Hello, I'm Professor Brian Bushee. Welcome back. This video is going to kick off our look at issues related to long lived assets. We're going to start with tangible assets. So, things like property, plants, and equipment. I have a long list of things that I want us to get through. So, let's get started, I'm going to define a long lived asset as any asset that's going to provide benefits for more than one year. There are two types of long lived assets that we're going to talk about. First, there are tangible assets, these are physical assets, things like property, plant, and equipment. If you decide to sell one of these on eBay, either somebody would have to come over with a big truck to pick them up, or you'd have to use a lot of shipping costs to send them. The second type are intangible assets, these are things like goodwill, brand names, patents, and customer lists. These are not physical assets, instead, they represent the cost of some kind of contractual right, that will get you some kind of future benefit. And if you sold these on eBay it wouldn't even require a stamp because they're not physical assets. The accounting issues that we're going to talk about are first of all, what goes into the acquisition costs for the assets. Then how do we spread that cost over time through depreciation amortization. Next, what happens if you spend more money on the asset in the middle of its life, what do we do with these ongoing costs? Fourth, what do we do when we dispose of the assets, and finally, what happens if the value of the asset becomes impaired at any point in time? Before we dive into these issues, I want to talk a little bit about the difference between capitalizing a cost, and expensing a cost, which is something that's going to come up a lot this week. So when we talk about capitalizing a cost, what it means is that when we incur a cost, so we have a credit to cash, or a credit to some kind of payable, we debit an asset, so capitalizing means we create an asset for the cost that we just incurred. Then in the future, let's say, over ten years, we systematically reduce that asset each year, and recognize an expense, so that we have a total expense over the ten years of 100 which equals the original cost that we incurred. When we talk about expensing a cost, we take the same cost, and then in this case, we debit expense immediately, so we recognize the entire cost as an expense, with no asset. Then there are no journal entries that we need in the future, and we end up with the same expense over the ten years of 100 in this case. So, capitalizing versus expensing doesn't change the total expense you recognize, it still has to equal the original cost, instead it changes the timing of when that expense hits your income statement. >> So, the choice here is $100 of expense in year 1, or $10 expense in each of years 1 to 10, how do you choose? Is it better to get it over with, or better to smooth it out over time? >> Well, the best approach is to choose capitalization, or expensing to communicate what's going on in your business. So, if some cost is going to benefit future revenue, then we should probably capitalize and amortize it. If it's not clear that the cost is going to benefit future revenue, then we should be expensing it immediately. Now we'll talk about specific guidelines to help make this choice later on in the video. But, this is something you want to be aware of because the number two source of accounting frauds after revenue recognition frauds is this problem of expense recognition. Where companies will capitalize when they should've expensed, or expensed when the should've capitalized, because they want to shift the timing of earnings, one way, or another. So, this is definitely something to be cognizant of, and to question whether managers are doing this appropriately. >> First we're going to talk about what goes into the acquisition costs for long-lived assets, in other words, what determines the initial value that a long term asset has when it first shows up on the balance sheet? What you want to do is capitalize all costs necessary to get the asset ready for it's intended use. Obviously this would include the purchase price of the asset, but it could also include delivery charges, or installation costs that are needed to get the asset up, and running, those can be added to the balance in the asset account. For self constructed assets, and this means that you're building your own long lived asset, you also get to capitalize the interest on any debt that's incurred to finance the asset's construction. And what that means is that instead of debting interest expense when we have an interest cost we're going to debt the value of the asset so basically put that interest cost as part of the value of the asset, and appreciated over time. So, in this case the interest expense that you see on the income statement will not necessarily reflect all of the interest cost incurred by the firm. >> How would capitalized interest affect EBITDA? My sister says that EBITDA is the best measure of performance. Would capitalized interest affect EBITDA? >> That's a really good question. When people calculate EBITDA they subtract interest expense on the income statement. This capitalized interest won't show up, as part of interest expense on the income statement, and won't get added back. But, the capitalized interest goes into the balance of the long term asset account, which then gets depreciated. So, the way the capitalized interest will actually hit the income statement is just part of depreciation, which will then get added back as part of EBITDA. So, it turns out that, even though we capitalize interest, it won't show up in the EBIDTA measure, it'll get added back through depreciation, so you're okay in this situation by having a capitalized interest. You're not going to miss it, if you want to remove interest from your measure performance as you do in EBIDTA [SOUND] One more point with acquisition costs. If the costs include multiple classes of assets. Let's say you buy land, building and machinery with all one purchase price, the cost has to be allocated into the separate asset classes. We saw this back in the relic spotter case where Rebecca Park bought land, and building for one hundred and fifty five thousand, and had to allocate that into land versus building, and the reason was because they had different depreciation rates over time with land not being depreciated. What I'm going to do is go through an example in this video to highlight these different stages that we've looked at. Our example's going to concern Bott Incorporated which manufactures golf clubs, Bott has built a new piece of equipment to put grips on the golf clubs, Bott spends $4,500 cash on raw materials, and $3,000 cash on labor, they also incur 500 of interest costs, under an interest payable, to finance the building of the equipment. I'm going to go ahead, and put up the pause sign, and let you take a crack at trying to do this journal entry. So, in the journal entry, we're going to debit Equipment asset for 8,000, that's going to put all of the costs into the asset balance. Those costs included 7500 of cash costs, so there's a credit to cash, that's the raw materials, and labor, and $500 of interest cost under the Interest Payable, so there's a credit to Interest Payable for 500. I'm also going to, carry forward an equipment T account through this example, so we can see how these different transactions affect it. >> Raw materials? Labor? This sounds like the Work-in-process inventory account you talked about before. >> Yes, it's a great catch, great analogy. This is exactly the same as we saw in week four with work in process, where all the costs to manufacture something go into an inventory account. The only difference here is instead of making things to sell as we did in the inventory case, we're making something to keep. We're making a piece of equipment that we're going to use to generate revenue over, and over, and over again in the future. The key point is that all of these costs go into the asset account. In the case of inventory, they stay there until they sell the product, in the case of equipment, they stay in the asset until we use that equipment to generate revenue, and when we do that, we're going to recognize depreciation expense. Now that we've acquired an asset, we can talk about depreciating the asset over time. Some of this is going to be a review of what we talked about earlier in the course, although there'll be some new wrinkles. A reminder with the terminology, if it's a tangible asset we call it depreciation, and if it's an intangible asset we call it amortization. There's a number of elements that you need to consider when you're going to calculate depreciation. So first, there's something called the depreciable basis. This is the difference between the acquisition cost, which we just saw, and the salvage value. Remember, the salvage value is what we think the asset'll be worth when we're done using it at the end of its useful life. The useful life is how long we think we're going to use the asset. In prior examples, we've always done number of years, you could also do this based on number of units, so if you thought an asset would produce 5 million units over its life, and this year we produced 1 million units, then would take one fifth of the value as depreciation in year 1. And then the final element is the depreciation pattern either straight line, or accelerated, and we'll talk more about this in a second,. Remember that all of these elements are chosen by management, management makes their best estimate at the time the acquire the asset, and they try to choose these estimates in a way to communicate how they plan to use that equipment over time. So, in terms of depreciation methods, straight line is by far the most common that's used in financial statements, it's very rare that you'll see a financial statement that doesn't use straight line. This is the formula that we've seen in the past where depreciation expense is the difference between the acquisition cost, and the salvage value, otherwise known as the depreciable basis divided by the useful life. There are also accelerated methods of depreciation, these used to be more common of finance statements, but now a days you almost never see them. Couple methods are double declining balance, sum of the years digits, since these are never used, I'm not going to hold you responsible for learning these formulas. But, I'm afraid that I will lose my license as an accounting professor if I don't tell you how they work, so here are the formulas, you can try them out if you want, but you'll almost never see them in practice, instead the accelerated method that you will see is something called MACRS. This stands for Modified accelerated Cost Recovery System, this came into the US in 1986 when it replaces ACRS, which was the Accelerated Cost Recovery System. This is what's required in US tax returns, and I say you have to call your tax accountant for details because there's no formula here, it's just what's been determined in the tax code. So, you have to go look up the tax code in a book, or online to figure out what the accelerated depreciation schedule would be for a given asset. And this is just in the US, but just about every country in the world has their own accelerated depreciation schedule that they use for tax purposes, which you have to look up to find the specifics in each given country. The key point is that firms can use different methods for their taxes, than they do on their financial statements. >> Why would a company choose different methods for tax, and financial reporting purposes? Why is the tax method required, whilst the financial statement method can be anything? >> Excellent question, this is a key point, and we'll talk more about this point in week eight. But, you've gotta keep it in mind that the goals of tax reporting, and finance reporting are quite different. For tax reporting, the government's goal is to raise cash revenue. Now given that people always try to cheat on taxes, the government wants to be as explicit as possible in setting depreciation rules, so people don't have this wiggle room to try, and cheat on their taxes, or try to manage their taxes downward if we want to be a little bit more kind. But, for financial reporting, we want managers to communicate how the companies doing, are you getting enough revenue to cover all the costs of doing business? And by giving managers the ability to choose the depreciation method, to choose the salvage value, and the useful life to reflect how they in