FADM Term 1 2017

SESSION: 6

Long term assets – PP&E and

Intangibles

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Learning objectives

1. Understand the difference between Property, plant and equipment and

Intangible assets
2. Accounting
i. Determining the acquisition cost
ii. Determining the depreciation expense under various methods
iii. Account for impairment
iv. Account for gain/loss on sale of assets

3. Read and analyze the footnotes relating to Property, Plant and Equipment
and Intangibles from a real financial statement

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 6.1. Long term Assets

What are the critical assets needed by the following companies to succeed?

Wal-Mart Stores Inc. Stores network, ability to procure at low cost

Pfizer Inc. R&D
Starbucks Corporation Brand
Eicher Motors Limited Factory
Coca Cola Brand, distribution network. Secret formula
Arcelor Mittal Steel plants
Facebook Brand, social network
Apple Great products, brand, Steve Jobs

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6.1. Long term Assets

• PP&E – land, buildings, manufacturing facilities, office equipment, and

vehicles that are used in operations
• Intangibles – patents, copyrights, brand name, goodwill, etc

• Companies do not sell these assets for profit but the assets do generate profits
because they are used in the company’s operations.

PP&E Intangibles

Physical Presence Yes No

Valuation uncertainty Easy to value Hard to value

Therefore, the accounting approach for PP&E and Intangible assets will be
affected by their respective characteristics

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6.2. Property Plant & Equipment (PPE) – overview of accounting

 As the benefits PP&E are expected to extend beyond one year, the
acquisition cost is capitalized when the PP&E is bought. Capitalizing
means the entire amount of the cost is shown as an asset in the balance
sheet.
Asset (+A) Dr.
Cash or Payable (-A or +L) Cr.

 Capitalized costs are eventually charged as an expense to income through

different processes:
1. Amortization
2. Impairment
3. Gains / losses on disposal of assets

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6.2. Property Plant & Equipment (PPE) – overview of accounting

1. Amortization
 This is the process of allocating the asset’s value to those future periods when
its benefits are expected to be earned, typically over the asset’s useful life.

 For example if an asset’s useful life is 5 years, then 1/5 of the asset’s value will
be charged as an expense during each of those five years.

 Most common example of amortization is depreciation which is the

terminology used for amortizing property, plant and machinery (PP&E).

Depreciation (Amortization) (+E, -SE) Dr.

Accumulated depreciation (+CA) Cr.

Note that accumulated depreciation is subtracted from Gross asset value to arrive
at the net value (also called as carrying value) and this amount is shown on the
balance sheet.

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6.2. Property Plant & Equipment (PPE) – overview of accounting

2. Impairment
 In certain circumstances, market forces or nature may destroy substantial parts
of the asset’s value. In such a case, we write down the value of the asset to its
current fair value (i.e., market value) through a process of impairment. The
amount of impairment is charged as an expense during the period when the
value destruction occurred.

Impairment Expense (+E,-SE) Dr.

Provision for impairment or Asset (+CA or –A) Cr.

 Note that amortization is a periodic charge that occurs every period over the
asset’s life. Impairment is a one-time event.

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6.2. Property Plant & Equipment (PPE) – overview of accounting

What happens when an asset is sold or disposed?

 When an asset is sold or disposed, the value of the asset is reduced to zero
in the balance sheet. Any difference between the sale proceeds and the
remaining carrying value of the asset is charged as a gain or a loss on sale
of asset to the income statement.

Cash (+A) Dr. (Sale proceeds)

Loss on sale of asset (+E, -SE) Dr. (plug)
Asset (-A) Cr. ( carrying value)

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6.2.1. PP&E – Determining Acquisition Cost

What is given up to obtain the asset?

 Include all costs required to bring the asset into serviceable or usable
condition and location.

