Chapter 10 - Plant Assets, Natural Resources and Intangibles CHAPTER 10 PLANT ASSETS, NATURAL RESOURCES AND INTANGIBLES Related Assignment Materials Student Learning Objectives Conceptual objectives: C1. Explain the cost principle for computing the cost of plant asset. C2. Explain depreciation for partial years and changes in estimates C3. Distinguish between revenue and capital expenditures, and account for them. Analytical objectives: A1. Compute total asset turnover and apply it to analyze a company's use of assets. Procedural objectives: P1 Compute and record depreciation using straight-line, units-of-production, and declining-balance methods. P2. Account for asset disposal through discarding, or selling, an asset. P3. Account for natural resource assets and their depletion. P4. Account for intangible assets. P5A Account for asset exchanges Quick Studies* Questions Exercises* Problems* 1, 2, 3, 4, 20 10-1, 10-2, 10-15 10-1, 10-2, 10-3, 10-21 7, 8 10-8 10-11, 10-12 10-4, 10-5 10-13, 10-25 10-14, 10-15 10-4 10-13 10-22 16 10-5, 10-7 5, 17, 18, 19 10-3, 10-4, 10-6 10-9 10-4, 10-5, 10-6, 10-7, 10-8, 10-9, 10-10, 10-18, 10-25 10-16, 10-17, 10-24, 10-25 10-1, 10-3, 10-3 10-4, 10-6 10-1, 10-2, 10-4, 10-7, 10-9 10-1, 10-2, 10-6 10-3, 10-5, 10-6 10-5, 10-6 9 10-10, 10-11 10-18 10, 11, 12, 13, 14, 15 6 10-11, 10-12 10-19, 10-20 10-8 10-14 Beyond the Numbers 10-7 10-8 10-5, 10-8 10-23, 10-24 *See additional information on next page that pertains to these quick studies, exercises and problems. 10-1 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 10 - Plant Assets, Natural Resources and Intangibles Additional Information on Related Assignment Material The Serial Problem for Success Systems continues in this chapter. Problems 10-1A and 10-3A can be completed using Excel. Problems 10-1A, 10-2A and 10-8A can be completed with QuickBooks. Problems 10-1A and 10-8A can be completed with Sage 50 Software. Connect (Available on the instructor’s course-specific website) repeats all numerical Quick Studies, all Exercises and Problems Set A. Connect provides new numbers each time the Quick Study, Exercise or Problem is worked. It allows instructors to monitor, promote, and assess student learning. It can be used in practice, homework, or exam mode Synopsis of Chapter Revisions New Glarus Brewing Co.: NEW opener with new entrepreneurial assignment Reorder presentation of plant assets New learning notes on book value and depreciation Updated asset turnover analysis using Boston Beet and Molson Coors New goodwill example using Facebook's purchase of WhatsApp 10-2 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 10 - Plant Assets, Natural Resources and Intangibles Chapter Outline I. Notes Plant Assets—Tangible assets used in a company's operations that have a useful life of more than one accounting period. Consistent with cost principle, recorded at cost. Cost includes all normal and reasonable expenditures necessary to get the asset in place and ready for its intended use. Must be normal, reasonable and necessary for its intended use. A. Machinery and Equipment Costs include all normal and necessary expenditures to purchase them and prepare them for their intended use (purchase price, taxes, transportation charges, insurance while in transit, and the installing, assembling and testing of machinery and equipment). B. Buildings 1. If purchased, cost usually includes its purchase price, brokerage fees, taxes, title fees, attorney costs, and all expenditures to make it ready for its intended use (any necessary repairs or renovations such as wiring, lighting, flooring and wall coverings). 2. If constructed for own use, cost includes materials and labor plus a reasonable amount of indirect overhead cost (heat, lighting, power, and depreciation on machinery used to construct the asset). Cost also includes design fees, building permits, and insurance during construction. C. Land Improvements Costs that increase the usefulness of the land. 1. Examples: parking lot surfaces, driveways, fences, and lighting systems (all have limited useful lives). 2. Costs are charged to a separate Land Improvement account. 3. Costs are allocated to the periods they benefit (depreciated) D. Land Cost includes purchase price, real estate commissions, title insurance, legal fees, accrued property taxes, legal fees, title insurance fees, accrued property taxes, surveying, clearing, landscaping, and local government assessments (current or future) for streets, sewers, etc. Also includes cost of removal of any existing structures (less proceeds from sale of salvaged material). Land cost is not allocated to expense if it has an indefinite life. E. Lump-Sum Purchase A group of plant assets purchased with a single transaction for a lump-sum price. Individual asset cost is determined by allocating the cost of the purchase among the different types of assets acquired based on their relative market values. 