent and Trademark Office provides 10 years of protection, renewable as long as the trademark is in use

Asset Turnover Ratio

Another ratio that helps us evaluate a firm's use of its assets is the asset turnover ratio -Indicates how efficiently a company is using its assets -Defined as net sales divided by avg total assets --Ratio answers Q: How many dollars of sales are generated by each dollar invested in assets? Asset Turnover ratio = net sales / avg total assets -Asset turnover ratios vary significantly from industry to industry, so it is important to compare firms only in the same industry -Remember: all ratios have this in common - To be meaningful, ratios must be compared to the ratios from other years w/ the same company or w/ other companies

Relative Fair Market Value Method

A way to allocate the total cost paid for several long-term assets purchased together -Each asset's assigned cost is equal to the product of the total cost and the asset's percentage of the total market value of the assets -For the accounting records, the firm must calculate a separate cost for each asset. Why? -- B/c the firm will depreciate the building but it will not depreciate the land -Firms divide basket purchases price btw the building and land by using this method Ex. Suppose company purchased a building and its land together for one price of $100,000. The company would obtain a "market price", usually in the form of an appraisal, for each item separately. Then, the company uses the relative amounts of the individual appraisals to divide the purchase price of $100,000 btw the two assets. Suppose the building appraised at $90,000 and the land appraised at $30,000 (total = $120,000) - The building accounts for 3/4's of the total APPRAISED VALUE [$90,000 / $120,000 = 3/4] - So, the accountant records the building at 3/4's of the total cost of the BASKET PURCHASE [3/4 x $100,000 = $75,000] -Cost assigned to the land will be the remaining $25,000 [$100,000 - $75,000 = $25,000]

Long-Term Assets (Fixed Assets)

All businesses purchase long-term operational assets such as computers, copy machines, and furniture as well as short-term assets such as folders, paper, and pens -Before a firm purchases a long-term asset, it must determine: 1. How much rev. that asset will generate 2. How much the asset will cost (the cost of a long-term asset must include all of the costs to get the asset ready for use, e.g. setup, prep, training) -A business defers recognizing the expense of a long-term asset until the asset is actually used in the business. when it is used and the expense is recognized, the expense is called depreciation expense -Two categories of long-term assets: tangible assets and intangible assets -These assets are shown on the balance sheet in the last half of the asset section, after current assets -b/c carry value of property, plant, and equipment (PPE) is cost - accum. deprec., accountants say that PPE is reported at its amortized cost or its depreciated cost -The use of long-term assets is shown on the income statement with depreciation, depletion, and amortization expense (often the amount is included in the total of several accounts) -The statement of cash flows will indicate any cash expenditures for PPE as cash used for "investing activities" -Any cash received from the sale (disposal) of long-term assets will be shown as an inflow in the same section--cash from investing activities--of the statement -Remember: gain/loss on sale of long-term asset, reported on the income statement, is NOT the cash related to the sale The cash collected from the sale will appear on the statement of cash flows

Double-Declining Balance

An "accelerated method" of depreciation in which depreciation expense is based on a percentage of the asset's book value; depreciation expense is HIGHER in the EARLY PART of an asset's life and LOWER in the LATER part -Depreciating more of the asset in the first few years also helps even out the total expenses related to an asset, in later years the depreciation expense is lower but repair expenses are likely to be increases

Franchises

An agreement that authorizes someone to sell or distribute a company's goods or services in a certain area -The initial cost of buying a franchise is the franchise fee, and this is the intangible asset that is capitalized -It is amortized over the life of the franchise if there is a limited life (if indefinite it will not be amortized)

Straight-Line

An equal amount of depreciation expense is recognized in each accounting period of an asset's life [Acquisition cost - salvage value] / Estimated useful life in years = Annual depreciation expense] -A company's accounting records always preserve the acquisition cost of the asset and disclose the cost on the balance sheet or in the notes, so the company will keep the total accumulated depreciation in a separate account and subtract it from the acquisition cost of the asset on the balance sheet 1. Book value x (2/Estimated useful life in years) = Yearly expense Note: the calculation of the annual depreciation expense ignores any salvage value because book value equals cost minus accumulated depreciation, but salvage value must always be kept in mind so that the book value of the asset is never lower than its salvage value *The last year's depreciation expense will be the amount needed to get the book value of the asset equal to the salvage value

Revenue expenditure

Any expenditure that will benefit only the current accounting period is expensed in the period in which it is incurred (sometimes called revenue expenditure, although expense really captures its meaning in a more logical way) -Ex. ordinary repairs, routine maintenance, painting, tuneups for vehicles, or cleaning and lubricating equipment

Tangible Assets

Assets with physical substance (can be seen or touched) -Buildings, equipment, land

Carrying Value (Book Value)

Cost (acquisition cost) less total depreciation taken to date -"The asset is worth $10,000 on our books," does not mean the asset is actually worth that amount if it were sold -Instead it means that $10,000 is the carrying value or book value of the asset in the accounting records--It is the amount not yet depreciated -It is called the carrying value because that is the amount at which we carry our assets on the balance sheet

