LECTURE NOTES: Plant Assets, Natural Resources, and Intangible Assets

Chapter Objectives:

1. Describe the application of the cost principle to plant assets.2. Explain the concept of depreciation.

3. Compute periodic depreciation using different methods.

4. Describe the procedure for revising periodic depreciation.

5. Distinguish between revenue and capital expenditures, and explain the entries for these expenditures.

6. Explain how to account for the disposal of a plant asset.

7. Compute periodic depletion of natural resources.

8. Explain the basic issues related to accounting for intangible assets.

9. Indicate how plant assets, natural resources, and intangible assets are reported and analyzed.

10. Explain how to account for the exchange of plant assets (Appendix).

INTRODUCTION: Take the following Quiz on Plant Assets and then check the answers on the last page of the lecture notes after you have studied this chapter:

1. T or F: Depreciation is a valuation process.2. T or F: When land and buildings are purchased for a lump sum, the

Buildings account is debited for the total cost.3. T or F: All costs of getting a plant asset in place and ready for use are

debited to the Plant Asset account.4. T or F: When disposing of a plant asset, first update depreciation.5. T or F: Maintenance expenditures are capital expenditures.6. T or F: When selling a plant asset at a gain, do not recognize the gain.7. T or F: Gains on the exchange of similar plants should be recognized if

have commercial substance.

Name the depreciation method in which each occurs:8. Salvage is ignored in the calculation. __________________________9. A rate per hour or some other measure of the asset’s output is calculated.

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_____________________________10. A constant amount of depreciation exists _______________________

I. Types of Long-Term Assets.A. Distinguish between current and long-term assets

1. Current assets consist of cash and assets that will be sold (merchandise inventory), realized (collected or turned into cash, such as receivables), or consumed (supplies, prepaid insurance, etc.) within one accounting period, usually a year.

2. Long-term assets will provide benefit to the company beyond one year.

B. Define and give examples of plant assets. 1. Plant assets (also called fixed assets; capital assets; property, plant,

and equipment; or plant and equipment) are assets that:a) have a useful life of more than one year;b) are acquired for use in the operation of the business;c) are not intended for resale to customers in the normal

course of business such as merchandise inventory; andd) are tangible (capable of being touched, physical).

2. Plant assets are usually subdivided into four:a) Land, such as a building site.b) Land improvements—the title of an account to which the

cost of improvements to real estate are debited such as driveways; parking lots, fences, sidewalks, and underground sprinkler systems (all of which have a limited life).

c) Buildings such as stores, offices, factories, and warehouses.d) Equipment such as store check-out counters, cash registers,

coolers, office furniture, factory machinery, automobiles, computers, and delivery equipment.

C. Define and give examples of natural resources. 1. Natural resources (also called wasting assets) are long-term assets

that are acquired to extract or remove resources from land or from the ground.

2. Natural resources consist of standing timber and underground deposits of oil (where oil wells are used to extract it), gas, coal (mined), and minerals such as gold, silver, copper, etc which are mined as well.

D. Define and give examples of intangible assets.1. Intangible assets are long-term assets used in the business that lack

physical substance. To help understand the concept of intangible can be difficult to understand but think of an insurance policy (which will probably be a current asset) as that has value despite the fact that you cannot see it or feel it.

2. Intangible assets consist of legal rights, privileges, and competitive advantages and are listed as:

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a) Patents—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.

b) Copyrights—an exclusive grant from the federal government that allows the owner to reproduce and sell an artistic or published work for the life of the creator + 70 years.

c) Trademarks (trade names)—a word, phrase, jingle, or symbol that identifies a particular enterprise or product.

d) Franchises (licenses)—a contractual arrangement under which the franchisor grants the franchisee the right to sell certain products, render specific services, or use certain trademarks or trade names, usually within a designated geographical area.

e) Goodwill—the value of all favorable attributes that relate to a business enterprise such as exceptional management, desirable location, good customer relations, skilled employees, high-quality products, and harmonious relations with labor unions. Since the measurement of goodwill is a subjective valuation (what dollar value can be put on this asset), it is only recorded only by the acquiring company when there is a transaction that involves the purchase of an entire business. In that case goodwill is the excess of cost over the fair market value of the net assets (assets less liabilities) acquired.

