U 8 FLASH
porting and Analyzing Long-Lived Assets
Learning Objectives
1. Explain the accounting for plant asset expenditures.
2. Apply depreciation methods to plant assets.
3. Explain how to account for the disposal of plant assets.
4. Identify the basic issues related to reporting intangible assets.
5. Discuss how long-lived assets are reported and analyzed.Chapter Outline
Learning Objective 1 – Explain the Accounting for Plant Asset Expenditures
Plant Assets (also called property, plant, and equipment) are resources that have
physical substance (a definite size and shape), are used in the operations of a business, and are
not intended for sale to customers.
It is important for companies to (1) keep assets in good operating condition, (2) replace worn-
out or outdated assets, and (3) expand its productive assets as needed.
Determining the Cost of Plant Assts—the historical cost principle requires that
companies record plant assets at cost.
Cost consists of all expenditures necessary to acquire an asset and make it ready for its
intended use.
If a cost is not included in a plant asset account, then it must be expensed immediately. Such
costs are referred to as revenue expenditures.
Costs that are not expensed immediately but are instead included in a plant asset account
are referred to as capital expenditures.
Cost is measured by the cash paid in a cash transaction or by the cash equivalent price
paid when companies use noncash assets in payment.
o The cash equivalent price is equal to the fair value of the asset given up or the fair value
of the asset received, whichever is more clearly determinable.
Once cost is established, it becomes the basis of accounting for the plant asset over its useful
life.
Land—companies often purchase land as a building site for a manufacturing plant or office. The cost
of land includes:
The cash purchase price.
Closing costs such as title and attorney’s fees.
Real estate broker commissions.
Accrued property taxes and other liens on the land assumed by the purchaser.
All necessary costs incurred in making land ready for its intended use increase the Land
account.
Land improvements—structural additions with limited lives that are made to land, such as
driveways, parking lots, fences, and underground sprinklers.
The cost of land improvements includes all expenditures necessary to make the
improvements ready for their intended use.
Buildings—facilities used in operations, such as stores, offices, factories, warehouses, and
airplane hangars.
All necessary expenditures relating to the purchase or construction of a building are charged
to the Buildings account.
When a building is purchased, such costs include the purchase price, closing costs
(attorney’s fees, title insurance, etc.), and real estate broker’s commissions.
When a new building is constructed, its cost consists of the contract price plus payments
made by the owner for architect’s fees, building permits, and excavation costs.
The inclusion of interest costs in the cost of a constructed building is limited to interest
costs incurred during the construction period. Equipment—includes assets used in operations, such as store check-out counters, office
furniture, factory machinery, and delivery trucks.
The cost of equipment consists of the cash purchase price, sales taxes, freight charges, and
insurance during transit paid by the purchaser. It also includes expenditures required in
assembling, installing, and testing the unit.
Two criteria apply in determining the cost of equipment:
(1) The frequency of the cost—one time or recurring.
(2) The benefit period—the life of the asset or one year.
Expenditures During Useful Life—during the useful life of a plant asset, a company may
incur costs for ordinary repairs, additions, and improvements.
Ordinary repairs are expenditures to maintain the operating efficiency and expected
productive life of the unit.
o They are usually fairly small amounts that occur frequently throughout the service life.
o Examples of ordinary repairs include motor tune-ups and oil changes, the painting of
buildings, and the replacing of worn-out gears on factory machinery.
o Ordinary repairs are recorded as Maintenance and Repairs Expense as incurred.
Additions and improvements are costs incurred to increase the operating efficiency,
productive capacity, or expected useful life of the plant asset.
o They are usually material in amount and occur infrequently during the period of
ownership.
Because the expenditures for additions and improvements increase the company’s
investment in productive facilities and are generally added to the plant asset
affected, they are capital expenditures.
Learning Objective 2 – Apply Depreciation Methods to Plant Assets
Depreciation is the process of allocating to expense the cost of a plant asset over its useful
(service) life in a rational and systemic manner.
Such cost allocation is designed to properly record expenses (efforts) with associated revenues
(results).
Depreciation affects the balance sheet through accumulated depreciation, which companies
report as a deduction from plant assets. It affects the income statement through depreciation
expense.
Depreciation is a cost allocation process, not an asset valuation process.
The book value—cost less accumulated depreciation—of a plant asset may differ significantly
from its fair value.
Depreciation applies to three classes of plant assets:
o Land improvements
o Buildings
o Equipment
Depreciation does not apply to land because its usefulness and revenue-producing ability
generally remain intact as long as the land is owned.
Recognizing depreciation for an asset does not result in the accumulation of cash for
replacement of the asset.
