chapter 8

CAPITAL ASSETS—TANGIBLE AND INTANGIBLE

A Canadian Staple's Capital Costs

Nine out of 10 adult Canadians shop at Canadian Tire every year, and 40 percent of Canadians shop there every week, the company website boasts. In fact, the location of Canadian Tire's 475 retail stores allows it to serve more than 90 percent of the Canadian population. It is no surprise, then, that this market reach translates into a significant amount of capital assets, both tangible and intangible. Indeed, the company logo, the instantly recognizable red triangle with the green maple leaf, is a significant intangible asset for the company. However, that specific asset does not have any capitalized asset value on Canadian Tire's balance sheet.

According to Huw Thomas, Canadian Tire's Executive Vice-President, Financial Strategy and Performance, the logo would be on the balance sheet “if we had done a lot of work to create that triangle as a brand.” Instead, the creation of the brand's value happened over a long period, and Canadian Tire did not capitalize any costs associated with that process. “If we had,” Mr. Thomas continues, “we would have the potential for the creation of further intangibles, because the brand obviously has significant value. But current accounting (and IFRS) doesn't have you carry the value of assets like that on your balance sheet.” Intangible assets that have been purchased, however, are carried on the balance sheet. For example, Canadian Tire's acquisition of the Mark's Work Wearhouse chain includes the capitalization of intangibles, such as the company's well-established brand name. All of the goodwill that appears on the balance sheet has been gained through acquisitions, Mr. Thomas says.

On a large acquisition such as Mark's Work Wearhouse, the company calculates the fair value of the various assets it has acquired, including any trademarks. “You create models as to what that trademark might be worth, looking into the future, and then the difference between the total amount that you've paid, less the fair value of the net assets you've acquired, represents goodwill,” explains Mr. Thomas. “That becomes an asset that sits on the balance sheet, and every year you have to assess whether the goodwill amount has become impaired.” The company would do an impairment assessment for any asset on the balance sheet, whether intangible or tangible, he adds.

Canadian Tire owns 70 percent of the land and buildings for the main stores in its network. The costs to develop a new store location include acquiring the land and the legal costs associated with that purchase, as well as the physical construction of the store itself. As portions of the building are completed, progress payments for the construction are capitalized, Mr. Thomas explains. During the construction period, the company also capitalizes interest costs associated with funding the land purchase, and project costs for the building. “We have a set of specific internal guidelines around what can be capitalized and what can't be,” says Mr. Thomas, “and that is consistent with GAAP.”

“There are various differences between current accounting under Canadian GAAP and IFRS,” Mr. Thomas continues. These differences include the choice to record property and equipment at fair values (under a revaluation model) or at cost, and the IFRS requirement to separately account for and depreciate significant parts of a property and equipment asset. “As IFRS requires borrowing costs that are directly attributable to the construction of a qualifying asset to be capitalized as part of the cost of that asset,” concludes Mr. Thomas, “the move to IFRS will not have any significant impact on our accounting for real estate development projects.”

USER RELEVANCE

Capital assets provide the underlying infrastructure of many companies. They include the real estate, buildings, equipment, vehicles, computers, patents, and so on that companies need to carry out their day-to-day operations. They often require a substantial outlay of funds to acquire, which means that companies will often secure long-term mortgages or other forms of debt to finance them. Another common way to acquire long-lived assets is to lease them. You may find some assets on a statement of financial position labelled as “assets under capital leases.”

Because of their importance to business operations, their high costs, and their long lives, the role that capital assets play in a company's success needs to be understood by financial statement users. Users need to monitor the assets' lives so that they can anticipate the future outflows of cash to replace them. They need to know what methods a company has chosen to depreciate its assets, and what impact those methods have on the statement of earnings. They also need to understand that the value carried on the balance sheet for capital assets represents a future benefit that the company expects to earn from using the assets. If the company did not expect to earn the carrying values through its use of the assets, it would be required to write them down (i.e., reduce the carrying values). In most instances, companies expect to earn amounts that are significantly higher than the carrying values of their capital assets.

This chapter will provide you, as a user, with the necessary background information on capital assets so that you can better understand the impact that these assets have on the financial statements.

CAPITAL ASSET RECOGNITION

Assets must have probable future value for the company. The company must also have the right to use them and must have acquired that right through a past transaction. When a company buys a capital asset, both of these conditions exist: it has the right to use the asset and a transaction has occurred. Therefore, the only asset criterion that merits further discussion is the probable future value, which takes at least two forms. Capital assets are used, first and foremost, to generate revenues, usually by producing products, facilitating sales, or providing services. Therefore, the future value is represented by the cash that will eventually be received from the sales of products and services. This type of value is sometimes referred to as value in use. Because of the long-term nature of capital assets, these cash flows will be received over several future periods.

The second source of value for capital assets is their ultimate disposal value. Many capital assets are used until the company decides to replace them with a new asset. For example, a business may use a truck for four or five years and then trade it in for a new one. This type of value is called residual value (or resale value) and can be very important, depending on the type of asset.

Value in use is normally the most appropriate concept for capital assets because companies usually invest in them to use them, not to sell them. Residual value cannot, however, be totally ignored, because it represents the asset's expected value at the end of its use. In Chapter 2, you were introduced to how we use residual value to determine the amount of depreciation that should be recorded.

The difficulty with the value in use concept for capital assets is that the future revenue (and ultimately income) that will be generated by using the asset is inherently uncertain. The company does not know to what extent the demand for its products or services will continue into the future. It also does not know what prices it will be able to command for its products or services. Other uncertainties relate to technology. Equipment can become obsolete as a result of technological change. New technology can give competitors a significant advantage in producing and pricing products. Technological change can also reduce or eliminate the need for the company's product. Consider a manufacturer of cassette tapes when CDs came on the market, or a videotape or VCR manufacturer with the advent of DVDs.

Uncertainty about the asset's value in use also gives rise to uncertainty about its eventual residual value, since the ultimate residual value will depend on whether the asset will have any value in use to the ultimate buyer. There may also be a question of whether a buyer can even be found. Equipment that is made to the original buyer's specifications may not have much residual market value because it may not meet the needs of other potential users.

HOW ARE CAPITAL ASSETS VALUED?

In the sections that follow, the discussion is limited to valuation issues regarding property, plant, and equipment, which are similar to those relating to other non-current capital assets. At the end of the chapter, specific concerns and issues regarding natural resources and intangible assets are discussed.

In Canada, property, plant, and equipment are usually valued at historical cost, with no recognition of any other value unless the asset's value becomes “impaired” (i.e., the value of the estimated future cash flows is less than the current carrying value). IFRS allows the recognition of changes in the market values of property, plant, and equipment and you may come across companies that are using market value for their capital assets. Before Canadian practice is discussed in detail, several possible valuation methods will be considered.

Historical Cost

In a historical cost valuation system, the asset's original cost is recorded at the time of acquisition. Changes in the asset's market value are ignored in this system. During the period in which the asset is used, its cost is expensed (depreciated) using an appropriate depreciation method (discussed later in this chapter). Market values are recognized only when the asset is sold. The company then recognizes a gain or loss on the sale, which is determined by the difference between the proceeds from the sale and the net book value (or carrying value) of the asset at the time of sale. The net book value or carrying value is the original cost less the portion that has been charged to expense in the form of depreciation. This net book value is sometimes called the depreciated cost of the asset.

Market Value

Another possible valuation method records capital assets at their market values. There are at least two types of market values: replacement cost and net realizable value.

Replacement Cost

In this version of a market valuation system, the asset is carried at its replacement cost—the amount that would be needed to acquire an equivalent asset. At acquisition, the historical cost is recorded because this is the replacement cost at the time of purchase. As the asset is used, its carrying value is adjusted upward or downward to reflect changes in the replacement cost. Unrealized gains and losses are recognized for these changes. The periodic expensing of the asset, in the form of depreciation, has to be adjusted to reflect the changes in the replacement cost. For example, if the asset's replacement cost goes up, the depreciation expense will also have to go up, to reflect the higher replacement cost. A realized gain or loss is recognized upon disposal of the asset. The amount of the gain or loss is determined by the difference between the proceeds from the sale and the depreciated replacement cost at the time of sale.

Net Realizable Value

With a net realizable value system, assets are recorded at the amount that could be received by converting them to cash; in other words, from selling them. During the periods when the assets are being used, gains and losses are recognized as their net realizable values change over time. Depreciation in this type of system is based on the net realizable value and is adjusted each time the asset is revalued. The recognition of a gain or loss at the time of sale should be for a small amount, since the asset should be carried at a value close to its resale value at that date. This system is not consistent with the notion of value in use, which assumes that the company has no intention of selling the asset. IFRS allows this valuation system. As Canadian companies adapt to IFRS, companies may opt to use net realizable value.

The word “market” must be used with some care. The preceding discussions assume that both the replacement market and the selling market are the markets in which the company normally trades. There are, however, special markets if a company has to liquidate its assets quickly. The values in these markets can be significantly different from those in normal markets. As long as the company is a going concern, these specialty markets are not appropriate for establishing values for the company's assets. On the other hand, if the company is bankrupt or going out of business, these specialty markets may be the most appropriate places to obtain estimates of the assets' realizable market values. It might be difficult to determine a market value under either method if the assets are very specialized.

What Is Canadian Practice?

In Canada, most capital assets are valued at their depreciated historical cost (the remaining portion of their original acquisition cost). During the periods of use, the asset's cost is expensed using a depreciation method that is rational, systematic, and appropriate to the asset.

With the adoption of IFRS, some companies may decide to change to the market values for their capital assets. Under this valuation method, the assets are revalued every three or four years. During the intervening years, the assets are depreciated using the same depreciation methods that are used under the cost method. A detailed description of this method is covered in intermediate financial accounting courses.

Under both historical cost and net realizable value, an asset cannot be valued at more than the amount that can be recovered from it. The net recoverable amount is the total of all the future cash flows related to the asset, without discounting them to present values. If it is ever determined that an asset's carrying value exceeds its net recoverable amount, the carrying value must be written down and the difference recognized as an impairment loss.

Ethics in Accounting

ethics in accounting

Capitalizable Costs

At the date of acquisition, the company must decide which costs associated with the purchase of the asset should be included as a part of the asset's cost, or capitalized. The general guideline is that any cost that is necessary to acquire the asset and get it ready for use is a capitalizable cost. Any cost incurred that is not capitalized as part of the asset cost would be expensed in the period of the purchase. The following is a partial list of costs that would normally be capitalized (i.e., included in the cost of a capital asset).

The reason for capitalizing ancillary costs (such as taxes on the purchase price, legal costs associated with the purchase, shipping or transportation costs, and preparation, installation, and set-up costs) is the matching principle. If these related costs are recorded as part of the asset's cost, they will be charged to expense in future periods, as depreciation, in order to match them to the revenues that are generated while the asset is being used.

The determination of which costs appropriately belong in an asset account is not always easy. For example, consider a company purchasing new equipment. The salaries of the employees who develop the specifications for the new equipment, negotiate with potential suppliers, and order the equipment are normally not included in the acquisition cost. This is true even though the time spent by these employees is necessary to acquire the asset. On the other hand, if a significant amount of employee time is required to install the new equipment, these employees' wages are usually recorded as part of the cost of the equipment. The costs associated with clearing land in preparation for constructing a new building are usually added to the land account. The cost of digging the hole for the building's foundation, on the other hand, is usually added to the building account.

Land is a unique capital asset. Even after it has been used by a company for several years, land will still be there to be used indefinitely in the future. Therefore, unlike other capital assets, its cost is not depreciated. Consequently, assigning costs to land means that those costs will remain on the statement of financial position forever; they will not appear on the statement of earnings in the future, as depreciation expense.

Related to land is another category of capital assets that are commonly referred to as land improvements. The term land improvements refers to things done to the land to improve its usefulness, but which will not last forever. Examples include the installation of fencing, parking lots, lighting, and walkways. It is important to distinguish these types of items from the land itself, because the cost of these land improvements must be depreciated over their expected useful lives.

Deciding which costs to capitalize is also often influenced by income tax regulations. For tax purposes, companies would like to expense as many costs as possible, in order to reduce their taxable income and save on taxes. Capitalizing costs, on the other hand, means that companies have to wait until the assets are depreciated before the costs can be deducted for tax purposes. There is, therefore, an incentive to expense rather than to capitalize costs that are only indirectly related to the acquisition of assets, and companies may decide to expense costs for financial reporting purposes to bolster their arguments that the costs are expenses for tax purposes.

