Chapter 10: Long-lived assets
Learning Objectives
1. What measurement base is used for longlived assets?
2. What kinds of costs are capitalized and
how joint costs are allocated among assets?
3. What does asset “impairment” mean
and how is it recorded?
1
Learning Objectives (contd.)
4. How analysts can adjust for different
depreciation assumptions and improve
comparisons across companies?
5. How GAAP measurement rules
complicate ROA trend analysis and
comparisons across companies?
2
Asset
• An asset is something that
generates future economic
benefits and is under the
exclusive control of a single
entity.
• Examples: Cash, Accounts
receivables, investments,
inventories, property, plant and
equipment, intangible assets.
10-3
Long-Lived Assets
Assets Actively Used in Operations
Expected to Benefit Future Periods
Tangible ( Fixed)
Assets
Property, Plant,
Equipment ( PPE)&
Natural Resources
Intangible Assets
No Physical
Substance
4
Property, Plane and Equipment

PPE are acquired for use in
continuing operations over the life of
the asset to generate revenue.
5
PPE (contd.)

PPE are classified into two categories:
 Land (the cost is NOT subject to
depreciation)
 Depreciable assets: buildings,
equipment, motor vehicles, land
improvement.
 Matching principle is applied for the
periodical allocation of the cost of PPE
to expenses ( this process is referred
to as depreciation).
6
10-7
Control Over PPE

A fixed asset ledger card should be prepared
and maintained for each individual PPE asset
purchased.
 Include all the pertinent information relating to
the asset and its use.
 These data enable the management to
establish and maintain control over each
individual asset.
 It also assists in accounting for all transaction
relating to PPE assets.
8
Overview of Accounting for PPE
Acquisition
1. What costs to
capitalize?
Use
2. Depreciation
Disposal
4. Retirement
3. Post acquisition
expenditures
9
Costs include in the initial cost
Identify the various costs included in the initial
cost of property, plant, and equipment.
10
Costs to be Capitalized
General Rule
The initial cost of an operational asset
includes the purchase price and all
expenditures necessary to bring the asset to
its desired condition and location for use.
•PPE are acquired either by cash purchase or by
incurring a liability.
•If a liability is incurred, the interest charges
cannot be included in the cost of the asset except
for self-constructed assets.
•
11
Costs to be Capitalized- Equipment





Net purchase price
Taxes
Transportation costs
Installation costs
Modification to building necessary to
install equipment
 Testing and trial runs
12
Costs to be Capitalized – Land and Land
Improvements

Land:
 Purchase price
 Commissions
 Legal fees
 Closing fees
 Clearing fees
 Title search &
transfer fees
 Net razing cost of
an old building
Land
Improvements
(depreciable):
Driveways
Parking lots
Fencing
Landscaping
Private roads
13
Costs to be Capitalized- Building and
Nature Resources
Building
 Purchase price or
contract price
Cost of remodeling
Architectural fee
Building permits
Surveying cost before
construction
Interest capitalized
7 excavation cost
before construction
Natural Resources
Purchase price,
exploration and
development costs of:



Timber
Mineral deposits
Oil and gas reserves
14
Capitalization example:
Initial costs
All costs are capitalized.
15
Lump-Sum Purchases
Cost allocation for Lump-Sum Purchases.
16
Lump-Sum Purchases
Several assets are acquired for a single,
lump-sum price that may be lower than the
sum of the individual asset prices.
Allocation of the lump-sum
price is based on relative
market value of the individual assets.
Asset 1
Asset 2
Asset 3
Must separate costs because many assets have different
depreciable lives, and some (land) are not depreciated.
17
Tax versus financial reporting incentives

The allocation of costs between land and
buildings affects the amount of income that
will be reported in future periods.
Allocation 1:
Allocation 2:
• Lower
depreciation
• Higher
depreciation
$500
$100
Land

