ACCT Session 15

Ordinary Repairs and Maintenance Costs

-Costs that result from the "normal use" of the asset -Incurred to maintain the normal function (use) of the asset -Recorded as expenses in the period when incurred -Examples: oil changes, replacing headlights, etc.

Improvement and Betterment costs

-Expenditures that increase the productive life, the operating efficiency, or the capacity of the asset -Referred to as "capital expenditures" -Capitalized by increasing the book value of the asset -So, they lead to a larger depreciation expense in the future

Depreciation, two types

1) Expensed (for non-manufacturing plant and equipment) 2) Capitalized as part of Work in Process (for manufacturing plant and equipment)

Depreciation Choice

A firm's management has considerable discretion over the choice of the depreciation method to be used for financial reporting purposes, as well as the estimates of useful life and salvage value. Firms can use different depreciation methods and estimates for income tax and for financial reporting purposes. In the U.S. that is typically the case. In the U.S., the depreciation schedules to be used to determine the firm's taxable income (each period) are mandated by the IRS which offers little or no discretion. (They are based on an accelerated depreciation method.) Typically, whether for tax or for financial reporting, the total amount of the depreciation expense that may be reported over the life of the asset will be the same regardless of the method used.

Q3: A delivery van costing $10,000 is expected to have a $3,000 salvage value at the end of its useful life of 5 years. Assume that the truck was purchased on January 1, 2019. Compute the depreciation expense for year 2 using the double-declining-balance method.

A: 2400 10K - 4K = 6K * 0.4 = 2400

Interest Capitalization Example: On January 1, 2016, the firm began construction of a new manufacturing plant. The project was expected to take 3 years to complete at a cost of $4,000,000. For 2016, the firm's average investment in the plant under construction amounted to $750,000. For the year, the firm's average outstanding interest bearing debt (liabilities) amounted to $2,500,000 with an average interest rate of 8%. How much interest should the firm capitalize in 2016 related to the construction of the plant?

A: can only capitalize 60,000 Want to capitalize interest that is used for the construction, aka 750,000 Multiply this by 8% interest rate to find amount of interest that we need to capitalize 140,000 → take 2.5 million, subtract 750,000 and multiply by 0.08 ***There is interest capitalization because there is a loan

Impairment

An asset impairment arises when it is expected that the firm will not be able to recover the carrying (net book) value of the asset. Compare the carrying value of the asset and the undiscounted net cash flows attributable to it. A variety of different events and changes in circumstances might indicate an impairment, e.g., a)a decrease in the market value of the asset; b)a change in the way that the asset is used; c)a forecast that demonstrates continuing losses associated with the asset; d)an adverse change in the legal or business climate the affects the value of the asset.

Q1: Which of the following costs should be capitalized immediately (there may be more than one)? A.Paid $1,000 for routine maintenance of machinery. B.Paid $2,000 to rent equipment for two years. C.Paid $5,000 to equip the production line with new instruments that measure quality. D.Paid $20,000 to repair the roof on the building. E.Paid $1,000 to refurbish a machine, extending its useful life.

Answer: B, C, E A) routine maintenance → no capitalization, expensed right away B) paying 2K to rent equipment → yes capitalization, basically prepaid rent, you do capitalize that because it is an asset account C) paid 5k to equip production line with new instruments that measure quality → yes capitalization because it is an improvement D) paid 20k to repair the roof on a building→ no capitalization, this is an expense, repairing roof is part of routine maintenance, unless we are given the info that the repairment improved useful life, we can't say it's capitalization E) paid 1k to refurbish a machine, extending its useful life → yes capitalization, its an improvement and it clearly extends useful life Purchasing PPE → form of capitalization, later on expensing it through depreciation **Capitalization → delaying expense because of the matching principle

Long-Lived Assets

Are not acquired for resale to customers. Are used in the operations of the business to generate revenues for multiple accounting periods. Tangible (Land, Buildings, Equipment). Intangible (Patents, Trademarks, Copyrights, Goodwill).

