Finance and Accounting II

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Capital Expenditures - Asset Improvements & Extraordinary Repairs

*Asset Improvements* —> capital expenditures —> Recorded as DEBIT / INCREASES to the fixed asset account —> adds service value to the asset (B/c the cost of the delivery truck has increased, depreciation for the truck will also change over its remaining life) *Extraordinary Repairs* —> capital expenditures —> DEBIT Accumulated Depreciation —> Recorded as DECREASE in an accumulated depreciation account —> revise depreciation for current and future periods (B/c the forklifts useful life has changed, depreciation for the forklift will also change based on the new book value of the forklift.)

3 Depreciation Expense Methods

*Not necessary for a company to use only one method of computing depreciation for all of its fixed assets.* (EX: a company may use one method for depreciating equipment and another method for depreciating buildings. And another different method for income and property taxes) *Three Depreciation Methods:* 1. Straight-line Depreciation 2. Units-of-output Depreciation (units-of-production method) 3. Double-declining-balance (accelerated depreciation)

Revenue Expenditures - Ordinary Maintenance

*Ordinary Maintenance and Repairs* —> Revenue Expenditure —> benefits only current period —> recorded as DEBIT / INCREASES to Repair and Maintenance Expense on Income Statement

Physical vs. Functional Factors of Depreciation

*Physical Depreciation* - factors include wear and tear during use or from EXPOSURE TO WEATHER *Functional Depreciation* - factors include obsolescence and CHANGES IN CUSTOMER NEEDS that cause the asset to no longer provide services for which it was intended. (EX: Equipment may become obsolete due to changing technology)

Intangible Assets

- DO NOT exist physically - long-lived assets that are used in the operations of a business and are not held for sale. (EX: Patents, Copyrights, Trademarks, Goodwill) To determine: - initial cost - amortization, which is the amount of cost to transfer to expense, results from passage of time or decline in usefulness

Characteristics of Fixed Assets

- exists physically and thus, are tangible - owned and used by the company in its normal operations - not offered for sale as part of normal operations BUT may be sold (EX: cars and trucks offered for sale by automotive dealership are NOT fixed, but a tow truck used in normal operations of dealership is a fixed asset)

Double-declining-balance (accelerated depreciation)

- provides for a DECLINING periodic expense over the expected useful life of the assets - the estimated residual value is NOT considered, yet it should NOT be depreciated below its estimated residual value. - provides a higher depreciation in the first year of the assets use, followed by declining depreciation amounts. - *Assets revenues are often greater in the EARLY YEARS of its use than in later years - thus double depreciation method provides a good matching of depreciation expense with the assets revenues* Three Steps A. Determine the straight line percentages, using the expected useful life. B. Determine the double-declining-balance rate by multiplying the straight line rate from step 1+2 C. Compute the depreciation expense by multiplying the double-declining-balance rate from step 2 times the book value (cost minus accumulated depreciation) of the asset

Units-of-output Depreciation (units-of-production method)

- provides the same amount of depreciation expense for EACH UNIT of output of the asset - depending on the asset, the units of output can be expressed in terms of hours, miles driven or quantity produced - (EX: the units of output for a truck = miles driven) (EX: the units of output for manufacturing = units of product)

Three Factors in Computing Depreciation

1. *Initial cost* 2. *Expected useful life* - estimated at the time the asset is placed into services - estimates are available from industry trade associations - not uncommon for different companies to use different useful life for similar assets - the internal revenue service (IRS) also publishes guidelines for useful lives, which may be helpful for financial accounting purposes 3. *Estimated residual value* - estimated at the end of its useful life when asset is placed into service - sometimes also called scrap value, salvage value, or trade in value

Two Steps to Calculate Straight-line Depreciation

1. Annual Depreciation = Cost - Residual Value / Useful Life 2. First Year Partial Depreciation = Annual Depreciation x n / 12

Two Common Misunderstandings of Depreciation

1. Does NOT measure a decline in the market value of a fixed asset. - instead it is AN ALLOCATION of a fixed assets cost to expense / over the assets useful life. - the book value of a fixed asset (cost less accumulated depreciation) usually does NOT agree with the assets market value. - justified because a fixed asset is for USE in a company's operations rather than for resale. 2. Does not provide cash to replace fixed assets as they wear out. *Depreciation, unlike most EXPENSES, does not require outlay of cash when it's recorded*

3 Factors in Computing Depreciation Expense

1. Initial cost - determined using the concepts discussed and 2. Expected useful life 3. Estimated residual value

Two parties to lease contract are:

1. Lessor - party who OWNS the asset 2. Lessee - party whom the rights to USE the asset are granted by the lessor

Straight-line Depreciation Method

1. Straight-line Depreciation - provides the SAME amount of depreciation expense for EACH YEAR of the assets useful life - MOST WIDELY USED - when an assets revenues are about the same from period to period, straight line depreciation provides a good matching of depreciation expense with the assets revenues Two Steps: Annual Depreciation = Cost - Residual Value / Useful Life First Year Partial Depreciation = Annual Depreciation x 3 / 12

Costs Associated with CONSTRUCTING Fixed Assets

1. include direct costs incurred in the CONSTRUCTION (EX: labor and materials) that should be capitalized as a DEBIT to an account entitled: Construction in Progress 2. When construction is complete costs are reclassified by: CREDITING Construction in Progress & DEBITING the proper fixed asset account such as: Building.

Three Classifications of Cost

A cost that has been incurred may be classified as a: 1. *Fixed Asset* - include land, buildings or equipment - last MORE THAN one year - used in normal operations - standby equipment for later use is still classified as a fixed asset - Fixed Assets that have been abandoned or are no longer used in operations are NOT classified as Fixed Assets 2. *Investment* - long-lived Assets that are NOT used in the normal operations - held for future resale - reported on the Balance Sheet under Investments section - (EX: undeveloped land acquired for future resale would be classified and reported as an investment, NOT land) 3. *Expense* - NOT purchased for long-lived use

EXAMPLE of Units-of-Output: Equipment acquired at the beginning of the year at a cost of $180,000 has an estimated residual value of $10,000 has an estimated useful life of 40,000 hours, and was operated 3,600 hours during the year. Determine a) the depreciation cost, b) the depreciation rate, and c) the unit-of-output depreciation for the year.

A) depreciation cost = $180,000 - $10,000 = $170,000 B) depreciation rate = $170,000 / 40,000 hours = $4.25 per hour C) unit-of-output = 3,600 hours * $4.25 = $15,300

EXAMPLE Double-Declining-Balance: Equipment acquired at the beginning of the year at a cost of $125,000 has an estimated residual value of $5,000 and an estimated useful life of 10 years. Determine a) the double-declining-balance depreciation for the first year.

A. 1/10 * 2 = 20% B. $125,000 * 20% = $25,000

Advantage vs. Disadvantage of a Lease Contract

ADVANTAGE: - lessee has access to an asset without having to spend funds or obtain financing to buy the asset - expenses such as maintenance and repair costs may be responsibility of the lessor DISADVANTAGE - asset becomes obsolete before the end of its useful life can be mitigated by leasing an asset

Amortization Expense

Amount of cost to transfer to Expense Results from the passage of time or decline in the usefulness of an intangible asset

Fixed Asset Accounts

Common costs of acquiring fixed assets are DEBITED to the related fixed asset accounts: 1. *Building* - architects fees - engineer fees - insurance costs incurred during construction - interest on money borrowed to finance construction - sales tax - repairs (purchase of existing building) - modify for use 2. *Machinery and Equipment* - sales taxes - freight - installation - repairs (purchase of used equipment) - reconditioning (purchase of used equip) - insurance while in transit - assembly - modify for use - testing for use - permits from gov agencies 3. *Land* - purchase price - sales tax - permits for government agencies - brokers commission - title fees - surveying fees - real estate taxes - grading and leveling

Copyrights

Copyright: the exclusive right to publish and sell a literacy, artistic, or musical composition. Issued by the federal government for 70 years beyond the authors death. Costs of copyrights include all the costs of creating the work + any other costs of obtaining the copyright Amortized over their estimated useful lives.

Adjusting Entry to Record Depreciation

DEBIT - Depreciation Expense CREDIT - Accumulated Depreciation = Contra Asset ** contra asset: allows original cost to remain unchanged **

Adjusting Entry to Record Depletion

DEBIT Depletion Expense, CREDIT Accumulated Depletion Depletion of mineral deposit.

Depreciable Cost

Depreciable Cost - The difference between a fixed assets initial cost and it's residual value. Total is the amount of the assets cost that is ALLOCATED over its useful life. *Initial cost - Residual Value = Depreciation Cost = total periodic depreciation expense* *if a fixed asset has NO residual value, then its entire cost should be allocated to depreciation*

EXAMPLE of Straight-line Depreciation:

Equipment acquired at the beginning of the year at a cost of $125,000 has an estimated value of $5,000 and an estimated useful life of 10 years. Determine a) the depreciation cost, b) the straight line rate, and 3) the annual straight line depreciation. A) depreciation cost = initial price - residual value $125,000 - $5,000 = $120,000 B) the straight line rate = 10 / 1 = 10% C) annual straight line depreciation = $120,000 * 10% OR $120,000 / 10 yr. = $12,000

Revising Depreciation Estimates

Estimates of residual values and useful lives of fixed assets may change due to abnormal wear and tear or obsolesces. When new estimates are determined, they are used to determine the depreciation expense for the future. The depreciation expense recorded in earlier years is not affected.