• Lower net
income
$100
• Lower taxes
Building
• Higher net
income
$500
Land
• Higher taxes
Building
For financial reporting and tax purposes, the allocation
is guided by their relative market value.
18
Lump-Sum Purchases
On May 13, we purchase land and building
for $200,000 cash. The appraised value of
the building is $162,500, and the land is
appraised at $87,500.
How much of the $200,000 purchase price
will be charged to the building account?
19
Lump-Sum Purchases
Asset
Land
Building
Total
Appraised
Value
(a)
$ 87,500
162,500
$ 250,000
% of
Value
(b)*
35%
65%
Purchase
Price
(c)
$ 200,000
200,000
Assigned
Cost
(b × c)
$ 70,000
130,000
$ 200,000
* $87,500÷$250,000 = 35%
The building will be apportioned $130,000
of the total purchase price of $200,000.
Prepare the journal entry to record the purchase.
20
Lump-Sum Purchases
GENERAL JOURNAL
Date
Description
May 13 Land
Building
Page 14
PR
Debit
Credit
70,000
130,000
Cash
200,000
21
Exercise – Joint costs
Total cost of $260,000 ($10,000 cash, $250,000
credit). Individual fair value is determined as if
purchased separately.
Asset (Fair value / Total FV)
Bldg. (100,000 / 325,000)
Equip. (185,000 / 325,000)
Land ( 40,000 / 325,000)
Total 325,000
Journal entry:
Building
Equipment
Land
Cash
Mort. Payable
x Total Cost = Cost
x 260,000 = $ 80,000
x 260,000 = 148,000
x 260,000 = 32,000
$260,000
80,000
148,000
32,000
10,000
250,000
22
Self-Constructed Asset
Identify the items included in the cost of a selfconstructed asset and determine the amount of
capitalized interest.
23
Self-Constructed Assets Costs

Cost of self-constructed assets includes:
1. direct materials,
2. direct labor,
3. factory overhead (variable overhead and
fixed overhead).
 When self-constructing an asset, two
accounting issues must be addressed:
 Overhead allocation to the self-constructed
asset.
 Proper treatment of interest incurred during
construction.
24
Interest Capitalization
Under certain conditions, avoidable
interest incurred on qualifying assets is
capitalized.
Interest that could have
been avoided if the asset
were not constructed
and the money used to
retire debt.
An asset constructed:
 For a company’s own
use.
As a discrete project
for sale or lease.
GAAP limits the amount of interest capitalized to the
lower of (1) Actual Interest or (2) Avoidable interest.25

Interest Capitalization

Capitalization of interest begins when




construction begins
interest is incurred, and
qualifying expenditures for assets
consturtion are incurred.
Capitalization ends when . . .


The asset is substantially complete and
ready for its intended use,
or when interest costs no longer are being
incurred.
26
Interest Capitalization
= Average Accumulated Expenditures x
interest rate
Interest is capitalized based on Weighted
Average Accumulated Expenditures
(WAAE).
Qualifying
expenditures
weighted for the
number of months
outstanding during
the current
accounting period.
Qualifying expenditures
include labor, material and
overhead incurred on the
construction project
during accounting period.
27
Interest Rate used in Interest
Capitalization
If the qualifying
asset is financed
through a specific
new borrowing . . .
If there is no specific
new borrowing, and
the company has
other debt . . .
. . . use the specific
rate of the new
borrowing as the
capitalization rate.
. . . use the weighted
average cost of other
debt as the
capitalization rate.
28
Example - Interest Capitalization for
Self-Constructed Assets

Capitalization period: 1/2/x2 to 6/30/x3

Specific construction debt: $1,500,000 at
11% annual int. rate. This debt was
borrowed on 9/30/x1 to finance the project.

Other debt during the construction period:
1. $4,000,000 at 12% annual int. rate.
2. $8,000,000 at 15% annual int. rate.

