ACCT 101, Session 6: PP&E and Intangibles

Dr. Richard M. Crowley
rcrowley@smu.edu.sg

https://rmc.link/

Front matter

Learning objectives

PP&E, Intangibles (Chapter 7)

  1. Understand which assets qualify as PP&E and Intangibles
  2. Account for acquisition and depreciation of PP&E
  3. Understand additional issues related to PP&E
  4. Account for intangibles

What are Non-current Assets?

Non-Current Assets

  • Long term investments
  • Construction in Progress
    • Incomplete skyscrapers
    • Incomplete manufacturing plants
    • Incomplete complicated machinery
      • Tungsten cathode, LPP Fusion, 1.25 years

Non-Current Assets

Non-Current Assets

  • Property, Plant, and Equipment, PP&E
    • Buildings
    • Land improvements
    • Furniture and Fixtures
    • Equipment
    • Machinery
    • Vehicles

Non-Current Assets

  • Intangibles
    • Patents
    • Internally developed software
    • Trademarks and names
    • M&A value (goodwill)
  • Not accounted for intangibles
    • Reputation
    • Own brand name
    • Management quality

What will we need to do?

Asset Related expense account
Land (freehold) None
Land (leasehold) Depreciation
Buildings Depreciation
Furniture & fixtures Depreciation
Machinery Depreciation
Vehicles Depreciation
Land improvements Depreciation
Natural resources Depletion
Intangibles (with finite useful lives) Amortization
Intangibles (with indefinite useful lives) None

PP&E Acquisition

What do we include?

PP&E has useful life or extends useful life, whereas expenses do not extend useful life but merely maintain or restore working order. [IAS 16]

  • Include as an asset:
    • Anything with useful life
    • Anything extending useful life
  • Expense:
    • Maintenance
      • Maintenance doesn’t extend useful life, it just keeps useful life where it should be

Purchasing (IAS 16)

  • Include:
    • Purchase price at historical cost
      • Net of discounts
    • Duties and non-refundable taxes
    • Employee benefits
      • For setting up the PP&E, such as insurance
      • Purchase commissions
    • Site preparation
    • Delivery and handling
    • Installation and/or assembly
    • Testing expenses
      • Net of test good proceeds
    • Fees incurred

Purchasing (IAS 16)

  • What don’t we include?
    • Opening ceremonies
      • No useful life after
    • Advertising a new product
      • A direct expense for operations, not the PP&E
    • Business costs due to dealing with customers
      • Operating costs
    • Admin/overhead costs
      • Operating costs

Examples of PP&E Value

PP&E Typical costs included in asset's value
Land Purchase price, commission (to agents), taxes paid, fees (legal, surveying), grading (changing elevation), removing unwanted structures
Land improvements Fencing, paving, lighting, security systems, landscaping
Buildings (constructed) Architect's fees, contractors' fees, materials, labor and overhead, interest on funds borrowed for construction
Buildings (purchased) Purchase price, commission (to agents), taxes paid, repair and renovation costs
Equipment Purchase price, transport, insurance during transit, sales tax, installation, testing (net of useful products)

Check

What is the asset value of the following:

  1. $10,000 of land with a $1,000 stamp duty (tax) and a $300 opening party
  2. A $5,000 machine, where testing cost $1,000 but created $500 of useful inventory.

Basket purchasing

  • Often, companies purchasing groups of assets
    • Firesales or deals with other companies
  • We call this basket purchasing
    1. Determine the market value of each asset
    2. Allocate a percent of market value to each asset
    3. Allocate basket price by percentages to assets
  • Record journal entries as usual

Basket purchasing example

Situation: Bought Machinery (MV: $8,000), Land (MV: $10,000), and Equipment (MV: $2,000) for $10,000 in one cash purchase

Check

Determine the value of each item in the following basket purchase for $90,000 cash:

  1. A service van worth $30,000
  2. A small tract of land worth $50,000
  3. A large amount of inventory worth $20,000

Repairs

  • Standard repairs are an expense
    • They don’t increase useful life
      • They maintain it
  • Repairs that increase useful life should be capitalized
    • Add the repair cost to asset value

Capitalize repairs only when useful life changes

Depreciation, Revisited

Why we depreciate

  • Recognize usage of assets over time
    • Even though we still have the asset, it’s lost value
      • Not as new
    • Charge to income statement as depreciation expense
    • Recognize on balance sheet as accumulated depreciation on a specific asset account
      • Contra asset
  • Matching principal
    • We used the asset to generate revenue, so we need to match asset usage (expense) to this revenue

Depreciation in every day life

How much does 1 year affect the value of the following?

