3
Capitalize vs Expense
Revenue Expenditures
– Merely maintain a given level of services
– Should be Expensed
Capital Expenditures
– Provide future benefits (useful life > 1 year)
– Should be Capitalized
Debit Expense
Debit Asset
5
1. Acquisition - What Costs to
Capitalize?
General Rule:
– Capitalize (add to an asset account) the
costs to acquire the asset and to prepare
it for its intended use.
Dr. Asset (purchase price, sales tax,
delivery, installation, etc)
Cr. Cash, Notes Payable, etc
Land – Has indefinite life and therefore is not depreciated
– Historical Cost includes: Purchase price, Closing costs, Cost to get ready for intended
use (Note: Sale of salvaged materials reduces cost)
Land Improvements – Have definite life and therefore are depreciated
– Fences, walls, parking lots, driveways
Buildings – Have definite life and therefore are depreciated
– Proportionate share of purchase price, or construction cost, Closing Cost, Architect & Attorney fees
Machinery, Equipment, Furniture & Fixtures – Purchase price (net of cash discounts), Freight & handling,
Insurance while in transit, Installation
Self Constructed
Assets
What to Capitalize?
Direct Materials & Labor
Variable Overhead
Apply Fixed Overhead
Interest During Construction, if constructed
–for company’s own use
–by someone else and progress payments &/or
deposit are required
8
2. Depreciation
(Cost Allocation) Depreciation is a method of cost
allocation.
– it is used to allocate the capitalized cost
of PP&E over the years benefited
(matching)
– Note: depreciation will decrease the
carrying value of the asset, but it is not a
valuation technique (i.e., book value is
not market value)
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2. Depreciation
(Cost Allocation)
Useful Life
Salvage Value
Depreciation methods
– (1) Activity (units-of-production)
– (2) Straight-line
– (3) Double-declining balance
– (4) 150 percent declining balance
– (5) Sum-of-the-years digits
– (6) MACRS (income tax depreciation)
– Under IFRS, depreciation accounting is very similar to US GAAP.
10
Class Example
Given the following information regarding an automobile purchased by the company on January 2, 2008:
Cost to acquire = $10,000
Estimated life = 4 years
Estimated miles = 100,000 miles
Salvage value = $2,000
Calculate depreciation expense for the first two years under each of the following methods.
11
(1) Units-of-Production (Activity)
Assume that the car was driven 20,000 miles in the year 2008, and 30,000 miles in 2009.
Annual depreciation =
Cost - Salvage Value x Current Activity Total expected activity
For 2008= 10,000 - 2,000 x 20,000 = $1,600
100,000 miles
For 2009 = 10,000 - 2,000 x 30,000 = $2,400
100,000 miles
12
(2) Straight-Line
= $10,000 - $2,000 = $2,000 per year
4 years
Cost - Salvage
Estimated Life Annual depreciation =
13
(3) Double-Declining Balance
DDB is an accelerated depreciation technique. It
generates more expense in the early years and
less in the later years.
Annual depreciation = % (Cost - A/D)
where A/D is the accumulated depreciation for all
prior years, and the percentage is double the
straight line rate, or 2 x 1/Estimate life. In the
example, the % = 2 x 1/4 = 2/4 = 50%.
Depreciation expense (D.E.)for:
2008 = 50% x (10,000 - 0) = $5,000
2009 = 50% x(10,000-5,000) = $2,500
14
(4) 150% Declining Balance
150%DB is another accelerated depreciation technique. It also generates more expense in the early years and less in the later years.
Annual depreciation = % (Cost - A/D)
where A/D is the accumulated depreciation for all prior years, and the percentage is 1.5 times the straight line rate, or
1.5 x 1/Estimate life. In the example, the % =
1.5 x 1/4 = 37.5%.
Depreciation expense (D.E.)for:
2008 = 37.5% x (10,000 - 0) = $3,750
2009 = 37.5% x(10,000-3,750) = $2,344
15
(5) Sum-of-the-years Digits SYD is another accelerated technique that calculates
more expense in early years and less in later years.
Annual depreciation = Fraction x (Cost-Salvage)
where the fraction is calculated as follows:
Numerator = declining years (highest first)
Denominator = sum of the years digits
In the class example, the denominator is
4+3+2+1 = 10
D.E. for 2008 =4/10(10,000-2,000) = $3,200
D.E. for 2009 = 3/10(10,000-2,000) = $2,400
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(6) MACRS
MACRS (modified accelerated cost recovery system) is a technique developed by the IRS for tax reporting. It utilizes combinations of DDB, 150%DB, and SL to calculate a table of percentages that can be applied to any depreciable asset.
Additionally, the IRS assumes no salvage value, and a half year in the first and last year of depreciation (some limitations on fourth quarter purchases).
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Change in Estimate
The change in estimate affects only the current and
future years; we do not go back and change the
previous years that have already been posted.
To calculate the new depreciation expense, first find
out how much depreciation has been posted (the
Accumulated Depreciation to date).
Then use the following formula (to modify the
straight-line depreciation rate):
Remaining Book Value - New Est. Salvage
Remaining Estimated Life
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Class Problem: Problem 9-7
(a)Book Value at 1/1/06:
First: annual depr. expense =
(180-30)/10 = 15/yr.
Then Accumulated Depr. to 1/1/11:
15 x 5 yrs = $75,000
So BV = 180,000 - 75,000 = 105,000
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Class Problem: Problem 9-7
(b) Estimate for 2011, assuming revised
useful life:
BV - SV = 105,000 - 30,000 = $9,375 per yr.
