Chapter 7

QUICK CHECK 1: Smatter corporation purchased land for a new building. Which of the following costs would not be included in the cost of the land? A) Purchase price of the land B) Cost of demolishing an old garage located on the land C) Cost of a new parking lot constructed on the land D) Brokerage commission paid to the real estates agent who handled the land transaction

C - Cost of a new parking lot constructed on the land. This would be considered a new expense, and the parking lot is a new asset that would depreciate.

QUICK CHECK 9: The depreciation method that does not initially use the residual value in depreciation calculations is the: A) Straight-line method B) Units-of-production method C) Double-declining balance method D) Direct method

C - The double declining balance method starts out by dividing 1 by the number of years your asset will have value. This gives you a rate to later figure out each years depreciation.

Capital Expenditures vs. Expense: New storage compartments added to the company truck

Capital Expenditure - It extends the assets capacity

Capital Expenditures vs. Expense: Modification of body for new use of truck

Capital Expenditure - It is going to extend the life of the vehicle since it is a upgrade

Capital Expenditures vs. Expense: Major Engine Overhaul on Company Vehicle

Capital Expenditure: - It is going to extend the life of the vehicle since it is a upgrade

Partial Year Depreciation

Companies purchase planet assets when they need them. Not just the beginning of the year. Therefore you must compute depreciation for partial years.

Research & Development Costs

Costs incurred to develop and create new products. Represents perhaps the most valuable activity many companies engage in, particularly companies in the software, technology, aerospace, pharmaceutical, and consumer products industries.

QUICK CHECK 5: Capitalizing a cost involves increasing what type of account? A) Liability B) Expense C) Stockholders' Equity D) Asset

D - Asset, this is because when you capitalize the cost you are extending the life or increasing the capacity of an asset.

QUICK CHECK 12: Which of the following is an intangible asset? A) Land B) Leasehold Improvements C) Equipment D) Copyright

D - Copyright

QUICK CHECK 14: Which of the following is a measure of profitability? A) Quick (acid-test) ratio B) Net Sales C) Inventory Turnover D) Return on Assets (ROA)

D - Return on Assets

Formula: Depreciable Cost

DC = Assets Cost - Estimated Residual Value

Formula: DDB Depreciation

DDB Depreciation / year = (1 / Useful Life in Years) * 2

Units-of-production Depreciation Method

A fixed amount of depreciation is assigned to each unit of output, or unit of service, produced by the asset

QUICK CHECK 2: Carlos Company purchased a building and land for $400,000 in total. Individually, the land appraised for $84,000 and the building appraised for $336,000. How much of the purchase price should be allocated to the cost of the land?

$80,000

How to separate Basket Purchases

1 - Take each asset and determine its market value. 2 - Divide the assets market value by the total of all assets markets value. This will give you the percentage of Total Market Value 3 - Multiply the percentage by the total fixed price paid for the assets 4- The result will be the cost of each asset within the bundle

Goodwill Special Features

1) Goodwill is recorded only when it is purchased in the acquisition of another company. Companies never record goodwill they create for their own business. 2) According to GAAP is not amortized because for many entities, it increases in value over time.

Reasons why Plant Assets are Complex

1) They have long lives 2) Depreciation affects income taxes 3) Companies may have gains or losses when they sell plant assets

Causes of Depreciation

1. Physical wear and tear - Ex. Vehicles 2. Obsolescence - Ex. Technology

QUICK CHECK 4: When a company expenses the cost of maintenance for its heating and cooling system, that cost will appear on its: A) Income Statement B) Statement of Retained Earnings C) Balance Sheet D) Statement of Stockholders' Equity

A - Income Statement, You define your expenses on your income statement

DuPont Analysis

A detailed approach to measuring the rate of return on equity (ROE)

Modified Accelerated Cost Recovery System (MACRS)

A special depreciation method used only for income-tax purposes. Depreciation for 15-year and 20-year assets is used 150% declining-balance method Under 150% DB, annual depreciation is computed by multiplying the straight-line rate by 1.50 (instead of 2.00 as for DBB).

Depletion

Actually tracking the flow of a natural resource from its raw state, through inventory to the cost of goods sold or some other expense on the income statement.

Adjusting Depreciable Assets Useful Life

After an asset is in use, managers may change its useful life on the basis of experience and new information

Amortization

Allocating the cost of an asset (or liability) to expense over the period its useful life. This is depreciation on leasehold improvements.

Trademarks / Trade names

Also known as Brand names. Distinctive identifications of products or services

Plant Assets

Also known as Property, Plant, and equipment or fixed assets. Are long-lived assets that are tangible. Land, buildings and equipment are examples.

