Notes

The resources that determine a company's productive capacity are often called Long-Lived Assets (Capital Intensity = Noncurrent Assets/ Total Assets). These assets, which are listed as noncurrent assets on the balance sheet, may be either tangible or intangible assets.

Tangible Assets have physical substance, that is, they can be touched. The three kinds of long-lived tangible assets are:

• Land used in operations.
• Buildings, Fixtures and Equipment used in operations.

These first two tangible assets are also called Property, Plant and Equipment.

• Natural Resources used in operations.

We are interested in the creation of Journal Entries related to:

• Acquisition

Under the cost principle, all reasonable and necessary expenditures made in acquiring and preparing an asset for use should be recorded as the cost of the asset. Therefore, the Cost of an asset is given by: Cost = Price -- Discount + Transportation Cost + Installation Cost + Preparation Cost. Since PPE are more expensive than inventories, there are 3 different methods through which the company can buy them:

• Cash (coming from Operating Activities)
• Debt (Loans from Bank or Issuing Bonds in the Market)
• Equity (Additional Capital from Equity Issuance by Stockholders).

Most assets require substantial expenditures during their lives to maintain or enhance their productive capacity. These expenditures include cash outlays for ordinary repairs and maintenance, major repairs, replacements, and additions. The expenses that are encountered before the assets become ready-to-use should be included in the initial cost. Expenditures that are made after an asset has been acquired are classified as follows:

• Ordinary repairs and Maintenance are expenditures that maintain the productive capacity of the asset during the current accounting period only. These cash outlays are recorded as expenses in the current period. This expense is included in the Income Statement
• Improvements or Expansion Expenses are expenditures that increase the productive life, operating efficiency, or capacity of the asset. These capital expenditures are added to the appropriate asset accounts. They occur infrequently, involve large amounts of money, and increase an asset's economic usefulness in the future through either increased efficiency or longer life. Examples include additions, major overhauls, complete reconditioning, and major replacements and improvements, such as the complete replacement of an engine on an aircraft.

This expense will be included in the Balance Sheet, meaning that it will be capitalized.

In some cases, the company cannot buy the PPE from external subjects, but it creates its own PPE. Think about the case of very special machineries that are not available in the market so that it needs to create them. In order to build the PPE, the firm will bear a number of expenses associated with the construction such as labour, materials and also interests.

PPE in construction is an Asset. The firm will capitalize such costs by debiting the asset account once the cash payment is made.

• Depreciation (Use)

Long-lived assets can be considered as prepaid expenses for which the firm paid in one accounting period. Nevertheless, as any other prepaid expense, its benefits will occur in next accounting periods once the firm will use them. As the long-lived assets will be used in a repeated manner for a certain number of periods, the firm has to allocate part of that cost (namely the prepaid expense) in each period. This is in line with the matching expense principle according to which the firm has to record the expenses in the period in which they are incurred namely in the period in which the associated revenues have been earned. Long-lived assets contribute to generate revenues so, once the revenues are recognized, the firm has to recognize not only the expenses incurred to purchase the materials, but also the expenses related to the use of the PPE.

The term used to identify the matching of the cost of using buildings and equipment with the revenues they generate is depreciation. Thus, depreciation is the process of allocating the cost of buildings and equipment over their productive lives using a systematic and rational method.

At the end of the accounting period we need to make an adjusting entry to recognize the use of equipment and buildings for the period (depreciation expense). The depreciation will be included in the income statement as a separate item or as a component of the cost of goods sold. The amount of depreciation expense accumulated since the acquisition date is reported on the balance sheet as a contra-account, Accumulated Depreciation, and deducted from the related asset's cost, as the allowance for doubtful accounts for the accounts receivables, indirectly reduces the value of PPE. So, we have a gross amount of PPE (that represents the acquisition cost of the PPE) and a net amount that represents the difference between the acquisition cost and the accumulated depreciation.

As for the allowance for doubtful accounts, the accumulated depreciation doesn't only contain the current depreciation included in the current income statement, but also the depreciation occurred in the past (since the acquisition of PPE). Thus, the accumulated depreciation represents the extent to which we used PPEs and the net amount of PPEs tells us the magnitude of economic benefits that PPEs still generate in the future.

Thus, the net book value (or carrying value) of a long-lived asset is the difference between its acquisition cost and the accumulated depreciation from the acquisition date to the balance sheet date.

The point is how we compute the depreciation. We need three amounts:

• Acquisition Cost
• Estimated Useful Life, estimate of the assets' useful economic life to the company. In other words, it is the amount of time the firm expects to use the asset.
• Estimated Residual Value at the end of the assets' useful life. Managers' estimate of the amount that the company expects to recover upon disposal of the asset at the end of the estimated useful life. Imagine that, at the end of the estimated useful life, the firm decides to sell PPE. The value for which PPE would be sold is the estimated residual value that the firm uses to compute the depreciation expense.

