Transcript for:
Lecture 10/21: Long-Term Asset Accounting

hello Financial Accounting students have you guys read chapter 8 yet chapter eights a long chapter it's a technical chapter but it's really important so I'm hoping you've read the book and let's try to get through this as smoothly as we can so put simply chapter 8 accounting for the long term operational assets a lot of students think of this as our depreciation chapter the bulk of the chapter is about depreciation but there's also a few other important topics in here as well so here we go so the first thing that we need to do before we can begin depreciating it is figure out what is the cost of these long term operational assets what counts so as we started looking at long term operational assets we're going to break them into two basic categories so first we have tangible assets things that can be seen and touched things that have a physical presence like buildings trucks land machines equipment computers furniture and fixtures all of those things have physical presence usually that's what we think of first when we picture our assets then we have intangible assets which are rights or privileges they cannot be seen or touched so sometimes we have something that represents that intangible asset but it's not the asset itself so for example if I write a book and there's a copyright on the book I might have a document that represents that it's copyrighted and if I destroy that document that's not good but the book still exists the writings still exist so the the intangible is not represented by a piece of paper a certificate or a document it was the ideas so brights and privileges so we'll get more into intangibles later that's kind of a new topic so within our tangible long-term assets here they've broken it into three categories property plant and equipment Natural Resources and land so starting with property plant and equipment sometimes we refer to this as such fixed assets there's a lot of different names under fixed assets we might have machinery and equipment computers and equipment vehicles furniture and fixtures so those would all be things that would go under fixed assets and with these assets we're going to depreciate them over their useful life before we proceed let me ask what does depreciate mean did you say something like an asset losing value over time if you did that's a really common misconception and I want to correct that before we proceed depreciation or depreciating has nothing to do with the asset losing value or the asset being used up in our common usage of the word depreciate that might be true we might refer to something depreciating and its value is going down in value over time but in accounting that's not quite right and I want to make sure we get this right from the beginning so let me give you the definition of depreciate to depreciate is to systematically allocate the cost of an asset over its useful life to systematically allocate the cost of an asset over its useful life so what that means is that we're going to systematically allocate we're gonna break up the original cost of the asset and we're going to expense it over the assets useful life over the period in which we use that asset and we benefit from it it doesn't matter if the asset goes up or down in value we're still going to depreciate it regardless of any changes in value what we're trying to do is take the original of historical cost that we have on the books and spread it out matching it to the periods in which we benefit from it did you hear them word in there matching depreciation is all about the matching concept we want to match our expense our expense of using this asset to the periods in which there's corresponding revenue we're trying to expense the asset into the time periods in which we benefit from using that asset so really depreciation is an application of the third part of the matching concept it has nothing to do with the asset losing value over time what if we're dealing with something like a building which you know real estate typically goes up in value over time should we still depreciate it of course we should I hear students ask these kinds of questions though when an instructor has accepted the definition that depreciation has something to do with an asset losing value over time we're declining in value over time and when a student then asked well what about a building that goes up and value over time why don't we still depreciate that and they have a hard time coming up with a good answer because they've started out with a erroneous definition of depreciation so stick with my definition to systematically allocate the cost of an asset over its useful life which means we're going to break up the historical cost of the asset and expense it matching it into periods in which we benefit from using that asset so today we'll learn some different methods of depreciating that'll be the focus of the chapter then we have natural resources so depending on what kind of business you might operate you could have natural resources some examples might be mineral deposits oil and gas reserves timber stands coal mines etc so with natural resources and again it depends on what industry you're working in you may not ever deal with natural resources in your career or you might deal with them a lot who knows but with these assets we're going to deplete them over their useful life you want to know the definition of depletion to systematically allocate the cost of an asset over its useful life hmm we've heard that before right that's the same definition I gave for depreciate so deplete is to natural resources as depreciate is to property plant and equipment they made the same thing we're going to systematically break up the cost of our natural resource and expense it over the period in which we benefit from it and we'll learn a technique to do that today and then finally there's land they give land its own category we separate land out because hypothetically land has an infinite life and is not subject to depreciation does land really have an infinite life hmm have you been around long enough to know that's a tricky one right as far as we know land has an infinite life ideally but I've lectured on this topic on a day when a sinkhole opened up and swallowed up somebody's home tell that land owner that land has an infinite life I lectured on this on another day when homes on the cliffs overlooking the ocean crumbled into the sea tell that land owner that land has an infinite life so I say hypothetically land has an infinite life and what that means is that we don't subject it to depreciation because mathematically it would be impossible we'd be taking the cost of our land and dividing it up over the years in which we would benefit from using the land so we take the cost of the land and we divide it by infinity and then we'd appreciate it well that's kind of silly we can't break it up over an infinite number of years so what accounting Theory just says leave it alone assume that it's going to last forever and we leave land alone and we don't depreciate it so when it comes to intangible assets we break them up into two basic categories first we have intangibles with an identifiable useful life meaning we know how many years it's valid for so like a patent or a copyright we know how many years a patent or copyright is valid for and therefore we will amortize the intangible over its useful life what is amortized let me help you out to systematically allocate the cost of an asset over its useful life yep same definition so depreciate is to property plant and equipment deplete is to Natural Resources and amortize is to intangible assets so same idea we're going to take the cost of the intangible asset and we're going to expense it over its useful life assuming it's an identifiable useful life and then finally we have intangibles with an indefinite useful life indefinite can mean it goes on forever or could mean we're just not sure but either way we don't know the useful life and therefore we're not going to amortize it so for intangibles with an indefinite useful life the cost of these assets is not expensed unless it can be shown that there has been an impairment in value what's an impairment in value well let me give you an example they give us they're showing us some burgers and fries down there so let's talk about fast food let's say that all of us in the class pull our funds together and we buy a McDonald's franchise to buy two McDonald's franchises expensive you're buying the right to operate a McDonald's and so we put our money together and we're running our McDonald's and everything's going fine at our McDonald's restaurant but at a different McDonald's on the other side of the valley somebody orders a cheeseburger with extra ketchup and extra pickles and they bite into their cheeseburger and there's a finger in their cheeseburger that's disgusting that's horrible rate but thank goodness that wasn't at our McDonald's well what happens the value of our McDonald's franchise has been damaged it's been impaired we bought a McDonald's franchise rather than just opening up our own hamburger restaurant because it had name brand recognition it was something recognizable and identifiable and customers like going to McDonald's and it's recognized throughout the world we paid a lot of money for our McDonald's franchise for those reasons well now that reputation has been tarnished it's been impaired so it's not just my example is disgusting maybe you'll remember it as an example of impairment in value so the value of our McDonald's franchise was impaired because something disgusting happened at a different McDonald's the good thing is I find that the American public is very forgiving they'll forget about the finger in the cheeseburger right people say I'm never eating there again ever well maybe for like three months or six months and then they change their minds anyhow that's the concept of impairment in value so let's keep going when we talk about our long-term tangible assets what counts in the cost we need a