The materiality criterion also plays a part in which costs are capitalized. Small expenditures related to the purchase of an asset may be expensed rather than capitalized, because expensing them is simpler and adding small amounts to the cost of the asset would not change it significantly.

Basket Purchases

Sometimes a company acquires several assets in one transaction. This is called a basket purchase. For example, when a forest products company buys timberland, it acquires two distinct assets—land and timber. Therefore, the price paid for the timberland must be divided between the land and the timber, on the basis of their relative fair values at the time of acquisition. This is necessary for three reasons: first, full disclosure requires that each important type of asset be reported separately on the statement of financial position; second, assets that have different rates of depreciation have to be recorded separately in the accounts; and third, some assets, such as land, are not depreciated at all. Suppose that the timberland's purchase price was $880,000 and the fair values of the land and timber were assessed at $250,000 and $750,000, respectively. (Sometimes when assets are acquired in a group it is possible to negotiate a price that is less than the sum of the selling price of the individual assets.)

In this case, the fair value of the land is 25% ($250,000 ÷ $1,000,000) of the total fair value. Therefore, 25% of the total purchase price should be assigned to the land, and the remaining 75% of the cost should be assigned to the timber. Accordingly, a cost of $220,000 (0.25 × $880,000) would be recorded in the land account, and the remaining $660,000 (0.75 × $880,000) of the purchase price would be recorded in the timber account. In the case of timberland, splitting the cost has significant implications for the company because the cost of the land will not be depreciated but the cost of timber will be expensed through depreciation as the timber is harvested.

Another example of a basket purchase is the purchase of a building. Part of the real estate cost must be allocated to the land on which the building is sitting and the remainder to the building. If the building includes various pieces of equipment or furniture, part of the purchase cost will have to be allocated to these items as well. Management's bias in favour of higher income would motivate them to allocate more of the overall cost to the land, and less to the building and other depreciable assets. However, their conflicting desire to pay less income tax would motivate them to allocate a smaller portion of the total cost to the land, and a larger portion to the building and other amortizable assets.

IFRS also requires companies to look within assets such as buildings to see if there are any component parts of the asset that have useful lives that are different from the asset as a whole. For example, assume a company determines that the cost of a building is $750,000 and its useful life is expected to be 35 years. The roof of the building, however, may only last for 15 years. The company should allocate a portion of the original cost of $750,000 to the roof, list the roof as a separate asset and depreciate it over the 15 years.

Interest Capitalization

The issue of interest capitalization deserves special consideration. Companies often borrow money to finance the acquisition of a large capital asset. The interest paid on the borrowed money is sometimes capitalized, by including it in the capital asset account rather than recording it as an expense. This is often a major issue for companies that construct some of their own capital assets. For example, some utility and natural resource companies construct their own plant assets. In addition to the costs incurred in the actual construction of these assets (including materials, labour, and overhead), these companies may also incur interest costs if they borrow money to pay for the construction.

Under IFRS, companies can capitalize interest costs for capital assets that are constructed or acquired over time, if the costs are directly attributable to the acquisition. The interest costs can only be capitalized until the capital asset is complete and ready for use, however. Once the asset is ready to use, all subsequent interest costs must be expensed through the statement of earnings.

For assets that are purchased rather than constructed, interest costs are usually not capitalized. The time between acquisition and when it is ready to use is usually too short to make interest capitalization meaningful.

DEPRECIATION CONCEPTS

Depreciation is a systematic and rational method of allocating the cost of capital assets to the periods in which the benefits from the assets are received. This matches the asset's expense in a systematic way to the revenues that are earned in using it, and therefore satisfies the matching principle, described in Chapter 2. The company does not show the capital asset's entire cost as an expense in the period of acquisition, because the asset is expected to help generate revenues over multiple future periods. Matching some portion of a capital asset's cost to the company's revenues, along with its other expenses, results in a measurement of net profit or loss during those periods.

To allocate the expense systematically to the appropriate number of periods, the company must estimate the asset's useful life—that is, the periods over which the company will use the asset to generate revenues. The company must also estimate what the asset's ultimate residual value will be at the end of its useful life. It does this by looking at the current selling price of similar assets that are as old as the asset will be at the end of its useful life. Once the asset's useful life and residual value have been estimated, its depreciable cost (acquisition cost minus the residual value)—the portion of the asset's cost that is to be depreciated—must then be allocated in a systematic and rational way to the years of useful life. (The term “acquisition cost” refers here to the total capitalized cost of the asset.)

It is important to note that depreciation, as used in accounting, does not refer to valuation. Rather, it is a process of cost allocation. While it is true that a company's capital assets generally decrease in value over time, depreciation normally does not attempt to measure this change in value each period.

The choice of which method to use to allocate a cost across multiple periods will always be somewhat arbitrary. Accounting standards require that the depreciation method reflect the pattern of the economic benefits that are expected to be realized from using the asset. Simply stated, the chosen depreciation method must be a rational and systematic method that is appropriate to the nature of the capital asset and the way it is used by the enterprise. In addition, the method of depreciation and estimates of the useful life and residual value should be reviewed on a regular basis.

Even though accounting standards do not specify which depreciation methods may be used, most companies use one of the methods discussed in the next section.

Depreciation Tutorial

DEPRECIATION METHODS

As accounting standards developed, rational and systematic methods of depreciation capital assets were created. The simplest and most commonly used method (used by more than 50 percent of Canadian companies) is the straight-line method (illustrated in Chapter 2), which allocates the asset's depreciable cost evenly over its useful life. Many accountants have argued in favour of this method for two reasons. First, it is a very simple method to apply. Second, for assets that generate revenues evenly throughout their lives, it properly matches expenses to revenues. It might also be argued that, if an asset physically deteriorates evenly throughout its life, then straight-line depreciation would reflect this physical decline.

A second type of depreciation method recognizes that the usefulness or benefits derived from some capital assets can be measured fairly specifically. This method is usually called the units-of-activity or production method. Its use requires that the output or usefulness that will be derived from the asset be measurable as a specific quantity. For example, a new truck might be expected to be used for a specific number of kilometres. If so, the depreciation cost per kilometre can be calculated and used to determine each period's depreciation expense, based on the number of kilometres driven during that accounting period.

For certain assets, the decline in their revenue-generating capabilities (and physical deterioration) does not occur evenly over time. In fact, many assets are of most benefit during the early years of their useful lives. In later years, when these assets are wearing out, require more maintenance, and perhaps produce inferior products, the benefits they produce are much lower. This scenario argues for more rapid depreciation in the early years of the asset's life, when larger depreciation expenses will be matched to the larger revenues produced. Methods that match this pattern are known as accelerated or declining-balance methods of depreciation.

A fourth, but rarely used, depreciation method argues that for some assets the greatest change in usefulness and/or physical deterioration takes place during the last years of the asset's life, rather than in the first years. Capturing this pattern requires the use of a decelerated or compound interest method of depreciation. Although this type of depreciation method is not used much in practice, it is conceptually consistent with a present-value method of asset valuation.

Exhibit 8-1 illustrates the pattern of depreciation expense under the three methods with predictable methods of depreciation: straight-line, accelerated, and decelerated (these methods are discussed in detail later). Exhibit 8-2 illustrates the pattern of decline in an asset's carrying value under the same methods. The graphs are based on a $10,000 original cost, a 40-year useful life, and zero residual value.

EXHIBIT 8-1 ANNUAL DEPRECIATION EXPENSE

EXHIBIT 8-2 ASSET CARRYING VALUE

In Exhibit 8-1, you can see that with the straight-line method, the depreciation expense for each period is the same; this produces the even (or straight-line) decline in the asset's carrying value shown in Exhibit 8-2. With the accelerated method, Exhibit 8-1 shows that the annual depreciation expense is higher in the earlier years; this causes a faster decline in the net carrying value during the earlier years of the asset's life, as seen in Exhibit 8-2. For the decelerated method, on the other hand, Exhibit 8-1 shows that the depreciation expense is much lower in the earlier years; this results in a much slower decline in the asset's carrying value during the earlier years of the asset's life, as shown in Exhibit 8-2. However, although the pattern of recognition is different, the total amount of expense taken over the asset's life is the same for all methods. This is evidenced by the fact that, as shown in Exhibit 8-2, all the methods start with a carrying value of $10,000 and end with a carrying value of zero (indicating that each method transfers the entire depreciable cost to expense during the asset's life).

Note that Exhibits 8-1 and 8-2 do not show the units-of-activity or production method because there is usually no consistent or predictable pattern with this method, since the annual amount of depreciation expense depends on the actual usage each year.

To now illustrate each of the depreciation methods, we will use the following example:

Straight-Line Method

The most commonly used method of depreciation for financial reporting is the straight-line method, which assumes that the asset's cost should be allocated evenly over its life. Using our example, the depreciation would be calculated as in Exhibit 8-3.

Depreciation expense of $9,000 is recorded each year for five years, so that by the end of the asset's useful life the entire depreciable cost of $45,000 (i.e., $50,000 − 5,000) is expensed and the carrying value of the asset is reduced to its residual value of $5,000.

Even though the straight-line method can be described by the estimated useful life and estimated residual value, it is sometimes characterized by a rate of depreciation. The rate of depreciation with the straight-line method is determined by taking the inverse of the number of years, 1/N, where N is the number of years of estimated useful life. In the case of the asset in the example, depreciating it over five years means a rate of 1 ÷ 5, or 20% per year. This is referred to as the straight-line rate. Note that 1 ÷ 5 or 20% of the depreciable cost of $45,000 is $9,000 per year.

Units-of-Activity or Production Method

Another method to calculate depreciation uses as its basis the assumption that benefits from a capital asset are directly related to the output or use of that asset. Note that the straight-line method of depreciation assumes that benefits derived from capital assets are related to time, disregarding how much the assets are actually used during each period. In contrast, the units-of-activity or production method relates benefits to actual usage, which means that it best satisfies the matching principle.

EXHIBIT 8-3 STRAIGHT-LINE METHOD OF DEPRECIATION

Under the units-of-activity method, the asset's useful life is estimated and expressed as units of output or activity, rather than years of service. For example, trucks can be depreciated using this method if their expected useful lives can be expressed in kilometres driven or hours used. Machinery used in manufacturing products may have an expected useful life based on the total number of units of output. Depreciation expense is then determined by calculating the depreciation cost per unit, and multiplying this cost per unit by the actual number of units produced or used for the period. The formula for calculating depreciation expense per unit for the units-of-activity or production method is as follows:

To calculate the depreciation expense for the period, simply multiply this per-unit cost by the total number of units produced or used during the period. Exhibit 8-4 illustrates this method using our previous example.

EXHIBIT 8-4 UNITS-OF-ACTIVITY OR PRODUCTION METHOD OF DEPRECIATION

Accelerated or Declining-Balance Method

The accelerated method of depreciation assumes that most of the benefits from the asset's use are realized in the early years. Most accelerated methods are calculated by multiplying the asset's carrying value by a fixed percentage. Because the carrying value (cost less accumulated depreciation) decreases each year (since the accumulated depreciation increases each year by the amount of the depreciation expense recorded), the resulting amount of depreciation expense decreases each year.

The formula for calculating accelerated or declining-balance depreciation follows:

The percentage that is used in these calculations is selected by management based on their judgement of how quickly the asset's usefulness will decline. The faster the expected decline, the higher the percentage selected. Different types of capital assets will be assigned different percentages. A capital asset with a relatively long expected useful life (such as a building) would have a fairly small percentage (such as 5% or 10%), while a capital asset with a relatively short expected useful life (such as equipment) would have a larger percentage (such as 20% or 30%).

One method of establishing the percentages to be used is the double-declining-balance method. With this method, the percentage selected is double the straight-line rate. Thus, using the example shown in Exhibit 8-3, the acquisition cost of an asset with a five-year expected useful life would be depreciated over five years on a straight-line basis (that is, 1/5 or 20% per year), but would be depreciated at 40% using the double-declining-balance method. However, even though this method appears to be based on fairly concrete numbers, it must be remembered that the 40% rate is very questionable (since the 20% is based on an estimate and doubling it is arbitrary).

Exhibit 8-5 shows the calculation under double-declining-balance depreciation using our ongoing example. Note that, under this method, the asset's residual value does not directly enter into the calculation of the depreciation expense. Instead, the estimated residual value serves as a constraint; the final net book value should equal the residual value. In the example in Exhibit 8-5, this means that in 2015 the company has to record $1,480 of depreciation expense, to reduce the asset from its net book value of $6,480 at the end of 2014 to its residual value of $5,000 at the end of 2015.

