chapter 8 - pp&e

Property, Plant and Equipment and Other Long-lived Assets

Chapter 8

October 15 - 17

Classifying Long-lived Assets

• Assets used in the business that have a useful

life of more than one year and are not intended

for resale are classified as long-lived or fixed

assets. Depending on their nature, they may be

further classified as:

– Property, plant & equipment (aka PPE or tangible

fixed assets)

– Natural resources

– Intangible assets.


• Property, plant and equipment

– Tangible assets that are used in the production or sale of other

assets or services, and have a useful life of more than one year.

– These assets are not intended for sale to customers (or else

they'll be classified as inventories) and should have useful

lives of more than one year, or else they'll be considered

supplies.

– E.g. Land, and buildings, fixtures, and equipment.


• Natural Resources

– Tangible assets that are physically removed or consumed and

are restored to their previous form only by an act of nature.

– E.g. mines, timberlands, and oil fields.

• Intangible Assets

– Assets used in the normal operations of business that have

no physical substance and generally have some degree of

uncertainty concerning future benefits.

– E.g. copyrights, patents, trademarks, franchises, and

goodwill.

Acquisition / Valuation of Long-Lived Assets

• PPE

– The cost of PPE includes both the acquisition cost

plus any costs necessary to place the asset in

working condition. This would include the invoice

price (less any discounts), transportation,

unpacking and assembly costs, and costs of

conducting trial runs.

• Natural Resources

– The cost of natural resources include their

acquisition, exploration costs, development and

restoration costs.


• Intangible – Intangible assets are recorded at their acquisition price plus

any other costs necessary to make them ready for use.

These would include the purchase price, legal fees to

acquire and protect the intangible assets, and other

incidental expenses to acquire the asset.

– Internally created intangible assets are generally expensed

as incurred because of the difficulty in determining their

market values and the uncertainty over their future benefits

and economic lives.


• Intangible– The most frequently reported intangible asset is goodwill.

– The only way to report goodwill as an asset is to purchase

another business.

– Goodwill represents the difference between the acquisition price

and the fair market value of an acquired firm’s identifiable net

assets (assets – liabilities). If a company acquires another

company for a price that exceeds the fair market value of all of

its identifiable net assets (including current and fixed assets plus

any identifiable intangible assets such as patents, copyrights,

licenses and trademarks), the excess is assumed to be for

goodwill.

Accounting at Acquisition

• Revenue expenditure (expense) or Capital

expenditure (capitalize)?

– To qualify as an asset, the resource must be expected to provide future benefits. If future benefit is uncertain, the resource must be expensed.

– Most assets require expenditures during their lives to maintain or enhance their productive capacity. Accountants need to determine whether these expenditures are revenue expenditures (expense) or capital expenditures (capitalize).

Accounting at Acquisition

• How about if a company constructs an asset

for its own use instead of buying from a

manufacturer?

• How about expenditures after acquisition?

Expenditures after Acquisition

• The general treatment for asset expenditures incurred after the point

of acquisition depends on whether

– the nature (and usability) of the asset has changed, and/or

– its original useful life has been extended because of the expenditure.

• Revenue expenditures refer to outlays that merely maintain the

productive capacity of the asset. These expenditures are recurring in

nature and do not alter the nature or useful life of the asset, and are

charged as an expense of the period.

• Capital expenditures that alter the nature of the asset are capitalized

and added to the cost of the asset. Extraordinary repairs that

prolong the life of the asset are also capitalized.


Type of Capital or

Expenditure Revenue Identifying Characteristics

Ordinary Revenue 1. Maintains normal operating condition

repairs and 2. Does not increase productivity

maintenance 3. Does not extend life beyond original

estimate

Extraordinary Capital 1. Major overhauls or partial

repairs replacements

2. Extends life beyond original estimate

Additions Capital 1. Increases productivity

2. May extend useful life

3. Improvements or expansions

Financial Statement Effect

Current Current

Treatment Statement Expense Income Taxes

Capital Balance sheet

Expenditure account debited Deferred Higher Higher

Revenue Income statement Currently

Expenditure account debited recognized Lower Lower


To solve this problem, many companies have policies

regarding the expensing of all expenditures below a certain

amount according to the materiality constraint.

Improper Capitalization of Expenditures

• Accounting for expenses as capital expenditures increases current income because it spreads a single period’s operating expenses over many future periods as depreciation expense, and it increases cash flows from operations by moving cash outflows from the operating section to the investing section of the cash flow statement.

• WorldCom inflated its income and cash flow from operations by billions of dollar by capitalizing expenditures that should have been recorded as current period expense.

• Sulcus Computer Corp. was found by the SEC to have capitalized operating expenses as part of the costs of acquisitions.

Accounting Over the Useful Life

• Depreciation is a systematic process of allocating the

cost of a long-lived fixed asset over the periods that it

provides benefits.

• The same process as applied to natural resources is

called depletion and as applied to intangible assets is

referred to as amortization.

• Depreciation/ depletion/amortization is not a

revaluation process; it is merely a cost allocation

procedure.

Accounting Over the Useful Life

• Unlike PPE and natural resources, intangible assets are

classified according to whether they have definite or indefinite

lives.

• Intangible assets that have definite (limited) lives are

amortized over their useful lives. Examples include patents

and copyrights.

• Intangible assets that have indefinite lives are not amortized

because they are considered to have a potentially unlimited

life. Instead, they are subject to a regular annual review for

impairment (involving an asset write-down of value).

Examples of indefinite life intangible assets include goodwill

and trademarks.

Depreciation Concepts – Definitions

• Service or useful life

– the length of time over which the company expects

to use the asset, which may or may not be equal to

the asset's actual operating life.