notice that we can make sure we're recording the right amount to be depreciated so when it comes to buildings we take the purchase price of the building of course sales taxed there's not usually sales tax on buildings but I suppose if there was then we could add that in title search transfer Docs Realtors and attorneys fees these are essentially what we refer to as like escrow costs all of the costs that go into buying a building which is real property so that's a complicated process there's all kinds of magical fees that you have to pay in that process so all of that would get worked together and then finally they say remodeling costs now this is not that we want to give the building a makeover a few doubt few years down the road this does initial remodeling to get them building ready for its intended purpose so let's say that we bought a building was previously used as retail space and now we want to use it for medical office space we're gonna have to do some remodeling in order to get it ready for its intended use so those initial remodeling costs to get it ready for intended use all of this goes together all of it would go together and we would put it on the books in one lump called building and we debit building for the sum of the whole thing and then later we'd work on depreciating the building equipment similar idea we're gonna take the purchase price lest any discounts of course and what we actually pay for the equipment sales tax that's highly likely when it comes to equipment delivery and installation whatever we have to do to get it to us and ready to use and then finally cost to adapt to intended use so if it requires some kind of special setup to get the equipment ready for its intended purpose that's also counted in the original cost of the equipment and again we take all of these costs we add them up and we put them on the books in one lump called equipment and later we'll work on depreciating that and then we have land so for layout we need to know what to count as land so that we keep it separate and we don't depreciate it so of course the purchase price sales tax on land I really don't think so I can't think of any jurisdiction that has sales tax on land but I suppose if it existed that we would add it in title search transfer Docs Realtors and attorneys fees so again we're talking about real property so all of these the escrow costs that we might have to pay would go into the cost of the land cost of removal of old buildings and grading costs so both of those items can be described as getting the land ready for its intended use so if there's an old building on the piece of land that we bought that we didn't want we just wanted the piece of land then if we're going to remove the building that's part of the cost of getting the land ready for its intended use grading so if we need to make our flat bottle e or hilly lot flat whatever we have to do to get it ready for its and did use initially so all of that would go together we'd add it all up and we put it on the books as land and we'd keep it separate from our other long-term assets and we know not to depreciate it because it's a special asset so that brings us to the concept of a basket purchased allocation so I just said we want to keep the land separate on our books so we know not to depreciate it but that's kind of a problem in the real world because typically when you buy a building it just comes with the land under it nobody ever says any guess what I just bought a new house and oh and the land under it it kind of is implied that that comes with it and typically the way we do these types of real real property transactions the building and the land are lumped together so here we're gonna learn a technique that's Baskett purchased allocation where we're gonna be separating out the various types of assets that might be included in a purchase like this so a baby company they purchased land and a building for two hundred and forty thousand dollars cash an appraiser estimated that the land has a market value of ninety thousand and the building has a market value of two hundred seventy thousand what does that add up to ninety plus 270 that's three hundred and sixty thousand so we're feeling pretty good the appraiser says that the land and building that we just bought for 240 is worth 360 now that's just an opinion though right but anyhow I feel pretty good about our purchased but the real question is how will we assign the 240 $240,000 cost between the land and the building remember we have to record our assets at cost not at their fair market value but we record them at what we paid for it so here's how we use the basket purchase allocation technique previously this semester we talked about the idea that we cannot use what the appraiser sets we have issues in terms of reliability concept and of course the historical cross concept says nope don't worry about fair market value you're gonna record it at what you actually pay for it but that said we can still use some of the information from the appraiser we don't disregard it entirely so we're gonna take the appraisers opinion the market value of the building at 270 the market value of the land at 90 and that all adds up to three hundred and sixty thousand but then we convert that into percentages what the appraiser is suggesting is that the building to seventy out of 360 represents 75 percent of the value and the land 90 divided by 360 represents twenty five percent of the value so while we can't use the appraisers dollars we can use the appraisers percentages so again we took 270 thousand divided by 360 360 thousand and that equals seventy five percent ninety thousand divided by 360 thousand and that gives us 25 percent so we're then going to apply those percentages to our actual cost of 240 so for the building we take 240 thousand times seventy five percent and we're going to allocate 180 thousand dollars to the building and for the land we take 240 thousand times twenty five percent and we get sixty thousand so we'd allocate sixty thousand to the land so in terms of what we're recording we would debit building 180 thousand debit land sixty thousand and credit cash for two hundred and forty thousand so we're recording our assets at cost using the appraisers percentages not the values that the percentages from the appraiser so that's how we do a basket purchase allocation and that's important that we keep the building and the land separate because we're going to need to depreciate the building and specifically not depreciate the land so big picture as we're going through this chapter the basic idea is that we're going to acquire funding we need money we're gonna use the money to buy our assets long term operational assets we're going to use the offset and then at some point we're going to retire the asset we might just dispose of it we might sell it but at some point we'll be done with the asset and then we will acquire more funding and start it all over again so that's the basic life cycle of an operational asset so finally we're ready to get into our three depreciation methods there are other depreciation methods but these are the three that you will be accountable for this semester so first we have the straight-line method this is the easiest of the three probably the one that you're gonna going to like the most it results in the same amount of depreciation each accounting period so it's gonna we're gonna compute it once we're gonna do it the same every single year then we have double declining balance method this is what we refer to as an accelerated depreciation method which means it's going to result in more depreciation in the early years of the assets life and then it's going to decline somewhat rapidly in the later years of the assets life so essentially it's pushing more depreciation upfront and then it trails off quite quickly so it's going to result in different amounts of depreciation and then finally we have units of production and we don't want to use this too literally units of production depreciation can be used on a variety of different assets but it's going to result in varying amounts of depreciation in different accounting periods depending on the number of units produced or let me rephrase that depending on how much we use the asset so it couldn't literally be units produced how many widgets does this machine produce this year and we can depreciate it based on the number of widgets produced but we could also use it for something like a vehicle so a truck how many miles did we drive the truck or maybe a how many pages did it print this year and we can depreciate it based on that or we can use it on a machine and rather than counting units we can count how many machine hours the machine ran during the year so units of production can be used on a variety of different assets it doesn't have to be literal units of production but it's gonna result in different amounts of depreciation so we've got three depreciation methods here and I already mentioned that there are in fact more depreciation methods how do we know which one to use do we get to just choose well the answer is yes a business owner can choose which depreciation method they want to use on which assets they can decide to do each asset individually and use different depreciation methods or they might decide that all of the certain type of assets will be depreciated using straight line but these other types are all gonna be done under double-declining it's up to the business owner to choose I personally would go back to the matching concept I would want to choose the depreciation method that does the best job of matching the expense of my assets into the periods in which I use them so for something like furniture furniture and fixtures in the office I would use straight line because we benefit from having that furniture somewhat equally every year double declining though I might suggest that would be a good idea for something like a computer something that's highly productive and useful early in its life so you know you get a new computer and it's awesome for