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BUS780
Intangible Assets
Assets -a. with future economic benefits, b. no physical substance, c. with high degree of uncertainty concerning the future benefit.
Long-Lived Tangible and Intangible Assets 4
asset impairment of long-lived assets. 5. To understand the accounting treatment for the disposition of long-lived assets.
When an expenditure occurs, accountants have to decide whether the expenditure should be debited into an expense account (expense) or to an asset account (capitalize). If the expenditure is expensed, it becomes a period expense and will be deducted from the income of the current year.
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Expense an expenditure may have tax benefit (thus, increase cash flows) if it is tax deductible but it will reduce the current years income. If an expenditure is capitalized, it will be reported on the balance sheet as an asset and will be subject to depreciation or amortization in the future years.
Long-Lived Tangible and Intangible Assets
a. The expenditure will be recognized as an asset and will not reduce current years income. b. the cost allocation of the asset over the life of the asset (i.e., depreciation expense) will reduce future years income.
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According to Stickney and Weil (2006), the impact of the improper capitalization of costs that WorldCom paid to other carriers of the telecommunication lines results in an increase of earnings by $53.1 billion and $17.1 billion in 2000 and 2001, respectively. The restated earnings of WorldCom indicated a net loss of $48.9 billion and $15.6 billion for 2000 and 2001, respectively.
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Mr. Olofson's (Finance Executive of Global Crossing) August, 2001 letter says the company may have improperly capitalized the real-estate lease on its Madison, N.J., headquarters building.
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a = asset; e = expense
(source: figure 8.3 of textbook)
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At acquisition, PPE is recorded at the acquisition cost. At the end of period, PPE is also reported at cost. Acquisition cost includes the purchase price and any costs necessary to bring the asset to the location and condition for its intended use.
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PPE (except for land) is subject to depreciation. Depreciation is a process of cost allocation, not a process of asset valuation. If the acquisition cost or the selfconstructed cost is greater than the market value at time of delivery, Lower of cost or market is applied (see Wal-Mart, expl. 5 on
p370).
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Cost of Land
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Cost of land includes: 1. Purchase price. 2. Title search fee. 3. Closing fee. 4. Clearing fee. 5. Back property taxes (unpaid by previous owner). 6. Net razing cost of an old building. 7. Land improvements with unlimited (permanent in nature) life. (landscaping, pavements, street lights,etc.) 8. Assessment by cityTangible and Intangible Assets project. for drainage Long-Lived
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Cost of Buildings
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Cost of Buildings includes: 1. contract price(including materials, labor, etc.), 2. cost of remodeling, 3. Architects fee, 4. building permits, 5. surveying cost before construction, 6. interest cost (for self-constructed building), 7. excavation cost before construction. * Costs of strike or accidents are expensed.
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Cost of Equipment
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Any cost occurred to acquire and to bring the equipment to the location and condition for its intended use.
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Cost of Equipment includes: 1. purchase price, 2. freight-in, 3. insurance in transit, and 4. foundation cost, installation cost, cost of test runs and assembling cost. Not including: Cash discount lost, unnecessary storage cost and hauling charges from storage for delivery of equipment.
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General Motors incurs the following costs in searching and acquiring the land and building:
1. Purchase price of land and building, $1,000,000. 2. Fees paid to lawyers related to the purchase, $10,000. 3. Transfer taxes paid to the city, $2,000. 4. Salaries earned by management personnel during the search for the site and the negotiation of its purchase, $8,000.
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Example (contd.)
5. Operating expenditures for company automobiles used during the search, $75. 6. Depreciation charges for company automobiles used during the search, $65. 7. Fees paid to engineer for a repot on the structural soundness of the building, $15,000. 8. Uninsured costs to repair automobiles damaged in an car accident during the search, $3,000. 9. Profits lost on sales the company failed to make because, during the search, management paid insufficient attention to a potential new customer, $20,000.
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Example (contd.)
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What is the cost of land and Building? x Cost of both land and building: items 1 to 6 x Cost of building: item 7 x Items 8 and 9 ? Cost of both land and building should be allocated to cost of land and cost of building, respectively, based on the relative market value of land and building.
