Ch. 7 — Operating Assets

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 designed to stimulate investment in operating assets and, therefore, are not guided by the matching concept.

Revision of Depreciation

-Depreciation expense is based on estimates of useful life and residual value. -As new or additional information becomes available, a company will often find it necessary to revise its estimates of useful life, residual value, or both. -To revise depreciation expense, the following steps are performed: • 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.

Depreciation

-Depreciation is the process of 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. -The matching principle provides the conceptual basis for measuring and recognizing depreciation. -The amount of depreciation recorded each period, depreciation expense, is reported on the income statement. -Accumulated depreciation, which represents the total amount of depreciation expense that has been recorded for an asset since the asset was acquired, is reported on the balance sheet as a contra-asset. • Cost - Accumulated Depreciation = Book Value

*Revenue Expenditures

-Expenditures that do not increase the future economic benefits of the asset are called revenue expenditures and 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. -An example of a revenue expenditure is the ordinary repair and maintenance of an asset.

*Capital Expenditures

-Expenditures that extend the life of the asset, expand the productive capacity, increase efficiency, or improve the quality of the product, are called capital expenditures. -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. -These expenditures typically involve relatively large dollar amounts. -Examples of capital expenditures include extraordinary or major repairs, additions, remodeling of buildings, and improvements (sometimes called betterments).

Depreciation for Partial Years

-Fixed assets are purchased (or disposed of) at various times throughout the year. -If the fixed asset is purchased (or disposed of) at the beginning or end of an accounting period, a full year of depreciation is recorded. -If, however, the asset is purchased (or disposed of) 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.

*Expenditures after Acquisition

-In addition to expenditures made when property, plant, and equipment is purchased, 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).

Operating Assets

-Operating assets are the long-lived assets that are used by the company in the normal course of operations -Unlike inventory, operating assets are not sold to customers -Instead, operating assets are used by a company in the normal course of operations to generate revenue -Operating assets are divided into 3 categories: • Property, plant, and equipment also known as fixed assets. They include land, buildings, machines, equipment, and automobiles • Intangible assets do not have physical substance. They include patents, copyrights, trademarks, licenses, franchises, and goodwill • Natural resources are naturally occurring materials. They include timberlands and deposits such as coal, oil, and gravel -Operating assets represent future economic benefits, or service potential, that will be used in the normal course of operations -At acquisition, an operating asset is recorded at its cost, including the cost of acquiring the asset and the cost of preparing the asset for use (historical cost principle)

Property, Plant, and Equipment (PPE)

-Property, plant, and equipment are tangible operating assets and include: • 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)

Straight-Line Method

-Straight-line depreciation method allocates an equal amount of an asset's cost to depreciation expense for each year of the asset's useful life. -It is appropriate to apply this method to those assets for which an equal amount of service potential is considered to be used each period. -The computation of straight-line depreciation expense is based on an asset's depreciable cost, which is the excess of the asset's cost over its residual value. -Straight-line depreciation expense for each period is calculated as follows: • Annual Straight-Line Depreciation Expense = (Cost - Residual Value) ÷ Expected Useful Life in Years

Cost of a Fixed Asset

-The cost of a fixed asset is an expenditure necessary to acquire the asset and to prepare the asset for use -Expenditures that are included as part of the cost of the asset are said to be capitalized -Expenditures that are not included as part of the cost of the asset are expensed immediately

Declining Balance Method

-The declining balance depreciation method 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. -It results in a larger amount of depreciation expense in the early years of an asset's life relative to the straight-line method. -The double-declining balance depreciation rate is two times the straight-line rate: • Double Declining Balance Rate = 2 X Straight-Line Rate • Straight-Line Rate = 100% ÷ Estimated Life in Years

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).

-This allocation is called depreciation for property, plant, and equipment assets, amortization for intangible assets, and depletion for natural resources.

Disposal of Fixed Assets

-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. -Involuntary disposal occurs when assets are lost or destroyed through theft, acts of nature, or by accident. -Two journal entries are required for disposals of fixed assets: • An entry to record depreciation expense up to the date of disposal. • An entry to: o Remove the asset's book value (credit the cost of the asset and debit the related accumulated depreciation). o 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.

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, depreciation expense can be computed using the units-of-production method. -Usage is typically gauged by a measure of productive capacity such as miles, hours, or production. -To compute depreciation expense under the units-of-production method, the depreciation cost per unit is determined as shown in the following equation: • Depreciation Cost per Unit = (Cost - Residual Value) ÷ Expected Usage of the Asset (in Units) -Next, the depreciation cost per unit is multiplied by the actual usage of the asset: • Units-of-Production Depreciation Expense = Depreciation Cost per Unit X Actual Usage of the Asset (in Units)

The following information is necessary in order to measure depreciation:

• cost of the fixed asset • estimated useful life (or expected life) of the fixed asset • residual value (salvage value) of the fixed asset o Cost of the fixed asset is any expenditure necessary to acquire the asset and to prepare the asset for use. o The useful life of an asset is the period of time over which the company anticipates deriving benefit from the use of the asset. o The residual value (also called salvage value) is the amount of cash or trade-in consideration that the company expects to receive when an asset is retired from service. • Cost — Residual Value = Depreciable Cost

Typical Costs of Acquiring PPE

-Land Improvement • Purchase price • Sales taxes • Installation costs -Land • Purchase price • Real estate commissions • Delinquent property taxes • Closing costs (attorney, title, and survey fees) • Clearing and grading costs • Demolition of unwanted buildings, minus any salvage -Building • Purchase price • Closing price • Architectural fees • Cost of building permits • Excavation costs • Remodeling fees -Equipment • Purchase price • Sales taxes • Transportation costs • Insurance during transportation • Cost of trial runs