Chapters 7 and 8
Long-term Assets
Long-Term Assets
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Long-term assets mainly consist of
property, plant, and equipment (PPE).
These assets often makeup the largest
asset amounts.
Future expenses arising from these longterm assets often makeup the larger
expense amounts—typically reflected in
depreciation expense and asset writedowns.
What is Included in Cost?

All expenditures necessary to make asset
ready for its intended use.
Postacquisition Expenditures:
Betterments or Maintenance?
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Betterments:
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Increase asset’s useful life
Improve quality of asset’s output
Increase quantity of asset’s output
Reduce asset’s operating costs
Accounting treatment
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Betterments are capitalized
Maintenance expenditures are expensed
Depreciation Factors and Process
Depreciation requires the following estimates:
1.
Useful life – period of time over which the
asset is expected to generate cash inflows
2.
Salvage value – Expected disposal amount for
the asset at the end of its useful life
3.
Depreciation rate – an estimate of how the
asset will be used up over its useful life.
Variance in Depreciation
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A company can depreciate different
assets using different depreciation rates
(and different useful lives).
Whatever depreciation rate is chosen,
however, it must generally be used
throughout the useful life of that asset.
Changes to depreciation rates can be
made, but they must be justified as
providing “better quality” financial
reports.
Depreciation Methods
Depreciation Methods:
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1.
2.
Straight-line method
Accelerated Methods (Double-decliningbalance method)
Straight-line Method
Straight-line method: Under the straight-line
(SL) method, depreciation expense is
recognized evenly over the estimated useful
life of the asset.
 Consider the following example
An asset (machine) with the following details:
(1) cost of $100,000
(2) salvage value of $10,000
(3) useful life of 5 years
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Straight-line Depreciation Example
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For the straight-line method, we use our
illustrative asset to assign the following amounts
to the depreciation formula:
SL Example
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For the asset’s first year of usage, $18,000 ($90,000 * 20%) of
depreciation expense is reported in the income statement.
At the end of that first year the asset is reported on the
balance sheet as follows:
Net book value (NBV) is cost less accumulated depreciation.
At the end of year 2, the net book value will be reduced by
another $18,000 to $64,000.
Double-declining-balance method
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Double-declining-balance method. For the
double-declining-balance (DDB) method,
we use our illustrative asset to assign the
following amounts to the depreciation
formula: (2 x BV) / Useful Life
Double-declining-balance method
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The asset is reported on the balance
sheet as follows:
In the second year, $24,000 ($60,000 
40%) of depreciation expense is recorded
in the income statement and the NBV of
the asset on the balance sheet follows:
DDB Depreciation Schedule
Comparison of Depreciation Methods
Asset Sales
Asset Impairments
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Impairment of plant assets is determined by comparing
the sum of the expected future (undiscounted) cash
flows generated by the asset with its net book value.
Companies must recognize a loss if the asset is deemed
to be impaired.
When a company takes an impairment charge, assets
are reduced by the amount of the write-down and the
loss is recognized in the income statement, which
reduces current period income.
Accumulated Depreciation
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Does not represent the accumulation of any
tangible thing.
Sum of the original cost that has been
expensed.
Funding the purchase of new assets is
usually unrelated to depreciation.
Can distort ROA calculations!
Book Value
EBITDA
Depreciation
Net Income
ROA
Age of assets
1/1/99 12/31/99 12/31/00 12/31/01 12/31/02 12/31/03
1,000,000 900,000 800,000 700,000 600,000 500,000
220,000 220,000 220,000 220,000 220,000
100,000 100,000 100,000 100,000 100,000
120,000 120,000 120,000 120,000 120,000
12.6% 14.1% 16.0% 18.5% 21.8%
1
2
3
4
5
Analysis of Useful life and Percent Used
Up
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Estimated useful life =
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Percent used up =
Intangibles
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Goodwill
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R&D
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What is it?
Impairment test
Patents, copyrights
Marketing
Natural Resources
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Depletion
Equity Securities
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What is an equity investment?
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Why would a firm invest in the equity of
another firm?
Accounting for Investments
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GAAP identifies three levels of
influence/control:
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Passive
Significant influence
Control
Passive
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Passive. In this case the purchasing company is
merely an investor and cannot exert any influence
over the investee company. Its goal for the
investment is to realize dividend and capital gain
income. Generally, passive investor status is
presumed if the investor company owns less than
20% of the outstanding voting stock of the investee
company.
Significant influence
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Significant influence. In certain circumstances, a
company can exert significant influence over, but not
control, the activities of the investee company.