10-3 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 10 - Plant Assets, Natural Resources and Intangibles Chapter Outline II. Notes Depreciation—The process of allocating the cost of a plant asset to expense in the accounting periods benefiting from its use. Recorded as a debit to Depreciation Expense and a credit to Accumulated Depreciation. A. Factors in Computing Depreciation 1. Cost—described in section I above. 2. Salvage value—(residual value or scrap value) an estimate of the asset's value at the end of its benefit period. 3. Useful life—(service life) length of time the asset is expected to be productively used in a company's operations. Factors affecting useful life include: a. Inadequacy—the insufficient capacity of plant assets to meet the company's growing productive demands. b. Obsolescence—refers to a plant asset that is no longer useful in producing goods or services with a competitive advantage because of new inventions and improvements. 4. Relationships: a. Depreciable cost = Cost – Salvage Value b. Book Value = Cost – Accumulated Depreciation B. Depreciation Methods 1. Straight-line method—charges the same amount to expense for each period of the asset’s useful life. Method used by most companies. Computation: Cost minus salvage value (equals the depreciable cost) divided by the number of accounting periods in the asset's useful life equals the periodic depreciation. 2. Units-of-production method—charges a varying amount of cost to expense for each period of an asset’s useful life depending on its usage. Examples of capacity measurements: miles driven, product outputs, hours used. Computation: a. Cost minus salvage value divided by the total number of units expected to be produced during assets useful life equals the depreciation per unit. b. Depreciation per unit is multiplied by number of units consumed in the period equals the period’s depreciation. 3. Declining-balance method—an accelerated depreciation method which yields larger depreciation expenses during the early years of an asset's life and smaller charges in later years. Computation: Multiply the asset's beginning of period book value by a depreciation rate (usually twice the straight-line rate) to determine the period’s depreciation. If double the straight-line rate is used the method is referred to as double declining-balance. (Note that salvage value is not used in the calculation.) 10-4 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 10 - Plant Assets, Natural Resources and Intangibles Chapter Outline Notes 4. Depreciation for tax reporting—differences between financial and tax accounting systems are normal and expected. a. Many companies use accelerated depreciation in computing taxable income because it postpones its tax payments by charging higher depreciation expense in the early years and lower amounts in the later years. b. Federal income tax law rules for depreciating assets are called the Modified Accelerated Cost Recovery System (MACRS). c. MACRS is not acceptable for financial reporting because it allocates costs over an arbitrary period that is less than the asset's useful life. C. Partial Year Depreciation When an asset is purchased (or disposed of) at a time other than the beginning or end of an accounting period, depreciation is recorded for part of the year. D. Revising Depreciation If estimated salvage and/or useful life is revised: 1. Depreciation expense computations are revised by spreading the remaining cost to be depreciated over the revised useful life remaining. Book value – Revised Salvage Value Remaining Life 2. The revision is referred to as a change in an accounting estimate and is reflected in current and future financial statements, not prior statements. E. Reporting Depreciation 1. Cost of plant assets and accumulated depreciation are reported on the balance sheet or in its notes. 2. To satisfy the full-disclosure principle, the depreciation method or methods used must be disclosed in a balance sheet note. 3. Plant assets are reported at their undepreciated costs (book value), not at fair value. (basis is going-concern assumption) Exception: Impairments (permanent decline in fair value) allow asset write-downs to fair value. 4. Accumulated depreciation (normal credit balance) on the balance sheet does not represent funds accumulated to buy new assets when the presently owned assets must be replaced. 