The balance in the Accumulated Depreciation represents the total amount of the asset’s cost
that the company has charged to expense to date; it is not a cash fund.depreciation is simply a systematic way of allocating the cost of the asset over its life.
Depreciation does not attempt to bring the asset to fair value. Think of buildings that are very
old and have been owned by an individual or a company for a long time. The book value of
these assets (cost less accumulated depreciation) is probably small. The buildings have
probably not depreciated at all. Rather, they have probably appreciated.
Factors in Computing Depreciation:
Cost—all expenditures necessary to acquire the asset and make it ready for intended use.
Useful life—estimate of the expected life based on need for repair, service life, and
vulnerability to obsolescence.
Salvage value—estimate of the asset’s value at the end of its useful life.
management is responsible for determining useful life and salvage, as well as selecting the
depreciation method. Discuss ways to estimate the useful life and salvage value.
Depreciation Methods—depreciation is generally computed using one of three methods:
1. Straight-line.
2. Declining-balance.
3. Units-of-activity.
Each of these depreciation methods is acceptable under generally accepted accounting
principles.
Management selects the method it believes best measures an asset’s contribution to revenue
over its useful life.
Once a company chooses a method, it should apply that method consistently over the useful
life of the asset
Straight-line depreciation is used for some or all of the depreciation taken by more than 95%
of U.S. companies.
Straight-Line—companies expense an equal amount of depreciation each year of the asset’s
useful life.
To compute the annual depreciation expense, we divide the depreciable cost (the cost of
the plant asset less its salvage value) by the estimated useful life.
When an asset is purchased during the year, rather than on January 1, it is necessary to
prorate the annual depreciation for the proportion of a year used.
Declining-Balance— computes depreciation expense using a constant rate applied to a declining
book value.
This method is called an accelerated-depreciation method because it results in higher
depreciation in the early years of an asset’s life than does the straight-line approach.
Companies can apply the declining-balance approach at different rates, which result in varying
speeds of depreciation.
A common declining-balance rate is double the straight-line rate. This method is referred to
as the double-declining-balance method.
Units-of-Activity—useful life is expressed in terms of the total units of production or the use
expected from the asset.
The units-of-activity method is ideally suited to factory machinery.
This method is generally not suitable for such assets as buildings or furniture because activity
levels are difficult to measure for these assets. The amount of depreciation is proportional to the activity that took place during that period.
Using the example in the book of the small delivery truck purchased by Bill’s Pizzas on January
1, 2027:
Cost $13,000
Expected salvage value $1,000
Estimated useful life (in years) 5
Estimated useful life (in miles) 100,000
Computation of straight-line depreciation:
($13,000 - $1,000) 5 years = $2,400 per year
Rate: 100% 5 years = 20% per year
Depreciation Schedule Assuming Straight-Line Depreciation
Depreciable Value
Annual
Depreciation
End of Year
Accumulated Book
Year Cost Rate Expense Depreciation Value
2027 $12,000 20% $2,400 $ 2,400 $10,600
2028 12,000 20% 2,400 4,800 8,200
2029 12,000 20% 2,400 7,200 5,800
2030 12,000 20% 2,400 9,600 3,400
2031 12,000 20% 2,400 12,000 1,000
Total $12,000
Go over the example in the book of the delivery truck purchased by Bill’s Pizzas on January 1,
2027, using the double-declining-balance method. The Appendix expands the example to
show that when using the declining-balance method, the salvage value is ignored in the
beginning. However, the asset cannot be depreciated below its salvage value.
Depreciation Schedule Assuming Double-Declining-Balance Depreciation
Rate = 100% ÷ 5 years = 20%, 20% × 200% (DDB) = 40% per year
End of Year
Year
Book
Value
Beginning
of Year
Depreciation
Rate
Annual
Depreciation
Expense
Accumulated
Depreciation
To Date
Book
Value
2027 $13,000 × 40% = $ 5,200 $5,200 $7,800
2028 7,800 × 40% = 3,120 8,320 4,680
2029 4,680 × 40% = 1,872 10,192 2,808
2030 2,808 × 40% = 1,123 11,315 1,685
2031 685 685 12,000 1,000
Total $12,000Computing depreciation under units-of-activity is the much the same as straight line. The only
difference is that the life is expressed in terms of activity rather than years. Activity may be
measured in units produced, miles driven, or hours flown, depending on the asset. Returning
to the example of Bill’s delivery truck the units-of-activity depreciation would be computed as
follows:
($13,000 - $1,000) 100,000 miles = $0.12 per mile
Depreciation Schedule Assuming Units-of-Activity Depreciation
End of Year
Year
Units of
Activity
(Miles)
Depreciation
Rate
Annual
Depreciation
Expense
Accumulated
Depreciation
Book
Value
2027 15,000 × $0.12 = $ 1,800 $ 1,800 $11,200
2028 30,000 × 0.12 = 3,600 5,400 7,600
2029 20,000 × 0.12 = 2,400 7,800 5,200
2030 25,000 × 0.12 = 3,000 10,800 2,200
2031 10,000 × 0.12 = 1,200 12,000 1,000
Total 100,000
miles
$12,000
Students need to have a good understanding of the effect different methods of depreciation
have on the Income Statement and the Balance Sheet.
