Transcript Chapter 10
CHAPTER 10
CAPITAL ASSETS
Capital assets (fixed assets) are:
Long-lived
Used in the operations of a business
Not intended for sale to customers.
Capital assets have two classes: 1. Tangible 2. Intangible (can touch it) (can’t touch it)
TANGIBLE CAPITAL ASSETS
Tangible capital assets include:
property, plant and equipment like:
Land + land improvements
Buildings + improvements
Equipment + freight + installation
natural resources such as mineral deposits, oil and gas reserves, and timber
INTANGIBLE CAPITAL ASSETS
What are they?
Patents, copyrights, sports contracts, and trademarks, goodwill
Intangible capital assets provide future benefits through the special rights and privileges they possess.
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DETERMINING THE COST OF CAPITAL ASSETS
Capital assets are recorded at cost ( cost principle ). Cost consists of all expenditures necessary to 1.
2.
Acquire the asset and Make it ready for its intended use.
These costs include purchase price , freight costs , and installation costs .
So, how do you come up with a cost figure?...
MEASUREMENT OF CAPITAL ASSET COST
Funny you should ask…
Cost is measured by cash paid , or by the cash equivalent price when other assets are used instead.
The cash equivalent price is equal to the value of 1.
the asset given up or 2.
the asset received, fair market whichever is more clearly determinable.
LAND
The cost of land can include: 1.
2.
3.
4.
Purchase price Closing costs such as title and legal fees Accrued property taxes and other liens land assumed by the purchaser on the Land improvements like: 1.
2.
3.
4.
Parking lots Fencing Landscaping Lighting
BUILDINGS
The cost of buildings includes all necessary expenditures relating to purchase or construction.
When purchased:
Purchase price and closing costs.
When making building ready for its intended use:
Expenditures for remodelling, replacing or repairing the roof, floors, wiring, and plumbing, etc..
When constructed , cost consists of:
Contract price, architects’ fees, building permits, interest payments during construction, and excavation costs.
EQUIPMENT
1.
The cost of equipment consists of:
Cash purchase price, 2.
3.
4.
Freight charges, duties or tariffs Insurance against loss during transit, As well as all costs to assemble, install, and test it.
WHY AMORTIZATION?
(Depreciation - Review)
During an asset’s life, its usefulness may decline because of usage or obsolescence.
Amortization is the process of allocating to expense the cost of a capital asset over its useful life.
Amortization is designed to match expenses with revenues in accordance with the matching principle .
Recognition of amortization does not result in the accumulation of cash for the replacement of the asset, nor the use of cash, although an expense is recognized.
Land is the only capital asset that is not amortized.
AMORTIZATION METHODS
Three methods of recognizing amortization are: 1.
Straight-line , 2.
Declining-balance (includes CCA ), and 3.
Units of activity .
Each method is acceptable under GAAPs . Management selects the method that is appropriate for their company, it should be applied consistently .
1. STRAIGHT-LINE METHOD
Historical Cost Salvage Value Useful Life (in years) Annual Rate of Amortization
1. STRAIGHT-LINE METHOD
DECLINING-BALANCE METHOD
Based on a declining book value (cost less accumulated amortization).
The amortization rate remains constant, but the net book value declines each year.
Book Value (at beginning of year) Declining balance rate Amortization Expense (for the year)
DECLINING-BALANCE (cont.)
If you aren’t given a rate for declining balance, use the following formula: Rate = 100% .
NEW!
Useful Life Example: Business buys $10,000 piece of equipment with a salvage value of $1,000 is expected to last for 10 years. However, management feels that the DECLINING BALANCE METHOD is best for amortizing this asset.
100% .
= 10% 10 years
DECLINING-BALANCE METHOD
UNITS-OF-ACTIVITY METHOD
EXAMPLE (assume the following): Mine of 1,000,000 m 3 of ore Total Cost of Resource – Salvage Value preparing for use: $50,000,000 75,000 m 3 of ore.
Amortization Cost per Unit
Total Amortizable Costs of Mine
X
$ 50,000,000 1,000,000
Amortization Units Used
$ 50.00
Cost this
Total Amortization Expense $ 3,750,000 (75,000 m 3 x $50/unit)
UNITS-OF-ACTIVITY METHOD
REVISING AMORTIZATION
Change in Amounts or Speed
If annual amortization is inadequate or excessive, a change should be made.