Generally, significant influence is presumed if the
investor company owns 20-50% of the voting stock
of the investee company.
Control
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Control. When a company has control over
another, it has the ability to elect a majority of the
board of directors and, as a result, the ability to
affect its strategic direction and hiring of executive
management. Control is generally presumed if the
investor company owns more than 50% of the
outstanding voting stock of the investee company.
Intercorporate Investments
Some terms
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Mark-to-market
Realized
Recognized
Ready market
Trading security
Available for sale security
Passive - No ready market
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Account for at cost
No mark-to-market
Investment Classifications
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GAAP allows for two possible classification is equity
investments:
Available-for-sale. Investments in securities that
management intends to hold for capital gains and
dividend income; although it may sell them if the
price is right.
Trading. Investments in securities that management
intends to actively trade (buy and sell) for trading
profits as market prices fluctuate.
Passive - Ready market
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Trading or Available for sale depending on
management’s intentions
Both are marked-to-market
For trading securities the gain/loss is recognized
prior to being realized (on income statement)
For available for sale securities recognition is at
realization. Until then the holding gain/loss is kept in
an the equity section of the balance sheet (not on
income statement)
Are Changes in Asset Value Income?
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Changes in the carrying amount of the investment
(asset) has a corresponding effect on equity:
Assets  = Liabilities + Equity 
The central issue in the accounting for investments
is whether this change in equity is income.
The answer depends on the investment
classification.
Example of Trading and Available for
sale
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10/1/98 Buy 10 shares @ $15 each
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12/21/98 Market value rises to $18
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Record at cost
Mark-to-market
02/20/99 Sell 10 shares @20 each
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Gain (loss) = Sales price – Book Value
Held To Maturity Investments
Equity Method Investments
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Equity Method accounting is required for
investments in which the investor company can
exert “significant influence” over the investee.
Significant influence is the ability of the investor to
affect the financial or operating policies of the
investee.
Equity Method Investments
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Ownership levels of 20-50% of the outstanding common stock of
the investee company presume significant influence.
Significant influence can also exist when ownership is less than
20% if, for example,
 the investor company is able to gain a seat on the board of
directors of the investee company, or
 when the investor controls technical know-how or patents that
are used by the investee company, or
 when the investor company is able to exert control by virtue of
legal contracts between it and the investee company.
Accounting for Equity
Method Investments
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Initially record investment at cost.
Increase asset to reflect proportionate share of net
income. Essentially treats their income as yours.
Dividends decrease investment. Treated as a return
of investment. They are not considered income.
No mark-to-market
Income recognized rarely equals either cash flow or
actual change in market value.
Equity Method Accounting
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Assume that HP acquires a 30% interest in Mitel
Networks. On the date of acquisition, Mitel reports
$1,000 of stockholders’ equity, and HP purchases its
30% stake for $300.
Assume that Mitel reports net income of $100 and
pays dividends of $20 (30% or $6 to HP)
Equity Method Accounting
Following are the balance sheet and income statement impacts for the
preceding transactions:
Your turn
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1.
2.
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Initially L purchases 30% of S for $9 when
the book value of S = $30
S has income of $20 and pays total
dividends of $10
S has a loss of $10 and pays total dividends
of $20
Record L’s yearly income from S and
investment in S
Equity method
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Why would a firm prefer using the equity
method over consolidation?
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Blue and Yellow = Green example
Equity method cautions!
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Income shown on income statement is not
really income.
The asset shown is not at market value.
Potentially liabilities are “hidden” off balance
sheet.
Business Combinations (Over 50%)
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2 companies brought together as single accounting
entity.
Results in a combination of both the investor and
investment firm’s financial statements.
Purchase method must be used for acquisition of
another company.
Prior to 2002 and outside of U.S., under certain
conditions the pooling of interests method was/is
used.
Investments with Control —
Consolidation Accounting
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Accounting for business combinations
(acquisitions) involves one additional step to
equity method accounting.
Consolidation accounting replaces the
investment balance with the assets and liabilities
to which it relates, and it replaces the equity
income reported by the investor company with
the sales and expenses of the investee company
to which it relates.
Consolidation Accounting
Consolidation with Purchase Price Above
Book Value
Foreign Currency Translation
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Many companies conduct operations, not only in
countries outside of the US, but also in currencies
other than $US.
Many purchase assets in foreign currencies, borrow in
foreign currencies, and transact business with their
customers in foreign currencies.
US corporations can have subsidiaries whose entire
balance sheets and income statements are stated in
foreign currencies.
Foreign Currency Translation Adjustment
at Ford Motor Company
Income Statement Effects of Currency
Swings
McDonald’s: