Financial Accounting, Fourth Canadian Edition

Libby, Libby, Short, Kanaan, Gowing

Connect Study Guide

prepared by Robert G. Ducharme, MAcc, CA

CHAPTER 9: Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles

What You Really Need to Know

1. Define, classify, and explain the nature of long-lived assets and interpret the fixed asset turnover ratio.

a. Noncurrent assets are those that a business retains for long periods of time, for use in the course of normal operations rather than for sale. They may be divided into tangible assets (land, buildings, equipment, natural resources) and intangible assets (including goodwill, patents, and franchises).

b. The cost allocation method utilized affects the amount of net property, plant, and equipment that is used in the computation of the fixed asset turnover ratio. Accelerated methods reduce carrying amount (net book value) and increase the turnover ratio.

2. Apply the cost principle to measure the acquisition and maintenance of property, plant, and equipment.

Acquisition cost of property, plant, and equipment is the cash-equivalent purchase price plus all reasonable and necessary expenditures made to acquire and prepare the asset for its intended use. These assets may be acquired by using cash, debt, or equity, or through self-construction. Expenditures made after the asset is in use are either capital expenditures (betterments, improvements, extraordinary repairs) or revenue expenditures (ordinary repairs and maintenance):

a. Capital expenditures provide benefits for one or more accounting periods beyond the current period. Amounts are debited to the appropriate asset accounts and depreciated or depleted over their useful lives.

b. Revenue expenditures provide benefits during the current accounting period only. Amounts are debited to appropriate current expense accounts when the expenses are incurred.

3. Apply various depreciation methods as assets are held and used over time.

Cost allocation methods: In conformity with the matching process, cost (less any estimated residual value) is allocated to periodic expense over the periods benefited. Because of depreciation, the carrying amount of an asset declines over time and profit is reduced by the amount of the expense. Common depreciation methods include straight-line (a constant amount over time), units-of-production (a variable amount over time), and double-declining-balance (a decreasing amount over time).

· Depreciation—buildings and equipment.

· Depletion—natural resources.

· Amortization—intangibles.

4. Explain the effect of asset impairment on the financial statements.

When events or changes in circumstances reduce the estimated future cash flows of long-lived assets below their carrying amounts, the carrying amounts should be written down (by recording a loss) to the fair value of the assets.

5. Analyze the disposal of property, plant, and equipment.

When assets are disposed of through sale or abandonment,

· Record additional depreciation since the last adjustment was made.

· Remove the cost of the old asset and its related accumulated depreciation or depletion.

· Recognize the cash proceeds.

· Recognize any gains or losses when the asset’s carrying amount is not equal to the cash received.

6. Apply measurement and reporting concepts for natural resources and intangible assets.

The cost principle should be applied in recording the acquisition of natural resources and intangible assets. Natural resources should be depleted (usually by the units-of-production method) usually with the amount of the depletion expense capitalized to an inventory account. Intangibles with definite useful lives are amortized by using the straight-line method. Intangibles with indefinite useful lives, including goodwill, are not amortized, but are reviewed at least annually for impairment. Intangibles are reported at their carrying amount on the statement of financial position.

7. Explain the impact on cash flows of the acquisition, use, and disposal of long-lived assets.

Depreciation expense is a non-cash expense that has no effect on cash. It is added back to profit on the statement of cash flows to determine cash from operations. Acquiring and disposing of long-lived assets are investing activities.

Recognize how to find financial information in the financial statements

STATEMENT OF FINANCIAL POSITION
Under Long-Lived Assets
Property, Plant, and Equipment (net of
accumulated depreciation)
Natural resources (net of accumulated
depletion)
Intangibles (net of accumulated
amortization, if any) / INCOME STATEMENT
Under Operating Expenses
Depreciation and depletion
expense or as part of
Selling, general, and administrative
expenses and
Cost of sales (with amount of
depreciation expense disclosed in a
note)
STATEMENT OF CASH FLOWS
Under Operating Activities (Indirect Method)
Profit
+ Depreciation expense
- Gains on sales of assets
+ Losses on sales of assets
Under investing activities:
+ Sales of assets for cash
- Purchases of assets for cash / NOTES
Under Summary of Significant Accounting Policies
Description of management’s choice for depreciation methods, including useful lives, and the amount of annual depreciation expense, if not listed on the income statement.
Under a Separate Footnote
If not specified on the statement of financial position, a listing of the major classifications of long-lived assets at cost and the balance in accumulated depreciation and depletion.

What to Watch Out For

Overview

Accounting and reporting issues related to long-lived assets, the resources that determine the productive capacity of a business, are the focal points of this chapter. Long-lived assets include both tangible assets (such as land, buildings, equipment, natural resources) and intangible assets (such as goodwill, patents, and franchises).

Financial Statement Analysis Matters

You will need to know how to compute the fixed asset turnover ratio. You should understand what this ratio is measuring so that you will be able to interpret this ratio. You will also be expected to understand how the cost allocation method utilized affects the computation of this ratio.

Acquisition Costs and Subsequent Expenditures

In general, the acquisition cost of a long-lived asset includes all reasonable and necessary expenditures made to acquire the asset, place it in its operational setting and prepare it for its intended use. You will need to know how to measure and record the acquisition cost.

Most long-lived assets require substantial expenditures during their lives. Ordinary repair and maintenance costs relating to property, plant, and equipment are classified as revenue expenditures and immediately expensed. Extraordinary repairs and betterments are classified as capital expenditures and added to the related asset accounts. In this regard, make sure that you are able to distinguish between revenue and capital expenditures and properly record these additional expenditures.

Depreciation, Depletion, and Amortization

Recall the discussion of a deferred expense from chapter 4. A deferral results when cash is paid to a vendor, supplier, or other entity before the related expense is incurred. The amount is initially recorded in an asset account when the company acquires the asset because a benefit will be realized in the future. As time passes, adjusting entries are used to reduce the asset that is being used up (as the benefit is realized) and record the expense (which matches it with the related revenues generated).

A long-lived asset represents a future benefit paid for in advance that will be used to generate revenues during the life of the long-lived asset (in essence, it is a deferral). Accordingly, in conformity with the matching process, the expense associated with the use of the long-lived asset must be matched with, or allocated to the same period as, the revenues that are generated.

The allocation process is called depreciation for property, plant, and equipment, depletion for natural resources, and amortization for intangibles. In addition to being able to determine and record depreciation expense using the straight-line, units-of-production and declining balance methods, you will need to know how to compute and record depletion and amortization expense.

Changes in Depreciation Estimates

Depreciation is based on two estimates, useful live and residual value, made at the time a depreciable asset is acquired. As managers gain experience with the asset, one or both of these initial estimates may need to be revised. In addition, betterments, extraordinary repairs, and additions may be added to the original acquisition cost at some time during the asset's use. You will be expected to be able to calculate the new revised amount for depreciation expense due to the changes described above.

Impairments and Disposals

When the estimated future cash flows of a long-lived asset falls below its carrying amount (net book value), the carrying amount should be written down to the recoverable amount of the asset. The recoverable amount is the higher of the assets value in use or its fair value less costs to sell. You will need to know how to write down impaired long-lived assets.

When long-lived assets are disposed of, the cost of the asset and the related accumulated depreciation or depletion must be removed from the related accounts. You should know how to compute the gain or loss that will result when the disposal price is different from the carrying amount of the asset.

Libby, Libby, Short, Kanaan, Gowing Financial Accounting Fourth Canadian Edition