FA2: Module 9
PPE and intangible assets
1.
2.
3.
4.
5.
Definition and valuation
Determining the cost of PPE
Intangibles
Disposal of capital assets
The equity method (time permitting)
1. Definitions – Long-lived assets
Property, plant and equipment (PPE) are
tangible items, acquired for use in the
revenue-producing activities of the enterprise
and expected to be used for more than one
period.
Investment property: land/buildings held for
rent or capital appreciation
Biological assets: living plants and animals
Intangible assets: legal/contractual rights
Goodwill: unidentifiable asset
1. Valuation
Cost model: Long-lived assets are valued at
cost of acquisition, development, betterments,
etc., less accumulated depreciation and
accumulated impairment losses.
Revaluation model: Asset is periodically
revalued to its fair value and carried at
revalued amount less accumulated
depreciation and impairment.
Fair value model: Asset revalued to fair value
every year; no depreciation
2. Determining the cost of PPE
Capital assets are measured at historical cost,
the cash or cash equivalent price of obtaining
the asset and bringing it to the location and
condition necessary for its intended use.
Costs included in historical cost include all
costs reasonable and necessary to prepare the
asset for its intended use.
Historical cost is a reliable measure of the fair
value of the asset at the date of acquisition.
2. Valuation at initial acquisition
a.
b.
c.
d.
Basic examples
Lump sum purchases
Decommissioning cost obligations
Subsequent expenditures
a. Basic examples: Cost of land
The cost of land includes:
• The purchase cost of the land
• Legal and registration fees associated with
closing the transaction
• Cost of preparing the land for intended use
(landscaping, clearing, etc.)
• Assumption of taxes in arrears or other
encumbrances
• Land improvements that have indefinite life
a. Basics: Buildings and equipment
The cost of buildings include all costs related
to acquisition (as with land) or construction
(direct materials, direct labour, overhead).
This also includes interest costs incurred
during construction.
The cost of equipment includes purchase price
(less any discounts), taxes, tariffs, freight
charges, assembly and installation costs, costs
of conducting trial runs.
Example: Slavin Company
Machine 101 was purchased and put into operation on
July 31. The following items and expenditures were
noted:
Invoice cost
$19,000
Cash discount received (2%)
380
Transportation charges
570
Operator wages (August)
975
Installation/testing costs
950
Insurance premium (1 yr)
450
Damage from dropping
200
What was the cost of Machine 101?
b. Lump sum purchases (basket purchases)
When several assets are purchased for a single
lump sum, the purchase cost must be allocated
to the individual assets acquired. This is
typically done on the basis of relative fair
market value of each asset as at the date of
acquisition. Accountants might use:
•Appraisal (for insurance or other purposes)
•Assessed valuation for property taxes
Lump sum purchases: Example
The firm purchases land and a building for
$100,000. According to the city assessors, the
land’s appraised value is $60,000, and the
building’s appraised value is $20,000.
The entry to record the acquisition is:
c. Decommissioning obligations
Definition: Legal or constructive (expectation
by outsiders) obligation associated with the
retirement of a tangible long-lived asset that
the entity is required to settle.
The PV of obligation (using pre-tax riskadjusted rate) is estimated, if it can be done
with reasonable precision, and charged
(debited) to cost of asset, with an offsetting
credit to a liability account. Every year,
interest (accretion) expense is computed on,
and added to, the liability.
DCO example
Acme Incorporated has a management
practice of dismantling its equipment at the
end of their useful life and selling them for
scrap. For new equipment purchased in 20x1
for a cost of $70,000, the anticipated net costs
(cost less scrap revenue) are $10,000. The
equipment has an estimated useful life of 20
years. The pre-tax risk-adjusted rate is 8%.
Required: Prepare journal entries to record
acquisition of equipment and adjusting entries
at the end of 20x1 and 20x2.
d. Subsequent costs
These are costs incurred after acquisition for
ordinary maintenance, major inspections,
overhauls, . . .
Maintenance and ordinary repair costs (costs
incurred to keep asset in normal working
order) are expensed as incurred.
Subsequent costs should be capitalized if:
1. They enhance the service
potential or useful life of the asset; and
2. The costs involved are material
Subsequent costs to capitalize
1. Additions: extensions, expansions or
enlargements. The cost can be added to
carrying value of original asset, or can be
treated as new component.
2. Replacement of major part (Betterment):
derecognize replaced part (with any gain or
loss on disposal) and capitalize cost of new
part
3. Major inspection (major overhaul):
Capitalized; any remaining costs related to
previous inspections are derecognized
Subsequent costs example
1. Regular machine maintenance was carried
out for $22,000.