10-5 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 10 - Plant Assets, Natural Resources and Intangibles Chapter Outline III. Notes Additional Expenditures—Those made to operate, maintain, repair, or improve plant assets after their initial purchase. To record these expenditures one must decide whether to capitalize (increase an asset) or expense in current period. A. Ordinary Repairs—expenditures to keep an asset in normal, good operating condition. They do not materially increase the asset's life or productive capabilities. 1. Treated as revenue expenditures (also called income statement expenditures). Recorded as expenses on current period's income statement. 2. Examples: cleaning, repainting, and lubricating. B. Betterments (Improvements) and Extraordinary Repairs— expenditures to make a plant asset more efficient or productive; both are treated as a capital expenditure. 1. Betterments often involves adding a component to an asset that does not always extend its useful life. a. Examples: adding a wing to a building or changing a machine from manual function to automatic. b. Debited to the asset account. c. The increase in asset’s book value results in need to revise future depreciation. 2. Extraordinary repairs or replacements are expenditures that do extend the asset's useful life beyond its original estimate. a. Examples: roofing replacement and major overhauls of machinery and equipment. b. Treated as capital expenditures (debited to asset account) because they benefit future periods. 10-6 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 10 - Plant Assets, Natural Resources and Intangibles Chapter Outline IV. Notes Disposals of Plant Assets—Assets may be discarded, sold, or exchanged due to wear and tear, obsolescence, inadequacy, or damage by fire or other accident. General accounting steps in a disposal of a plant asset: Record depreciation up to the date of disposal—this also updates Accumulated Depreciation. Remove account balances of the disposed asset—including its Accumulated Depreciation. Record any cash (and/or other assets) received or paid in the disposal. Record any gain or loss resulting from comparing the asset's book value with the market value of any assets received. Exception: in the case of an exchange that lacks commercial substance—discussed in Appendix 10A. A. Discarding Plant Assets—no longer useful and has no market value Follow general accounting steps above. 1. If fully depreciated, no loss. 2. If not fully depreciated, record loss equal to the book value. B. Selling Plant Assets Follow general accounting steps above. 1. Sale is at a gain if value received exceeds book value. 2. Sale is at a loss if value received is less than book value. 10-7 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 10 - Plant Assets, Natural Resources and Intangibles Chapter Outline V. VI. Notes Natural Resources—Assets that are physically consumed when used. Examples include timber, mineral deposits, and oil and gas fields. Often called wasting assets. A. Cost Determination and Depletion 1. Recorded at cost, which includes all expenditures necessary to acquire the resource and prepare it for its intended use. 2. Depletion is the process of allocating the cost of natural resources to the period when it is consumed 3. Depletion expense (debit) per period is based on the units extracted. The calculation is similar to units-of-production depreciation. Accumulated depletion is credited in the recording. 4. Natural resources are reported on the balance sheet at cost less accumulated depletion. B. Plant Assets Used in Extracting When the usefulness of these plant assets is directly related to the depletion of the resource, the plant asset is depreciated in proportion to the depletion of the resource (use units-of-production method and the life of the resource). Intangible Assets—Certain nonphysical assets (used in operations) that confer on owners long-term rights, privileges, competitive advantages. Examples in B below. A. Cost Determination and Amortization 1. Recorded at cost when purchased. If simply developed by the business, relative immaterial costs are expensed. 2. Amortization—process of systematically allocating cost of intangible asset to expense over its estimated useful or economic life. (If it has an indefinite useful life, it should not be amortized but is tested annually for impairment—this test is discussed in advanced course) a. Useful or economic life may differ from legal life. b. Computed on a straight-line basis (cost divided by useful or economic life) c. Amortization period cannot exceed 40 years. d. Debit Amortization Expense and credit Accumulated Amortization. e. Leasehold improvements are amortized over the life of the lease or the life of the improvements whichever is shorter. Debit Rent Expense to amortize. 3 Gross acquisition cost is disclosed on the balance sheet along with their accumulated amortization. 