Accounting - Chapter 9

book value

the difference between the cost of a depreciable asset and its related accumulated depreciation cost - accumulated depreciation

lessor

A party that has agreed contractually to let another party use its asset for a period at an agreed price.

lessee

A party that has made contractual arrangements to use another party's asset for a period at an agreed price.

impairment

A permanent decline in the fair value of an asset.

three factors in computing depreciation

(1) Cost. All expenditures necessary to acquire an asset. (2) Useful life. Useful life is an estimate of the expected productive life, also called service life, of the asset for its owner. - Useful life may be expressed in terms of time, units of activity (such as machine hours), or units of output. (3) Salvage value. Salvage value is an estimate of the asset's value at the end of its useful life for its owner. - Companies may base the value on the asset's worth as scrap or on its expected trade‐in value. Like useful life, salvage value is an estimate. - In making the estimate, management considers how it plans to dispose of the asset and its experience with similar assets.

advantages of leasing an asset

(1) Reduced risk of obsolescence. Frequently, lease terms allow the party using the asset (the lessee) to exchange the asset for a more modern one if it becomes outdated. (2) Little or no down payment. To purchase an asset, most companies must borrow money, which usually requires a down payment of at least 20%. (3) Shared tax advantages. In a lease, the lessor gets the tax advantage because it owns the asset. It often will pass these tax savings on to the lessee in the form of lower lease payments. (4) Assets and liabilities not reported. Reporting lower assets improves the return on assets (discussed later in this chapter). Reporting fewer liabilities makes the company look less risky. - Certain types of leases, called operating leases, allow the lessee to account for the transaction as a rental, with neither an asset nor a liability recorded.

cost of land

(1) the cash purchase price (2) closing costs such as title and attorney's fees (3) real estate brokers' commissions (4) accrued property taxes and other liens on the land assumed by the purchaser - All necessary costs incurred in making land ready for its intended use increase (debit) the Land account.

financial statements

- Depreciation expense is reported on the income statement. - Accumulated depreciation is reported on the balance sheet as a deduction from plant assets.

lease

A lease is a contractual agreement in which the owner of an asset (the lessor) allows another party (the lessee) to use the asset for a period of time at an agreed price.

double‐declining‐balance method

A common declining‐balance rate is double the straight‐line rate. Using that rate, the method is referred to as the double‐declining‐balance method.

capital leases

A contractual agreement allowing one party (the lessee) to use another party's asset (the lessor); accounted for like a debt‐financed purchase by the lessee. - The lessee shows the leased item as an asset on its balance sheet, and the obligation owed to the lessor as a liability.

operating lease

A contractual agreement allowing one party (the lessee) to use the asset of another party (the lessor); accounted for as a rental by the lessee.

obsolescence

A decline in revenue‐producing ability may also occur because of obsolescence. - Obsolescence is the process by which an asset becomes out of date before it physically wears out.

straight-line method

A depreciation method in which companies expense an equal amount of depreciation for each year of the asset's useful life.

units‐of‐activity method

A depreciation method in which useful life is expressed in terms of the total units of production or use expected from the asset.

declining‐balance method

A depreciation method that applies a constant rate to the declining book value of the asset and produces a decreasing annual depreciation expense over the asset's useful life.

accelerated‐depreciation method

A depreciation method that produces higher depreciation expense in the early years than the straight‐line approach. - In early years, declining‐balance depreciation expense will exceed straight‐line. In later years, it will be less than straight‐line.

return on assets

A profitability measure that indicates the amount of net income generated by each dollar of assets; computed as net income divided by average total assets. - This ratio is computed by dividing net income by average total assets. (Average assets are commonly calculated by adding the beginning and ending values of assets and dividing by 2.) - Return on assets indicates the amount of net income generated by each dollar of assets. - Thus, the higher the return on assets, the more profitable the company.

trademark (trade name)

A word, phrase, jingle, or symbol that distinguishes or identifies a particular enterprise or product. - Because trademarks and trade names have indefinite lives, they are not amortized.

depreciation rate

Alternatively, we can compute an annual rate at which the company depreciates the delivery truck. - 100% divided by the useful life

cash equivalent price

An amount equal to the fair value of the asset given up or the fair value of the asset received, whichever is more clearly determinable. - Once cost is established, it becomes the basis of accounting for the plant asset over its useful life.

