Wednesday, May 25, 2022

M-6.1.1 PPE Accounting: Capitalize vs expense, Acquisition cost, Useful life, Depreciation methods

Hello everyone again thanks for coming in on saturday uh today we are going to discuss uh ppnd property plan and equipment uh whatever fixed assets our business can have and what to do with us fix assets in accounting .

And let's let me start by sharing the lectures uh these are mit lectures they are a bit old 2004 but uh people in the accounting didn't change much since then and just in case we will have uh our last module today uh about .

Oh accounting guidance which is modern like the most up-to-date and we will see uh we will discuss where we can find the most recent accounting guides okay so where we will start with that lecture is to understand how the matching principle influences the capitalization .

Of long-lived assets and the expenses of capitalized cost too much revenues generated in the use of long-leaked assets the lecture the lecture also touches a bit about deferred taxes we will not cover that today it's .

Kind of a bit complicated area to explain and it might confuse a lot of people including myself sometimes i'm not i'm not a big tax guy some people specialize on that i i only have like average knowledge of that sufficient to .

Do my work not not much than that okay so let's see what we have here capitalize what do what do we mean by capitalizing the costs it means that we will we will show that assets on the balance sheet so that assets have future benefits .

And the opposite of capitalization of costs is expansion of costs uh when benefits are immediate or future benefits are too uncertain like research and development sorry i got a bit of cold so i'm not in a best shape to present today but let's uh let's continue so .

What does it mean what does capitalization mean in terms of double entry in terms of accounting entries so if we go to our transaction list we can find that we bought for example we acquired equipment for 10 000 k let's add here these .

And aim to use that equipment in our equipment to produce goods services okay so if we buy that equipment for a sale and if we are a reseller of equipment we .

Will put that equipment into our inventory account but if we do that for production purposes we capitalize it we debit equipment account on our balance sheet we do not uh debit expense account and an example of the opposite .

Uh for example we acquired an equipment for 2000 and we have an accounting policy that we treat some equipment of 2000 or less let me add here as an expense so in that case we kind of have we can write write it off uh but however .

The accounting guidance on that stuff there is a separate account in gob guidance which says uh dedicated exactly for that matter which says that u.s gov doesn't permit the establishment of capitalization threshold however for the ease of record keeping many reporting entities .

Establish a capitalization threshold to specify the minimum amount of costs that must be incurred before such costs can be capitalized um and the assumption is why we can do that or is when we can prove that any effect from such threshold .

Uh will be immaterial so let's let's add this comment here um just in case so though it is not all load under uh us gap uh you can still do that if you believe there if you can prove that the effect will be immaterial insignificant let's let's see what's going on here .

Okay is sound okay is video quality okay okay okay so let's go back to our lectures so capitalization means that we put it on the balance sheet assets are consumed in future to generate future revenues current assets like inventory prepaid rent and .

Insurance non-current assets like planned buildings machinery uh non-current and tangible assets like patents so some of these some of these are current assets and they usually are consumed within one year within 12 months and if it's not current if it's more .

Than 12 months then it's like property planted equipment and intangible assets so what what do we need to know to account for uh non non-current assets properly we need to know the acquisition costs uh expected user for service life salvage value and the pattern of .

Depreciation and they also have a note here that the length is the only non-current asset that is never depreciated amortized and we need all of that because actually an accounting standard requires us to have that let me let me share the guidance with you real quick so it will be ppmd .

Accounting right pwc okay so anyone can get this guide totally free and i advise you to download it because from time to time they change their minds and they remove the guidance from .

From the website but later they upload it up so i don't know if if it will stay there but there are also other big four guys from uh instant what instant young deloitte kpmg okay so let's let's look into guidance so there is quite a bit of changes uh but they are mostly immaterial or they .

Relate to like recent developments they do not uh touch basics much okay okay so basically what we see here is uh property planted equipments consist of long leaf assets .

Uh let's see if i can add some land and land improvements buildings machinery and equipment furniture and fixtures and usually long-lived assets means that they are more than 12 months uh the useful life is more than 12 months .

Sorry i i need to take a pause um i got a bit of a cold okay we are back and that's interesting that uh ppnd accounting standards uh which is accounting standard codification 360. .