Financial Analysis and Interpretation: Fixed Asset Turnover Ratio

Fixed Asset Turnover Ratio: - measure of a company's efficiency in using its fixed assets to generate revenue - measures the number of dollars of sales earned per dollar of fixed assets FATR: sales / average book value of fixed assets The HIGHER the fixed Asset Turnover, the MORE efficiently a company is using its fixed assets in generating sales. The SMALLER ratios are associated with companies that require large fixed asset investments. The LARGER ratios are associated with firm that are more labor intensive and require smaller fixed asset investments. Two uses: 1. Compared across time for a single company 2. Compared across companies

Disposal of Fixed Assets

Fixed assets that are not longer useful may be discarded or sold. In such cases fixed assets must be removed from the accounts. However if a fixed Asset is still being used, its cost and accumulated depreciation should remain in the ledger even if the asset is fully depreciated. B/c of accountability. If not recorded, then no evidence the continued existence of the asset. Cost and accumulated depreciation data on such assets are often needed for property tax and income tax reports.

Depreciation Factors

For an asset placed into or taken out of service during the first half of the month, many companies compute depreciation for the ENTIRE month. Asset is treated like it had been purchased or sold on the first day of that month.

Capital and Revenue Expenditures Example

GTS Co. paid $1200 to upgrade a hydraulic life and $45 for an oil change for one of its delivery trucks. DEBIT - Delivery Truck $1200 CREDIT - cash $1200 DEBIT - Repairs and Maintenance Expense $45 CREDIT - cash $45

Goodwill

Goodwill: refers to an intangible asset of a business that is created from such favorable factors as: Location, product quality, reputation, managerial skills Allows a business to earn a GREATER rate of return than normal. Does NOT amortized - however a loss should be recorded if the future prospects of the purchased form become impaired. Loss = other expenses on income statement. GAAP allow goodwill to be recorded only if it is objectively determined by a transaction. EX: Purchase a business at a price in excess of the fair value of its net assets (assets - liability). The cxcess is recorded as goodwill and reported as an intangible asset

Financial Reporting for Fixed Assets and Intangible Assets

INCOME STATEMENT Depreciation Expense Amortization Expense - report separated or disclosed in a note BALANCE SHEET Fixed Assets - each class should be disclosed on the face of the statement or in the notes. - may be shown at their book value = net amount Accumulated Depreciation + Cost - should also be displayed normally as part of the Fixed Asset section, either by class or in total - mineral rights may be shown net of depletion in the face of the balance sheet, following a note disclosing the accumulated depreciation. Intangible Assets - usually reported in a separate section following the fixed assets - the balance of each class of intangible assets should be disclosed of any amortization cigarettes

Discarding Fixed Assets - fully used

If a fixed Asset is no longer used and has no residual value, it is discarded. The entry to discarding removes the asset and it's related Accumulated depreciation from the ledger. DEBIT Accumulated depreciation—Equip, CREDIT Equipment

Discarding Fixed Assets - not fully used

If an asset has NOT fully depreciated, depreciation should be recorded BEFORE removing the asset from the account records. DEBIT depreciation expense—Equipment, CREDIT Accumulated depreciation—Equip To record current depreciation on equipment discarded ($600 x 3/12) Then to discard equipment: DEBIT Accumulated Depreciation—EQUIP DEBIT Loss on Disposal of Equipment CREDIT Equipment To write off Equipment is discarded.

Depreciation for Federal Income Tax

Internal Revenue Code uses: Modified Accelerated Cost Recovery System (MACRS): to compute depreciation for financial statements and tax purposes. 8 classes - each with its own depreciation rate - most common classes = five and seven year - five-year: automobiles and light duty trucks - seven-year: machinery and equipment MACRS does not result in significantly different amounts then would have been reported using one of the three depreciation methods.

