Financial AccountingA Decision-Making Approach, 2nd Edition

King, Lembke, and Smith

John Wiley & Sons, Inc.

Prepared byDr. Denise English,

Boise State University

*

After reading Chapter 10, you should be able to:

1. Describe long-lived nonfinancial assets and their importance for decision making.

2. Describe the valuation methods used for long-lived nonfinancial assets both at acquisition and after acquisition, and explain how these methods facilitate decision making.

3. Explain how intangible assets differ from tangible assets; describe the similarities and differences in accounting and reporting for tangible and intangible assets, and describe how they might affect decision making.

4. Define key ratios and indicators for financial analysis related to long-lived nonfinancial assets, and use these ratios and indicators to understand a company’s activities and financial position.

5. Describe the different means of financing asset acquisitions, and indicate the important considerations for decision making relating to financing asset acquisitions and reporting for them.

CHAPTER TEN

OPERATING ASSETS AND INTANGIBLES

Understanding Operating Assets

Operating assets are those used in a company’s central activities and are often labeled fixed assets or property, plant, and equipment.

Operating assets are tangible in nature because they have physical existence.

Operating assets are long-lived because they are expected to last beyond a single period or operating cycle.

Operating Asset Evaluation Measures

Operating assets are usually costly, and an evaluation of them often focuses on whether they are being used efficiently and profitably. A commonly used measure of profitably is:

Net Income $1,500,000 Return on Assets = ---------------------------- = ---------------- = 15%

Average Total Assets $10,000,000

A high return on assets relative to other investment alternatives signals a good use of investment capital.

Some companies separate the return on assets calculation into two components that contribute to Return on Assets: Net Income Sales Net Income

---------------- X --------------------------- = ----------------------------- Sales Average Total Assets Average Total Assets

The first component is Margin on Sales indicating the portion of sales remaining as profit after expenses. The second component is Asset Turnover, a measure of the effectiveness with which assets are used.

Inventory Evaluation Measures

A similar measure to Asset Turnover is Fixed Asset Turnover, calculated as follows:

SalesFixed Asset Turnover = -----------------------------

Average Fixed Assets

The higher the turnover, the more efficient the enterprise is in generating revenues using its current investment in property, plant, and equipment.

Inventory Evaluation Measures

Determining Operating Asset Cost

The cost of operating assets includes all costs necessarily incurred to acquire those assets such as:– Shipping charges borne by the purchaser;– Transfer costs such as legal fees;– Costs of preparing operating assets for their

intended use;– Interest costs incurred on borrowing when

operating assets are constructed over an extended period of time.

How much?

Matching the Costs of Operating Assets

All operating assets with the exception of land have lives that are limited by wear and tear, deterioration, and obsolescence.

When operating assets are no longer useful to the company, they are sold or scrapped; any proceeds upon disposal are referred to as salvage value.

Operating assets’ net cost or depreciable base is the difference between cost and salvage value.

Depreciation is the process used to match the expired net cost of the operating asset against the benefits it provides during its useful life.

Allocating the Cost of Operating Assets

The allocation of the cost of a tangible operating asset to the periods benefiting from its use is referred to as depreciation.

In order to maintain the historical cost of operating assets in the accounts, a separate account called Accumulated Depreciation (a contra-asset account) is used in which the amounts of the asset cost that have expired are accumulated.

The book value of an asset is the amount at which the asset is reported on the balance sheet and is equal to the original cost of the asset minus the accumulated depreciation to date.

Allocating the Cost of Operating Assets: an Example

A delivery van costing $40,000 expected to last 5 years, after which it will have a salvage value of $3,000, is anticipated to provide equal benefits each year of its life.

Annual Adjusting Entry: Depreciation expense $ 7,400 Accumulated Depreciation $ 7,400

Balance Sheet Presentation after 4 years:Equipment $ 40,000

Less Accumulated Depreciation (29,600) Book value $ 10,400

======

We Deliver

Depreciation Methods

The depreciation methods used most commonly for financial reporting are:

1) Straight-line

2) Declining-balance

3) Activity-based depreciation.

The first two methods are calculated based upon the passage of time, while the third is based upon the usage of the asset.

We Deliver

Straight-Line Depreciation

An equal amount of cost is allocated to each period benefited and is reported as Depreciation Expense in the income statement (as in the earlier example for the delivery van).

This method is appropriate when the asset provides approximately equal benefits each period.