It doesn't include any specific guidance for capitalization of costs incurred during the development of self-constructing assets for reporting entity on all news so we we can acquire assets like if we buy a car we just buy a car it's it's just we purchased an assets for the cash in some situations we can do like a .

Self-constructed assets when we have workers when when we have of course some contractors and we we spend time and money and resources of the company to construct that assets and there is actually not much direct guidance in ac360 and i i can remind you that accounting standard codification is is called .

Authoritative guidance that means that it is like a primary guidance and only if you do not have guidance in authoritative guidance you you can look for other places and one of the places where we can look for that capitalization is a statement of position .

Uh of from the financial reporting executive committee of the aicpa accounting for certain course so though there is no straightforward guidance we can find guidance as that relates only for to self-constructed assets .

So now let's let's see what guidance say accounting for capital projects let's see do they do they have some lists so basically they do not uh provide us with a concise statement to answer the questions so what is the acquisition cost so acquisition costs .

To figure out what is an acquisition cost you need to go to the guidance and find your situation and then uh go go go through it like paragraph two paragraph and make .

Sure that you classifies everything correctly what is expected useful service life ah that will require your judgement so you will you will need to figure it out on yourself usually big companies uh have uh like a policy .

So for example in in our company if we acquire a new truck we usually say that it's useful life is five years if we acquire a used truck we say that it's usually useful life is three years and we might call so in some other industries that useful life uh okay is it is it in guidance or in .

Uh i got a comment that text is bad let me see uh have you tried i just quality let me on my phone .

On my phone it's not that bad uh in your youtube in your youtube you can have in the top right corner you can have a three dots and if you click a three dots you can .

Change the quality uh i don't know let me let me try to show it here so this is this is my youtube and here i can adjust the quality so this is my translation but on your mobile phone in the top right corner you will have .

Three dots around here and if you click on those three dots you will see quality and you you can try to adjust it to the maximum possible it might also be the case uh with uh with your internet connection if if you're trying to .

Access the lecture from um like not from wi-fi but from a cellular internet it it might be a bit challenging in in terms of quality i i tried it on my phone and it there it looks good enough on the phone i i can't i can't tell you uh .

Let me see how i don't think you you will see that so on on my phone it's it's it's pretty pretty good i would say uh sorry for it sorry for that technical pause everyone .

Let's let me just fix fix fix everything back okay we are back we are back in business okay so what is the acquisition cost we actually need to go to a standard to figure that out what's the expected useful service life uh .

We need to apply our judgments to determine that uh what is a salvage value salvage value is if you expect to sell if you expect your asset to have any value at the end of its useful life you you determine that based on its judgment .

It might be scrap value frequently uh people assign zero value to their assets what pattern of depreciation should be used to allocate expense of a useful life most of the time a straight line depreciation is used .

Sometimes you might use like a unit of production method if you have a manufacturing equipment and you manufacture uh products on it and your volumes will rise significantly year over year like in one year you can manufacture a thousand in the other year .

Maybe twenty thousand in the third year five thousand in this fourth year fifty thousand in that case you might want to conclude that your equipment should be amortized based on production unit method and depending on the usage of that equipment you will calculate the .

Depreciation but let's go further i believe we will have some advices about that so to determine the acquisition cost we need to understand what is giving up to obtain the assets so we include all the costs required to bring the assets into serviceable or usable condition and location .

So not only purchase price but also the cost to bring the assets into serviceable or usable condition and location purchased assets purchase price plus costs to prepare the assets for use installation transport cash financing down payment plus loan mode .

Um as you might remember in our practice exercises so we have we have a building acquired with a mortgage and we debited full value of the building and we credited cash and the credited mortgage .

So for capitalization reasons we put full value here and let's let's see the second example we have um we have equipment acquired for 10 000 i will highlight it with different color and we also have .

We paid trucking company 2000 for equipment transportation to this site and we capitalize both of these costs because this is a cost to bring an equipment to operating location and to put it into a productive state to prepare the assets for use .

Uh purchase price plus cost to prepare this for use for the practice for the homework i will i will add a bit of these questions installation transport all of that self-constructed costs direct costs of construction financing costs which we borrowed to finance construction .

