Chapter 6 fixed assets

OPEN UNIVERSITY HCMC MBA PREPARATORY COURSE Principles of Financial Accounting 06/04/16 NGUYEN TAN BINH - PHAN DUC DUNG Chapter Long-Lived Assets and Depreciation 06/04/16 NGUYEN TAN BINH - PH Learning Objectives After studying this chapter, you should be able to:  Measure the acquisition cost of tangible assets such as land, buildings, and equipment  Compute depreciation for buildings and equipment using various depreciation methods  Differentiate financial statement depreciation from income tax depreciation  Explain depreciation’s effects on cash flow 06/04/16 NGUYEN TAN BINH - PH Learning Objectives After studying this chapter, you should be able to:     Distinguish expenses from expenditures that should be capitalized Compute gains and losses on disposal of fixed assets Interpret depletion of natural resources Account for various intangible assets 06/04/16 NGUYEN TAN BINH - PH Overview of Long-Lived Assets  Long-lived assets - resources that are held for an extended time, such as land, buildings, equipment, natural resources, and patents  These assets help produce revenues over many periods by facilitating the production and sale of goods or services to customers 06/04/16 NGUYEN TAN BINH - PH Overview of Long-Lived Assets  Tangible assets - physical items that can be seen and touched, such as land, natural resources, buildings, and equipment   Also known as fixed assets or plant assets Intangible assets - rights or economic benefits, such as franchises, patents, trademarks, copyrights, and goodwill that are not physical in nature 06/04/16 NGUYEN TAN BINH - PH Overview of Long-Lived Assets   Terms for allocation of costs over time:  Depreciation - allocation of the cost of tangible assets to the periods in which the assets are used  Depletion - allocation of the cost of natural resources to the periods in which the resources are used  Amortization - allocation of the cost of intangible assets to the periods that benefit from these assets Land is not depreciated because it does not wear out or become obsolete 06/04/16 NGUYEN TAN BINH - PH Acquisition Cost of Tangible Assets  The acquisition cost of long-lived assets is the purchase price, including incidental costs required to complete the purchase, to transport the asset, and to prepare it for use 06/04/16 NGUYEN TAN BINH - PH Acquisition Cost of Tangible Assets  Land   The acquisition cost of land includes costs of land surveys, legal fees, title fees, realtor commissions, transfer taxes, and the demolition costs of old structures Under historical cost accounting, land is carried on the balance sheet at its original cost even if the market value of the land is many times that of the original cost 06/04/16 NGUYEN TAN BINH - PH Acquisition Cost of Tangible Assets  Buildings and Equipment   Costs should include all costs of acquisition and preparation for use, such as sales taxes, transportation costs, installation costs, and repairs to the asset prior to use Costs included in the cost of an asset are capitalized (added to the asset account), as distinguished from being expensed immediately 06/04/16 NGUYEN TAN BINH - PH 10 Depreciation Based on Units  Unit depreciation - a depreciation method based on units of service when physical wear and tear is the dominating influence on the useful life of the asset   A depreciation rate per unit is determined by dividing the depreciable value (cost less residual value) by the useful life in units To determine depreciation expense, the actual usage of the asset is multiplied by the depreciation rate 06/04/16 NGUYEN TAN BINH - PH 16 Depreciation Based on Units  A truck with a cost of $41,000 and a residual value of $1,000 has a useful life of 200,000 miles During the year, the truck is driven for 45,000 miles Depreciation expense is calculated as follows: ($41,000 - $1,000)/200,000 = $.20 per mile 45,000 x $.20 = $9,000* *Depreciation over the life of the asset will fluctuate as the usage of the asset fluctuates 06/04/16 NGUYEN TAN BINH - PH 17 Declining-Balance Depreciation   Accelerated depreciation - any depreciation method that writes off depreciable costs more quickly than the ordinary straight-line method based on expected useful life Double-declining-balance (DDB) depreciation - the most popular form of accelerated depreciation  It is computed by doubling the straight-line rate and multiplying the resulting DDB rate by the beginning book value 06/04/16 NGUYEN TAN BINH - PH 18 Declining-Balance Depreciation  Computing DDB depreciation:    Compute a rate by dividing 100% by the number of years of useful life Double the rate Ignore the residual value, and multiply the asset’s book value at the beginning of the year by the DDB rate  06/04/16 Stop depreciation when the book value reaches the residual value NGUYEN TAN BINH - PH 19 Declining-Balance Depreciation  A truck with a cost of $41,000 and a residual value of $1,000 has a useful life of years Double-declining-balance depreciation expense is calculated as follows: 100% / = 25% x = 50% per year Year 1: $41,000 x 50% = $20,500* Year 2: ($41,000 - $20,500) x 50% = $10,250* *Depreciation over the life of the asset declines each year 06/04/16 NGUYEN TAN BINH - PH 20 Comparing and Choosing Depreciation Methods   Straight-line gives the same depreciation expense each year of the useful life of the asset DDB gives accelerated depreciation expense (more than regular straight-line) in the first years of the useful life of the asset  Companies will often switch from DDB to straight-line part way through the life of the asset to compensate for the fact the DDB may not fully depreciate the asset 06/04/16 NGUYEN TAN BINH - PH 21 Comparing and Choosing Depreciation Methods   Companies not always use the same depreciation methods for all types of depreciable assets The choice of depreciation alternatives comes from several places:    Tradition or use by other companies in the industry Better matching of expenses with revenues The nature of the industry and the equipment and the goals of management 06/04/16 NGUYEN TAN BINH - PH 22 Depreciation and Cash Flow  Depreciation does not generate cash   Depreciation allocates the original cost of an asset to the periods when the asset is used Accumulated depreciation is merely the total amount that an asset has been depreciated throughout its life 06/04/16 NGUYEN TAN BINH - PH 23 Effects of Depreciation on Cash  Depreciation has no effect on ending cash balances because it is a noncash expense  Before taxes, changes in the depreciation method affect only the Accumulated Depreciation and Retained Earnings accounts 06/04/16 NGUYEN TAN BINH - PH 24 Effects of Depreciation on Income Taxes  Depreciation is a deductible noncash expense for income tax purposes  If depreciation expense is higher, taxes are lower, and more cash can be kept for use in the business Accelerated depreciation generally has higher depreciation expense Depreciation does not generate cash, but it does have a cash benefit if it results in lower taxes   06/04/16 NGUYEN TAN BINH - PH 25 Gains and Losses on Sales of Tangible Assets  Assets are often sold before the end of their useful lives   When an asset is sold, a gain or loss usually occurs The gain or loss is the difference between cash received and the net book value of the asset given up 06/04/16 NGUYEN TAN BINH - PH 26 Recording Gains and Losses  Remember that when depreciation is recorded, two accounts are affected, Depreciation Expense and Accumulated Depreciation  Accumulated depreciation reduces the book value of the fixed asset  The disposal of a fixed asset requires the removal of its book value (carrying amount), which appears in two accounts, the asset account and Accumulated Depreciation 06/04/16 NGUYEN TAN BINH - PH 27 Recording Gains and Losses A piece of equipment with an original cost of $50,000 that has $20,000 of accumulated depreciation is sold for $35,000 cash The journal entry to record this transaction is as follows: Cash Accumulated depreciation Equipment Gain on sale of equipment* 35,000 20,000 50,000 5,000 *[35,000 - (50,000 - 20,000) = 5,000] 06/04/16 NGUYEN TAN BINH - PH 28 Recording Gains and Losses A piece of equipment with an original cost of $50,000 that has $20,000 of accumulated depreciation is sold for $23,000 cash The journal entry to record this transaction is as follows: Cash Accumulated depreciation Loss on sale of equipment* Equipment 23,000 20,000 7,000 50,000 *[23,000 - (50,000 - 20,000) = -7,000] 06/04/16 NGUYEN TAN BINH - PH 29 Income Statement Presentation  Gains and losses on sales of assets are usually insignificant, so they are included as “other income” on the income statement References: Horngren, Introduction to financial accounting 06/04/16 NGUYEN TAN BINH - PH 30 [...]