Long term Assets.

Characteristics of long-term assets:

1) Long term assets have useful life of more than one year (opposite to current assets that a company expects to convert to cash within 1 year)

2) They are used in the operation of business (long term assets are used in the normal course of business and when they held for speculative reasons, they should be classified as long-term investments)

3) They are not intended for resale to customers (asset that a company intends to resell to customers should be classified as inventory).

Types of long-term assets

Tangible assets – long-term assets with physical substance (land, building, equipment).

Natural resources - Long-term assets purchased for the economic value that can be taken from the land and used up. They are depletable assets that can be converted to inventory by cutting, pumping, mining or other forms of extraction (mines, timberland, oil fields).

Intangible assets – long-term assets that have no physical substance (patents, copyrights, software, trademarks, brands, licenses, goodwill, leaseholds, franchises).

Long-term assets are reported at carrying value (book value), i.e. the unexpired part of an asset’s cost. If a long-term asset loses some or all of its potential to generate revenue before the end of its useful life, it is considered impaired.

All long-term assets are subject to an annual impairment evaluation. Asset impairment occurs when the carrying value of a long-term asset exceeds its fair value (fair value – amount for which the asset could be bought or sold in a current transaction). A reduction in carrying value as the result of impairment is recorded as a loss.

 

Accounting for long-term assets.

Three important points in a useful life of the long-term assets and the corresponding accounting procedure:

 

1) Acquisition: measurement of cost

2) Use:

- Allocation of expired cost to periods benefited

- Accounting for subsequent expenditures, such as repairs, maintenance

3) Disposal: Recording of disposals

 

I. Property, Plant and Equipment.

PP&E are accounted through depreciation. Depreciation – periodic allocation of the cost of asset over its estimated useful life. It is a gradual conversion of the cost of the asset into an expense.*Land is not depreciated because it has an unlimited life.

Factors in computing depreciation.

1) Cost – the net purchase price of an asset + all reasonable and necessary expenditures to get an asset in place and ready for use.

2) Residual value (disposal value) – portion of an asset’s acquisition cost that a company expects to recover when it dispose of the asset.

3) Depreciable cost – an assets cost less its residual value. Depreciable cost is allocated over the useful life of the asset. It is depreciable cost, not acquisition cost that is allocated over a plant asset’s useful life!

4) Estimated useful life – number of years an asset is expected to be used, usually estimated on the basis of past experience with similar assets

 

Methods of computing depreciation:

1) Straight-line method: depreciable cost is spread evenly over the estimated useful life of the asset. Depreciation depends only on the passage of time

 

Annual depreciation = (Cost – Residual Value)/Estimated Useful Life (in years) = N (per year)

 

2) Production method: depreciation is solely a result of use of the asset.

 

Annual depreciation = (Cost – Residual Value)/Estimated Units of Useful Life (for example, miles or units) = N (per mile or unit)

 

This ratio will be than multiplied by a number of miles driven, units produced of the relevant accounting period.

 

3) Declining-Balance Method is based on assumption that depreciation is larger in earlier years of useful life of the asset and smaller in later years. It is a declining balance method, because we apply a fixed rate to the carrying value (the declining balance).

 

Fixed rate = 100%/ number of years of estimated useful life.

If we take twice the straight-line depreciated percentage we get double-declining-balance method.

 

II. Natural Resources

Natural resources are accounted through depletion.

Depletion – allocation of costs resulting from exhaustion of natural resources.

Take the example of a coal mine. Depletion charge for ton of coal is calculated as follows:

Depletion charge = (Purchase price of the mine – its estimated residual value)/ estimated amount of coal

Accumulated depreciation = total amount of coal mined and sold x depletion charge

 

III. Intangible assets

Intangible assets are accounted through amortization. Amortization – allocation of asset cost to the periods it benefits.

Subject to amortization and annual impairment test: copyright, patent, leasehold, software, noncompete covenant (a contract limiting the rights of others to compete in a specific industry or line of business for a specified period), customer list (a list of customers or subscribers). These are intangible assets with definite useful life.

Subject to annual impairment test only: goodwill (the excess of the amount paid for a business over the fair market value of the business’s net assets), trademark, brand name, franchise, and license.

*Impairment test is performed to determine if the assets justify their value on the balance sheet.

71. Contributed Capital & corporate statements.

Corporate statements are the primary means of communicating accounting information about a business to decision-makers. There are four major financial statements of a corporation: income statement, statement of stockholders’ equity, balance sheet, and statement of cash flows.

Income statement summarizes the revenues earned and expenses incurred by a business over an accounting period. Many people consider it the most important financial report because it shows whether a business achieved its profitability goal. Net income, the bottom line of this statement, is the measure most commonly used to evaluate a company’s performance.

Statement of stockholders’ equity shows changes in the components of the stockholders’ equity over an accounting period. The statement of stockholders’ equity has at least three components:

1) Contributed capital – the stockholders’ investment in the corporation.

2) Retained earnings - earnings of the corporation less any losses, dividends and transfers to contributed capital that are reinvested in the business

3) Treasury stock - shares of its own stock that a corporation has bought back on the open market.

Contributed capital deals with long-term equity financing of a corporation and refers to a capital that stockholders invest in a corporation. This is a major means of financing a corporation. Contributed capital consists of money raised through stock issues. A corporation can issue two types of stocks:

- Common stocks (They have voting rights and provide their owners with the means of controlling the corporation)

- Preferred stocks (They give their owners preference over common stockholders, usually in terms of receiving dividends and in terms of claims to assets if the corporation is liquidated).

Balance sheet (often called statement of financial position) shows the financial position of the business on a certain date, usually the end of the months or year. The balance sheet presents a view of the business as the holder of resources, or assets, that are equal to the claims against those assets. The claims consist of the company’s liabilities and the stockholders’ equity.

Statement of cash flows shows how a company’s operating, investing and financing activities have affected cash during an accounting period. It explains the net increase/decrease in cash during the period. The primary purpose of this statement is to provide information about a company’s cash receipts and cash payments, in this way showing a company’s liquidity position. A secondary purpose is to provide information about a company’s operating, investing and financing activities during the accounting period.

To ensure that the financial statements are understandable to their users, a set of practices,called generally accepted accounting principles (GAAP), has been developed to provide guidelines for financial accounting.