Relationship with net income

As a result of changing estimates, net income increases When you increase useful life (denominator in the equation), depreciation expense is decreasing and so therefore net income is increasing

Q6: If the sale of a depreciable asset results in a gain, the proceeds from the sale were

B - greater than book value Current fair value is basically the price you are selling -- proceeds from sale cannot be greater than market value, must be the same Proceeds is greater than net book value because it is a gain C Not correct because cost hasnt been depreciated -- book value is going to be lower than initial cost Gain → when proceeds are greater than book value!!

Q5: When the estimate of an asset's useful life is changed, A.Only depreciation expense in the current year is affected. B.Only depreciation expense for current and future years is affected. C.Depreciation expense for all past periods is affected. D.There is no change in the amount of depreciation expense recorded for future years.

B is correct answer We are using the prospective approach ***if the useful life is increasing, depreciation expense is decreasing and so net income is increasing

Q4: A delivery van costing $10,000 is expected to have a $3,000 salvage value at the end of its useful life of 5 years. Assume that the truck was purchased on January 1, 2019. Compute the depreciation expense for year 3 using the double-declining-balance method.

Beginning net book value = 6K - 2400 = 3600 Then multiply it by 0.4 = 1440 How much do we need to fully depreciate the asset? 10K - 3K = 7K Up tp year 2, we had depreciated by 6,400 So only need to depreciate 600 dollars more, even tho using the formula u get depreciation expense of 1440, only recognize 600 as actual depreciation expense

The Flow of Manufacturing Costs

Blue arrows -- capturing capitalization Taking raw materials, depreciation, or wages and debiting them to an asset account specifically work in process inventory Red arrows -- expensing, opposite of capitalization, taking depreciation and expensing it right away rather than debiting it to an asset account

Manufacturing Inventory Costs Review

Costs incurred in the manufacturing process, to produce goods for sale, are capitalized as a cost of Work-in-Process Inventory when they are incurred. These costs include: -Cost of raw materials used -Direct labor costs -Depreciation of manufacturing-related equipment -Utilities and other costs related to manufacturing Subsequently, those costs are transferred (from Work-in-Process inventory) to the Finished Goods inventory as production is completed and the goods become available for sale. It is only when the goods are sold and delivered to the customer that the costs of producing them are expensed as the Cost of Goods Sold(when the inventories are removed from the Finished Goods inventory account).

Self-Construction, Example: Instead of purchasing the aircraft, Delta incurred the following costs to build the aircraft. -Used materials, cost = $40 million-Incurred wages (not paid), $10 million -Used equipment, relevant depreciation was $7 million -$1 million of utilities used to build the aircraft -$2 million of interest costs incurred, during the period of construction, on a $59 million loan undertaken to finance the project What should the journal entries be?

Debit all of these individual costs through the PPE asset account Then since you finance loan you are still going to have **important note: important to see how all the payables the inventory and the depreciation are debited to an asset account NOT an expense account You are not debiting depreciation expense or wage expense, you are debiting PPE

Example Acquisition of PPE by Purchase "On January 14, Delta Air Lines purchased an aircraft paying $1,000,000 cash and issuing a 10-year note for $59,000,000."

Debit equipment 60 mill, credit cash 1 mill and credit note payable 59 mill

Q7: Lambert Furniture Corp sold furniture and fixtures that were eight years old for $3,500 in cash. The assets had been purchased for $40,000 and had been depreciated using the straight-line method with no residual value and a useful life of ten years. What is the journal entry to record this sale transaction?