copyright

An exclusive right granted by the federal government allowing the owner to reproduce and sell an artistic or published work. - Copyrights last for the life of the creator plus 70 years. - The cost of the copyright consists of the cost of acquiring and defending it.

patent

An exclusive right issued by the U.S. Patent Office that enables the recipient to manufacture, sell, or otherwise control an invention for a period of 20 years from the date of the grant. - The initial cost of a patent is the cash or cash equivalent price paid to acquire the patent. - If the owner incurs legal costs in defending the patent in an infringement suit, the owner adds those costs to the Patents account and amortizes them over the remaining life of the patent.

buildings

Buildings are facilities used in operations, such as stores, offices, factories, warehouses, and airplane hangars. - Companies charge to the Buildings account all necessary expenditures relating to the purchase or construction of a building. - Interest costs incurred to finance a construction project are included in the cost of the asset when a significant period of time is required to get the asset ready for use. - However, the inclusion of interest costs in the cost of a constructed building is limited to interest costs incurred DURING the construction period. - Interest costs that come after the construction has been completed are debited to the Interest Expense account

accounting for intangible assets

Companies record intangible assets at cost. - If an intangible has a limited life, the company allocates its cost over the asset's useful life using a process similar to depreciation. - The process of allocating to expense the cost of intangibles is referred to as amortization. - The cost of intangible assets with indefinite lives should NOT be amortized. - To record amortization of an intangible asset, a company increases (debits) Amortization Expense and decreases (credits) the specific intangible asset. - Evaluating a company's amortization of intangibles helps users determine if net income is overstated.

additions and improvements

Costs incurred to increase the operating efficiency, productive capacity, or expected useful life of a plant asset. - they are capital expenditures and are typically debited to the plant asset affected

depreciable assets

Depreciation applies to three classes of plant assets: land improvements, buildings, and equipment. - Each of these classes is considered to be a depreciable asset because the usefulness to the company and the revenue‐producing ability of each class decline over the asset's useful life. - LAND IS NOT A DEPRECIABLE ASSET. Its usefulness and revenue‐producing ability generally remain intact and can even increase due to scarcity.

depreciation

Depreciation is the process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systematic manner. - Such cost allocation is designed to properly match expenses with revenues - The book value—cost less accumulated depreciation—of a plant asset may differ significantly from its fair value. They are different things.

earnings management

Earnings management reduces earnings quality. - To minimize earnings management, accounting standards now require immediate loss recognition on impaired assets. - Critics of write‐downs note that after a company writes down assets, its depreciation expense will be lower in all subsequent periods.

equipment

Equipment includes assets used in operations, such as store check‐out counters, office furniture, factory machinery, and delivery trucks. - The cost of equipment consists of the cash purchase price, sales taxes, freight charges, and insurance during transit paid by the purchaser. - It also includes expenditures required in assembling, installing, and testing the unit. - Two criteria apply in determining the cost of equipment: (1) the frequency of the cost—one time or recurring, and (2) the benefit period—the life of the asset or one year.

revenue expenditures

Expenditures that are immediately charged against revenues as an expense.

capital expenditures

Expenditures that increase the company's investment in plant assets. - Some companies, in order to boost current income, have improperly capitalized expenditures that they should have expensed.

research and development costs

Expenditures that may lead to patents, copyrights, new processes, and new products; must be expensed as incurred.

ordinary repairs

Expenditures to maintain the operating efficiency and expected productive life of the asset. - Ordinary repairs are debited to Maintenance and Repairs Expense as incurred.

depreciation and income taxes

For tax purposes, taxpayers must use on their tax returns either the straight‐line method or a special accelerated‐depreciation method called the Modified Accelerated Cost Recovery System (MACRS). - Depreciation per financial statements is usually different from depreciation per tax returns.

disposal of plant assets

If the disposal does not occur on the first day of the year, the company must record depreciation for the fraction of the year to the date of disposal.

sale of plant assets

In a disposal by sale, the company compares the book value of the asset with the proceeds received from the sale. - If the proceeds from the sale exceed the book value of the plant asset, a gain on disposal occurs. - If the proceeds from the sale are less than the book value of the plant asset sold, a loss on disposal occurs - Companies report a gain on disposal of plant assets in the "Other revenues and gains" section of the income statement. - Companies report a loss on disposal of the plant asset in the "Other expenses and losses" section of the income statement.

