Introductory Accounting B

Introductory Accounting B B11-A291 / B11-A027 Mark Binder, CA Chapter 12

Learning Objectives • Describe capital assets and issues in accounting for them. • Apply the cost principle to compute the cost of capital assets • Explain, record and calculate amortization using the straight line, units of production and double declining balance • Explain and calculate amortization for partial years • Explain and calculate revised amortization • Account for asset disposal through discarding, selling or exchanging an asset • Discuss the accounting for natural resources and their amortization

Capital Assets • If a company has capital assets they usually are the largest group of assets they have. • Most companies have some capital assets which make them very significant. • Capital assets have a useful life of more than 1 year or 1 accounting cycle, unlike current assets.

Cost of a Capital Asset • Capital assets are recorded at cost which is consistent with the cost principle. • Cost include all costs which are reasonable and necessary. • Reasonable and necessary can be interpreted as normal and necessary.

Factory Equipment • Cost of factory equipment includes: • Invoice cost (less any discount). • Freight. • Unpacking costs. • Assembly costs. • Installation costs. • Testing and adjustment costs.

Land • Cost of land includes: • Cost of land. • Real estate commissions. • Insuring title. • Legal fees. • Accrued property taxes.

Land • Cost of land can also include: • Surveying costs. • Clearing costs. • Grading costs. • Draining costs. • Landscaping costs.

Land • Sometimes when land is purchased special assessments can be issued by the municipality. • These would also be included in the cost of the land. • Examples of this include: • Roadways. • Sidewalks. • Sewers.

Land With Building • Frequently, land is purchased with a building already on it. • If the purchaser has not intent to use the building, the total cost of the land with the building is considered to be the cost of the land. • In this case the purchaser usually plans on demolishing the building.

Land With Building • In such a case the cost of the land will include: • Cost of the land. • Cost of the building. • Removal costs less any salvage value for materials.

Land With Building • Assume a company buys a downtown site for $100,000. • The site has a number of condemned buildings on it. • The removal costs of the condemned buildings is $22,000. • The material from the condemned buildings has a salvage value of $2,000. • There are also brokerage fees of $5,000, legal fees of $3,000 and $2,000 of land title costs.

Land With Building • The total cost of the land in this case is: Site costs $100,000 Condemned building removal costs $22,000 Salvage value of material ($2,000) Brokerage fees $5,000 Legal fees $3,000 Land title costs $2,000 Total land costs $130,000

Land Improvements • Land is presumed to have an intrinsic cost and is not amortized. • However, improvements to land such as parking lots are amortized. • These costs are usually put into an account called land improvements.

Land Improvements • Land Improvements would include: • Surfacing costs. • Driveways. • Fences. • Lighting and security systems.

Buildings • Cost of a building can include: • Purchase price. • Brokerage fee. • Taxes. • Title fees. • Legal costs. • Real estate agency costs.

Buildings • Other costs of the building include: • Renovations. • Wiring. • Lighting. • Flooring. • Wall coverings.

Buildings • When a company constructs a building for it’s own use indirect overhead costs such as: • Heat. • Lighting. • Power. • Amortization of machinery.

Buildings • Cost of construction can also include: • Design fees. • Building permits. • Insurance (during construction) • Interest (during construction). • The book does not include interest but it is commonly included. • Once a building is complete costs such as insurance and interest are considered operating costs.

Machinery and Equipment • Machinery and Equipment typically includes the following: • Purchase price (less any discount). • Taxes (except GST). • Transportation costs. • Insurance costs (While being transported). • Installation, testing and assembly.

Lump Sum Purchase • Often when a purchase is done the cost is not split between the building and the land. • It is important to split the costs because land is not amortized while the cost of the building is. • Assume a company purchases land and building for $100,000.

Lump Sum Purchase • The land is appraised as $50,000 and the building is appraised as $75,000. • Notice the total appraisal cost is greater than the purchase price. • Frequently the appraisal costs will not equal the purchase price of land and building. • See excel spreadsheet.

Capital Assets • Capital Assets have useful lives of more than one year. • The matching principle demands that the usefulness used in each accounting period be recorded. • We call this process amortization. • In the past this process was called depreciation and depletion in the case of natural resources.

Capital Assets • These terms are still used but less frequently than the general term amortization. • Three factors are needed when computing amortization: • Cost • Salvage value. • Useful or service life

Cost • Discussed previously. • All costs reasonable and necessary.

Salvage Value • An estimate of the value at the end of it’s useful life.

Useful or Service Life • The useful or service life is the length of time the asset will be used in the company’s operation. • It is not necessarily the total productive life of the asset. • The Useful or Service life is dependent on company policy.

