Chapter 12
Investments
in
Operating Assets
Financial Statement Items Covered
Balance Sheet
Long-term Assets
Property, Plant, &
Equipment
Accumulated
Depreciation
Intangible Assets
Income
Statement
Depreciation Expense
Amortization Expense
Loss on Impairment
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Statement of
Cash Flows
Operating
Asset depreciation
(indirect method)
Financing
Cash paid (received)
to purchase (from
sale of) long-term
assets
Cash paid to acquire
another company
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What are Long-Term
Operating Assets?
Long-Term Operating Assets
Long-term operating assets are
– not held for resale to customers
– are used by a business to generate
revenues
Long-term operating assets include
– Property, plant, and equipment
– Intangible assets
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Property, Plant, and Equipment
“PP&E”
– Tangible, long-lived assets
– Acquired for use in business operations
•Land
•Buildings
•Machinery
•Equipment
•Furniture
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Intangible Assets
Long-lived assets
– Used to facilitate the operation of a
business
– Do not have physical substance
•Patents
•Trademarks
•Licenses
•Franchises
•Goodwill
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Long-Term Asset Issues
Evaluate
Acquire
Estimate
and
Recognize
possible
acquisition of
long-term
operating
assets
long-term
operating assets
periodic
depreciation
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Monitor
Dispose
asset value for
possible decline
of the asset
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Deciding Whether to
Acquire a Long-Term
Operating Asset
Capital Budgeting
The process of evaluating a long-term
project that may include purchasing
property, plant, and equipment
Common capital budgeting models:
– Payback period
– Accounting rate of return
– Net present value
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Payback Period
The time it takes for a company to
recover its original investment in cash
Initial Investment
Payback Period =
Annual Cash Inflow
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Accounting Rate of Return
Projects are approved if their rate of
return exceeds some predetermined
rate
Accounting Rate = Annual Accounting Income
of Return
Initial Investment
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Net Present Value
Utilizes the concept of the time value
of money
A project is undertaken only if the
present value of the cash inflows from
the project exceeds the present value of
the cash outflow
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Acquisition of Plant,
Property, & Equipment
Acquisition of PP&E
The cost of PP&E includes any costs
necessary to bring the asset to the
condition and location for its intended
use
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Items Included in PP&E
Acquisition Cost
Land
Purchase price, commissions, legal fees,
escrow fees, surveying fees, clearing and
grading costs
Land Improvements
(e.g., landscaping,
paving, fencing)
Cost of improvements, including
expenditures for materials, labor and
overhead
Buildings
Purchase price, commissions,
reconditioning costs
Equipment
Purchase price, taxes, freight, insurance,
installation, and any expenditures
incurred in preparing the asset for its
intended use
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Acquisition for Cash
Purchase price
Discount*
Net Price
6% sales tax on purchase price
Freight charges
Installation costs
Total Acquisition Cost
$900
850
150
$15,000
(300)
$14,700
1,900
$16,600
*terms 2/10, n/30; payment made within discount period
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Subsequent Expenditures
Normal repairs and maintenance are
expensed in the current period
Expenditures which extend the useful
life or increase the productive capacity
are capitalized
– Asset book value is increased
– Annual depreciation is revised
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Acquisition Through Leasing
A lease is a contract whereby
• one party (lessee)
• is granted the right to use property
• owned by another party (lessor)
• for a specified period of time for a
specified cost
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Lease Types
Operating lease - equivalent to a rental
– Lease payments charged to expense
Capital lease – equivalent to a purchase
– The asset acquired is recorded in property,
plant and equipment
 The leased asset is depreciated over the
lease period
– A lease liability is shown in the liability
section of the balance sheet
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Acquisition by Exchange
The acquisition price of the asset is equal to
fair market value of noncash consideration
plus any cash given
Land
Capital Stock
780,000
780,000
To record the purchase of land in exchange for 10,000 shares of
stock when market price of the stock was $78 per share
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Acquisition Through Donation
The asset is recorded at its fair market
value at time it is received
Land
Gain - Donated Asset
500,000
500,000
To record the receipt of land through donation.
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Acquisition With a Basket Purchase
Fixed assets purchased for a lump sum
need to be recorded separately
The total purchase price must be
allocated among individual assets
received in proportion to their
appraised values
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Example:
Acquisition With a Basket Purchase
Fair Value of Assets:
Land
300,000
Building
900,000
Price Paid
$1,000,000
Land
Building
Appraised Relative
Value
Percentage Allocation
300,000
25.0%
250,000
900,000
75.0%
750,000
1,200,000
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100.0% 1,000,000
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Acquisition of an Entire Company
All acquired assets are recorded on the
books of the acquiring company at
their fair values as of the acquisition
date
The excess of the purchase price over
the fair value of the identifiable assets
represents goodwill
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Acquisition Through
Self-Construction
Self-constructed assets are recorded at
cost, including all expenditures
necessary to build the asset and make it
ready for its intended use
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Acquisition Through
Self-Construction
Costs include:
– Materials and labor used directly in construction
– A reasonable share of general overhead
– If interest is included it is called capitalized interest
Interest should be included equal to the amount that
could have been saved if the money used on the
construction had instead been used to repay loans
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Acquisition of
Intangible Assets
Intangible Assets
• Long-term
• Nonmonetary
• Generate revenues
– Grant a right to use of a product, process,
name, image, customer list, or business
practice
• Uncertainty about future benefits greater
than that of tangible assets
• Specifically identifiable
– Except goodwill
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Patent
An exclusive right to use, manufacture, process,
or sell a product granted by the U.S. Patent
Office. Patents have a legal life of 17 years, but
their economic life may be shorter
Copyright
The exclusive right of the creator or heirs to
reproduce and/or sell an artistic or published
work. Granted by the U.S. government for a
period of 50 years after the death of the creator.
Amortized over the shorter of its economic life
or legal life.
Trademark and
Trade Names
A symbol or name that allows the holder to use
it to identify or name a specific product or
service. A legal registration system allows for
an indefinite number of 20-year renewals
Franchise
An exclusive right to use a formula, design,
technique, or territory.
Goodwill
The ability of a company to earn above-normal
income. Recorded goodwill is the excess
amount paid to acquire a company, over and
above the fair market value of the company’s
identifiable assets.
Accounting for Goodwill
A business combination occurs when
one company buys all of the assets of
another company
The combination is accounted for using
the purchase method (as if one
company is buying the other)
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Purchase Method
The identifiable assets and liabilities are
recorded at their fair values
– The excess of the purchase price over the fair
value of the identifiable net assets is
recorded as goodwill
• Goodwill represents the company’s
reputation, superior business practices, and
market position
• Goodwill is only recorded when it is
purchased
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Determining Goodwill
Book Value
Fair Value Difference
Assets:
Cash
Accounts Receivable
Inventory
Plant, Property, & Equip
Patent
Liabilities
Accounts Payable
Long-term debt
50,000
250,000
400,000
350,000
-
50,000
250,000
450,000
500,000
100,000
(100,000)
(200,000)
(100,000)
(200,000)
Net Assets
750,000
1,050,000
50,000
150,000
100,000
-
Purchase price paid
Net assets, book value
1,300,000
(750,000)
550,000
Adjust net assets to fair value:
Inventory
Plant, Property, & Equip
Patent
Goodwill
Financial Accounting, 7e Stice/Stice, 2006 © Thomson
50,000
150,000
100,000
300,000
250,000
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Depreciation and
Amortization
Depreciation:
What it Is ... and Isn’t
IS
• The systematic
allocation of an
asset’s cost to the
periods of benefit
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IS NOT
• Accumulation of a
cash fund for asset
replacement
• A determination of
an asset’s current
value
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Depreciation
Causes of depreciation:
– Physical deterioration
•Due to use, passage of time, and
exposure to the elements
– Obsolescence
•Outdated, outmoded, or inadequate
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Depreciation Factors
Residual value (salvage value)
– An estimate of the asset’s worth at the