Notice that both the estimated useful life and the estimated residual value are estimates therefore also depreciation expense to include in the income statement is also an estimate. Because of significant differences among companies and the assets they own, accountants have not been able to agree on a single best method of depreciation. Therefore, managers have to define the systematic and rational method to allocate the overall cost of PPEs to each accounting period namely to choose the Depreciation Method. The depreciation method can be different for specific assets or classes of assets. Yet, it is important that the depreciation method is consistent over time to ensure the comparability of the financial statements. There exist 3 possibilities:

• Straight-line Method (most common, used by more than 98% of companies for many or all of their assets). Under the straight-line method, an equal portion of an asset's depreciable cost is allocated to each accounting period over its estimated useful life. (Cost - Residual Value)* 1/Useful life = Depreciation Expense).

"Cost -- Residual Value" is the amount to be depreciated, also called the Depreciable Cost, while the formula "1/Useful life" is the Straight-Line Rate.

Notice that: Depreciation expense is a constant amount each year. Accumulated depreciation increases by an equal amount each year. Net Book Value decreases by the same amount each year until it equals the estimated residual value. This is the reason for the name straight-line method. Notice, too, that the adjusting entry can be prepared from this schedule, and the effects on the income statement and balance sheet are known.

• Units of Production Method This method relates depreciable cost to total estimated productive output. The formula to estimate annual depreciation expense under this method is as follows: Depreciation Expense = ((Cost-Residual Value)/Estimated Total Production) * Actual Production Dividing the depreciable cost by the estimated total production yields the depreciation rate per unit of production, which is then multiplied by the actual production for the period to determine depreciation expense. Notice that, from period to period, depreciation expense, accumulated depreciation, and book value vary directly with the units produced. In the units-of-production method, depreciation expense is a variable expense because it varies directly with production or use. The units-of-production method is based on an estimate of an asset's total future productive capacity or output, which is difficult to determine.

• Declining Balance Method (Accelerated) In this method, we assume that PPE are used more in the first years of their estimated useful life. This can happen as PPE may be more productive when they are new. Thus, instead of allocating the depreciable cost in equal manner across the estimated useful life, we allocate a greater amount at the beginning of the useful life and a lower amount at the end. It is why the declining balance is also called accelerated depreciation method. Among the diverse accelerated depreciation method that a firm can use, we focus on the double-declining balance rate according to which the usage of the PPE at the beginning is double than at the end of the useful life. In particular, to determine the depreciation expense to report in the income statement, we use the following formula: Depreciation expense = (Acquisition cost - Accumulated depreciation) * 2/Useful Life.

Notice that accumulated depreciation, not residual value, is included in the formula. Since accumulated depreciation increases each year, net book value (cost minus accumulated depreciation) decreases. The double-declining rate is applied to a lower net book value each year, resulting in a decline in depreciation expense over time. As with the other methods, the net book value should not be depreciated below the residual value. Occasionally, before the end of the estimated useful life, if the annual computation reduces net book value below residual value, only the amount of depreciation expense needed to make net book value equal to residual value is recorded, and no additional depreciation expense is computed in subsequent years. More likely, in the last year of the assets estimated useful life, whatever amount is needed to bring net book value to residual value is recorded, regardless of the amount of the computation.

These differences between the straight-line and the accelerated depreciation method have important implications for the net income and the income taxes. Indeed, at the beginning of assets' useful life, depreciation expenses would be higher if the accelerated depreciation method is preferred to the straight-line method. Consequently, the net income at the beginning of assets' useful life would be lower if the accelerated depreciation method is used. Yet, the method would be advantageous from a tax point of view as income taxes will also be lower. Instead, at the end of the estimated life, depreciation expense will be higher if the straight-line method is preferred to the accelerated method. In this case, net income will be higher if the accelerated method is used. Nevertheless, taxes will also be higher.

Moreover, there is also evidence that firms using an accelerated depreciation method make significantly larger capital investments than firms that use straight-line depreciation.

Assets are defined as economic resources with probable future benefits acquired in an exchange transaction. On the date of the exchange, an asset is measured at historical cost. However, later in its useful life, when an asset is not expected to generate sufficient cash flows at least equal to its book value, we say the asset's book value is impaired. Corporations must review long-lived tangible and intangible assets for possible impairment. Two steps are necessary:

• Test for Impairment

  • Impairment occurs when events or changed circumstances cause the estimated future cash flows of these assets to fall below their book value.
  • If net book value > estimated future cash flows, then the asset is impaired.
  • Otherwise (<) no adjusting entry is recorded.

• Computation of Impairment Loss

  • For any asset considered to be impaired, companies recognize a loss for the difference between the asset's book value and its fair value (a market concept).
  • Impairment Loss = Net Book Value - Fair Value . That is, the asset is written down to fair value.