1.
2.
When a change is made, There is no correction of previously recorded amortization expense, and Amortization expense for current and future years is revised using the normal formulas. When asset is bought/sold part way through a year, that year’s amortization must be prorated.
REVISING AMORTIZATION
Change in Method
If you decide to change the amortization method, a prior period adjustment must be made
1.
When you change any accounting policy you: Do NOT revise prior years’ financial stmts 2.
3.
Calculate the total change for all prior years and charge it directly to the Capital account Record this year’s amortization using the new method.
Why would it be done this way?
C.C.A.
Capital Cost Allowance
CCA is the government’s method of calculating amortization for tax purposes.
CCA is exactly like the Declining Balance method.
However, CCA only allows you to recognize ½ a year’s amortization in the year of disposal AND purchase.
CCA rates are specific, and are the maximum allowable rates for a year.
See page 472 for a schedule of CCA rates for asset classes.
C.C.A. and Income Taxes
Must report using GAAPs
Most firms use straight-line (it’s easy)
But taxes are determined using tax law (CCA).
This creates a discrepancy. Observe CCA vs. Straight Line CCA Straight Line Year 1 Year 2 Year 3 Year 4
C.C.A. and Income Taxes
The discrepancy is charged to an account called Deferred Income Tax
Most people (especially politicians) think that this account represents legitimate tax that corporations have somehow evaded paying.
Not the case. It arises from the discrepancy between CCA for tax purposes, and amortization using GAAPs.
Date April 30 Particulars Income Tax Expense Deferred Income Taxes Cash Debit 25,000 Credit 5,000 20,000
EXPENDITURES DURING USEFUL LIFE
Ordinary repairs are expenditures to maintain the operating efficiency and expected productive life of the capital asset.
Expenditures are usually immaterial in amount and occur infrequently.
They are operating expenses and are debited to Repairs Expense .
Additions and improvements are costs incurred to increase operating efficiency, productive capacity, or expected useful life of the capital asset.
They increase a company’s investment in productive facilities, so
They are capital expenditures and are debited to the capital asset .
CAPITAL ASSET DISPOSALS
(Example: equipment costing $5,000 with $1,100 of amortization was sold for $4,000 on September 30 th ) 1 Amortization for the fraction of the year to the date of disposal must be recorded Date Sept 30 Particulars Amortization Expense Accumulated Amortization (assumed) Debit 100 To record 9 months of depreciation on disposed asset.
Credit 100
CAPITAL ASSET DISPOSALS
2 Remove the value of all accounts associated with that asset, and record receipt of cash.
Date Sept 30 Particulars Debit Cash Accumulated amortization Equipment Gain on sale of equipment To record gain on the sale of buffing equipment.
4000 1200 Credit 5000 200 Gain or loss equals = Selling Price – Book Value $200 = ( $4,000 - $3,800) Historical Cost – Accumulated Amortization
CAPITAL ASSET DISPOSALS (cont.)
Alternatively, you can combine all three steps into one journal entry.
The only difference here is that Accumulated Amortization will not include the value of the last write-off (step 1).
Date Sept 30 Particulars Cash Amortization expense Accumulated amortization Equipment Gain on sale of equipment Debit 4000 100 1100 Credit $1,200 5000 200
NATURAL RESOURCES
Natural resources (wasting assets), consist of standing timber and underground deposits of oil, gas, and minerals. They have two distinguishing characteristics: 1.
They are physically extracted in operations.
2.
They are replaceable only by an act of nature.
NATURAL RESOURCES Acquisition Cost
The acquisition cost of a natural resource is the cash or cash equivalent price necessary to acquire the resource and prepare it for its intended use.
If the resource is already discovered, cost is the price paid for the property.
NATURAL RESOURCES Amortization
The units-of-activity method is generally used to calculate amortization
ILLUSTRATION 10-24
STATEMENT PRESENTATION OF AMORTIZATION
Accumulated Amortization, a contra asset account , is deducted from the cost of the natural resource in the balance sheet as follows: Lane Coal Company Balance Sheet (partial) December 31, 2003
Assets Capital assets Coal mine Less: Accumulated amortization Net book value $ 5,000,000 384,000 4,616,000
INTANGIBLE ASSETS
Intangible assets cannot be touched.