asset turnover

Indicates how efficiently a company uses its assets to generate sales; calculated as net sales divided by average total assets. - When we compare two companies in the same industry, the one with the higher asset turnover is operating more efficiently. - The asset turnover helps users determine how effectively a company is generating sales from its assets.

franchise

Is a contractual arrangement under which the franchisor grants the franchisee the right to sell certain products, to perform specific services, or to use certain trademarks or trade names, usually within a designated geographic area. - Another type is a license. - Franchises and licenses may be granted for a definite period of time, or the time period may be indefinite or perpetual. - When a company incurs costs in connection with the acquisition of the franchise or license, it should recognize an intangible asset. - In the case of a limited life, a company amortizes the cost of a franchise (or license) as operating expense over the useful life. - If the life is indefinite or perpetual, the cost is not amortized.

land improvements

Land improvements are structural additions with limited lives that are made to land, such as driveways, parking lots, fences, landscaping, and underground sprinklers. - The cost of land improvements includes all expenditures necessary to make the improvements ready for their intended use. - Debit the total of these costs to Land Improvements account. - Land improvements have limited useful lives. - As a result, companies expense (depreciate) the cost of land improvements over their useful lives.

revising periodic depreciation

Management should periodically review annual depreciation expense. - If wear and tear or obsolescence indicates that annual depreciation is either inadequate or excessive, the company should change the depreciation expense amount. - When making the change, the company (1) does not change previously recorded depreciation expense, but (2) revises depreciation expense for current and future years. - Now, (1) determine new depreciable cost, (2) divide by remaining useful life

plant assets

Resources that have physical substance, are used in the operations of a business, and are not intended for sale to customers. (PPE, fixed assets, etc) - Except for land, plant assets decline in service potential (ability to produce revenue) over their useful lives. - Companies must (1) keep assets in good operating condition (2) replace worn‐out or outdated assets (3) expand its productive assets as needed

intangible assets

Rights, privileges, and competitive advantages that result from the ownership of long‐lived assets that do not possess physical substance. - Intangibles may be evidenced by contracts, licenses, and other documents. Intangibles may arise from the following sources: 1. Government grants, such as patents, copyrights, licenses, trademarks, and trade names. 2. Acquisition of another business in which the purchase price includes a payment for goodwill. 3. Private monopolistic arrangements arising from contractual agreements, such as franchises and leases.

profit margin

That ratio is calculated by dividing net income by net sales. It tells how effective a company is in turning its sales into income—that is, how much income each dollar of sales provides. PROFIT MARGIN X ASSET TURNOVER = RETURN ON ASSETS

depreciable cost

The cost of a plant asset less (minus) its salvage value.

historical cost principle

The historical cost principle requires that companies record plant assets at cost. - Cost consists of all expenditures necessary to acquire an asset and make it ready for its intended use. (Freight costs, installation costs, etc. are apart of the equipment cost)

amortization

The process of allocating to expense the cost of an intangible asset.

goodwill

The value of all favorable attributes that relate to a company that are not attributable to any other specific asset. - These include exceptional management, desirable location, good customer relations, skilled employees, high‐quality products, fair pricing policies, and harmonious relations with labor unions. - Therefore, companies record goodwill only when there is an exchange transaction that involves the purchase of an entire business. - When an entire business is purchased, goodwill is the excess of cost over the fair value of the net assets (assets less liabilities) acquired. - In recording the purchase of a business, a company debits the identifiable acquired assets and credits liabilities at their fair values, credits cash for the purchase price, and records the difference as the cost of goodwill. - Goodwill is not amortized because it is considered to have an indefinite life.

depreciation methods

Three methods: 1. Straight‐line 2. Declining‐balance 3. Units‐of‐activity - Management selects the method it believes best measures an asset's contribution to revenue over its useful life. - Once a company chooses a method, it should apply that method consistently over the useful life of the asset. - Consistency enhances the ability to analyze financial statements over multiple years. - Straight‐line depreciation is used for some or all of the depreciation taken by more than 95% of U.S. companies.

annual depreciation expense

To compute the annual depreciation expense, we divide depreciable cost by the estimated useful life. - depreciation cost X the depreciation rate