the first year maybe you're in a handoff but then by the time two years or three years comes around you're feeling like it's pretty outdated and worn out and it's slow and you want a new one so double declining balance might be appropriate for something like a computer accelerating the depreciation into the early years of the assets life when it's most productive and then I might use units of production for something like it vehicle so if we have a truck or a delivery van or something like that we would depreciate it depending on how much we use it how many miles did we drive the vehicle so I would choose depreciation method trying to accomplish the best matching possible but some companies just say nope we're gonna use straight light for everything because it's the easiest another say no we're gonna just use double declining balance on everything because that's what we like and that's completely fine with in the accounting guidelines but again I always come back to match II because I love the matching concept so we're gonna get into these three different methods and learn how to actually do them so first we're looking at straight-line depreciation and how to compute it record it and what it does to our financial statements so we're looking at this man the van has a salvage value of $4,000 and an estimated useful life of four years so they're throwing some terminology at us here that we haven't talked about yet so it appears that we're buying a van for twenty three thousand five hundred we're gonna get a 10 percent discount on that so now we're not really buying it for twenty three thousand five hundred we have to subtract the discount we do have to pay transportation cost on the van and we also have to customize it to get it ready for use in our business and all of that conveniently adds up to a nice round textbook e twenty four thousand dollars apparently no sales tax on the van no licensing fees none of that so just twenty four thousand two even and they tell us that it has a salvage value of four thousand what that means is what we think the van will be worth when we're done using it so the scrap value it's another way of saying it so we think it'll be worth four thousand dollars when we're done using it and we believe that it's gonna have an estimated useful life of four years so here's another point in accounting where we're using estimates we don't have real information we don't have a crystal ball so we're estimating the salvage value we don't know if 4,000 is true or not but that's our best educated guess and we also don't know that the useful life is going to be for years it might be three years or five years it could be ten years we don't know but we think it's gonna be four years so we're estimating is that okay in accounting so often we think of accounting this being very black and white that there's a right answer and a wrong answer and here again in this chapter we're dealing with accountants making estimates because waiting for real information isn't practical I can't say sorry I can't appreciate the man because I don't know but it's real salvage value it's going to be and I don't know how many use it for so I'm just not gonna depreciate it until I have that information well that's gonna create some problems so we do have to come up with estimates and accept that our estimates are going to be good enough so what we're gonna do is we're gonna take the cost of the van and divide it up an expensive over its useful life so here's the start of our scenario so we issued stock to acquire funding of $25,000 on January 1st so we debit cash credit common stock that should be old news back to chapter one right cash just going up and our common stock is going up and of course our cash flow is F a then we purchased the van I love this January 1st there's so many assets so we acquire on January 1st in this text book it's amazing the amount of business that they conduct on January 1st which is a federal holiday and most businesses are closed but that's fine they're buying the van on January 1st which for computational reasons is really convenient for us so we'll gladly accept it but in the real world that doesn't always happen so we purchased the van on January 1st for a net cost of 24,000 dollars so we debit van so we keep that asset separate we give it its own column its own account so we debit van and we credit cash for 24,000 it's Vance going up Cassius going down so that's an acid exchange and our cashflow course is I a investing activity we're putting our money into and asked that an investment we that we hope to benefit from for several years a long term aspect so then we use the vant and generate revenue so they say eight thousand dollars of revenue for the period so let's deal with that first so revenues going up eight thousand dollars which is gonna bring up our net income and therefore our retained earnings and cash is going up eight thousand dollars so we're debiting cash crediting revenue and our cash flow courses okay that's what we're in business to do and then we have to depreciate the van and here's how this works under straight-line we're gonna take the cost of the asset twenty four thousand minus the salvage value and then we're gonna divide that by years of useful life so we've got twenty four thousand minus four thousand so that's twenty thousand in our numerator and we divide that by four years and we have five thousand dollars of depreciation per year so each and every year we have to record our depreciation and we're going to do that by debiting depreciation expense and crediting accumulated depreciation so let's talk about that journal entry every time we record depreciation regardless of which method we're using it's gonna be the same debit depreciation expense credit accumulated depreciation but let's talk about those account titles because they're both new so depreciation expense is an expense account as you would expect so that goes over here on the income statement so the expense is going up with a debit therefore bringing our net income down and therefore our retained earnings is going down and then we're crediting a new account called accumulated depreciation accumulated depreciation is a contra set account so last chapter we learned about contra asset accounts a contra account is an opposite it's against so it's a negative asset that's gonna carry a normal credit balance and it's an offset against the related asset so here we're recording five thousand dollars of accumulated depreciation so we're recording that with the credit it's an offset against its next-door neighbor which is the van itself so we make a separate column for accumulated depreciation that carries a normal credit balance we're gonna leave the van alone we have to leave it on the books at historical cost but then right next door will have this contra asset that goes against the van and there we are recording our accumulated depreciation and that's a permanent account so that's gonna roll forward it will accumulate all of the depreciation on this asset so our Book value at the end of year one Book value that's a new term and it's a really critical term this chapter book value is the cost of the asset less the accumulated depreciation so at the end of year one we take twenty four thousand dollars the cost of the van - our accumulated depreciation which is just one year of depreciation that's five thousand so our Book value at the end of year one is nineteen thousand if we continue with our straight-line depreciation well our Book value be at the end of year two fourteen thousand that's right and then at the end of year three we subtract another five thousand so at the end of your three book value would be nine thousand and then at the end of year four subtracted another five thousand our book value would be four thousand hey that's the same as our salvage value so what we're finding out here this is not a coincidence a fully depreciated asset will have them it's book value will be the same as its solid value and that computation is built right into our into our straight-line depreciation formula when we take the cost of the asset - the salvage and / years of useful life mathematically what that will leave after in this case four years of useful life after four years it's going to leave a Book value equal to our salvage value and that is by design so basic rule we can depreciate an asset down below its salvage value so our Book value cannot go below our salvage value for straight-line that's really easy we just stopped appreciating after four years but for our other two methods we're gonna have to keep an eye on that so remember that tuck that away for a moment we cannot depreciate our asset down below its salvage value so once the book value equals the salvage value we stop depreciating so let's remember that when we get to double declining balance and units of production methods so on our financial statements what does this do well in revenue it looks like we're making steady revenue of $8,000 a year and then our depreciation expenses also steady $5,000 per year because it's straight line it's the same every year under assets our van is there all four years but what we see is our accumulated depreciation the contrast ax is growing 5,000 each year and at the end of any of those years we can compute our Book value by taking the van - the accumulated depreciation and so at the end of year four what do we see we take van of twenty four thousand minus accumulated depreciation of twenty thousand and our book value sure enough would be four thousand dollars on our statement of cash flows really not a lot going on the revenues coming in we bought the van we issued some stock but keep in mind the depreciation has no in act on our cash so recording depreciation expense does not involve any cash we're it's it's actually a year-end adjustment and you know you're an adjustments don't involve any cash so we're just matching the expense of our offset to the period in which it belongs so we're spreading that offset out and we're expensing it over those four years