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Financial Accounting: PPE and Intangibles

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Financial Accounting

Eleventh Edition
Global Edition

Chapter 7
PPE and
Intangibles

Copyright © 2018 Pearson Education, Inc. All Rights Reserved.


Course Overview
Details of common asset accounts:
➢Cash: Bank Reconciliation ✓
➢Receivables: Impairment & notes interests ✓
➢Inventory ✓
➢Property, plant and equipment (This Lecture)
Details of common liability accounts (Lecture 8)
Details of equity (Lecture 9)
Details of Statement of Cash Flow (Lecture 10)

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Long-Lived Assets and Related
Expense Accounts

*Note: Land can be freehold (not depreciated) or leasehold (amortized)


In this course we assume freehold
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Learning Objectives
7.1 Understand the different types of long-term assets
7.2 Determine the cost of PPE on initial recognition
7.3 Understand when to capitalize or expense
subsequent costs
7.4 Measure and record depreciation
7.5 Understand the recognition and subsequent
measurement of intangible assets
7.6 Evaluate a company’s performance based on its
assets
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Learning Objective 7.1
Understand the different types of long-term assets
•Property, Plant, & Equipment (P,P&E)
– Long-term assets used in the business (e.g.
buildings, vehicles, computers)
•Natural Resources
– Assets of estimated value, typically attached to the
ground (e.g. oil, gas, timber, coal)
•Intangible Assets
– Non-physical long-term assets (e.g. patent, client
list, goodwill)
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Understand the different types of
long-term assets
Property, Plant and Equipment (PPE):
• Property includes land and buildings
• Plant typically include factories and other productive
assets (e.g. assembly line, commercial air conditioner,
machinery)
• Equipment are other long-term assets for use in the
business (e.g. furniture, vehicles, computers)

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Learning Objective 7.2
Determine the cost of PPE on initial recognition
Remember the cost of any asset is the sum of all the
costs incurred to bring the asset to its intended use.
• Costs include:
‒Purchase price
‒Taxes
‒Commissions
‒Other costs to make the asset ready for use

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Determine the cost of PPE on initial
recognition (1 of 10)
Land
• Costs to obtain a flat land ready to be built on
• Costs include:
– Purchase price
– Brokerage commission
– Survey fees
– Legal fees
– Taxes
– Expenditures for grading and clearing land
– Removing any unwanted buildings
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Determine the cost of PPE on initial
recognition (2 of 10)
Land Improvements
• Items located on the land but not a part of the building
structure:
– Driveways signs
– Fences
– Sprinkler systems
– Lighting
– Parking lot
– Other similar items

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Determine the cost of PPE on initial
recognition (3 of 10)
Airbus signs a €300,000 note payable to purchase a parcel
of land for a new logistic site. Airbus also pays €10,000 for
real estate commission, €13,000 of stamp duty, a €1,000
land survey fee, and €16,000 to pave the parking lot—all in
cash. What should Airbus recognize as the cost of this
land?

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Determine the cost of PPE on initial
recognition (4 of 10)
Airbus signs a €300,000 note payable to purchase a
parcel of land for a new logistic site. Airbus also pays
€10,000 for real estate commission, €13,000 of stamp
duty, a €1,000 land survey fee, and €16,000 to pave the
parking lot—all in cash. The journal entry is:

The parking lot is in land improvements

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Determine the cost of PPE on initial
recognition (5 of 10)
Building, Machinery, and Equipment
• Cost of constructing a building includes:
– Architectural fees
– Building permits
– Contractors’ charges
– Payment for material, labor, and overhead
– Interest on money borrowed to finance
construction

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Determine the cost of PPE on initial
recognition (6 of 10)
Building, Machinery, and Equipment
• Cost of purchasing a building includes:
– Purchase price
– Brokerage commission
– Sales and other taxes
– Expenditures to repair and renovate building for its
intended purpose