These loans have been outstanding since
1/1/x2.
Operational Assets: Acquisition
29
Example (contd.)
 Weighted
Average Interest Rate (of other debt):
Total interest = 480,000 +1,200,000 = 14%
Total Principle
12,000,000
or 12% x 4,000,000 +15% x 8,000,000 = 14%
12,000,000
12,000,000
 Expenditures
on the construction during 20x2 and
20x3 were as follows: 1/2/x2
$800,000
7/1/x2
$1,000,000
10/1/x2
$600,000
3/1/x3
$900,000
Operational Assets: Acquisition
30
Example (contd.)
 The
amount of interest to be capitalized for 20x2:
Computing the Weighted-Average
Accumulated Expenditures (WAAE):
1/2/x2 $800,000 x 12/12 = $800,000
7/1/x2 1,000,000 x 6/12 =
500,000
10/1/x2 600,000 x 3/12 =
150,000
2,400,000
$1,450,000
 Capitalized
Interest (Avoidable Interest) for 20x2:
$1,450,000 x 11% x 12/12= $159,5001
1.$1,450,000 < $1,500,000 11% int. loan borrowed
specifically to finance the project
Operational Assets: Acquisition
31
Example (contd.)
 Actual
interest incurred in 20x2:
$1,500,000 x11% + $4,000,000 x 12% +
$8,000,000 x 15% = $1,845,000.
Interest exp. = actual int. - capitalized int.
= $1,845,000 - 159,500
= $1,685,500
Operational Assets: Acquisition
32
Example (contd.)
 Journal
entry to record the construction
costs and interest expense for 20x2:
2,559,5001
Building
Interest Expense 1,685,500
Cash
4,245,000
1.construction costs of 20x2 plus the capitalized
interest of 20x2 (2,400,000+159,500=2,559,500).
Operational Assets: Acquisition
33
Example (contd.)
 The
amount of interest to be capitalized for 20x3:
WAAE of 20x3:
1/1/x3 $2,559,500 x 6/6 =$2,559,500
3/1/x3
900,000 x 4/6 = 600,000
6/1/x3 1,800,000 x 1/6 = 300,000
$3,459,500
 Capitalized interest for 20x3:
WAAE
Int. Rate
$1,500,000 x 11% x 6/12= $ 82,500
1,959,5001 x 14% x 6/12= 137,165
219,665
1. 3,459,500-1,500,000
Operational Assets: Acquisition
34
Example (contd.)
 Actual
interest incurred in 20x3:
Same as in x2 = $1,845,000.
Int. exp. Of x3 = 1,845,000-219,665= 1,625,335
 Journal
entry to record the construction costs
and int. exp. for x3:
Building
2,919,6651
Interest Exp.
1,625,335
Cash
4,545,000
1.$900,000 + 1,800,000 + 219,665 = 2,919,665
(costs of 20x3 plus the capitalized interest)
Operational Assets: Acquisition
35
Example (contd.)
 Reporting:
Income Statement
(for the year ended 12/31/x2)
Other Revenues & Expenses:
Interest Expenses
$1,845,000
Less: Capitalized Int.
(159,500)
$ 1,685,500
Notes:
Accounting Policy
 Capitalized interest: during 20X2, total interest
expense was $1,845,000 of which $159,500
was capitalized and $1,685,500 was charged to
expense.
Operational Assets: Acquisition
36
Interest capitalization can distort trends
The income decline
becomes larger once the
distortion is removed.
Income will be even lower without capitalizing interest.
37
Depreciation Methods
Depreciation Methods:
( a) Straight-line method
( b) Double-declining balance
( c) Sum-of-the-years’ digits
38
Depreciation method recap:
Basic concepts

The costs of productive assets must be apportioned to
the periods in which they provide benefits (matching
principle).
• Buildings
Depreciation • Equipment
Amortization • Intangibles
Depletion