In this case, only a small amount of depreciation had to be taken in the final year. In other cases, however, a large amount of depreciation expense might have to be recorded in the last year of the asset's life in order to make the final carrying value equal to its residual value. For example, suppose that the residual value of the equipment was expected to be only $2,000 (rather than $5,000). If this were the case, the depreciation schedule would be the same as shown in Exhibit 8-5 except that in 2015 the company would have to record $4,480 of depreciation expense in order to reduce the asset's carrying value from $6,480 at the end of 2014 to its assumed residual value of $2,000 at the end of 2015.

Recording Depreciation Expense

Regardless of the depreciation method, the recording of the expense is the same. The account Depreciation Expense is debited and Accumulated Depreciation is credited. The credit side of the entry is made to an accumulated depreciation account, not to the asset account. The accumulated depreciation account is a contra asset account that is used to accumulate the total amount of depreciation expense that has been recorded for the capital asset over its lifetime. The asset account shows the asset's acquisition cost, and the accumulated depreciation account shows how much of the cost has already been expensed. To give statement users more information, the accumulated depreciation account is used as an offset to the asset account, instead of reducing the asset directly. If users can see what the original cost was, they may be able to estimate how much the company will have to pay to replace the asset. Also, when the accumulated depreciation is offset against the asset, users can determine how much of the asset has been depreciated and can make a judgement about how soon the asset will need to be replaced.

EXHIBIT 8-5 DOUBLE-DECLINING-BALANCE METHOD OF DEPRECIATION

Capital assets are rarely acquired on the first day of a fiscal year. Most assets are acquired partway through the year, and companies have to then choose among the following accounting conventions for calculating depreciation. One convention is “the nearest whole month” rule. This convention calculates depreciation for the whole month if the asset was purchased in the first half of the month, because the asset was used for most of the month. If the asset was purchased in the last half of the month (the 15th of the month to the end), no depreciation is taken in that month, because the asset was used for less than half a month. A second convention is the “half year” rule. In this convention, half a year's depreciation is taken in the year the asset is acquired and in the year of disposal no matter when the asset was acquired or sold in the year. There are other conventions that can be used but knowing these two is sufficient for now.

In financial statements, companies normally show the total original costs of all tangible capital assets separately by category (such as land, buildings, and equipment) with accumulated depreciation for each category. Some companies show only one total for accumulated depreciation for all the various asset categories. Many companies show only the total net book value (cost less accumulated depreciation) in the statement of financial position, with the details provided in a note to the financial statements.

An example of detailed disclosures regarding property, plant, and equipment (sometimes called fixed assets) and related accumulated depreciation is shown in Exhibit 8-6. The information provided by Finning International Inc. related to its land, buildings, and equipment in its 2009 annual report is fairly typical of the type of supporting detail that is usually provided in notes accompanying the financial statements. Finning International is the largest Caterpillar dealer, selling, leasing, and servicing Carterpillar's heavy equipment in Canada.

In addition to recording regular depreciation expense, companies must periodically compare their assets' carrying values with the future benefits they expect to derive from their use. If the net book value, or carrying value, of an asset is higher than the future amount recoverable from the asset, it must be written down and a loss recorded to reflect the impairment in the asset's value. (Note that this is conceptually similar to the lower of cost and market valuation that is applied to inventories: the value recorded for an asset should not exceed its net realizable value, through use and/or sale.)

CORPORATE INCOME TAXES

The Canada Revenue Agency (CRA) does not allow companies to deduct depreciation expense when calculating their taxable income. However, it does allow a similar type of deduction, called capital cost allowance (CCA). In other words, although accountants deduct depreciation expense when they calculate net earnings on the statement of earnings, they have to use capital cost allowance instead of depreciation expense when they calculate the company's taxable income on its income tax return. CCA is calculated in a manner similar to accelerated depreciation, with several exceptions (described below).

EXHIBIT 8-6  FINNING INTERNATIONAL INC. 2009 ANNUAL REPORT

Since the depreciation expense for accounting purposes and CCA for tax purposes are usually different amounts, the net carrying value of the capital assets in the company's accounting records will be different from the value in its tax records. For tax purposes, the net carrying value of capital assets is referred to as their undepreciated capital cost (UCC). So, while a company's accounting records will show the net book value (NBV) of its capital assets, its tax records will show a different value (the UCC) for these assets. To account for this difference, a deferred tax asset or liability results.

While it is not the purpose of this text to teach you about income taxes, which are subject to very complex rules, you should understand the basics of how capital cost allowance works. For tax purposes, capital assets are grouped into classes as defined by the Income Tax Act. For example, most vehicles are grouped into Class 10 and most equipment into Class 8. Each class has a prescribed rate that is used to calculate the maximum amount that may be deducted. For example, Class 10 has a rate of 30% and Class 8 has a 20% rate. In the year of acquisition, however, the maximum CCA that may be deducted for new assets is half of the normal amount.

Continuing with our previous example of a company that purchases equipment with a cost of $50,000 (and an estimated useful life of five years with a residual value of $5,000), and assuming that the equipment falls into Class 8 with a CCA rate of 20%, for tax purposes the company can deduct the following during the first four years.

Since the UCC is the equivalent of net book value for tax purposes, it declines each year by the amount of CCA claimed.³ You should also note that neither the estimated useful life of the asset nor its residual value are relevant for CCA calculations.

We have deliberately not shown 2015 in the table above, because what will be done for tax purposes in the final year of an asset's life depends on several factors that are beyond the scope of an introductory accounting text.

Assuming the company uses straight-line depreciation for accounting purposes, the annual depreciation expense is $9,000 per year (as shown in Exhibit 8-3). Exhibit 8-7 presents some additional data for the company and the calculation of income taxes for the first year of the asset's life, using an income tax rate of 40%.

It seems logical that the tax expense reported on the statement of earnings should be calculated based on the accounting earnings before tax that is reported on the statement of earnings, multiplied by the tax rate.⁴ In this example, the tax expense for the year will be $10,000 (as shown above). However, the amount owed to the CRA will be based on the taxable income reported on the company's income tax return. In this example, the tax payable for the year will be $11,600 (as shown above). The difference between these two amounts is recorded as a deferred income tax asset of $1,600. The journal entry to record the company's taxes is as follows:

EXHIBIT 8-7 DEFERRED INCOME TAX CALCULATIONS

As you can see in the preceding entry, the debit to tax expense is less than the credit to the tax payable account. To make the entry balance, we therefore have to debit the difference to a deferred income tax account.

As shown in the lower portion of Exhibit 8-7, the $1,600 difference between the amount of income tax expense for the period and the amount of income tax that has to be paid currently reflects the difference between the carrying values of the capital assets for accounting purposes (NBV of $41,000) and tax purposes (UCC of $45,000), multiplied by the tax rate. Whenever the carrying value of the capital assets for tax purposes is larger than their carrying value for accounting purposes, less tax will be paid in the future because the larger amount remaining for tax purposes will result in larger tax deductions in the future. The deferred income tax amount is therefore recorded as an asset, because it represents a benefit in the form of future income tax reductions.

The deferred income tax account will have a credit balance and be called a deferred income tax liability whenever the carrying value of the capital assets for tax purposes (their UCC) is smaller than their carrying value for accounting purposes (their NBV). When this occurs, more tax will have to be paid in the future, because the smaller UCC will result in smaller future CCA deductions. Thus, a deferred income tax liability represents tax that will have to be paid by the company later in the life of the capital assets, when the CCA deductions for tax purposes will be lower.

In summary, these deferred income tax balances arise from differences between the carrying value of capital assets for tax purposes (i.e., their undepreciated capital cost) compared with their carrying value for accounting purposes (i.e., their net book value). The discussion of income taxes is continued in Chapter 9.

CHOICE OF DEPRECIATION METHOD

Companies are free to use any of the depreciation methods that have been discussed, or other systematic and rational methods that suit their circumstances. The majority of companies use the straight-line method, probably because of its simplicity.

For practical reasons, because CCA is required for income tax purposes, many smaller companies choose to use it for their accounting depreciation as well. By doing so, they only have to do one set of calculations, and their record keeping and tax reporting are simplified.

CHANGES IN DEPRECIATION ESTIMATES AND METHODS

Because the expected useful life and residual value are estimates, the assumptions used in their estimation may change over time. Companies must periodically revisit these estimates to ensure that they are still valid. For example, after an asset has been in service for several years, the company may change its estimate about the asset's remaining useful life. The asset may last longer or deteriorate faster than originally anticipated. Like all accounting estimate changes, a change in an estimate that is used to calculate depreciation is handled prospectively (in current and future periods). Note that there is no restatement of prior periods when an estimate is changed.

To illustrate how a change in depreciation assumptions is handled, the depreciation example in Exhibit 8-3 will be used. Assume that after the asset has been depreciated for three years the company decides that it has three more years of useful life left (i.e., it is now expected to have a useful life of six rather than five years), and its residual value at the end of the 2016 is expected to be $2,000. Based on these new assumptions, the company will recalculate its depreciation for years 2014, 2015, and 2016. The new calculation is based on the remaining net book value of $23,000 at the end of 2013, as shown in Exhibit 8-3. The revised depreciation schedule will be as shown in Exhibit 8-8.

The disclosure of changes in estimates in financial statements usually describes the nature of the change and the effects on the current year, if they are material. Companies are not required to make this type of disclosure, but voluntary disclosure improves the usefulness of the financial information.

Depreciation amounts can also change when new costs are added to the asset account as a result of major repairs or improvements to the asset. These generally will require new estimates of the asset's useful life and/or residual value, and are handled in the same way as changes in accounting estimates are.

During an asset's life, a company may also decide that a different depreciation method would more appropriately match the depreciation expense with the benefits received from the asset. If the decision to change to a different depreciation method is made as a result of changed circumstances, experience, or new information, the change is treated in the same way as changes in estimates are. The new depreciation method is applied to the asset's carrying value at the time that the change is made, and the company uses the new method over the asset's remaining useful life. If, however, the company determines that the change in depreciation method will provide more reliable and relevant information, the change must be recognized retrospectively by restating prior years' financial statements to incorporate the new depreciation method.

EXHIBIT 8-8 EXAMPLE OF CHANGES IN ESTIMATES OF USEFUL LIFE AND RESIDUAL VALUE

ADDITIONAL EXPENDITURES ON CAPITAL ASSETS DURING THEIR LIVES

It was mentioned above that new costs may be added to an asset account during the asset's life for major repairs and improvements. Typically, there will also be expenditures for maintenance and minor repairs throughout an asset's life. We must therefore consider how we should account for these types of costs. Should they be capitalized, as part of the asset's cost, or charged directly to expense? If these costs are capitalized, they will be charged to expense over several periods, in the form of depreciation. On the other hand, if they are expensed, they will go directly onto the current period's statement of earnings.

The general guideline to be followed here is that non-routine costs (such as those for major repairs and improvements) are usually capitalized, while the costs of routine items (such as maintenance and minor repairs) are expensed. The former types of costs are likely to increase the future benefits to be received from the asset (by extending its useful life, lowering its operating costs, or increasing its productivity). Therefore, in terms of the matching principle, it makes sense to capitalize these expenditures and then depreciate them over the periods that benefit from them.

WRITEDOWNS AND DISPOSALS OF PROPERTY, PLANT, AND EQUIPMENT

Sometimes the future recoverable value of a capital asset (which reflects its ability to generate revenue and contribute to earnings in the future) declines below its carrying value. Some possible reasons for this decline are technological change, damage to the asset, or a change in the company's market. If the recoverable value of an asset is less than its net book value, the company must reduce (or write down) the asset's carrying value. This is accomplished by recognizing a loss on the statement of earnings and increasing the accumulated depreciation account by the amount of the loss. Increasing the accumulated depreciation decreases the net book value of the asset.

For example, suppose that at the end of the 2013, when the book value of the asset in Exhibit 8-3 is $23,000, the company determines that as a result of damage to the equipment the recoverable amount from its future use will be only $20,000. The following entry would be made to record the required writedown:

In all likelihood, subsequent to this decline in value the company would review the asset's estimated useful life and residual value so that changes could be made to the depreciation in future periods, if necessary.

At the end of an asset's useful life, the company usually disposes of it and replaces it with another asset, especially if the line of business is growing and prospering. In lines of business that are declining or being discontinued, old assets are not replaced and may even be sold or written off before they reach the end of their useful lives.