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Determine the cost of PPE on initial
recognition (7 of 10)
Building, Machinery, and Equipment
• Cost of equipment:
– Purchase price (less any discounts)
– Transportation from the seller
– Insurance while in transit
– Sales and other taxes
– Purchase commission
– Installation costs
– Cost to test the asset before it’s placed in service
– Cost of any special platforms
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Determine the cost of PPE on initial
recognition (8 of 10)
• Lump-Sum (or Basket) Purchases of Assets
– Purchase several assets for a single lump-sum
amount
– Total cost divided among the assets based on
relative market values (or called fair value)
– Purchase price =/= market values because there
may be discounts/surcharges
– Market value is usually determined by third party
sources
– Technique is called the relative-sales-value
method
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Determine the cost of PPE on initial
recognition (9 of 10)
Airbus purchases land and a building in Luxemburg.
The building sits on two acres of land, and the
combined purchase price of land and building is €2.7
million. An appraisal indicates that the land’s fair value
is €1 million and the building’s fair value is €2 million.

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Determine the cost of PPE on initial
recognition (10 of 10)
Airbus purchases land and a building in Luxemburg.
The building sits on two acres of land, and the
combined purchase price of land and building is €2.7
million. An appraisal indicates that the land’s fair value
is €1 million and the building’s fair value is €2 million.

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Learning Objective 7.4
Measure and record depreciation

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Measure and Record Depreciation
(1 of 3)

Book Value
Plant assets are recorded on the balance sheet at their
book value.
Book Value = Cost − Accumulated Depreciation
(sometimes called net book value)

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Accumulated Depreciation
• Shows the sum of all depreciation expense
• The balance increases over the asset’s life
• Is a contra-asset account, a normal credit balance.

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Exhibit 3-5 PPE on the Balance Sheet
Carrying amount (Book Value): Cost of the plant asset
minus accumulated depreciation
Excerpt from the Balance Sheet:

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Measure and Record Depreciation
(2 of 3)

• Depreciation
– Process of allocating a plant asset’s cost to
expense over its life
– Necessary as plant assets wear out, grow
obsolete, and lose value over time
– Allocates cost against revenue it helps earn each
period (matching principle)
– Depreciation expense is reported on the income
statement
– Freehold Land is not depreciated

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Measure and Record Depreciation
(3 of 3)

• Cost
‒ Purchase price and all costs to get plant asset
ready for use, known amount
• Estimated Useful Life
‒ Length of service expected from using the asset,
estimated amount
• Estimated Residual Value
‒ Expected cash value of an asset at the end of its
(intended) useful life, estimated amount

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Exhibit 7-5 Allocating Cost of Assets Over
Useful Life

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Depreciation Methods (1 of 6)
• Three main depreciation methods:
– Constant allocation (straight line)
– By actual usages (units of production)
– Accelerated allocation (double-declining balance)

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Exhibit 7-6 Data for Depreciation
Computations (1 of 4)

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Depreciation Methods (2 of 6)
• Straight-Line Method
– Equal amount of depreciation assigned each
period
– Depreciable cost = depreciable base:
– Equal to cost - residual value
– divided by useful life (in years/months) to
determine annual/monthly depreciation
expense

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Exhibit 7-6 Data for Depreciation
Computations (2 of 4)

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Depreciation Methods (3 of 6)
Straight-Line Method

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Exhibit 7-7 Straight-Line Depreciation
Schedule

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Depreciation Methods (4 of 6)
• Units-of-Production Method
– Fixed amount of depreciation is assigned to each
unit of output produced by the asset
– Depreciable cost is divided by useful life–in units
of production–to determine fixed amount per unit
– Per-unit amount then multiplied by the actual
number of units produced each period to compute
depreciation expense

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Exhibit 7-6 Data for Depreciation
Computations (3 of 4)

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Exhibit 7-8 Units-of-Production (UOP)
Depreciation Schedule
Assume that Airbus expects to drive the truck 20,000
miles during the first year, 30,000 during the second,
25,000 during the third, 15,000 during the fourth, and
10,000 during the fifth.