• Mineral deposits
• Wasting assets
Depreciation is not intended to track the
asset’s declining market value but to allocate
the cost over its economic life.
39
Depreciation method recap :
(a) Straight-line method example
40
Depreciation method recap :
(b) Double-declining balance example
Switch to
straight-line
method
41
Depreciation method recap :
(c) Sum-of-the-years’ digits example
= n(n+1)/2
42
Compare depreciation methods:
Alternative patterns
(a)
Compare Alternative
depreciation methods
(a) Annual depreciation charges
Total depreciation
expenses will be the
same
(b)
(b) Net book value (carrying
value)
Ending book values
will be the same
43
Depreciation:
Methods used in financial reports
Straight-line is the most popular
depreciation method for financial
reporting purposes.
44
Straight-Line
On January 1, we purchase equipment for
$50,000 cash. The equipment has an
estimated service life of 5 years and
estimated residual value of $5,000.
What is the annual straight-line
depreciation?
45
Straight-Line
Annual
Straight-line
Depreciation
=
=
Acquisition
Residual
–
Cost
Value
Estimated Service Life in
Years
$
= $
–
50,000
$
5,000
5
9,000
46
Straight-Line
Year
1
2
3
4
5
Depreciation
(debit)
Accumulated
Depreciation
(credit)
Accumulated
Depreciation
Balance
$
$
$
$
9,000
9,000
9,000
9,000
9,000
45,000
$
9,000
9,000
9,000
9,000
9,000
45,000
9,000
18,000
27,000
36,000
45,000
Undepreciated
Balance
(book value)
$
50,000
41,000
32,000
23,000
14,000
5,000
Residual Value
Note that at the end of the asset’s
useful life, BV = Residual Value
47
Accelerated Methods : Sum-of-the-Years’
Digits (SYD)
SYD depreciation is computed as follows:
SYD
= ( Cost
Depreciation
* Sum-oftheYears'Digits
= (
Residual
–
) ×
Value
Useful
Life
× [
Remaining Years
of Useful Life
Sum-of-the-Years
Digits*
Useful
Life
+ 1 ] )
2
48
Sum-of-the-Years’-Digits (SYD)
On January 1, we purchased equipment
for $50,000 cash. The equipment has
a service life of 5 years and an
estimated residual value of $5,000.
Using SYD to compute depreciation
for the first two years.
49
Sum-of-the-Years’ Digits (SYD)
* Sum-oftheYears'Digits
=
(
Useful
Life
× [
Useful
Life
+ 1 ] )
2
=
=
=
(
5
30
15
× [
÷
2
5
+ 1]) ÷ 2
Use this in your computation of SYD
Depreciation for Years 1 & 2.
50
Sum-of-the-Years’ Digits (SYD)
SYD
= (
Depreciation
Cost
Remaining Years
of Useful Life
Residual
–
) ×
Value
Sum-of-the-Years
Digits
5
15
$ 15,000 Depreciation in Year 1
= ( $ 50,000 – $ 5,000 ) ×
=
4
= ( $ 50,000 – $ 5,000 ) ×
15
=
$ 12,000 Depreciation in Year 2
51
Sum-of-the-Years’ Digits (SYD)
Fraction
5/15
4/15
3/15
2/15
1/15
Depreciation
(debit)
Accumulated
Depreciation
Balance
$
$
$
15,000
12,000
9,000
6,000
3,000
45,000
15,000
27,000
36,000
42,000
45,000
Undepreciated
Balance
(book value)
$
50,000
35,000
23,000
14,000
8,000
5,000
Residual Value
52
Declining-Balance (DB) Methods
DB depreciation


Based on the straightline rate multiplied by
an acceleration factor.
Computations initially
ignore residual value.
Stop depreciating
when:
BV=Residual Value
53
Double-Declining-Balance (DDB)
DDB depreciation is computed as follows:
DDB =
Book
Value
× ( 2 ÷ Useful Life )
Note that the Book Value
will get lower each time
depreciation is computed!
54
Double-Declining-Balance (DDB)
On January 1, we purchase equipment
for $50,000 cash. The equipment has a
service life of 5 years and an estimated
residual value of $5,000.
What is depreciation for
the first two years using
double-declining-balance?
55
Double-Declining-Balance (DDB)
DDB =
Book
Value
× ( 2 ÷ Useful Life )
= $ 50,000 × ( 2 ÷ 5 )
= $ 20,000 1st Year Depreciation
= ($50,000 - $20,000) × (2 ÷ 5)
= $ 12,000 2nd Year Depreciation
56
Double-Declining-Balance (DDB)
Year
1
2
3
4
5
Depreciation
(debit)
$
$
20,000
12,000
7,200
4,320
1,480
45,000
Accumulated
Depreciation
Balance
$
2,592
20,000
32,000
39,200
43,520
45,000
Undepreciated
Balance
(book value)
50,000
$
30,000
18,000
10,800
6,480
5,000
We usually have to force depreciation in the
latter years to an amount that brings BV = Residual Value.
57
Reporting Fixed assets –Carrying value
Define and measure carrying value
58
Measuring the carrying amount:
Carrying value = Original Purchase Price – Accumulated Depreciation