• Disposal of Property, Plant and Equipment

  • In some cases, a business may voluntarily decide not to hold a long-lived asset for its entire life. The company may drop a product from its line and no longer need the equipment that was used to produce it, or managers may want to replace a machine with a more efficient one. These disposals include sales, trade-ins, and retirements. A business may also dispose of an asset involuntarily, as the result of a casualty such as storm, fire or accident. Disposals of long-lived assets seldom occur on the last day of the accounting period. Therefore, depreciation must be recorded on the date of disposal for the amount of cost used since the last time depreciation was recorded. Therefore, the disposal of a depreciable asset usually requires two journal entries:

    • An adjusting entry to update the depreciation expense and accumulated depreciation accounts.
    • An entry to report the disposal. The cost of the asset and any accumulated depreciation at the date of disposal must be removed from the accounts. The difference between any resources received on disposal of an asset and its book value at the date of disposal is treated as a gain or loss on the disposal of the asset. This gain (or loss) is reported on the income statement. It is not an operating revenue (or expense), however, because it arises from peripheral or incidental activities rather than from central operations. Gains and losses from disposals are usually shown as a separate item on the income statement.

So far, we focused on the tangible assets namely on long-lived assets that have physical presence and can be touched. However, tangible assets are not the only long-lived assets present in the balance sheet of a company. Intangible Assets are increasingly important resources for organizations. An intangible asset, like any other asset, has value because of certain rights and privileges often conferred by law on its owner. The majority of intangible assets usually are evidenced by a legal document. The most common types of intangible assets are the following:

• Goodwill (recognized in a business combination), by far the most frequently reported intangible asset is goodwill (cost in excess of net assets acquired). The term goodwill arises from factors such as customer confidence, reputation for good service or quality goods, location, outstanding management team, and financial standing. From its first day of operations, a successful business continually builds goodwill. In this context, the goodwill is said to be internally generated and is not reported as an asset. The only way to report goodwill as an asset is to purchase another business. Often the purchase price of the business exceeds the fair value of all of its net assets. Why would a company pay more for a business as a whole than it would pay if it bought the assets individually? The answer is to obtain its goodwill. For accounting purposes, goodwill is defined as the difference between the purchase price of a company as a whole and the fair value of its net assets.
• Trademarks: A trademark is a special name, image, or slogan identified with a product or a company; it protected by law. Trademarks are among the most valuable assets a company can own. Although trademarks are valuable assets, they are rarely seen on balance sheets. The reason is simple; intangible assets are not recorded unless they are purchased. Companies often spend millions of dollars developing trademarks, but most of those expenditures are recorded as expenses rather than being capitalized as an intangible asset.
• Copyrights: A copyright gives the owner the exclusive right to publish, use, and sell a literary, musical, or artistic piece for a period not exceeding 70 years after the author's death.
• Technology: Includes costs for computer software and Web development.
• Patents: A patent is an exclusive right granted by the federal government for a period of 20 years, typically granted to a person who invents a new product or discovers a new process. The patent enables the owner to use, manufacture, and sell both the subject of the patent and the patent itself.
• Franchises: Franchises may be granted by the government or a business for a specified period and purpose. A city may grant one company a franchise to distribute gas to homes for heating purposes, or a company may sell franchises, such as the right to operate a KFC restaurant. Franchise agreements are contracts that can have a variety of provisions. They usually require an investment by the franchisee; therefore, they should be accounted for as intangible assets.
• Licenses and Operating Rights: Obtained through agreements with governmental units or agencies; permit owners to use public property in performing their services.
• Others, including customer lists/relationships, noncompete covenants, and contracts and agreements.

Intangible assets differ from the tangible assets along 3 dimensions:

• Even if the life cycle of intangibles can be divided in 3 periods (Acquisition, Use and Disposal) as the tangible assets, intangible assets are recognized in the balance sheet only if they are purchased from external parties. Intangibles that are internally generated are not included in the balance sheet (contrary to tangible assets for which we discussed the case of the construction in process representing tangible assets that are built inside the firm). The difference is due to the difficulty to measure intangible in a reliable manner. As one of the characteristics of accounting is reliability, we will report only the intangibles for which the value can be determined in a reliable way through to a market transaction with external parties.
• We will not refer to depreciation rather to amortization
• We will not determine the amortization for all the intangible assets. Rather, we can distinguish intangible assets into:
  • Intangible assets with a Definite Useful Life. The cost of an intangible asset with a definite life is allocated on a straight-line basis each period over its useful life in a process called amortization that is similar to depreciation. Most companies do not estimate a residual value for their intangible assets. Amortization expense is included on the income statement each period and the intangible assets are reported at cost less accumulated amortization on the balance sheet.
• Intangible assets with an Indefinite Useful Life. Intangible assets with indefinite lives are not amortized. Instead, these assets must be reviewed at least annually for possible impairment of value by first using qualitative factors to determine whether it is more likely that not (that is, it is greater than a 50 percent likelihood) that the fair value of the indefinite-life intangible is less than its carrying amount. Qualitative factors can include, for example, negative effects due to increases in costs, decreases in cash flows beyond expectations, an economic downturn, or deterioration in the industry.