Normally, at the end of an asset's life, it is sold. If the company has accurately projected the residual value, there will be no gain or loss on the sale of the asset. However, if the residual value was not estimated accurately, either a gain or loss will result from this transaction. For example, suppose that the asset in Exhibit 8-3 is sold at the end of its useful life for $6,000. (Recall that its original cost was $50,000 and that its residual value was expected to be $5,000.) The following entry would be made to record its sale:

In this entry, the total depreciation recorded during the asset's life is removed from the accumulated depreciation account, at the same time as the original cost is removed from the equipment account. Note that the net of these two amounts is the asset's carrying or net book value at the time of sale, $5,000 ($50,000 − 45,000). Note also that you cannot simply credit the equipment account for the net amount of $5,000, as that would leave $45,000 in the asset account and $45,000 in the accumulated depreciation account when the asset is no longer owned by the company.

If the asset had been worthless at the end of its useful life, the asset's disposal would be recorded as above, except that no cash would be received. If we assume that no cash is received, then the write-off of the asset in our example would result in the following entry:

Note that, since the asset is worthless, the remaining net book value of $5,000 is written off and recorded as a loss on disposal.

NATURAL RESOURCES

Companies that deal with natural resources face some unique problems not associated with investments in property, plant, and equipment. For example, consider the situation of oil exploration companies, which incur large costs in their attempts to find oil. Some explorations are successful in finding oil and others are not. Should the costs of unsuccessful exploration be capitalized on the statement of financial position as assets, or should they be written off directly as expenses? If these costs are capitalized as assets, this implies that they have future value. But do they? And if the costs are capitalized, how should they be expensed? That is, what is the useful life of the asset being created, and what is a reasonable pattern of depreciation expense allocation over the useful life?

At the time of writing of this textbook, under IFRS there did not yet exist a standard for the oil and gas industry. Instead, companies were encouraged to continue to use accounting methods that had been used in the past as long as they continued to provide relevant information. In Canada, such companies have a choice of two methods to account for exploration costs: the full cost method and the successful efforts method. The full cost method capitalizes the costs of all explorations, both successful and unsuccessful, as long as the expected revenues from all the explorations are estimated to exceed the total costs. (The logic behind capitalizing the costs of unsuccessful exploration efforts is that, even though these attempts were not successful, they are necessary costs of finding oil and will produce future benefits because they will lead to successful attempts.) The successful efforts method, on the other hand, capitalizes only the cost of successful explorations and expenses any unsuccessful exploration costs. Sufficient time is allowed to determine whether an effort is or is not successful.

Generally, smaller oil companies use the full cost method, because using the successful efforts method would make their earnings appear to be very uneven from one accounting period to another, depending on the results of the wells they drilled during that particular period. Larger oil companies drill more wells every period, so they tend to use the successful efforts method because it is simpler to apply and its use over a large base does not produce uneven results from period to period.

Exhibit 8-9 includes examples from two companies.

EXHIBIT 8-9  ACCOUNTING FOR EXPLORATION AND DEVELOPMENT COSTS—FULL COST AND SUCCESSFUL EFFORTS METHODS

Note that Alberta Oilsands Inc., an exploration and development company involved in the petroleum and natural gas industry in the Athabasca region of Alberta, uses the full cost method. It capitalizes the costs of drilling both productive and unproductive wells. In contrast, Suncor Energy Inc., a company involved in oil development in the tar sands of northern Alberta, uses the successful efforts method for its acquisition costs and exploratory drilling costs. Exploratory drilling costs of wells without proven reserves are expensed. Under the full cost method, all exploration costs are first capitalized and then expensed, through depreciation, over the life of the producing wells. Consequently, initial expenses are lower and subsequent depreciation charges are higher. Under the successful efforts method, only the costs associated with successful sites are capitalized and later depreciated over the period of production. Consequently, initial expenses are higher as the costs of the unsuccessful wells are expensed and subsequent depreciation charges are lower.

The depreciation of natural resources is often referred to as depletion. The depreciation method most commonly used is the units-of-activity or production method. For example, in the case of an oil field, the total number of barrels of oil expected to be produced from the field would be estimated. The depreciation expense would then be calculated by dividing the capitalized costs by the estimated total number of barrels to be produced from the field, to get a depreciation rate per barrel. This would then be multiplied by the number of barrels extracted each period.

For example, assume that a company estimates a field to contain 2 million barrels of oil. During an accounting period, 500,000 barrels of oil are extracted from the field. If the capitalized costs related to the oil field are $6 million, then the depletion expense recorded for the period would be $1.5 million.

INTANGIBLE ASSETS

As discussed earlier in the chapter, some assets can have probable future value to the company but not have any physical form. The knowledge gained from research and development or the customer awareness and loyalty produced by a well-run promotional campaign are examples of possible intangible assets. The companies that engage in these activities certainly hope that they will benefit from having spent money on them. However, the difficulty of determining the costs of producing intangible assets such as research and development knowledge or customer awareness and loyalty, and of quantifying the benefits that will be derived from them, make intangible assets a troublesome area for accountants. Although accountants would generally agree that these might constitute assets, the inability to provide reliable data concerning their costs and future benefits makes it hard to record these items objectively in the company's accounting system.

The capitalization guideline for intangible assets is that, if they are developed internally, the costs of developing them are expensed as incurred and no asset values are recorded. If intangible assets are purchased from independent entities, however, they can be capitalized at their acquisition costs.

An exception to this general guideline occurs with the development costs for a product or process. If certain conditions are met, these development costs may be capitalized and depreciated over the product's useful life. However, the basic research costs that occurred prior to any decision to develop the product or process are still expensed. The conditions for capitalization stipulate that the product or process must be clearly definable, technical feasibility must be established, management must intend to market the product in a defined market, and the company must have the resources needed to complete the project. These requirements are intended to ensure that development costs will be capitalized only if the product or process is actually marketable and will therefore produce future benefits in the form of revenues.

The depreciation of an intangible asset is often referred to as amortization. Depreciating the cost of an intangible asset is similar to depreciating other capital assets. The company must estimate the asset's useful life and residual value (if any). Because of the estimation problems associated with intangible assets, this is sometimes very difficult to do. Typically, the method to depreciate intangibles is the straight-line method, with a residual value of zero. The useful life depends on the type of intangible asset. The one aspect of depreciation that is different for intangibles is that the accumulated depreciation account is rarely used. Most companies reduce their intangible assets directly, when they depreciate them. Because of the uncertain valuation of intangibles and the fact that these assets normally cannot be replaced, it is not as important for users to know what the original costs were. For example, the journal entry to record the depreciation of a patent would probably be as follows:

When estimating the useful life of an intangible asset, both the economic life and the legal life should be considered. Many intangible assets (such as patents and copyrights) have very well-defined legal lives, but may have less well-defined and shorter economic lives. Any intangible asset that has a definite life should be depreciated over its economic life or its legal life, whichever is shorter.

Note, however, that some intangible assets (such as trademarks and goodwill) have indefinite lives. Intangible assets with indefinite lives should not be depreciated in the usual manner. Instead, each of these assets must be evaluated each year to determine whether there has been any impairment in its value. If there has, the asset should be written down. If there has not, the asset will remain at its current carrying amount until the following year, when it will be evaluated again.

Several types of intangible assets pose special problems. These are discussed in the following sections.

Advertising

Companies spend enormous amounts of money advertising their products to increase current and future sales. Do expenditures on advertising create an asset for the company? If the advertising is successful, then the answer is probably yes. But how can the company know whether the advertising will be successful and what time periods will receive the benefits? If customers buy the company's products, it may be due to the advertising; but it may also be because they just happened to be in the store and saw them on the shelf, or because their neighbours have one, or because of many other factors. The intent of advertising is clearly to generate future benefits, which would usually lead to recording an asset; but determining the existence of the future benefits and measuring their value can be extremely difficult. These measurement uncertainties are so severe that accountants generally expense all advertising costs in the period in which the advertising occurs. If a company does capitalize this type of cost, it has to provide very strong evidence to support the creation of an asset.

Many companies spend a lot on advertising related to sporting events such as the Olympic Games and the World Cup. In many of these cases, the money is spent not just on advertisements during the games but also on pre-game financial support to the athletes, who then wear clothing and use equipment with the sponsors' logos on it. As you can probably imagine, it is very difficult to know how much future benefit will be received from these expenditures, and over what period of time.

Patents, Trademarks, and Copyrights

Patents, trademarks, and copyrights are legal entitlements that give their owner rights to use protected information. If the protected information has economic value, then the agreements are considered assets. Of course, determining whether they have value or not, and estimating the period over which the rights will continue to have value, can be a difficult task. Each entitlement may have a legal life associated with it, which may differ from its economic life. For example, in Canada a patent has a legal life of 20 years, but this does not mean that it will have an economic life of 20 years. The patent on a computer chip, for example, may have a useful economic life of only a few years, as a result of technological innovation. On the other hand, trademarks like Coca-Cola^® may have an indefinite life. Copyrights have a legal term of the life of the creator plus 50 years. As with any intangible asset, the legal life serves as a maximum in the determination of the asset's useful life for accounting purposes.

A company usually records these types of intangible assets only if it buys them from another entity. The costs of internally developed patents, trademarks, and copyrights are generally expensed, although some easily identifiable costs (such as registration and legal costs associated with obtaining a patent, trademark, or copyright) may be capitalized. These costs are then usually depreciated on a straight-line basis over the asset's estimated useful life.

In some cases, significant costs are subsequently incurred to defend and enforce patents, trademarks, and copyrights. Any costs related to successfully defending or enforcing these rights can be capitalized.

Goodwill

The intangible asset called goodwill represents the above-average profits that a company can earn as a result of a number of factors. For example, exceptional management expertise, a desirable location, and excellent employee or customer relations could give one company an economic advantage over other companies in the same industry and enable it to earn above-average profits.

Companies incur costs to create these types of goodwill. Advertising campaigns, public service programs, charitable gifts, and employee training programs all require outlays that, to some extent, contribute to the development of goodwill. This type of goodwill is sometimes referred to as internally developed goodwill.

As with other intangible assets, the costs of internally developed goodwill are expensed as they are incurred. In practice, goodwill is recorded as an asset only when it is part of the purchase price paid to acquire another company. Goodwill is not an easily identifiable asset, but is represented by the amount paid by the acquiring company for various valuable but intangible characteristics of the acquired company (such as good location, good management, etc.). These characteristics, in effect, give the acquired company a value that exceeds its identifiable assets (its buildings, inventory, etc.).

The measurement and recognition of goodwill are discussed in more detail in Appendix B at the end of the book. At this point, the most important thing to note about goodwill is that it can be acquired only through the purchase of another company at a price that is greater than the value of its identifiable assets.

As mentioned in an earlier section, an intangible asset with an indefinite life—such as goodwill—is not depreciated. Instead, management is required to periodically review the goodwill's carrying value to determine whether there is evidence that it has been impaired. If it has, the goodwill should be written down (i.e., reduced in value) and an impairment loss recognized.

Examples of the disclosure of goodwill and other intangible assets are shown in Exhibit 8-10 for Ballard Power Systems Inc., which designs, manufactures, sells, and services fuel cell products. As at December 31, 2009, Ballard Power Systems' reported goodwill and other intangible assets accounted for 25 percent of the company's total asset value. By contrast, its property, plant, and equipment constituted only 20 percent of its total assets. This is not uncommon in some industries, especially with high-technology ventures.

Note as well that the value reported for Ballard Power Systems' goodwill ($48.106 million) did not change during the year, which seems to indicate that there was no impairment or writedown, nor any more acquisitions.

EXHIBIT 8-10 EXAMPLE OF A COMPANY WITH LARGE AMOUNTS OF GOODWILL AND OTHER INTANGIBLE ASSETS, BALLARD POWER SYSTEMS INC.

