1 FINANCIAL ACCOUNTING a user perspective Sixth Canadian Edition Chapter 8 Capital Assets— Tangible and Intangible Prepared by: Lynn de Grace C.A. Capital Assets— Recognition 2 A capital asset Has value in use • • Used to generate future revenue through sales of products or services Cash received over several future periods Used until replaced with a new asset • Can have residual (or resale) value John Wiley & Sons Canada, Ltd. ©2011 Valuation of Capital Assets 3 Alternative 1 – Historical cost Original cost of the asset Expensed (amortized) over the useful life Gain or loss on sale • • Recognized only when sold Difference between the proceeds of the sale and the net book value Net book value (or carrying value) • • Original cost less amortization Also called the amortized cost of the asset John Wiley & Sons Canada, Ltd. ©2011 Valuation of Capital Assets Alternative 2: Market Value—Replacement Cost Amount that would be needed to acquire an equivalent asset Unrealized gains and losses are recognized as the replacement value of the asset changes Amortization would need to be adjusted each time the replacement value changes John Wiley & Sons Canada, Ltd. ©2011 4 Valuation of Capital Assets Alternative 3: Market Value—NRV Amount that would be received by converting the asset to cash Unrealized gains and losses are recognized as NRV changes Amortization is adjusted each time NRV is adjusted When the asset is sold or disposed of, the gain or loss will be small John Wiley & Sons Canada, Ltd. ©2011 5 Valuation of Capital Assets 6 Canadian practice: Use historical cost (original acquisition cost). Meets objectives: reliable, verifiable, objective Amortize cost over the period of use Market value changes are not recognized until the asset is disposed of. IFRS: • • Companies may opt to use NRV to value capital assets Unrealized gains and losses are reported directly in shareholders’ equity as a revaluation reserve. John Wiley & Sons Canada, Ltd. ©2011 Capitalizable Costs 7 Costs to acquire and prepare the asset for use • • • • • • Purchase price (less any discounts) Transportation costs Preparation, installation and set-up costs Direct taxes Interest costs (on self-constructed assets) Legal costs associated with the purchase John Wiley & Sons Canada, Ltd. ©2011 Basket Purchases 8 Several assets acquired in one transaction Price paid is divided between the assets on the basis of their relative fair values at the time of acquisition John Wiley & Sons Canada, Ltd. ©2011 Basket Purchases 9 Timberland Example Asset Land Timber Fair Values % of fair value Purchase Price Allocation 250,000 25% $220,000 750,000 75% 660,000 $1,000,000 100% $ 880,000 $ John Wiley & Sons Canada, Ltd. ©2011 Interest Capitalization 10 Companies often borrow money to finance • • A capital asset The construction of a capital asset IFRS - Interest paid on borrowed money may be capitalized for assets constructed or acquired over time. John Wiley & Sons Canada, Ltd. ©2011 Amortization Concepts 11 Systematic and rational method of allocating the cost of capital assets to the periods in which the benefits from the assets are received (the useful life) Does not refer to the value of the asset Respects the matching concept John Wiley & Sons Canada, Ltd. ©2011 Amortization Methods 12 Straight-line method Production method Accelerated or declining-balance method Decelerated or compound interest method John Wiley & Sons Canada, Ltd. ©2011 Straight-Line Method 13 Allocates the cost evenly over the life of the asset Estimates needed for: • • Useful life Residual value Advantage is simplicity John Wiley & Sons Canada, Ltd. ©2011 Straight-Line Method 14 EXAMPLE – Data/Assumptions: • • Original cost Estimated • • $50,000 Residual value Useful life $5,000 5 years John Wiley & Sons Canada, Ltd. ©2011 Straight-Line Method 15 Amortization = Expense = Original Cost - Estimated Residual Value Estimated Useful Life $50,000 - $5,000 5 years = $9,000 per year John Wiley & Sons Canada, Ltd. ©2011 Straight-Line Method 16 Amortization Schedule Year 1 2 3 4 5 Beg. Book Value $50,000 41,000 32,000 23,000 14,000 Amortization Ending Book Expense Value $9,000 $41,000 9,000 32,000 9,000 23,000 9,000 14,000 9,000 5,000 $45,000 John Wiley & Sons Canada, Ltd. ©2011 Units of Production Method 17 Assumptions • Benefits