II. Purchasing Plant Assets.1. Identify the costs to be included in the cost of plant assets. All

normal costs to acquire the asset and prepare it for use are included. Plant assets are recorded at cost in accordance with the cost principle (GAAP) of accounting.

2. Cost consists of all normal expenditures necessary to acquire the asset and make it ready for its intended use and includes the list or invoice price, delivery charges, installation charges, sales taxes, insurance charges while in transit, testing costs, painting and lettering on a new delivery truck, etc. For example if a delivery truck was purchased for $21,400, has air conditioning installed at a cost of $600, pays sales taxes of $1,320, and has painting and lettering done at a cost of $500, the Delivery Truck will be debited on the books at $23,820. The cost of motor vehicle license and insurance paid on the truck (for several months in advance) would be debited to an expense and prepaid insurance accounts.

3. The key word to remember when determining the cost of the plant asset is the word, “normal.” Costs from carelessness, vandalism, and other abnormal causes are debited to expense accounts such as

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Repairs Expense account because the expenditure did not add to the usefulness of the asset—it simply restored the asset to a usable condition. For example to determine the cost of a newly acquired piece of equipment given the following information: purchase price, $2,000; installation charges, $300; sales tax, $100, initial testing of the asset, $150; and repairs for breakage due to dropping the equipment while unloading off the truck, $300—the Equipment will be debited for $2,550 and Repairs Expense will be debited for $300.

A. Determine the costs of land, buildings, and land improvements. 1. Group purchase of assets—when land and buildings are purchased

in a package deal, an apportionment needs to be made between the value of the land and the value of the buildings for two reasons (1) so that asset values can be reflected properly in the accounting records and on the financial statements, and (2) to allow a determination of depreciation on the buildings, since land does not depreciate. The following example illustrates how this apportionment is done with a group or basket purchase:

Group Purchase Example

Purchase Building with Land @ Total Price $100,000

Appraisal shows the following values:

FMV (Fair Market Value) Building $75,000 60%

FMV Land $50,000 40%Total Appraised Value $125,000 100%

To allocate the purchase price in fair proportion:

Building: $75,000 x $100,000 = $60,000 $125,000

Land: $50,000 x $100,000 = $40,000 $125,000

If the building requires any other costs to make the building ready for use such as remodeling, and replacing or repairing the roof, floors, electrical wiring, plumbing, etc., these costs would then be added and debited to the Building account. If the land needs additional costs (see LAND below), and then these costs would be added and debited to the Land account.

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2. LAND costs includes the purchase price; closing costs such as real estate brokers’ commissions, title and attorney’s fees (legal fees); accrued property taxes (delinquent by the seller but paid by the buyer) and other liens on the land assumed by the buyer; amounts spent on draining, clearing, grading, etc. to get the land ready for use; and net costs of razing and removing of unwanted buildings already existing on the land. For example, assume a piece of land was purchased for $100,000 which included an old warehouse that is razed at a net cost of $6,000 ($7,500 in costs less $1,500 proceeds from salvaged materials) with $1,000 in attorney and $8,000 in real estate broker’s commission, the cost of the Land would be calculated as follows:

Amount to Debit to Land accountCash price of the property $100,000Net removal cost of warehouse 6,000Attorney’s fees 1,000Real Estate broker’s commission 8,000Cost of land $115,000

3. BUILDING costs for a newly constructed building includes all construction (contract price) costs, architect’s fees, building permits, excavation costs, insurance and interest costs during construction. The inclusion of interest costs is limited to the construction period as after the building has been placed in use, the cost of interest on borrowed funds to finance the constructions are debited to Interest Expense.

4. LAND IMPROVEMENTS that were listed above are debited to this asset account because these improvements have limited useful lives and their maintenance and replacement are the responsibility of the company and they are depreciated over their useful lives.