Comprehensive Example of Capital Asset Disclosures

Due to the large number of policy issues associated with accounting for capital assets, companies usually have extensive disclosures about them in their notes. Exhibit 8-11 shows excerpts from the summary of significant accounting policies related to property, plant, and equipment, goodwill, and other intangible assets in the 2009 annual report of Imperial Oil Limited. The company operates Esso retail gas stations throughout Canada, and is a major Canadian producer of crude oil and natural gas. Notice that the note includes references to the following:

• the successful efforts method of accounting for its exploration and development activities
• its treatment of the costs of maintenance, repairs, and improvements (indicating that only those that prolong the service life or increase the capacity of an asset are capitalized)
• its policy regarding the capitalization of interest charges on capital projects under construction
• extensive discussion of its depreciation and depletion policies, for both tangible and intangible assets (including the methods and estimates of useful lives being used for different types of assets)
• its policy of periodically reviewing its properties and goodwill to check for impairment of their values

EXHIBIT 8-11  EXAMPLE OF DISCLOSURE OF SIGNIFICANT ACCOUNTING POLICIES RELATED TO CAPITAL ASSETS, IMPERIAL OIL LIMITED, 2009

STATEMENT ANALYSIS CONSIDERATIONS

The choice of depreciation method affects both the value of the assets reported on the statement of financial position and the amount of expense reported on the statement of earnings. The use of different depreciation methods for capital assets can therefore produce significantly different results in the financial statements of two otherwise similar companies. For example, during the first few years of its assets' lives, a company using the straight-line method will show higher carrying values for its capital assets on its statement of financial position, as well as lower expenses on its statement of earnings, than a similar company using an accelerated depreciation method. For many companies, depreciation is one of their largest expenses; consequently, the choice of a depreciation method can have a significant impact on a company's net earnings.

Probably the biggest concerns in the analysis of capital assets are understanding which assets are not reported on the statement of financial position (i.e., those that were developed internally and therefore not recorded as assets), and what market values can be assigned to the capital assets that are reported on the statement of financial position. The historical cost figures for property, plant, and equipment may be very old. Even though the company is not holding these assets for resale, it will have to replace them at some point and, therefore, the replacement cost may be relevant. In Canada, companies are not required to disclose replacement cost information. Under IFRS, however, companies can choose to value their property, plant, and equipment at fair value. Most companies have decided to stay with historical cost because it is easier and less expensive to implement.

Another issue is that the user is not able to determine how much is invested in each component of property, plant, and equipment if these assets are reported as a single amount. This information could be important to users as they attempt to anticipate future outflows of cash for the replacement of these assets. Although some additional information is usually provided in the notes that accompany the financial statements, in most cases it is still not detailed enough to be very useful. Even if a company assigns three separate amounts for property, plant, and equipment, the user is still missing some important pieces of information that could be useful in evaluating the company. For example, if a single amount for buildings is disclosed, the user still does not know how many buildings are included, where they are located, when the buildings were acquired, or when they will have to be replaced. Without this information, the user has no way of determining fair values or replacement costs.

A potentially big problem is that many intangible assets that have been developed internally do not appear on the company's financial statements, because their costs have been expensed as they were developed. For example, it is possible for a company to have developed a patent that will generate revenues for several years. This potentially valuable economic resource is typically not listed as an asset at all. A similar problem arises with respect to goodwill. If it has been developed internally, goodwill will not appear on the company's statement of financial position as an asset, even though it may exist and be very valuable. The large dollar amounts that companies are willing to pay for goodwill when they purchase other companies testify to the substantial value that these assets can have. A failure to consider these assets can lead different analysts to draw significantly different conclusions about a company's value.

A final general concern with regard to financial statement analysis is whether the capital assets listed on the company's statement of financial position are really worth the amounts that are reported. For example, the conditions that gave rise to goodwill at the date of acquisition may have changed since that time. Suppose the goodwill was due to the technical expertise of some key employees of the business that was acquired. If these employees retire, or otherwise leave the company after acquisition, then the goodwill could be worth much less. Although this decline in value may result in an impairment loss being recorded, but due to the way the annual impairment test is conducted, it also might not. For this reason, analysts generally have a considerable amount of skepticism about the value of goodwill and other intangible assets.

Using the Return on Assets (ROA) Ratio

Despite the unknowns associated with capital asset values, a ratio called the return on assets ratio, or ROA, is widely used to assess how well management has used the company's assets to generate earnings. This ratio expresses the total return (or earnings) that was earned as a percentage of the total assets that were used to generate the earnings.

The ROA is calculated using the company's net earnings for the period, which does not factor in payments to debtholders or dividend payments to shareholders. Interest expense, however, is deducted in the calculation of net earnings and needs to be added back into the ROA calculation. Interest expense is added back into the net earnings amount so that interest expense and debt payments are treated in a similar way—i.e., the earnings amount should not factor in either of these amounts.

A further complication arises because interest is a deductible expense in the calculation of income tax expense. Therefore, when the net earnings figure is adjusted for the interest expense, we must also adjust the amount of income tax expense. In other words, the tax saving associated with the interest expense deduction must be removed from the earnings. The return on assets is therefore calculated by taking what the net earnings would have been without any interest charges and dividing it by the total assets (expressed as the average for the period, if possible: Assets at beginning of period + Assets at end of period ÷ 2). The following shows how the formula is derived:

For H&M, the calculation of ROA for the year ended November 30, 2009, is as follows (with the krona amounts shown in thousands):

As is the case with many ratios, a single ROA figure is not as meaningful as a comparison of rates of return over time, or across companies. However, before using ROA to compare different companies, you should check the notes to the financial statements to determine whether the companies' depreciation policies are comparable, as different depreciation policies will affect both the earnings and the total assets. You should also determine whether the companies have recently invested in new assets. This information will be available on the statement of cash flows. The acquisition of new assets will immediately increase the total asset amount but may not immediately increase the company's earnings proportionately; thus, they may temporarily decrease the ROA.

SUMMARY

In this chapter, we described the initial acquisition of capital assets—both tangible and intangible—noting the types of costs that are capitalized and recorded in the asset account. Capital assets include land, buildings, vehicles, equipment, natural resources, intangibles, and many other assets that have a useful life of more than one year. We explored several systematic, rational methods including the straight-line, declining balance, and units-of-output methods that are commonly used to depreciate the cost of capital assets. Depreciation expense is an estimate of the cost arising from the use of the assets each period. It is up to management to determine the appropriate depreciation rates, and to estimate the assets' useful lives and residual values.

We also took a brief look at the Canada Revenue Agency (CRA) in regard to depreciation. Because the CRA requires companies to use capital cost allowance for income tax purposes, there is usually a difference between the tax expense reported on the statement of earnings and the amount of income tax that is actually owed to the CRA. This difference is recorded as a deferred income tax asset or liability.

Because depreciation methods are based on estimates, it is important for management to periodically review the useful life and residual value assumptions to determine if they are still appropriate. If new values are established, the asset's remaining net book value is depreciated over its remaining useful life using the new values. Also, if a company decides to change depreciation method because a new method now seems more appropriate, it will depreciate the remaining depreciable cost of the asset over its remaining useful life using the new method.

We completed the chapter with a discussion of the return on assets ratio, including both its calculation and its limitations.

Additional Practice Problems

ABBREVIATIONS USED

CCA	Capital cost allowance
CRA	Canada Revenue Agency
NBV	Net book value
ROA	Return on assets
UCC	Undepreciated capital cost

SYNONYMS

Acquisition cost Cost Original cost Capitalized cost

Depreciated cost Net book value Carrying value

Depreciation Amortization

Units-of-activity method Production method

GLOSSARY

Accelerated method A method of depreciation that allocates a higher portion of an asset's cost to the earlier years of its life than to the later years.

Amortization A term sometimes used for the depreciation associated with intangible assets that are not natural resources.

Basket purchase A purchase of assets in which more than one asset is acquired for a single purchase price.

Capital assets Long-lived assets that are normally used by the company in generating revenues and providing services (e.g., buildings, equipment, etc.).

Capital cost allowance The deduction permitted by the Canada Revenue Agency for tax purposes, instead of depreciation.

Capitalizable cost A cost that can be recorded as an asset, rather than being expensed immediately.

Capitalized A term used to describe a cost that has been recorded as an asset, rather than an expense.

Carrying value The acquisition cost of a capital asset minus its accumulated depreciation. Synonym for net book value.

Compound interest method A depreciation method that calculates the expense for a period based on the change in the asset's present value.

Decelerated method A method of depreciation that allocates a lower portion of an asset's cost to the earlier years of its life than to the later years.

Declining-balance method A depreciation method that calculates the expense each period by multiplying the rate of depreciation by the asset's carrying value (which declines each period).

Deferred asset or liability An asset or liability account that arises when there is a difference between the carrying value of assets or liabilities for tax purposes versus those for accounting purposes. With respect to capital assets, it represents the tax effect of the difference between their carrying value for accounting purposes and their carrying value for tax purposes.

Depletion A term sometimes used to describe the depreciation of the cost of natural resources to expense, over the lives of the resources.

Depreciated cost The portion of the cost of a capital asset that is to be depreciated over its useful life; the original cost of the asset less its estimated residual value.

Depreciation The allocation of the cost of capital assets to expense over their useful lives.

Depreciation cost The calculated depreciation amount for an asset using an acceptable depreciation method.

Development costs Costs incurred to get a product or service ready for commercial production, after the initial stages of exploration or research (to discover the product or service) have been completed.

Double-declining-balance method A particular type of declining-balance depreciation method that is calculated by using a percentage rate that is double the rate that would be used for straight-line depreciation.

Earnings management The practice of choosing revenue and expense methods so that earnings are increased or decreased in particular accounting periods, or smoothed over time.

Full cost method A method of accounting for the exploration costs of oil and gas exploration companies in which all costs of exploration are capitalized and depreciated, without regard to the success or failure of individual wells. Commonly used in smaller oil and gas companies.

Goodwill An intangible asset that represents a company's above-average earning capacity as a result of reputation, advantageous location, superior sales staff, expertise of employees, etc. It is only recorded when a company acquires another company and pays more for it than the fair market value of its identifiable net assets.

Impairment loss The decline in the recoverable value of an asset below its current carrying value. It is recognized as a loss on the statement of earnings.

Intangible asset A non-physical capital asset that usually involves a legal right, which will provide future economic benefits to the organization.

Interest capitalization The recording of interest as part of the cost of constructing a capital asset.

Land improvements Improvements made to land that increase its usefulness, but which have limited lives and therefore have to be depreciated.

Net book value An asset's carrying value on the company books, found by subtracting its accumulated depreciation from the original cost.

Net realizable value An asset's selling price minus any costs to complete and sell it, or the net amount of cash that is expected to be obtained from an asset.

Net recoverable amount The estimated future net cash flow from the use of a capital asset, together with its residual value.

Production method A method of depreciation that allocates an asset's depreciable cost to the years of its useful life based on the volume of production or usage during each period. Synonym for the units-of-output or units-of-activity method.

Rate of depreciation A percentage that describes the amount of depreciation to be recorded during a given period. For straight-line depreciation, the rate is the reciprocal of the number of years of useful life.

Replacement cost An asset's market value, as determined from the market in which the company can purchase the asset, or the cost to reproduce the asset based on current prices of the inputs.

Resale value An asset's market value, as determined from the market in which it can be sold.

Research costs Costs incurred to discover new products or service. Subsequent costs to get the products or services ready for commercial production are classified separately, as development costs.

Residual value A capital asset's estimated net realizable value at the end of its useful life; measured using the current selling price of similar assets that are as old as the asset will be at the end of its useful life.

Return on assets ratio A measure of the amount of earnings (before deducting interest expense) earned in relation to the value of the assets of the business. Indicates how effectively the assets are being used to generate earnings.

Straight-line method A method of determining depreciation by dividing the original cost less the estimated residual value by the useful life of the asset. Allocates the same amount as depreciation expense each year.

Straight-line rate The rate of depreciation for the straight-line method, calculated as the reciprocal of the number of years of useful life (i.e., 1 ÷ years of life).

Successful efforts method A method of accounting for the exploration and drilling costs of oil and gas exploration companies in which only the costs of exploration for successful wells are capitalized and depreciated. The costs of unsuccessful efforts are charged to expense. Commonly used in larger oil and gas companies.

Tangible asset An asset that has physical substance.

Undepreciated capital cost An asset's carrying value for tax purposes. The portion of the asset's original cost that has not yet been deducted as capital cost allowance.

Units-of-activity method A method of depreciation that allocates an asset's depreciable cost to the years of its useful life as a function of the amount of its usage or production each period. Synonym for units-of-output or production method.

Useful life An estimate of the period of time over which an asset will have economic value to the company.

Value in use The value of an asset that is expected to result from using it in the business. Only relevant if the intent is to use the asset rather than sell it.

Self-Assessment Quiz

ASSIGNMENT MATERIAL

Assessing Your Recall

8-1 Describe what is meant by “value in use” versus “resale value,” as applied to capital assets.