There are two ways that long-lived assets could be
measured on balance sheets:
Expected benefit approach:
$$
• Discounted present
value
• Net realizable value
Estimated value in
an output market
where the asset is
sold
Economic sacrifice approach:
$$
• Historical cost
• Replacement
cost
Estimated value in an
input market where
the asset is
purchased
GAAP uses historical cost because the numbers are
reliable and verifiable.
59
Measuring the carrying amount

Assume a truck originally costing $100,000, is
two years old, has a remaining life of 8 years,
is being depreciated on a straight-line basis,
and is expected to have no salvage value.

Historical cost less accumulated
depreciation is the carrying value reported
on balance sheets:
$100,000 – {(100,000/10) *2} = $80,000 (
Carrying amount)
Carrying value = Cost – Accumulated Depreciation
60
Assets held for sale


When firms actively try to sell assets they own, the
asset groups should be classified on the balance sheet
as “held for sale”.
When assets are held for sale, they are reported at the
lower of book value or fair market value minus costs to
sell.
$2,304,000
$2,500,000
$2,350,000
$46,000
Book value
Fair value
Expected
cost to sell
 So, these assets would be shown on the
balance sheet at $2,304,000.
10-61
International perspective


In the U.K., companies are permitted to revalue land
and buildings.
Suppose a building that originally cost ₤20 million and
has an accumulated depreciation balance of ₤10
million is appraised at ₤35 million. The entry to writeup the building is:
DR Building
DR Accumulated depreciation
CR Revaluation reserve

£15,000,000
10,000,000
£ 25,000,000
And the new book value becomes:
10-62
Post-acquisition Expenditures
Identify the post-acquisition expenditures need to
be capitalized or expensed.
63
Post-acquisition Expenditures:
Capitalize or Expense?

GAAP capitalizes costs (i.e., record the
cost in an asset account) incurred after
the asset has been placed in use as long
as the expenditure:
 Extends the asset’s useful life
 Increases its productive capacity
(e.g. attainable production units)
 Increases its production efficiency
(e.g., fewer raw materials)
 Increases the asset’s other economic
benefits
64
Post-acquisition Expenditures:
Capitalize or Expense?

If there is no increase in economic
benefits (or future service potential),
the expenditure is charged to
income as an expense.
65
Post-acquisition Expenditures:
Subsequent costs

In January 2008 (three years later), Winger
spent an additional $8,000 on the machine:
Ordinary repairs
and maintenance
Install new
component
$2,000
$6,000
Increases the
economic benefit
(future service
potential) of the
machine.
Expense to income
statement: record as
repair expenses.
Capitalize to balance
sheet : Adding values
into the asset
accounts.
66
Expenditures Subsequent to Acquisition
Normally we debit an
expense account for
amounts spent on:
Maintenance
and ordinary
repairs.
Normally we debit the
asset account for
amounts spent on:
Improvements
(betterments),
replacements, and
extraordinary repairs.
Additions
.
Rearrangement
s and other
adjustments.
67
Case Study: Impact of WorldCom’s
Misapplication of Asset Capitalization Rules
68
Asset Impairment
What asset “impairment” means and how it is
recorded.
69
Asset Impairmentsa

Unlike inventory which is reported
at LCM, PPE and Intangibles are
reported at cost except for
impairments.

An impairment occurs when the
book value of an asset is not fully
recoverable.
a. Based on SFAS No. 144: Accounting for
the Impairment or Disposal of Long-Lived
Assets and SFAS No. 142: Goodwill and
Other Intangible Assets
Operational Assets: Utilization and
Disposition
70
Impairment of Value
Accounting treatment differs.
Operational assets
to be held and used
Tangible and
intangible
with finite
useful lives
Intangible
with
indefinite
useful lives
Operational assets
held to be sold
Goodwill
71
Operational Assets Held for Use – a.
Tangible Assets and Finite-Life Intangibles

SFAS No. 144 (effective 2002) requires
test for impairment only when events
or changes in circumstances indicate
that the book value of this asset (or
asset group) may not recoverable.

