Class 5: Current & Long-Term Assets

Wren Redfield – 9/11/2024

 Net Accounts Receivable

❖ A/R are reported on the balance sheet net of the allowance for doubtful
accounts
⏵ Increases (credits) in the allowance = bad debt expense

❖ 2 methods to estimating bad debt expense/ increases to the allowance:

1. Percent of A/R (Balance Sheet Method)
2. Percent of sales (Income Statement Method)

B/S method: I/S method:

calculate desired ending balance calculate BDE directly and add
of ADA and plug BDE to arrive at this to the ADA T-Account to get
the ending balance ending ADA balance
 A/R: A Simple Timeline

❖ Sept 30, 2020: We make $500 in credit sales

⏵ DR A/R (A) 500 We record our

CR Sales (Rev) 500 sales
❖ Dec 31, 2020: We estimate bad debts at 20% of credit sales

We make the
⏵ DR BDE (Exp) 100
adjustment at
CR ADA (XA) 100
period close
 A/R: A Simple Timeline

❖ March 31, 2021: We receive $400 owed to us

⏵ DR Cash (A) 400 We record the collection:

CR A/R (A) 400 “delete the A/R”
❖ June 1, 2021: Last customer goes out of business and confirms will not pay

⏵ DR ADA (XA) 100

We record the write-off:
CR A/R (A) 100 “delete the A/R and
allowance”
 Inventory and Cost of Goods Sold

❖ Measuring the amount of inventory requires 2 key decisions . . .

1. Number of Units
– Perpetual: an ongoing count of units is maintained during the year
– Periodic: units in inventory are counted at end of the fiscal year

2. Assumed Cost Per Unit

– Average cost: uses the average for sales of inventory
– First-in, first-out: assumes the oldest units are sold first
– (newest units are still in inventory)
– Last-in, first-out: assumes the newest units are sold first
– (oldest units are still in inventory)
 Inventory Example

❖ On January 2, 2018, YETI purchased $15,000 worth of kitchen grade stainless steel at
$3/lb

❖ On January 14, 2018, YETI purchased an additional $10,000 worth of stainless steel at
$4/lb

❖ Question: How many pounds of stainless steel does the company hold in its inventory?

Answer: 7,500 lbs

$15,000/$3 = 5,000 lbs
$10,000/$4 = 2,500 lbs
 Inventory Example

❖ During the year, the company makes 10,000 tumblers and ramblers, using
6,000 pounds of stainless steel and sells all of them for $300,000

❖ How much profit does YETI earn on this transaction?

– i.e., what is the company’s revenue and cost for this transaction?

❖ How much is the remaining inventory worth?

– i.e., what is the inventory balance on the balance sheet?
 Inventory Example

❖ What we know… We sold 6,000 lbs of stainless steel

YETI’s Pounds of Cost
Purchases Stainless Steel Per Pound
January 2 5,000 $3/lb
January 14 2,500 $4/lb
Total 7,500 It Depends
How much of the 6,000 came from the purchase on Jan 2?
How about Jan 14?
 Inventory and Cost of Goods Sold

❖ Real world
⏵ Different units of inventory have different prices
⏵ Prices may fluctuate across time or across suppliers

❖ 4 inventory methods to calculate COGS

⏵ Perpetual
⏵ First-in-First-Out (FIFO)
⏵ Last-in-First-Out (LIFO) Periodic
⏵ Average Cost
Inventory and Cost of Goods Sold
Inventory Systems and Cost-flow Assumptions

Definitions

INVENTORY = # of units in inventory x assumed cost per unit

COST OF GOODS SOLD = # of units sold x assumed cost per unit

T-account for inventory:

Inventory
Debit (+) Credit (-)

Beginning Balance

+Purchases - Cost of goods sold

Ending Balance
Inventory and Cost of Goods Sold
Inventory Systems and Cost-flow Assumptions

Definitions

INVENTORY = # of units in inventory x assumed cost per unit

COST OF GOODS SOLD = # of units sold x assumed cost per unit

From the T-account we can back out cost of goods sold:

Beginning inventory xxx (from prior balance sheet)

+ Purchases xxx

Inv. Available For Sale xxx (subtotal)

– Ending inventory xxx to current balance sheet

Cost of Goods Sold xxx to current income statement

 Journal Entries

Step 1: Inventory Purchase

Dr. Inventory 250

Cr. A/P or Cash 250

Step 2: Sale of Inventory

Dr. Cost of Goods Sold 120

Cr. Inventory 120 **Note: sales will also have a
revenue JE !!
 Perpetual Count Method
❖ Each sales journal entry also records the COGS and the reduction to inventory.

❖ Step 1: Do a physical inventory count.

❖ Step 2: Post the adjusting entry to COGS.

❖ Example: At point of sale

Debit: Cash or A/R $100
Credit: Revenue $100
To record revenue.

Debit: Cost of Goods Sold $25

Credit: Inventory $25
To record expense.

❖ What type of company would do this method?

 Periodic Count Methods

❖ Periodic Methods: LIFO, FIFO, and Average Cost

❖ Individual sales journal entries do not record the COGS or the reduction to inventory.