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Depreciation Methods (5 of 6)
• Accelerated Depreciation, E.g., Double-Declining-
Balance Method
– Writes off a larger amount of cost near the start of
asset’s useful life, because some assets tend to be
more heavily used at the start of their useful life.
E.g. aircrafts allocated to fly different lines
– DDB: Most frequently used accelerated
depreciation method

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Depreciation Methods (6 of 6)
• DBB depreciation:
– Take asset’s book value at the beginning of the
year as depreciable cost for the year.
– Multiply by a constant percentage = two times the
straight-line depreciation rate
• DDB differs from others in two ways:
– Residual value is ignored initially
– Last-year depreciation is a “plug”:
Estimated useful life (in this case 5 years) is
always respected. Last-year depreciation is
calculated backward from the residual value.
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Exhibit 7-6 Data for Depreciation
Computations (4 of 4)

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Exhibit 7-9 Double-Declining-Balance
(DDB) Depreciation Schedule

Note:
1st year $41,000 (book value) is used instead of $40,000 as in other methods
Last-year is calculated backward from “book value – residual value =
depreciation needed” = 4,314 instead of 0.4 x 5,314 = 2,126
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Comparing Depreciation Methods (1 of 2)
• Straight-line
‒ Best for plant assets that generate revenue evenly
over time
• Units-of-production
‒ Best for assets that wear out because of use
• Double-declining-balance
‒ Best for assets that generate more revenue earlier
in their useful life

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Comparing Depreciation Methods (2 of 2)

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Exhibit 7-10 Depreciation Patterns
Through Time

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Exhibit 7-11 Depreciation Methods
Used by 170 Companies

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Other Issues in Accounting for Plant
Assets
• Plant assets are complex because
– They have long lives
– Possible accounting changes in the future
– Their amounts are usually large (expensive)
– Depreciation greatly affects income taxes
– Companies may have gains or losses when they
sell plant assets

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Depreciation for Tax Purposes
• Most companies use straight-line depreciation for
financial reporting, but the accelerated or another
method for tax purposes.
– E.g. Hong Kong prescribes specific rates for
various assets
• Accelerated depreciation provides faster tax
deductions (by lowering net taxable income) → Tax
deductions reduce income taxes (during the earlier
years) → Reduced income taxes helps conserve cash

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Exhibit 7-12 The Cash Flow Advantage of
Accelerated Depreciation for Tax Purposes

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Depreciation for Partial Period
Suppose Airbus purchases a warehouse building on
April 1 for €500,000. The building’s estimated life is 20
years, and its estimated residual value is €80,000.
Airbus’s fiscal year-end is December 31.

If purchase is made before 15th of a month (1-14), count


the month’s depreciation. Else, exclude the month’s
depreciation (treat like it is purchased next month).
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Changes in Estimates of Useful Lives
or Residual Values (1 of 2)
• After an asset is in use, managers may change its
useful life based on experience or new information.
– Called a change in accounting estimate

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Changes in Estimates of Useful Lives
or Residual Values (2 of 2)
Assume a Lenovo’s equipment cost $50,000 and originally had a
useful life of 10 years (no residual value). Lenovo used the asset
for 4 years, resulting in accumulated depreciation of $20,000 and
a remaining book value of $30,000. Management now believes
the asset will remain useful for an additional 8 years.

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Impairment of PPE (1 of 2)
• Impairment
– Both tangible and intangible long-term assets must
be tested annually
– Occurs when recoverable amount fall below the
asset’s net book value
– Recoverable amount = higher of:
fair value less cost of disposal (selling) and
value-in-use (generating cash with intended use)
– If impaired, must adjust the carrying value
downward to the fair value/value in use

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Impairment of PPE (2 of 2)
Assume the fair value less cost of disposal was
$300 million and the value-in-use was $100 million
when the carrying amount of a factory was $700
million. The recoverable amount was $300 million.
The company recognized an impairment loss of $400
million with the following journal entry (in millions):

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Measurement Subsequent to Initial
Recognition
• Under IAS 16, an entity elects one out of two
measurement models for each class of property,
which is defined as a grouping of assets of similar
nature and use in an entity’s operations.
– Cost model
– Record assets at historical cost less
impairments
– Revaluation model (Fair Value method)
– Record assets at their fair market values

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Using Fully Depreciated Assets
• A fully depreciated asset:
– Is an asset that has reached the end of its
estimated useful life
– Can continue to use asset, but will not record
anymore depreciation
– Remove the asset’s cost and accumulated
depreciation when the asset is disposed of

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Learning Objective 7.3
Understand when to capitalize or expense subsequent
costs

