RCMA 1: LONG TERM ASSETS | Phoenixnotebook

LONG TERM ASSETS

Majority of the business organizations purchase long-term assets that they intend to keep for a extended period of time. These organizations use depreciation to spread the cost of physical assets over a period of time that they provide benefit to the organization, and at the same time, for tax and accounting purposes.

Long-Term Assets are assets that are expected to be used, replaced and/or converted to cash beyond the normal operating cycle of at least 12 months.

Tangible Assets are physical items owned by a company, such as equipment, buildings, and inventory. Whereas, intangible assets are nonphysical items that have a monetary value because they represent potential revenue.

Depreciation is an accounting method for estimating that decline over time. It helps organizations match their revenues with costs, including those of assets used to generate revenues. Depreciation calculation requires various judgements from management.

A. Tangible assets

Asset cost includes all acquisition, shipping, installation, and preparatory expenses.
Estimated useful life of the asset is crucial for planning its benefits to the organization.
Predicted salvage value at the end of the asset's life should be estimated; depreciation should not reduce the asset's value below this salvage value.
Management selects a depreciation method based on the asset's usage pattern.

B. Depreciation Methods

Straight line depreciation method

Evenly spreads the cost of an asset over its estimated useful life. This means that the same amount of depreciation expense is recognized each accounting period until the asset's value reaches its salvage value. It's straightforward, commonly used, and simple, making it easy to understand and calculate.
Formula:

(cost of the asset – estimated salvage value) / estimated useful life of an asset

Example:

ABC Company purchases equipment for $27,000 and expects to sell the equipment for $6,000 at the end of five years. ABC Company will then depreciate the equipment for $4,200. At the end of five years the net asset value of the equipment will then be $6,000.

($27,000 - $6,000) / 5 Years = $4,200

2. Sum of the Year’s Digits (SOYD) depreciation method

is an accelerated depreciation technique where the depreciation expense decreases over time. In this method, the total useful life of the asset is expressed as a sum of the years' digits (e.g., for a 5-year asset, the sum would be 1+2+3+4+5 = 15). Another way to get the denominator is: n(n+1)/2.
This depreciation method also assumes that the asset would be more beneficial and product in the early years than in the later years
Each year, the asset's depreciable value is divided by the sum, and then multiplied by the remaining years of useful life. This results in higher depreciation expenses in the earlier years of the asset's life and lower expenses in the later years, reflecting the asset's decreasing utility and value over time.

Example:

An organization purchases machinery for $30,000 and expects to sell it for $6,000 at the end of five years. The depreciable amount is $24,000 (cost of $30,000 less the salvage value of $6,000). For year 1, the numerator in the unique fraction is 5 because there are five years remaining in the asset's life at the beginning of that year. The denominator is the sum of the year's digits, which is 15 (1 + 2 + 3 + 4 + 5).

This table shows the depreciation expenses for each year using the sum of the years digits (SYD) depreciation method.

Double Declining Balance (DDB) Depreciation Method

Another accelerated depreciation method that calculates annual depreciation of an asset by multiplying the book value of the asset, which is cost less accumulated depreciation, by 2/n where n is equal to the number of years in the asset’s useful life. Until the asset has depreciated to its salvage value, the computation is repeated annually.

Formula:

Depreciation Expense = 2 × ( 1/Useful Life ) × Book Value at Beginning of Period

Using this method, depreciation costs are higher in the early years of an asset's life and progressively go down. The DDB approach will result in a larger total depreciation over the asset's life, but the straight-line method will eventually equalize the depreciation expense.

Units of Production (UOP) Depreciation Method

a technique used to allocate the cost of an asset over its useful life based on the actual usage or production levels of the asset. Unlike traditional methods such as straight-line or declining balance, which allocate depreciation evenly over time, the units of production method allocates depreciation based on the number of units produced, hours worked, or any other measure of usage.
This method is particularly useful for assets whose usage can vary significantly from one period to another. It ensures that depreciation expense closely reflects the asset's actual contribution to revenue generation or productivity. The formula for calculating depreciation under this method involves dividing the depreciable cost of the asset by the total expected units of production or usage and then multiplying it by the actual units produced or hours used during the accounting period.

Understanding depreciation methods is key because they impact financial statements differently:

Accelerated methods, like double-declining balance, front-load expenses, lowering reported profits and asset values quicker.
Simpler methods, such as straight-line, spread expenses evenly, showing higher profits early and slower asset value decline.
Different methods are used for financial records and taxes:
Accelerated methods reduce taxes early but might increase them later.
Simple methods can lead to steady taxes but may not maximize tax benefits.

Impairment of tangible assets

Impairment of tangible assets is a critical concept in accounting and finance, particularly in the context of financial reporting and asset valuation

It occurs when the carrying amount of a tangible asset exceeds its recoverable amount. The carrying amount is the asset's book value on the balance sheet, while the recoverable amount is the higher of an asset's fair value less costs to sell or its value in use.
Tangible assets may become impaired due to various reasons such as physical damage, technological obsolescence, changes in market conditions, or adverse changes in legal regulations affecting the asset's usefulness.

The process for calculating impairment losses involves two main steps:

Step 1 - Recoverability Test:

Future undiscounted cash flows expected from the asset are compared to the book value (cost less accumulated depreciation) of the asset.
If future cash flows exceed the book value, the asset is considered recoverable, and no impairment exists. No further action is needed.
If future cash flows are less than the book value, the asset is considered unrecoverable, and impairment loss must be calculated and recognized.