❖ Step 1: Do a physical inventory count at the end of the fiscal year to find the ending
balance
❖ Step 2: Add the purchases to your inventory account
❖ Step 3: Use one of 3 Periodic methods to find COGS from the inventory T-account

❖ What type of company would use this method?

 Periodic Count Methods

(Step 3) Determining COGS from inventory T-account:

Beginning inventory xxx (from prior balance sheet)

+ Purchases xxx

Cost of Goods Available

For Sale xxx (subtotal)
– Ending inventory xxx (from physical count)

Cost of Goods Sold xxx to current income statement

 3 Periodic Methods Through an Example

Let’s go back to our YETI example (and assume they had $0 in beg. inventory
balance):

First purchase: 5,000 pounds of steel at $3/pound

Second purchase: 2,500 pounds of steel at $4/pound

YETI uses 6,000 pounds of steel in the goods they sell for the reporting period.
 3 Periodic Methods Through an Example

❖ Inventory purchases
⏵ 5,000 lbs at $3/lb → total cost: $15,000
⏵ 2,500 lbs at $4/lb → total cost: $10,000
Resulting inventory balance: $25,000

▪ Inventory needs
Sell cups that used 6,000 lbs of steel during the
reporting period
 3 Periodic Methods Through an Example

❖ What are the Cost of Goods Sold (COGS) and Ending

Inventory balances under:
a) FIFO?
b) LIFO?
c) Weighted Average Cost?
 First-in-First-Out (FIFO)

❖ Inventory purchased first is sold first

❖ Ending Inventory → Latest purchases

❖ COGS → Oldest inventory items

First-in-First-Out (FIFO)
Pounds Cost per lb Total Cost
Purchase #1 5,000 $3 $15,000
Purchase #2 2,500 $4 $10,000

Pounds Cost per lb Total Cost

COGS 5,000 $3 $15,000

1,000 $4 $4,000
$19,000

Pounds Cost per lb Total Cost

Ending 1,500 $4 $6,000
Inventory (7,500-6,000)
 Last-in-First-Out (LIFO)

❖ Inventory purchased last is sold first

❖ Ending Inventory → Oldest purchases

❖ COGS → Latest inventory items

Last-in-First-Out (LIFO)
Pounds Cost per lb Total Cost
Purchase #1 5,000 $3 $15,000
Purchase #2 2,500 $4 $10,000

Pounds Cost per lb Total Cost

COGS 2,500 $4 $10,000

3,500 $3 $10,500
$20,500

Pounds Cost per lb Total Cost

Ending 1,500 $3 $4,500
Inventory (7,500-6,000)
 Weighted Average Method

❖ Use a weighted averaged unit cost

𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 $ + 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 $

𝑇𝑜𝑡𝑎𝑙 𝑈𝑛𝑖𝑡𝑠 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑑 + 𝑇𝑜𝑡𝑎𝑙 𝑈𝑛𝑖𝑡𝑠 𝑖𝑛 𝑡ℎ𝑒 𝐵𝑒𝑔. 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

= 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

Weighted Average Cost
Pounds Cost per lb Total Cost
Purchase #1 5,000 $3 $15,000
Purchase #2 2,500 $4 $10,000

15, 000 + 10,000 + (𝑁𝑜 𝑏𝑒𝑔. 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦)

= $3.33ത /𝑢𝑛𝑖𝑡
5,000 + 2,500 + (𝑁𝑜 𝑏𝑒𝑔. 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦)

Pounds Cost per lb Total Cost

COGS 6,000 $3.33ത $20,000

Pounds Cost per lb Total Cost

Ending 1,500 $3.33ത $5,000
Inventory
 Based on what we’ve done so far…

❖ Question: Assuming inventory cost per unit rises over time, what are the
effects of using FIFO vs. LIFO on a company’s financial statements?
⏵ COGS?
⏵ Net Income?
⏵ Tax expense?
FIFO Avg. Cost LIFO

COGS $19,000 $20,000 $20,500

End Inv. Bal. $6,000 $5,000 $4,500

 FIFO:
Financial Statement Implications

❖ Assuming inventory costs rise over time

⏵ inflation
❖ Since FIFO takes from earliest (cheapest) bucket first:
⏵ COGS is SMALLER than under other methods (LIFO & Average Cost)
⏵ A smaller COGS leads to a BIGGER NET INCOME
⏵ A bigger net income leads to LARGER TAX EXPENSE

❖ Reports more relevant information on the balance sheet

 LIFO:
Financial Statement Implications

❖ Assuming inventory costs rise over time

❖ Since LIFO takes from latest (most expensive) bucket first:

⏵ COGS is LARGER than under other methods (FIFO & Average Cost)
⏵ A larger COGS leads to a SMALLER NET INCOME
⏵ A smaller net income leads to SMALLER TAX EXPENSE

❖ Reports more relevant information on the Income Statement

 Weighted average Cost:
Financial Statement Implications

❖ Assuming inventory costs rise over time

❖ Since Average Costs and averages the total cost per unit:
⏵ COGS, NET INCOME & TAX EXPENSE are IN BETWEEN FIFO and
LIFO results
FIFO Avg. Cost LIFO