8-2 Outline the types of costs that should be capitalized for a piece of equipment.

8-3 Describe the procedure that is used to allocate the cost of a basket purchase of assets to each asset that is acquired.

8-4 Explain why interest can be capitalized as part of an asset's construction costs.

8-5 Discuss the purpose of depreciation expense and the possible patterns of depreciation for a company.

8-6 Discuss the factors that should be taken into consideration when choosing a depreciation method.

8-7 Describe how to measure the residual value that is used in depreciation methods.

8-8 Describe how residual value and useful life are used in the calculation of depreciation under the following methods: straight-line, units-of-activity or production, and declining-balance.

8-9 Explain what is done when a company changes its estimate of an asset's useful life and/or residual value partway through the asset's life.

8-10 Explain what capital cost allowance (CCA) is and how it relates to depreciation expense.

8-11 Outline the differences between CCA and declining-balance depreciation.

8-12 Discuss the nature of deferred income taxes in the context of differences between depreciation and CCA.

8-13 Explain what a deferred income tax asset represents.

8-14 Describe the conditions under which intangible assets can be recorded in a company's accounting system, and use research and development costs, patents, and goodwill as examples.

8-15 Describe the guidelines under which the costs of intangible assets can be expensed over the assets' lives, and use research and development costs, patents, and goodwill as examples.

8-16 Discuss the conditions under which a company is required to record an impairment in the value of its capital assets.

Applying Your Knowledge

8-17 (Capitalizing costs related to capital assets)

C & M Securities made several expenditures during the current fiscal year, including the following:

Required:

1. For each of the items listed above, indicate whether the cost should be debited to land, land improvements, buildings, equipment, or an expense account.
2. For each item that was expensed, explain why it was not appropriate to add the amount to an asset.

8-18 (Acquisition costs and interest capitalization)

House Builders of Canada decided to expand its facilities and upgrade some of its log preparation equipment. The following events occurred during the year:

Required:

1. Determine the costs that should be capitalized as assets by Home Builders of Canada in its land, buildings, and equipment accounts.
2. State what should be done with any of the costs that are not capitalized.
3. If Home Builders of Canada borrowed money to finance the expansion, what two options would it have regarding the interest cost?

8-19 (Acquisition costs; basket purchase)

Morton Company purchased two machines at an industrial auction. It paid $120,000 for the two machines together, even though machine #1 was appraised at $62,000 and machine #2 was appraised at $70,000.

The company spent $5,000 transporting the two machines to its plant. It spent $6,000 installing machine #1, whereas machine #2 just had to be plugged in. Repairs to get the machines in working order totalled $3,000 for machine #1 and $16,000 for machine #2. Some repairs had been anticipated when the company purchased the machines, but the repair costs for machine #2 were $12,000 higher than expected. The repairs were deemed essential and both machines now work well.

Required:

Calculate the total cost that should be capitalized for each machine.

8-20 (Basket purchase and depreciation)

On March 20, 2011, FineTouch Corporation purchased two machines at auction for a combined total cost of $236,000. The machines were listed in the auction catalogue at $110,000 for machine X and $155,000 for machine Y. Immediately after the auction, FineTouch had the machines professionally appraised so it could increase its insurance coverage. The appraisal put a fair value of $105,000 on machine X and $160,000 on machine Y.

On March 24, FineTouch paid a total of $4,500 in transportation and installation charges for the two machines. No further expenditures were made for machine X, but $6,500 was paid on March 29 for improvements to machine Y. On March 31, 2011, both machines were ready to be used.

The company expects machine X to last five years and to have a residual value of $3,800 when it is removed from service, and it expects machine Y to be useful for eight more years and have a residual value of $14,600 at that time. Due to the different characteristics of the two machines, different depreciation methods will be used for them: machine X will be depreciated using the double-declining-balance method and machine Y using the straight-line method.

Required:

Prepare the journal entries to record the following:

1. The purchase of each machine
2. The transportation, installation, and improvement costs for each machine
3. The depreciation expense to December 31, 2011, for each machine

8-21 (Depreciation calculations and journal entries; two methods)

Polar Company purchased a building with an expected useful life of 40 years for $600,000 on January 1, 2011. The building is expected to have a residual value of $40,000.

Required:

1. Give the journal entries that would be made by Polar to record the building purchase in 2011 and the depreciation expense for 2011 and 2012, assuming straight-line depreciation is used.
2. Repeat part “a,” but now assume that double-declining-balance is used.

8-22 (Calculation of depreciation; three methods)

On April 29, 2011, SugarBear Company acquired equipment costing $150,000, which will be depreciated on the assumption that the equipment will be useful for five years and have a residual value of $12,000. The estimated output from this equipment is as follows: 2011—15,000 units; 2012—24,000 units; 2012—30,000 units; 2014—28,000 units; 2015—18,000 units. The company is now considering possible methods of depreciation for this asset.

Required:

1. Calculate what the depreciation expense would be for each year of the asset's life, if the company chooses:
   1. The straight-line method
   2. The units-of-production method
   3. The double-declining-balance method
2. Briefly discuss the criteria that a company should consider when selecting a depreciation method.

8-23 (Calculation of depreciation by three methods, plus CCA)

A machine that produces cell phone components is purchased on January 1, 2011, for $100,000. It is expected to have a useful life of four years and a residual value of $10,000. The machine is expected to produce a total of 200,000 components during its life, distributed as follows: 40,000 in 2011; 50,000 in 2012; 60,000 in 2013; and 50,000 in 2014. The company closes its books on December 31 each year.

Required:

1. Calculate the amount of depreciation to be charged each year, using each of the following methods:
   1. Straight-line method
   2. Production method
   3. Double-declining-balance method
2. Which method results in the highest depreciation expense:
   1. during the first two years?
   2. over all four years?
3. Calculate the amount of capital cost allowance that could be claimed in each of the first two years, assuming the machine is subject to a CCA rate of 40%.

8-24 (Depreciation, including CCA; income calculation; deferred tax liability)

On July 1, 2011, Silver Stone Company purchased equipment for a cost of $450,000 with an expected useful life of 15 years and an anticipated residual value of $30,000. This is the company's only capital asset and, for tax purposes, it is a Class 8 asset with a CCA rate of 20%. Silver Stone's income tax rate is 25%.

For the year 2012 (the second year of the equipment's life), Silver Stone reported sales of $1,500,000 and operating expenses other than depreciation of $1,050,000. In addition to the equipment, the company held other assets with a total carrying value of $930,000 on December 31, 2012.

Required:

1. Assuming Silver Stone uses straight-line depreciation, what amount of net earnings will it report for 2012? What will its return on assets be, using the year-end value of the total assets and assuming there is no interest expense?
2. What is the maximum amount of CCA that Silver Stone could claim for tax purposes in 2012? Based on this, how much taxable income will the company have and how much income tax will it have to pay for 2012?
3. Give the journal entry to record the company's income taxes for 2012.
4. If Silver Stone had used double-declining-balance depreciation (in both 2011 and 2012), what amount of net earnings would it have reported for 2012? What would the return on assets have been (again using the year-end value of the total assets and assuming there is no interest expense)?
5. For what type of assets is it appropriate to use double-declining-balance depreciation?

8-25 (Production method depreciation with change in estimate)

A company paid $66,000 for a machine and was depreciating it by the units-of-production method. The machine was expected to produce a total of 150,000 units of product, and to have a residual value of $6,000. During the first two years of use, the machine produced 45,000 units.

At the beginning of the machine's third year of life, its estimated lifetime production was revised from 150,000 to 120,000 units; its estimated residual value was unchanged.

Required:

Calculate the amount of depreciation that should be charged during the third year of the machine's life if 25,000 units are produced that year.

8-26 (Asset acquisition, subsequent expenditures, change in estimate, and depreciation)

South Seas Distributors completed the following transactions involving the purchase and operation of a delivery truck:

2011	Transaction Description
May 27	Paid $35,600 for a new truck, plus $4,272 in HST, which can be reclaimed from the federal government. It was estimated that the truck would be sold for $15,000 after four years.
June 9	Paid $3,500 to have special racks installed in the truck. The racks did not increase the truck's estimated resale value. The truck was put into service after the racks were installed.
Dec. 31	Recorded straight-line depreciation on the truck.

2012
Apr. 5	Paid $650 for repairs to the truck's fender, which was damaged when the driver scraped a loading dock.
July 23	Paid $8,000 to have a refrigerating unit installed in the truck. This increased the truck's estimated resale value by $1,000.
Dec. 31	Recorded straight-line depreciation on the truck.

Required:

Prepare journal entries to record the above transactions.

8-27 (Asset expenditures)

Comfort Zone Housing paid $80,000 for a new air-conditioning system in an existing building.

Required:

Identify the account that should be debited and briefly explain your reasoning, in each of the following cases:

1. The expected useful life of the air-conditioning system is the same as the remaining useful life of the building it was installed in.
2. The air-conditioning system is expected to have a useful life of 15 years, while the building it was installed in is expected to have a remaining useful life of 30 years.

8-28 (Asset expenditures, changes in estimates, and depreciation)

Canada Canning Company owns processing equipment that had an initial cost of $106,000, expected useful life of eight years, and expected residual value of $10,000. Depreciation calculations are done to the nearest month using the straight-line method, and depreciation is recorded each December 31.

During the equipment's fifth year of service, the following expenditures were made:

Jan. 7	Lubricated and adjusted the equipment to maintain optimum performance, at a cost of $500.
Mar. 13	Replaced belts, hoses, and other parts that were showing signs of wear on the equipment, at a cost of $350.
June 28	Completed a $14,000 overhaul of the equipment. The work included the installation of new computer controls to replace the original controls, which had become technologically obsolete. As a result of this work, the estimated useful life of the equipment was increased to 10 years and the estimated residual value was increased to $11,000.

Required:

1. Prepare journal entries to record each of the above transactions.
2. Calculate the depreciation expense that should be recorded for this equipment in the fourth year of its life, in the fifth year of its life (the year in which the above transactions took place), and in the sixth year of its life.

8-29 (Asset refurbishment, changes in estimates, and depreciation)

At the end of 2011, Spindle Works Inc. owned a piece of equipment that had originally cost $21,000. It was being depreciated by the straight-line method, and had $8,500 of accumulated depreciation recorded as of the end of 2011 after the yearly depreciation was recorded.

At the beginning of 2012, the equipment was extensively refurbished at a cost of $9,500. As a result of this work, the productivity of the equipment was significantly improved, its total estimated useful life was increased from 10 to 14 years, and its residual value was increased from $4,000 to $7,000.

Required:

1. Calculate the age of the equipment at the end of 2011.
2. Give the journal entry to record the refurbishment of the equipment at the beginning of 2012.
3. Give the adjusting entry to record the depreciation of the equipment at the end of 2012.

8-30 (Acquisition, change in estimates, depreciation, and disposal)

On July 1, 2008, Steelman Company acquired a new machine for $140,000 and estimated it would have a useful life of 10 years and residual value of $7,000. At the beginning of 2011, the company decided that the machine would be used for nine more years (including all of 2011), and at the end of this time its residual value would be only $1,000. On November 1, 2012, the machine was sold for $83,000. The company uses the straight-line method of depreciation and closes its books on December 31.

Required:

Give the necessary journal entries for the acquisition, depreciation, and disposal of this asset for the years 2008, 2011, and 2012.

8-31 (Straight-line depreciation with disposal)

On October 4, 2011, C and C Sandblasters Company purchased a new machine for $45,000. It estimated the machine's useful life at 12 years and the residual value at $4,000. On March 25, 2012, another machine was acquired for $70,000. Its useful life was estimated to be 15 years and its residual value $6,000. On May 24, 2013, the first machine was sold for $28,000. The company closes its books on December 31 each year, uses the straight-line method of depreciation, and calculates depreciation to the nearest month.

Required:

Give the necessary journal entries for the years 2011 through 2013 for both machines. Include the depreciation of the second machine on December 31, 2013.

8-32 (Straight-line and declining-balance depreciation with disposal)

On March 1, 2011, Zephur Winds Ltd. purchased a machine for $80,000 by paying $20,000 down and issuing a note for the balance. The machine had an estimated useful life of nine years, and an estimated residual value of $8,000. Carson uses the straight-line-method of depreciation and has a December 31 year end. On October 30, 2013, the machine was sold for $62,000.