For the purpose of this test, assets are
grouped at the lowest level in which the
cash flows of each group are
independent.
Operational Assets: Utilization and
Disposition
72
The Accounting Treatment for
Impairment (for Held for Use Tangible and finite-Life
Intangibles)
Steps:
1. Conduct the Recoverability Test.
2. Compute the Impaired Amount.
Operational Assets: Utilization and
Disposition
73
Asset impairment:
The impairment loss is the difference between the fair
value of the asset and the carrying amount of the asset
According to SFAS No. 144 Guidelines:
 Step 1: If the events or changes in circumstances
raised the possibility that certain long-lived assets
may be impaired, go to step 2.
 Step 2: Estimate the future undiscounted net
cash flows expected from the use and disposal of
the asset.
If the future undiscounted net cash flows are less
than the carrying amount of the asset, the
impaired asset must be written down.
74
Step 1: Conduct the Recoverability
Test

Compare the book value (BV) of the
asset with the undiscounted expected
future cash flows (EFCF) of the asset
(asset group).
If BV > Undiscounted EFCF, the
impairment has occurred and the
impaired amount should be written
off.
Operational Assets: Utilization and
Disposition
75
Step 2: Compute The Impaired
Amount

Impaired amount
= Book value - fair value
(if the fair value is available) or

Impaired amount
= Book value – estimated fair value1
(if fair value is not available)
1. discounted present value of the future cash flows
of the asset can be the estimated fair value
Operational Assets: Utilization and
Disposition
76
Asset impairment:
SFAS No. 144 guidelines
Recoverable value
• Market value, price of
similar assets, or PV of
future net cash inflows.
77
Asset impairment: An Example
Solomon Corporation manufactures a variety of consumer electronics products. The
growing popularity of DVD players is expected to reduce the demand for Solomon’s
videocassettes. The videocassettes are produced on an assembly line consisting of five
special purpose assets with a carrying amount (net book value) of $2,000,000.
Solomon’s management believes that this change in the business climate threatens the
recoverability of these assets’ carrying amount. Assume the current fair value of the
entire assembly line is $1,000,000.
a.
Impairment possible?
Yes!
b.
Undiscounted net
cash flows expected
$1,500,000
c.
Are cash flows lower
than carrying amount?
d.
Impairment loss
Expected net operating cash flows:
2005
$800,000
2006
400,000
2007
200,000
100,000
Expected salvage value
Total undiscounted
$1,500,000
cash flows
Yes!
The difference between the fair vale of the
asset and the carrying amount of the asset.
2,000,000-1,000,000=1,000,000
78
Disposition or retirement of long-lived
assets
Disposition or retirement of long-lived assets.
79
Disposition or retirement of long-lived assets

Suppose the asset in Exhibit 10.9 is sold at the end
year 2 for $5,000 when its book value is $3,780. The
entry to record this disposition is:
DR Cash
DR Accumulated depreciation
CR Long-lived assets
CR Gain on sale of assets


$5,000
6,720
$10,500
1,220
Dispositions of individual assets take place frequently,
so gains and losses do not qualify for extraordinary
item treatment.
Both original cost and accumulated depreciation must
be removed from the balance sheet.
80
Obligations arising from retiring longlived assets (SFAS No. 143)
 Kali records the asset retirement obligation when the asset is
placed into service:
DR Drilling rig (asset retirement cost)
CR ARO liability
$8,167,000
$8,167,000
 This results in additional depreciation expense:
DR Depreciation expense
CR Accumulated depreciation-drilling rig
$1,633,400
$1,633,400
10-81
Intangible Assets
Identify the various costs included in the initial
cost of intangible assets.
82
Intangible assets:
Overview

Intangible assets convey future benefits to their
owners.
Patent
Trademark

Examples of Intangible assets:
Patents, Copyrights, Trademarks,
Franchises and goodwill.
Characteristics of Intangible assets:




Lack physical substance.
Future benefits less certain than tangible
assets.
Owner with exclusive rights.
10-83
Costs to be Capitalized
Intangible Assets

The accounting for acquired intangible assets
is straight-forward:



The asset is first recorded at the arm’s length
transaction price.
Then amortized (think “depreciation”) over its
expected useful life.
Difficult financial reporting issues arise when
the intangible asset is developed internally
instead of being purchased.
84
Patents

An exclusive right recognized by law and granted
by the US Patent Office for 20 years.