Comparison of Depreciation Expense with Three Methods of Depreciation
Year Straight-Line
Double-Declining
Balance Units-of-Activity
2027 $ 2,400 $ 5,200 $1,800
2028 2,400 3,120 3,600
2029 2,400 1,872 2,400
2030 2,400 1,123 3,000
2031 2,400 685 1,200
$12,000 $12,000 $12,000
Note that total depreciation is the same for the five-year period. The depreciable cost has been
expensed over the useful life or the estimated activity. Depreciation and Income Taxes—the internal Revenue Service (IRS) allows corporate taxpayers
to deduct depreciation expense when computing taxable income.
The IRS does not require the taxpayer to use the same depreciation method on the tax return
that it uses in preparing financial statements.
Many large corporations use straight-line depreciation in their financial statements in order to
maximize net income; at the same time, they use a special accelerated-depreciation method on
their tax returns in order to minimize their income taxes.
For tax purposes, taxpayers must use on their tax returns either the straight-line method or a
special accelerated-depreciation method called the Modified Accelerated Cost Recovery
System (MACRS).
Depreciation Disclosure in the Notes—companies must disclose the choice of depreciation
method in their financial statements or in related notes that accompany the statements.
Revising Periodic Depreciation—management should periodically review annual depreciation
expense. If wear and tear or obsolescence indicates that annual depreciation is either inadequate
or excessive, the company should change the depreciation expense amount.
When a change in an estimate is required, the company makes the change in current and
future years but not to prior periods.
o 1. The company does not change previously recorded depreciation expense.
o 2. The company revises depreciation expense for current and future years.
The rational for this treatment is that continual restatement of prior periods would adversely
affect the users’ confidence in financial statements.
Companies must disclose in the financial statements significant changes in estimates.
Impairment—is a permanent decline in the fair value of an asset.
So as not to overstate the asset on the books, the company records a write-down, whereby the
asset’s cost is reduced to its new fair value during the year in which the decline in value occurs.
In the past, some companies improperly delayed recording losses on impairments until a year
when it was “convenient” to do so—when the impact on the company’s reported results was
minimized.
The practice of timing the recognition of gains and losses to achieve certain income results is
known as earnings management.
Accounting standards now require immediate loss recognition of impaired assets.
Learning Objective 3 – Explain How to Account for the Disposal of Plant Assets
Plant Asset Disposals—companies dispose of plant assets that are no longer useful to them.
There are three ways in which companies make plant asset disposals:
1. Sale.
2. Retirement.
3. Exchange.
Whatever the disposal method, the company must determine the book value of the plant
asset at the time of disposal to determine the gain or loss.
Sale of Plant Assets—the company compares the book value of the asset with the proceeds
received from the sale. If the proceeds from the sales exceed the book value a of the plant asset,
a gain on disposal occurs. If the proceeds from the sale are less than the book value of the
plant asset sold, a loss on disposal occurs.
Retirement of Plant Assets—companies simply retire, rather than sell, some assets at the endof their useful lives. Companies record retirement of an asset as a special case of a disposal
where no cash is received.
Learning Objective 4 – Identify the Basic Issues Related to Reporting Intangible Assets
Intangible Assets—rights, privileges, and competitive advantages that result from ownership of
long-lived assets. Intangible assets lack physical substance, yet many companies’ most valuable
assets are intangible.
Intangibles may be evidenced by contracts, licenses, and other documents. Intangibles may
arise from the following sources:
o Government grants, such as patents, copyrights, licenses, trademarks, and trade names.
o Acquisition of another business in which the purchase price includes a payment for
goodwill.
o Private monopolistic arrangements arising from contractual agreements, such as
franchises and leases.
Accounting for Intangible Assets—companies record intangible assets at cost. Intangibles are
categorized as having either a limited life or an indefinite life.
If an intangible has a limited life, the company allocates its cost over the asset’s useful life
using a process similar to depreciation.
The process of allocating to expense the cost of intangibles is referred to as amortization.
The cost of intangible assets with indefinite lives should not be amortized.
o To record amortization of an intangible asset, a company increases Amortization and
decreases the specific intangible asset.
o Intangible assets are typically amortized on a straight-line basis.