Debit to cash, debit to loss, debit to accumulated depreciation 32k and credit furniture 40k When disposing of an asset, removing both asset such as furniture and removing accumulated depreciation by debiting it 32k because we know that they are selling it 8 years, each year its 4k

Definition of goodwill

Excess of purchase price minus the fair value of the firm's identifiable asset

A note on interest capitalization

Firms can capitalize interest costs on any debt outstanding during the period of construction. -The amount of interest that can be capitalized is based on the amount of the firm's average investment in the self-constructed asset. -Capitalization of borrowing costs ends when the asset is ready for its intended use

GAAP Impairment Benchmarks

First, assess whether impairment is needed: Net book value > estimated undiscounted future cash flows If yes, then recognize impairment holding loss: Netbook value - Fair market value = impairment loss

Changing Estimates

For financial reporting purposes, firms are permitted to change the estimates they use to account for depreciation (i.e., estimates of useful life and/or salvage value). What do we do? -We do NOT make retro-active adjustments to the financial statements. -That is, we do not revise and restate the depreciation for the years prior to the change. -Instead, the depreciation is to be revised going forward. This is called the prospective method and it is used to account for all changes in any of the estimates used to derive the amounts reported in the financial statements.

Acquisition of PPE by Self-Construction Pt 2

Here, firm has to expend cash, materials, pay workers, use equipment and account for depreciation as well as interest → all important components needed to construct equipment/building Debit PPE rather than an expense account In inventory, we are debiting work in process, here we are debiting PPE because it is a long-lived asset **difference is that interest cost related to construction are included here and capitalized as well Purchasing of long-lived asset -- do NOT capitalize interest When you are constructing an asset it takes a much longer period of time compared to purchase, which is at a point in time Interest will be capitalized for self-construction but not for purchase **firms like capitalizing interest → they dont have to recognize it as an expense so makes profits nicer

Self-Construction, Example 2: Now, suppose that, instead of constructing the airplane itself, Delta had contracted with Boeing to have Boeing build the aircraft for it. How would Delta account for this acquisition/arrangement?

If the aircraft is being constructed for Delta's own use (rather than for sale), Delta would account for the acquisition as a self-construction. Delta would capitalize all of the (contract) payments that it made to Boeing (the contractor/builder) & During the period of construction, Delta would also capitalize any interest cost on debt used to finance those payments. --> The way Delta would account for this is the same, by capitalizing all contract payments to PPE Doesn't matter whether you are contracting a company or building it your own Going to account for it by capitalizing all payments to PPE, NOT going to recognize expense

Depreciation example - straight-line Rita's Pita Company bought a new dough machine at the beginning of the year at a cost of $6,000. The estimated useful life of the machine was four years and the residual value was $1,000. Assume that Rita estimated that the useful life of the machine was 9,000 hours. Actual annual usage was 3,600 hours in year 1; 2,700 hours in year 2; 1,800 hours in year 3; and 900 hours in year 4.

Net book value → purchase price of 6k- depreciation expense of 1,250 for future years, subtracting ACCUMULATED depreciation Why would you use straight-line vs. double declining? -Use double-declining if firm uses asset more in earlier years Double declining balance → take rate of straight line and multiply by 2 -For straight line = ¼ -For double declining = ½ each year -After year 1 → net book value is going to be 6k - 3k Take next 3k dollars and multiply it by 50% After year 2 → net book value is 15k Next step is to multiply that by 50% → 7500 dollars, but that amount is greater than salvage value of 500 dollars, so only record 500 dollars in year 3 In year 4 we have zero depreciation expense, have already fully recorded depreciation

Depreciation explained

Periodic depreciation can be thought of as an estimate of the cost of a long-lived asset used each period. (And, accumulated depreciation is the sum of the past periodic costs.) The factors that may influence the amount of periodic depreciation are: -acquisition cost -salvage value -the amount that the firm expects to recover from the disposal of the asset. It represents the part of the cost of the asset that will not be used (will not be depreciated). expected useful life -the period over which the asset is expected to provide benefits and over which its cost is to be depreciated. -expected useful life -the period over which the asset is expected to provide benefits and over which its cost is to be depreciated. There are several methods that may be used to determine the amount of periodic depreciation. The choice of the particular one(s) that a firm will use is management's.

Matching principle

Producing inventory and haven't sold it yet → not going to recognize expense right away but rather going to capitalize it Take work-in-process and then transfer it to finished goods

Purchased asset vs. self-constructed asset

Purchased asset, i.e. buying land Mostly purchase price that will be capitalized Self-constructed asset, i.e. constructing a building -Amount that will be capitalized is all of the costs that are used to construct the asset -Also going to be capitalize interest cost of any debt used for construction -Any interest cost paid on that outside financing will also be capitalized as part of the asset What this implies -- if we look at interest expense, it wont reflect all of the interest firm is paying because some of that interest will actually be capitalized to an asset account, so its not recognized on income statement

Important note

Repair and maintenance cost for assets used in production are capitalized as part of the cost of work-in-process inventory

Ordinary repairs and maintenance vs. improvement/betterment

Repairs → expense it right away Routine maintenance Do not increase future benefit because they just maintain normal function of the asset, thus they are not capitalized Improvements → capitalizing it, because when we are making these improvements we are increasing the value of the asset so it's going to have a more expected future benefit Basically upgrading PPE

PPE - have self-constructed PPE and purchased PPE

Self-constructed -- firm constructs it on its own, taking raw materials and hiring workers to build building Purchase PPE -- buying an existing building or machine

Impairment Example Information

Solomon Corporation manufactures a variety of consumer electronics products. The growing popularity of its BluRay Disc players is expected to reduce the demand for its DVD player. The DVD player is produced on an assembly line consisting of five special purpose machines that have a total historical cost of $5,000,000 and accumulated depreciation of $3,000,000 as of the end of 2016. Thus, the 2016 net book value of the machines is $2,000,000. Solomon's management believes that this change in the market threatens the recoverability of the carrying value of these machines. Management estimates that the machines have a remaining useful life of 3 years and the operating cash flows attributable to the production and sale of DVD players and the disposal of the equipment are:

Depreciation diff methods

Straight-line → simplest method, often chosen by default Double declining balance → we are multiplying the rate at which we are recognizing Recognizing same depreciation expense every year Depreciation by 2, which means we are going to depreciate the asset faster in earlier years, and in later years there is going to be less depreciation Form of accelerated depreciation -- depreciating more and earlier years relative to straight-line Sum-of-years digit → another way of doing accelerated depreciation, except here we take the useful life remaining Recognize more depreciation expense in earlier years Units of production -- whenever you have some kind of measurable units that you could measure, i.e. how many pages you've printed or how many hours you've used a machine Would take productive output for the year and divide it by total estimated productive output **firm can use diff depreciation methods for diff assets

Cost of Long Lived assets, for Purchased Assets

The amount to be capitalized should include all of the costs necessary to prepare the asset for its intended use: -Purchase price̶ -Delivery costs̶ -Installation and testing costs, etc.

Cost of Long Lived assets, for Self-Constructed Assets

The amount to be capitalized should include the total of the costs to construct the asset AND the interest cost for any debt used to finance the construction during the period of construction. [Note: This accounting implies that during the periods when the asset is being constructed, the income statement will not report the total amount of the interest cost incurred by the firm.]

Why do we capitalize interest?

We think of interest as a necessary component of asset, without financing would not be able to construct asset in the first place

Disposal

When a long-lived asset is disposed of (sold or scrapped), it is to be removed from the firm's accounting records (i.e., its net book value -cost and accumulated depreciation -is to be removed from the accounts), and any gain or loss from the disposal recognized. Gain/Loss from Disposal = Proceeds -Net Book Value

Acquisition of PPE by Self-Construction

With one exception, the cost of PP&E (buildings and/or equipment) acquired by self-construction is determined in exactly the same way as a cost of a manufactured product i.e. raw materials, wages, depreciation of production ppe, utilities etc. The exception is that, for self-constructed PP&E (but not for manufactured inventory for sale), the cost will also include interest costs on debt outstanding during the period of construction. -The amount of interest to be capitalized is based on the amount that the firm has invested in the self-constructed asset (to date).