Chapter 9 lecture note on Property Plant andE.ppt

Editor's Notes

• #1: Chapter 9: Plant and intangible assets.
• #2: Plant assets are tangible assets that are used actively in the operations of an entity. It’s fully expected that these assets, sometimes referred to as property, plant, and equipment, will benefit future periods. When a plant asset is acquired, it is recorded at its historical cost. Once the asset is placed in service, a portion of the asset’s cost is allocated to depreciation expense as the asset becomes older.
• #3: There are three major categories of plant assets: Tangible plant assets are long-term assets that have physical substance. Examples include land, buildings, equipment, furniture, and fixtures. Intangible assets are noncurrent assets with no physical substance. Examples include patents, copyrights, trademarks, franchises, and goodwill. Natural resources are acquired for extracting valuable resources to be used in the business. Examples include oil reserves, timber, and other minerals. This chapter will review the accounting issues related to these three categories.
• #4: There are three accountable events to discuss. When a plant asset is acquired, it is recorded at its historical cost. The next slide will show how this cost is determined. Once the asset is placed in service, a portion of the asset’s cost is allocated to depreciation expense as the asset becomes older. Finally, at the end of an asset’s useful life, it’s disposed of and removed from the books and records. The accounting for plant assets usually covers several accounting periods.
• #5: The cost of a plant asset includes the purchase price as well as all costs necessary to get the asset in place and ready for its intended use. The purchase price, net of any cash discounts available, is recorded. Finance charges are not included in the cost of an asset. If a purchase is financed over a period of time, the interest cost is charged as an expense when incurred. Let’s see how to determine the cost of a plant asset on the next slide.
• #6: On May 4th, Heat Company buys a new machine for $52,000. Sales tax is 8%. Heat Company also pays $500 in shipping costs, $1,300 in set-up costs, and $4,000 in testing costs. What is the recorded cost of the equipment to Heat Company. . What is the cost of the machine?
• #7: Part I Remember that the cost of an asset includes the purchase price plus any cost that is necessary to get the asset in place and ready for use. The cost of the new machine is $61,960. Part II The entry to record the purchase includes a debit to the asset account and a credit to Cash.
• #8: When purchasing land, the cost includes the purchase price and other costs generally incurred in connection with land acquisitions. Many of these costs are related to obtaining legal title to the land. Also remember that land is not a depreciable plant asset. Land improvements include parking lots, driveways, fences, sidewalks, landscaping, and any outdoor lighting systems. Land improvements are depreciated over their useful life.
• #9: Whether we purchase or construct a building, the cost should include the purchase price plus any attorney fees, title fees, and repairs made prior to using the building. If the building is built, the cost will include all the necessary construction costs as well as the costs just mentioned. Machinery and equipment are recorded at their purchase price less any available cash discount. If the company pays delivery charges on a truck, these costs are included in the cost of the truck. If any special parts need to be installed to make the machinery or equipment ready for its intended use, these costs will be included in the price of these assets. Insurance and property taxes are expenses in the current period; they are not part of the acquisition cost of an asset.
• #10: It is not uncommon to have a lump-sum purchase of assets. The most common example may be when purchasing a building and land. Remember, the land is not depreciable but a building is. A portion of the purchase price must be assigned separately to the building and to the land. When faced with this type of problem, accountants normally divide the cost between the assets on the basis of relative fair market values.
• #11: After a plant asset is purchased, the company may incur additional expenditures on that asset. These expenditures may be for repairs and maintenance, overhauls, upgrading the asset, and similar expenditures. One way to handle these types of expenditures is to treat them as Capital Expenditures and charge the amounts to an asset account on the balance sheet. In some cases, the expenditures may be treated as Revenue Expenditures and charged to current period income as expenses. For each expenditure subsequent to acquisition of a plant asset, decide if the expenditure is to be treated as a Capital or Revenue expenditure. Generally, subsequent expenditures for ordinary repairs are treated as revenue expenditures and charged to current period income as expenses. Subsequent expenditures that are for betterments are classified as extraordinary repairs. These should be treated as capital expenditures and charged to the asset account.
• #12: Depreciation is a process of cost allocation. The cost of an asset is allocated to expense over its useful life in some rational and systematic manner. Do not confuse asset valuation, an economic concept, with allocation. The unused portion of the asset’s cost appears on the balance sheet. A portion of the cost is allocated to expense on the income statement each accounting period.
• #13: When dealing with depreciation, there are several terms and concepts to understand. Book value is calculated as the historical cost of the asset minus the accumulated depreciation. Book value is the undepreciated cost of the asset. Accumulated depreciation represents the depreciation taken on the asset since its purchase. Accumulated depreciation is a contra-asset account and is subtracted from the asset account to determine book value. Assets are depreciated as we use them to help earn revenue. As assets are used, they incur physical deterioration and obsolescence. Now, let’s look at some common methods of calculating depreciation expense.