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A building and land were purchased at $100,000. The market value of building and land was $30,000 and $90,000, respectively. Building 25,0001 Land 75,0002 Cash 100,000
1. 30,000/(30,000+90,000)=25%, 25%x100,000 = 25,000 Long-Lived Tangible and Intangible Assets 2. 90,000/(30,000+90,000)=75%,
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Cost of self-constructed assets includes: 1. direct materials, 2. direct labor, 3. factory overhead (variable overhead and fixed overhead).
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Background of SFAS No. 34 (effective in 1979) Only capitalize the interest on funds borrowed for construction.
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Interest can only be capitalized for qualifying assets which must meet the following criteria: 1. Assets are constructed for firms own use or constructed as discrete projects for sale or lease to others (i.e., ships, real estate developments). 2. Capitalization will make a difference on the earnings per share.
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20X6, total interest expense was $1,845,000 of which $159,500 was capitalized as the cost of the selfconstructed building and $1,685,500 was charged to expense.
Long-Lived Tangible and Intangible Assets
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Example (contd.)
Journal entry to record the construction costs and interest expense for 20x6 is:
Building 2,559,500 Interest Expense 1,685,500 Cash 4,245,000
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Example (contd.)
Reporting:
Income Statement (for the year ended 12/31/x6) Other Revenues & Expenses: Interest Expenses $1,845,000 Less: Capitalized Int. (159,500) $ 1,685,500 Notes: Accounting Policy Capitalized interest: during 20X6, total interest expense was $1,845,000 of which $159,500 was capitalized and $1,685,500 was charged to expense.
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If intangible assets are developed internally, all the R&D costs are expensed.
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A firm consumes the services of long-lived assets to generate revenue, the cost of these assets should be expensed over time to match the revenue generated (in compliance with the matching principle). The process of allocating the depreciable cost (cost the salvage value) of assets over the estimated economic life is called depreciation (amortization) for tangible (intangible) assets.
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Cost Allocation of LongLived Assets Over the Life of the Assets (contd.)
For intangible assets, the salvage value is zero. For tangible assets, the salvage value could be either positive, zero or even negative (i.e., dismantling a nuclear power plant).
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The estimation of service life and salvage value is at the discretion of managers (see the case of Waste Management on p378). The choice of depreciation method is also at the discretion of mangers. Earnings would be affected when different depreciation methods or different estimates were used.
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Depreciation Methods
a. Straight-Line. b. Sum-of-the-Years-Digits (SYD). c. Declining-Balance.
Straight-Line Method
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Cost is allocated evenly through the life of the P.P.E. Example 1: Machine costing $10,000 was purchased on 1/1/x1. The estimated residual value of the machine is $2,000 and the estimated life of the machine is 4 years.
Depreciation Expense per year: ($10,000 - 2,000)/ 4 = $2,000 12/31/x1 Depreciation Expenses 2,000 Accumulated Depreciation 2,000
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information in example 1, except that the machine was purchased on 3/11/x1 rather than 1/1/x1.
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Sum-of-the-Years-Digits (SYD)
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Example : Machine costing $10,000 was purchased on 1/1/x1 with an estimated residual value of $2,000 and an estimated life of 4 years.
Value Year *Depr. Base Fraction Expense at the end x1 $8,000 4/10 $3,200 6,800 x2 $8,000 3/10 $2,400 4,400 x3 $8,000 2/10 $1,600 2,800 x4 $8,000 1/10 $800 2,000
Long-Lived Tangible and Value * Depr. Base= Cost - Residual Intangible Assets 45
Depr. **Book
Declining-Balance Method
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Depreciation Exp.= constant rate book value at the beginning of the period
x Residual
value is not considered in the computation. x Assets cannot be depreciated below the residual value. x The constant rate is expressed as a function of a straight-line annual depreciation rate.
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Example : Machine costing $10,000 purchased on 1/1/x1, with a residual value of $2,000 and an estimated life of 4 years. A double declining-balance method is used to depreciate the machine. Thus, the constant rate is twice of the S-L Depr. Rate (2 x 25% = 50%).
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Example (contd.)
Book Value of Asset at Beg. of Constant Depr. Book Value Year the Year Rate Exp. At the End x1 $10,000 50% $5,000 $5,000 x2 $5,000 50% 2,500 2,500 x3 $2,500 50% 500* 2,000* x4 2,000 50% 0 2,000
*Assets cannot be depreciated below the residual value.
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(MACRS) is used to compute tax depreciation expense for assets purchased in or after 1987. MACRS was enacted by Congress in the Tax Reform Act of 1986. Assets are classified in 8 property classes. A specified GAAP depreciation method is used in computing the depreciation expense for all classes (i.e., for a 3-year life PPE, DDB is used).
