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Chapter Seven Outline

by: Nicholas D'Ambrosio

Chapter Seven Outline ACG2021

Marketplace > University of Florida > Finance > ACG2021 > Chapter Seven Outline
Nicholas D'Ambrosio

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Detailed outline of chapter seven of our textbook.
Introduction to Financial Accounting
Class Notes
finance, Accounting, financial accounting, business
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This 8 page Class Notes was uploaded by Nicholas D'Ambrosio on Sunday October 9, 2016. The Class Notes belongs to ACG2021 at University of Florida taught by in Fall 2016. Since its upload, it has received 3 views. For similar materials see Introduction to Financial Accounting in Finance at University of Florida.


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Date Created: 10/09/16
Chapter Seven: Plant Assets, Natural Resources, Intangibles VII. Plant Assets, Natural Resources, Intangibles This chapter will be discussing plant assets, natural resources, and intangibles. Below are the textbook definitions of these terms: Also it is important to know how these assets and resources decrease in value. The following chart shows how to record a decrease in value of these assets and resources: A. Measure and Account for the Cost of Plant Assets Here is the basic working rule for measuring the cost of an asset: The cost of any asset is the sum of all costs incurred to bring the asset to its intended use. 1. Land The cost of land includes its purchase price, brokerage commission, survey fees, legal fees, and any back property taxes that the purchaser pays. Land cost also includes expenditures for grading and clearing the land and for removing unwanted buildings. The cost of land does NOT include the cost of fencing, paving, security systems, and lighting. These are separate plant assets called land improvements, and they are subject to depreciation. 2. Buildings, Machinery, and Equipment The cost of constructing a building includes architectural fees, building permits, contractors’ charges, and payments for material, labor and overhead. When an existing building is purchased, its cost includes the purchase price, brokerage commission, sales and other taxes paid, and all expenditures to repair and renovate the building for its intended purpose. The cost of equipment includes its purchase price, plus transportation from the seller to buyer, insurance while in transit, sales and other taxes, purchase commission, installation costs, and any expenditures to test the asset before it’s placed in service. 3. Land Improvements and Leasehold Improvements As discussed earlier, paving, fencing, security systems, etc. are all land improvements and have their own account. They depreciate like any other account. Equipment that is leased and improved upon is referred to as leasehold improvements. Depreciation of leasehold improvements are called amortization. 4. Lump-Sum (or Basket) Purchases of Assets Often companies buy their assets in a package deal. In order to identify the cost of each asset, the total cost is divided among the assets according to their relative sales value. This is called the Relative Sales-Value Method. The diagram below will help calculate the relative sales value method: B. Distinguish a Capital Expenditure from an Immediate Expense Expenditures that increase the asset’s capacity or extend its useful life are called capital expenditures. Capital expenditures are said to be capitalized, which means the cost is added to an asset account and not expensed immediately. Costs that do not extend the asset’s capacity or its useful life, but merely maintain the asset or restore it to working order, are recorded as expenses. The diagram below will help distinguish between the two. C. Measure and Record Depreciation on Plant Assets As a reminder, the book value of an asset = cost – accumulated depreciation. 1. Depreciation Methods a. Units of Production Method In this method, a fixed amount of depreciation is assigned to each unit of output, or service, produced by the asset. Under this method, depreciation can be found by using the following formula: b. Double Declining Balance Method The DDB method is the most frequently used accelerated depreciation method. It computes annual depreciation by multiplying the asset’s declining book value at the beginning of the year by a constant percentage, which is two times the straight line depreciation rate. Here’s how it is computed: 2. Comparing Depreciation Methods Here is how and when the three depreciation methods are typically used: - Straight Line Method: plant assets that generate revenue evenly over time. - Units of Production Method: asset that wear out because of physical use rather than obsolescence. - DDB method: assets that generate more revenue earlier in their useful lives and less in later years. 3. Depreciation for Tax Purposes There is a special depreciation method used only for income tax purposes called the Modified Accelerated Cost Recovery System (MACRS). MACRS uses the above diagram to calculate depreciation. 