Return on Assets (ROA)

Also known as rate of return on total assets, it measures how effectively and how efficiently a company has used its assets to generate net income (profit)

Estimated Residual Value

Also known as scrap value or salvage value, it is the expected cash value of an asset at the end of its useful life

Straight-line Depreciation Method

An equal amount of depreciation is assigned to each year (or period) of asset use. The depreciable cost is divided by the asset's useful life in years to determine the annual depreciation expense.

Capital Expenditures

An expenditure that increases an asset's capacity or extends its useful life. Capital expenditures are debited to an asset account. Note: Costs that do not extend the asset's capacity or its useful life, but merely maintain or restore the asset, are expenses.

Formula: Straight-line Depreciation

Depreciation per year = (Cost - Residual Value) / Useful Life (In Years)

Journal Entry: Suppose the final year's depreciation expense was just recorded for a machine that had an original cost of $60,000 and is estimated to have zero residual cost.

Dr. Accumulated Depreciation - Machinery $60,000 Cr. Machinery - $60,000 Note: To dispose of a fully depreciated machine.

Journal Entry: Amortization of the purchased patent, expected life of 16 years. Create a journal entry for the first year of amortization.

Dr. Amortization Expense - Patents $12,500 Cr. Patents $12,500

Journal Entry: Suppose FedEx acquires Europa Company at $10 million dollars. Europa's assets have a market value of $9 million, and their liabilities are marketed at $2 million. Create the record of acquisition.

Dr. Assets $9,000,000 Dr. Goodwill $3,000,000 Cr. Liabilities $2,000,000 Cr. Cash $10,000,000

Journal Entry: Sale of equipment. Equipment original cost of $10,000, Accumulated Depreciation of $2,000, Sold for $5,000

Dr. Cash $5,000 Dr. Accumulated Depreciation - Equip $2,000 Dr. Loss on Sale of Equipment $3,000 Cr. Equipment $10,000

Journal Entry: Sale of equipment. Equipment original cost of $10,000, Accumulated Depreciation of $2,000, Sold for $9,000

Dr. Cash $9,000 Dr. Accumulated Depreciation - Equip $2,000 Cr. Equipment $10,000 Cr. Gain on Sale of Equipment $1,000

Journal Entry: ExxonMobil sold one third of their new oil inventory. Ignore the entry to sales revenue and make a journal entry for Cost of Oil Sold

Dr. Cost of Oil Sold $10,000,000 Cr. Oil Inventory $10,000,000

Journal Entry: Straight-line Depreciation for Equipment originally purchased at $10,000 with the residual life of $0, 1 full year of depreciation, 10 years of useful life

Dr. Depreciation Expense $1,000 Cr. Accumulated Depreciation Equipment $1,000 Note: To update depreciation Formula: ($10,000 - $0) / 10 years = $1,000 / year

Journal Entry: Straight-line Depreciation for Equipment originally purchased at $10,000 with residual life $100, 9 months of depreciation, 10 years of useful life

Dr. Depreciation Expense $742.50 Cr. Accumulated Depreciation Equipment $742.50 Note: To update depreciation Formula: (($10,000 - $100) / 10 years) = $990 / year Partial Depreciation: $990 * (9/12) = $742.50

Journal Entry: FedEx has a long-term asset with the net book value of $100 million. The estimated future cash flows is $80 million and the fair market value is $70 million. Test the asset for impairment and make the correct journal entries.

Dr. Impairment Loss on Long-term Asset $30 million Cr. Long-term Asset $30 million Note: Net Book Value ($100) is greater than Future Cash Flows ($80) , the asset is impaired. Loss (30) = Net Book (100) - Fair Value (70)

Journal Entry: Trade an old asset originally purchased at $10,000 with the accumulated depreciation of $8000 in for a new asset worth $15,000. You paid $7,000 in cash to cover the remainder of the trade.

Dr. New Asset $15,000 Dr. Accumulated Depreciation $8,000 Cr. Old Asset $10,000 Cr. Cash $7,000 Cr. Gain on Asset Exchange $6,000

Journal Entry: ExxonMobil depletes 3 million barrels @ $10 per barrel. They transfer this oil into their inventory. Make a journal entry to show this transition.

Dr. Oil Inventory $30,000,000 Cr. Oil Reserve $30,000,000

Journal Entry: ExxonMobil buys an oil reserve for $100 million. It contains roughly 10 million barrels of oil. Make a journal entry to record the purchase of the oil reserve.

Dr. Oil Reserve $100,000,000 Cr. Cash $100,000,000

Journal Entry: Purchase a Patent for $200,000

Dr. Patents $200,000 Cr. Cash $200,000

Normal Relationship Asset Value

Estimated future cash flows represent the largest of the three amounts, followed by fair value, and then net book value.