LEASING Fixed Assets

Lease - a contract for the use of an asset for a period of time - SHORT-TERM and not extending beyond one year. - lessee pays rent on a periodic basis for the lease term DEBIT Rent Expense, CREDIT Cash - Lease Terms: renewal option may be disclosed in the notes to the financial statements

Fixed Assets

Longterm of permanent assets such as equipment, machinery, buildings or land Also called 'plant assets' or PPE (plant, property, equipment) *often are a significant portion of the total assets of a company*

Losses on Discarding Fixed Assets

Losses are reported on the INCOME STATEMENT

Patents

Manufacturers may acquire exclusive rights to produce and sell goods with one or more unique features called a patent. The federal government issues to inventors for life of 20 years. Business may purchase patent rights from others, or it may obtain patents developed by its own research and development. Any R&D costs are usually recorded as current operations expenses in the period of which they incurred. DEBIT Initial cost + legal fees to an asset account - cost is written off, or amortized, over the years of useful life - expected useful life may be less than its legal life (EX: could become useless due to technology or consumer tastes) - normally computed using the straight-line method DEBIT an amortization expense account, CREDIT the patents account. *a separate contra asset account is usually NOT used for intangible assets*

Define Capital Vs. Revenue Expenditures

Occurs once a fixed asset has been ACQUIRED AND PLACED into service, costs may be incurred for: 1. *Revenue Expenditures* - costs that benefit only the CURRENT PERIOD - ordinary maintenance and repairs (DEBIT repairs and maintenance, CREDIT cash) 2. *Capital Expenditures* - costs that improve the asset or extend its USEFUL LIFE - improving an asset (DEBIT fixed asset account (Delivery Truck), CREDIT cash) - extraordinary repairs that extend the assets useful life (DEBIT Accumulated Depreciation—forklift, CREDIT cash)w

Accounting for Depreciation

Over time fixed assets, with the EXCEPTION OF LAND, lose their ability to provide services. *Depreciation* = the periodic recording of the cost of fixed assets as an EXPENSE Costs of fixed assets, such as equipment and buildings should be recorded as expense over their useful life. **Land has an unlimited life, it is NOT depreciated.**

Comparison of Intangible Assets

Patent exclusive right to benefit from an INNOVATION amortization period - estimated useful life not to exceed legal life periodic expense: amortization expense Copyright Exclusive right to benefit from a literary, artistic, or musical COMPOSITION amortization period - estimated useful life not to exceed legal life periodic expense: amortization expense Trademark Exclusive use of a NAME, TERM, or SYMBOL NONE amortization period Impairment loss of fair value less than carrying value (impaired) Goodwill Excess of purchase price of a business / the fair value of its net assets (assets - liabilities) NONE amortization period Impairment loss of fair value less than carrying value (impaired)

Costs of ACQUIRING Fixed Assets

Purchase price of asset + costs of acquiring the fixed asset (EX: freight or installation/service fees) Recorded by DEBITING the related fixed asset account such as: Land, Building, Land Improvements, our Machinery and Equipment Unnecessary costs that DO NOT increase the assets usefulness are recorded as an EXPENSE. - vandalism - mistakes in installation - uninsured theft - damage during unpacking and installing - fines for not obtaining proper permits from government agencies

Steps to Classifying Costs

Step 1: Is the purchased item long lived?? YES - recorded on balance sheet as fixed asset or investment. Next step. NO - recorded on income statement as an expense Step 2: is the asset used in normal operations? YES - fixed asset NO - investments Record on Balance Sheet under proper classification

Accounting for Leases - FASB vs. IASB

The Financial Accounting Standards (FASB) and the International Accounting Standard Board (IASB) currently are focusing on a joint project to merge U.S. and international standards. Under the proposed standard lessors and lessees would be required to record assets and liabilities to certain long-term lease contracts.

Natural Resources

The fixed assets of some companies include: Timber Metal Ores Minerals As these resources are harvested and mined and then sold, a portion of their cost is DEBITED to an expense account. Process of transferring the cost of natural resources to an expense account is called DEPLETION.

depletion of natural resources

The process of transferring natural resources to an expense account Depletion Expense = CONTRA ASSET = reported on the BALANCE SHEET as a deduction from the cost of resource. Two Steps How to Determine Depletion: 1. Determine the depletion rate: Depletion rate = cost of resources / estimated total units of resource 2. Multiply the depletion rate by the quantity extracted from the resource during the period: Depletion Expense = depletion rate * quantity

Trademark

Trademark: a name, term, or symbol used to identify a business and its products. Under federal law, businesses can protect their trademarks by registering them for 10 years and renewing the registration for 10-year periods. Legal costs of registering a trademark are recorded as an asset. If a trademark is purchased from another business: - it's cost is recorded as an asset - considered to have an indefinite useful life - not amortized - instead reviewed periodically for impaired value Impaired value - trademark should be written down and a loss recognized

Two Steps of Units-of-Output Depreciation

Two Steps: 1. Depreciation per Unit = Cost - Residual Value / Total Units of Output 2. Depreciation Expense = Depreciation per Unit * Total Units of Output Used


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