III. The Terminology of Depreciation.A. Define depreciation and depreciation expense. Depreciation is an allocation

process, not a valuation one. 1. Depreciation is the process of allocating the cost of a plant asset to

expense over its useful (service) life in a rational and systematic manner. Cost allocation provides for the proper matching of expenses and revenues in accordance with the matching (GAAP) principle.

2. Depreciation expense is the expense that results from the allocation of this cost.

3. TYPICAL STUDENT MISCONCEPTION: Students tend to think of depreciation as a process to determine the market value of an asset. Plant assets are purchased for use, not for resale. Thus depreciation has nothing to do with market value. The objective of

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depreciation is to allocate the cost of a plant asset over the years that the asset will be used in the production of revenue. In other words, we are trying to match the cost of a plant asset against the revenue it produces.

4. Adjusting entry for depreciation involves a debit to Depreciation Expense and a credit to Accumulated Depreciation. Recall from early chapters that the Accumulated Depreciation is a contra asset account with a normal credit balance. Depreciation is recorded in the Accumulated Depreciation account, rather than directly in the asset account, so as to maintain both the asset account showing the original or historical cost of the asset and the accumulated depreciation account showing how much the asset has depreciated (as this information will be needed when filing tax returns to determine the amount of gain or loss on the sale of the asset). The entry:

General Journal Page 1Date Account Title P.R Debit Credit20-- Adjusting Entries

Dec 31 Depreciation Expense—name of asset 1,000.00 Accumulated Depreciation—name of asset 1,000.00

The depreciation expense is reported on the income statement and accumulated depreciation is reported as a deduction from plant assets on the balance sheet.

Factors Needed to Calculate Depreciation.1. Cost —recall from above that plant assets are recorded at cost, in

accordance to the cost principle which is the invoice price plus all of the normal and necessary expenditures of getting it ready for use.

2. Estimated salvage value (SV) (scrap value, trade-in value, residual value)—the amount that an asset is expected to be worth at the end of its productive life. The amount is an estimate and in making the estimate, management considers how it plans to dispose of the asset and its experiences with similar assets. Also, the federal government and some trade associations publish guidelines for determining the salvage value of many assets.

3. Estimated useful life (EUL) of an asset is the number of years the asset is expected to remain useful. Useful life can be expressed in time (years of life) or in terms of output (hours of operation, miles driven, number of pages, etc.). TYPICAL STUDENT MISCONCEPTION: Students often think the estimated useful like (EUL) of a plant asset is the actual period of time the asset will last. For example, your car may last 12 years. However, the key word is useful. If a business intends to use that car for only three years, then three years becomes the EUL on which depreciation will be computed.

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IV. Traditional Depreciation Methods—each method is acceptable under GAAP. The objective is to select the method that best measures an asset’s contribution to revenue over the useful life. Once a method is chosen, it should be applied consistently over the useful life of the asset. Consistency enhances the comparability of financial statements.

A. The straight-line method. 1. Formula : (Cost minus salvage) divided by estimated useful life

(life in years) equals depreciation per year (annual depreciation). The straight-line depreciation method gets its name from the fact that if annual depreciation charges under this under this method were plotted on graph paper, the result would be straight line.

2. Preparing the depreciation schedule—a table that lists for a plant asset the amount of depreciation for each year and the accumulated depreciation and book value (BV) (cost – accumulated depreciation or the undepreciated cost of the asset) of that plant asset at the end of the year. CAUTION: Book value should NOT be confused with market value which is what the asset could be sold for on a given date; it has no relationship to the calculations for depreciation. Book value is what an asset is worth on the books of the firm at a certain date (cost not yet allocated to expense).