so next we're gonna get into double declining balance this is a little bit more complicated here that give us a whole screen of words steps it's kind of overload to me I'm gonna run through the steps really quickly but I think it's better learned by looking at an example so we'll go through these same three steps as we look at some numbers with it so as I mentioned earlier double declining balance is what we refer to as an accelerated depreciation method meaning we accelerate we pushed more depreciation into the early years of the assets life and then it's going to rapidly decline in the later years and here's how we're going to compute it so first we have to determine the straight-line rate of depreciation which is simply 1 divided by years of useful life second we're gonna multiply that straight line rate by 2 doubling it hence the term double declining so we're doubling our straight line rate and then thirdly we're going to multiply our double declining rate by the book value of the asset at the beginning of the period good thing we just learned what book value is right it's the cost of the asset minus the accumulated depreciation so let's apply these steps to our example here so first we're gonna compute our straight line rate so we just take 1 divided by 4 so under the straight-line method we'd be depreciating 25% of the absent each year so for our van with four years of useful life we take 1 divided by 4 and under straight-line we have 25% of the asset depreciated each year but under double declining we double-bass so we multiply it by two and our double declining rate is now 50% and then we're going to multiply our double declining rate of 50% by the book value of the asset at the beginning of the year well at the beginning of year one when we bought the van the book value is just 24,000 there is no accumulated depreciation yet so we take 24,000 times 50% so in year one our depreciation is going to be $12,000 then in year two we compute our book value at the beginning of the year which is the cost of 24,000 minus our accumulated depreciation well there's only been one year of depreciation recorded which was 12,000 which is a lot by the way we're depreciating half of the asset in year one talk about an accelerated depreciation method there it is right so our book value would be 24 minus 12 which of course is 12 and so we take 12,000 times 50% and on our year two depreciation expense therefore is 6,000 and then we move on to year three we take 24,000 minus the accumulated depreciation which is the sum of the two prior years twelve plus six so we're adding up all of our prior depreciation which is eighteen thousand so we take 24,000 minus 18,000 gives us six thousand and we multiply that by 50% and we get three thousand right it's not hard math six thousand times fifty percent is three thousand why do you think they struck that out and changed it to two thousand remember that little tidbit you can't to depreciate the asset down below its salvage value so when we look at this van at the very beginning the first thing we should do doesn't matter what depreciation method were using is acknowledge how much depreciation will be take on this van so if the salvage value is fourth thousand we're going to be taking $20,000 of depreciation expense on this man regardless of what method so when we reach 20,000 we have to stop and that's conveniently built into our computations in straight-line method but double declining balance it just lets us keep going so we have to know well wait a minute 12 and 6 I'm already at 18 if the maximum maximum the amount of depreciation that can be taken is 20,000 then I can only take another $2,000 of depreciation here now I'm at 20,000 and I have to stop so then we move on to year four well we already know the answer is zero but just walk through the math with me so we take the cost of 24,000 minus our accumulated depreciation so 12 plus 6 plus 2 is 20 and that leaves us with 4000 we multiply that by 50 percent and our depreciation expense should be 2,000 but again we have to strike that out and change it to zero because the maximum depreciation that could be taken is 20 thousand so we have to stop so we're gonna do 12,000 in year 1 6000 and year 2 2000 and year 3 and 0 in year 4 definitely an accelerated depreciation method pushing the depreciation heavily into the earlier years and then trailing off rapidly in the later years so under both methods so far a straight line and double declining we've taken 20 thousand dollars of depreciation so after 4 years it works out the same but how much goes into each year varies by method as we look at our financial statements what they've shown here they've changed the scenario a bit and maybe that's why we chose to use double declining is that our asset was helping us generate more revenue in the early years so in year 1 we have 15,000 your 2 goes down to 9000 dr3 it goes down to 5000 and near 4 goes down to 3,000 and our depreciation fams is trailing off as well so maybe we chose double-declining because we knew that its productivity and its ability to help us earn revenue who was going to decline over time as well and again on our books if we look at our van less accumulated appreciation that is our book value so we can compute the book value at the end of any one of these years and again not a whole lot going on on the statement of cash flows because depreciation doesn't involve any cash so our third and final method of depreciation that we'll be learning is units of production so let's take a look how to do this some of it should look kind of familiar here they've broken it down into two basic steps so first we need to compute our deeply sorry depreciation charge per unit of production and that starts out a lot like straight-line cost minus salvage and then we're gonna divide that by our total estimated units of production and that will result in a depreciation charge per unit then we're gonna take that depreciation charge per unit multiply it by the units of production in our current period and that will give us our depreciation expense for the period and again we don't have to take this super literally about units of production it could be hours it could be miles driven so those units could be a variety of different things but any unit by which we can measure the usage of a given ask that could be our unit of production so we're going to apply us to the van so talking about our same van we take the cost of 24,000 minus salvage of 4,000 so that results in $20,000 the cop the cost minus salvage 20,000 and we're going to break that up over 100,000 miles and that results in a depreciation charge of 20 cents per mile I do want to emphasize here that we switched to units of production we're no longer concerned with for years it doesn't matter the estimated useful life anymore the new estimated useful life is a hundred thousand miles so the four years doesn't matter but you'll see here in our example conveniently only in textbook land of course we drive the van for four years it could have been two years it could have been ten years it could have been seven years it doesn't really matter how many years but we're gonna depreciate that van until we drive a hundred thousand miles once we exceed a hundred thousand miles we have to stop depreciating because mathematically if we're taking twenty thousand divided by a hundred thousand miles we're going to end up exceeding 20 thousand dollars of depreciation if we keep depreciating beyond a hundred thousand miles so here's the thing we have to now track our miles driven so in year one we drive 40,000 miles we multiply that by twenty cents per mile and that's eight thousand dollars a depreciation in year one year two we drive only twenty thousand miles and again when you multiply it by 20 cents per mile so our depreciation expense is four thousand year three we drive 30 thousand miles times twenty cents equals six thousand dollars of depreciation and then finally near four we drive fifteen thousand miles times twenty cents is in fact three thousand but again they strike it out and they change it to two thousand why well we drove more than a hundred thousand miles so we have to stop depreciating once we hit a hundred thousand miles we have to stop depreciating once our sum of depreciation our accumulated depreciation is that twenty thousand so 8 plus 4 is 12 plus 6 gives us 18 plus 3 more puts us at 21,000 and that's not OK so we striped the three thousand we mark it down to two thousand make sure you watch for this in your homework both on double declining balance method ad units of production method that you watched those final years to make sure we're not exceeding the allowable depreciation which on this as $20,000 cost minus Salvage so when we look at our financial statements what we see here we come varying revenue which might be why we chose to use units of production depreciation is that we were gonna use our asset differently each year and produce a different amount of revenue each year so we see our depreciation expense going up and down eight thousand then only four thousand then back up to six thousand and then way down to two thousand so it's kind of bouncing around depending on how much we use the asset it's matching the use of the asset to the peers in which we benefit from it so we've chosen this method because we think it's gonna do the best job matching on our balance sheet again we see van less accumulated depreciation so at any point we can compute our book value of the van which again at the end of year four at the end of your four we see our van is at twenty four thousand the historical cost of course and then we subtract our accumulated depreciation of twenty thousand so our book value of the van at the end is four thousand exactly the salvage value and that's gonna be the same in under any of the three methods and again statement of cash flows is the same nothing's really changed because depreciation doesn't involve cash when we get to disposing of the asset which is X then we'll deal with cash and computing gains and