Download CHAPTER 10 Capital assets

CHAPTER
10
CAPITAL ASSETS

Capital assets (fixed assets) are:




Long-lived
Used in the operations of a business
Not intended for sale to customers.
Capital assets have two classes:
1. Tangible (can touch it)
2. Intangible (can’t touch it)
TANGIBLE CAPITAL ASSETS
Tangible capital assets include:
 property, plant and equipment like:




Land + land improvements
Buildings + improvements
Equipment + freight + installation
natural resources such as mineral deposits,
oil and gas reserves, and timber
INTANGIBLE CAPITAL ASSETS
What are they?
 Patents, copyrights, sports contracts, and
trademarks, goodwill
 Intangible capital assets provide future
benefits through the special rights and
privileges they possess.
 ©
DETERMINING THE COST OF
CAPITAL ASSETS


Capital assets are recorded at cost (cost
principle).
Cost consists of all expenditures necessary to
1.
2.
Acquire the asset and
Make it ready for its intended use.
These costs include purchase price, freight costs,
and installation costs.
So, how do you come up with a cost figure?...
MEASUREMENT OF
CAPITAL ASSET COST
Funny you should ask…
 Cost is measured by cash paid, or by the cash
equivalent price when other assets are used instead.

The cash equivalent price is equal to the fair market
value of
1.
2.
the asset given up or
the asset received,
whichever is more clearly determinable.
LAND

The cost of land can include:
1.
Purchase price
Closing costs such as title and legal fees
Accrued property taxes and other liens on the
land assumed by the purchaser
Land improvements like:
2.
3.
4.
1.
2.
3.
4.
Parking lots
Fencing
Landscaping
Lighting
BUILDINGS

The cost of buildings includes all necessary
expenditures relating to purchase or construction.

When purchased:


When making building ready for its intended use:


Purchase price and closing costs.
Expenditures for remodelling, replacing or repairing the roof,
floors, wiring, and plumbing, etc..
When constructed, cost consists of:

Contract price, architects’ fees, building permits, interest
payments during construction, and excavation costs.
EQUIPMENT

The cost of equipment consists of:
1.
2.
3.
4.
Cash purchase price,
Freight charges, duties or tariffs
Insurance against loss during transit,
As well as all costs to assemble, install,
and test it.
WHY AMORTIZATION?
(Depreciation - Review)





During an asset’s life, its usefulness may decline
because of usage or obsolescence.
Amortization is the process of allocating to expense
the cost of a capital asset over its useful life.
Amortization is designed to match expenses with
revenues in accordance with the matching principle.
Recognition of amortization does not result in the
accumulation of cash for the replacement of the
asset, nor the use of cash, although an expense is
recognized.
Land is the only capital asset that is not amortized.
AMORTIZATION METHODS

Three methods of recognizing amortization are:
1. Straight-line,
2. Declining-balance (includes CCA), and
3. Units of activity.
Each method is acceptable under GAAPs.
Management selects the method that is appropriate for
their company, it should be applied consistently.
1. STRAIGHT-LINE METHOD
Historical Cost
Salvage Value
Annual Rate of
Amortization
Useful Life
(in years)
1. STRAIGHT-LINE METHOD
DECLINING-BALANCE METHOD
 Based
on a declining book value (cost less
accumulated amortization).
 The
amortization rate remains constant, but
the net book value declines each year.
Book Value
(at beginning of
year)
Declining
balance rate
Amortization
Expense
(for the year)
DECLINING-BALANCE (cont.)

If you aren’t given a rate for declining
balance, use the following formula:
NEW!
100%
Rate =
.
Useful Life
Example: Business buys $10,000 piece of equipment with a salvage
value of $1,000 is expected to last for 10 years.
However, management feels that the DECLINING BALANCE
METHOD is best for amortizing this asset.
100%
10 years
.
= 10%
DECLINING-BALANCE METHOD
UNITS-OF-ACTIVITY METHOD
EXAMPLE (assume the following):
Mine of 1,000,000 m3 of ore
Cost of finding,
dropping aValue
shaft and
Total Cost of Resource
– Salvage
preparing for use: $50,000,000
This year
we harvested 75,000 m3 of ore.
Total Units
Available
Total Amortizable Costs of Mine
Total Units
available
Amortization
X
Cost
per
Unit
Amortization per unit used
Total Amortization Expense
Amortization
Cost per Unit
$ 50,000,000
1,000,000Amortization
Units Used
$
$
Cost this
50.00 ($50,000,000
Period / 1,000,000)
3,750,000
3
(75,000 m x $50/unit)
UNITS-OF-ACTIVITY METHOD
REVISING AMORTIZATION
Change in Amounts or Speed


If annual amortization is inadequate or
excessive, a change should be made.
When a change is made,
1.
2.