COGS $19,000 $20,000 $20,500

End Inv. Bal. $6,000 $5,000 $4,500

 Inventory Example 2

DogGone Biscuits sells specialty dog treats all across the United States.
DogGone Biscuits had three inventory purchases throughout the
reporting year (and had $0 in its beginning inventory balance):
First purchase: 500 pounds of biscuits at $8/lb
Second purchase: 200 pounds of biscuits at $9/lb
Third purchase: 600 pounds of biscuits at $10/lb
Over the course of the year, DogGone Biscuits sold 850 lbs of dog
biscuits.
 Applying What We Learned

❖ Inventory purchases
⏵ 500 pounds at $8/lb → total cost: $4,000
⏵ 200 pounds at $9/lb → total cost: $1,800
⏵ 600 pounds at $10/lb → total cost: $6,000
❖ Resulting inventory balance: $11,800

❖ Inventory needs
⏵ Sells 850 pounds of dog biscuits during the reporting period
 DogGone Biscuits Question

❖ What are the COGS and Ending Inventory balances

under:
a) FIFO?
b) LIFO?
c) Average Cost?
 Applying What We Learned

❖ Inventory purchases
⏵ 500 pounds at $8/lb → total cost: $4,000
⏵ 200 pounds at $9/lb → total cost: $1,800
⏵ 600 pounds at $10/lb → total cost: $6,000
❖ Resulting inventory balance: $11,800

❖ Inventory needs
⏵ Sells 850 pounds of dog biscuits during the reporting period
First-In-First-Out (FIFO)
# Units Cost per Unit Total Cost

First Purchase 500 $8 $4,000

Second Purchase 200 $9 $1,800

Third Purchase 600 $10 $6,000

# Units Cost per Unit Total Cost

COGS 500 $8 $4,000

200 $9 $1,800

150 $10 $1,500

850 $7,300

# Units Cost per Unit Total Cost

Ending Inventory 450 (1300-850) $10 $4,500

Last-In-First-Out (LIFO)
# Units Cost per Unit Total Cost

First Purchase 500 $8 $4,000

Second Purchase 200 $9 $1,800

Third Purchase 600 $10 $6,000

# Units Cost per Unit Total Cost

COGS 600 $10 $6,000

200 $9 $1,800

50 $8 $400

850 $8,200

# Units Cost per Unit Total Cost

Ending Inventory 450 (1300-850) $8 $3,600

Weighted Average
# Units Cost per Unit Total Cost

First Purchase 500 $8 $4,000

Second Purchase 200 $9 $1,800

Third Purchase 600 $10 $6,000

4000 + 1,800 + 6,000 + (𝑁𝑜 𝑏𝑒𝑔. 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦)

= $9.08/𝑢𝑛𝑖𝑡
500 + 200 + 600 + (𝑁𝑜 𝑏𝑒𝑔. 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦)

# Units Cost per Unit Total Cost

COGS 850 $9.08 $7,715

# Units Cost per Unit Total Cost

Ending Inventory 450 $9.08 $4,085
 Big Picture

❖ So why should (do) firms use different methods?

– Depends on industry
– Life cycle of the product
– Strategy adopted by the company
 Inventory Valuation

❖Regardless of whether a company uses LIFO, FIFO, or average cost,

they must determine the appropriate value to put into their inventory
account when they manufacture a product or purchase merchandise
for resale.

❖Up till now we used cost – i.e. price we paid – to value inventory

❖Measurement rule:
Lower of cost or market

What does ‘market’ mean?

 Lower of cost or market

❖ Inventory is valued at the lower of cost or market.

⏵ For example, if it costs Jimmy Choo $200 to make a pair of shoes, but the market value
(i.e., the price the company can sell the shoes) is only $100, the shoes should go into their
inventory account at $100. (Scenario 1)
⏵ If the market value of the shoes is (more realistically) $900, the shoes should go into the
inventory account valued at $200. (Scenario 2)

Jimmy Choo Shoes Scenario 1 Scenario 2

Shoe cost $200 $200
Shoe market value $100 $900
Shoe inventory value $100 $200
 So What are Write-Downs?

❖ Measurement rule:
Lower of cost or market

❖ If the market value of inventory is below its cost, we have to ‘write it down’
⏵ I.e. inventory write-off

Debit: Inventory Loss XX (Income Statement)

Credit: Inventory XX (Balance Sheet)

❖ Accounting “conservatism”!
❖ Cannot “write up” an asset
 Long-term Assets

❖ Also called Non-current Assets and Capital Assets

❖ Includes land, major improvements (capital expenditures),

buildings, machinery, equipment, intangibles, and natural resources

❖ With an expected useful life longer than one year

 Long-term Assets

❖ With an expected useful life longer than one year

⏵ Some portion of this value is used up every accounting period, while
the other amounts remain for the future What have we seen before
that this applies to?

