Matching Principle for PP&E

Long-lived Assets Corporate Accounting Changes in Depreciation Estimates „ „ „ Caused by change in asset life or Salvage Value Apply the change prospectively, i.e., to future years (no restatement of past years’ results) Example: Cost = $100K, SV = 0, Initial UL estimate of 5 years. After 2nd year, spend $30K on improvement that extends UL by 3 years (i.e., to total of 8). „ What is annual depreciation expense for each of the first two years? „ What is book value at the end of 2nd year? „ How do we account for the improvement? „ What is annual depreciation expense for years 3 and beyond? Changes in Depreciation Estimates „ „ Example: Cost = $100K, SV = 0, Initial UL estimate of 5 years. After 2nd year, spend $30K on improvement that extends UL by 3 years (i.e., to total of 8). What is annual depreciation expense for each of the first two years? „ „ What is book value at the end of 2nd year? „ „ $[100 – (20*2)] K = $60k How do we account for the improvement? „ „ $(100 – 0)/5 = $20K Capitalize the improvement costs. BV increases to $ (60+30) = 90K What is annual depreciation expense for years 3 and beyond? „ Years left = (5-2) + 3 = 6 „ Therefore, depreciation expense = $90K/6 = $15 Changes in Depreciation Estimates Cash Acquire PP&E Yr 1 Depr. Yr 2 Depr Improve ment Year 3 Depr. PP&E – Acc. Depr =L Ret. Earn Changes in Depreciation Estimates Cash Acquire PP&E Yr 1 Depr. Yr 2 Depr Improve ment Year 3 Depr. –100 PP&E 100 – Acc. Depr =L Ret. Earn Changes in Depreciation Estimates Cash Acquire PP&E Yr 1 Depr. Yr 2 Depr Improve ment Year 3 Depr. –100 PP&E – Acc. Depr =L Ret. Earn 100 20 –20 20 –20 Changes in Depreciation Estimates Cash Acquire PP&E Yr 1 Depr. Yr 2 Depr Improve ment Year 3 Depr. –100 –30 PP&E – Acc. Depr =L Ret. Earn 100 +30 20 –20 20 –20 Changes in Depreciation Estimates Cash Acquire PP&E Yr 1 Depr. Yr 2 Depr Improve ment Year 3 Depr. –100 –30 PP&E – Acc. Depr =L Ret. Earn 100 20 –20 20 –20 15 –15 +30 Disposal (retirement): Gain or Loss „ Computation: „ „ „ „ Gain (Loss) = Proceeds from selling the asset - book value, where BV = Acquisition cost - Accumulated Depreciation associated with the asset Bookkeeping: Remove asset’s historical cost and accumulated depreciation from the balance sheet and record Gain (Loss). Example: At end of 7th year, when BV is $15K, sell Asset from last example for scrap value of $2K. BB Sale EB Cash + PP&E - Acc. Dep. + OA = L + CC + RE . 130K 115K . . . . Disposal (retirement): Gain or Loss „ Computation: „ „ „ „ Gain (Loss) = Proceeds from selling the asset - book value, where BV = Acquisition cost - Accumulated Depreciation associated with the asset Bookkeeping: Remove asset’s historical cost and accumulated depreciation from the balance sheet and record Gain (Loss). Example: At end of 7th year, when BV is $15K, sell Asset from last example for scrap value of $2K. Cash + PP&E - Acc. Dep. + OA = L + CC + RE BB . 130K 115K . . . . Sale 2K (130K) (115K) (13) EB 0 0 Disposal Gross PP&E 130 Cash 130 Book value at time of sale = 15 Sale value = 2 Book value after sale = 0 Acc. Deprecn. 115 115 Loss on sale (RE) 13k 2k Gain/loss on sale of asset – book keeping Dr Cash Dr Loss on sale of asset Dr Acc. Deprecn. Cr PP&E 002k 013k 115k 130k A brief review of the SCF „ Cash From (Used by) Investing Activities: „ „ „ Cash From (Used by) Financing Activities: „ „ Report Cash Used to Purchase PP&E Report Cash Rec’d (if any) from Disposing off PP&E What if PP&E is purchased using borrowed funds? Cash From (Used by) Operating Activities: „ „ Under the Indirect Method, firms start with Reported Net Income and remove non-cash effects What non-cash effects of PP&E bookkeeping are embedded in Net Income? An Application: Inferring PP&E Events Following are from Nike’s financial statements Balance Sheet Property, plant and equipment,net (Note 3) Identifiable intangible assets (Notes 1 and 6) 1998 1997 1,153.1 922.4 435.8 464.2 Statement of Cash Flows -- Operations Net Income Depreciation Amortization and other 1998 $399.6 184.5 49.0 Statement of Cash Flows -- Investing Additions to property, plant and equipment Disposals of property (505.9) 16.8 - Data source: Nike, Inc. Fiscal Year 1998 Annual Report. 