  1. Smart phone
  2. Car
  3. Textbook
  4. Fiction book

Depreciation methods

  1. Straight line
    • We’ve seen this one already!
    • \(Depr = \frac{Cost-Salvage}{\#Periods}\)
  2. Units of production (a.k.a. units of activity)
    • \(Depr = (Cost-Salvage) \frac{Units~Used}{Total~Units}\)
  3. Double declining balance
    • \(P = 2/\#Periods\)
    • \(Depr = (Cost - Accum~Depr) \cdot P\)

Salvage value (a.k.a., residual value)

Never go below salvage value. Stop depreciating when you hit salvage value

Picking a depreciation method

The depreciation method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by an entity. [FRS 16:60]

  • Expect variation in methods used, as different firms may argue different usage patterns for the same assets

The method must be used consistently from period to period. [FRS 16:61, 62]

  • You generally can’t change methods during the life of an asset

Straight-line depreciation

\[ Depr = \frac{Cost-Salvage}{\#Periods} \]

  • Constant over time
    • Same amount per year
  • Partial years: multiply by the \(Months\ used/12\)
  • Will end up at salvage value after \(\#Periods\) periods

Check: Straight-line

You have a $100k asset which you will use for 5 years, with $25,000 salvage value. What is straight-line depreciation in years 1 and 2?

Units of production depreciation

\[ Depr = (Cost-Salvage) \times \frac{Units\ Used}{Total\ Units} \]

  • Constant per unit produced
    • Same amount per unit, but units vary by year
  • Partial years: no change
  • Will end up at salvage value after the total number of units are produced

Check: Units of production

You have a $100k asset which you will use for 5 years, with $25,000 salvage value. What is units of production depreciation in years 1 and 2? Usage will be 10%, 30%, 40%, 10%, and 10% for each year.

Double declining balance depreciation

\[ Depr = (Cost - Acc\ Depr)\times P,\quad P=\frac{2}{\#Periods} \]

  • More depreciation early, less later
  • Partial years: multiply by the \(Months\ used/12\)
  • Can hit salvage value early – stop depreciating at this point

Double declining balance depreciation

\[ Depr = (Cost - Acc\ Depr)\times P,\quad P=\frac{2}{\#Periods} \]

Steps for calculation:

  1. Determine the percentage to deduct each period, \(P=\frac{2}{\#Periods}\)
  2. Determine net asset value, \(NAV = Historical~Cost-Accum~Depr\)
  3. Determine the maximum depreciation, \(max=NAV \cdot P\)
  4. If not the last period:
    • Check if \(NAV-max \ge salvage\)
    • If it is, depreciation is \(max\)
    • If it is not, depreciation is \(NAV - salvage\)
  5. If the last period:
    • Take \(NAV - salvage\) as your depreciation

Check: DDB

You have a $100k asset which you will use for 5 years, with $25,000 salvage value. What is double declining balance depreciation in years 1 and 2?

Depreciation comparison: no salvage value

Situation: You have a $100k asset which you will use for 5 years, with $0 salvage value. Determine depreciation using the 3 methods. Usage will be 10%, 30%, 40%, 10%, and 10% for each year.

Depreciation comparison: salvage value

Situation: You have a $100k asset which you will use for 5 years, with $25,000 salvage value. Determine depreciation using the 3 methods. Usage will be 10%, 30%, 40%, 10%, and 10% for each year.

Natural resources

  • Depletion
    • Just like units of production depreciation
    • Different name as resources are depleted when mined
      • Meaning the amount of resources left has decreased

Notes on depreciation

  • Useful life is an estimate
  • Salvage value is an estimate
  • Depreciation method is a choice
  • 0 net asset value (NAV) \(\ne\) unusable
    • NAV \(=\) asset value minus its accumulated depreciation
    • You won’t record any more depreciation after hitting 0

Other issues in PP&E

Income taxes

  • Depreciation method affects your taxes!
    • This makes double-declining balance look more enticing

Long lives

  • Partial years
    • Straight-line and DDB: Multiply yearly depreciation by \(Months\ used/12\)
    • Units of production: No change needed, as fewer units produced controls for this
  • Many things change over time
    • This includes the accuracy of your depreciation assumptions
      • Length of time, salvage value
    • Increased life from maintenance is an example
  • Use new assumptions going forward
    • Essentially treat as a new asset with a historical cost equal to the current NAV, for the purpose of depreciation calculations

Example of partial years

Situation: Bought an asset on September 30th for $10,000, with useful life of 7 years and $3,000 of salvage value. What is depreciation under straight line and DDB for the asset as of December 31st of the same year?

  • Months passed: 3 months
    • Oct, Nov, Dec
  • Straight-line
    • Full year is: \(\frac{10,000-3,000}{7}=1,000\)
    • Partial year is: \(1,000 \times \frac{3}{12} = 250\)
  • DDB
    • Full year is: \((10,000 - 0)\times \frac{2}{7} = 2,857.14\)
    • Partial year is: \(2,857.14\times \frac{3}{12} = 714.29\)

Example of changing assumptions

Situation: Bought an asset on January 1st 20X0 for $10,000, with useful life of 7 years and $3,000 of salvage value, to be accounted for using straight line depreciation. In year 20X2 it was determined that the asset would only last 6 years in total, with 0 salvage value, and should be accounted for using DDB. What is the depreciation expense in years 20X0 through and 20X2?