• #14: Regardless of the method used to calculate depreciation expense, three variables must be known: (1) the asset’s cost; (2) the estimated residual value expected to be received at the end of its useful life, and (3) the estimated useful life of the asset. When using the straight-line method, depreciation expense is calculated by taking cost minus residual value and dividing by the years of useful life. Let’s see how this works.
• #15: Part I On January 1st, 2007, Bass Company purchased a boat for $24,000. The estimated useful life is 5 years and the estimated residual value is $3,000. Can you calculate the amount of annual depreciation? Part II This calculation was relatively easy. Did you get the annual depreciation of $4,200? Now let’s look at a schedule of the annual depreciation over the life of the asset.
• #16: Notice that depreciation expense is the same amount in each of the 5 years. If this amount was plotted on a graph, it would be a straight-line. That is how the name for this method was determined. Accumulated depreciation increases by four thousand two hundred dollars each year. The cost of the asset less accumulated depreciation at the end of any year is called book value. Book value decreases by four thousand two hundred dollars each year. At the end of the asset’s useful life, the book value is equal to the estimated residual value. This should be true regardless of the method used.
• #17: Thus far, this chapter has covered the depreciation of an asset purchased on January 1st. However, relatively few assets will actually be purchased on January 1st. One way to determine depreciation for assets purchased throughout the year is to use the half-year convention. Using this convention, in the year of acquisition, a company would record half a year, or six months, of depreciation. Let’s see how how this works.
• #18: Part I In this example, a company purchased equipment for $75,000 on some date in 2007. The equipment has a useful life of 10 years and an estimated residual value of $5,000. This company uses straight-line depreciation for all of its plant assets. Let’s calculate depreciation expense for 2007 using the half-year convention. Part II Using straight-line depreciation, the depreciation expense for an entire year would be $7,000. This amount is determined by taking cost less residual value and dividing it by the useful life. Since the company uses the half-year convention, divide the annual depreciation in half for the first year. The depreciation expense for 2007 would be $3,500.
• #19: There are several appealing reasons to use a declining-balance method for depreciation. One reason to consider the declining-balance method is to better match depreciation expense with revenue generated. The idea is that a newer asset will generate more revenue in early years rather than later years, so depreciation expense should be higher in the early years of ownership and less in later years. Another reason that the declining-balance method is appealing to use for financial statement reporting is that it is similar to the depreciation method used for tax purposes. Calculating depreciation expense under the double-declining-balance method is a three step process. The first step is to calculate the straight-line depreciation rate. Do this by dividing one hundred percent by the asset’s useful life. The second step is to calculate the double-declining-balance rate, which is done by multiplying the straight-line rate times two. The third and final step is to determine depreciation expense. Multiply the double-declining rate times the book value of the asset at the beginning of the period. Under the double-declining-balance method estimated residual value is ignored. Let’s look at an example.
• #20: Part I On January 1st, 2007, Bass Company purchased a truck for $24,000. The estimated useful life is 5 years and the estimated residual value is $3,000. Can you calculate the amount of annual depreciation using the double-declining-balance method? Part II The first step is to calculate the straight-line depreciation rate. Recall that this is done by dividing 100% by the asset’s useful life. In this case divide 100% by the 5-year useful life to get a straight-line rate of 20%. The second step is to calculate the double-declining-balance rate. Do this by multiplying the straight-line rate times 2. In this case that would be 20% times two, or 40%. The third and final step is to determine depreciation expense. Multiply the double-declining rate times the book value of the asset at the beginning of the period. In this case, multiply the beginning book value (cost less accumulated depreciation) of $24,000 by 40%. Depreciation expense for 2007 is $9,600. Remember, under the double-declining-balance method ignore estimated salvage value.
• #21: Part I While book value should always be equal to the estimated salvage value at the end of an asset’s useful life, it just will not work properly using the double-declining-balance method. In this case, the book value at the end of 2011 needs to be equal to $3,000, the estimated residual value. The only way that can work is to force depreciation expense in the last year to be the amount needed to bring book value down to residual value. In 2011, depreciation expense will be recorded at $110. This amount is determined by subtracting the salvage value of $3,000 from the book value at the end of 2010, $3,110. Part II Notice that no matter which depreciation method is used, the total depreciation taken at the end of an asset’s life will be the same. In this case, for both the straight-line method and the double-declining-balance method, total depreciation taken is $21,000.
• #22: Auditors review management’s estimates for useful lives and residual values for reasonableness. The principle of consistency ensures that companies avoid switching depreciation methods from period to period, unless there is a compelling reason for the change.