 Purchased Assets: Purchase price plus cost to prepare the asset for use
(taxes, transport, installation, transport)

 Self-Constructed Assets
 Direct costs of construction such as engineering and architectural fees,
raw materials used in construction , labor, overhead
 Financing costs (interest on funds borrowed to finance construction)

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6.2.1. PP&E – Determining Acquisition Cost

Illustration 1. HM Corp. purchases new lab equipment on January 1, 20X1. The

purchase details are as follows
The price of equipment = 13,000
Trade-in allowed by manufacturer = 3,000
Cash discount because of early payment = 500
Freight charges for delivery = 500
Payment to electrician and engineer for installation = 1,000
Reimbursement to two key employees for expenses = 2,000
incurred while visiting the manufacturer’s plant in
another city to receive training on operating the new
equipment
Interest paid on loan taken to finance the purchase = 1,200

Cost of new equipment recorded as asset = 16,000

[13,000– 500+500+1000 + 2000]

Journal entry
New equipment (+A) Dr 16,000
Old equipment (-A) Cr 3,000
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Cash (-A) Cr 13,000
6.2.2. PP&E – recording depreciation

 Continuing with illustration # 1, what is the depreciation expense for

Year 1 using the Straight-Line Method

Cost = $16,000 Useful life = 5 years Salvage value = $1,000

Annual Depreciation Expense = (Cost – salvage value) / useful life

($16,000 -$1,000)/5 = $3,000

Journal entries
Depreciation expense (+E, -SE) Dr 3,000
Accumulated depreciation (+XA) Cr 3,000

Advantage of this method - simplicity

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6.2.2. PP&E – recording depreciation

Continuing with illustration # 1, What is the depreciation expense for Year 1

using the Accelerated method – (double declining balance)

Straight line depreciation rate = 100% / 5 = 20%

Double declining rate = 2 X SLM rate = 40%
Double declining depreciation expense = double declining rate X Beginning
period book value
Year Book value at the Depreciation expense Book value at the
beginning of year (40% of BV) end of year

1 16,000 6,400 9,600

2 9,600 3,840 5,760
3 5,760 2,304 3,456
4 3,456 1,382 2,074
5 2,074 829 1,245
Total

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6.2.2. PP&E – recording depreciation

Advantage:

 A similar method is accepted by tax authorities. The faster an asset is written

off for tax purposes, the greater the tax deferral to future periods and more
funds are available for operations immediately

 Conceptually, decreasing depreciation charges over time compensate for

Increasing repair and maintenance costs
Decreasing revenue and operating efficiency
Higher uncertainty of revenues in later years of aged assets ( due to obsolescence)

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6.2.2. PP&E – recording depreciation

Continuing with illustration # 1, what is the depreciation expense for Year 1

using the Activity (units-of production) method

It is expected that the new equipment will produce 40,000; 45,000; 50,000; 55,000;
and 60,000 units over the next 5 years

Depreciation per unit = (Cost - salvage value) / Total units of production

= (16,000 – 1,000)/250,000 = $0.06 / unit

Depreciation expense = Depreciation per unit X Units produced in period

= 0.06 * 40,000 = $2,400 for the first year

This method is used in industries like steel, heavy machinery

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6.2.3. PP&E – accounting for changes in estimates

Change in Depreciation Estimates

 This is caused by change in asset life or Salvage Value. In such cases the
change prospectively applied, i.e., to future years (no restatement of past
years’ results)

 Illustration #2
Cost = $100K, Salvage value = 0, Useful life estimate of 5 years
After 2nd year, spend $30K on improvement that extends the useful life by 3
years (i.e., to total of 8).

i. What is annual depreciation expense for each of the first two years?
Depreciation = (100,000 – 0)/5 = 20,000

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6.2.3. PP&E – accounting for changes in estimates

ii. What is book value at the end of 2nd year?

Cost – depreciation for year 1 and 2 = 100,000 – 20,000 – 20,000 = 60.000

iii. How do we account for the improvement?

Capitalize this cost as it will increase the useful life of asset
New book value of asset = 60,000 from step (ii) + 30,000 of improvement = 90,000

iv. What is annual depreciation expense for years 3 and beyond?

New book value at the beginning of year 3 = 90,000 (from step iii)
There is no change in salvage value
Revised useful life will now be 3 years under the old assumption + 3 years due to
improvement i.e. 6 years in total.
New depreciation = (90,000 – 0) / 6 = 15,000

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6.2.3. PP&E – accounting for changes in estimates

Accounting for gain / loss on sale of asset

Continuing with illustration # 2, at end of 7th year the asset is sold for 2,000.
How do we account for it?

