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Week 2 621 Notes

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Week 2 621 Notes

Uploaded by

carolinaceballos79
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© © All Rights Reserved
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Download as PDF or read online on Scribd
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Long-Term Assets (Week 2) Topics '* Overview of long-term/capital assets ‘* Depreciation methods: straight line, units-of-production, double-declining-balance The historical cost principle requires companies to record Property, Plant, and Equipment (PPE) assets at cost. Cost consists of all expenditures incurred in acquiring an asset and bringing it to the point of intended use. This is defined as capital expenditure. It is important to know when to capitalize a cost (as ‘opposed to expensing it). This decision has a direct and significant impact on current profits. Cost is recorded either as the actual cash paid in a transaction or as the cash equivalent price paid when ‘non-cash assets are given up. The cash equivalent price is equal to the fair value of the asset given up or the fair value of the asset received, whichever is more clearly determinable. Let's try some questions: Fred buys a new truck by paying $15,000 cash and trading in his old truck ($10,000 market value). What is the cash equivalent price of the truck? $15,000 + Klojooo 925.000 ‘Summer transfers 1,000 shares of Apple Corporation to Pete in exchange for his townhouse. The shares ‘were originally purchased for $155 but are now trading at $320. What is the cash equivalent price of the house? § 320 x 1,000 = $320,000 Value Measurement: IFRS 13 permits businesses to report certain assets and liabilities at fair market value (as opposed to book value). This is only allowed for items with readily-available market values on the measurement date, such as short-term investments in stocks. The cost of an asset = The sum of all the costs incurred to bring the asset to its intended purposes, net of all discounts jand The cost of land includes the following costs paid by the purchaser: © The purchase price ©The brokerage commission * The closing costs (ex. survey, legal, registration, title, and transfer fees) ‘© Any property taxes in arrears * The cost for grading and clearing the land and demolition of unwanted existing development Quick example: Juliana purchases one acre of land for $200,000 for her new business, a coffee shop. She also pays 4% in brokerage commission and $4,000 in transfer taxes. After the purchase is completed, she will pay $2,000 to clear the land, a $1,000 survey fee, and $2,000 for a new advertising sign. What will be the book value of the land? Purchase price of the land: $700,000 ‘Add related costs: Brokerage commission $000 Transfer taxes 4,000 Land clearing O90 Survey fee 1,090 Total incidental costs 15,000 Total cost of the land $2a00_ Juliana has capitalized the total land cost, meaning she will debit the asset (land) account for $215,000. ‘The advertising sign is expensed since it is not a necessary cost to ready the land for use. The cost of land is not depreciated. Land Improvements Land and Land Improvements are kept separate because, unlike Land, Land Improvements are depreciated. Some common examples of Land Improvements are: © Lighting © Paving + Landscaping © Signs © Fences * Sprinkler system Land improvements, like many other items in accounting, requires a certain level of professional Judgement. Sometimes, trees and other plants are better classified as Land if they are not expected to decline in value and don’t need to be depreciated. This is an instance of accountants being required to use their best judgement since there aren’t clear rules. ‘Assuming Juliana spends $3,000 on plants expected to last five years in addition to the $2,000 sign on July 1, 2022, the journal entry for the cash expense is: aly 7 Land |r proverents GYOoo Cash Za0e ‘Some examples of long-lived assets which are depreciated (like land improvements) are equipment, furniture, and computers. Betterment intenance !provement to an asset which either improves the quality/functionality of the asset or extends its useful life. The costs of betterments are capitalized (they increase the book value of the : regular work done (or other expense incurred) on an asset (can also be referred to as a repair) which allows the asset to be used as is, with no significant added life. Maintenance and repair costs are expensed (they do not increase the value of the asset). Let's try some questions: Sheri adds a new extension to her soda bottle filling machine which will now cap the bottles (they were previously capped manually). This is (betterment maintenance and it should be lizedy expensed, Hee Atie’scar had a broken exhaust, so he purchased a new one onlin. Since he uses the car for delivering pizzas, the cost of the car part should be considered betterment /(maintenance) and it should be capitalized /@xpensed. Will pays $2,200 for insurance on his work truck. This is betterment /‘intenance and it should be captaleed(Gxpensed) —_ The last two examples, which are expensed, end up reducing net income. Hence, managers may be ‘motivated to capitalize repairs, especially if their compensation is partly or fully based on profits. Alternatively, expensing a capital addition incorrectly reduces income. Some managers might be motivated to do this to reduce taxes. Of course, either act is unethical and probably illegal. Depreciation First, let’s make some key points about depreciation: ‘* Depreciation is not a process of valuation: Businesses do not depreciate assets based on their market value- depreciation is always based on an asset's actual cost. ‘© Depreciation does not mean that businesses set aside cash to replace assets once they are fully depreciated: A business can choose to have a cash fund for asset replacement, but depreciation doesn’t measure/report this in any way. * Depreciation is sometimes related to physical wear and tear: With the exception of land, physical wear and tear plays a factor in the depreciation rate of many assets (cars, buildings, equipment). ‘* Depreciation is sometimes related to obsolescence: Some assets are simply depreciated because of expected obsolescence (computers). These types of assets may be physically fit for onger term use, but efficiency Can be improved by upgrading regularly ‘Measuring depreciation Depreciation is based on three factors about the asset: cost, estimated useful life, and estimated salvage value. An asset's cost minus its salvage value (also called residual value) is called depreciable cost. Three methods are commonly used in Canada to calculate depreciation: straight-line, units-of- production, and double-declining-balance. Straight-Line Method This is the simplest depreciation method because it allocates an equal amount of depreciation to each period of asset use. The equation for straight-line depreciation is Straight-line depreci Cost ~ Salvage value Estimated Useful Life in Years For review, let’s assume the UCW Bookstore uses the straight-line method for its new desktop ‘computer, purchased on January 1, 2023. The computer cost $900 with a salvage value of $100. It is expected to last one year and the bookstore makes depreciation entries right before each quarterly reporting period. What is the quarterly depreciation expense for the computer? ‘The journal entry to record the quarterly depreciation expense: Mac zi [Depreciation 2x 0en! Zoe : Kicwmrlabed (ere ciehian ~Cocapare Zoo | $400 - goo = B200 fer qverter FL. OCR. = Y qnecters Note that the depreciation rate is % (1/number of depreciation periods). We can make a straight-line depreciation schedule to present the asset (computer) being written down over a one-year time frame: Asset | Depreciation | Depreciable | Depreciation | Accumulated | Asset Book Date__| Cost Rate Cost Amount _| Depreciation Value ijan-23 [$900 $800 31-Mar-23 1a x $800 = $200 $200 700, 30-Jun-23 1/4 x_ 800 200 Foo 300 30-Sep-23 1/4 |x 800 200 $00 Er 31-Dec-23 1/4 [x 800 = 700 $00 (00 Units-of-Production Method The Units-of-Production (also known as Units-of-Activity) method allocates a fixed amount of depreciation to each unit of output produced by the asset. The equation for units-of-production depreciation per unit of output is: Units-of- production = Cost — Salvage value Depreciation per Unit of Output Estimated Useful Life in units of production Let's try another example. On January 1, 2023, the bookstore purchased a used truck for $21,000 (used for transporting inventory). The bookstore will use this truck for five years at which point it will have a salvage value of $1,000. The total expected usage is 100,000 kilometers. The units-of-production depreciation per unit of output is: a, #iiece = $0.20 per Km {00,000 Ems v2 ‘The number of kilometers driven each year is shown in the table below. For simplicity’s sake, let’s prepare this depreciation schedule by years and not quarters: ‘Asset | Depreciation | Number of | Depreciation | Accumulated | Asset Book Date__| Cost_| PerKilometer | Kilometers | Amount | Depreciation | Value 1Jan-23 | $21,000 $21,000 31-Dec-23 $0.20 [x 19,000 $3,800 $3,800 17,200 3LDec24 0.20 |x 21,000 4200 $000 13.000 31:Dec-25 0.20 | x 20,000 000 12,000 4,000 31-Dec-26 0.20 x_ 23,000 4,600 lb 60o G,FO0 31-Dec-27 0.20 [x 17,000 |= 3,400 | 24000 | 1,000 Let's try a couple of questions: Wendy, who maintains lawns, has purchased a used lawnmower for $1,500 and is depreciating it over the next two years under the assumption that it will be used for 2,000 hours before dying, At the end of Its useful life, the mower is expected to have a value of $100. How much will the mower be depreciated G1,500 - ¢loo £0.70 Per hour © Year 1, when it was used for 1,150 hours? 70.70 /ne xX _1,/89 |. E505 BV: 8 595 HO.10 fe xX L189 hours = F505 NEV . eee eee eres @o20/nr X 7 OO heves= B70 NG: F 65 Salvage. Valve exceeded ! Ping: §645- #)08% (5543) Olena is depreciating her $50,000 specialized widget-making machine. It is expected to last three years, at which point it will be scrapped for $1,000. Over that time span, the machine should produce 200,000 widgets. How much will the machine be depreciated in: 88,000— #1008 7 FO.24 fer widget 300,000 wits nev © Year 1, when it produced 60,000 widgets? $0. 4 Blore. 64 19,367.04 1672.96 Let's try a couple of questions again: Edwin, who runs a hedge fund, is depreciating a very fast, top-end $12,000 computer. As the computer will be used for trading for one year and then for less important, supporting functions for the next two (salvage value of $2,000), how much will the computer be depreciated in: Név: SL. cate =B=FRF% OPE cate: %=667 © Year1: 812,000 xX 64.7 $4000 © Year2: $4000 ¥ £6 7 © Year3: 7 No Mec 667 0 00) L 2,006 already 00. va Plug FY,000 -#2,000 = #2,000 =~ Salwexe value excecsedl Ken, a professional driver, is buying a $750,000 supercar. The car is expected to last four years, at which point it will hold an expected market value of $90,000. How much will the supercar be depreciated in: SL. cae ys 25% 008 cave? MY = Sov, N@y. Year1: $750,000 x 56% = $F7S, 00. B375,00 Year 2: & 275,00

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