Step 2 - Impairment Loss:

If the asset is unrecoverable, management estimates the fair value of the asset, which will be less than the book value.
The impairment loss to be recognized is the difference between the book value of the asset and the fair value of the asset. This step can involve various methods for fair value estimation.
Methods include quoted market prices for similar assets, outside appraisals, discounting future cash flows, or internal appraisals based on industry expertise.
The impairment loss is recorded in the period it's identified.

After recognizing an impairment loss, future annual depreciation on the asset should be recalculated to reflect the revised value, along with any updated estimates of remaining useful life and salvage value.

In essence, this process ensures that assets are accurately valued on the balance sheet, reflecting their recoverable amounts, and impairment losses are recognized when necessary, leading to transparent financial reporting and informed decision-making.

Example:

Company XYZ owns a commercial building with a book value of $500,000 and expected future undiscounted cash flows of $350,000. However, recent market conditions and changes in demand have led to a decrease in property values, and the fair value of the building is estimated to be $300,000.

Step 1 - Recoverability Test:

Future Cash Flows: Company XYZ estimates the future cash flows expected from the continued use of the building, which amount to $350,000.

The book value of the building is $500,000.
Since the future cash flows of $350,000 are less than the book value of $500,000, the building fails the recoverability test, indicating potential impairment.

Step 2 - Impairment Loss:

Fair Value Determination: Company XYZ estimates the fair value of the building to be $300,000.
Impairment Loss Calculation: The impairment loss is calculated as the difference between the book value and the fair value of the building:

Impairment Loss = Book Value - Fair Value

= $500,000 - $300,000

= $200,000

To record loss on the building

Loss on Impairment 200,000

Building 200,000

E. Sales of Tangible Assets

Recognition of Gains or Losses: When a fixed asset is sold, organizations recognize gains or losses.
Depreciation Adjustment: Before calculating any gain or loss, depreciation should be brought current.
Removal of Historical Cost and Accumulated Depreciation: At the time of sale, the historical cost of the asset along with all related accumulated depreciation should be removed from the organization's records.
Gain Recognition: If the asset is sold for more than its book value at the time of sale, a gain is recorded.
Loss Recognition: Conversely, if the asset is sold for less than its book value at the time of sale, a loss is recorded.

F. Intangible assets

Intangible assets encompass a diverse range of assets, each with specific accounting treatments.
Assets with a finite life, such as patents or copyrights, are amortized similarly to tangible assets depreciation, often utilizing straight-line amortization with zero salvage values. The impairment assessment for these assets follows a two-step process akin to tangible assets.
Intangible assets with indefinite lives, like trademarks or brands, are not amortized but are carried at cost and periodically reviewed for impairment, usually annually or when potential issues arise.
The impairment test for these assets involves comparing the recorded value to fair value, with any recognized impairment loss reflecting the difference.
Goodwill, which arises from business acquisitions exceeding the fair value of net identifiable assets, is subject to a specific impairment assessment.
This evaluation compares the fair value of the reporting unit containing goodwill to its recorded value.
If fair value exceeds book value, goodwill remains unimpaired.
Conversely, if fair value falls short, impairment is recognized, limited to the amount of goodwill recorded.

Multiple Choice Questions

1. Which of the following best defines long-term assets?

Assets used, replaced, or converted to cash within the normal operating cycle.
Assets expected to be utilized, replaced, or converted to cash beyond the normal operating cycle.
Assets held for speculative purposes.
Assets held for less than 12 months.

2. Which depreciation method evenly spreads the cost of an asset over its estimated useful life?

Sum of the Years' Digits (SYD) method
Double Declining Balance (DDB) method
Straight-line method
Units of Production (UOP) method

3. In the Sum of the Years' Digits (SYD) depreciation method, what does the denominator of the fraction represent?

The total useful life of the asset
The remaining useful life of the asset
The salvage value of the asset
The total depreciation expense

4. Which of the following statements regarding the Double Declining Balance (DDB) depreciation method is true?

It results in lower depreciation expenses in the early years of an asset's life.
It spreads depreciation expenses evenly over the asset's useful life.
It eventually equals the depreciation expense of the straight-line method.
It is a simpler method compared to the straight-line method.

5. The Units of Production (UOP) depreciation method is particularly useful for which type of assets?

Assets with a short useful life
Assets with a predictable usage pattern
Assets with a constant value over time
Assets with a steady production rate

Problem Solving

ABC Company purchases equipment for $50,000 and expects to sell it for $10,000 at the end of its useful life. If the company estimates the equipment's useful life to be 10 years, calculate the annual depreciation expense using the straight-line method.

An organization acquires a machine for $80,000 with an expected salvage value of $5,000 after 8 years. Using the Sum of the Years' Digits (SYD) method, calculate the depreciation expense for the third year.

XYZ Corporation buys a delivery truck for $40,000. The truck is expected to travel 120,000 miles over its useful life and have a salvage value of $5,000. In the first year, the truck travels 30,000 miles. Determine the depreciation expense for the first year using the Units of Production (UOP) method.

Company A purchases a piece of equipment for $60,000. The equipment is expected to have a useful life of 5 years and a salvage value of $5,000. Calculate the depreciation expense for the second year using the Double Declining Balance (DDB) method.

An organization acquires a patent for $100,000 with an indefinite life. Due to changing market conditions, the fair value of the patent decreases to $80,000. Determine the impairment loss to be recognized.

Answer key:

Multiple Choice Questions

B) Assets expected to be utilized, replaced, or converted to cash beyond the normal operating cycle.
C) Straight-line method
A) The total useful life of the asset
C) It eventually equals the depreciation expense of the straight-line method.
B) Assets with a predictable usage pattern