❖ Key issues related to long-term assets:

⏵ How much of the asset do we have now? End. Balance
⏵ How much of the asset have we used up during the period? Adjustment
 Types of Long-term Assets

Tangible Assets
1. Productive assets (e.g. machinery, buildings, and vehicles)
2. Natural resources (e.g. timber and natural gas)
3. Land Tangible: can feel,
touch
Intangible Assets
1. Identifiable intangibles with limited lives (e.g. software, patents)
2. Identifiable intangibles with indefinite lives (e.g. brand logos and
trademarks)
3. Goodwill
 Definition: Expenses
In case of long-term assets:
Assets that have limited
useful lives

“Expenses are outflows of assets or incurrences of liabilities (or a

combination of both) from delivering or producing goods, rendering
services, or carrying out other activities that constitute the entity’s
ongoing major or central operations.” (Con 6, paragraph 80)
 Expensing Long-term Assets

Tangible Assets
1. Productive assets
⏵ “Depreciation”
2. Natural resources
⏵ “Depletion”
3. Land
⏵ NOT depreciated – stays at cost
 Expensing Long-term Assets

Intangible Assets
1. Identifiable intangibles with limited lives
⏵ “Amortization”
2. Identifiable intangibles with indefinite lives
⏵ Not amortized – stays at cost
3. Goodwill
⏵ Not amortized – stays at cost

What do we mean by “at cost”?

 Exchange-price (Cost) Principle

❖ Accounts record transfers of resources at prices agreed on by the

parties to the exchange at the time of exchange.

❖ Historical Cost
⏵ The amount paid, or the fair market value of the liability incurred
or other resources surrendered, to acquire an asset and place it
in a condition and position for its intended use
 Capitalizing versus Expensing

Note: there are two approaches to accounting for costs incurred. . .

⏵ Expense: immediately expense off the cost on the income statement

⏵ Rent expense, salary expense, etc.
Benefits span > 1
reporting period

⏵ Capitalize: recognize the cost as an asset on the balance sheet

(“capitalize”) and expense off gradually
⏵ Think: prepaid rent → rent expense, machinery → depreciation, etc.
 Depreciation

▪ Expense Recognition Rule: The purchase of some assets (e.g., equipment

and manufacturing plants) are not immediately recognized as expenses
and must be capitalized on the balance sheet

▪ Instead, the expense is recognized gradually over the estimated life of

the asset → DEPRECIATION

▪ Let’s look at what we use to calculate it…

 Some Useful Definitions
❖ Cost of an Asset (Acquisition Cost)
❖ Cash price plus all costs necessary to place the asset into its intended useful state.

❖ Salvage Value
❖ The expected value at the end of the life of the asset.

❖ Amount to be Depreciated
❖ Cost – Salvage Value
“Net PPE” – what we
list on our “books”!
❖ Book Value
❖ Cost – Accumulated Depreciation
 PPE Natural Intangibles
Some Useful Definitions Resources

❖ Depreciation/Depletion/Amortization
❖ The process of assigning the cost of a long-term asset to expense.

❖ Accumulated Depreciation/Depletion/Amortization
❖ Contra asset account used to record depreciation/ depletion/ amortization expense.
❖ *** Not a decrease to PP&E directly

❖ For example:

❖ Dr DEPRECIATION EXPENSE (Exp) XXX

❖ Cr ACCUMULATED DEPRECIATION (XA) XXX
 More on Accumulated Depreciation
❖ This contains all the past depreciation recognized by a company

❖ This is a contra asset to PP&E

⏵ It’s netted against gross PP&E to give PP&E net of accumulated
depreciation

Gross PP&E (A) Acc. Depreciation (XA) Net PPE (A)

BB 0 BB 0 BB 0 BB 0

EB 0
 Basic Accounting for Capital Assets

1. Recording the acquisition of the asset (capitalize)

2. Allocating the cost of the asset to expense over its useful life (depreciation)

3. Recording any repairs or improvements to the asset (capital expenditures)

4. Recording the sale or disposal of the asset

 Applying this to your life…

1. Buy (or build) a house and record the cost

2. Allocating the cost of the house to expense over its useful life

3. Recording any repairs (e.g., leaks) or improvements (e.g., finish a basement)

to the house

4. Recording the sale of the house

 PPE & Depreciation: 10-K Example
Let’s look at Royal Caribbean Cruises' financial statements
▪ For fiscal year 2018, how much
– Depreciation did they
expense?
– Accumulated depreciation do
they have?
– How long are the estimated
useful lives of ships?
– What are the residual values
of the ships?
 Royal Caribbean
Answer taken from the Income
Statement on F-4 (page 84 of
PDF)
❖ For fiscal year 2018, how much
– Depreciation did they expense?
– $1.03B
 Royal Caribbean Answer taken from Note 7
on F-22 (page 103 of PDF)

❖ For fiscal year 2018, how much

– Accumulated depreciation do they have?
– $8.97B
 Answers were taken from
the PP&E section of Note 2
Royal Caribbean on F-10 (page 90 of PDF)

❖ For fiscal year 2018, how much

– How long are the estimated useful lives of ships?
– 30 years

– What are the residual values of the ships?

