Chapter 7 - Financial Accounting

Tangible Assets (Physical) 

• Land 

• Land Improvements 

• Buildings 

• Equipment 

• Natural Resources 

Intangible Assets (Lack of Physical Substance/ Existence often based on legal contract) 

• Patents 

• Trademarks 

• Copyrights 

• Franchises 

• Goodwill 

Property, Plant, and Equipment (PP&E) 

The original cost of the asset + all expenditures necessary to get the asset ready for use 

Land

Included the cost of the land and all expenditures necessary to get the land ready for its intended use 

• Costs to get the land ready for use include items such as: 

  • Real estate commissions and fees 

  • Back property taxes or other obligations 

  • Clearing, filling, and leveling the land 

Cash received from the sale of salvaged materials reduces the total cost of land (REDUCES LAND)

Land Improvements

• Amounts spent to improve the land 

  • Ex: parking lots, sidewalks, driveways, landscaping 

  • put on the land

  • Limited useful lives and are recorded separate from the Land account 

 

Buildings

• Administrative offices, retail stores, manufacturing facilities, and storage warehouses 

• Costs of getting a building ready for use include items such as: 

  • Realtor commissions and legal fees 

  • Remodeling costs 

• If a firm constructs a building rather than purchasing it (capitalize interest cost) 

Equipment

Machinery used in manufacturing, computers and other office equipment, vehicles, furniture, and fixtures 

• The cost of equipment might include sales tax, shipping, assembly, and any other costs to prepare the asset for use 

• Recurring costs (such as annual property insurance and annual property taxes on vehicles) are expensed as incurred (don’t include things that extend life of equipment in this expense) 

Natural Resources

• Examples: oil, natural gas, timber, and salt 

• Distinguished from other assets by the fact that they are physically used up, or depleted 

  • Recorded at cost plus all other costs necessary to get the natural resource ready for its intended use 

Purchased intangibles

Record at their original cost plus all other costs necessary to get the asset ready for use

Intangible assets developed internally 

Expense in the income statement most of the costs for them in the period we incur those costs 

Research and Development (R&D) 

Cost incurred to conduct research and to develop a new product or process 

• Reported as an expense in the income statement rather than as an intangible asset in the balance sheet 

  • Bc of difficulty in determining portion that benefits future periods 

 

Advertising 

• Cannot tell what portion of today's advertising: 

  • Benefits future periods 

  • How many periods it might benefit 

• Not reported as intangible asset in the balance sheet 

• Reported as expenses in the income statement in the period incurred 

Patents

Exclusive right to manufacture a product or to use a process 

• Granted for a period of 20 years 

• When purchased: 

  • Capitalize the purchase price plus legal and filing fees 

 

• When developed internally: 

  • Capitalize legal and filing fees only (R&D costs are expensed as incurred) 

Copyrights

Exclusive right of protection given to the creator of a published work 

• Granted for the life of the creator plus 70 years 

• Allows holder to pursue legal action against anyone who attempts to infringe the copyright 

  • Accounting is virtually identical to that of patents 

Trademarks

Word, slogan, or symbol that distinctively identifies a company, product, or service 

• Renewable for an indefinite number of 10-year periods 

• Capitalize legal, registration and design fees 

  • Advertising costs expensed as incurred 

Franchises

Local outlets that pay for the exclusive right to use the franchisor's name and to sell its products within a specified geographical area 

• The franchisee records the initial fee as an intangible asset 

• Additional periodic payments to the franchisor are usually expensed as incurred 

• Legal agreement between two companies 

Goodwill

The portion of the purchase price that exceeds the fair value of identifiable net assets 

• Recorded only when one company acquires another company 

• Net assets = assets acquired – liabilities assumed 

• Most companies also create goodwill to some extent through advertising, employee training, and other efforts 

  • However, as it does for other internally generated intangibles, a company must expense costs incurred in the internal generation of goodwill 

Capitialize

if it benefits future periods

Expense

if it benefits only the current period

Materiality 

An item is said to be material if it is large enough to influence a decision 

• When an expenditure is not material, the item is typically recorded as an expense regardless of its expected period of benefit 