Book value at the end of 7th year = Book value at the beginning of 3rd year –
depreciation from years 3-7
= 90,000 (from step iii) – 15,000 (from step iv)* 5 years
= 90,000 – 75,000 = 15,000
Sale price = 2,000
Gain / (loss ) = (13,000)

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6.2.3. PP&E – accounting for changes in estimates

Journal entry -
Cash (+A) Dr 2,000
Accumulated depreciation (-XA) Dr 115,000
Loss on sale of asset (+E,-SE) Dr 13,000 (plug)
PP&E (-A) Cr 130,000

130,000 = 100,000 initial cost + 30,000 improvement

115,000 = depreciation from year1-7, 20,000 + 20,000 + 15,000 + 15,000

+15,000 + 15,000 + 15,000

How would this transaction affect the statement of cash flows

• Cash of 2,000 will show up as cash inflow from investing activities
• If an indirect method is being used, loss of 13,000 will be added back to the net
6-18 income to arrive at cash flow from operations. Why?
 Intangible assets

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6.3. Intangible assets - Six major categories

1. Marketing-related - Trademarks or trade names, newspaper mastheads, Internet

domain names, and non-competition agreements. In the United States trademarks or trade
names have legal protection for indefinite number of 10 year renewal periods.

2. Customer-Related Intangible Assets - Examples: Customer lists, order or production

backlogs, and both contractual and non-contractual customer relationships.

3. Artistic-Related Intangible Assets - Examples: Plays, literary works, musical works,

pictures, photographs, and video and audiovisual material. Copyright granted for the life of the
creator plus 70 years.

4. Contract-Related Intangible Assets - Examples: Franchise and licensing agreements,

construction permits, broadcast rights, and service or supply contracts.

5. Technology-Related Intangible Assets - Examples: Patented technology and trade

secrets granted by a government body. Patent gives holder exclusive use for a period of 20 years.

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6.3. Intangible assets - Six major categories

What about brand name, exceptional management, desirable location, good

customer relations, skilled employees, high-quality of products, etc. ?

• Recorded as a part of GOODWILL when an entire business is purchased.

• Goodwill is measured as the excess of ...

cost of the purchase over the fair value of the identifiable net assets
(assets less liabilities) purchased.

• Recorded typically to “balance the balance sheet” 

Internally created goodwill is not capitalized.

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6.4. Intangible assets – accounting challenges

 What intangibles get put on the balance sheet are only the tip of the iceberg

 Only identifiable intangibles are recorded. These intangibles

 arise out of contractual or other legal rights
 are separable from a company and can be sold

 For this reason most “true” intangible assets of companies are not on the balance
sheet. E.g. of intangibles not recorded include brand value of the company, CEO
expertise, human resources etc.

 Even for intangible assets on the balance sheet only a small part of the value is
reflected on the balance sheet. For e.g., balance sheet typically only puts filing and
legal costs of patents, not the cost of the science to develop the patent

 Typically acquired intangibles are on the balance sheet but internally developed
intangibles are not
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6.4. Intangible assets – accounting challenges

The Nike Trademark

In the early 1970’s, Carolyn Davidson, a graduate student studying graphic

design, created the Nike swoosh for Phil Knight, owner of Blue Ribbon
Sports. Phil was seeking a new logo and asked Carolyn to create a design. Phil
chose the now popular ‘swoosh’ logo and paid Carolyn’s invoice of
approximately $35 for her work.*

Source: Nikebiz: Company Overview: History, 1970s. “The Birth of the Nike Brand, and Company.”
http://www.nikebiz.com/company_overview/history/1970s.html
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6.4. Intangible assets – accounting challenges

Acquisition of WhatsApp by Facebook for $17 billion

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6.4. Intangible assets – accounting challenges

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6.4. Intangible assets – accounting challenges

Manner Acquired
Internally
Type of Intangible Purchased Created Amortization Impairment Test

Recoverablility test
Limited-life intangibles Capitalize Expense* Over useful life and then fair-value
test

Indefinite-life intangibles Capitalize Expense* Do not amortize Fair-value test only

* except for direct costs, such as

legal costs

Capitalized costs includes all costs necessary to make the intangible asset ready
for its intended use such as (i) purchase price; (ii) Legal fees; (iii) Other incidental
expenses.
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6.5. R&D costs

Research and development (R&D) costs are not in themselves intangible assets.
• Frequently results in the development of patents or copyrights such as
new product, process, idea, formula, composition, literary work etc.
• Companies spend considerable sums on research and development.