losses when we dispose with that asset so we're gonna figure out how gains and losses on the disposal disposal of the long term asset will affect our financial statements so let's say on January first oh how convenient January first again January first year five the van is sold for forty five hundred dollars cash I just want to point out how textbook II this is we bought this van on January first year one we drive it for exactly four years and four years later we sell the van on January first to textbook II for me but I guess it's convenient for the sake of numbers in the real world that's pretty unlikely so we sell the van for $4,500 cash now without looking at all the words here on the screen let me just ask you something if you bought a vehicle for twenty four thousand dollars and then four years later you sell it for forty five hundred dollars cash do you feel like you have a gain or a loss I know you probably see the word gain on the screen but I'm sorry I personally feel like that's a loss if I buy a vehicle for twenty four thousand dollars and it goes down there's forty five hundred dollars in four years and I sell it for only forty five hundred dollars I feel like that's a big giant loss but that's not how we do it in accounting we don't use feel use to start with but we need to do the computations so what they're showing us here at the top if we take the book value of the asset at that point in time which is four thousand and we compare it with our cash proceeds which is forty five hundred our cash proceeds exceed the book value and therefore we have a gain of five hundred dollars so that's how they've completed the game I'm gonna focus in on the journal entries in my three-step method which you'll find yourself using a couple times this chapter three questions for you which will help you write the journal entry question 1 what do I get I'm selling the van for $4,500 cash what do I get you get cash so you're gonna debit cash for $4,500 what do I get rid of so question 2 what do I get rid of well you're selling the van so you get rid of the whole van so credit van $24,000 what else do you get rid of well when you get rid of the van you also get rid of the accumulated depreciation with it so you can't just leave that hanging out on your books for all of eternity if you sell the van the related appreciation goes away too so to make that go away that's a debit of $20,000 so then question three what's the difference meaning mathematically what do I need to do to make my journal entry balance I've got forty five hundred and twenty thousands those twenty four thousand five hundred in the debits and only twenty four thousand under credits that means I need another five hundred in the credit column and therefore it's a credit that makes it in gain we call it a gain on disposal of van so again it's a credit means it's a game because games to act like revenue and losses act like expenses in terms of our debits and credits so in terms of recording this this is the correct journal entry but I do want to point out I really don't like the way that they show this they have an account called book value of Van her book value on Van that is not in the count title it's a computation so that's improper I don't care for it at all so I've redone it I split it into two columns so we have van so we're taking 24,000 away from Van and zeroing zeroing out that account an accumulated depreciation we're debiting 20,000 bringing it back to zero as well so in terms of our our journal entry cash is going up 4500 manas going down 24,000 accumulated depreciation is being wiped out to zero remember it's a contra asset so it carried a credit balance and now we're zeroing it out and then the difference is our gain which is gonna increase our retained earnings by 500 and be a credit to gain on disposal which behaves like revenue so we put it here as if it's revenue and it brings up our net income the cash flow on all of this would be I a it was I a when we bought the fan and it's I a when we sell the van so this is a quick graph showing our different depreciation methods over the course of four years all three of them resulted in $20,000 of depreciation but very different in depending on what year right so the straight line right through the middle that's our straight-line depreciation taken an even 5,000 of depreciation each year this steep rapidly declining line is of course double declining balance method so it starts out high and then it drops off rapidly and then this one bouncing around is units of production depreciation so all three methods are perfectly acceptable and valid and simply result in a tiny difference of when will we expense the depreciation on our asset all three methods resulted after four years in twenty thousand dollars of depreciation so our choice of depreciation method is really just a timing difference if that makes sense so what about for taxes for tax purposes wouldn't we want to choose the depreciation method that results in the most appreciation expense and therefore would lower our net income our taxable income and result in less tax well when it comes to taxes the government says no we're gonna tell you how to depreciate we know better than you do and we've come up with a system that you're going to use so we don't get to choose our tax depreciation instead what we have is what's called the modified accelerated cost recovery system which is makers for short isn't that cute accountants just love acronyms of course the modified accelerated cost recovery system replaced the original accelerated cost recovery system which was acres they just put a little m in front of it and said it's brand new and shiny now so our rate of depreciation depends on the class life which is similar to years of useful life of the asset and the period in which were calculating our depreciation and they say there's currently six categories for property well four not counting real-estate so for like fixed assets not not including real estate they say there's three or five years seven year ten year fifteen year and twenty year property if you want to throw in real estate then we can get into twenty seven and a half 31 and 39 year property all this sounds like a headache doesn't it let me ask you something who writes tax law who writes our tax code who comes up with these tax laws well let me assure you it's not accountants because if it were the tax laws would be totally different and they make a whole lot more sense tax law is written by politicians and I mean that in a negative connotation tax law is written by politicians and it doesn't matter what side of the aisle or no aisle politicians often don't have a lot of experience with accounting and taxes and yet we trust them to write our tax laws a lot of times when I look at our tax code it makes sense and I can I can figure out what was trying to be accomplished with this tax law so when I used to teach the income tax class at the college for example um you can take a you can potentially take a deduction for donating money to a charitable organization and that tax law exists because they're trying to reward certain behavior they're trying to encourage you to donate to a charitable organization you can take a deduction for home mortgage interest so they're encouraging the behavior of home ownership you can take education credits so again they're trying to encourage a certain behavior which is going to school getting higher education and then there's other things that they penalize you for so like withdrawing money from a retirement account early they penalize you for doing that they to save the money not pull it out early so a lot of times when we look at tax code we can say okay I kind of see what they were trying to accomplish they're trying to reward a certain behavior or punish a different behavior they're trying to accomplish something specific but then we get to makers and I really can't make any sense of it so they divide all of the existing assets into six categories three five seven ten what's done with two four six eight why three five and seven and then we just skipped ten fifteen and twenty like there's nothing in between and what they put into each of these categories is somewhat bizarre so for example a car would be five year property a computer would be five-year property software would be three year property but a phone would be seven-year property wait a cars five-year property and a phone a seven-year property what do you replace more often your phone or your car hmm something doesn't seem right and then we get into these other strange categories 10 15 and 20 year property which you'll hardly use but they have some very specific applications there's things like if you have a barn it could be 15 year property but if there's cows in your barn it's 10 year property but if there's grain in your barn then it's 15 but if there's grain in your silo and cows in the barn it goes back to 10 but if there's cows in the silo and grain in the bar and then it goes back to 15 did any of that make sense no probably not I'm just making up gibberish but there is there's some really bizarre laws there's one like that with boats as well as to whether they push something or pull something it's very bizarre you're thinking why did anybody come up with this who spent the time to decide that a barn or a boat belongs in this category and a phone should be seven years but a computer in a car or five years who's who thought this through and I point right back to our elected politicians love them or hate them and they write the tax law the IRS is responsible for implementing forcing that tax law but it's our politicians that write the crazy tax laws so what do you need to know in terms of income tax depreciation what I need you to know is that it's done using a system called makers and makers will tell you the class life of your assets and we're gonna take a look at how it's done but I don't need you necessarily to be able to do this just to know that it exists so for using makers and we have property that is five-year property of