A company may capitalize the following
 the cost of acquiring an externally developed patent.
 filing fees for internally or externally developed patents.
 the legal fees for acquiring and successfully defending a
patent (internal or external).

A company cannot capitalize the following
 legal fees for unsuccessfully defending a patent.

R& D costs that lead to an
internally developed patent
are expensed in the period
incurred.
85
Patents
Genetech, Inc. has developed a new device.
Research and development costs totaled
$30,000. Patent registration costs consisted of
$2,000 in attorney fees and $1,000 in federal
registration fees.
What is Genetech’s patent cost?
Torch’s cost for the new patent is $3,000.
The $30,000 R & D cost is expensed as
incurred.
86
Copyrights



A form of protection given by law to
authors of literary, musical, artistic, and
similar works.
Copyright owners have exclusive rights
to print, reprint, copy, sell or distribute,
perform and record the work.
Generally, the legal life of a copyright
is the life of the author plus 70 years.
87
Trademarks

A symbol, design, or logo
associated with a business.

If internally developed,
trademarks have no recorded
asset cost.

If purchased, a trademark is
recorded at cost.

Registered with U.S. Patent
Office and renewable
indefinitely in 10-year periods.
88
Franchises and License

A franchise is a contractual agreement
under which the franchiser grants the
franchisee the right to sell certain
products or service or to use certain
tradenames or trademarks

A license is a contractual agreement
between a governmental body (i.e., city,
state, etc.) and a private enterprise to use
public prope
89
Goodwill
Goodwill
Occurs when one
company buys
another company.
Only purchased
goodwill is an
intangible asset.
The amount by which the
purchase price exceeds the fair
market value of net assets acquired.
90
Goodwill
Eddy Company paid $1,000,000 to purchase
all of James Company’s assets and
assumed James Company’s liabilities of
$200,000. James Company’s assets were
appraised at a fair value of $900,000.
91
Goodwill
What amount of goodwill should be
recorded on Eddy Company books?
a.
b.
c.
d.
$100,000
$200,000
$300,000
$400,000
92
Intangible assets:
Research and development (R&D)



Recoverability of R&D expenditures (i.e., the
future benefit) is highly uncertain at the start of
a project.
So, SFAS No. 2 requires virtually all R&D
expenditures to be expensed as incurred.
The FASB justified expensing all R&D for
three reasons:
1. The future benefits are highly uncertain and difficult to predict.
2. A causal relationship between current R&D and future
revenue (the benefit) has not been demonstrated.
3. Whatever benefits may arise cannot be objectively measured.
10-93
Research and Development (R&D)
Research
 Planned search or critical investigation aimed at discovery of
new knowledge . . .
Development
 The translation of research findings or other knowledge into a
plan or design . . .
Accounting Treatment for R&D costs:
 R&D costs incurred under contract for other
companies are expensed against revenue from
the contract.
 Operational assets used in R&D should be
capitalized if they have alternative future uses.
94
Intangible assets:
Software development

SFAS No. 86 extends the accounting
treatment for R&D to internal expenditures
for software development.
Expensed
as incurred
Technological feasibility established
Development
expenditures $$
Befor
Development
expenditures $$
Capitalized
and
amortized
After
Software project time line
10-95
Intangible assets:
Purchased in-process R&D

When one firm buys another firm, the total purchase
price must be apportioned among the individual assets
acquired.
$950
Price paid for
company

$500
In-process R&D (no
alternative future use)
$200
Other in-process R&D
$250
Tangible assets
Immediately
written off
Allocation of
purchase price
Managers have a strong incentive to
allocate a large portion of the purchase
price to purchased in-process R&D.
10-96
Software Development Costs
SFAS No. 86
“Accounting for the Costs of Computer Software
to be Sold, Leased, or Otherwise Marketed”