Useful or Service Life • Some companies use assets till they fall apart. • This would indicate a useful life similar to the productive life of the asset. • Other companies frequently replace their assets. • In such a case the useful life would be much smaller than the productive life.

Factors to Consider • In estimating useful life you should consider: • Inadequacy – A company grows more rapidly than expected and the asset is no longer adequate for the company. • Obsolescence – technology has made asset no longer useful to the organization.

Inadequacy and Obsolescence • Both are difficult to predict. • Usually companies will rely on past experience, engineering studies, standards in industry to estimate useful life. • It is possible that two companies with identical assets will have very different estimates of useful life.

Amortization • There are many methods of amortization. • We will examine 3: • Straight line. • Units of Production. • Double Declining Balance.

Straight Line • In straight line amortization the amount does not change from one year to the next. • For example, assume a semi-trailer has a cost of $100,000 with a salvage value of $25,000 and a useful life of 5 years.

Straight Line • The formula for straight line is: Cost – Salvage value = annual amortization useful life • In our example: $100,000 – $25,000 = $15,000 per year 5 years

Straight Line • The journal entry is: Dr: Amortization expense. semi-trailer $15,000. Cr: Accumulated amortization. semi-trailer $15,000. • Accumulated amortization is a contra asset like the allowance for doubtful accounts.

Straight Line • Virtually all assets will have a unique accumulated amortization account. • In straight line amortization the expense remains the same from one year to the next. • The book value (cost – accumulated amortization) declines along a straight line. • The book value stops at the salvage value. • Amortization never continues past the salvage value.

Units of Production • The Units of production method is in many ways similar to straight line. • In both cases we divide the cost less salvage value by the estimate of useful life. • In straight line the estimate is in years. • In units of production it is in units. • So, we need to be able to estimate the useful life of the asset in units to be produced.

Units of Production • Assume we have just purchased a digital copier with an estimated useful life of 1,500,000 copies. • The copier cost $40,000 and has an estimated salvage value of $10,000. • The units of production method is a two step process.

Units of Production • Compute the amortization per unit. • Multiply the amortization per unit (step 1) x number of units used in the current period.

Amortization Per Unit • Amortization per unit = Cost- Salvage value Total units of production Amortization per unit = $40,000 - $10,000 1,500,000 Amortization per unit = $0.20 per copy

Step 2 • Multiply amortization per unit by the number of units produced in the period. • If the copy had 400,000 copies in the year the amortization would be computed as: • 400,000 x $0.20 = $8,000.

Declining Balance Method • There are many declining balance methods. • The one we will examine is called double declining balance. • This is very similar to the method used for tax purposes in Canada. • It is called an ‘accelerated method’ because it gives higher amortization in the early years of use.

Three Step Process Assume our prior example of the semi trailer which cost $100,000 with an estimated life of 5 years. • Compute the straight line amortization rate. 100% / useful life = Straight line rate. 100% / 5 = 20%.

Three Step Process • Step 2: take the rate in step 1 and double it. • This is why it is called ‘double’ declining balance. • In our case 20% x 2 = 40%.

Three Step Process • Amortization expense = double declining balance rate x beginning of period book value. • In our case in year 1 40% x $100,000 = $40,000 • See excel spreadsheet for remaining years.

Salvage Value • As mentioned the salvage value is the estimate of the value of the asset when the company plans on disposing it. • Therefore total amortization expense over the life of the asset cannot be more that the Cost – Salvage value.

Salvage Value • Put in another way, the book value (cost – accumulated amortization) cannot be below salvage value. • This can cause problems with both the double declining method and the units of production methods.

Salvage Value • If the total units over the useful life is more than the estimate in units of production the amortization expense could become larger than cost – salvage value. • In other words the book value could be below the salvage value.

Salvage Value • The same thing can happen with double declining balance depending on the salvage value. • The solution to this problem is to only take amortization to the point where the book value is equal to salvage value. • Frequently, this creates a ‘plug’ in the final year.

Complications • There are two complications to the basic amortization problem: • Purchase in the middle of the year. • Revising rates

Purchase in the Middle of the Year • If an asset is purchased in the middle of the year the amount of amortization needs to be ‘pro-rated’ for the amount of the year the asset was owned. • In our semi-trailer example we had amortization expense per year of $15,000.

Purchase in the Middle of the Year • If we purchased the asset on August 31 our first year amortization would be: $15,000 x 4/12 = $5,000. • In following years under straight line it would be $15,000 each year. • We have to do the same ‘pro-rated’ calculation for double declining balance.

Introductory Accounting B