course we're going to depreciate at a five-year property for five OH six years five your property is depreciated for six years and seven-year property obviously we do Bruton be depreciated over the course of eight years hmm this is pretty strange isn't it so when it comes to five-year property it really is being depreciated over five years but income tax depreciation makers uses something called the half year convention so makers is driven by double declining balance but it uses the half of your convention which is pretty much them saying hey we don't care what day of the year you buy your asset on it could be January 1st or December 31st or March 42nd or July 17th it doesn't matter what day it is we're going to assume that you own the offset from half of the year therefore everything is purchased on July 1st so it's driven by double declining balance depreciation so if we take one divided by five years we would depreciate 20% of our offset each year under straight line but then for double declining we double down we'd be at 40% and what they're doing here is taking a half year in your one so half a 40% so there's a half one two three four and then in the final year is another half so there's a half here at the beginning and a half year at the end with four years between so that really is five years but spread out over six accounting periods and we can do the same math with seven-year property so they did 1/7 to get there straight line rate and then they multiply that by two to get their double declining rate but then they divide it by two again because the first year is a half year so again they've got a half at the beginning one two three four five six and another half year at the end and if we just use their percentages we multiply it by the original cost of the asset so it's a little bit neater and tidier them the double declining method we don't have to compute the book value of the asset asset at the beginning of each year we just take the percentages that are given to us in the depreciation tables and we multiply it by the cost of the asset and we get our total depreciation over the course of the assets life adds up to ten thousand dollars in this case oh yeah and by the way there's no salvage value what that's not very realistic is it again tax law written by politicians so non accountants but politicians so yeah makers depreciation says thou shalt use half of your convention I mean everything is bought and sold halfway through the year and that nothing has any salvage value you're gonna depreciate all of your assets right down to zero so for income taxes you're gonna use makers and again what I need you to know is that tax depreciation is usually different than our book depreciation we use makers makers involves the half of your convention and no salvage value I think those are probably the key points if you know that much about tax depreciation you should be fine do keep in mind that we're potentially then going to have two different depreciation methods one that we use on our books we might choose straight-line double declining or units of production and then separately on our taxes we will compute our tax return using makers depreciation some small businesses opt out of having a separate book depreciation method and they'll just adopt whatever tax depreciation it is some small businesses don't actually compute their own depreciation they wait for their accountant to do it when they do their tax return and they only record it then so some small businesses do use their tax depreciation as their book depreciation but many businesses are going to have book depreciation and then separately they have a different tax depreciation for you estimates so earlier in this chapter we had to make some estimates we had to estimate the useful life of the asset in years we had to estimate the salvage value of her asset what if we're wrong well here's what we do so estimates get revised when new information surfaces I do want to emphasize that we would only revise an estimate if something significant changes not just a small slight change but some new information that significantly changes our computations so for example McGraw Company purchased a machine on January 1st year one for $50,000 mcgraw estimated that the machine would have a useful life of eight years and a salvage value of three thousand so for using straight-line would take cost minus salvage so fifty thousand - three thousand we got forty seven thousand then so that'd be the total depreciation that we're planning to take over the assets light forty seven thousand and then we divide forty seven thousand by eight giving us five thousand eight seventy five of depreciation per year so we will depreciate forty seven thousand dollars over the course of eight years which equals five thousand eight seventy five under straight-line so then at the beginning of the fifth year our human depreciation at this point in time is 23,500 we've taken four years of depreciation so fifty eight seventy five times for the machines Book value at this point in time would be the cost of fifty thousand minus twenty three thousand five hundred so we've got a book value of twenty six thousand five hundred so assume at the beginning of the fifth year we revised the expected life to be fourteen years rather than eight so something dawned on us on January 1st of year five oh my gosh this asset is going to have a much longer life than we thought it's gonna be 14 rather than eight and that is a significant difference right that's a big difference so what we do we do not go back in time and change what we've already done we don't reopen prior accounting periods we just let it be so what we do is change it going forward so the machines remaining life is ten more years right we're four years in it's January 1st of year five we thought we were halfway done halfway to eight but now they're changing it to fourteen so we have ten more years so we're gonna take the remaining the book value twenty six thousand five hundred still - are stylish of three thousand that gives us twenty three thousand five hundred and we'll divide that up over the remaining ten years and we get 23 fifty and depreciation per year so twenty three thousand five hundred of depreciation has already been taken so the remaining twenty three thousand five hundred is gonna be divided up over ten years so that's twenty three fifty per year ultimately we're still going to depreciate forty seven thousand dollars of depreciation on this asset but it'll be much greater in the first four years and much smaller in the later ten years in order to get there so that's how we revised the estimate here they say assume the original expected life remained at eight years but magrav revised its estimated salvage value so instead of what was it originally three thousand now they've changed it to six thousand so we divide that up among the remaining four years so the expected life is still eight years total and we take our current Book value twenty six thousand five hundred minus six thousand salvage so we're at twenty thousand five hundred and we break that up over the remaining four years of useful life so these types of revisions are somewhat rare you won't come across this a whole lot in the real world the reality is that when we make estimates there is a certain amount of wiggle room that you know we may not be right out and we might be off by a little bit and that's accepted and normal when the change is so significant that it could potentially influence how somebody might perceive the financial health of the company they would it would influence the opinion of the average reader of the financial statements then it becomes material and we need to deal with revising an estimate like we've learned to do here continuing expenditures for operational assets when we have assets we end up spending money on them so they break that down into three different categories here to me the first one is the most intuitive and one of them the third one specifically is not very intuitive so we need to talk about that and learn when that applies so first when we have routine maintenance minor repairs things that we do to keep our assets in good working order I'm emphasizing all these buzzwords here so the things that we do normally to keep our asset in normal working order so the routine maintenance the minor repairs we just expense them as they happen expensed as incurred so assume the company spent five hundred dollars cash for routine maintenance on machinery we debit repairs expense we credit cash that's it cash is going down retained earnings is going down because we have an expense cash flows Oh a that one I think is pretty intuitive I think you would have guessed that but let's keep going the other two are a little bit harder so caustic get capitalized and capitalized means added into the asset so let's say that a McGraw company the Machine originally costs $50,000 with an estimated salvage of 3,000 and predicted life of 8 years and we had our accumulate accumulate depreciation and all that so then we assume that they make an overhaul expenditure of $4,000 in the machines fifth year so they spent some significant money beyond just routine maintenance beyond just keeping it in normal working order so we spent a significant amount of money on this overhaul and it's going to have an influence on the assets productivity it's an improvement to the asset so in that case we're going to capitalize it and we're going to add that $4,000 into the asset so we've made an improvement to the asset we add that to the asset so we debit machine and we credit cash so this time it's an asset exchange and what we see is our cash flow is I a investing activity now of course the next step would then be changing our depreciation revising our estimates and changing our depreciation I won't bother with all that detail it's kind of beyond the scope of what we need to do here but know that if we're making a major improvement to an asset beyond just basic you know basic routine maintenance then we're going to capitalize