  • Years 20X0 and 20X1
    • Normal straight line problem:
      • \(Expense = (10,000 - 3,000) / 7 = 1,000\)
  • Year 20X2
    • Determine NAV (new cost): \(10,000 - 1,000 - 1,000 = 8,000\)
    • Years left: \(6 - 2 = 4\)
    • New Acc. Depr.: \(0\)
    • \(DDB = (8,000 - 0) \times \frac{2}{4} = 4,000\)

Retirement

  • Retirement \(=\) throwing the asset out
  • Adjust the PP&E value to include partial depreciation (if any)
    • Same as usual depreciation methods
  • Record retirement:

Asset at 0 net asset value (NAV)

  • No gain or loss here

Asset at \(>0\) net asset value

  • Debit loss on asset retirement

Sale

  • Sale is like retirement, but you are receiving some cash instead of nothing.
  • Adjust the PP&E value to include partial depreciation (if any)
    • Same as usual depreciation methods
  • Record a sale:

Loss (NAV \(>\) Cash)

  • Debit loss on asset sale

Gain (NAV \(<\) Cash)

  • Credit gain on asset sale

Exchange

  • Exchange is the same as a sale, but with non-cash settlement
    • Ex.: Exchange machinery for a car
  • Adjust the PP&E value to include partial depreciation (if any)
    • Same as usual depreciation methods
  • Record an exchange:

Loss (NAV \(>\) Asset received)

  • Debit loss on asset sale

Gain (NAV \(<\) Asset received)

  • Credit gain on asset sale

Example of disposal

Situation: A machine bought for $10,000 has $4,000 of accumulated depreciation, but the firm no longer needs the asset. Record the following possible outcomes: 1) Disposal of the machinery; 2) Sale for $4,000 cash; 3) Exchange for an $8,000 Warehouse

Practice

  1. Get the in class activity spreadsheet on eLearn Session_6_Activity_Depr.xlsx
  2. Calculate depreciation for the assets listed in the file using each method

Intangibles

What are intangibles?

  • Literally “not perceptible by touch”
    • Things you can’t hold, but still have value
  • Patents
  • Copyrights
  • Franchise rights
  • Licenses
  • Trademarks
  • Goodwill (i.e. excess acquisition price)

Patents

  • Most cited: US4683202A
    • Filed 25/10/1985
    • \(>\) 8,000 citations

The present invention is directed to a process for amplifying any desired specific nucleic acid sequence contained in a nucleic acid or mixture thereof. The process comprises treating separate complementary strands of the nucleic acid with a molar excess of two oligonucleotide primers, and extending the primers to form complementary primer extension products which act as templates for synthesizing the desired nucleic acid sequence. The steps of the reaction may be carried out stepwise or simultaneously and can be repeated as often as desired.

Patents

Copyrights

  • © or “rights reserved”
\(\quad\)

Franchise Rights

\(\quad\)

Licenses

  • Software licenses
  • Can be for a period or infinite
    • Periodic licenses treated as a prepaid expense
    • Infinite licenses treated as an asset
      • Unless the license usefulness is clearly limited
\(\quad\)

Trademarks

  • ™ or ®
\(\quad\)

Goodwill

  • The amount paid for a company in an acquisition above its updated book value
    • If price < updated book value, negative goodwill
  • Microsoft bought LinkedIn
    • $25B price
    • LinkedIn had about $4B book value
      • Note: LinkedIn’s assets were worth more than their book value
    • As much as $17B was goodwill
\(\quad\)

Valuing intangibles

  • If internally generated
    • Legal costs for titles can be capitalized (registration costs)
      • Added to asset account
    • Generation costs are expensed
      • Exception: Development after Research can be capitalized under IFRS (IAS 38)
  • If purchased
    • Record at cost

Why do we have this difference? It’s because purchases have more reliable values.

What about depreciation?

  • Intangibles are not physical items, so they doesn’t depreciate

  • They can lose value over time

  • Solution for infinitely lived items:

    • Revalue when doing financial statements
    • Involves decreasing book value to match the current (lower) value, if lower, by a process called impairment
    • We generally never increase book value

  • Solution for finitely lived items:

    • Amortize their value
    • Works like straight line depreciation with 0 salvage value
    • Can also be impaired

Impairment is not covered on the exam

Amortization

  • Amortization is like depreciation for intangibles
  • Debit Amortization expense
  • Credit accumulated amortization
  • Always use straight-line with 0 salvage value
  • Example:
  1. Bought a patent for $100 cash. It has 5 years of life.
  2. Recorded amortization after 1 year.
  3. Recorded amortization after another year.

Notes on Intangibles

  • Determining the life of intangibles:
    • Often, this is based on a country’s laws
      • Copyright duration is set by each country
      • Trademark law determines trademark life
    • Mergers will be infinitely lived, but are often impaired

End matter

Wrap up

  • For next week
    1. Recap the reading for this week
    2. Read the pages for next week
      • Chapter 8 (Liabilities)
      • Tricky subject, reading highly recommended
      • We’ll spend 2 weeks on liabilities
    3. Homework 3 to turn in next week
      • Available on eLearn
      • Submit on eLearn
    4. Practice on eLearn
      • Practice on Journal entries (#2)
      • Automatic feedback provided
  • Survey on the class session at rmc.link/101survey6

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