1999. An Application: Inferring PP&E Events Property, plant and equipment includes: Land Buildings Machinery and equipment Construction in process Less accumulated depreciation 1998 $93.0 337.3 887.4 248.2 1,819.6 666.5 1997 $90.8 241.1 735.7 151.6 1,425.8 503.4 $1,153.1 $922.4 “Capitalized interest expense was $6.5 MM, $2.8 MM, and $0.9 MM for the fiscal years ended May 31, 1998, 1997 and 1996 respectively.” - Data source: Nike, Inc. Fiscal Year 1998 Annual Report. 1999. An Application: Inferring PP&E Events The change in Nike’s Accumulated Depreciation account is $666.5 - $503.4 = $163.1MM. What 1998 events probably accounted for this change? The change in Nike’s gross PP&E account is $1,819.6 - $1,425.8 = $393.8 MM. What 1998 events probably accounted for this change? An Application: Inferring PP&E Events PP&E (A) Beg Balance Additions Disposals Ending balance Accumulated depreciation (XA) Beg Balance Depreciation expense Acc Dep of disposed off assets Ending balance An Application: Inferring PP&E Events PP&E (A) Beg Balance 1425.8 Additions 505.9 112.1 Ending balance Disposals 1819.6 Accumulated depreciation (XA) 503.4 Beg Balance 184.5 Depreciation expense Acc Dep of disposed off 21.4 assets 666.5 Ending balance An Application: Inferring PP&E Events Investing CF from disposals of property = $16.8 But the PP&E account shows disposals = $112.1 and Acc Dep associated with disposals = $21.4 Hence, BV of disposals = $112.1 - $21.4 = $90.7 Loss on disposals = $90.7 - $16.8 = $73.9 Tax and Timing Effects „ Tax Depreciation „ „ „ Tax Reporting ≠ Financial Reporting ==> timing differences in measurement of income „ „ „ „ Accelerated depreciation No judgment in determining depreciation expense Why would a firm prefer accelerated depreciation for tax purposes? Why does government allow this? Why not use the tax method for financial reporting? Different depreciation for tax and financial reporting gives rise to Deferred Taxes Tax and Timing Effects Cambridge Innovations bought a $90,000 asset at the beginning of 2001. Financial reporting Asset life Depreciation rate Residual value Year 2001 2002 2003 3 years Straight line $0 Financial reporting depreciation 30,000 30,000 30,000 Tax reporting 2 years MACRS: 60%, 40% $0 Schedule of depreciation Depreciation Accumulated Tax difference reporting difference, depreciation end of the year 54,000 24,000 24,000 36,000 6,000 30,000 (30,000) 0 Accounting for Timing Differences: 2001 „ In Year 1, income before depreciation is $80,000 for both financial and tax reporting. The tax rate is 30% with no anticipated change. Financial reporting Tax reporting NI before Depr 80,000 80,000 – Depreciation 30,000 –54,000 = NI before taxes 50,000 26,000 × 30% × 30% Tax Payable 7,800 Tax Expense 15,000 Tax Expense = Tax Payable + ??? ??? = $7,200 is “Deferred Tax Expense” Deferred Taxes over Time Deferred taxes caused by timing differences are temporary; they reverse over time. Year Year 2001 2002 2003 „ „ Financial reporting depreciation 30,000 30,000 30,000 Tax Depreciation Deferred Acc. Depr Difference, reporting difference Tax depreciation Expense (EB) 54,000 24,000 7,200 24,000 36,000 6,000 1,800 30,000 0 (30,000) (9,000) - Def Tax Liability (EB) 7,200 9,000 0 Timing differences that create / increase deferred taxes are called originating differences Timing differences that remove / decrease deferred taxes are called reversing differences Summary „ „ „ „ Depreciation is the systematic allocation of capital expenditures over the revenue-producing period of a long-lived asset (matching principle). Depreciation is a function of acquisition cost, economic life, depreciation rate, and salvage value. Depreciation does not involve cash. Only the acquisition and disposal of long-lived assets involve cash. Deferred taxes arise due to differences in book (GAAP) and tax depreciation.