it and add it into the asset itself the third treatment to me this was the hardest one and maybe the least intuitive when we have a cost that extends the life of an asset specific words that you should look for those are your buzzword extends the life of an asset in that case the amount of expenditure should reduce the balance in accumulated depreciation so soon the company spent $4,000 for cash improvements that extended the life of the machine by two years so rather than expense it and a rather than add it into the asset itself they have us put it against accumulated depreciation so we're debiting accumulated depreciation bringing down our accumulated depreciation remember it's a contra asset and we credit cash what that does is open up more book value of the asset to be depreciated over the extra two years of useful life so then again of course the next thing we would do is change our computation of depreciation to add in an extra two years of useful life and again I think that's a little bit beyond the scope of where we need to go here here it shows you how to do it but I'm not going to clutter your brains with that right now but I do want to emphasize this one is a little bit strange it's not necessarily intuitive it's one that you need to study and learn so if it says extends the life you are debiting accumulated depreciation and again your cash flow as I a investing activity we're considering this an investment in a long term asset I don't necessarily need you to be able to view this so I'm gonna skip over that and keep moving so our next topic is depletion we're gonna calculate depletion which applies to Natural Resources and I'm hoping this looks familiar to you I think you already know how to do depletion depletion is actually done the same as units of production depreciation so we'll take the cost of the asset minus salvage divided by our total estimated units recoverable and we get our depletion charge per unit of resource and then we take that depletion charge per unit multiply it by the number of units extracted and sold so that's kind of unique to Natural Resources then multiplied by units extracted and sold and that's our periodic depletion expense so here's our example apex coal-mining paid four million dollars cash to purchase a mine expected to yield sixteen million tons of coal after all the call is extracted the mine is not expected to have any salvage value go figure right during the year the company extracted and sold three hundred and sixty thousand tons of coal so step one we have to compute our depletion charge per unit so we take cost minus salvage four million minus the zero and we divided by 16 million tons and we come up with 25 cents per ton extracted and sold and then they tell us that it was three hundred and sixty tons so we multiply three hundred sixty tons times twenty five cents per ton our depletion depletion avoid I'm tongue tied our depletion expense for the year will be ninety thousand dollars so here they're showing our journal entries just to buy the coal mine we debit coal mine credit cash which would be a big giant ia for our cash flow and then to record depletion expense we debit a new account called depletion expense we keep it separate from depreciation and then they have a credit coal mine directly so we don't have an accumulated depletion we put directly against the offset and we do need to be careful with that on our balance sheet we need to show coal mine less depletion or net of depletion so that the readers of the financial statements know that we've netted out the depletion that that's not our historical cost necessarily if the cost left the depletion so essentially we're gonna display our book value on the balance sheet so that's depletion moving on we're gonna look at our intangible access so first we need to learn what some of these intangibles are and I'm going to run through those quickly when it comes to the intangibles I don't need you to memorize them I don't need you to memorize how years any particular intangible is valid for if I want you to amortize something it's gonna tell you how many years you don't have to guess you don't have to memorize it so it will be evident in front of you how many years you should amortize something over and if it doesn't tell you how many years then maybe that's a good hint that it's not supposed to be amortized so a trademark a name or symbol that identifies a company or product the cost of the trademark may include design purchase or defense of the trademark so I think you you're all familiar with the concept of trademark we have some amazing trademarks these days well you think of a really good valuable trademark it's so good that it doesn't even need words if I see you wearing a shirt with a swoosh on it I know it's nice it doesn't even have to say Nike um if you go and you get a hamburger someplace with golden arches out front I know we're talking about McDonald's right these are great trademarks that have immense value to these companies you know my favorite one I can imagine the inventors of this amazing trademark hey listen I have this great idea our symbol our trademark it's not gonna be one line it's not gonna be two lines we're gonna put three lines next to each other adidas how simple is that but it's so recognizable I kept saying well maybe not very creative but it's working for them right if I see you wearing pants with three stripes down the side those are indeed us so what about this part the defense of a trademark so let's say that my dad's name is Mike and my dad really likes cheap shoes so I decided to open up a shoe company called Mikey's and we're gonna make cheap shoes and our trademark is an upside-down swoosh what do you think is this gonna be a problem I have a strange feeling we're gonna receive a strongly worded letter telling us to cease and desist can I open up a shoe company called my keys and use an upside-down swoosh is my trademark probably not so for Nike the defense of that trademark would be part of their cost of maintaining their trademark a patent the exclusive legal right to produce and sell a product that has one or more unique features typically the legal life of the patent is 20 years but again I like I told you if I need you to amortize something I'm gonna tell you how many years so don't worry about that so we would acquire a patent when we have some brilliant idea it gives us the right to produce and sell that product and again it has to be unique copyrights protection of writings musical composition work of art or other intellectual property so the protection extends for the life of the creator plus 70 years that's a long time right so of course like you guys are very careful about honoring copyrights you wouldn't download illegally music unless of course the Creator has been dead for 70 years so I know how you're all into classical music so maybe that's okay but more recent artists of course you're honoring those copyrights so that one has a number of years but sometimes it's confusing because it's the life of the creator plus 70 years so is that identifiable or indefinite it's an interesting one but I can don't worry about it if I need you to amortize something I'm going to tell you how many years a franchise exclusive right to sell products or perform services in certain geographic areas most often when we think of a franchise fast-foods the first thing that comes into mind but there's lots of other types of businesses that are franchised so beyond things like fast food there's things like say roto-rooter or a storage unit another one gas stations not all of those gas stations are operated by corporate when you go to get gas at Chevron it's not operated by Chevron corporate it's a local owner investor that has purchased a franchise and operates that local gas station so it's much beyond fast food there's lots of different franchises out there but fast food is usually the thing we think of first when we talk about franchises so that's a quick rundown of a few different intangibles let's get into our computations goodwill goodwill is an intangible asset goodwill requires a little extra extra thought here the excess of cost over fair value of net tangible assets acquired in a business acquisition well there's your definition so now I'm sure goodwill is crystal clear you know what to do now right hmm it's actually a really good definition but it requires a lot more breaking down than that when we talk about goodwill put in simple terms it's the positive feelings it's the book of business it's maybe a reputation that comes with a business as the owner of a business you don't get to record your goodwill as you develop goodwill over the years but if somebody else buys out your business they might be buying some of that goodwill so we're looking at this company Bendigo and we're going to buy Bendigo so assume the buyer that could be us is willing to pay $300,000 cash to acquire Bendigo's this is a restaurant why wouldn't we just open our own restaurant why do we need to acquire Bendigo's used restaurant well maybe don't think of it as used maybe there's some really good things about Bendigo so it's got a reputable name and people like the men you people have years of memories and good times they've spent at Bendigo's restaurants so it comes with all of this goodwill so yeah sure we can go out and start our own restaurant and start it fresh and new but here we're looking at buying Bandidos because we think it might come with something beyond just the assets and liabilities that are on its balance sheet so Bendigo's balance sheet shows assets of two hundred thousand liabilities of fifty thousand and equity of one hundred and fifty thousand so when we acquire Bendigo's what do we get well we get their assets and we get their liabilities do we also get their stockholders equity nope that doesn't exist anymore so when when we acquire another company we get their assets and their liabilities so the buyer is willing to pay three hundred thousand cash to acquire Bendigo's and the assets have a fair value of two hundred