10-8 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 10 - Plant Assets, Natural Resources and Intangibles Chapter Outline Notes B. Types of Intangibles 1. Patent—an exclusive right granted to its owner to produce and sell a patented item or to use a process for 20 years. Costs of research and development leading to a new patent are expense when incurred. 2. Copyright—the exclusive right to publish and sell a musical, literary, or artistic work during the life of the creator plus 70 years. 3. Franchises and Licenses—rights that a company or government grants an entity to deliver a product or service under specified conditions. If agreement is for indefinite or perpetual period, costs are not amortized. 4. Trademarks and Trade Names—symbols, names, phrases, or jingles identified with a company, product, or service. 5. Goodwill—specific meaning in accounting: the amount by which the value of a company exceeds the value of its individual assets and liabilities. Implies the company as a whole has certain valuable attributes not measured among its individual assets and liabilities. Goodwill is measured as the excess of cost of an acquired entity over the valuable of net assets acquired. Not recorded unless an entire company or business segment is purchased. It is not amortized but is tested annually for impairment. 6. Leasehold—the rights to possess and use leased property granted by the property’s owner (lessor) to the lessee in a contract called a lease. Recorded, if there was a cost involved, as an intangible asset by the lessee (or sublessee). As Leaseholds are amortized, the cost is charged to Rent Expense. 7. Leasehold improvements—alterations or improvements to leased property, such as partitions, painting, and storefronts. Amortization results in debit to Amortization Expense— Leasehold Improvements. VII. Global View—Compares U.S. GAAP to IFRS A. Accounting for Plant Assets—both systems are broadly similar on issues involving cost determination, additional expenditures and disposal. 1. Decreases in value—although both systems require recording decline in value to be recorded as asset impairment, the test for impairment under each system differs. U.S.GAAP uses fair value and IFRS uses recoverable costs (fair value – costs to sell). 2. Increase in value—U.S. GAAP prohibits recording increases in plant asset value whereas IFRS permits upward asset reevaluation. 10-9 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 10 - Plant Assets, Natural Resources and Intangibles Chapter Outline VII. VIII. Notes B. Accounting for Intangibles—similarities and differences are consistent with accounting for plant assets however the requirements for recording increases in value of intangibles is very restrictive and rare. Decision Analysis—Total Asset Turnover A. Measure of company’s efficiency using assets to generate sales. B. Calculated by dividing net sales by average total assets. Exchanging Plant Assets —Appendix 10A A. Accounting for the exchange depends on whether the transaction has commercial substance. Commercial substance exists if the company’s future cash flows change as a result of the transaction. B. If commercial substance exists, a gain or loss is recorded based on the difference between the book value of the assets given up and the market value of the assets received. C. If exchange lacks commercial substance, no gain or loss is recorded, and the asset received is recorded based on the book value of the assets given up. 10-10 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 10 - Plant Assets, Natural Resources and Intangibles VISUAL #10-1 FORMULAS FOR DEPRECIATION METHODS 1. STRAIGHT LINE FHC* - Estimated salvage = Estimated useful life Annual Depreciation *Full Historical Cost 2. UNITS OF PRODUCTION a) b) (Depreciable) FHC - Estimated salvage Cost per = Predicted units of production Unit CPU* x units produced in period = Depreciation for PERIOD (In last year, depreciate to estimated salvage value; never depreciate below this amount.) **Cost Per Unit 3. DOUBLE-DECLINING BALANCE Book Value (beginning of year) x RATE* = Depreciation (for that year) *RATE The rate used is constant and it is twice what the straight line rate would have been for this asset. (In the last year, depreciate to estimated salvage value; never depreciate below this amount.) 