Long Lived Assets

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Lecture 14
Long-Lived Assets
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Goals of Todays Class
Tangible Assets:
Acquisition of PP&E
Purchase
Construction
Depreciation
Disposal of PP&E
Impairment of PP&E

Intangibles & Goodwill

Tangible Assets
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4
Types of Transactions That Affect
the Net Book Value of PPE

Transactions that increase PPE
Acquisitions of PPE by purchase
Acquisitions of PPE by self-construction
Expenditures for improvements and betterments

Transactions that decrease PPE
Depreciation
Disposal of PPE by sale or abandonment
Permanent impairment of value
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Depreciation
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PP&E $XXX
Cash (Liabilities) $XXX

The amount debited to the PP&E account includes the
costs both of purchasing the item and of transporting the
equipment to the firms facilities, installation, set-up and
testing prior to normal use i.e. the cost of the PP&E
includes all costs incurred to acquire the asset and to
prepare it for normal intended use.

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Pre-acquisition appraisal
In-transit insurance
Wages of employees
involved in the
acquisition
Installation and set-up
costs
Duty
= YES
Post-acquisition appraisal
Cost of opening
ceremonies
Interest on liabilities
outstanding during the
acquisition period
= NO
Note:
Only pre-acquisition costs
Only directly related to the acquisition
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- Example
On June 14, Delta Air Lines purchased
aircraft for $1,000,000 cash and a
$59,000,000 note payable.
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Depreciation
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Acquisitions of PPE by
self-construction
With one exception, the cost of PP&E (buildings and/or equipment)
acquired by self-construction is determined in exactly the same way
as a cost of a manufactured product i.e. raw materials, wages,
depreciation of production ppe, utilities etc.

The exception is that for self-constructed PP&E (but not for
manufactured inventory) the cost will also include interest costs on
debt outstanding during the period of construction. The amount of
interest is related to the amount of the firms investment in the self-
constructed asset.
PP&E
Cash
Materials Inventory
Wages Payable
Accumulated Depreciation
Interest Payable
$PPE
$CCC
$RMI
$WWW
$DDD
$III

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self-construction - Example
Instead of purchasing the aircraft, Delta incurred
the following expenses to build the aircraft.
Used materials, cost = $40 million
Incurred wages (not paid), $10 million
Used equipment, relevant depreciation was $7 million
$1 million of utilities used in building the aircraft
Incurred $2 million in interest on a loan acquired for
financing the project
What should the journal entries be?
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self-construction - Example

PP&E 60
Materials inventory 40
Wages payable 10
Accumulated Depreciation 7
Utilities payable 1
Interest Payable 2
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Another Example for the
capitalization of interest expense
How much interest should the firm capitalize in 2012 related to the construction of
the plant?
To record the interest associated with the investment in the plant under
construction:

To record remaining interest:
On January 1, 2012, the firm began construction of a new manufacturing plant. The
project was expected to take 3 years to complete at a cost of $4,000,000. For 2012,
the firms average investment in the plant under construction amounted to $750,000.
For the year, the firms average outstanding interest bearing debt (liabilities)
amounted to $2,500,000 with an average interest rate of 8%.

Some pointers on Interest
Capitalization
Firms can capitalize interest costs on
debt outstanding during the period of
construction.
The amount of interest that can be
capitalized is based on the amount of the
firms average investment in the self-
constructed asset.
Capitalization of borrowing costs
terminates when the asset is ready for its
intended use

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Depreciation
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Expenditures for improvements
and betterments
Ordinary repairs and maintenance
Recorded as expenses in period in which occurred
Referred to as revenue expenditures
Examples: oil changes, replacing headlights, etc.
Results from normal operation of the asset

Additions and Improvements
Expenditures that increase productive life, operating efficiency,
or capacity
Referred to as capital expenditures
Capitalized by increasing the book value of the asset
Lead to higher depreciation expense in the future

Distinction is difficult to make managerial judgment

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and betterments
Ordinary repairs and maintenance:
Paid cash to replace air filters on A/C units

Paid cash to update the administrative buildings
HVAC system

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and betterments
Note: ordinary repairs and maintenance for
machinery used in production are capitalized
as part of work-in-process inventory
Paid cash to replace air filters on airbrush unit used
to paint/produce motorcycles

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Depreciation
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Depreciation
Expensed (for non-manufacturing plant and
equipment):

Depreciation Expense $DDD
Accumulated Depreciation $ DDD

Capitalized as part of Work in Process (for
manufacturing plant and equipment):

Work in Process $DDD
Accumulated Depreciation $DDD
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How to calculate depreciation
GAAP does not determine specifically how firms are to estimate the depreciation cost.
However, several methods are common in practice:

Method Annual Depreciation Computation
Base x Rate

Straight - line (Original Cost - Salvage
Value)
1
Estimate d useful life (years)