2. A major overhaul was carried out on some
equipment at a cost of $65,000. A major
overhaul is expected every five years.
3. The building roof was replaced at a cost of
$25,000. The old roof had a cost of
$18,000 and was two-thirds depreciated.
4. A new wing was added to the building at a
cost of $175,000.
3. Intangible assets
Intangible assets are characterized by a lack of
physical substance. Their value typically
derives from some form of legal or
contractual right they confer upon the holder.
For many firms, their most important
intangibles are not reported on the balance
sheet.
Intangible capital assets
Internally
developed
Identifiable Development
costs, patents,etc.
Sometimes
capitalized
Externally acquired
Patents,
trademarks,
copyrights,
licenses, franchises
Capitalized
Purchased goodwill
NonInternally
identifiable developed
goodwill
Capitalized
Never capitalized
Internally developed intangibles
Can capitalized as long as:
1. The asset in question is identifiable, i. e.,
asset is separable from entity or asset
derives from some contractual or legal
rights;
2. Asset recognition criteria are met:
1. Entity has control
2. Future economic benefits
3. Cost is reliably measurable
Research and development
Research is original and planned
investigations undertaken in the hope of
gaining new scientific or technical knowledge.
Research is expensed as incurred.
Development is application of research
findings or other knowledge to design or plan
for production of new or improved products,
done before commercial production begins.
Development costs can be capitalized if
certain criteria are met.
Development capitalization criteria
1. Asset proven to be technologically feasible
2. Management intends to complete and
market or use asset
3. Entity is able to use asset
4. Probable future economic benefits clearly
established
5. Adequate resources to complete project
6. Costs can be reliably measured
A9-16
Amortization of intangibles
Intangible assets are amortized over their
useful lives. Generally, they are amortized on
a straight-line basis, although other
amortization methods could be used.
If useful life is considered to be indefinite,
there is no amortization. Indefinite life
intangibles need to tested periodically for
impairment.
Goodwill
Goodwill is the difference between the market
value of the entity as a going concern and the
sum of the fair values of the entity’s
identifiable net assets (assets – liabilities).
Goodwill arises from such things as:
-effective advertising
-employee training
-entity’s reputation in the marketplace
-strategic location, etc.
Calculating Goodwill
Goodwill is recorded only when an entire
business is purchased, and is recorded as the
excess of the cost of the business over the fair
value of net assets acquired.
1. Establish cost of acquisition of entity:
cash payment plus other consideration
2. Establish fair value of all identifiable
assets and liabilities. Fair value of net
assets acquired is fair value of assets less
fair value of liabilities.
3. Goodwill = 1 – 2
Accounting for goodwill
Internally generated goodwill is not
capitalized because it is impossible to identify
and measure with any reliability.
Goodwill is not amortized, but is subject to
impairment tests.
Example: A9-26
5. Disposal of PPE
Two principal steps:
1. Record depreciation or amortization
expense up to date of disposal of asset, if
applicable.
2. Remove historical cost of asset and its
associated depreciation. Record cash
received. Gain or loss is difference
between cash received and book value of
asset at date of disposal.
Example: A9-22
4. Equity method (mod. 8, time permitting)
a. Equity method basics
Basics: Investor records its proportionate share
of investee income as its own income (debit to
investment account), and reduces the investment
account by its share of investee dividends
received.
e. g., Big buys 25% of voting shares of Small for
$100 on January 1. At year end, Small reports
net income of $40 and declares and pays a cash
dividend of $20.
4.b. Acquisition cost greater than book value
The purchase discrepancy is the difference
between the cost of investment acquired and the
book value of investor share of investee net
assets on acquisition date. This difference arises
from under- or overstated assets and/or liabilities
on the investee balance sheet; or unrecorded
goodwill. The investor must attribute the
purchase discrepancy to depreciable assets (and
then amortize it), non-depreciable identifiable
assets/liabilities, or goodwill.
Example: A11-23
4.c. Investee discontinued operations
Investor company must record separately its
share of investee income attributable to
discontinued operations. If these items are
material from the investor’s point of view, they
must be presented separately on investor’s
income statement. In practice, this is rare.
4.d. Intercompany transactions
Principle: An economic entity cannot earn a profit
by selling to itself. From an economic point of
view, affiliated companies are (at least partly) a
single entity.
Investor company cannot earn a profit simply by
transferring assets to or from investee. Profits are
earned only by selling to an external party.
Intercompany sales cause no problems as long as
the asset in question is ultimately sold to an
external party. Adjustments must be made if a
“profitable” intercompany sale occurs and the
asset remains “inside” the investor-investee entity.