Okay here we have here we have an example let's see let's let's go to our transaction practice we have quite a bit of an accounting entries done already let's copy our example so we purchased new equipment we paid .

920k to vendor we paid for transportation we paid insurance for transportation and we paid uh we estimate that maintenance will cost 4000 in the first year and will rise by about 20 .

Annually okay let's try to copy all of that into our practice file okay so debit property planner equipment i'm taking the accounts from let's so that will be just an equipment .

Credit credit credit okay vendor of the machine uh depending on the situation whether we paid whether we already paid that paid these values .

It will be cash cash cash so nine hundred twenty thousand sixty two i i'm using just dollars not uh probably i need to invest more money let's .

Let's do 92 000 60 62 000 oh no um okay i'm trying to not uh put our company into the negative cash .

Position 10 000 will be just a hundred so and all of these are credits so all of these are capitalizable expenses it we can we can an argument can be made about uh insurance let's see where it is .

So an argument can truly be made about insurance but uh that insurance is probably kind of required and if it's not required it might be reasonable uh taking into account the value of the equipment uh to ensure it uh later when you when we will go .

Through the standard we will try to find if if the standard says anything specific about insurance during transportation and maintenance costs they are not capitalizable especially the ones which which you incur after you put equipment .

In the operation and that's that's also determined by the standard example two portland products acquired a workstation pays 2000 down payment to vendor signs three year not payable pays employees 5 5500 to configure the work test .

Spends 12 000 to train the employees who will operate the workstation okay so debit equipment okay debit so that is for down payment and it will be let's call it .

Two thousand uh cash sorry it will be credit credit uh not payable let's see if i have any accounts for the notes accounts payable mortgage okay other .

Long-term debt credit most of the time uh most of the time when we pay the employees to do something that will reflect in our payroll expense so i would say the first debit .

Uh we most likely credit payroll expense but we will also need to make sure that let it be parallel expense product and training training is usually not capitalizable but we will we will check onto that later .

Uh let's see uh let's add it to q a i'm i'm more interested what other arguments how they argue about whether it is capitalizable or not okay .

So as a long-term debt let's call it 18 thousand and that will be fifty five hundred and cash was two thousand we got that and now i will move it here and i will do .

Debit payroll expense credit cash so i reflect parallel expenses first and then i will reflect that the amount was capitalized that's usually how it happens in the accounting so you you record your salaries .

Based on your procedure and then at months and or year end you start to make reclasses related to capitalization let me do some highlighting here this is how and this is how okay okay .

Let me see the timing 10 45 okay okay so these are basically the entries which we do so here they do not capitalize training and we will we will look into that further myers is constructing a new production facility expected complexion date is 6 .

2002. uh we spent 1.2 million for materials 1.6 million to architects and laborers interest payable equal to 10 percent uh incurs fees related to zoning inspection etc and basically what we have in that example we have a capitalization of all of these items so .

We capitalize material expenses we capitalize basically we capitalize direct costs of our ss construction and as well if we if we borrowed money to construct that assets or if we the standard says it in a way that if we if we have to incur .

Any interest when we construct an assets and that's basically any situation when we have some general borrowings as well so we have general borrowings we constructs and assets instead of repaying those borrowings and we capitalize that costs and the cost is capitalizable to your balance of that assets .

It's the example here it's kind of simplified so it's not it's probably it's probably won't be the full amount of that interest which you will be able to capitalize it will depend on how much and when you use those borrowings and how long .

Your construction was and uh what what what will what were the balances okay salvage value requires managerial judgment uh estimated proceeds at disposal net of selling costs um .

So why why do we need a salvage value uh we need it to calculate uh depreciation so your depreciation calculation will be acquisition cost less sell salvage value divided by your userful life or or your other pattern of uh of depreciation so you will depreciate .

Only depreciable basis not the acquisition cost uh and depreciation basis acquisition costs less less less salvage value useful life again it's your managerial judgment it's a time period or which the asset .

Will be used and many factors can i affect your your estimate in that respect so first of all that will be uh what's what what is the substance of that assets if it's a car it's one term if it's a building the other term .

Uh you also have like a tax uh requirements related to depreciable basis of different assets you can think about developing your policy around that but most of the time it will be just you your judgment your judgment which you most of the time you will use your judgment to develop a policy .