derived are related to the output or use of an asset Requires that the useful life can be expressed as units of output John Wiley & Sons Canada, Ltd. ©2011 Units of Production Method 18 Data/Assumptions: • Original cost $50,000 • Estimated • Residual value $5,000 • Usage: Year 1 4,000 units Year 2 5,000 units Year 3 6,000 units Year 4 4,500 units Year 5 3,000 units 22,500 units John Wiley & Sons Canada, Ltd. ©2011 Units of Production Method 19 Amortization Expense per = Unit = Cost - Residual Value Estimated Total Units of Output $50,000 - $5,000 22,500 units = $2.00 per unit John Wiley & Sons Canada, Ltd. ©2011 Units of Production Method 20 Amortization Schedule Year 1 2 3 4 5 Cost per Unit $2.00 2.00 2.00 2.00 2.00 Units Amortization Ending NBV Produced Expense $4,000 5,000 6,000 4,500 3,000 $8,000 10,000 12,000 9,000 6,000 $45,000 John Wiley & Sons Canada, Ltd. ©2011 $42,000 32,000 20,000 11,000 5,000 Accelerated Depreciation Methods 21 Amortization • Multiply the carrying value of the asset by a fixed percentage Carrying value decreases each year Amortization expense decreases each year John Wiley & Sons Canada, Ltd. ©2011 Accelerated Depreciation Methods 22 Percentage rates • Lower when asset has longer life Double-declining-balance method • Percentage is double the straight-line rate • Residual value • Not used for calculations • Serves as a constraint Formula • (Cost – Accumulated Amortization at beginning of period) X Amortization % = Amortization Expense John Wiley & Sons Canada, Ltd. ©2011 Double Declining Balance Method 23 Data: • • • Original cost Estimated Residual value Estimated Useful life $50,000 $5,000 5 years Rate Calculation: DDB rate = DB% x SL rate John Wiley & Sons Canada, Ltd. ©2011 = 2 x 1/n yrs = 2 x 1/5yrs = 40% Double-Declining- Balance Method 24 Amortization Schedule Amortization Expense $20,000 Ending NBV 1 Beginning NBV $50,000 2 30,000 12,000 18,000 3 18,000 7,200 10,800 4 10,800 4,320 6,480 5 6,480 1,480 5,000 Year John Wiley & Sons Canada, Ltd. ©2011 $30,000 Recording Amortization Expense 25 The same journal entry is used for all amortization methods: Amortization expense (SE) XX Accumulated amortization (XA) XX Use of a contra-asset account—more informative than reducing the asset directly. John Wiley & Sons Canada, Ltd. ©2011 Corporate Income Taxes 26 Canada Revenue Agency (CRA) • Amortization expense is allowed to be deducted to calculate accounting income • Capital cost allowance (CCA) instead must be used to calculate taxable income John Wiley & Sons Canada, Ltd. ©2011 Corporate Income Taxes 27 Must add back amortization expense to net income and deduct CCA instead. Results in a temporary difference between accounting income and taxable income Result is a future income tax liability or asset (Amortization Expense – CCA) x Tax Rate = Future Income Tax Asset/Liability John Wiley & Sons Canada, Ltd. ©2011 Capital Cost Allowance (CCA) 28 Capital assets are grouped into classes and assigned a maximum rate Example: Vehicles: Class 10 - rate 30 % Equipment: Class 8 - rate 20 % Most classes are declining balance John Wiley & Sons Canada, Ltd. ©2011 Capital Cost Allowance (CCA) 29 Company purchases new equipment (Class 8) costing $50,000 CCA calculation: Year Rate UCC CCA (Cost-Accumulated CCA) 1 20% x 50,000 x 50% = 5,000 2 20% x (50,000 - 5,000) = 9,000 3 20% x (50,000 - 14,000) = 7,200 4 20% x (50,000 - 21,200) = 5,760 John Wiley & Sons Canada, Ltd. ©2011 Future Income Taxes Accounting Taxable Income Income Revenues Amortization CCA Other Expenses Income Before Tax Taxes at 40% $100,000 $100,000 (9,000) — — (5,000) (66,000) (66,000) 25,000 29,000 $10,000 $11,600 John Wiley & Sons Canada, Ltd. ©2011 30 Future Income Taxes 31 Journal entry: Income Tax expense (SE) Future tax asset (A) Income taxes payable (L) 10,000 1,600 *(Future tax liability if a credit balance) John Wiley & Sons Canada, Ltd. ©2011 11,600 Changes in Depreciation Estimates 32 Estimates of useful life and residual value may change over time - amortization may change as a result. Example: Data/assumptions • • • • Original cost Estimated • Residual value • Useful life Straight-line amortization NBV at end of year 3 John Wiley & Sons Canada, Ltd. ©2011 $50,000 $5,000 5 years $9,000 $23,000 Changes in Amortization Estimates 33 Change in year 4 