The depreciation expense each period is equal to the depreciable base (cost minus salvage value) divided by its expected useful life.

We Deliver

Declining-Balance Depreciation

Many assets are expected to provide greater benefits, be more efficient and effective, and cost less for repairs and maintenance in their earlier years.

Declining-balance depreciation is an accelerated depreciation because it allocates more cost to early years and less to later years.

Using declining-balance depreciation, a constant percentage is applied each year to the decreasing book value (cost minus accumulated depreciation) of the asset. Thus, the amount of depreciation each year is less as the book value decreases.

We Deliver

The percentage of depreciation taken each year depends on how fast the asset is to be depreciated. Two common rates are 200% and 150% because these are also acceptable for tax reporting.

If a delivery van costing $40,000 is to be depreciated over a 5-year life at a 200% rate, and is assumed to have a $3,000 salvage value, the calculations would be as follows:

Year 1 (2.00 x 1/5) x ($40,000) = $16,000 Year 2 (2.00 x 1/5) x ($40,000 - $16,000) = $ 9,600 Year 3 (2.00 x 1/5) x ($40,000 - $25,400) = $ 5,760 Year 4 (2.00 x 1/5) x ($40,000 - $31,360) = $ 3,456 Year 5 Depreciate down to salvage ($3,000) = $ 2,184

Declining-Balance Depreciation

We Deliver

Activity-Based Depreciation

Depreciation can be based on usage rather than the passage of time. The service-hours depreciation method bases the computation on the ratio of number of hours the asset was used during the year to the total number of hours expected in its service life.

The units-of-production method is similar but is based on the number of units produced during the current period as a percent of the total expected production from the asset over its useful life.

We Deliver

If the same $40,000 van, estimated to last for 100,000 miles, was driven 25,000, 18,000, 20,000, 15,000 and 12,000 miles respectively during the first 5 years, the depreciation calculations would be:

Year 1 (25,000/100,000) x ($40,000 - $3,000) = $9,250

Year 2 (18,000/100,000) x ($40,000 - $3,000) = $6,660

Year 3 (20,000/100,000) x ($40,000 - $3,000) = $7,400

Year 4 (15,000/100,000) x ($40,000 - $3,000) = $5,550

Year 5 (12,000/100,000) x ($40,000 - $3,000) = $4,440

Activity-Based Depreciation

We Deliver

Comparison of Depreciation Methods

Depreciation Method

Description Van Example Year 1

Depreciation Expense

Premise

Straight-line Equal depreciation expense each year

$7,400 Constant passage of time

Declining-balance

Constant depreciation rate applied to declining book value

$16,000 Accelerated passage of time

Activity-based Percentage of actual to expected usage applied to depreciable base

$9,250 Varied based upon actual usage

We Deliver

Depreciation and Income Taxes

Depreciation reduces taxable income, but does not require a cash outflow for the expense.

Thus, depreciation reduces the cash outlay for income taxes paid, thereby providing a “tax shield”.

Accelerated depreciation methods are preferred because the tax savings are experienced sooner, rather than later (and the time value of money is important!).

Depreciation and Income Taxes

With few exceptions, a Modified Accelerated Cost Recovery System (MACRS) is used for federal tax reporting. It requires:– Shorter depreciation periods for various categories of

assets;– Salvage value be ignored in the computation;– Either double-declining or 150-percent-declining

balance depreciation be used, depending upon asset type, with a switch to straight-line in the year when it becomes greater.

– Straight-line depreciation for longest-life asset categories.

Depreciation of Manufacturing Assets

All costs of producing inventory must become part of the cost of goods produced; thus, the cost of depreciable assets such as factory buildings and equipment used in the production of inventory must be assigned to units of inventory.

The costs become part of Cost of Goods Sold when the inventory is sold.

No depreciation expense related to manu-facturing assets is reported directly in the Income Statement because of its inclusion in Cost of Goods Sold.

Depletion: Matching the Costs of Natural Resources

Resource-bearing land is acquired at a cost that includes the value of anticipated recoverable resources contained within.

The land is generally less valuable after the resources are removed (salvage value), and the net cost (cost – salvage) should be matched with the benefits provided.

Depletion is the process of allocating the net cost of the land to the units of the natural resources as part of the cost of the natural resource. Depletion costs will not be seen as a separate line item on the income statement, but are a part of the cost of the resources sold.