to use the asset, we get better information. We get information about how managers are going to use up their long-lived assets that we wouldn't get if we were following a one size fits all tax reporting approach. So, don't be, to be scared off by these two methods of reporting. One, tax reporting, is to generate tax revenue, it's very explicit. Financial reporting, the goal is to provide users information, and the best way that we can often do that is to provide flexibility, and discretion. Anyway, a key point to remember is that regardless of the method used for depreciation, total depreciation expense has to be the same over the life of the asset. Here's a little picture to show you how this would work. So, on the Y-axis, I have the Net Book Value of a piece of equipment, so how much the equipment is worth on the books. And on the X-axis, I have the number of years. So Straight-line depreciation takes you from the acquisition cost at the acquisition year. Down to the Salvage Value at the End of the Useful Life in a Straight-line, even fashion, so we've got the same depreciation expense every year. Any kind of accelerated method, you're going to have a bigger drop in the book value in early years. But then that'll taper off, so you get to the same place by the end of the useful life, with the difference being that there's more depreciation expense in our early years, and less depreciation expense in later years. So let's get back to our Bott example, Bott management decides that the equipment will have a useful life of six years with a $2,000 salvage value. Bott has to recognize one year of depreciation using the straight-line method. If you remember a couple slides back, the acquisition cost of the equipment was $8,000. So let me put up the pause sign, and you can try to calculate one year of depreciation under the straight-line method So, the equation is annual depreciation equals the acquisition cost minus the salvage value all divided by the useful life. So, if we pop in the numbers, we've got $8,000 acquisition cost minus $2,000 salvage value is $6000 of depreciable base, spread over six years would give you 1,000 of depreciation per year. >> How could Bott's management have any earthly idea what the heck this equipment will worth in six years? Do managers just make this stuff up? >> No, you're right. It is sort of tricky to ask managers to provide these estimates. because how could anybody know for certain today whether you're going to use a piece of equipment for six years, or seven years, or five years into the future. All we ask is that managers give us their best estimate. And that best estimate is better than just saying, writing it all off immediately as an expense when you're going to use it for five or six years, or just saying that it's going to last for 30 years when you're going to use it five, or six years. So, just get as close to how you plan to use it. And again managers can change these assumptions at any point, we'll see that in the next video, and so hopefully what we get from the depreciation assumptions, is manager's best estimate as of today, how they think they're going to use a long lived asset. Now, that we've calculated the amount of depreciation for one year, we have to do the journal entry, and there's going to be a little wrinkle here. So, Bott management estimates that three-quarter of the time the equipment was used to produce golf club inventory, the rest of the time it was used for the personal golf clubs of the sales force, and the top management, which is a perk that Bott provides these employees. So, this one's a little tricky, I'm going to go ahead, and put up the pause sign, and if you want a challenge, go ahead and try to figure out the journal entry. Here's the journal entry let's start with the credit, so we credit accumulated depreciation for 1,000, that's one year of depreciation that we calculated on the prior slide. We're going to debit work-in-process inventory for 750, which is three-quarters of a thousand. We debit work-in-process because if you remember when we talked a few weeks ago about inventory, depreciation on equipment that you use to produce inventory is part of manufacturing overhead, and it needs to go into work-in-process as part of the inventory, and eventually cost of goods sold. Then we debit depreciation expense for 250, this is going to be the depreciation expense for the clubs of the sales force in top management. Their costs are under SG&A, Sale, and General Administrative expense, it's a period cost, so we go ahead and expense it right away. We'll bring up the equipment T account, nothing happened, we'll also bring up an accumulated appreciation T account, and show that we have a credit due to this journal entry, I am not going to bring up work in process, or, depreciation expense, T account, because were not tracking those in this example. >> Here is a work in process inventory, I was sick during the inventory video, coud you explain why this is not all depreciation expense? >> Yeah, I'm sorry you weren't feeling well during the week four videos, but this is a good place to review how we handle depreciation. So remember depreciation could either be a product cost, or a period cost. A product cost where, if the depreciation is used in the manufacturing process, it goes directly into inventory, and won't show up on the income statement until the inventory is sold, and then it'll be part of costs of goods sold. So, costs of goods sold will include part of the depreciation. Period costs would be it's part of selling general, and administrator expenses, so providing [SOUND] the employees this perk, this form of compensation. In that case it is expensed as it's incurred, so we have depreciation expense go on the income statement right away. So, keep in mind that depreciation can either go into inventory, and cost a good sole, or it can go directly on to SGNA. Well, looking at the time. We've already gone over 20 minutes, and I've only gotten through 40% of my list of things to cover [LAUGH] with tangible assets. So, probably a good idea to split this into two videos. So, why don't you go ahead, and rest up and re-join me next video, where we'll pick up, and talk about, ongoing costs, disposals, and impairment along with assets. I'll see you then. >> See you next video.