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Recovery 3-year 5-year 7-year 10-year 15-year 20-year Year (200% DB) (200% DB) (200% DB) (200% DB) (150% DB) (150% DB)
1 33.33 20.00 2 44.45 32.00 3 14.81* 19.20 4 7.41 11.52* 5 11.52 6 .. 5.76 7 8 9 10.00 5.00 18.00 9.50 14.40 8.55 11.52 7.70 9.22 6.93 7.37 6.23 6.55* 5.90* 6.55 5.90 6.56 5.91 Long-Lived Tangible and Intangible Assets 14.29 24.49 17.49 12.49 8.93* 8.92 8.93 4.46
covery 3-year 5-year 7-year 10-year 15-year 20-year Year (200% DB) (200% DB) (200% DB) (200% DB) (150% DB) (150% DB)
10 6.55 5.90 11 3.28 5.91 12 5.90 13 5.91 14 5.90 15 5.91 16 2.95 17 18 19 20 21 Long-Lived Tangible and Intangible Assets
4.461 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 2.231 52
Amortization of Intangibles
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Amortization: a cost allocation of intangibles with finite lives (i.e., patents, copyrights) over the estimated life of intangibles. Current Practice: to amortize over the shorter of the legal or useful life, not to exceed 40 years No amortization for trade names, trademarks and goodwill.
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Amortization Method
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Straight-line method (unless the company can prove other methods are more appropriate) Residual value is, in general, zero and partial year amortization applied Journal entry for amortization: Amortization Expense xxx Intangible Asset xxx (i.e., patents).
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Intangible Assets 1. Patents 2. Copyrights 3. Trade Names & Trademarks 4. Franchises or Licenses 5. Organization Costs 6. Goodwill
Amortization The shorter of useful or 20 legal life Life of creator The shorter of useful or + 70 years legal life not to exceed 40 years Unlimited None Contractual agreements Unlimited Unlimited Same as copyright 5 - 10 years None
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Accounting treatment: no retroactive effect and make no adjustment for the past years misstatement. Spread the remaining undercoated balance (i.e., the book value) less the revised (new) residual value over the revised (new) estimate of the remaining life of the assets.
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Machine costing $10,000 acquired on 1/1/x1. Revised Estimates Estimates on 1/1/x1 on 1/1/x3 Residual value $2,000 $1,000 Life 4 years 5 years
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Example: (Contd.)
Year Depr. Exp Acc. Depr Book Value x1 $2,0001 2,000 8,000 x2 $2,0002 4,000 6,000 x3 $1,667 5,666.7 4,333.3 x4 $1,667 7,333.4 2,666.6 x5 $1,667 9,000.1 1,000
1. (10,000-2,000)/4 = $2,000 2. (6,000-1,000)/(5-2) =1666.7
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Basic principle for capitalization of these costs: Capitalize the cost if it can: a. extend the life of the existing asset, or b. increase the service quality of the existing asset, or c. increase the productivity of the existing asset (including the reduction of unit cost). Otherwise, expense the cost.
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PPE and Intangibles are reported at cost except for impairments. An impairment occurs when the book value (cost accumulated depreciation) of an asset is not fully recoverable.
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GAAP requires test for impairment only when events or changes in circumstances indicate that the book value of this asset may not recoverable.
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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.
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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
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Impairment (contd.)
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After the write off, the fair value (or the estimated fair value if fair value is not available) becomes the new cost base for depreciation. No restoration of impaired loss is allowed for tangibles and finite-life intangibles assets held for use.
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Impairment (contd.)
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1. A description of the impaired asset or asset group. 2. The facts and circumstances leading to the impairment. 3.The amount of the loss. 4.The method used to determined the fair value.
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Tangible and Events indicate Intangible with BV not finite life recoverable
Goodwill
2. BV of goodwill implied FV
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5.
A building costing $300,000 with accumulated depreciation of $200,000 was sold for $70,000. The journal entry to record the transaction is:
Cash 70,000 Accu. Depre. 200,000 Loss 30,000 Building
300,000
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An automobile costing $20,000 with accumulated depreciation of $15,000 was abandoned. The journal entry to record the transaction is:
Accu. Depre. 15,000 Loss 5,000 Automobile
20,000
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