If you if you buy and use many similar assets you you will need a policy at the end of the day if you're a small business with just a few assets you can use your judgment and i remind you that this is all about accounting your taxes .

Your tax depreciation will be determined based on the tax code and it will be different from accounting depreciation methods what does gaapolo production method we already discuss it that we determine uh we determine our depreciable basis the amount we need to depreciate and then we think about what's useful .

Life of our assets will be it can be like a based on machine hours of our equipment so when we use machine hours we will depreciate if we don't use machine hours we will not depreciate we will not uh record an expense uh let's see .

Emission these depreciation basis of a thousand house is expected provides twenty south during year one the machine use for tucson what is the depreciation expense for year one what is the machine book value at the end of year one let me see do we have much left here okay .

We i hope we still have time for in for some practice okay so how do we enter depreciation debit debit credit let's see what depreciation account depreciation expense equipment and then credit credit will go to .

Accumulated depreciation equipment we have all the calculations here so uh first of all i i skip one transaction here which is the acquisition of this 50 000 stuff so i just record depreciation then we .

May later we may record the acquisition of the item or we can do it right now okay edit credit let's say we got we got all of the stuff on on loan um other loan from that okay .

Fifty thousand minus fifty thousand so we got all the stuff on a debt and then we uh depreciate six hundred six to fifty so that would be your entries for the depreciation of that equipment and obviously your net book value of the .

Equipment at the end is 43 750 irina could you please advise did quality adjustment help help you i i'm just wondering uh i i believe from what i see on my phone uh .

Though i have kind of a relatively bigger screen the picture quality is tolerable it it's not stellar uh but it's it's readable even with my not that perfect side .

Okay 50k so that's that's when we depreciate based on production method and we also have straight line an example hertz acquires car for his rental fee for thirty thousand each it expects to rent each car for three years sells them .

For fifteen thousand 000 each what is the depreciation expense what is the cars book value okay and we basically have the same we we have the same uh address here oh not insurance expense sorry .

That should be called different okay so we acquired uh thirty thousand thirty thousand we acquired the car and we depreciated the car um 7500 .

7500 depreciation expense 7500 so as you see uh we deduct we deduct uh liquidation costs uh residual value uh from from acquisition cost and we determine that's 15 000 is the depreciation .

Uh depreciation value depreciation basis and two years is their useful life so they want to use cars only two years and then sell them for 7 500. so that's our depreciation expense okay let's scroll down so depreciation .

Bookkeeping at the time of acquisition so that's basically what we what we have just done uh s s we salvage value yeah i forgot the term salvage value which is can be residual value or you you can find a few definitions so 15 in case of hertz when they sell .

The cars for 15 they expect to sell the car for 15 000 uh that is a salvage value so you calculate depreciable basis you calculate depreciation as a depreciation basis divided by useful life okay here we have t accounts i don't i don't think .

We we we've already been through a lot of accounting entries i don't think we need t accounts anymore so i i skip it accelerated depreciation and accelerated depreciation is a term you will mostly see in tax accounting and tax accounting in respect of depreciation .

Allows you to depreciate your assets on a faster basis and straight line or then production method and it allows you to recognize higher depreciation expense in the earlier years of an assets user for life differences between tax depreciation and financial reporting depreciation expense gives rise to deferred tax account .

So so deferred taxes is something that ah that exists as you might know there are differences between um gap profits between accounting profit and between tax profit and you are getting taxed on a tax profit .

And accounting wants to present your tax expense consistently with accounting basis and to do so uh there is a concept of deferred taxes deferred income tax expense and deferred tax assets and deferred tax liabilities and that's that's a complicated matter .

Not for today for today we we are done with this lecture we will move to the next lecture let's see in the schedule if i if i have links yeah i have links um a bit a bit more exercises on property plan .

And equipment okay and a link to the next stream here okay let me see what we've got here so we will we will we will review changes in depreciation .

Estimates uh how they impact our accounting okay so mostly mostly we will deal with changes or we also got a disposal disposal is something we covered a bit in cash flow statements but we will look on that into .

More details in foreign ppnd events okay not not everything in this lecture is applicable for today but let's let's meet in a few minutes thank you

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