– 15%
 Bonus tidbit

❖ From “Critical Accounting Policies” in the MD&A

❖ 29 years instead of 30 years? $63.8M more in depreciation expense

❖ No residual value instead of 15%? $243.0M more in depreciation expense
 Remember last week…

❖ “Today we learned that some numbers in the financial statements are not
based on solid verifiable information”

Accounting numbers are the ‘best estimates’

F-22 Raptor
EXAMPLE
On April 1, 2023, an F-22 Raptor (asset) with an
estimated life of 5 years and an estimated salvage value
of $27M was acquired. The asset had a cash price of
$171M. The fiscal year-end is December 31.
 Step 1: Recording the acquisition

❖ GAAP requires all direct or incidental costs incurred in acquiring an asset and
preparing it for its original intended use to be capitalized as part of the cost of
the asset
⏵ e.g., Sales taxes, Shipping costs, Preparation costs

Journal entry

Dr PP&E (A) $171,000,000

Cr Cash (A) $171,000,000
 Basic Accounting for Long-Term Assets

1. Recording the acquisition of the asset

2. Allocating the cost of the asset to expense over its useful life
 Step 2: Allocating the cost
❖ Definition of expense is using up of an asset. In this case we are using it up
over time.
⏵ Depreciation Expense for Property, Plant and Equipment (PPE)
⏵ Amortization Expense for Intangible Assets
⏵ Depletion Expense for Natural Resources

❖ We record an expense and reduce the value of the net asset via accumulated
depreciation

❖ The gross asset does not change

 Step 2: Allocation the cost

❖ Two pieces of information the company must estimate to allocate the asset to
expense properly

⏵ Estimated life: how long is the asset projected to be productive (i.e. future
benefit)?
⏵ Salvage value: how much can the asset be sold for at the end of the useful?

What types of information would you consider if you had to

make this estimate?
 Step 2: Allocating the cost

❖ Measurement Issues:

⏵ The company must predict use and salvage value far into the future

⏵ Based on specific firm’s use, not economic life or market value

⏵ Usually cannot observe true usage, even after it occurs

 Step 2: Allocating the cost

❖ Measurement Biases:

⏵ Long-term nature means biases may take a long time to show up (this
creates incentives)

⏵ Managers likely to reassess usage (and thus change policies) when under
pressure to perform

If you are under pressure to increase profit, what could you

change in your depreciation estimates to increase profits in
the short term?
 Step 2: Allocating the cost
❖ Depreciation Methods

❖ Methods: There are four common methods used to compute depreciation:

1. Straight-line
2. Double-declining balance (“Accelerated” Method)
3. Units-of-production

The choice of the method depends on what management believes to be the “true”
pattern of economic use of the asset.
 Step 2: Allocating the cost

1. Straight-line:
• Charges an equal amount per time period
• Appropriate for assets that lose their usefulness evenly over their lives
• We’ve done this before

Same depreciation expense every period

 Method 1: Straight-Line Depreciation
❖ EXAMPLE On April 1, 2023, an F-22 Raptor (asset) with an estimated life of 5
years and an estimated salvage value of $27M was acquired. The asset had a
cash price of $171M. The fiscal year-end is December 31.

❖ 1) Compute straight-line depreciation for the current year.

Cost – Salvage Value NOTE: The purchase happens in April
Depreciation rate =
Useful life in years
→ This means that only 9/12 months
$171M - $27M
= in 2023 were “used”
5 years

= $28.8M for the first whole year = $28.8M * (9/12) for 2023 = $21.6M for 2023
 Method 1: Straight-Line Depreciation
❖ EXAMPLE On April 1, 2023, an F-22 Raptor (asset) with an estimated life of 5 years
and an estimated salvage value of $27M was acquired. The asset had a cash price of
$171M. The fiscal year-end is December 31.

❖ 1) Compute straight-line depreciation for the current year.

ADJUSTING ENTRY:

Debit: DEPRECIATION EXPENSE (Exp) 21.6M

Credit: ACCUMULATED DEPRECIATION (XA) 21.6M
 Method 1: Straight-Line Depreciation
❖ EXAMPLE On April 1, 2023, an F-22 Raptor (asset) with an estimated life of 5 years
and an estimated salvage value of $27M was acquired. The asset had a cash price of
$171M. The fiscal year-end is December 31.
Key Point: Straight
line – same amount of
❖ 2) Compute straight-line depreciation for the next year.
deprecation every
reporting period of the
ADJUSTING ENTRY: same length

Debit: DEPRECIATION EXPENSE (Exp) $28.8M

Credit: ACCUMULATED DEPRECIATION (XA) $28.8M
Method 1: Straight-Line Depreciation

2023

2024

Book Value of ‘Net PPE’ @ 12/31/2024 = 171,000,000 – 50,400,000 = 120,600,000

 Step 2: Allocating the cost
2. Double-declining balance:
• Accelerated method
• Charges higher amounts in early time periods
• appropriate for assets that lose their usefulness more quickly at the
beginning of their lives.
• Weigh earlier years with more depreciation

2
Depreciation = Book value X
Useful life in years
 Method 2: Double-Declining Balance
***Stop depreciating when book value = salvage value

This is the traditional formula for double declining method.