X Declining
Balance
(Original Cost - Accum. Depn) x X
Estimated useful life (years)

Sum - of - Years
Digits
(Original Cost - Salvage
Value)

x Useful life remaining (years)
Sum of digits of total useful life**

Units of Production (Original Cost - Salvage
Value)

x Productive output for year
Total estimated productive
output

** Sum of digits of total useful life = ( n x (n + 1) )/2 where, n =
estimated useful life

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Exercise
Ritas Pita Company bought a new dough machine at the beginning of the year
at a cost of $6,000. The estimated useful life of the machine was four years
and the residual value was $1,000. Assume that the estimated productive
life of the machine was 9,000 hours. Actual annual usage was 3,600 hours
in year 1; 2,700 hours in year 2; 1,800 hours in year 3; and 900 hours in
year 4.
Straight-line depreciation?
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Exercise
Note: Initial cost = $6,000; estimated useful life = four years; residual value =
$1,000; estimated productive life = 9,000 hours; actual annual usage =
3,600 hours in year 1; 2,700 hours in year 2; 1,800 hours in year 3; and 900
hours in year 4.
Units of production?
Declining Balance Depreciation Method
Modifies the normal straight-line rate to accelerate depreciation

Commonly 2 times the straight-line rate (double-declining balance)

Or 1.5 times the straight-line rate (150%-declining balance)

Straight-line annual percentage rate = 100% / useful years

100% / 4 years = 25%

Double-declining will use 2 x 25% = 50%

150%-declining will use 1.5 x 25% = 37.5%

Begins with Book Value and ends with Salvage Value
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Exercise
hours in year 4.
Double-declining-balance?
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Exercise
hours in year 4.
Sum-of-years-digits?
What happens when depreciation estimates change?
Firms can change their depreciation methods or assumptions
Changes happen prospectively (i.e., going forward)
Firm X has a truck purchased for $20,000; salvage value is $4,000
Estimated useful life is 4 years [20,000 (BV) - $4,000 (SV)] / 4 $4,000
Depr Expense
Accum Depr: Truck Truck
$20,000
Firms can change their depreciation methods or assumptions
Changes happen prospectively (i.e., going forward)
Firm X has a truck purchased for $20,000; salvage value is $4,000
Estimated useful life is 4 years [20,000 (BV) - $4,000 (SV)] / 4 $4,000
Accum Depr: Truck
$4,000
Truck
$20,000
After first year of use, Firm X adjusts estimate of useful life to total of 6 years
[16,000 (BV) - $4,000 (SV)] / 5 remaining years $2,400
Depr Expense
$4,000
What happens when estimates change?
On January 1, 2001, a firm acquired a depreciable asset
at a cost of $160,000. The estimated useful life of the
asset and its salvage value were determined to be 20
years and $10,000 respectively. The firms uses the
straight line method for depreciation.
What is annual depreciation?
(160,000-10,000)/20 = 7,500
At the end of 2010 (10 years later) what would the
balance sheet look like?
Equipment 160,000
Accumulated Depreciation 75,000
Net Book Value of Equipment 85,000
At the start of 2011 the firm revises its estimate of the useful life,
determining that 5 years are left (instead of 10 from the original
estimate).
What do we do?
We do NOT make retro-active adjustments to the financial
statements.
That is, we do not restate depreciation for the last 10 years to 10,000
per year
We simply revise the depreciation charge going forward.
For the remaining 5 years annual depreciation is:
[(160,000-75,000)-10,000]/5 = 15,000

This is called the prospective method and it is used to account for all
changes in the estimates used to derive the amounts reported in the
financial statements. But it is NOT used if a firm changes
accounting method (i.e., straight line to accelerated).
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Depreciation
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Disposal of PPE by sale or
abandonment
Cash (and/or other assets)
[Loss on Sale
PP&E
[Gain on Sale
CCC
LLL]
DDD

PPE
GGG]

Loss on Abandonment
PP&E
LLL
DDD

PPE

Disposal of PPE by sale
Disposal of PPE by abandonment
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Non-Operating Losses: Example
A firm purchased a computer for $5000 and intended
to use it for five years, at which time it estimates that
it will have zero salvage value. Suppose after three
years it sells the computer for $500 because it is
largely obsolete. Assuming the firm always used
straight line depreciation, how does it record the
transaction?:

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Non-Operating Gains: Example
A firm purchased a computer for $5000 and intended
to use it for five years, at which time it estimates that
it will have zero salvage value. Suppose after three
years it sells the computer for $2500. Assuming the
firm always used straight line depreciation, how does
it record the transaction?:

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Depreciation
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Asset Impairments: When to Evaluate
Any time an event suggests carrying amount may not be recoverable

