Hello I'm Professor Brian Boucher welcome back. This is part two of our look at the issues related to long live tangible assets. In this video we're going to talk about how to handle ongoing costs related to these long lived assets and how you account for their disposal or their impairment. Let's get started. Now we're going to talk about what happens with ongoing costs for a long-lived asset. So you have some long-lived asset, and you have to keep spending some money on it in the future, what do you do with those costs? You should expense those costs when they're related to the maintenance of the asset. So an usual or expected maintenance costs would be expensed. Things like oiling up the parts, tightening the screws, replacing the belts. Any cost that you anticipate you would need to do to maintain the quality of the asset. We said only capitalize costs. And remember, capitalize means we add the cost to the value of the asset on the balance sheet. When the cost either increased the useful life of the asset, or increased the value of the asset. Anytime we capitalize costs and add them to the asset, it will affect our future depreciation expense. And what we might have to do is adjust our useful life and salvage value assumptions, if we do really think that these costs are increasing the useful life or increasing the value. If we do make any changes in these assumptions, we recompute depreciation expense going forward, we don't have to go back and restate what happened in the past, just apply the new depreciation expense into the future. And when we do that we're going to use the net book value in place of the acquisition cost as the new historical cost of the asset. Now I'm going to do an example in a little bit to show you how this works. >> Wouldn't routine maintenance increase the life and the value of the asset? >> Could you please be more specific on the exact rules one would apply to determine whether costs should be expensed or capitalized? >> There actually are no hard and fast rules for applying capitalizing versus expensing in this case. Instead we give managers the discretion to apply these guidelines that if a cost increases a life, or increases the value, then it can be capitalized. And I think the best way to illustrate what we mean by this is with a couple of examples. So first let's say I buy a new car. Part of the value of that car assumes that I'm going to do routine maintenance. It assumes that I'm going to change change the oil when needed. That I'm going to rotate the tires. And so those routine maintenance costs should be expensed. So certainly the life of the car would be less if I didn't do that, but it's assumed that when you buy the car, that you're going to do that kind of routine maintenance. Now think of a different kind of cost that it could have with the car. Let's say I put a flame red decal on the side, I put a little spoiler on the back, maybe a T top. So if you're a fan of the old Smokey and. Smokey and the Bandit movies. You'll know what I'm talking about. But anyway, that kind of customization of the car, is going to increase its life, I'm going to be more willing to use it longer. Increase its value, people would pay more for it, so that will, those kinds of costs could be capitalized. Another example. Let's say I have a building made out of wood. Wood needs to be painted every now and then to maintain the building. So the cost of painting a wood building would be routine maintenance and expense. Now let's say I have a brick building. You don't need to paint brick to keep it up. It'll last other last anyway. So if I paint a brick building, presumably I'm doing that to extend its life. I'll keep it longer, or increase its value. And so the cost of painting would be capitalized for a brick building, but expensed as maintenance for a wood building. That sort of seems like a trivial decision, but actually one of the big frauds earlier in the century was all around this issue. WorldCom was basically taking routine maintenance, which should be expensed, and capitalizing it, which helped its EBITDA. Because what it was doing, it's turning an expense into depreciation. And of course, depreciation does not effect your EBITDA. So this is not a neutral decision. And there have been situations where companies have abused this to make themselves look much better. >> [SOUND] Let's go back to our Bott example. Now Bott spends $200 cash on routine maintenance for the equipment. I'll put up the pause sign and you can try to do this journal entry. So, for the journal entry we're going to credit cash for 200 because we're spending $200 cash. And were going to debit maintenance expense because as routine maintenance, this gets expensed immediately, it doesn't get added to the asset nd depreciated over time. Now with a coffee out here is that this is a little bit more complicated than this, Remember in the prior video, this equipment is used to both produce inventory and personal clubs for top management and sales force. So, what's really going to happen is 75% of this maintenance expense will really go to work-in-process inventory, and 25% will be in SG&A expense. The key point is that none of it goes into the equipment account and none of it effects accumulated depreciation. Next, Bott spends $600 cash on a new attachment to the equipment that will allow it to add grips to the new style of extra-long putter. So I'll put up the pause sign and you can try to figure out this journal entry. In this journal entry, we're going to have a credit to cash for 600, because we're spending $600 cash. This time the debit's not to an expense but instead it's to the equipment account. The logic here is that the new attachment is going to allow us to use the equipment longer, or make the equipment more valuable so we get to capitalize the cost and as you can see we add 600 to the equipment T account. Now that Bott management has made this capital improvement, they decide that the new attachment will increase the useful life of the equipment to ten years going forward from this point. So, ten remaining years, with a salvage value of $600. Bott now has to recognize one more year of depreciation. So we're going to have to change our depreciation formula going forward. [SOUND] What we do is we use our same Straight-line formula, but we replace acquisition cost with the Net Book Value at the time of the change in assumptions. [SOUND] Let me