This refers to “200%” double declining balance.
Book Value = NET PPE Value

2
Depreciation = Book value X
Useful life in years
 Method 2: Double-Declining Balance
❖ Compute double-declining balance depreciation for the current year?
2
Depreciation = Book value X
Useful life in years
= ($171M – 0) x 2/5
= $68.4M for the first whole year

CURRENT YEAR: $68.4M x 9/12 = $51.3M

DEPRECIATION EXPENSE 51.3M

ACCUMULATED DEPRECIATION 51.3M
 Method 2: Double-Declining Balance
❖ Compute double-declining balance depreciation for the following year?
2
Depreciation = Book value X
Useful life in years
= ($171M – $51.3M) x 2/5
New book value
= $47.88M for the first whole year = Acquisition
Cost – ending
Accumulated
Depreciation

DEPRECIATION EXPENSE 47.88M

ACCUMULATED DEPRECIATION 47.88M
Comparison of Methods (Raptor)
Purchase price $171 million, $27 million salvage value, and estimated useful life of 5 years.
** These numbers used a purchase date of Jan 1st – for simplification

Straight Line 200% - declining

balance
Year Dep Exp Net BV Dep Exp Net BV
1 28.8 142.2 68.4 102.60
2 28.8 113.1 41.04 61.56
3 28.8 84.6 24.62 36.94
4 28.8 55.8 9.94 27.00
5 28.8 27.0 0 27.0
Total 144 144
 Step 2: Allocating the cost
3. Units of Production Method

• Natural resource companies allocate a cost per unit

• Cost is matched against revenue when sold
• Called depletion
• It has the same effect as depreciation
• Depletion is computed using the units-of-production / units of use method.
 Method 3: Units of Production
EXAMPLE A mine with an estimated 90,000 tons of a valuable mineral was
acquired for $306,000; the salvage value of the land is expected to be
$18,000 once the mineral has been removed.
In the first year of operation, 6,000 tons of the mineral were extracted from
the mine and sold.

1) Compute depletion expense for the first year.

Cost – salvage value $306,000 - $18,000

Depletion rate = = = $3.20 per ton
Number of units 90,000 tons

Depletion exp. for the year:

$3.20 x 6,000 tons = $19,200
Method 3: Units of Production
2) Prepare the adjusting entry:
Depletion Expense (Exp) 19,200
Accumulated Depletion (XA) 19,200

3) How do the PP&E T-accounts look?

Gross PP&E (A) Acc. Depletion (XA) Net PPE (A)

306,000 19,200 306,000
19,200

306,000 19,200 286,800

Depletion Expense
19,200

19,200
 Recap: Depreciation Journal Entries

Accumulated Depreciation is a contra-asset account

DR Depreciation Expense xxx

CR Accumulated Depreciation xxx
 Recap: Depreciation on Balance Sheet

Balance Sheet
Asset 171.0
Accumulated Depreciation (28.8)
Book Value (net PPE) 142.2

❖ Book value (net PPE) is defined as the original capitalized cost less any
accumulated depreciation.
⏵ It is the amount that appears on the balance sheet.

❖ How will this compare to Market value?

 Valuation: Lower of Cost or Market

❖ Many assets are measured at the Lower of Cost or Market (recall

inventory example)
⏵ Required by GAAP
⏵ Applies to inventory, investments, long-term assets, etc.

Market

Cost
 Valuation: Lower of Cost or Market
❖ Order:
⏵ First: measure at cost
⏵ Later: revalue at market value if market is lower than cost

❖ Write-down:
⏵ When you reduce the asset’s book value and record an offsetting expense

DR Loss from write-down xxx

CR Asset (inventory, investment, etc.) xxx

❖ Cannot “write up” an asset

 Basic Accounting for Capital Assets

1. Recording the acquisition of the asset

2. Allocating the cost of the asset to expense over its useful life

3. Recording any repairs or improvements to the asset

 Post acquisition costs - Capitalize vs. Expense

❖ Costs incurred to repair/improve an asset can either be:

⏵ Capitalized
⏵ Added to ‘gross’ value of asset
⏵ Expensed
⏵ Immediately expensed to reduce net income

❖ This is the ‘other side’ of the journal entry to the decrease in

cash/increase in AP related to the repair/improvement
Post acquisition costs

When to Use Each Alternative

1. Capital expenditures (“capex”):

• Increase the life or capacity of the asset beyond the original
expectation
• These expenditures are added to the cost of the original asset
and are depreciated over the remaining useful life

Think about owning a home: What are some activities that

would be considered capital expenditures?
Post acquisition costs

When to Use Each Alternative

2. Expenses:

• Any costs incurred in normal recurring repairs and maintenance

of the asset
• Expensed in the period incurred

Think about owning a home: What are some activities that

would be considered expenses?
 Capitalize vs. Expense – Journal Entries

❖ Capitalized
Debit: Asset xx
Credit: Cash/Accounts Payable xx

❖ Expensed immediately

Debit: Maintenance/Repairs expense xx

Credit: Cash/Accounts Payable xx

 Capitalize vs. Expense: Discussion

❖ Suppose you are the CEO of a company. Your company made some repairs to
its assets.