... benefit if it results in lower taxes   06/ 04/ 16 NGUYEN TAN BINH - PH 25 Gains and Losses on Sales of Tangible Assets  Assets are often sold before the end of their useful lives   When an asset is sold, a gain or loss usually occurs The gain or loss is the difference between cash received and the net book value of the asset given up 06/ 04/ 16 NGUYEN TAN BINH - PH 26 Recording Gains and Losses  Remember... the resulting DDB rate by the beginning book value 06/ 04/ 16 NGUYEN TAN BINH - PH 18 Declining-Balance Depreciation  Computing DDB depreciation:    Compute a rate by dividing 100% by the number of years of useful life Double the rate Ignore the residual value, and multiply the asset’s book value at the beginning of the year by the DDB rate  06/ 04/ 16 Stop depreciation when the book value reaches the... and the equipment and the goals of management 06/ 04/ 16 NGUYEN TAN BINH - PH 22 Depreciation and Cash Flow  Depreciation does not generate cash   Depreciation allocates the original cost of an asset to the periods when the asset is used Accumulated depreciation is merely the total amount that an asset has been depreciated throughout its life 06/ 04/ 16 NGUYEN TAN BINH - PH 23 Effects of Depreciation... time For example, the life of a truck can be measured in miles driven 06/ 04/ 16 NGUYEN TAN BINH - PH 13  Straight-Line Depreciation  Straight-line depreciation - a method that spreads the depreciable value evenly over the useful life of an asset Depreciation = Acquisition cost - Residual value expense Years of useful life 06/ 04/ 16 NGUYEN TAN BINH - PH 14 Straight-Line Depreciation  A truck with a... Depreciation Expense and Accumulated Depreciation  Accumulated depreciation reduces the book value of the fixed asset  The disposal of a fixed asset requires the removal of its book value (carrying amount), which appears in two accounts, the asset account and Accumulated Depreciation 06/ 04/ 16 NGUYEN TAN BINH - PH 27 Recording Gains and Losses A piece of equipment with an original cost of $50,000... = 5,000] 06/ 04/ 16 NGUYEN TAN BINH - PH 28 Recording Gains and Losses A piece of equipment with an original cost of $50,000 that has $20,000 of accumulated depreciation is sold for $23,000 cash The journal entry to record this transaction is as follows: Cash Accumulated depreciation Loss on sale of equipment* Equipment 23,000 20,000 7,000 50,000 *[23,000 - (50,000 - 20,000) = -7,000] 06/ 04/ 16 NGUYEN... dividing the depreciable value (cost less residual value) by the useful life in units To determine depreciation expense, the actual usage of the asset is multiplied by the depreciation rate 06/ 04/ 16 NGUYEN TAN BINH - PH 16 Depreciation Based on Units  A truck with a cost of $41,000 and a residual value of $1,000 has a useful life of 200,000 miles During the year, the truck is driven for 45,000 miles Depreciation... straight-line part way through the life of the asset to compensate for the fact the DDB may not fully depreciate the asset 06/ 04/ 16 NGUYEN TAN BINH - PH 21 Comparing and Choosing Depreciation Methods   Companies do not always use the same depreciation methods for all types of depreciable assets The choice of depreciation alternatives comes from several places:    Tradition or use by other companies in... (50,000 - 20,000) = -7,000] 06/ 04/ 16 NGUYEN TAN BINH - PH 29 Income Statement Presentation  Gains and losses on sales of assets are usually insignificant, so they are included as “other income” on the income statement References: Horngren, Introduction to financial accounting 06/ 04/ 16 NGUYEN TAN BINH - PH 30 ... depreciable value is the difference between the acquisition cost and the predicted residual value  Residual value - the amount received from disposal of a long-lived asset at the end of its useful life 06/ 04/ 16 NGUYEN TAN BINH - PH 12 Depreciation of Buildings and Equipment  Useful life (economic life) - the time period over which an asset is depreciated The useful life is the shorter of the physical life