There is no correction of previously recorded
amortization expense, and
Amortization expense for current and future
years is revised using the normal formulas.
When asset is bought/sold part way
through a year, that year’s amortization
must be prorated.
REVISING AMORTIZATION
Change in Method


If you decide to change the amortization
method, a prior period adjustment must
be made
When you change any accounting policy
you:
Do NOT revise prior years’ financial stmts
2. Calculate the total change for all prior years
and charge it directly to the Capital account
3. Record this year’s amortization using the new
method.
Why would it be done this way?
1.
C.C.A.
Capital Cost Allowance




CCA is the government’s method of calculating
amortization for tax purposes.
CCA is exactly like the Declining Balance method.
However, CCA only allows you to recognize ½ a
year’s amortization in the year of disposal AND
purchase.
CCA rates are specific, and are the maximum
allowable rates for a year.
See page 472 for a schedule of
CCA rates for asset classes.
C.C.A. and Income Taxes

Must report using GAAPs



Most firms use straight-line (it’s easy)
But taxes are determined using tax law (CCA).
This creates a discrepancy. Observe
CCA vs. Straight Line
CCA
Straight Line
Year 1
Year 2
Year 3
Year 4
C.C.A. and Income Taxes



The discrepancy is charged to an account called
Deferred Income Tax
Most people (especially politicians) think that this account
represents legitimate tax that corporations have
somehow evaded paying.
Not the case. It arises from the discrepancy between
CCA for tax purposes, and amortization using GAAPs.
Date
April 30
Particulars
Income Tax Expense
Deferred Income Taxes
Cash
Debit
Credit
25,000
5,000
20,000
EXPENDITURES DURING
USEFUL LIFE

Ordinary repairs are expenditures to maintain the
operating efficiency and expected productive life of
the capital asset.



Expenditures are usually immaterial in amount and occur
infrequently.
They are operating expenses and are debited to Repairs
Expense.
Additions and improvements are costs incurred to
increase operating efficiency, productive capacity,
or expected useful life of the capital asset.


They increase a company’s investment in productive
facilities, so
They are capital expenditures and are debited to the
capital asset.
CAPITAL ASSET DISPOSALS
(Example: equipment costing $5,000 with $1,100 of amortization was sold for $4,000
on September 30th)
1
Amortization for the fraction of the year to the
date of disposal must be recorded
Date
Sept 30
Particulars
Debit
Amortization Expense
100
Accumulated Amortization (assumed)
To record 9 months of depreciation on disposed asset.
Credit
100
CAPITAL ASSET DISPOSALS
2
Remove the value of all accounts associated
with that asset, and record receipt of cash.
Date
Sept 30
Particulars
Debit
Cash
Accumulated amortization
Equipment
Gain on sale of equipment
Credit
4000
1200
5000
200
To record gain on the sale of buffing equipment.
Gain or loss equals = Selling Price – Book Value
$200 = ($4,000 - $3,800)
$1,200) = $3,800
Historical($5,000
Cost ––Accumulated
Amortization
CAPITAL ASSET
DISPOSALS (cont.)

Alternatively, you can combine all three
steps into one journal entry.
 The
only difference here is that Accumulated
Amortization will not include the value of the last
write-off (step 1).
Date
Sept 30
Particulars
Cash
Amortization expense
Accumulated amortization
Equipment
Gain on sale of equipment
Debit
4000
100
1100
Credit
$1,200
5000
200
NATURAL RESOURCES


Natural resources (wasting assets), consist of
standing timber and underground deposits
of oil, gas, and minerals.
They have two distinguishing characteristics:
1. They are physically extracted in operations.
2. They are replaceable only by an act of
nature.
NATURAL RESOURCES
Acquisition Cost

The acquisition cost of a natural
resource is the cash or cash equivalent
price necessary to acquire the
resource and prepare it for its
intended use.

If the resource is already discovered,
cost is the price paid for the property.
NATURAL RESOURCES
Amortization

The units-of-activity method is generally
used to calculate amortization
ILLUSTRATION 10-24
STATEMENT PRESENTATION OF
AMORTIZATION
Accumulated Amortization, a contra asset account, is
deducted from the cost of the natural resource in the
balance sheet as follows:
Lane Coal Company
Balance Sheet (partial)
December 31, 2003
Assets
Capital assets
Coal mine
Less: Accumulated amortization
Net book value
$
5,000,000
384,000
4,616,000
INTANGIBLE ASSETS

Intangible assets cannot be touched.