3. Straight-line rate —the annual percent of depreciation in the straight-line method. It is calculated by dividing 100% by the estimated life in years (100% ÷ estimated life in years) or can also be calculated by 1 ÷ estimated life in years. Refer to the following depreciation schedule that has the column for depreciation rate and rather than cost, the column is showing “Depreciable Cost” (Cost – Salvage): NOTE: the book value (BV) at the end of the schedule, $1,000, is the estimated salvage value (SV) which you CANNOT depreciate beyond as DEPRECIATION STOPS WHEN THE BV REACHES SV:

YearDeprec.Cost x

Depr.Rate =

Depr.Expense

Accum Depr.End of Year

Book ValueEnd of Year

2014 $12,000 20% $2,400 $2,400 $10,600 2015 12,000 20% 2,400 4,800 8,2002016 12,000 20% 2,400 7,200 5,8002017 12,000 20% 2,400 9,600 3,4002018 12,000 20% 2,400 12,000 1,000

4. How to prorate for part of a year . When as asset is owned for less than a whole year, depreciation is prorated for the partial year. However, depreciation is usually not prorated for less than half a month known as the half-month convention. The half-month convention means to figure depreciation to the nearest whole month. If an asset is purchased from the 1st – 15th of the month, the accountant counts the whole month as if purchased on the 1st of the month. If an asset is purchased on the 16th to the end of the month is considered to be purchased on the first day of the next

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month. TO PRORATE FOR PART OF A YEAR, multiply annual depreciation times the months used that year. Below is the calculation of the first year’s depreciation for a truck acquired on April 12. Since the asset was purchased on the 12th, the full month of April is considered therefore the annual depreciation of $24,000 x 9/12 (as used the asset for 9 months) = $18,000. For an exercise to test your understanding of prorating for part of a year, determine the portion of $2,400 annual depreciation charge to be recorded as of December 31 for an asset purchased on:

a) May 2 ($2,400 x 8/12 = $1600.b) October 18 ($2,400 x 2/12 = $400.c) April 28 ($2,400 x 8/12 = $1,600.d) January 14 ($2,400).e) December 16 ($0).

B. The units-of-production method (units-of-activity depreciation) is based on the assumption that depreciation results solely from using the asset, not from the passage of time. That is, there is a direct relationship between the amount of depreciation each year and the actual output of the asset. The unit of output used to measure an asset’s life should be appropriate for that asset (hours of operation for a tractor, miles driven for a truck, number of copies for a copy machine, etc.). The following two step process to determine the depreciation:

1. Step1: Determine depreciation per unit : (Cost minus salvage) divided by estimated units of output equals depreciation per unit.

2. Step 2: Determine the current year’s depreciation : Depreciation per unit times actual output for the year equals depreciation expense. The following depreciation schedule shows a column for the Units of Activity and Depreciation Cost/Unit (NOTE: Regardless of how many miles the truck is driven the last year or succeeding years, the final year can only show 10,000 for the total depreciable cost of $120,000 as you CANNOT depreciate beyond that amount and that the final book value is the estimated salvage value of $20,000 (DEPRECIATION STOPS WHEN BV REACHES SV):

YearUnits of

Activity xDepr.

Cost/Unit =Depr.

ExpenseAccum. Depr.End of Year

Book ValueEnd of Year

2014 12,000 $1.00 $12,000 $12,000 $128,000 2015 36,000 1.00 36,000 48,000 92,0002016 30,000 1.00 30,000 78,000 62,0002017 32,000 1.00 32,000 110,000 30,0002018 10,000 1.00 10,000 120,000 20,0003. TYPICAL STUDENT MISCONCEPTION: When using the units

of production method, students often think that they are finished after calculating the depreciation per unit. This calculation is Step 1 of the calculation process and only gives part of the answer. Step

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2 must also be done to multiply the depreciation per unit times the number of units used to arrive at the final answer.

C. The declining-balance method—a depreciation method that allows greater depreciation in the early years of the life of a plant asset and less depreciation in later years. This is achieved by applying a constant rate to each year’s decreasing book value. The declining-balance method is the most common accelerated depreciation method (a depreciation method that allows greater depreciation in early years and smaller amounts in later years). The sum-of-the-years’ digits method is rarely used but is tested on the Certified Bookkeeper Exam. An ADVANTAGE of using an accelerated depreciation method, such as the double declining-balance method, is that depreciation will be higher in early years when repairs are lower, and lower in later years when repairs are higher. Thus expenses will be evened out over the years. The following two step process is the formula to determine the depreciation:1. Step 1: Determine the constant rate (2 times the straight-line

rate). Cost times rate (double the straight-line rate) equals depreciation for the first year. Accelerated methods of depreciation permit more depreciation in early years and less in later years. Salvage is not deducted in this method, but depreciation always STOPS AT THE POINT OF SALVAGE as with the other depreciation methods.