time of its disposal
Depreciable cost
– The original cost minus the residual
value
Estimated useful life
– A measure of the service potential in
terms of years or units produced
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Depreciation Methods
Straight-line
– Allocates an equal amount of asset cost
per year
Units-of-production
– Allocates cost based on the productive
output of the asset
Declining balance
– An accelerated method which allocates
more cost to depreciation in the early
years than the later years
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Depreciation Methods Illustrated
Assume the following information:
Equipment purchase date January 1, 2006
Acquisition cost
$40,000
Estimated residual value
$4,000
Depreciable cost
$36,000
Estimated useful life
5 years
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Straight-Line Depreciation
 Cost - Residual Value 
Useful Life
 $40,000 - $4,000 
5 years
= Annual Depreciation
= $7,200
Year Depreciation Accum Dep Book Value
2006
2007
2008
2009
2010
7,200
7,200
7,200
7,200
7,200
7,200
14,400
21,600
28,800
36,000
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32,800
25,600
18,400
11,200
4,000
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Straight-Line Method
Straight-line Depreciation
$35,000
$30,000
$25,000
$20,000
$15,000
$10,000
$5,000
$0
1
2
3
4
5
An equal amount
of depreciation
expense is
allocated to each
period
Year
Annual Depreciation
End of Year Book Value
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Declining-Balance Method
Annual depreciation is determined by applying
a fixed percentage to the remaining book value
at the beginning of each year
1
 rate = percentage rate
life
1
 2 = 40%
5
‘rate’ is the multiple of straight-line
(double is 2 times the straight-line rate)
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Declining-Balance Method
40%  remaining book value
40%  (cost - accum dep)
Year 1: 40%  ($40,000 - 0) = $16,000
Year 2: 40%  ($40,000 - $16,000) = $9,600
Year
2006
2007
2008
2009
2010
Beginning
Book Value Depreciation Accum Dep
40,000
16,000
16,000
24,000
9,600
25,600
14,400
5,760
31,360
8,640
3,456
34,816
5,184
1,184
36,000
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Ending
Book
Value
24,000
14,400
8,640
5,184
4,000
2010’s expense is
adjusted so that
ending book value
is not less than
established
residual value
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Declining-Balance Method
Double Declining-Balance
Depreciation
$30,000
$25,000
$20,000
$15,000
$10,000
$5,000
$0
1
2
3
4
5
Year
Annual Depreciation
Accelerated
methods allocate a
greater portion of
cost to the earlier
years of the
asset’s life
End of Year Book Value
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Comparison of Straight-line and
Double-Declining Balance
$18,000
$16,000
$14,000
Both methods
allocate a
depreciable cost of
$36,000 over a fiveyear period
$12,000
$10,000
$8,000
$6,000
$4,000
$2,000
$0
1
2
Straight-Line Method
3
4
5
Year
Declining Balance Method
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Selecting a Depreciation Method
for Financial Reporting Purposes
Management may choose any GAAP-based method for
financial reporting
Theoretically, best to use a method that reflects the pattern of
the asset’s revenues or benefits
– The straight-line method is appropriate for assets whose benefits
diminish on a fairly uniform basis
– The double-declining-balance method is appropriate for assets that
give up a greater portion of their benefits in the early years
Most companies use the straight-line method due to its
simplicity
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Choosing a Depreciation Method
for Tax Purposes
IRS Code stipulates depreciation
method and techniques
– Method depends on the statutory “class
life” category
– Current recovery periods range from 3
to 20 years for personal property
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IRS Depreciation
Recovery Periods and Lives
Cost
Recovery
Period (Yrs)
Personal Property
4 years or less
4 to < 10 years
10 to < 16 years
16 to < 20 years
20 to < 25 years
25 years or more
Real Property
residential rental
nonresidential
3
5
7
10
15
20
27.5
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Method
200% DB
150% DB
straight-line
Choosing a Depreciation Method
for Tax Purposes
Salvage value is ignored for tax purposes
The half-year convention is used
– Property is depreciated for half the taxable year in
which it is placed in service, regardless of when
use actually begins
Deferred tax liability arises
– Accelerated depreciation for tax purpose vs
straight-line depreciation for financial purpose
– Earlier years have higher tax deductions
– Later years have higher taxable income
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Depreciation and Cash Flow
Depreciation is not a source of cash; it