They are rights, privileges, and competitive advantages that result from the ownership of long-lived assets that do not possess physical substance.
Do Problems: P10-2A, and 7A
TYPES OF INTANGIBLE ASSETS
Patents
Copyrights
Trademarks and Trade Names
Franchises and Licenses
Goodwill
Research and Development Costs
COPYRIGHTS
Copyrights are granted by the federal government giving the owner the exclusive right to reproduce and sell artistic or published work
Copyrights extend for the life of the creator plus 50 years
TRADE MARKS/NAMES
Word, phrase, jingle or symbol that distinguishes or identifies a particular enterprise or product
If indefinite life, do not amortize. Test for impairment
PATENTS
Exclusive right to manufacture, sell or control granted for 20 years
Legal costs of protecting a patent in an infringement suit are added to the Patent account and amortized over the remaining life of the patent
FRANCHISES
Contractual agreement under which the franchiser grants the franchisee the right
To sell certain products
To render specific services or to use certain trademarks or trade names, usually within a designated geographic area
Annual fees are not capitalized, but are expensed.
LICENSES
Operating rights permit the enterprise to use public property in performing its service (i.e. the use of airwaves for radio or TV broadcasting)
Annual fees are NOT capitalized, but expensed.
GOODWILL
Goodwill represents favourable attributes that relate to a business enterprise
Recorded only in an exchange transaction that involves the purchase of an entire business
Goodwill = (Price paid – Equity in Business)
Goodwill is not written off as it has an unlimited useful life. It must be tested regularly for impairment .
Impairment is when fair market value for an assets drops below the book value.
GOODWILL
100,000 cash
-
75,000 Equity acquired 100,000 How does goodwill arise?
Cash Other Assets Goodwill Firm A 100,000 300,000 Firm B 50,000 100,000 How?
400,000 150,000 = 25,000 goodwill Firm AB 50,000 400,000 25,000 475,000 Liabilities Equity 200,000 200,000 400,000 75,000 75,000 150,000 How?
275,000 200,000 475,000 275,000
-
100,000 cash + 25,000 goodwill = 200,000
GOODWILL
Two steps:
ONE: If FMV > Book Value = no impairment
TWO: If not, then Goodwill is impaired.
Things to consider in determining FMV:
Significant adverse change in legal or business climate Adverse action by a regulator Unanticipated competition Loss of a key personnel More-likely-than-not expectation that a significant portion of a reporting unit will be sold or disposed of Impairment of a significant asset group within a reporting unit Recognition of a goodwill impairment loss by a subsidiary
RESEARCH AND DEVELOPMENT COSTS
Research costs–record as an expense incurred when
Development costs– capitalize if associated with an identifiable, feasible product. Otherwise, expense What does identifiable and feasible mean?
ACCOUNTING FOR INTANGIBLE ASSETS
In general, accounting for intangible assets is the same as for capital assets. Intangible assets are: 1.
2.
3.
Recorded at cost ; Written off over useful life in a rational and systematic manner; At disposal, book value is eliminated and gain or loss, if any, is recorded.
AMORTIZATION
Amortizable intangible assets:
Have defined lives
Allocate cost to expense over the shorter of
Useful (economic) life, or
Legal life
Straight-line method of amortization is used
Unamortizable Intangible assets:
Have indefinite useful lives,
Do not amortize, and
Must be tested for impairment (when fair market value for an assets drops below the net book value).
FINANCIAL STATEMENT PRESENTATION
Capital Assets are often combined on the Balance Sheet.
If so, there should be full disclosure in the notes to the financial statements, which means disclose:
Balances in each major asset class,
Accumulated amortization of each major class, (or of assets in total),
Amortization methods used should be described , and
Amount of amortization expense for the period disclosed as well.
ASSET TURNOVER RATIO
The ratio that shows how efficiently a company uses its assets to generate sales is the asset turnover ratio . Net Sales
Average Total Assets
=
Assets Turnover
RETURN ON ASSETS
The ratio that shows the profitability of assets used in the earnings process is the return on assets . Net Income
Average Total Assets
=
Return on Assets