remind you where we are in terms of the Net Book Value. We have $8600 balance in Equipment account $1000 balance in Accumulated Depreciation. So that's a Net Book Value of 7600. Let me throw up the pause sign, and we'll see if you can calculate the new Annual Depreciation under these assumptions. [SOUND] So in the equation, we're going to have 7600 for Net Book Value minus 600 for the Salvage Value. And notice the salvage value has dropped from 2,000 down to 600 because we're anticipating keeping the equipment longer. And the longer we keep it, the more its salvage value drops. So we take that depreciable base of 7,000, 7,600 minus 600, spread it over the ten year useful life going forward and we get a new annual depreciation of $700. Are companies allowed to change depreciation assumptions whenever they want? This seems fishy to me. They should have to restate their old financial statements. >> Companies are not only allowed to change depreciation assumptions at any time, it's actually good practice for managers to change their assumptions if something big has changed with how they plan to use the asset. Remember we're counting on managers to communicate how long their going to use this asset to generate revenue. If something changes in that estimate, either because they've done some kind of additional expenditure to increase the life of the asset, or something has happened, so the asset's not going to last as long then, it's good practice for them to communicate that through new depreciation assumptions. Now, of course, it would be fishy if they were just changing assumptions to try to meet an earnings target, to try to make their earnings look better. So part of our job as users of financial statements is to first try to identify these changes in depreciation assumptions when they happen. And then see if we can find any other information about what the company is doing to see if they're justified. We don't go back and restate prior financials because our assumption is whatever managers' best estimate was in the past that's what we use for those financials. Now their best estimate has changed and so we'll just change the financials going forward. >> Now that we've figured out the annual depreciation let's go ahead and do the journal entry. Bott's management estimates that 100% of the time the equipment was used to produce golf club inventory. Of course, this made the sales force and top management a little upset. Because they weren't using the machines at all to make their personal putter grips. But what it means for the journal entry, is that all of the depreciation's going to go into an inventory account. So let me put up the Pause sign and have you take a crack at this journal entry. So in this journal entry, we're going to, again, credit accumulated depreciation like we did in a prior video. But we're only going to debit work in process inventory, because 100% of the equipment time was use to produce inventory, none of it was used for personal use, and so there's no SG&A component to this. We can then go ahead and put that 700 into the accumulated depreciation account. Next we're going to talk about disposal of property plant and equipment. So what happens if you decide you want to sell the piece of equipment before the end of its useful life. What you do is you take the historical cost of the asset out of the property plan and equipment account, so historical cost would be the acquisition cost plus any other cost that you've added to it over time. You also remove all the related depreciation from accumulated depreciation, which makes sense if we don't have the asset anymore, we don't need the depreciation on the asset. A gain or a loss on the sale of PP&E will be recorded when the proceeds from the disposal are more or less than the net book value, respectively where net book value is the difference between historical cost and accumulated depreciation. The journal entry is going to look like this. We're going to debit cash for the sale amount, the cash that we received from selling the PP&E. We'll credit the specific property, plant and equipment account where we pull out that entire historical cost. We will debit accumulated depreciation, so we can pull out the full balance of the depreciation in the piece of equipment. If we sold at a gain or a loss, this is not going to balance. If the net book value is greater than the cash, then we have a loss and we want to debit loss on sale. If the net book value is less than the cash we received, then we'll have a gain on the sale and we'll plug a gain. Note that we won't have both a gain and a loss on this transaction, we're going to have one of the two, and which one we have. Depends on whether we got more cash than the net book value or less than cash than net book value. >> Why would a company ever get a gain, or suffer a loss, on selling its equipment? Wouldn't it be the case that the company would sell it for exactly what it is worth? >> Now the company is probably selling the piece of equipment for its market value, but keep in mind that the gain or loss is not relative to the market value. The asset hits relative to the book value of the asset. The book value of the asset is a function of how much we've depreciated it to this point, which is a function of those depreciation assumptions, the useful life and the salvage value that we made when we bought the piece of equipment. So if we depreciate too much, we bring down the value too far, we'll end up having a gain when we sell it. If we depreciate it too little, we don't depreciate it enough, we'll end up having a loss when we sell it. So think of this gain or loss as a last ditch correction, to get us to the point where the total expense over the life of the piece of equipment is the difference between what we originally paid for and what we ultimately sold it for at it its market value. >> Let's see how this journal entry works in this Bott example. So Bott is in financial distress due to high employee turnover. So all those sales people are now upset because they can't use the grip machine for their personal clubs, and they're starting to leave the company. So Bott decides to subcontract the grip work, which means to have basically another company do that work for them. And it's going to sell it's piece of equipment for $5,500. Now let me bring up the T account so you can see where we are so far. And now I'm going to put up the pause