• #23: You know that salvage value and useful life of a plant asset are both estimates. Like all estimates, new information may come to light that will warrant a revision of a previous estimate. Let’s see how accountants handle the revision of previous estimates.
• #24: In this example, a company purchased equipment on January 1st, 2004, for $30,000. The equipment is estimated to have a 10-year useful life and no salvage value at the end of its useful life. The company uses the straight-line method for all plant assets and begins recording depreciation on this equipment in 2004. The original computations for 2004 through 2006 are continued. During 2007, new information is learned about the equipment that causes a revision of the estimate of the equipment’s useful life. The equipment is now believed to have a total useful life of eight years. Depreciation expense for three years has already been recorded (2004, 2005, and 2006), so there are five years remaining in the equipment’s useful life. In this case, accountants take the book value at the date of revision of the estimate, that is, 2007, and subtract any estimated salvage value at the time of revision. This total is to be divided by the remaining useful life of the asset at the date of revision. Let’s calculate the proper depreciation expense for 2007.
• #25: Part I The asset had a cost of $30,000 and a ten-year useful life with no salvage value. Under straight-line depreciation, $3,000 of expense is recorded in each of the years 2004, 2005, and 2006. Let’s calculate the depreciation expense at December 31st, 2007. Part II The original cost of the asset was $30,000. Accumulated depreciation has a balance of $9,000 at the beginning of 2007. The remaining book value is $21,000 and the remaining useful life of the asset is five years, so depreciation for each of those five years will be $4,200.
• #26: If an asset’s value decreases and cannot be recovered through future use or sale, the asset is considered to be impaired and should be written down to its net realizable value.
• #27: When a plant asset is disposed of, the first thing to do is update depreciation to the date of disposal. After completing the update, the journal entry can be created. The journal entry begins by the recording of a debit to the cash account, if cash was received, or credit to the cash account, if cash was paid by the company. In addition, it must be determined whether a gain or loss is associated with the disposal. A gain is recorded with a credit, just like revenue, and a loss is recorded with a debit, just like an expense account. The entry is completed by removing the plant asset’s cost from the books with a credit, and removing the related accumulated depreciation with a debit. Let’s see how to calculate the gain or loss associated with the disposal.
• #28: If the amount of cash received is greater than the book value of the asset (cost less accumulated depreciation), a gain is associated with the disposal. If the cash received is less than the book value of the asset, a loss will be recorded. When the amount of cash is exactly equal to the book value of the asset, there will be no gain or loss in connection with the disposal. Now let’s look at a specific example of disposal of a plant asset.
• #29: On September 30th, 2007, Evans Company sells a machine for $60,000. The machine was purchased on January 1st, 2002, for $100,000, had an estimated salvage value of $20,000, and a useful life of ten years. Evans uses straight-line deprecation. Let’s answer the following questions.
• #30: Part I What is the amount of depreciation to be recorded on September 30th, 2007, to bring the depreciation up to date? Part II Annual depreciation is eight thousand dollars. For the nine months ending September 30th, 2006, Evans will record six thousand dollars in depreciation.
• #31: Part I After updating the depreciation, what is the machine’s book value? Part II Book value is calculated as cost of $100,000 minus the accumulated depreciation of $46,000. So, for Evans’ machine, the book value is $54,000.
• #32: Part I Did the sale of the machine result in a gain or a loss? Part II To determine a gain or loss, compare the cash received of $60,000 with the book value of $54,000. Since Evans received more cash than the book value, Evans has a gain of $6,000.
• #33: Part I Now, you have all the pieces of information necessary to record the sale. Part II Record the disposal with a debit to Cash for $60,000, a debit to Accumulated Depreciation for $46,000, a credit to Gain on Sale for $6,0000, and a credit to Machinery for $100,000.
• #34: On May 30th, 2006, Essex Company exchanges a used airplane and $35,000 cash for a new airplane. The old airplane given up has a historical cost of $40,000 dollars, accumulated deprecation to the date of exchange of $30,000, and a fair value of $4,000. The first thing we need to determine is whether a gain or loss will result. Remember that our accounting depends upon whether a gain or a loss is indicated on the transaction.
• #35: Part I Does this exchange of airplanes result in a gain or a loss? Part II The book value of the airplane given up is $10,000 and the fair value of the airplane given up is $4,000. By comparing the $10,000 dollar book value with the $4,000 fair value, Essex has a $6,000 loss on the exchange. The general rule is that when we exchange productive assets and a loss is indicated, the loss is recognized in full.
• #36: Part I Let’s prepare the journal entry to record the exchange. Part II Begin by recording the parts of the journal entry that are known. The old airplane is being given up, so we debit Accumulated Depreciation and credit the old Airplane account for their respective amounts. Cash is also being given up in the amount of $35,000 and there’s a loss on the transaction of $6,000. Now, just debit the new Airplane account for $39,000. This amount represents the fair value of the assets given up in the exchange: Cash of $35,000 and the old Airplane of $4,000.