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Understand when to capitalize or
expense subsequent costs
• Capitalized means the cost is added to an asset
account
– Capitalize when cost increase the asset’s capacity
or extends its useful life
– i.e. useful life or units of production is increased
• Expensed means the cost is deducted from income
– Expense when cost maintains usefulness of asset
• Capital expenditure → money spent to acquire or
significantly improve a company’s fixed assets

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Exhibit 7-4 Capital Expenditure or
Immediate Expense for Costs
Associated with a Delivery Truck

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Learning Objective 7.5
Account for PPE disposals

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Account for PPE disposals (1 of 8)
• Before accounting for disposal, the business should
bring the depreciation up to date to:
– Update the asset’s final book value
– Record the expense up to the date of disposal

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Account for PPE disposals (2 of 8)
Disposing of a Fully Depreciated Asset for No
Proceeds. Suppose the final year’s depreciation
expense has just been recorded for a machine that cost
$60,000 and has a residual value of zero.

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Account for PPE disposals (3 of 8)
Disposing of a Not Fully Depreciated Asset for No
Proceeds. Suppose FedEx disposes of equipment that
cost $60,000. This asset only has $50,000 of
accumulated depreciation and a book value of $10,000.

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Account for PPE disposals (4 of 8)
Selling a PPE. Suppose the company sells equipment
on September 30, 20X8 for $7,300 cash. The equipment
cost $10,000 when purchased on January 1, 20X5 and
has been depreciated straight-line. It had an estimated
life of 10 years with no residual value.
The depreciation entry on September 30, 20X8 is:

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Account for PPE disposals (5 of 8)

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Account for PPE disposals (6 of 8)
Selling a PPE. Suppose the company sells equipment
on September 30, 20X8 for $7,300 cash. The
equipment cost $10,000 when purchased on January 1,
20X5 and has been depreciated straight-line. It had an
estimated life of 10 years with no residual value.
The entry to record the sale is:

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Account for PPE disposals (7 of 8)
• Exchanging PPE
– Trade in old assets for new ones
– Nonmonetary exchanges
– Based on fair values of assets involved
– Differences between fair values of old and new
assets results in a gain or loss

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Account for PPE disposals (8 of 8)
Exchanging PPE. Assume an old delivery car cost
$9,000 with accumulated depreciation of $8,000. The
company trades the old automobile for a new one with a
fair market value of $15,000 and pays $10,000 of cash.

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T-Accounts for Analyzing PPE
Transactions (1 of 2)

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T-Accounts for Analyzing PPE
Transactions (2 of 2)
Suppose you started the year with buildings that cost
$100,000. During the year, you bought another building
for $150,000 and ended the year with buildings that cost
$180,000. What was the cost of the building you sold?

*
X = 100,000 + 150,000 − 180,000

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Accounting for Natural Resources
(1 of 2)

• Natural Resources
– Long-term assets such as iron ore, petroleum (oil),
and timber
– Depletion – tracks the flow of a natural resource
from its raw state through inventory to cost of
goods sold (same as units-of-production)
– Depletion expense (Expense account) on the
income statement
– Accumulated depletion (Contra-Asset account)
on the balance sheet

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Accounting for Natural Resources
(2 of 2)

For example, an oil lease may cost Royal Dutch Shell


$100,000 and contain an estimated 10,000 barrels of
oil. If 3,000 barrels are extracted (assuming the
company paid cash, $10 a barrel), the following entry is
made:

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Learning Objective 7.5
Understand the recognition and subsequent
measurement of intangible assets

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Understand the recognition and subsequent
measurement of intangible assets
• Intangible Assets
– Long-term assets with no physical form
– Carry special rights
– Patents, copyrights, trademarks, franchises,
leaseholds, and goodwill
– Two categories
▪ Finite lives → Amortization recorded (over the
life)
▪ Indefinite lives → Checked annually for
impairment
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Accounting for Specific
Intangibles (1 of 8)
• Patents
– Granted by a government
– Give the holder excusive right to produce and sell
invention
– In Hong Kong, short-term patents cover 4-8
years and standard patents cover 3-20 years.
– In Mainland, 20 years for invention, 10 for utility
model or design