2. Step 2: Determine the year’s depreciation : Book value at the beginning of the year times the constant rate equals depreciation for later years.

3. Calculation for partial year . For partial first year, apply fraction of year to product of cost times the constant rate. For later years, fraction is not required. The following example is showing the two step process of the formula in the first year when the asset was purchased on April 12 (40% x $140,000 (cost) = $56,000 x 9/12 months used = $42,000) and then the second year (40% x $98,000 (BV at the beginning of the year) = $39,200. The following depreciation schedule shows how the BV at the beginning of the year is multiplied times the constant rate to equal the annual depreciation. NOTE how DEPRECIATION STOPS WHEN BV REACHES SV (an asset CANNOT be depreciated beyond its SV) so the last year is whatever is needed to complete to SV:

YearBV @ beg.of year x

Depr.Rate =

Depr.Expense

Accum. Depr.End of Year

Book ValueEnd of Year

2014 140,000 40% x 9/12 $42,000 $42,000 $98,000 2015 98,000 40% 39,200 81,200 58,8002016 58,800 40% 23,520 104,720 35,2802017 35,280 40% 14,112 118,832 21,1682018 21,168 40% 1,168 120,000 20,000CAUTION: If an asset has a large salvage value, the asset could be fully depreciated BEFORE it reaches the last year of depreciation. In

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that case the last year or years shows zero on the depreciation schedule.

4. Compare the units of activity, straight-line, and declining-balance methods. The principle of consistency applies; methods cannot be changed arbitrarily. Note all methods result in the SAME AMOUNT OF DEPRECIATION.

5. Revising Periodic Depreciation:a) If wear and tear or obsolescence indicates that annual

depreciation estimates are inadequate or excessive, a change should be made.

b) When a change is made, there is no correction of previously recorded depreciation expense. Instead, depreciation expense for current and future years is revised.

c) To determine the new annual depreciation expense, the depreciable cost at the time of the revision is divided by the remaining useful life.

d) To illustrate: Barb’s Florists decides on January 1, 2014 to extend the useful life of the truck one year because of its excellent condition. The company has used the straight-line method to depreciate the asset to date, and book value is $5,800 ($13,000 - $7,200). The new annual depreciation is $1,600, calculated as follows:

Book value, 1/1/17 $5,800Less: Salvage value 1,000Depreciable cost $4,800Remaining useful life 3 years (2017 - 2019)Revised annual depreciation ($4,800 ÷ 3) $1,600

V. Capital and Revenue Expenditures.A. Define each type of expenditure and distinguish between the two.

1. Revenue expenditures are expenditures for a plant asset that benefit only the current accounting period. Examples include repairs and maintenance expenses where the revenue expenditures are debited to such expense accounts. A revenue expenditure keeps the asset operating.

2. Capital expenditures are expenditures for a plant asset that benefit more than one accounting period. Capital expenditures increase either the value (operating efficiency) or the life of the asset and are debited to either the plant asset account or its accumulated depreciation account, depending on the type of expenditure (whether an addition, betterment, or extraordinary repair). A capital expenditure is one that increases the value of an asset (increases the operating efficiency or productive capacity) or prolongs its life.

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B. Distinguish among capital expenditures that are additions, betterments, and extraordinary repairs.1. Addition—a capital expenditure that literally adds on to an existing

plant asset, such as air conditioning to a car or a new wing to a building. Additions are debited to the plant asset account.

2. Betterment—a capital expenditure that improves a plant asset, such as replacing shingles with siding on a plant building or adding a part to a piece of equipment so that it works better, faster, etc. Betterments are debited to the plant asset account.

3. Extraordinary repairs—a capital expenditure that prolongs the life of a plant asset, such as new wiring in a building or an new engine in a vehicle. Extraordinary repairs are debited to the related accumulated depreciation account. A debit to accumulated depreciation reduces the amount of the accumulated depreciation and therefore the asset can be depreciated more by doing that for the amount of the extraordinary repair.