Required:

1. Prepare the journal entry to record the acquisition of the machine.
2. Assuming that the depreciation was correctly calculated and recorded in 2011 and 2012, prepare the journal entries to update the depreciation and record the sale of the machine on October 30, 2013.
3. Assume instead that the company used the double-declining-balance method to depreciate the cost of the machine:
   1. What amount of depreciation would be recorded in 2011 and 2012?
   2. What journal entries would be required to update the depreciation and record the sale of the machine on October 30, 2013?

8-33 (Exchange and disposal of capital assets)

On March 31, 2011, Hammer Inc. acquired new machinery by trading in old machinery, paying $15,000 cash, and issuing a 10% note payable for $10,000. The new machinery's estimated life is six years, with a residual value of $3,000.

The old machinery had been acquired on September 30, 2008, for $25,000. At that time, its estimated useful life was 10 years, with a residual value of $1,000. Depreciation was correctly recorded for 2008, 2009, and 2010. On the date of the trade-in, the old machinery's fair market value was approximately the same as its net carrying value.

The company uses the straight-line method of depreciation and closes its books on December 31.

Required:

1. Give the journal entry to record the 2011 depreciation of the old asset, up to the date of the trade-in on March 31.
2. Give the journal entry to record the trade-in of the old asset and the acquisition of the new one. (Hint: The cost of the new asset includes the value of the old asset plus the cash and note given in payment for the new asset.)
3. On March 31, 2017, the machinery acquired in 2011 was retired from service. Give the journal entries that should be made in 2017 related to this machinery, under each of the following assumptions:
   1. The machinery could not be sold, so the company wrote it off.
   2. The machinery was sold for $5,000.

8-34 (Exchange and disposal of capital assets)

On November 23, 2013, Radon Mines Company acquired new machinery by trading in old machinery and paying $23,000 cash plus another $15,000 borrowed from the bank at 8%. The new machinery's estimated life is six years, with a residual value of $8,000. The company uses the straight-line method of depreciation and has a December 31 year end.

The old machinery was acquired on March 31, 2009, for $25,000. At that time, its estimated useful life was 10 years, with a residual value of $4,000. Depreciation was correctly recorded for 2009, 2010, 2011, and 2012. On the trade-in date, the old machinery's fair market value was approximately the same as its net book value.

Required:

1. Give the journal entries that should be made in 2013 to record the depreciation and trade-in of the old asset, and the acquisition and depreciation of the new asset.
2. On June 30, 2019, the machinery acquired in 2013 was retired from service and sold for $4,000. Give the journal entries that should be made in 2019 related to this machinery.
3. Briefly explain how the answer to part “b” would differ if the residual value of the new machinery was estimated at $10,000 rather than $8,000.

8-35 (Oil and gas exploration, with full cost and successful efforts methods)

Consider the oil and gas exploration companies Wild Cat and Crazy Dog, which have identical histories. Both have been in operation for two years, during which they have each explored five sites a year at a cost of $3 million per site. Only one of the sites each year has proven to be economically viable; the remaining sites were dry holes. The oil reserves in each successful well are estimated at 600,000 barrels, which will be extracted evenly over a six-year period commencing in the year of discovery.

Required:

1. Assuming that Wild Cat Company uses the full cost method of accounting for its exploration expenditures, calculate what it would report for the following:
   1. The value of the oil wells asset on its statement of financial position at the end of each of the two years
   2. Depreciation expense on its statement of earnings for each of the two years
2. Assuming that Crazy Dog Company uses the successful efforts method of accounting for its exploration expenditures, calculate what it would report for the following:
   1. The value of the oil wells asset on its statement of financial position at the end of each of the two years
   2. Depreciation expense on its statement of earnings for each of the two years
3. At the end of the two-year period, which company has the more valuable oil wells asset? Over the two-year period, which company has been more profitable?

8-36 (Intangibles and depreciation)

Pinetree Manufacturing Company reports both equipment and patents in its statement of financial position.

Required:

1. Explain how the cost of each of these types of asset is determined.
2. If both the equipment and patents were purchased three years ago for $40,000 each and had estimated useful lives of 10 years, what amount would be reported for each of them in the statement of financial position at the end of the current period? Explain.
3. Financial analysts sometimes ignore intangible assets when analyzing financial statements. Do you think this is appropriate? Explain.

8-37 (Intangibles and depreciation)

Red Bear Ltd. purchased several intangible assets, as follows:

Asset	Purchase Cost
Licence	$  80,000
Customer list	60,000
Patent	160,000
Copyright	250,000

The following information is also available:

• In addition to the costs listed above, there were legal fees of $12,000 associated with the licence acquisition. The licence is valid in perpetuity, and sales of the products produced under the licence have been strong and are expected to continue at the same level for many decades.
• The customer lists are expected to be useful for the next six years.
• The patent has a legal life of 20 years, but technological changes are expected to render it worthless after about eight years.
• The copyright is good for another 40 years, but nearly all the related sales are expected to occur during the next 10 years.

Required:

1. Calculate the annual depreciation expense, if any, that should be recorded for each of these intangible assets.
2. Show how the intangible assets section of the statement of financial position would be presented four years after acquisition of these assets, assuming that there has been no evidence that their values have been impaired. Assume that a full year of depreciation was taken in the year of acquisition.

8-38 (Cash flow statement—review question)

Comparative statements of financial position and a statement of earnings for Ponderosa Pines Ltd. follow:

Ponderosa Pines Ltd.
Statements of Financial Position
As at December 31, 2011 and 2010

Ponderosa Pines Ltd.
Statements of Earnings
For the Year Ended December 31, 2011

Required:

Prepare a statement of cash flows for Ponderosa Pines Ltd. for the year ended December 31, 2011.

User Perspective Problems

8-39 (Expensing versus capitalizing the cost of tools)

During the current year, a large chain of auto mechanic shops adopted the policy of charging purchases of small tools costing less than $100 to expense as soon as they are acquired. In previous years, the company had carried an asset account, Small Tools, which it had depreciated over the average expected useful lives of the tools. The balance in the Small Tools account represented about 1% of the company's total capital assets, and the depreciation expense on them was 0.3% of its sales revenues. It is expected that the average annual purchases of small tools will be approximately the same amount as the depreciation that would have been charged on them.

Is this in accordance with IFRS? If so, briefly explain why. If not, identify the accounting principle or concept that has been violated and give a brief explanation of the nature of the violation.

8-40 (Nature of depreciation charges)

While discussing the values reported on the statement of financial position for land and buildings, an owner of a company said the following: “Land and buildings should not be recorded separately. They should be treated as a group of related assets. If you view them as a group, no depreciation should be charged on our buildings, because the increase in the value of our land each year more than makes up for any decline in the value of the buildings. Our company is located in a booming commercial area, and land values are rising all the time. In fact, even the value of our buildings has probably been increasing, rather than decreasing.”

Comment on the issues raised by the owner.

8-41 (Nature of depreciation charges)

The Piccolo Mondo Company purchased a computer system for $150,000. The company expects to use the system for five years, at which time it will acquire a larger and faster one. The new system is expected to cost $100,000. During the current year, the company debited $20,000 to its depreciation expense account “to provide for one-fifth of the estimated cost of the new computer system.”

Is this in accordance with IFRS? If so, briefly explain why. If not, identify the accounting principle or concept that has been violated and give a brief explanation of the nature of the violation.

8-42 (Valuation of capital assets)

Many users of financial statements argue that, for most of the decisions that creditors, investors, analysts, and other users have to make, reporting the market values of companies' assets would be more relevant than other “values.” Give two reasons why, despite the opportunity to report capital assets at fair value, companies continue to use historical costs as the basis for reporting these assets.

8-43 (Valuation of assets in discontinued operations)

Suppose that a company decides to discontinue one of its lines of business and sell the related assets. Describe what you think would be the most appropriate valuation basis for the capital assets of the discontinued operations during the interval between when the decision to discontinue the line of business is made and when the assets are sold. As an investor in the company, discuss what disclosures might be most useful to you in these circumstances.

8-44 (Capital assets as collateral for loan)

As a lender, discuss whether you would be more comfortable with a company having long-term assets in the form of (a) property, plant, and equipment, or (b) goodwill, when you consider making a long-term loan to the company.

8-45 (Capital assets as collateral for loan)

As a lender, discuss whether you would prefer to see long-term assets reported at historical cost or fair value. What advantages and disadvantages would you see under each valuation?

8-46 (Auditing and valuation of capital assets)

As an auditor, discuss how you might evaluate a company's property, plant, and equipment to decide whether the value of these assets were impaired and should be written down.

8-47 (Goodwill's effect on financial statements)

In some countries, companies can write off goodwill at the date of acquisition by directly reducing their shareholders' equity; that is, the write-off does not pass through net earnings. Suppose that a Canadian company and a company from a country that allows an immediate write-off of goodwill agreed to purchase the same company for the same amount of money. As a stock analyst, describe how the statements of financial position and statements of earnings would differ for the two companies after the acquisition. Discuss whether this would provide any advantage for either company.

8-48 (Impact of writedowns on remuneration)

Suppose that you are the accounting manager of a division in a large company and your remuneration is partly based on meeting an earnings target. In the current year, it seems certain that your division will not meet its target. You have some property, plant, and equipment that have been idle for a while but have not yet been written off. What incentives do you have to write off this asset during the current year? If you do write it off, how will this affect your future ability to meet the earnings targets for your division?

8-49 (Basket purchase price allocation)

Companies often face a basket purchase situation when they buy real estate, because the acquisition usually involves both the land that is purchased and the building that is located on the land. If you are the accounting manager, how would you go about allocating the real estate's purchase price between the land and the building? Why must you allocate the cost between these two assets? What incentives might you have to allocate a disproportionate amount to either the land or the building?

8-50 (Analysis of an R&D company)

As a stock analyst, discuss any difficulties or inadequacies that you might find with the financial statements of a company that is predominantly a research and development firm.

8-51 (Capital assets and company valuation)

Answer the following questions, assuming that you have been asked to analyze a potential acquisition by your company: (a) Which long-term assets on its financial statements are the most likely to be misstated by their carrying values? Explain your reasoning. (b) Is it possible that the company being considered for acquisition has some long-term assets that do not appear on its financial statements at all? Explain why or how this might occur.

Financial Analysis Assignments

Reading and Interpreting Published Financial Statements

8-52 (Reconstruction of capital asset transactions)

The consolidated statements of income, balance sheets, and cash flows of Finning International Inc. are presented in Exhibit 8-12. In addition, Finning International's note regarding its land, buildings, and equipment was presented earlier in this chapter, in Exhibit 8-6. As you may recall, Finning International is the largest Caterpillar dealer, selling, leasing, and servicing the large equipment in Canada.

Required:

Prepare summary journal entries to reconstruct the transactions that affected Finning International's land, buildings, and equipment in 2009 (i.e., acquisitions, disposals, and depreciation expense). Deal with the total land, buildings, and equipment, rather than the individual components. (Hint: You may find the use of T accounts helpful in reconstructing the events that affected the land, buildings, and equipment, and the accumulated depreciation account during the year.)

EXHIBIT 8-12A  FINNING INTERNATIONAL INC. 2009 ANNUAL REPORT

EXHIBIT 8-12B  FINNING INTERNATIONAL INC. 2009 ANNUAL REPORT

EXHIBIT 8-12C  FINNING INTERNATIONAL INC. 2009 ANNUAL REPORT

8-53 (Accounting policies related to capital assets)

Metro Inc. owns and operates several supermarkets and pharmacies in Quebec and Ontario. Exhibit 8-13 shows Metro's notes on significant accounting policies for intangible assets and goodwill accompanying its 2009 financial statements.

Required:

1. What major intangible assets does Metro own? Why does the company distinguish between the ones with definite lives and those with indefinite lives?
2. What method does Metro use to depreciate its intangible assets? Are they depreciated over their legal lives or useful lives? Explain why the treatment is appropriate.
3. Explain what the prescription files are. How are these related to Metro's major operations?
4. What is the source of the goodwill that Metro recognizes? Is the goodwill depreciated? Explain how Metro determines and recognizes any impairment loss on the goodwill.

8-54 (Research and development costs)

From its headquarters in Calgary and its development, operations, and marketing facilities in Arizona, Kansas, and Texas, Hemisphere GPS Inc. designs, develops, and manufactures commercial and industrial global positioning systems. The 2009 and 2008 consolidated statements of operations and deficit for Hemisphere GPS are shown in Exhibit 8-14.