sign and have you try to do the journal entry for this sale of the equipment. So here's the journal entry we're going to debit cash for $5,500, that's how much cash we're receiving for selling the piece of equipment, we need to get rid of the equipment from our balance sheet, so for the equipment account the balance was 8,600. We need to credit equipment for 8600 to zero that account out. For accumulated depreciation, the balance was 1700. So we need to debit accumulated depreciation to zero that account out. Now at this point, our debits don't equal our credits. What we need is a plug for loss on sale. And it's a loss on sale because the cash proceeds of 5500 are $1400 less than the net book value at this point, which is 6900. So we debit loss on sale for the $1400 difference. Next we're going to talk about impairment tests. Sometimes the value of a long lived asset drops below what it's listed on the books, this is what's called an impairment, and we may have to write down the value in that case. So there's three steps we have to look at for an impairment test. Step 1, have any circumstances changed that raised the possibility of an impairment? So, is the company performing poorly, or is the piece of equipment performing poorly? Which would make us think we may have a drop in it's value. If yes, then we move to step 2. Are the future undiscounted net cash flows from the asset, either from continuing to use it, or from selling it less than its net book value. So what you would do with this case is forecast out all the cash flows you'd get in the future from continuing to use the asset, or from selling it, just add up those future cash flows if they're less than what it's on the books, we're going to have to write it down through an impairment. If it turns out to be greater, then we're done, we don't have to go further. Step 3. We need to write down the book value of the asset, and record a loss equal to the difference between the fair value of the asset, and its net book value. To figure out the fair value of the asset, we need to use discounted cash flows. >> What are discounted cash flows? >> Yeah we had a little problem here in that we haven't talked about discounted cash flows yet. I've got three full videos next week to explain what discounted cash flows are and how to calculate them. So for now this is a place where you should make a mental note to come back and look at the slide again after you've learned what discounted cash flows are. But what you should take away at this point is the discounted cash flows are going to give you the fair market value whereas undiscounted cash flows will over state the true value of the asset. So, this is a conservative task. It makes it hard to find that an assets impaired. It really has to be impaired before you would take a write down. Let's now look at how to do a journal entry for an impairment. And let's say that instead of Bott selling the piece of equipment as we saw before, in an alternate reality, Bott decides to keep the equipment. But finds that it has been impaired due to employee sabotage. The sales force is in there doing bad things at night when no one's looking. So Bott management now goes through the three steps. And they find they have an impairment. And they estimate that the fair market value of the equipment is now $5,500. Here are the equipment and accumulated depreciation T-accounts to this point. I'll put up this pause sign, and you can try to take a stab at doing the journal entry for an impairment. So we're going to basically have the same journal entry as the sales transaction. The difference is that, obviously, we're not receiving any cash so there's no debit to cash. Instead we're going to debit equipment at the fair market value. So it's almost like we bought a new piece of equipment at this new fair value, in replacing the old one at the higher pre impairment value. So anyway, we debit equipment for $5500. We also credit equipment for $8600 to pull out the historical cost of the equipment. That we had pre-impairment. We take out all of the accumulated depreciation, so essentially we're starting over. So we debit accumulated depreciation for $1700. Our debits don't equal our credits at this point, so we have to plug and debit to impairment loss for $1400 which is the difference between the net book value of $6900 which is $8600 minus $1700 and the new fair value after the impairment of $5,500. To wrap up there are a few major differences between US Dap and IA for us for long lived assets and I wanted to summarize them all on this slide. When we look at the carrying value of long lived assets so the value that their on the balance sheet, under US GAAP, you have to use lower of cost or market so you can't write an asset up in value but you can write it down if it's impaired and you have depreciation expense recorded each period. Under IFRS you can either use lower-of-cost-or-market, just like under US GAAP or you can choose the fair value method. Under the fair value method property plan equipment is carried at fair value on the balance sheet at all times. Any unrealized gains or losses over a period either go through the income statement or directly to stockholders' equity. And I don't want to get into all the conditions that would determine one versus the other. There's also some differences for impairments. Under US GAAP, once you write an asset down, you can't write it back up in value at a later date. In other words, after you write an asset down due to impairment, that's the new historical cost. And then you can't write it back above that. But under IFRS, if you use the lower-of-cost-or-market method, assets that are written down due to an impairment can be written back up in value to the original cost of the asset less the accumulated depreciation. Another difference is that. In those impairment test, determination of whether impairment is necessary is based on the discounted present value of cash flows, whereas under U.S. GAAP, remember, it was based on that undiscounted measure of cash flows. And, again, there's discounting versus undiscounting, will make more sense next week, when we talk about how to do present values. >> And so that wraps up our two part blockbuster look at issues related to long lived tangible assets. And in the next video we'll talk about intangible assets, including everyone's favorite asset Goodwill. I'll see you then. >> See you next video.