• #37: Let’s change the subject from disposals of plant assets to intangible assets. Intangible assets lack physical substance, and that makes it difficult to determine the asset’s useful life or any residual value. Many intangible assets involve exclusive rights or privileges. Let’s review the major types of intangible assets and the related accounting on the next slides.
• #38: This is a list of the intangible assets to be discussed. Intangible assets are normally recorded at the purchase price plus any legal or related fees.
• #39: Amortization is the systematic write-off of the cost of an intangible asset over its useful or legal life, whichever is shorter. Amortization is the same concept as depreciation only it’s called a different name because it refers to intangible assets. The entry to record amortization includes a debit to Amortization Expense and a credit to the specific intangible asset account involved.
• #40: An intangible asset called goodwill can be created when one company buys another company. If the purchase price of the company is greater than the fair value of the net assets acquired, goodwill is associated with the transaction. Goodwill is not amortized. Each year there must be a test to see if there has been any impairment in the carrying value of the goodwill. If an impairment is determined to exist, the goodwill account will be reduced and the loss in value recognized.
• #41: A patent gives the holder the exclusive right to manufacture and sell an item or process for twenty years. Patents are amortized (a process just like depreciation) using the straight-line method over their useful lives, but never more than twenty years. Most companies amortize patents over a very short period of time.
• #42: A trademark or trade name is any symbol, name, phrase, or jingle that is identified with a company, product, or service. No other party may use the trademark or trade name without the permission of the holder. Many trade marks are extremely valuable. The name “Mercedes-Benz” is quite valuable, as is the name “Harley-Davidson.” We normally amortize the cost of trademarks over a short period of time using the straight-line method.
• #43: The holder of a franchise has the right to deliver a product or service under conditions granted by the franchisor. It’s almost impossible to drive down any major street without finding a number of franchise operations. The accounting for franchises can become quite complex. At this point, it is sufficient to be able to define the nature of a franchise.
• #44: A copyright grants to the holder the exclusive right to publish and sell musical, literary, or artistic work for the life of the creator plus 70 years. Most copyrights are amortized over a short period of time using the straight-line method.
• #45: According to generally accepted accounting principles, or GAAP, research and development costs should be expensed as incurred.
• #46: Now let’s turn to the last major subject to be covered in this presentation—natural resources. Natural resources abound. There are accounting issues associated with oil, coal, timber, gold, gravel, and a wide variety of other natural resources. In general, natural resources can be thought of as anything extracted from our natural environment. Accountants report natural resources at their cost less accumulated depletion. Depletion is the allocation of the cost of a natural resource over its useful life. The depletion studied in this text is very similar to straight-line depreciation. The cost of any natural resource must include all exploration and development costs as well as extraction costs. A portion of these total costs are charged to income each period through the depletion expense account. Let’s see how the accounting rules for natural resources work.
• #47: Begin the process of calculating depletion expense by determining the depletion expense per unit of natural resource. The numerator of the equation contains the resource cost less any estimated residual value. The denominator of the equation is the estimated total capacity of the natural resource expected to be extracted. For oil, the denominator is expressed in terms of barrels, for coal in tons, for timber in board feet, and the like for other resources.
• #48: The second step to determine the current period’s depletion expense is calculated by multiplying the depletion expense per unit, determined on the previous slide, by the number of extracted units sold during the period. Depletion expense, which becomes part of the cost of goods sold, is based on the number of units sold, not the number of units extracted. To determine the unsold inventory balance at the end of the current period, multiply the depletion expense per unit by the number of units on hand at the end of the period.
• #49: The development and extraction of many types of natural resources require highly specialized plant assets. Just think of the use of off-shore drilling platforms for oil and gas production. These specialized assets are recorded in a separate account from the natural resource and are depreciated over their useful lives.
• #50: Cash payments for plant assets appear as cash outflows for investing activities on the statement of cash flows. Remember, depreciation is a non-cash charge to income and is added back to net income under the indirect method of calculating cash flows from operating activities.
• #51: The units of output method is useful if the asset being used has a well recognized unit of output. For example, an automobile’s unit of output is the mile. We can calculate a depreciation cost per mile driven. The more miles driven, the higher the depreciation expense recognized. Modified accelerated cost recovery system is the depreciation method used when preparing a federal income tax return. The system is based on our declining balance method.
• #52: The sum-of-the-years’-digits method is an accelerated method that produces results that fall between double-declining balance and 150-percent of straight-line method. Because it is relatively difficult to compute, it is not used by many companies.
• #53: As this slide indicates, the straight-line method is used by the majority of companies. This is because of the simplicity of the calculation and ease of use.