Residual value Remaining useful life Amortization Expense = = = $2,000 3 years Remaining Book Value – Residual Value Useful Life $23,000 – $2,000 3 years $7000 per year for years 4, 5, and 6 John Wiley & Sons Canada, Ltd. ©2011 Write-down of Capital Assets 34 Net Recoverable Amount The total of all the future cash flows related to the asset, without discounting them to present values. If an asset’s carrying value exceeds its net recoverable amount, the carrying value must be written down and the difference recognized as an impairment loss. Under both historical cost and net realizable value, an asset cannot be valued at more than the amount that can be recovered from it. John Wiley & Sons Canada, Ltd. ©2011 Write-down of Capital Assets 35 If future recoverable amount of a capital asset declines below its carrying value Loss due to damage to equipment (SE) 3,000 Accumulated depreciation (XA) 3,000 John Wiley & Sons Canada, Ltd. ©2011 Sale of Capital Assets 36 Original cost and accumulated amortization removed from accounts Gain or loss: difference between cash received and book value of asset Cash (A) Accumulated amortization (XA) Equipment (A) Gain on sale of equipment (SE) 6,000 45,000 John Wiley & Sons Canada, Ltd. ©2011 50,000 1,000 Disposal of Capital Assets 37 If assets are disposed of and no cash is received: Accumulated amortization (XA) Loss on disposal of equipment (SE) Equipment (A) 45,000 5,000 John Wiley & Sons Canada, Ltd. ©2011 50,000 Capital Asset Disclosures 38 John Wiley & Sons Canada, Ltd. ©2011 Natural Resources 39 Capitalizing the costs as assets implies that they have future value Example: oil exploration Exploration costs methods • Full costing method – capitalizes the costs of all explorations, both successful and unsuccessful, as long as the expected revenues from all the explorations are estimated to exceed the total costs. Successful efforts method – capitalizes only the cost of successful explorations and expenses any unsuccessful exploration costs. Amortization of natural resources is called depletion John Wiley & Sons Canada, Ltd. ©2011 Intangible Assets 40 Intangible assets have probable future value but may not have physical form Guidelines: • If developed internally, expense costs as incurred • If purchased, acquisition costs can be capitalized John Wiley & Sons Canada, Ltd. ©2011 Intangible Assets - Amortization 41 Estimate useful life and residual value (if any) Straight-line method is most commonly used Accumulated amortization account rarely used Amortization expense (SE) Patents (A) XX John Wiley & Sons Canada, Ltd. ©2011 XX Intangible Assets 42 Advertising • Generally expensed as incurred • Difficult to justify future benefits Patents, Trademarks, Copyrights • Legal life is the maximum for amortizing • Useful, or economic life, is generally used for calculating amortization Goodwill • Capitalize if purchased but not amortized • Annual evaluation to determine if value is impaired—if so, write-down is required John Wiley & Sons Canada, Ltd. ©2011 Return on Assets 43 Widely used to assess how well management has used the assets to operate income Interest expense is added back to income to equate interest with dividends Interest expense is adjusted to reflect the fact that it is taxdeductible What does “tax deductible” mean? John Wiley & Sons Canada, Ltd. ©2011 43 Return on Assets ROA = = Income before Interest expense Average total assets Net income + [Interest expense - Tax savings of Interest Expense)] Average total assets = Net Income + [Interest Expense X (1 – Tax Rate)] Average total assets John Wiley & Sons Canada, Ltd. ©2011 Statement Analysis Considerations Choice of amortization method affects both the value of asset on balance sheet and the amount of expense on the income statement; Many valuable assets are not recorded on the balance sheet because they are internally developed, e.g., customer lists, intellectual property, human resources; Establishing the market values for some assets might be relevant if the company has to replace them; Soft assets, such as development costs, may require skepticism. What is a “soft asset” ? John Wiley & Sons Canada, Ltd. ©2011 45 Copyright 46 Copyright © 2011 John Wiley & Sons Canada, Ltd. All rights reserved. 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