Capital Expenditure

Cost that is recorded as an asset at the time it is incurred -Any expenditure that will benefit more than one accounting period -is expensed or amortized over the accounting periods in which it is used -Remodeling and improvement projects are capital expenditures b/c they will offer firms benefits over a number of years -Ex. Remodeling, such as new wiring system to increase the efficiency of the electrical system of a building; improvements, such as a more energy-efficient air-conditioning system, upgrading computer software to expand its capability or useful life

Salvage Value (Residual Value)

Estimated value the asset will have when the company is done with it--the salvage value is the estimated market value on the anticipated disposal date -Is an estimate that you may need to revise more than once during the life of the asset

Estimated Useful Life

How long the company plans to use the asset -May be measured in years or in units that the asset will produce

Segregation of Duties

Means that the person who has physical custody of an asset is not the same person who has record-keeping responsibilities for that asset

Research and Development Costs (R&D costs)

R&D costs have benefits to the firm -However, R&D costs are expensed and are not capitalized as part of the cost of an asset because it is not clear that these costs represent something of value

Intangible Assets

Rights, privileges, or benefits that result from owning long-lived assets that lack physical substance -Patents -Trademarks -Copyrights

Depreciation and Taxes

The accounting information a company presents on its financial statements is not he same information the company reports to the IRS on its federal income tax return -GAAP and the IRS require different information to be reported, so companies will use an information system that can produce two sets of data -For depreciating fixed assets (long-term), corporations use MACRS method to calc deduction for their tax returns (saves tax dollars this year, so company has more cash to buy assets next year to generate profits)

Depletion

The amortization of a natural resource -The company shows depreciation and depletion together on the balance sheet -Depletion is similar to the activity depreciation method, but it applies only to writing off the cost of natural resources -Ex. of such natural resources are land being used for oil wells and mines -Depletion cost is calculated in the same way activity depreciation method uses.

Gains and Losses

The difference between the proceeds from the sale of a long-term asset and the book value at the time of sale; positive diff. are gains, neg. diff. are losses -Calculate the gain or loss on the disposal of an asset by comparing the cash received for the sale of the asset--also known as cash proceeds--and the asset's book value at the time of disposal -A gain is a special kind of revenue that is shown on the income statement (under retained earnings) -A loss is a special kind of expense, and it is shown on the income statement

Goodwill

The excess of cost over market value of the net assets when one company purchases another company -When you see goodwill on a company's balance sheet, you know that it is a result of purchasing another company for more than the fair market value of its net assets -GAAP does not allow a company to recognize its internally developed goodwill, so a company's financial statements do not include goodwill -Not amortized b/c it is assumed to have an indefinite life

Acquisition cost

The historical cost principle requires a company to record an asset at the amount paid for the asset-its cost. -Cost includes all expenditures that are reasonable and necessary to get an asset in place and ready for use 1. When firm purchases land to use as location of building/factory, acq. cost includes: a. Price paid for land b. Real estate commissions c. Attorney's fees d. Costs of preparing the land for use (clearing/draining) >>In general, land is not depreciated (because land typically retains its usefulness and is not consumed to produce rev., its cost remains unchanged on the balance sheet as a long-term asset 2. When a firm purchases a physical plant, cost includes: a. Purchase cost of buildings/factories b. Costs to update or remodel the facilities c. Any other costs to get the plant operational 3. When a firm purchases equipment, cost include: a. purchase cost b. Freight-in (cost to have the equipment delivered) c. Insurance while in transit d. Installation costs, including test runs e. Cost of training employees to use the new equipment 4. When a firm constructs or renovates a building, acquisition cost includes: a. Architects' or contractors' fees b. Construction costs c. Cost of renovating or repairing the building >>Recall that depreciation is not meant to value an asset at its market value. Rather, it is the systematic allocation of the cost of an asset to the periods in which the asset is used by the firm to generate revenue

Market Value

The price at which an asset could be exchanged in the market between willing buyers and sellers

Amortization

The write-off (or expensing) of the cost of a long-term asset over multiple accounting periods -Usually relates to intangible assets - If an intangible asset has an indefinite useful life, the asset is not amortized (however, a firm will periodically evaluate the asset for any permanent decline in value and then write it down if necessary, this means reducing the amount of the asset and recording a loss that will go on the income statement) -Intangible assets that have a limited life are written off over their useful life or legal life (whichever is shorter, using straight-line amortization) -Accumulated depreciation and accumulated amortization are often added together for the balance sheet presentation

Allowances for depreciation and depletion

This is another way of expressing "accumulated" depreciation and depletion amounts

Capitalize

To record a cost as an asset rather than an expense -Until property, plant, and equipment are put into use, their costs remain as assets on the balance sheet -As soon as the firm uses the asset to help generate revenue, the financial statements will show some of expense on the income statement

Activity or Units of Production

Useful life is expressed as the total units of activity or production expected from an asset; asset is written off in proportion to its activity during the accounting period -Ex. of activities are miles driven or units produced 1. [Acquisition cost - salvage value] / Estimate useful life in activity units = Rate per activity unit 2. Rate x Actual activity level for the year = Annual depreciation expense >It is important to keep a record of the book value of the asset so that the company does not depreciate the asset lower than its estimated salvage value