VI. Disposing of Plant Assets. A company can dispose of a plant asset in one of three ways (1) retire or discard the plant asset (throw it away); (2) sell the plant asset; or (3) trade the asset in on another plant asset.

A. Disposal of plant assets with a retirement:1. Fully depreciated asset—a journal entry needs to be made to

remove the asset and its accumulated depreciation from the books. NOTE: When recording a plant asset disposal, the plant asset account is always credited and the related accumulated depreciation is always debited to remove them from the books. An example entry:

General Journal Page 1Date Account Title P.R. Debit Credit20--

Jan. 1 Accumulated Depreciation—Equipment 20,000.00Equipment 20,000.00

2. Discarding a Plant Asset with a Book Value (Asset is Not Fully Depreciated)—Loss on discarding of a plant asset is recognized for accounting and tax purposes. A journal entry will be made that shows there was a loss on disposal as the asset was not completely depreciated. An example entry:

General Journal Page 1Date Account Title P.R. Debit Credit20--

Jan. 1 Accumulated Depreciation—Equipment 15,000.00Loss on Disposal of Plant Assets 5,000.00

Equipment 20,000.00GENERAL FORMULA

Disposal of Plant Assets:SALE:

0 (No Gain or Loss)

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SP - BV = + (Gain)(Sales Price) (Book Value) - (Loss)

Trade-in:

Trade-in 0 (No Gain or Loss)

Allowance - BV = + (Gain)

(FMV) (Book Value) - (Loss)

B. Sale of plant assets. Three outcomes are possible when a plant asset is sold. How to DETERMINE GAIN (LOSS) IF SOLD:6. How to record the sale of a plant asset at book value. Update

depreciation to the date of disposal in order to bring the book value up to date, so that the gain or loss can be accurately determined. To determine the amount of gain or loss if any, the formula is: Sales Price (SP) – Book Value (BV). If the answer is zero, then there is no gain or loss which means the asset was sold at book value. A journal entry needs to be prepared to show that both the asset and the accumulated depreciation have been reduced by the amount recorded for that asset and to show the cash received on the sale. With the following example: $5,000 (SP) -$5,000 (BV) = 0 so no gain or loss. An Example entry:

General Journal Page 1Date Account Title P.R. Debit Credit20--

Jan. 1 Cash 5,000.00Accumulated Depreciation—Equipment 15,000.00

Equipment 20,000.007. How to record the sale of a plant asset at a gain. Gain or loss

on the sale of a plant asset is always recognized. To determine the amount of gain or loss if any, the formula is: Sales Price (SP) – Book Value (BV). If the answer is a positive number (greater than (>) zero), then there is a gain on sale. With the following example: $8,000 (SP) -$5,000 (BV) = +$3,000.An Example entry:

General Journal Page 1Date Account Title P.R. Debit Credit20--

Jan. 1 Cash 8,000.00Accumulated Depreciation—Equipment 15,000.00

Equipment 20,000.00Gain on Disposal of Plant Assets 3,000.00

8. How to record the sale of a plant asset at a loss. Gain or loss on the sale of a plant asset is always recognized. To determine the amount of gain or loss if any, the formula is: Sales Price (SP) – Book Value

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(BV). If the answer is a negative number (less than (<) zero), then there is a loss on sale. With the following example: $3,000 (SP) -$5,000 (BV) = -$2,000. An Example entry:

General Journal Page 1Date Account Title P.R. Debit Credit2008

Jan. 1 Cash 3,000.00Accumulated Depreciation—Equipment 15,000.00Loss on Disposal of Plant Assets 2,000.00

Equipment 20,000.00

PLANT ASSET DISPOSALS—EXCHANGE OF SIMILAR ASSETS:

Formula to Determine Gain (Loss) on Trade-in:

Trade-in 0 (No Gain or Loss)

Allowance - BV = + (Gain)

(FMV) (Book Value) - (Loss)