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Accounting for Specific
Intangibles (2 of 8)
Patents: Suppose Yamaha pays $170,000 to acquire a
patent on January 1, and the business believes the
useful life is 5 years. (when we amortize an intangible
asset, we typically credit the asset itself)

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Accounting for Specific
Intangibles (3 of 8)
• Copyrights
– Granted by a government
– Give the holder excusive right to reproduce and
sell a book, musical composition, film, or other
work of art
– In Hong Kong, copyrights extend 50 years beyond
the author’s life

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Accounting for Specific
Intangibles (4 of 8)
• Trademarks and Trade names
– Distinctive identifications of products or services
– Useful life may be set by contract
– Amortize cost over useful life
▪ May have indefinite life and not be amortized
▪ In Hong Kong, trademarks are registered for 10
years and renewal for 10 year periods thereafter

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Accounting for Specific
Intangibles (5 of 8)
• Franchises and Licenses
– Granted by a private business or government
– Right to sell a product or service in accordance
with specified conditions
– Includes restaurant chains and sports
organizations
– Often have indefinite lives (depends on the
contracts)

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Accounting for Specific
Intangibles (6 of 8)
• Goodwill
– The excess of the cost of purchasing another
company over the sum of the market values of the
acquired company’s net assets
– Only recorded when it is purchased
– Indefinite life

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Accounting for Specific
Intangibles (7 of 8)
Goodwill. Airbus acquires Europa Company for $10
million. Europa has assets with a market value of $9
million and $2 million in liabilities, therefore, net assets
equals $7 million. Airbus paid $3 million for goodwill as
follows:

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Accounting for Specific
Intangibles (8 of 8)
Goodwill. Airbus acquires Europa Company for $10
million. Europa has assets with a market value of $9
million and $2 million in liabilities; therefore, net assets
equals $7 million. The journal entry to record this
transaction is:

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Learning Objective 7.7
Evaluate a company’s performance based on its assets

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Evaluate a company’s performance
based on its assets (1 of 2)

Return on Assets (ROA)


Net income
ROA =
Average total assets

Where Average total assets =


( Beginning total assets + Ending total assets )
2

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Evaluate a company’s performance
based on its assets (2 of 2)
Airbus’ performance in comparison to Boeing and
General Dynamics is as follows:

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Chapter Summary
• PPE assets are recognized on the balance sheet for all
costs incurred to bring them into intended use
• They are presented on the balance sheet as “Cost –
Accumulated Depreciation”, which is called the Book Value
• The 3 main depreciation methods of PPE are:
1. Straight-line method
2. Units of Production method
3. Double-Declining Balance (DDB) method
• In method 1 and 2, the depreciable cost, calculated as
“Cost – Estimated Residual Value”, is divided by
“Estimated Useful Life”, either in time or units of production
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Chapter Summary
• In method 3, the depreciable cost is the book value of last
year ending balance, and the depreciation is calculated by
a constant rate which is 2x the straight-line rate
• In method 3, the estimated useful life (in years) are still the
same as that in straight-line method. The final-year
depreciation is calculated backward from the residual
value
• Every year, long-term assets need to be tested for
impairment, and they need to be written-down if their
recoverable amount is lower than book value

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Chapter Summary
• When disposing PPE, the accumulated depreciation needs
to be brought up-to-date first, then gain/loss of sale is used
to record the differences between book value and selling
proceeds
• Natural Resources are Depleted similar to the unit-of-
production method
• Intangible assets are Amortized if they have finite life

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Course Overview
Details of common asset accounts:
➢Cash: Bank Reconciliation ✓
➢Receivables: Impairment & notes interests ✓
➢Inventory ✓
➢Property, plant and equipment ✓
Details of common liability accounts (Next Lecture)
Details of equity (Lecture 9)
Details of Statement of Cash Flow (Lecture 10)

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Course Overview
Financial Statement Analysis:
•Current Ratio
•Receivable Turnover
•Gross Profit
•Inventory Turnover (Residence Period)
•Return on Assets

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Homework Assignments
• S7-8, E7-15A
• Due 5 Nov, 11:59pm
• Upload to Blackboard
• Late submission is not accepted

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