They are rights, privileges, and competitive
advantages that result from the ownership
of long-lived assets that do not possess
physical substance.
Do Problems:
P10-2A, and 7A
TYPES OF INTANGIBLE ASSETS
Patents
 Copyrights
 Trademarks and Trade Names
 Franchises and Licenses
 Goodwill
 Research and Development Costs

COPYRIGHTS
Copyrights are granted by the federal
government giving the owner the exclusive
right to reproduce and sell artistic or
published work
 Copyrights extend for the life of the creator
plus 50 years

TRADE MARKS/NAMES


Word, phrase, jingle
or symbol that
distinguishes or
identifies a particular
enterprise or product
If indefinite life, do not
amortize. Test for
impairment
PATENTS
Exclusive right to manufacture, sell or
control granted for 20 years
 Legal costs of protecting a patent in an
infringement suit are added to the Patent
account and amortized over the remaining
life of the patent

FRANCHISES

Contractual agreement under which the
franchiser grants the franchisee the right
To sell certain products
 To render specific services or to use certain
trademarks or trade names, usually within a
designated geographic area
 Annual fees are not capitalized, but are
expensed.

LICENSES
Operating rights permit the enterprise to
use public property in performing its
service (i.e. the use of airwaves for radio
or TV broadcasting)
 Annual fees are NOT capitalized, but
expensed.

GOODWILL




Goodwill represents favourable attributes that
relate to a business enterprise
Recorded only in an exchange transaction that
involves the purchase of an entire business
Goodwill = (Price paid – Equity in Business)
Goodwill is not written off as it has an unlimited
useful life. It must be tested regularly for
impairment.

Impairment is when fair market value for an assets drops below
the book value.
GOODWILL
-75,000
100,000 cash
Equity
acquired
= 25,000 goodwill
100,000
How does goodwill arise?
Firm A
Firm B
Firm AB
Cash
100,000
50,000
50,000
Other Assets
300,000
100,000
400,000
25,000
How?
Goodwill
400,000
150,000
475,000
Liabilities
200,000
75,000
275,000
Equity
200,000
75,000
400,000
150,000
275,000
How?
200,000
475,000
-100,000 cash
+ 25,000 goodwill
= 200,000
GOODWILL


Two steps:

ONE: If FMV > Book Value = no impairment

TWO: If not, then Goodwill is impaired.
Things to consider in determining FMV:




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
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Significant adverse change in legal or business climate
Adverse action by a regulator
Unanticipated competition
Loss of a key personnel
More-likely-than-not expectation that a significant portion of a
reporting unit will be sold or disposed of
Impairment of a significant asset group within a reporting unit
Recognition of a goodwill impairment loss by a subsidiary
RESEARCH AND DEVELOPMENT
COSTS

Research costs–record as an expense when
incurred

Development costs–capitalize if associated
with an identifiable, feasible product.
Otherwise, expense
What does identifiable and feasible mean?
ACCOUNTING FOR
INTANGIBLE ASSETS


In general, accounting for intangible assets
is the same as for capital assets.
Intangible assets are:
1.
2.
3.
Recorded at cost;
Written off over useful life in a rational and
systematic manner;
At disposal, book value is eliminated and gain or
loss, if any, is recorded.
AMORTIZATION

Amortizable intangible assets:
Have defined lives
 Allocate cost to expense over the shorter of

 Useful
(economic) life, or
 Legal life
Straight-line method of amortization is used
 Unamortizable Intangible assets:

 Have
indefinite useful lives,
 Do not amortize, and
 Must be tested for impairment (when fair market value
for an assets drops below the net book value).
FINANCIAL STATEMENT
PRESENTATION


Capital Assets are often combined on the Balance
Sheet.
If so, there should be full disclosure in the notes to
the financial statements, which means disclose:




Balances in each major asset class,
Accumulated amortization of each major class, (or of assets
in total),
Amortization methods used should be described, and
Amount of amortization expense for the period disclosed
as well.
ASSET TURNOVER RATIO

The ratio that shows how efficiently a company
uses its assets to generate sales is the asset
turnover ratio.
Net
Sales

Average
Total Assets
=
Assets
Turnover
RETURN ON ASSETS

The ratio that shows the profitability of assets
used in the earnings process is the return on
assets.
Net
Income

Average
Total Assets
=
Return on
Assets