is a noncash expense
Depreciation indirectly affects cash flow
– depreciation reduces taxable income
– results in lower income taxes being paid
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Changes in Estimated Useful Lives
Later events may require changes in
estimates of economic life and residual
value
– A change in estimate is not an error
correction
– A change in estimate is reflected by
spreading the remaining depreciable
cost over the remaining useful life of the
asset
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Amortization of Intangible Assets
Finite life intangibles:
– Amortize over the economic useful life or
legal life, whichever is shorter
– Not to exceed 40 years
– Direct subtraction from the asset account
Indefinite life intangibles:
– No amortization
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Impairment of
Asset Value
Impairment of Asset Value
Occurs when an event happens after the
purchase of an asset that reduces its
value
– Recognized in the financial statements as
a reduction in the value of the asset on the
balance sheet and a loss on the income
statement
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Recording Decreases
in the Value of PP&E
A two-step process to identify
impairments and record decreases in
the value of PP&E
Identify: An impairment loss exists if the
sum of estimated future cash flows from
the asset is less than its book value
Record: An impairment is measured as the
difference between the book value of the
asset and the fair value
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Impairment of Intangible Assets
Intangibles must be evaluated to
determine if
– Their estimated useful life has changed
– The intangible has become impaired
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Recording Increases
in the Value of PP&E
U.S. GAAP
– The principle of conservatism controls
– Increases in the value of PP&E are not
allowed under current U.S. GAAP
– Gains are recognized in income only
when assets are sold
IAS GAAP
– Upward revaluation permitted
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Disposal of
Long-Term Assets
Disposal of
Long-Term Assets
Disposal of long-term assets can occur
through retirement, sale, or trade-in of
operating assets
In each case, depreciation must be recorded
up to the date of the disposal and any gain
or loss recognized
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Retirement
Occurs when an operating asset is removed
from service and is disposed of without the
company receiving any proceeds
An difference between the cost and balance
in the accumulated depreciation account
results in a loss on retirement
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Sale
A gain occurs if the cash or other assets
received are greater than the book value at
the time of sale
A loss occurs if the consideration received is
less than the book value at the time of sale
Gains/Losses are reported in “Other”
section of the Income Statement
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Sale: Two Examples
Case 1
Cash received
Book Value of Truck
Cost
Accum Dep
Case 2
7,000
35,000
30,000
Gain (Loss) on Sale
5,000
4,000
35,000
30,000
2,000
5,000
(1,000)
When the disposal is recorded in the accounting
records, both the original cost of the truck and the
accumulated depreciation on the truck are removed
from the books.
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Trade-In
Trade-in allowance > book value of the
asset given up
a gain is realized
Trade-in allowance < book value of the
asset given up
a loss is realized
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Measuring PP&E
Efficiency
Fixed Asset (PPE)Turnover
Used to evaluate the appropriateness of the
level of a company’s PP&E
Sales
Fixed Asset Turnover =
Average PP&E
Can be interpreted as the number of dollars
in sales generated by each dollar of fixed
assets
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Fixed Asset Turnover Dangers
 The ratios for two companies in different
industries cannot be compared
 The reported amount of PP&E can be a
poor indicator of fair value
 Sales generated by leased assets are
included in the numerator, but the leased
assets are not included in the
denominator; upward bias in the ratio
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In Summary ...
• Long-term assets provide the infrastructure for production
and distribution
• Capital budgeting models include the payback period,
accounting rate of return, and net present value analysis
• Patents, franchises, licenses, and goodwill are intangible
assets.
• Straight-line and declining balance are common
depreciation methods
• Recognizing impairment for PPE is a two-step process
• Gain (loss) on asset disposal occurs if proceeds received
are greater (less) than the asset’s book value at date of sale
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