❖ If you are under pressure to increase profit, what choice (capitalize vs. expense)
would you make to increase profits in the short term?
 Basic Accounting for Capital Assets

1. Recording the acquisition of the asset

2. Allocating the cost of the asset to expense over its useful life

3. Recording any repairs or improvements to the asset

4. Recording the sale or disposal of the asset

 Sale or disposal of asset

❖ If we sell the asset, we need to make sure any record of the asset is
removed from the accounting records
⏵ Which accounts are affected?
⏵ Raptor (Asset) Yes
⏵ Accumulated Depreciation Yes
⏵ Depreciation Expense No
 Sale or Disposal of an Asset

❖Four steps in recording the disposal of an asset:

• Update accumulated depreciation to the date of disposal

• Remove the asset and accumulated depreciation from the records

• Record cash received or paid (if any)

• Record gain or loss (income statement) to complete the journal entry

Sale or Disposal of an Asset
EXAMPLE We sell the F-22 Raptor for $40M. The fighter jet cost us
$171M and there was $140M of accumulated depreciation at the
time of the sale. Prepare the journal entry to record the sale.

Dr. Cash 40M 1: Start with cash – it’s the easiest

Dr. Acc. Deprec. 140M 3: Acc. Dep. is next

Cr. Asset (gross) 171M 2: Then remove the asset

Cr. Gain 9M 4: Finally calc. gain or loss

* Acc. Dep. is a contra asset – so removing it is a debit

 What are Gains and Losses?

❖ Gains:
⏵ When the selling price is HIGHER than the ‘net’ book value of the sold asset

❖ Losses:
⏵ When the selling price is LOWER than the ‘net’ book value of the sold asset

❖ Gain/loss on asset sale is an income statement account that represents the net
effect of this transaction. It is typically put on the income statement below
“Operating Income” in “Other Income and Expenses”
 Rule for Calculating Gains and Losses

❖ Always calculate gain/loss at the END

❖ Gain/loss = equals the amount needed for your journal entries to balance
⏵ Positive → GAIN
⏵ Negative → LOSS

Cash 40M Debits:

Acc. Deprec. 140M 40 + 140 = 180
Asset (gross) 171M Credits:
171 + X = 180
Gain 9M
X=9
Debits Must = Credits
Gain/Loss on Sale Examples
Facts: PP&E = 12,000 & Acc. Dep = 6,600
NBV = 12,000 – 6,600 = 5,400
Loss (given it’s a “debit”)
Selling Price = 4,900 Cash 4,900
Gain/Loss on Sale 500
Selling Price less than book
Accumulated Depreciation 6,600
value.
Equipment 12,000

No Loss / Gain
Selling Price = 5,400 Cash 5,400
Accumulated Depreciation 6,600
Selling Price equal to book
Equipment 12,000
value.

Selling Price = 6,000 Cash 6,000

Accumulated Depreciation 6,600
Selling Price is greater than Equipment 12,000
book value. Gain/Loss on Sale 600
Gain (given it’s a “credit”)
 Recap: Sale or disposal of asset

1. We reduce the asset and accumulated depreciation amounts to zero.

2. We record the cash effects, and the difference goes to gain/loss on asset
sale.

3. Gain/loss on asset sale is an income statement account that represents

the net effect of this transaction. It is typically put on the income
statement below “Operating Income” in “Other Income and Expenses”
 Change in Estimates

❖ What happens if our assumptions change? Or we realize we made a bad or

incorrect assumption?

❖ If the error is not major, plan is to adjust as you go forward

⏵ Depreciation expense recognized in the past will not change
⏵ If material, restatement

❖ Accounting based largely on estimates – and estimates can change as

information changes
 Adjust going forward
❖ Purchased a $100M machine at the start of 2014 that we said had no
salvage value and a useful life of 10 years.
❖ At the start of 2018, we realize we only have 2 years left of use (6 years
total), but it will now salvage for $10M.
Cost of Machine $100M
Acc. Depr in 2018 $40M ($10M*4)
Book Value in 2018 $60M
Depreciation for 2018 $25M
Depreciation Book Value – Salvage Value $60M - $10M
= =
rate Remaining life in years 2 years
 Intangible Assets

⏵ 2 Types of Intangible Assets

1. Identifiable Assets
2. Goodwill

⏵ 2 Categories of Intangible Assets – for Amortization

1. Limited Life Intangibles

2. Indefinite Life Intangibles
Type of Intangible Assets
Type 1: Identifiable Assets
⏵These are assets that convey specific rights to the business.
They include:

1. Patents: the rights to use inventions

• Limited life

2. Copyrights: the rights to use literary or artistic works

• Limited life

3. Trademarks and brand names: distinctive symbols or names

• Indefinite life

4. Franchises and licenses: the rights to sell products

• Can be either
 Types of Intangible Assets
Type 2: Goodwill

❖ This is the one unidentifiable intangible asset. It has the following properties :