As one would expect for a company in a high-technology industry, Hemisphere GPS incurs substantial research and development (R&D) costs. However, the notes accompanying its financial statements reveal that the company's policy is to expense all these costs in the period in which they are incurred.

EXHIBIT 8-13  METRO INC. 2009 ANNUAL REPORT

EXHIBIT 8-14  HEMISPHERE GPS INC. 2009 ANNUAL REPORT

Required:

1. Calculate how much the losses from continuing operations would have been for 2009 and 2008 if Hemisphere GPS had been able to capitalize its R&D costs and then depreciate them on a straight-line basis over a six-year period, commencing in the year in which they were incurred. (Note: In order to do this with the data available, you will have to assume that 2008 was the company's first year of operations.)
2. Compare your results in part “a” to the losses from continuing operations shown in Exhibit 8-14. Are the differences significant?
3. Assume the company continues for many years with approximately the same level of R&D expenditures each year. Will there be a significant difference between its income or loss if the company capitalizes its R&D costs and then depreciates them, rather than expensing these costs in the period in which they are incurred?

8-55 (Accounting for oil and gas properties)

The portion of Imperial Oil Limited's summary of significant accounting policies dealing with property, plant, and equipment was presented earlier in this chapter, in Exhibit 8-11. As indicated earlier, Imperial Oil operates Esso retail gas stations throughout Canada and is a major Canadian producer of crude oil and natural gas.

Required:

1. What method does Imperial Oil use to account for its costs related to exploration and development activities? Explain in your own words how these costs are handled under this method.
2. What reason does Imperial Oil give for choosing this method of accounting for costs related to its exploration and development activities? Explain in your own words what you think this means.
3. Is the method that Imperial Oil uses to account for exploration and development costs the method that you would expect a large oil and gas company to use? Explain why or why not.

8-56 (Accounting for mineral properties)

Claude Resources Inc. is a Saskatchewan-based “junior” natural resource company involved in gold mining. Note 2 accompanying its 2009 financial statements outlines its significant accounting policies. The portion of this note related to mineral properties is reproduced in Exhibit 8-15.

Required:

1. Describe how Claude Resources determines the carrying value of its mining properties. What kinds of items are capitalized?
2. Is the method that Claude Resources uses to account for exploration and development costs the method that you would expect a mining company to use? Explain.
3. Describe how Claude Resources records interest on debt that is used for the acquisition and development of mining properties. At what point are the interest costs expensed?
4. Describe in your own words how Claude Resources determines whether its mining properties are impaired.

EXHIBIT 8-15  CLAUDE RESOURCES INC. 2009 ANNUAL REPORT

BEYOND THE BOOK

8-57 (Financial statement disclosures)

Choose a company, as directed by your instructor, and respond to the following:

1. Use the statement of financial position and the notes to the financial statements to prepare an analysis of the capital assets. First list the beginning and ending amounts in the various capital asset and accumulated depreciation accounts and then calculate the net change, in both dollar and percentage terms, for the most recent year.
2. If any of the amounts in part “a” have changed by more than 10 percent, provide an explanation for this change.
3. What percentage of the company's total assets is invested in property, plant, and equipment? Has this percentage changed significantly during the most recent year?
4. What depreciation method(s) does the company use?
5. Use the following formulae to examine the property, plant, and equipment (PPE) for the company:

   Average useful life of PPE = Total gross PPE ÷ Annual depreciation expense

   Average age of PPE = Total accumulated depreciation ÷ Annual depreciation expense

   Note: Remember that depreciation expense may not be separately disclosed in the statement of earnings but will usually appear in the cash flow statement.

   Compare your results with any information disclosed in the notes. Do these results make sense?

6. Does the company have any significant intangible assets? If so, describe each of them.

Case Primer

Cases

8-58 Manuel Manufacturing Company

Ramon Manuel, the president of Manuel Manufacturing Company, has e-mailed you to discuss the cost of a new machine that his company has just acquired.

The machine was purchased in Montreal for $150,000. Transporting it from Montreal to the company's Hamilton factory and installing the machine were Manuel's responsibilities. Unfortunately, the machine was seriously damaged during this process and repairs costing $40,000 were required to restore it to its original condition.

Mr. Manuel wants to ensure that he can capitalize these repair costs as part of the cost of the machine, and has therefore consulted you on the following points as he understands them:

1. The cost of a capital asset should include all the costs that are necessary to get it in place and ready for use. The damaged machine was inoperative, so the repairs were definitely necessary.
2. All the other costs related to the transportation and installation of the machine are being capitalized.
3. An asset is a cost that will produce economic benefits in the future. Since the machine will be very productive for the next few years, future periods will definitely benefit from the repairs. Therefore, the repair costs should be capitalized.
4. The matching principle says that expenses should be matched with the revenues they produce. The repairs did not generate any revenue, and therefore this cost should not be considered an expense. As a matter of fact, the machine itself did not generate any revenue in the current fiscal year, since it arrived in early December and was not repaired until late in the month.

Required:

Discuss how Manuel Manufacturing Company should account for the $40,000 cost of the repairs. Ensure that you explain your reasoning and address each of Mr. Manuel's arguments in your reply.

8-59 Eastern and Western Companies

Summary statements of financial position and statement of earnings information for Eastern Company and Western Company, covering the first year of operations for both, follows.

The operations of the two businesses are similar, and both companies have effective corporate income tax rates of 25%. Upon investigation, however, you find the following differences:

• Eastern is financed mainly by shareholders' equity, while Western is financed mainly by long-term debt.
• Eastern depreciates its equipment and buildings using the straight-line method with estimated useful lives of 10 years and 20 years, respectively, while Western depreciates its equipment and buildings using the declining-balance method with rates of 20% and 10%, respectively.

Required:

1. Without adjusting for differences in depreciation policy, which company has the higher rate of return on assets (ROA)?
2. Which company has the higher ROA after adjusting for differences in depreciation policy? (Hint: You can determine this either by using Eastern's depreciation method for Western, or by using Western's depreciation method for Eastern.)
3. Using numbers from this example, explain why you should adjust for differences in depreciation policies when comparing companies.
4. Using numbers from this example, explain why the ROA formula includes an adjustment for interest (after taxes) in the numerator.
5. If you were a shareholder or a potential shareholder in these companies, what other rate-of-return ratio would you want to calculate? Why would this ratio provide different insights than the return on assets ratio?

8-60 Rolling Fields Nursing Home

Rolling Fields Nursing Home purchased land to use for a planned assisted-living community. As a condition of the sale, a title search had to be performed and a survey completed. Rolling Fields incurred both these costs. In order to prepare the land for new construction, a barn that was on the land when it was purchased had to be torn down, and a rocky hill in the middle of the property had to be levelled. A series of streets, sidewalks, water mains, storm drains, and sewers through the planned community also had to be constructed. Finally, street lighting had to be installed and green spaces for recreation and rest had to be landscaped.

The year after the land was purchased, construction of new homes began. The homes are to be owned by Rolling Fields and will be rented on a long-term basis to elderly residents who no longer feel they can live completely on their own but do not yet need nursing home care. Rolling Fields will be responsible for all the maintenance and repair costs associated with the properties. By the end of the year, Phase 1 was complete and 30 homes had been constructed and were occupied. The average cost of each home was $180,000.

In the first year, repair and maintenance costs averaged $1,200 per property. The company also borrowed $4 million to finance the construction of the homes. Interest on the loan for the year was $308,000.

Required:

1. Determine which of the above expenditures should be capitalized.
2. For the expenditures that should be capitalized, identify the appropriate account to which the costs should be charged.
3. For the expenditures that should be capitalized, discuss how each asset class should be depreciated.

8-61 Hugh White

Hugh White is a real estate developer with several properties located throughout St. John's, Newfoundland. Although Mr. White sells most properties upon completion, in some instances he arranges to purchase the property either by himself or in a consortium with other investors.

During the current year, Mr. White was involved in two residential rental properties. The first property was purchased solely by Mr. White. Because it is operated as a proprietorship, he pays personal income taxes on any profits earned by this property. Consequently, he has a strong incentive to maximize expenses on this property in order to minimize its net earnings and his income tax liability.

The second property is very similar in nature to the property owned by Mr. White, but is owned by a group of professionals living in St. John's. They have purchased the property as an investment and hired Mr. White to be the property manager. The group is very concerned with earning a good return on the investment, and consequently Mr. White's compensation is based upon the property's profitability.

During the year, both properties required that new parking lots be constructed. Both new parking lots are significant improvements to the properties, since they are now paved and lighted and have security systems.

Required:

1. In discussions with Mr. White, you discover that he would like to capitalize the costs of the parking lot for which he is the property manager and expense the costs of the parking lot for his own building. What is his rationale for wanting these accounting treatments?
2. What is the appropriate accounting treatment for the costs of both parking lots?

8-62 Maple Manufacturing Company

Maple Manufacturing Company recently purchased a property for use as a manufacturing facility. The company paid $850,000 for a building and four hectares of land. When recording the purchase, the company's accountant allocated $750,000 of the total cost to the building and the remaining $100,000 to the land.

After some investigation and an independent appraisal, you determine that the building is deemed to have a value of only $435,000. You also discover that the property is located near a major highway providing excellent access for shipping, and is therefore quite valuable. Similar properties in the area have been selling for $125,000 per hectare.

Maple Manufacturing is a very successful company and has traditionally reported very high net earnings. Last year, the company paid more than $200,000 in income taxes.

Required:

1. Determine the appropriate allocation between the buildings and land accounts for this basket purchase. (Remember that four hectares of land were purchased.)
2. Why would the company's accountant have wanted to allocate most of the purchase cost to the building rather than to the land?

8-63 Preakness Consulting and Bellevue Services

Preakness Consulting and Bellevue Services are two petroleum engineering firms located in Calgary, Alberta. Both companies are very successful and are looking to attract additional investors to provide them with an infusion of capital to expand. In the past year, both companies had consulting revenue of $1.5 million.

On January 1, 2011, both companies purchased new computer systems. Currently, the only other asset owned by the companies is office equipment, which is fully depreciated. The computer systems, related hardware, and installation cost each company $660,000, and the systems have an expected life of five years. The residual value at the end of the five-year period is expected to be $30,000 in each case.

Preakness has chosen to depreciate the computer equipment using the straight-line method, while Bellevue has taken a more aggressive approach and is depreciating the system using the double-declining-balance method. Both companies have December 31 year ends and a tax rate of 25%. Information on their other expenses is as follows:

Required:

1. For each company, prepare a depreciation schedule showing the amount of depreciation expense to be charged each year for the computer system.
2. Prepare statements of earnings for the current year for both companies.
3. How might an unsophisticated investor interpret the financial results from part “b”? Is one company really more profitable than the other?

Critical Thinking Questions

8-64 (Valuation of capital assets)

Four years ago, Litho Printers Ltd. purchased a large, four-colour printing press for $450,000 with the intent of using it for 10 years. Recently, the production manager learned that replacing the press with a comparable new one now would cost $560,000. The manager also estimates that if the company were to sell the existing printing press now it would receive $280,000. On the other hand, the production manager estimates that the company could earn $930,000 from selling materials produced on the press over the next six years.

Required:

1. Under what conditions (if any) should the press be valued at $560,000?
2. Under what conditions (if any) should the press be valued at $280,000?
3. Under what conditions (if any) should the press be valued at $930,000?
4. What value should be assigned to the press in Litho Printers' financial statements?

8-65 (Accounting for idle assets)

Conservative Company purchased a warehouse on January 1, 2006, for $400,000. At the time of purchase, Conservative anticipated that the warehouse would be used to facilitate the expansion of its product lines. The warehouse is being depreciated over 20 years and is expected to have a residual value of $50,000. At the beginning of 2011, the company decided that the warehouse would no longer be used and should be sold for its book value. At the end of 2011, the warehouse still had not been sold and its net realizable value was estimated to be only $260,000.

Required:

1. Calculate the book value of the warehouse on January 1, 2011.
2. Prepare all the journal entries that Conservative should make during 2011 related to the warehouse.
3. If Conservative sells the warehouse in 2012 for $220,000, what entry would be made for the sale?
4. During 2011, the financial vice-president expressed concern that if Conservative put the building up for sale the company might have to report a loss, and he did not want to reduce 2011 earnings. He wanted to continue treating the warehouse as an operating asset. How would the 2011 and 2012 financial statements be different if the warehouse were still treated as an operating asset during 2011? From a shareholder's perspective, do you think the treatment makes any difference? Explain.