Remaining life 10 - 5 +3
Journal entry:
Depreciation Expense 9,375
Accum. Depreciation 9,375
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3. Postacquisition Expenditures: Betterments or
Maintenance? Betterments:
– Increase asset’s useful life
– Improve quality of asset’s output
– Increase quantity of asset’s output
– Reduce asset’s operating costs
Maintenance – maintain existing productivity or useful life
Accounting treatment – Betterments are capitalized
– Maintenance expenditures are expensed
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4. Disposal: Retirement, Sale or Trade-In
Retirement :
Dr. Loss (if not fully depreciated)
Dr. Acc Dep
Cr. Asset
Sale:
Dr. Cash
Dr. Acc Dep
Cr. Asset – Dr. Loss if BV > Cash or Cr. Gain if BV < Cash
Trade-ins (for dissimilar assets): asset received should be valued at
– the fair market value of assets given up, or
– the fair market value of the asset received, whichever is more evident and objectively determined
22
4. Disposal - continued
Using earlier example (cost = $10,000, salvage = $2,000). After 4 years straight-line, $8,000 would be in A/D.
1. Assume the asset is retired (no cash received)
Loss on retirement 2,000
Accumulated Depr. 8,000
Automobiles 10,000
2. Assume the asset is sold for $3,000:
Cash 3,000
Accumulated Depr. 8,000
Automobiles 10,000
Gain on sale 1,000
23
Class Exercise: Exercise 9-15
First calculate depreciation: DDB % = 1/5 x 2 = 2/5 = 40% Depr. Book Date % Cost - A/D Expense Value
1/1/09 25,000
12/31/09 40% (25,000 - 0) = 10,000 15,000
12/31/10 40% (25,000-10,000) = 6,000 9,000
12/31/11 40% (25,000-16,000) = 3,600 5,400
12/31/12 400* 5,000=SV
12/31/13 -0- 5,000
*formula will exceed salvage value limit in 2012; just depreciate $400, to salvage of $5,000.
24
Exercise 9-15, continued
(a) JE to scrap after 3 years, at 12/31/11, assumes
that no cash is received: Dr. Loss on Disposal 5,400 Dr. Acc Dep 19,600 Cr. Equipment 25,000
(b) JE to scrap after 5 years, assumes that no cash
is received: Dr. Loss on Disposal 5,000 Dr. Acc Dep 20,000 Cr. Equipment 25,000
25
Exercise 9-15, continued
(c) JE to sell for $8,000 after 3 years: Dr. Cash 8,000
Dr. Acc Dep 19,600
Cr. Equipment 25,000 Cr. Gain 2,600
(d) JE if, after 5 years, the equipment and $28,000 traded for a dissimilar asset with a fair market value of $30,000:
Dr. Asset (new) 30,000 Dr. Acc Dep 20,000 Dr. Loss 3,000 Cr. Equipment (old) 25,000 Cr. Cash 28,000
26
B. Intangible Assets Intangible assets are characterized by (1)
lack of physical evidence, and
(2) high uncertainty about future benefits.
Cost is amortized over useful life (or legal life, if less), but not to exceed 40 years.
– Exception is Goodwill, which is no longer amortized.
Under IFRS, revaluing intangibles is an option, but not a requirement. Under US GAAP, revaluation is not an option.
27
(1) Patents (20 year legal life) A company may capitalize the following
– the cost of acquiring an externally developed patent.
– filing fees for internally or externally developed patents.
– the legal fees for acquiring and successfully defending a patent (internal or external).
A company cannot capitalize the following:
– legal fees for unsuccessfully defending a patent.
– Most research and development costs for an internally developed patent.
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Research and Development
Costs (for internally developed
patents) Prior to 1974, most companies capitalized research
and development costs, then amortized the cost to future periods.
The FASB stated in SFAS 2 that, because “future benefits” were uncertain, companies should expense all R&D costs, unless they were related to tangible assets (like buildings and equipment) that had multi-year lives.
Companies complied with the standard, but for several years many companies actually reduced their R&D activities, because of concern for excess expense on the income statement.
29
Other Intangible Assets (2) Copyrights
– granted for the life of the creator plus 70 years.
– capitalization rules similar to patents: costs of internally developed copyright material cannot be capitalized.
(3) Trademarks and Trade Names
– granted for 10 year periods, but indefinite renewals.
– some of design costs may be capitalized.
(4) Organization Costs
– costs related to the creation of a company including underwriting fees, legal and accounting, licenses, titles, etc.
– treatment similar to R&D costs; even though there may be some future benefit, costs are expensed in the period incurred.
30
Other Intangible Assets -
continued (5) Software Development Costs (SFAS 86)
– Capitalize the costs of developing software for sale or lease.
– Expense software development costs if for internal use.
(6) Goodwill (also discussed in Chapter 8)
– Recognized when one company purchases another company.
– Causes include reputation, good customer relations, superior product development, etc.
– To calculate:
Purchase price paid for the company versus the fair market value of the net assets acquired
= Goodwill (the excess amount paid)
– No longer amortized, instead subjected to an impairment test
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IFRS vs. US GAAP: Revaluations to Fair
Market Value
One very important way in which IFRS differs from US GAAP involves the use of fair market value as a basis for valuation on the balance sheet.
– Under US GAAP, long-lived assets must be accounted for at original cost less accumulated depreciation.
– Under IFRS, companies can either follow the US GAAP method or they can periodically revalue their long-lived assets to fair market value.
In essence, US GAAP tends to follow a conservative “lower-of-cost-or-market” valuation principle, whereas IFRS allows managers the option to more closely follow a pure market valuation principle.
Copyright
32
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