Chapter 9 - Long-Term Capital Assets: Acquisition, Depreciation, and Disposal

Introduction to Long-Term Assets

• Course Context: The lecture begins by noting that the class is "out of 12" sessions, marking the quarter-way point or being "halfway to the halfway."

• Asset Classification:

  • Current Assets: Covered in the previous class, these include accounts receivable and notes receivable. These are short-term assets expected to be converted to cash within one year.

  • Long-Term Assets: These are items purchased for a business that are expected to be used for a period longer than one year. They are also referred to as capital assets, long-term capital assets, or long-lived assets.

The Lifecycle of Long-Term Assets

• The lifecycle of a capital asset consists of three primary stages:

  1. Acquisition (Buying): Recording the purchase of the asset.

  2. Usage: Recording depreciation and maintenance expenses over the asset's life.

  3. Disposal (Selling): Trading in, selling, or disposing of the asset.

• Recording the purchase is considered the easiest transaction, while recording the use and sale requires more detailed journal entries.

Step 1: Purchasing and Acquisition Costs

• Landed Cost: In accounting, the value recorded for a long-lived asset is its "landed cost," which is the total cost required to make the asset available for use.

• Inclusions in Cost:

  • Purchase price.

  • Delivery costs/Shipping fees.

  • Installation fees.

  • Sales taxes.

  • Heavy-duty electrical upgrades or reinforced flooring required for machinery.

  • Ductwork for specialized equipment.

• Case Study: Cedar Fair (Cedar Point/Canada's Wonderland):

  • Context: Cedar Fair owns Cedar Point in Ohio and Canada's Wonderland north of Toronto.

  • Transaction Details:

    • Base purchase price: $25,000,000$.

    • Delivery cost: $125,000$.

    • Assembly and preparation: $625,000$.

    • Incentive/Discount: Approximately $1,000,000$.

  • Total Calculation: The costs for delivery ($125,000$) and prep ($625,000$) total $750,000$. With the purchase price, the total asset value recorded was roughly $25,750,000$.

  • Journal Entry Example:

    • DR Equipment: $25,750,000$

    • CR Cash: $750,000$

    • CR Notes Payable: $25,000,000$

Ordinary vs. Extraordinary Repairs

• Ordinary Repairs and Maintenance: Regular costs for keeping an asset running. These are expensed in the period they occur.

• Extraordinary Repairs (Betterments): Significant repairs that increase the value or extend the life of the asset. These are considered capital expenditures.

• The Ford Focus Case Study:

  • A warning was given to stay away from 2012 to 2016 Ford Focus models due to major transmission failures.

  • Example: A specific car required 5 transmissions in 3 years.

  • Each transmission cost approximately $4,000$.

  • Most were covered under warranty, but significant repairs like this are often viewed as a "betterment," though this specific topic is noted as too complex for the upcoming midterm.

Step 2: Measuring the Use of Assets (Depreciation)

• Terminology:

  • Depreciation Expense: Used for tangible assets.

  • Amortization Expense: Often used for intangible assets.

• Accounting Treatment:

  • The asset account itself is debited when bought and credited when sold. It is generally not touched in between.

  • A Contra Account called Accumulated Depreciation is used to track the total depreciation taken over time. This account is contradictory/opposite to the asset account.

• Journal Entry for Annual Use:

  • DR Depreciation Expense

  • CR Accumulated Depreciation

• Consistency Principle: A business must choose one depreciation method and use it consistently. One cannot change methods year-to-year to manipulate profits because the tax department has its own mandated rules.

Depreciation Variables and Formulas

• To calculate depreciation, three values are required:

  1. Asset Cost (Actual): The known purchase/landed cost.

  2. Residual Value (Estimate): Also called Salvage Value; the expected value of the asset at the end of its useful life.

  3. Useful Life (Estimate): How long the business expects to use the asset or how much production is expected.

• The formula involves an Actual value and two Estimates. Therefore, the resulting depreciation amount is always an estimate.