All costs incurred to establish the
technological feasibility of a computer
software product are treated as R&D and
expensed as incurred.
Subsequent costs to obtain product masters
are to be capitalized as an intangible asset.
97
Software Development Costs
SFAS No. 86
Software project time line
Costs
Expensed
as R&D
Start of
R&D
Activity
Costs
Capitalized
Technological
Feasibility
Operating
Costs
Date of
Product
Release
Sale of
Product
98
Intangible assets:
Accounting in the United Kingdom



Marketing and advertising expenditures are
treated as period costs. R&D accounting
also similar to U.S. GAAP.
However, UK accounting rules allow
companies to write long-lived assets up to a
new higher carrying value when market
value exceeds historical cost.
One firm decided to put a balance sheet
value of $1.2 billion on its 60 trademarks
(called “brands” in the UK).
10-99
Learning Objective
How analysts can adjust for different
depreciation assumptions and improve
comparisons across companies
100
Depreciation Disclosures




Depreciation.
Balances of major classes of depreciable
assets.
Accumulated depreciation by asset or in
total.
General description of
depreciation methods used.
101
Financial analysis:
Depreciation differences
102
Financial analysis:
Finding average useful life

When a company uses straight-line depreciation, the ratio of
average gross PP&E divided by depreciation expense is a
rough approximation of estimated useful life:
103
Financial analysis:
Average useful life at Wal-Mart and Costco
Compared to $3.1 billion
reported depreciation expense
Using Costco’s estimated service life, Wal-mart’s
depreciations expense would be:
$2.7 =
$52.1
19 years
104
Wal-Mart and Costco Example (contd.)



Therefore, had Wal-Mart used Costco’s
deprecation life, its earnings will be reduced
by $400 million.
This adjustment process relies on many
assumptions (i.e., both companies assets
are similar and have similar lives and
residual value, etc.)
If the assumptions are incorrect, this
method will not result in correct adjustment.
10-105
Learning Objective
How GAAP measurement rules
complicate trend analysis and
Learning
ObjectiveLearning
comparisons across companies
106
Financial analysis and fixed assets:
ROA distortion example
Assume:
 No new capital
expenditures.
 Prices rise at 3% per year operating CF increases.
25%
20%
15%
10%
5%
0%
ROA chart shows improving
performance.
2005
2006
2007
2008
2009
Return on assets
107
Financial analysis and fixed assets
Why ROA appears to increase
Constant
amount
each year
Increases 3%
each year
Asset base
declines
each year
108
Financial analysis and fixed assets:
Rizzo Corporation
Same as CHEN
Assume:
 Long-lived asset age of
4.5 years.
 Capital expenditures
replace 10% of longlived assets each year.
 Prices rise at 3% per
year.
25%
ROA no longer
increases over time.
20%
15%
10%
5%
0%
2005
2006
2007
2008
2009
Return on assets
109
Financial analysis and fixed assets
Why Rizzo’s ROA is flat
Capital
expenditures
cause the
increase
110
ROA distortion Example (contd.)



Therefore, firms whose assets are
continually being replaced (i.e., Rizzo)
cannot be easily compared to firms with
aging assets such as Chen.
However, most firms do regularly replace
some assets.
Therefore, when assets are regularly
replaced, the average age of long-lived
assets remains fairly constant from year to
year.
10-111
ROA distortion Example (contd.)


One of the reasons causing the distortion
on ROA analysis is the historical cost basis
on depreciation of long-lived assets and the
reporting of these assets on financial
statements.
Within the same industry comparison of
ROA is usually meaningful due to
competition often leads firms to have
similar investments and operating
strategies (i.e., similar % increase in capital
expenditures).
10-112
Summary





The need for reliable and verifiable numbers causes
long-lived assets to be measured using historical cost.
The balance sheet amounts for intangible assets often
differ from their real value.
Changes in the amount of capitalized interest from one
period to another can distort earnings trends.
When comparing return on assets (ROA) ratios across
firms, remember that ROA drifts upward as assets
age.
Depreciation differences can complicate comparisons
across firms. Footnote details can be used to improve
these comparisons.
113