4. Depreciation for Partial Years Companies often buy plant assets in the middle of a year and therefore need to compute depreciation for partial years. In order to do this, first compute the annual depreciation, then multiply that number by the fraction of the year the asset was held. For example, if an asset is purchased on October 1 and annual depreciation is $1,000, with the accounting year ending December 31 , the partial depreciation would be calculated as: $1,000 x 3/12 = $250 As a rule, most companies record no monthly depreciation on assets purchased after the 15 of the month, and they record a full month’s depreciation on assets purchased on or before the 15 of the month. D. Analyze the Effect of a Plant Asset Disposal 1. Disposing of a Plant Asset for No Proceeds To account for disposal, remove the asset and its related accumulated depreciation from the books. A fully depreciated asset means that the asset is estimated to have zero residual value. To record an assets disposal, one must debit the accumulated depreciation account for the full amount of the asset’s depreciation (same as the asset’s cost if fully depreciated) and credit the equipment account for the same value. If a company disposes of a plant asset that is not fully depreciated, its remaining book value becomes recorded as an expense known as loss on disposal of plant asset. 2. T-Accounts for Analyzing Plant Asset Transactions Below is an illustration of how plant asset transactions affect various T accounts: E. Apply GAAP for Natural Resources and Intangible Assets 1. Accounting for Natural Resources The process by which natural resources are used up is referred to as depletion. If all of the resource extracted is regarded as sold, the amount depleted is transferred directly from long term assets to the income statement in the form of an expense. However, as in the case of an integrated oil company, if a portion of the extracted resource is not immediately sold, it becomes saleable inventory. Then, as the inventory is sold, its cost is transferred to an expense such as cost of goods sold. 2. Accounting for Intangible Assets Intangible assets are long lived assets with no physical form. Intangible assets fall into two categories: - Intangibles with finite lives that can be measured. We record amortization for these intangibles annually. Amortization expense is the title of the expense associated with intangibles. Amortization works like depreciation and is usually computed on a straight line basis. Amortization can be credited directly to the asset account. Intangible assets with finite lives are amortized over the shorter of legal or useful life. - Intangibles with indefinite lives. Record no amortization for these intangibles. Instead, check them annually for any loss in value (impairment), and record a loss when it occurs. Goodwill is the most prominent example of an intangible asset with an indefinite life. 3. Accounting for Specific Intangibles a. Patents Patents are federal government grants that give the holder exclusive right for 20 years to produce and sell an invention. Suppose a company purchases a patent for $170,000 and expects its useful life to be 5 years. Thus, the annual amortization cost is $34,000 ($170,000 / 5 = $34,000). This amount is credited to the patents account and debited to the amortization expense account. b. Copyrights Copyrights are exclusive rights to reproduce and sell a book, musical composition, film, or other work of art. Copyrights extend 70 years beyond the author’s life. The useful life of a copyright is usually no longer than 2 to 3 years. c. Trademarks and Trade Names Trademarks and Trade names are distinctive identifications of products or services. These can have either definite or indefinite lives. d. Franchises and Licenses Franchises and Licenses are privileges granted by a private business or a government to sell a product or service in accordance with specified conditions. The useful lives of many franchises and licenses are indefinite and, therefore, not amortized. e. Goodwill Goodwill is defined in accounting as: 4. Accounting for Research and Development Costs In general, US companies do not report research and development assets on their balance sheets. Rather, they expense research and development costs as they are incurred. F. Explain the Effect of an Asset Impairment on the Financial Statements GAAP requires that management of companies test both tangible and intangible long term assets for impairment. Impairment occurs when the expected future cash flows from a long term asset fall below the asset’s net book (carrying) value. If an asset is impaired, the company is required to adjust the carrying value downward from its book value to its fair value. In this case, fair value is based not on the expected future cash flows, but on the asset’s estimated market value at the date of the impairment test. The following illustration shows how to calculate for impairment: Under US GAAP, once a long term asset has been written down because of impairment, it may never again be written back up, should it increase in value. G. Analyze Rate of Return on Assets Rate of return on assets is known as ROA, and can be calculated with this formula: 1. DuPont Analysis: A More Detailed View of ROA Companies often perform a DuPont analysis, which breaks ROA down into two component ratios that drive it: (ROA = Net profit margin ratio x Total asset turnover) Net profit margin ratio measures how much every sales dollar generates in profit. Net profit margin ratio can be increased in one of three ways: 1.) increasing sales volume, or the amount of goods sold or services performed. 2.) Increasing sales prices. 3.) Decreasing cost of goods sold and operating expenses. Total asset turnover measures how many sales dollars are generated for each dollar of asset invested. It can be increased by 1.) Increasing sales in the way just described, 2.) Keeping less inventory on hand, or 3.) Closing unproductive or low-performing facilities. H. Analyze the Cash Flow Impact of Long Lived Asset Transactions Three main types of long lived asset transactions appear on the statement of cash flows: - Acquisitions - Sales - Depreciation (as well as amortization)


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