• Depreciable Cost Formula:     $\text{Depreciable Cost} = \text{Asset Cost} - \text{Residual Value}$

Methods of Calculating Depreciation

• 1. Straight-Line Method:

  • The most common and least complex method.

  • Calculates a constant annual expense.

  • Formula:         $\text{Annual Expense} = (\text{Cost} - \text{Residual Value}) \times \frac{1}{\text{Useful Life}}$

  • Example: Asset cost of $50,000$ and residual value of $10,000$. Depreciable cost is $40,000$. Over 10 years, the expense is $4,000/\text{year}$. Over 8 years, it is $5,000/\text{year}$.

• 2. Units of Production Method:

  • Depreciation is based on actual usage rather than time.

  • Formula:         $\text{Rate per Unit} = \frac{\text{Cost} - \text{Residual Value}}{\text{Total Estimated Production Usage}}$

  • Example: A car costs $50,000$ with a $10,000$ residual ($40,000$ depreciable cost) and is expected to last $100,000\,km$.

    • $\text{Rate} = \frac{40,000}{100,000} = 0.40\,\text{per km}$

    • If the car is driven $25,000\,km$ in year one, depreciation is $25,000 \times 0.40 = 10,000$.

• 3. Declining Balance Method:

  • An accelerated method that results in higher depreciation in early years.

  • Uses a multiplier (e.g., Double Declining uses $2 \times \text{Straight-line rate}$).

  • The residual value is not considered in the initial calculation, but the asset is not depreciated below the residual value.

  • Note: Detailed calculations for this method will not be on the exam.

Asset Impairment

• Impairment: When an asset is no longer worth its recorded book value due to obsolescence or technology changes.

• Historical Examples:

  • The decline of CDs and DVDs.

  • A DVD burner that cost $1,000$ years ago (often used for bootlegging) is worth very little today.

• Accounting Treatment: The business records an Impairment Loss on the income statement and reduces the book value of the asset.

Step 3: Selling and Disposing of Assets

• Net Book Value (NBV): The recorded value of the asset on the balance sheet.     $\text{NBV} = \text{Asset Cost} - \text{Accumulated Depreciation}$

• Disposal Process:

  1. Update Depreciation: Record depreciation expense up to the date of sale (e.g., for 6 months if sold July 1).

  2. Calculate Gain or Loss: Compare sale price to NBV.

     • If \text{Sale Price} > \text{NBV}, it is a Gain on Disposal (recorded like revenue on the right side).

     • If \text{Sale Price} < \text{NBV}, it is a Loss on Disposal (recorded like an expense on the left side).

• Closing the Accounts: When an asset is sold, both the asset account and its accumulated depreciation account must be closed out to zero.

• Journal Entry Example (Sale for a Gain):

  • Scenario: Asset cost $50,000$, Accum. Depreciation $45,000$, Sold for $7,000$.

  • NBV is $5,000$.

  • DR Cash: $7,000$

  • DR Accumulated Depreciation: $45,000$

  • CR Asset Account: $50,000$

  • CR Gain on Disposal: $2,000$

Intangible Assets and Natural Resources

• Intangible Assets: Assets without physical substance that provide value.

  • Licensing Rights and Software: Access to programs or music.

  • Logos and Trademarks: The University of Windsor "UWindsor" logo or the "Odette" brand on water bottles.

  • Patents: Examples like the Coca-Cola recipe (licensing rights/intellectual property rights).

  • Copyrights: Music anti-piracy protection.

• Natural Resources: Specifically relevant in Canada, such as mining resources (oil, nickel in the ground).

Questions & Discussion

• Question (Student): How do you get the expenses of the assets?

• Response (Professor): That is exactly what this introduction and today's details were about—translating the cost of the asset into periodic expenses через methods like straight-line or units of production.

• Administrative Note: The professor mentions a series called Ted Lasso as something to watch, though he avoids it so he doesn't miss class.