10-11 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 10 - Plant Assets, Natural Resources and Intangibles Alternate Demonstration Problem Chapter Ten A new machine costs $120,000, has an estimated useful life of five years and an estimated salvage value of $15,000 at the end of that time. It is expected that the machine can produce 210,000 widgets during its useful life. The New Times Company purchases this machine on January 1, 2013, and uses it for exactly three years. During these years the annual production of widgets has been 80,000, 50,000, and 30,000 units, respectively. On January 1, 2016, the machine is sold for $45,000. Required: 1. Calculate the depreciation expense for each of the first three years using: a. Straight-line b. Units-of-production c. Double-declining-balance 2. Prepare the proper journal entry for the sale of the machine under the three different depreciation methods. 10-12 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 10 - Plant Assets, Natural Resources and Intangibles 1a. Solution: Alternate Demonstration Problem Chapter Ten Straight-line The depreciation expense each year is equal to cost minus salvage value divided by useful life. In this example the cost is $120,000, the salvage value is $15,000, and the useful life is 5 years. Therefore, D 1b. = (120,000 - 15,000) / 5 = 21,000 each year Units-of-production The depreciation expense each year is equal to a rate [(cost minus salvage) divided by total production] multiplied by the actual number of units produced that year. In this example the rate would be $0.50 per widget, (120,000 - 15,000) / 210,000, and the depreciation expense for each of the first three years would be: D1 D2 D3 1c. = .50 = .50 = .50 x 80,000 x 50,000 x 30,000 = 40,000 = 25,000 = 15,000 Double-declining balance The depreciation expense each year is equal to a rate (twice the straight-line rate divided by useful life) multiplied by the asset’s net book value (cost minus accumulated depreciation) at the beginning of the year. In this example the rate would be 2/5, or 40%, and the depreciation expense for each of the first three years would be: D1 D2 D3 = = = .40 x .40 x .40 x 120,000 = 72,000 = 43,200 = 48,000 28,800 17,280 10-13 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 10 - Plant Assets, Natural Resources and Intangibles 2. The journal entry for the sale of the asset will have the same general form regardless of the method of depreciation adopted, except that whether there is a gain or a loss on the sale may change according to the depreciation method used. The gain or loss on disposal of the asset is determined by comparing the sale price, in this case $45,000, with the net book value of the asset at the time of the sale. Straight-line Cash ......................................... Accumulated depreciation ..... Loss on sale of machine ........ Machine .............................. 45,000 63,000 12,000* 120,000 * Book value of 57,000 less sale price $45,000 equals loss of $12,000 Units-of-production Cash ......................................... Accumulated depreciation ..... Machine .............................. Gain on sale of machine ... 45,000 80,000 120,000 5,000 * Sale price $45,000 less book value of $40,000 equals gain of $5,000 Double-declining balance Cash ......................................... Accumulated depreciation ..... Machine .............................. Gain on sale of machine ... 45,000 94,080 120,000 19,080 *Sale price $45,000 less book value of $25,920 equals gain of $19,080 10-14 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 10 - Plant Assets, Natural Resources and Intangibles Alternate Demonstration Problem #2 Chapter Ten A new van costs $25,000, has an estimated useful life of five years and an estimated salvage value of $5,000 at the end of that time. It is expected that the van will be driven 100,000 miles during its useful or service life. The Nation Express Company purchases this van on April 1, 2014. During 2014 the van is driven 13,000 miles and during 2015 it was driven 21,000 miles. Required: 1. Calculate the depreciation expense for 2014 and 2015 using: a. Straight-line b. Double-declining-balance c. Units-of-production 10-15 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 10 - Plant Assets, Natural Resources and Intangibles Solution: Alternate Demonstration Problem #2 Chapter Ten Straight Line Cost - Salvage value useful life = 25000 - 5000 5 years 20,000 5 $4,000 per year 2014: 4,000 x 9/12 = 3,000 2015: 4,000 Double declining balance 2 life 2014: 2/5 2015: 2/5 x book value x 25,000 = = Depreciation expense 17,500 10,000 x 9/12 = 7,500 7,000 x 12/12 = 7,000 10-16 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 10 - Plant Assets, Natural Resources and Intangibles Units of Production cost - salvage total miles = depreciation rate per mile Rate x actual mileage 25,000 - 5,000 100,000 miles = rate x actual mileage = Expense 2014: $ 0.20 x 13,000 = $ 2,600 2015: $ 0.20 x 21,000 = $ 4,200 $ = Depreciation expense 0.20 per mile (rate) 10-17 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.