Significant decrease in market price of asset

Adverse change in physical condition of asset

Adverse change in business climate or legal environment
that could affect value of asset

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U. S. GAAP Impairment: 2 benchmarks
First, assess whether impairment is needed:

Net book value > estimated undiscounted future cash
flows

If yes, then recognize impairment holding loss:

Net book value Fair market value = holding loss

Impairment loss flows into income from continuing operations
Impairment Loss $xxx
PP&E $xxx
Intangible Assets
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Long-lived assets that are contractual rather than physical
Patents & Copyrights, Trademarks, Licenses, Goodwill

Accounting for intangibles:
Definite life: Acquisition costs are capitalized and then
gradually expensed over life of asset (amortized) if purchased
from an external party (not developed). (e.g. patents).
Indefinite life: Not amortized. Tested annually for
impairment. (e.g.: Goodwill)

BUT: Internal development, R&D costs, advertising and
employee training are NOT assets as defined by FASB
must be expensed immediately.
Intangible Assets
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Accounting Goodwill is the excess of the
acquisition price over the Fair (Market)
Value of all separately identifiable assets
and liabilities acquired

Reflects non-identifiable assets
Synergies, human capital, or sometimes
overpayment

Recorded only when an entire business is
purchased; cannot be purchased as a stand-
alone asset
Intangible Assets: Goodwill
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Suppose Whole Foods acquires Bread & Circus for $10 mil cash. and
agrees to assume all B & C liabilities. The sum of the market values of B &
Cs assets (cash, inventory, trademarks, etc.) is $12 mill and of its
liabilities is $4 mill. Goodwill is calculated as follows:
Purchase price paid for Bread & Circus $10 million
Sum of the market values of B & C assets 12 million
Less: B & Cs liabilities (4 million)
Market value of B & C net assets 8 million
Excess is called Goodwill (a non-current asset) $2 million
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In November 2006 we acquired all of the voting interests of YouTube, a
consumer media company for people to watch and share original videos through
a web experience. The purchase price was $1.194 billion. The following table
summarizes the allocation of the purchase price for YouTube (in thousands):
Goodwill 1,134,687
Patents and developed technology 24,000
Tradename, customer contracts, 153,000
Net liabilities assumed (45,027)
Deferred tax liabilities (72,240)
Purchased in-process research and development -
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Next Class
Lecture 15 Snap On Tools Case
Lecture 15
Snap-On Tools PP&E
Todays Class

Review Long-lived assets

Snap-On Tools Case

Quick Review of Long-Lived Assets
Acquisition by Self-Construction
Capital Improvements
Depreciation
Disposal
Intangible Assets

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and betterments
Ordinary repairs and maintenance:
Paid cash to replace air filters on A/C units

Paid cash to update the administrative buildings
HVAC system

48
and betterments
Note: ordinary repairs and maintenance for
machinery used in production are capitalized
as part of work-in-process inventory
Paid cash to replace air filters on airbrush unit used
to paint/produce motorcycles

49
How to calculate depreciation
GAAP does not determine specifically how firms are to estimate the depreciation cost.
However, several methods are common in practice:

Method Annual Depreciation Computation
Base x Rate

Straight - line (Original Cost - Salvage
Value)
1
Estimate d useful life (years)

X Declining
Balance
(Original Cost - Accum. Depn) x X
Estimated useful life (years)

Sum - of - Years
Digits
(Original Cost - Salvage
Value)

x Useful life remaining (years)
Sum of digits of total useful life**

Units of Production (Original Cost - Salvage
Value)

x Productive output for year
Total estimated productive
output

** Sum of digits of total useful life = ( n x (n + 1) )/2 where, n =
estimated useful life

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Disposal of PPE by sale or
abandonment
Cash (and/or other assets)
[Loss on Sale
PP&E
[Gain on Sale
CCC
LLL]
DDD

PPE
GGG]

Loss on Abandonment
PP&E
LLL
DDD

PPE

Disposal of PPE by sale
Disposal of PPE by abandonment
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Long-lived assets that are contractual rather than physical
Patents & Copyrights, Trademarks, Licenses, Goodwill

Accounting for intangibles:
Definite life: Acquisition costs are capitalized and then
gradually expensed over life of asset (amortized) if purchased
from an external party (not developed).
Indefinite life: Not amortized. Tested annually for
impairment.

BUT: Internal development, R&D costs, advertising and
employee training are NOT assets as defined by FASB
must be expensed immediately.
Intangible Assets
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Accounting Goodwill is the excess of the
acquisition price over the Fair (Market)
Value of all separately identifiable assets
and liabilities acquired

Reflects non-identifiable assets
Synergies, human capital, or sometimes
overpayment

Recorded only when an entire business is
purchased; cannot be purchased as a stand-
alone asset
Snap-On Tools PP&E
(see handout)

Long Lived Assets

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