Depletion costs are allocated on a units-of-production basis by dividing the total cost to be allocated by the number of units of resources expected to be extracted.

Depletion: an example

Texas Gold, Inc. acquired an oil well for $34,000,000 containing an estimated 7 million barrels of crude oil and spent an additional $1,400,000 preparing it for production. The salvage value is estimated to be $1,000,000. During the first year, 1,200,000 barrels of oil were produced and sold. Depletion would be calculated as follows:

Cost ($34,000,000 + $1,400,000) – Salvage ($400,000) ---------------------------------------------------------------------------- = Estimated resources of 7,000,000 barrels

$5.00 per barrel depletion as part of the Cost of Resources Sold.

If other production costs per barrel are $2.50, then total costs of pro- duction are ($5.00 + $2.50) = $7.50 per barrel. For the first year, $7.50

x 1,200,000 barrels = $9,000,000 Cost of Resources (Goods) Sold would be expensed.

Disposals and Impairmentsof Operating Assets

Once specific operating assets are no longer needed, they are usually sold or scrapped.

The difference between the proceeds received (if any) and the book value (cost minus accumulated depreciation or depletion) requires a gain (or loss) be recognized.

Such gains and losses are not typically recurring income and thus their importance in the net income presentation is less significant.

For Sale

Assets Held for Disposal—when no longer used these assets must be written down to net realizable value (expected sales proceeds minus costs of disposal) if less than book value. They are no longer depreciated if not in use, and must be revalued to net realizable value each year if still held.

Asset impairments—an asset currently in use may become impaired, meaning that the expected future cash flow from using and ultimately selling it are less than its current book value. The asset must be immediately written down to its fair value and a loss recognized in the income statement.

For Sale

Disposals and Impairmentsof Operating Assets

Intangible Assets

Generally, accounting for intangibles that confer rights requires the same accounting treatment as other long-lived operating assets—they are recorded initially at cost, and that cost is matched with the benefits provided through a process of amortization.

Amortization is similar to depreciation, but GAAP limits the useful life of an intangible to 40 years. Typically a straight-line method is used and amortization is deducted directly from the intangible account.

The value of intangibles is subject to scrutiny because of the tentative nature of the economic benefits they provide.

Rights

Research and Development Costs

Research and development costs incurred to discover new knowledge and develop new products (or improve existing ones) are expected to provide future benefits.

Because of the uncertainty of realizing the future benefits, however, the FASB requires all such costs to be expensed as incurred.

For some companies these costs are significant, but necessary if the company hopes to survive in the long run. Net income will be impaired in the short-run for (hopefully) long run improvement.

Goodwill

An intangible asset of particularly tenuous nature is Goodwill. It is the combination of all those factors (location, reputation, management) that make the value of an ongoing business higher than the total value of the individual assets.

Goodwill is only recorded when one company purchases another in a business combination, and is measured as the difference between the total price paid for the business and the fair value of the individual identifiable assets less the liabilities acquired.

Goodwill must be amortized over the period of time benefiting from the excess earning power acquired, not to exceed 40 years.

ABCCompany

123Company

ABC123 Company

buys

Nonfinancial Asset Disclosures

In addition to the financial statement numbers, several other disclosures pertaining to non-financial assets are required:– the valuation basis for each type of nonfinancial asset;– the amortization methods for limited-life assets and the

amortization periods;– creditor’s claims on assets, including details of asset

financing arrangements and required future cash payments.

Financing Asset Acquisitions

Because operating assets are very costly, how asset acquisitions are financed may determine whether certain assets are acquired, and the profitability of the acquisition itself.

Two areas of interest affected by financing arrangements are tax benefits and loan security. Tax benefits can be acquired through buying and depreciating or “renting” through an operating lease arrangement. Security of the loan for the lender can be enhanced by establishing the asset as collateral for the loan.

Leasing Assets

There are two types of lease arrangements:1) An operating lease exists when the lease arrangement resembles a rental agreement. A more flexible commitment exists and rent expense (lessee) and rental income (lessor) is recognized to be more indicative of the nature of the lease agreement.2) A capital lease exists when most of the risks and rewards of ownership transfer from the lessor to the lessee. It is a long-term arrangement and resembles the lessee borrowing to buy the asset. The accounting for such a lease is similar to an installment purchase of an asset whereby the asset and a related liability are recorded at the present value of the future lease payments.

Copyright © 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Copyright © 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Copyright