• Salvage value or residual value

– estimated realizable value of the asset at the end of

its service life.

• Book or carrying value

– Cost less accumulated depreciation

Depreciation Concepts

The calculation of depreciation requires

three amounts for each asset:

Acquisition cost.

Estimated useful life.

Estimated residual value.

Alternative depreciation methods:

Straight-line

Units-of-production

Accelerated Method: Declining balance

Straight-Line Method

Cost - Residual Value

Life in Years

Depreciation

Expense per Year=

At the beginning of the year, Southwest purchased ground

equipment for $62,500 cash. The equipment has an estimated

useful life of 3 years and an estimated residual value of $2,500.

Depreciation

Expense per Year=

Depreciation

Expense per Year= $20,000

$62,500 - $2,500

3 years

Depreciation Accumulated Accumulated Undepreciated

Expense Depreciation Depreciation Balance

Year (debit) (credit) Balance (book value)

62,500$

1 20,000$ 20,000$ 20,000$ 42,500

2 20,000 20,000 40,000 22,500

3 20,000 20,000 60,000 2,500

60,000$ 60,000$

Residual Value

SLMore companies use the straight-line

method of depreciation in their financial reports than all other methods combined.

Straight-Line Method

Units-of-Production Method

Depreciation

Rate= Cost - Residual Value

Life in Units of Production

Step 1:

Step 2:

Depreciation

Expense=

Depreciation

Rate×

Number of

Units Produced

for the YearAt the beginning of the year, Southwest purchased ground

equipment for $62,500 cash. The equipment has a 100,000 mile

useful life and an estimated residual value of $2,500.

If the equipment is used 30,000 miles in the first year, what is the

amount of depreciation expense?

Units-of-Production Method

$62,500 - $2,500

100,000 miles = $.60 per mile

Depreciation

Rate=

Step 1:

Step 2:

$.60 per mile × 30,000 miles = $18,000Depreciation

Expense=

Accumulated Undepreciated

Depreciation Depreciation Balance

Year Miles Expense Balance (book value)

62,500$

1 30,000 18,000$ 18,000$ 44,500

2 50,000 30,000 48,000 14,500

3 20,000 12,000 60,000 2,500

100,000 60,000$

Residual Value

Accelerated Depreciation

Depreciation Repair

Expense Expense

Early Years High Low

Later Years Low High

Accelerated depreciation matches higher

depreciation expense with higher revenues

in the early years of an asset’s useful life

when the asset is more efficient.

Declining-Balance Method

Annual

Depreciation

expense

Net

Book

Value( )Useful Life in Years

2= ×

Cost – Accumulated DepreciationDeclining balance rate

of 2 is double-declining-

balance (DDB) rate.

Annual computation ignores residual value.

At the beginning of the year, Southwest purchased equipment for $62,500

cash. The equipment has an estimated useful life of 3 years and an

estimated residual value of $2,500.

Calculate the depreciation expense for the first two years.

Annual

Depreciation

expense

Net

Book

Value( )Useful Life in Years

2= ×

( )$62,500 ×3 years

2= $41,667

( )($62,500 – $41,667) ×3 years

2= $13,889


Year 1 Depreciation:

Year 2 Depreciation:

Depreciation Accumulated Undepreciated

Expense Depreciation Balance

Year (debit) Balance (book value)

62,500$

1 41,667$ 41,667$ 20,833

2 13,889 55,556 6,944

3 4,629 60,185 2,315

60,185$

( )($62,500 – $55,556) ×3 years

2= $4,629

Below residual value


Depreciation expense is limited to the amount that

reduces book value to the estimated residual value.

Depreciation Accumulated Undepreciated

Expense Depreciation Balance

Year (debit) Balance (book value)

62,500$

1 41,667$ 41,667$ 20,833

2 13,889 55,556 6,944

3 4,444 60,000 2,500

60,000$


Changes in Estimates

• If after using an asset for a few years, a company decides

that the asset’s useful life or salvage value is different

from its original estimates, a change in estimate may

occur.

• The company needs to revise the amount of depreciation

charged every year subsequent to the date of discovery

(prospectively).

Changes in Estimates

• Example: A fixed asset costing $10,000 with a useful life of 5

years and $2,000 salvage value is being depreciated under the

straight-line method. On Year 3, the company extends the

asset’s useful life to a total of 10 years with a salvage value of

$1,000. Calculate depreciation expense for all years:

Accounting for Disposal

• If an asset is disposed of at the end of its useful life, and

the salvage value is exactly equal to its disposal value,

then no gain or loss is recognized.

• Example: Asset originally costing $120,000 is retired at

the end of its useful life. Assume that the salvage value

of $15,000 is realized. Prepare the journal entry upon

disposal.

Accounting for Disposal

• If an asset is disposed of prior to the end of its useful life,

and the disposal price is not equal to its book or carrying

value (cost less accumulated depreciation), then a gain or

loss is recognized for the difference.

• Example: Equipment costing $10,000 with accumulated

depreciation of $4,000 was sold for $7,000. Prepare the

journal entry.

Focus on Cash Flows

Fixed Asset Turnover

Fixed

Asset

Turnover

Net Sales Revenue

Average Net Fixed Assets=

This ratio measures a company’s ability to generate sales given an

investment in fixed assets.

Southwest Airlines had $9,861 of revenue. End-of-year fixed assets were $10,874

and beginning-of-year fixed assets were $10,094. (All numbers in millions.)

Fixed

Asset

Turnover

$9,861

($10,094 + $10,874) ÷ 2= = 0.94

Delta Southwest United

1.26 0.94 1.68

2006 Fixed Asset Turnover Comparisons

chapter 8 - pp&e

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