and eighty thousand and we also have to assume the liabilities which that kind of comes with the territory when you buy another company you get their assets but you also get stuck with the liabilities that encumber those assets so the balance sheet says two hundred thousand of assets but the fair value of the assets is two hundred and eighty thousand this is one of the few times in accounting we're going to use the fair market value this is extremely rare but this is the exception we're gonna use the fair market value for the computation of goodwill so if you think back to the definition of goodwill instead it's the excess of cost over fair value of net tangible assets acquired it in business acquisition let's break that definition down very carefully so it's the excess of cost our cost of Biman digos would be three hundred thousand over the fair value of net tangible assets telling us go ahead use the fair value rather than the value of two hundred thousand of net tangible assets okay so let's talk about net tangible assets what they're referring to is our access less the liabilities that encumber them so if we take assets of 280 - liabilities of 50 our net tangible assets are two hundred and thirty thousand so goodwill is the excess of cost three hundred thousand over our net tangible assets which is 280 - fifty two hundred and thirty thousand so essentially why would we be willing to pay three hundred thousand dollars to acquire our net assets of two hundred and thirty thousand dollars why are we so crazy that we're over paying by seventy thousand dollars and the answer is that we believe that the company's coming with some goodwill we believe it's coming with goodwill so let's walk through that computation once more and learn how to do the journal entry I encourage you to use the three question method so question one what do I get so I get been Digos assets so debit assets for 280 a fair value what else do I get I get their liabilities so I have to credit liabilities for fifty thousand question - what do I get rid of a whole lot of cash I'm willing to spend three hundred thousand dollars to buy their assets and liabilities so a credit cash for three hundred thousand and then finally question three what's the difference and the answer is goodwill goodwill is the mathematical difference why are we willing to pay three hundred thousand dollars to acquire net tangible assets assets of 280 minus liabilities of 50 equals 230 thousand why are we willing to pay three hundred thousand dollars to acquire net assets of 230,000 and the answer is we must believe that it comes with about seventy thousand dollars in goodwill so we have a new asset an intangible asset called goodwill and we debit for seventy thousand dollars so that's how I do goodwill here's one more look at that journal entry I do encourage you to use the three question method to arrive at that journal entry but looking back at the definition the excess of cost 300 thousand over the fair value of net tangible assets of 280 minus 50 is 230 so the excess of 300 thousand over 230,000 makes it seem like wow we overpaid by seventy thousand dollars that represents the goodwill and that's what we were trying to acquire because we could have gone out and started our own business but instead we wanted to buy Bendigo's existing business because we believe it has some goodwill so amortization when we have an an intangible asset with an identifiable useful life we're going to amortize it so let's take a look at our example here flowers Industries purchased a newly granted patent for forty four thousand dollars cash although the pattern has a legal life of twenty years flowers estimates that it will be useful for only eleven years so do we use the legal life or the useful life and in accounting the answer is the useful life the annual amortization charges therefore 4,000 we take the $44,000 cost and we divide it up over 11 years which gives us four thousand dollars of amortization per year so in recording these transactions we debit patent which is a new asset and we credit cash so that's just an asset exchange and of course it's I a we're spending money on a long term asset and then each year we will record our amortization expense so we debit amortization expense patent and we credit patent directly so again they don't give us an accumulated amortization account I will mention in the real world we do typically use accumulated amortization but that they don't offer that in this text so we're going to you credit patent directly and then when we do our balance sheet again we need to be careful to show that it's patent net or less amortization so it's fine it's not necessarily wrong to credit patent directly as they're doing here as long as we carefully display it on our balance sheet so that the readers of the financial statements are confused or misled so that's how you do amortization how about impairment remember my horrible example from the beginning when we talked about finger and the cheeseburger that would be a pretty serious impairment right so here's our example intangible assets with indefinite useful lives must be tested for impairment annually so we need to consider if our intangibles have been damaged in any way if the fair value of the intangible asset is less than its Book value and impairment loss is recognized so assume that we determined that our goodwill has suffered a 30,000 dollar impairment in value so we would go ahead and expense that $30,000 and credit and goodwill directly so we're debiting and parent loss a new expense account bringing down our net income and retained earnings and we are crediting goodwill so something bad has happened that caused our goodwill to be damaged so we expense the 30,000 and we decrease the value of our goodwill on the books look what all of this is done to her one simple balance sheet don't you risk the face from the beginning when our balance sheet was like cash land and then just total assets and that was it that was the good old days this is now just our long-term asset section of the balance sheet they're displaying it in three columns which I don't love I think their format here is a little bit confusing but let's take a look at it so what are long term assets we have plant and equipment and we're looking at buildings less accumulated depreciation spent in buildings less accumulated depreciation this number over here 1,500,000 that represents the book value and then we have equipment less accumulated depreciation so a million seven hundred fifty thousand minus 1.2 million so this number over here to the right 550 thousand again is the book value so we're showing the asset less accumulated depreciation asset less accumulated depreciation and showing the book value of each of those assets land we just leave it alone so we put it over here 850 thousand and we have natural resources and notice how they show it mineral deposits less depletion so we don't have an accumulated depletion account there is no contract count so that it's already been netted out of these figures oil reserves less depletion and that's fine as long as we show that and then our total natural resources we have our intangibles I would suggest that they should say patent and goodwill should say patent net of amortization or less amortization goodwill should show goodwill net of impairment or less impairment loss to make sure that the readers of the financials are clear on that and then we add all of it up and we've got our total long-term assets oh that sure complicates the long term out of subsection of the balance sheet but it's all important stuff when you're reading the balance sheet we need to understand our assets and their depreciation depletion or amortization so in terms of our choice of depreciation method here they're comparing what happens if we use straight-line versus double declining balance so alpha company and Zeta company are exactly the same except for their choice of depreciation method and showing here is that that choice can potentially have an impact on our net income now remember for taxes don't worry about it we're all going to use the same type of tax depreciation under makers but in terms of our financial statements we do want to thoughtfully choose an appropriate depreciation method because it clearly impacts our bottom line so alpha company they have depreciation expense under straight-line method of $4,000 a year but at the beta company they're using double declining balance so it changes each year so what that's doing though is changing our net income which could potentially influence maybe somebody looking to invest and in this case alpha company looks better than theta company but really only because of our choice of depreciation method those differences also carry over to the balance sheet of course so if we take our asset less accumulated depreciation the book value of the assets at alpha company would be greater than at Zeta Company at least in year one and year two but do keep in mind that after the absence useful life has expired so in the case of our van for years and I don't know about this particular asset but once the app that was fully depreciated although this is just a tiny difference and it all washes out but here we're looking at your one in your two and it clearly does make a difference and again when it comes to the choice of depreciation method I go back to matching concept I want to choose the depreciation method that does the best job of matching but others will say you know I I want to choose the depreciation method that's gonna make my net income look the best which might be straight-line so different reasons for choosing depreciation methods I always favor the matching comes about what we do know is that our choice of depreciation method does influence our financial statements but over the long haul it's just a timing difference so that's it for chapter eight that was a lot to digest please let me know if you need any help on your homework assignment if you have any about the chapter materials thanks for staying with me guys