Types of intangible assets:
A patent is an exclusive right issued by the U.S. Patent Office that enables the recipient
to manufacture, sell, or otherwise control an invention for a period of 20 years from the
date of the grant.
o The initial cost of a patent is the cash or cash equivalent price paid to acquire the
patent.
o Legal costs in successfully defending a patent in an infringement suit are added to the
Patent account and amortized over the remaining life of the patent.
Copyrights are granted by the federal government and give the owner the exclusive right to
reproduce and sell an artistic or published work.
o Copyrights last for the life of the creator plus 70 years. However, the useful life of a
copyright generally is significantly shorter than its legal life.
o The cost of a copyright consists of the cost of acquiring and defending it.
A trademark or trade name is a word, phrase, jingle, or symbol that distinguishes or identifies
a particular enterprise or product.
o The creator or original user may obtain exclusive legal right to the trademark or trade
name by registering it with the U.S. Patent Office. Such registration provides 20 years’
protection and may be renewed indefinitely as long as the trademark or trade name is
in use.
o If a company purchases the trademark or trade name, the cost is the purchase price.
If the company develops the trademark or trade name itself, the cost includes
attorney’s fees, registration fees, design costs, successful legal defense costs, and
other expenditures directly related to securing it. A franchises is a contractual agreement under which the franchiser grants the franchisee the
right to sell certain products, to perform specific services, or to use certain trademarks or trade
names, usually within a designated geographic area.
o Another type of franchise is a license; licenses granted by a government body permit
a business to use public property in performing its services.
o When a company incurs costs in connection with the acquisition of the franchise or
license, it should recognize an intangible asset.
o Companies record as operating expenses annual payments made under a franchise
agreement in the period in which they are incurred.
o In the case of a limited life, a company amortizes the cost of a franchise (or license)
as operating expense over the useful life. If the life is indefinite or perpetual, the cost
is not amortized.
Goodwill represents the value of all favorable attributes that relate to a company that are not
attributable to any other specific asset. Goodwill is unique. Unlike assets such as investments and
plant assets, which can be sold individually in the marketplace, goodwill can be identified only with
the business as a whole. Goodwill is not amortized because it is considered to have an indefinite
life. However, goodwill must be written down if a company determines that its value has been
permanently impaired.
Research and development costs are expenditures that may lead to patents, copyrights, new
processes, and new products. Research and development costs present accounting challenges.
o It is sometimes difficult to assign the costs to specific projects.
o There are uncertainties in identifying the extent and timing of the future benefits of these
expenditures.
o As a result, companies record R&D costs as an expense when incurred (instead of as
an asset), whether the research and development is successful or not.
Learning Objective 5 – Discuss how Long-lived Assets are Reported and Analyzed
Presentation—usually, companies show plant assets in the financial statements under “Property,
plant, and equipment,” and they show intangibles separately under “Intangible assets.”
Either within the balance sheet or in the notes, companies should disclose the balances of the
major classes of assets, such as land, buildings, and equipment, and of accumulated
depreciation by major classes or in total.
In addition, they should describe the depreciation and amortization methods used and disclose
the amount of depreciation and amortization expense for the period disclosed.
Analysis—the presentation of financial information about plant assets enables decision makers to
analyze the company’s use of its plant assets. Two measures to analyze plant assets are:
Return on assets—an overall measure of profitability. This ratio is computed by dividing net
income by average assets. The return on assets ratio indicates the amount of net income
generated by each dollar of assets. The higher the return on assets, the more profitable the
company.
Asset turnover—indicates how efficiently a company uses its assets to generate sales—that
is, how many dollars of sales are generated by each dollar invested in assets. This ratio is
computed by dividing net sales by average total assets. When comparing two companies in the
same industry, the one with the higher asset turnover ratio is operating more efficiently; it is
generating more sales per dollar invested in assets. Profit Margin Revisited—as was discussed in Chapter 6 the profit margin ratio is calculated by
dividing net income by net sales.
o It tells how effective a company is in turning its sales into income—that is, how much
income each dollar of sales provides.
o The return on assets can be computed from the profit margin and the asset turnover.
Profit Margin × Asset Turnover = Return on Assets
Where:
o Profit Margin = Net Income Net Sales
o Asset Turnover = Net Sales Average Total Assets
o Return on Assets = Net Income Average Total Asset
This relationship has important strategic implications for management.
If a company wants to increase its return on assets, it can do so in two ways:
o by increasing the margin it generates from each dollar of goods that it sells (the profit
margin), or
o by increasing the volume of goods that it sells (the asset turnover).