• Companies generally have policies regarding 
  amounts that are not material. They will expense 
  all costs under a certain dollar amount, say 
  $1,000, regardless of whether future benefits are 
  increased 

Depreciation

Allocation of an asset's cost to expense over time 

• Not a valuation process: not referring to the change in value or selling price 

Debit: depreciation expense

Credit: accumulated depreciation

Book value =

= Cost - Accumulated depreciation

Service life

(useful life) 

• The estimated use the company expects to receive from the asset before disposing of it 

Residual value

(salvage value)

• The amount the company expects to receive from selling the asset at the end of its service life 

Depreciation method

The pattern in which the asset's depreciable cost (original cost – residual value) is allocated over time 

Depreciation Methods

In determining how much of an asset's cost to allocate to each year, a company should choose a depreciation method that corresponds to the pattern of benefits received from using the asset 

Three common methods: 

1. Straight-line 

2. Declining-balance 

3. Activity-based 

Straight-Line Depreciation

Depreciation expense = (Asset's cost – Residual value)/Service life

• same amount each year

Double-Declining-Balance Depreciation

• In the first year to calculate depreciation is to simply multiply cost times the depreciation rate 

• In the final year, the depreciation expense is the amount needed to reduce book value down to residual value 

• (1/year) x 2 = depreciation rate

• newest ending book value x rate = depreciation expense

Activity-Based Depreciation

Step 1: depreciation rate per unit = depreciable cost / total units expected to be produced

Step 2: depreciation expense = units of activity during the year x depreciation rate per unit 

Land

We record depreciation for land improvements, buildings, and equipment but we don't record depreciation for land 

• Unlike other long-term assets, land is not "used up" over time 

Tax Depreciation

• Accelerated methods reduce taxable income more in the earlier years of an asset's life 

• Most companies use: 

  • Straight-line for financial reporting 

  • Accelerated method for tax reporting, called MACRS 

Amortization

Allocating the cost of intangible assets to expense 

• Most intangible assets have a finite useful life that can be estimated 

  • The useful life of an intangible asset usually is limited by legal, regulatory, or contractual provisions 

• Most companies use straight-line amortization for intangibles 

Intangible Assets NOT subject to amortization

Goodwill and trademarks

Three Methods of Long-Term Asset Disposal 

1. Sale 

   1. Most common method 

2. Retirement 

   1. Occurs when a long-term asset is no longer useful but cannot be sold 

3. Exchange 

   1. Occurs when two companies trade long-term assets 

Gain on Sale

Sale (larger) - (Original cost - accumulated depreciation) (smaller) = Gain

• debit: cash and accumulated depreciation

• credit: asset and gain

Loss on Sale

Sales (smaller) - (Original cost - accumulated depreciation) (larger) = Loss

• debit: cash, accumulated depreciation, and loss

• credit: asset

Retirement

Original cost - accumulated depreciation = loss

• debit: accumulated depreciation, loss

• credit: asset 

Gain on Exchange

trade-in allowance (larger) - (cost - accumulated depreciation) (smaller) = gain

• debit: asset (new), accumulated depreciation

• credit: asset (old), cash, gain

Return on Assets =

= Net Income/Average total assets

• Indicates the amount of net income generated for each dollar invested in assets 

Profit Margin =

= net income/net sales

• indicates the earnings per dollar of sales

Asset turnover =

= net sales/average total assets

• measures the sales per dollar of assets invested

Impairment

• occurs when the expected future cash flows (expected future benefits) generated for a long-term asset fall below its book value 

• an asset's significant decline in value

• Record an impairment loss only when book value exceeds both future cash flows and fair value  

2-steps of impairment

Step 1: Test for impairment:  

• A long-term asset with a finite life is impaired if future cash flows are less than book value. 
   

Step 2: If impaired, record impairment loss: 

• The impairment loss is the amount by which book value exceeds fair value. 

• If the asset is not impaired, no loss is reported.