Copyrights

Exclusive rights to reproduce and sell a book, musical composition, film, or other work of art. Copyrights also protect computer software programs

Impairment

Expected future cash flows (which approx. the expected future benefits) from a long-term asset fall below the asset's net book (carrying) value (cost minus accumulated depreciation/amortization). Example: Pharmaceutical company has a patent on a new drug. The drug causes toxic side-effects. The patent is now determined to be impaired, because it lost value

Capital Expenditures vs. Expense: Repair of transmission on company truck

Expense - This is a reactive maintenance item

Capital Expenditures vs. Expense: Oil change on company truck

Expense - This is routine maintenance

Capital Expenditures vs. Expense: Replacement of tires

Expense - This is routine maintenance

Patents

Federal government grants that give the holder exclusive rights for 20 years to produce and sell an invention

Land Improvements

Fencing, paving, security systems and lighting.

Formula: Changing the Useful Life of a Depreciable Asset

From the period in which it is determined the useful life will be longer the formula should divide the remaining book value by the new estimated time remaining. New Annual Depreciation = Assets Remaining Book Value / Estimated Useful Life Remaining

Fair Value

If an asset is impaired, the company is required to adjust the carrying value downward from its book value to its fair value (The amount that a business could sell an asset for, or the amount it could pay to settle a liability)

Impaired Relationship Asset Value

If an asset's net book value exceeds it's estimated future cash flows. The process of accounting requires two steps: 1) Test the asset for impairment. If the net book value is greater than the estimated future cash flows, its impaired. 2) If the asset is impaired under step 1, compute the impairment loss.

Lump-Sum (Basket) Purchases of Assets

If you purchase several assets for a fixed price, you need to identify the cost of each asset separately. This is because assets will depreciate value, and if you do not depreciate the value properly you could overstate your assets.

Formula: Impairment Loss

Impairment Loss = Net book value - Fair value

Double-declining-balance (DDB) Depreciation Method

It is an accelerated depreciation method because it writes off larger amount of an asset's cost in the early years of its useful life. The method computes annual depreciation by multiplying the declining book value at the beginning of the year by a constant percentage that is two times the straight-line depreciation rate.

Why would companies opt to use accelerated depreciation methods for assets if they lose more value of the assets in early years?

It provides the fastest tax deductions, thus decreasing a companies immediate tax payments. This allows them to re-invest their savings directly back into the company.

Estimated Useful Life

Length of service expected from using the asset, which can be expressed in years, units of output, miles or some other measurement

Natural Resources

Long-term assets such as oil and gas reserves, coal mines, or stands of timber. As the natural resources is extracted, its cost is transferred to inventory. Later, as the inventory is sold, its cost is transferred tot he cost of goods sold in a manner similar to Chapter 6.

Intangible Assets

No physical form. These include patents, copyrights, and trademarks. It also includes Goodwill.

Fully Depreciated Assets

Once an asset has reached the end of its estimated useful life, it is fully depreciated. The company may still use the asset for a few more years, but it will no longer record depreciation as the book value of the asset is now zero

Selling Plant Assets

Prior to a sale, the depreciation must be updated. Use the partial-year depreciation formula to determine its current value.

Franchises and Licenses

Privileges granted by a private business or government to sell a product or service in accordance with specified conditions.

Formula: Return on Assets

ROA = Net Income / Average Total Assets

Formula: Partial Year Depreciation

Step 1) Calculate the Full-Year Depreciation Depreciation = (Full Year) * (Months)/12 (Full Year) = Depreciation for an entire year (Months) = The number of months the asset was losing value. If purchased at the end of March, it would be 9/12

Methods of Depreciation

Straight-line Method Units-of-production Method Double-declining balance Method

Cost of Land

The cost of land includes its purchase price (cash + any notes payable); brokerage commission, survey fees, legal fees; and any back property taxes the purchaser pays. Note: The cost of land does not include fencing, paving, security systems, and lighting. These are noted as Land Improvements

Depreciation Expense

The expense associated with plant assets. Land is the only plant asset that is not depreciated because its usefulness does not decrease.

Disposing of Fully Depreciated Assets

To account for an asset's disposal, remove it and its related accumulated depreciation from the books. If the asset is junked you would debit Accumulated Depreciation and credit the Asset

Formula: Units-of-production Depreciation

UoP Depreciation per unit of output = (Cost - Residual Value) / Useful Life in units of production

Goodwill

Very specific meaning in Accounting. Goodwill is defined as the excess of the cost of purchasing another company over the sum of the market values of the acquired companies net assets (assets minus liabilities)

Formula: DuPont Analysis

[1] Net Profit Margin Ratio = Net Income / Net Sales [2] Total Asset Turnover = Net Sales / Avg Total Assets ROA = [1] * [2]