• Defined: The unrecorded assets of an acquired company that are obtained

when one business is purchased by another
• Must be purchased to be recorded on the balance sheet
• Not recorded unless there is a merger or acquisition

❖Essentially – brand value is not on the Balance Sheet unless the company gets
bought or merged
Goodwill
Here’s how it works:
Facebook purchases WhatsApp for $19 billion in 2014

$5 billion = GOODWILL = growth potential

(for Facebook), synergies, overpaid?
** excess paid over fair value of net
$19 billion

identifiable assets

WhatsApp $14 billion = fair value of WhatsApp (i.e.,

inventory, PP&E, etc.) “net identifiable
assets”
Types of Intangible Assets

Note: Research and Development

The routine costs of searching for knowledge to create new
products or services (research) or to improve existing products
or services (development) are charged to expense as incurred
and are not recorded as intangible assets

Key: R&D is not an intangible asset – it’s expensed

 Categories of Amortization
❖ Limited Life Intangibles
• Systematically written off to expense over useful life
• Straight-line method
• This is called ‘amortization’
• Same effect as depreciation

❖ Indefinite Life Intangibles

• Not amortized
• Periodically tested for impairment
• ‘Impairment’ – similar to lower of cost or market rule
• Recognize a loss if market value lower than book value
 Amortization
⏵ Identifiable Intangibles → typically limited life
Same amortization expense every period
• Amortized over useful life
• Straight line method

⏵ Goodwill → indefinite life

• Considered to have a permanent life

• Not amortized (like land !!!!!!)
• Periodically tested for impairment (for public traded firms)
 Intangibles – Example 1
❖ Assume that FORD MOTOR COMPANY acquired a small auto parts company
for $900,000 in cash as well as paid the company’s liabilities of $350,000.
The following information was available about the assets of the acquired
company on the acquisition date:

Book Value Fair Market Value

Accounts Receivable $ 70,000 $ 70,000
Inventory 100,000 130,000
Building 500,000 800,000
Patent 1,000 100,000
Total 671,000 1,100,000
 Intangibles – Example 1
❖ Assume that FORD MOTOR COMPANY acquired a small auto parts company for $900,000
in cash as well as paid the company’s liabilities of $350,000. The following information
was available about the assets of the acquired company on the acquisition date:
Compute the amount of goodwill purchased in this
transaction.

Cash paid $ 900,000 Value of

+ liabilities assumed $ 350,000 what ‘paid’
Total amount paid $1,250,000
Value of
– Fair market value what
of assets acquired $1,100,000 acquired
Goodwill acquired $ 150,000 Difference
 Intangibles – Example 1
❖ Assume that FORD MOTOR COMPANY acquired a small auto parts company for $900,000
in cash as well as paid the company’s liabilities of $350,000. The following information
was available about the assets of the acquired company on the acquisition date:
The journal entry to record this acquisition would be:

Accounts Receivable 70,000 Fair market

We mark up the Inventory 130,000 value of
assets to FMV in assets
an acquisition
Building 800,000
acquired
Patent 100,000
Goodwill 150,000
Cash 900,000 Value of
Liabilities (various) 350,000 what
‘paid’
 Intangibles – Example 2
Microsoft acquired a small cloud-based music company for $1,900,000 in cash
along with assuming company debt totaling $250,000. The following
information was available about the assets of the acquired company on the
acquisition date:

Book Value Fair Market Value

Accounts Receivable $ 630,000 $ 630,000
PP&E 850,000 975,000
Customer Lists 0 30,000
Patent 6,000 150,000
Total 1,486,000 1,785,000
 Intangibles – Example 2
Microsoft acquired a small cloud-based music company for $1,900,000 in cash along with
assuming company debt totaling $250,000. The following information was available about
the assets of the acquired company on the acquisition date:
Take a few minutes to compute the amount of
goodwill purchased in this transaction.

Cash paid $ 1,900,000

Value of
+ liabilities assumed $ 250,000 what ‘paid’
Total amount paid $2,150,000
Value of
– Fair market value what
of assets acquired $1,785,000 acquired
Goodwill acquired $ 365,000 Difference
 Intangibles – Example 2
Microsoft acquired a small cloud-based music company for $1,900,000 in cash along with
assuming company debt totaling $250,000. The following information was available about
the assets of the acquired company on the acquisition date:

The journal entry to record this acquisition would be:

Accounts Receivable 630,000

PP&E 975,000
Customer List 30,000
Patent 150,000
Goodwill 365,000
Cash 1,900,000
Liabilities (various) 250,000
 Summary

▪ Tangible assets
– Make sure you know how to compute straight-line depreciation
– Disposals of assets (gain and loss)

▪ Intangible assets
– Definite and indefinite lives
– Goodwill

▪ Asset valuation
– Lower of cost or market
 Summary

▪ Current Assets
▪ A/R and ADA
▪ Inventory
▪ Cash & Cash Equivalents
▪ Liquidity

▪ Long-Term Assets
▪ Depreciation/Depletion
▪ Capital Expenditures
▪ Intangibles
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