Sales (bn)
Company FY 2015 R&D / Sales
Canon ¥3,800.3 8.64%
Daimler €149.5 4.41%
GlaxoSmithKline €23.9 14.88%
Johnson & Johnson $70.1 12.91%
Apple $233.7 3.45%
Roche CHF 48.1 19.90%
Procter & Gamble $76.3 2.62%
Samsung $177.4 7.40%

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6.5. R&D costs

• Research activities
• Planned search or critical investigation aimed at discovery of new
knowledge.
• Examples: Laboratory research aimed at discovery of new knowledge;
searching for applications of new research findings.
• Development activities
• Translation of research findings or other knowledge into a plan or
design for a new product or process or for a significant improvement to
an existing product or process whether intended for sale or use.
• Examples: Conceptual formulation and design of possible product or
process alternatives; construction of prototypes and operation of pilot
plants.
• Costs Associated with R&D Activities: Materials, Equipment, and Facilities,
Personnel, Purchased Intangibles, Contract Services, Indirect Costs
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6.5. R&D costs

• Accounting for R&D is problematic due to:

• High uncertainty of any potential benefits
• Time period between R&D activities and determination of success
• Intangible nature of most R&D activities

• Because of this most R&D costs are written off as expenses

• However, R&D is in fact valuable and will lead to future benefits. It is just
that we don’t know which R&D activities will be successful, and a very
small proportion of them are successful. Further, R&D spent in later stages
(typically the “D” in R&D) has less uncertain future benefits.

• Hence IFRS allows capitalization of development costs after technical

feasibility has been achieved. US GAAP is expected to also allow this soon.

• Both IFRS and US GAAP allow capitalization of software development costs

after achieving technical feasibility.

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6.6. Reading and analyzing PP&E and intangibles footnotes

Refer to ARCELORMITTAL’s financial statements and answer the following

Q1. How important is PP&E to this business?

Q2. What does PP&E comprise of ?

Q3. What is the gross value and the net book value of PP&E? What does this
mean?

Q4. How much of PP&E was sold and how much was purchased during 2015?

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6.6. Reading and analyzing PP&E and intangibles footnotes

Q5. How much was the depreciation and impairment expense for the year? How much is
this amount on a cumulative basis?

Q6. Have there been any changes in the depreciation policies of this company? How do you
feel about them?

Q7. What has led to the impairment of PP&E ?

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6.6. Reading and analyzing PP&E and intangibles footnotes

Q8. On average what is the assumed useful life of Machinery and Equipment?
[ Estimated life= Cost of depreciable asset / Annual depreciation ]

Q9. On average how old is the Machinery and Equipment for this company ?
[ Elapsed life = Accumulated depreciation / Annual depreciation ]

Q10. What is fixed asset turnover ratio for this company? What does this mean?
[Fixed asset turnover ratio = Sales / Net PP&E ]

It means each $1 invested in PP&E generates _____ in sales

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6.6. Reading and analyzing PP&E and intangibles footnotes

Refer to Facebook’s financial statements and answer the following

Q1. How important is PP&E to this business?

Q2. What are Facebook’s largest assets?

Q3. In many ways assets can be viewed as sources of future economic benefits.
Viewed from that perspective, how informative as Facebook’s assets about its
future business prospects?

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6.6. Reading and analyzing PP&E and intangibles footnotes

Q5. What are main intangible assets of FB? How did they come in place?

Q6. What is IPR&D? Why is it recorded as an asset?

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 Next Session
• Inter corporate investments – marketable securities
• Good luck for the mid-term exam

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