C. Trading in plant assets. When an asset is traded in (even for a similar asset) and a difference (boot which is cash, note payable, or both) is paid, a gain or a loss is recognized if the exchange has commercial substance (if future cash flows change as a result of the exchange). For income tax purposes neither a gain nor loss can be recognized. 1. Describe and illustrate accounting for a gain on a trade. (A gain

is recognized for accounting purposes. It is not recognized for tax purposes where, for tax purposes, the gain is subtracted from the cost of the new asset). The accounting method. The formula: Trade-in or fair market value (FMV) of the asset trading in – Book Value (BV) = Gain if the answer is positive. The cost of the new asset = Fair Market Value (FMV) (old) + Boot given. Asset Exchanged at a Gain, Trade-in allowance (FMV of old asset) ($8,000) – BV ($5,000) = +$3,000 gain which is RECOGNIZED (recorded in the journal entry to Gain on Disposal) in the books as it is being considered to have commercial substance. The cost of the new asset as follows: FMV value of old asset ($8,000) + Boot (Cash) given ($10,000) = $18,000 cost of new asset journalized as follows:

General Journal Page 1Date Account Title P.R. Debit Credit20--

Jan 1 Equipment (new) (FMV (old) + Boot Given) 18,000.00Accumulated Depreciation—Equipment 15,000.00

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Equipment (Old) 20,000.00Cash 10,000.00Gain on Disposal of Plant Asset 3,000

2. Describe and illustrate accounting for a loss on a trade. (A loss is recognized for accounting purposes. It is not recognized for tax purposes where the loss, for tax purposes, is added to the cost of the new asset). The accounting method. When a trade-in results in a loss for accounting purposes the loss is RECOGNIZED (recorded in the journal entry to Loss on Disposal) in the books. Refer to the example on handout, page 10—Asset Exchanged at a Loss. Trade-in allowance (FMV of old) ($4,000) – BV ($5,000) = -$1,000 which means a loss . The cost of the new asset as follows: FMV value of old asset ($4,000) + Boot (Cash) given ($10,000) = $14,000 cost of new asset and journalized as follows:

General Journal Page 1Date Account Title P.R Debit Credit20--

Jan. 1 Equipment (new) (FMV (old) + Boot Given) 14,000.00Accumulated Depreciation—Equipment 15,000.00Loss on Disposal of Plant Assets 1,000.00

Equipment (Old) 20,000.00Cash 10,000.00

3. The tax method —Federal income tax regulations do not allow a business to show a gain or a loss on the trade of similar plant assets. Therefore, a loss must be deferred into the cost of the new asset as follows: If the trade-in results in a loss: the cost of the new asset = BV (old) + Boot given or FMV of the new asset + Loss not recognized. If the trade-in results in a gain: the cost of the new asset = BV (old) + Boot given or FMV of the new asset - Gain not recognized. For Asset Exchanged at a Loss example above: Trade-in allowance (FMV of old) ($4,000) – BV ($5,000) = -$1,000 loss which is NOT RECOGNIZED but the loss is deferred into the cost of the new asset as follows: List price of new ($14,000) + Loss not recognized or deferred into the cost of the new asset ($1,000) = $15,000 cost of new asset journalized as follows:

General Journal Page 1Date Account Title P.R Debit Credit20--

Aug 3 Equipment (new) (FMV + Loss Deferred) 15,000.00Accumulated Depreciation—Equipment 15,000.00

Equipment (Old) 20,000.00Cash 10,000.00

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Example Problem–Steps in Determining Gain (Loss) on Trade:Problem: Eastern Company trades in equipment with a cost of $34,500 and accumulated depreciation to date of trade of $26,700 for equipment with a FMV of $42,000..

Step 1: Record any additional depreciation to date of trade(N/A on this problem)

Step 2: Calculate the Book Value (BV) (Cost - Accum. Deprec.)$34,500 - $26,700 = $7,800

Step 3: Calculate Gain (Loss) on Trade if Trade-in Allowance is $8,500:Trade-in

Allowance - BV$8,500 - $7,800 = + $700 (Gain)

(a) Federal income tax method is used:Cost of new = BV Old + Boot ($42,000 - $8,500)

$41,300 = $7,800 + $33,500 OR

Cost of new = FMV - Gain$41,300 $42,000 - $700

(b) IF accounting method is used:Cost of the new is $42,000 and a gain of $700 is recognized (recorded) as a credit to Gain on Disposal.

Step 3: Calculate Gain (Loss) on Trade if Trade-in Allowance is $7,200:Trade-in

Allowance - BV$7,200 - $7,800 = - $600 (Loss)

(c ) Federal income tax method is used:Cost of new = BV Old + Boot ($42,000 - $7,200)

$42,600 = $7,800 + $34,800 OR

Cost of new = FMV + Loss$42,600 = $42,000 + $600

(d) IF accounting method is used:

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Cost of new is the FMV of $42,000 and a loss of $600is recognized (recorded) as a debit to Loss on Disposal.

VII. Intangible Assets.A. Define amortization—the periodic write-off of an intangible asset which

is the allocation of the cost of an intangible asset to expense over its useful life in a systematic and rational manner.

B. Describe and illustrate entries for intangible assets and amortization. A contra asset account is not used to record amortization expense. Cost Allocation—Amortization where an example of a patent to be amortized over it maximum useful life of 17 years (Legal life = 20 years):1. Formula: Cost ÷ Shorter of Useful or Legal Life = annual

depreciation which is $16,000 in the example. This is the same formula as with straight-line depreciation which means amortization is also done using the straight-line method. But the difference when amortizing intangible assets, there is no salvage value as the asset is not disposed in the end. It all needs to be written off.

2. Journal entry:General Journal Page 1

Date Account Title P.R Debit Credit20-- Adjusting Entries

Dec 31 Amortization Expense—Patents 16,000.00 Patents 16,000.00

3. Goodwill

a) Goodwill is the value of all favorable attributes that relate to a business enterprise.

b) These attributes may include exceptional management, desirable location, good customer relations and skilled employees.

c) Goodwill cannot be sold individually in the marketplace; it can be identified only with the business as a whole.

d) Goodwill is recorded only when there is a transaction that involves the purchase of an entire business.

e) In that case, goodwill is the excess of cost over the fair market value of the net assets (assets less liabilities) acquired.

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f) Goodwill is NOT amortized (because it is considered to have an indefinite life), and is reported on the Balance Sheet under intangible assets.

4. Research and Development Costs

a) Research and development costs pertain to expenditures incurred to develop new products and processes.

b) These costs are not intangible costs, but are usually recorded as an expense when incurred.

VIII. Natural Resources.A. Define depletion—the allocation of the cost of natural resources to expense

in a rational and systematic manner over the resources useful life (the expense resulting from using up a natural resource. Depletion uses a units-of-production method and a contra asset account.

B. Describe and illustrate entries for natural resources and depletion. Depletion with an example of an oil well indicating the following two step process as with the units-of-production method.

1. Step1: Determine depletion per unit : (Cost minus salvage) divided by estimated total life in units equals depletion cost per unit.

2. Step 2: Determine the current year’s depletion : Depletion per unit times the number of units extracted and sold for the year equals depletion expense.

3. Prepare the journal entry : The contra asset account Accumulated Depletion is used to show the amount of asset has been depleted. With the handout example, the following entry would be made where the depletion per unit ($.75) should be taken times 1,200,000 barrels (units extracted and sold) for $900,000 depletion expense:

General Journal Page 1Date Account Title P.R Debit Credit20-- Adjusting Entries

Dec 31 Depletion Expense—Oil Well 900,000 Accumulated Depletion—Oil Well 900,000

IX. STATEMENT PRESENTATION AND ANALYSISA. Presentation :

1. Usually plant assets and natural resources are combined under “property, plant, and equipment” in the balance sheet. Intangibles are shown separately under intangible assets.

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2. Major classes of assets , such as land, buildings, and equipment, and accumulated depreciation by major classes or in total should be disclosed.

3. The depreciation and amortization methods that were used should be described. Finally, the amount of depreciation and amortization expense for the period should be disclosed.

B. Analysis1. The asset turnover ratio analyzes the productivity of a

company’s assets.2. It is computed by dividing net sales by average total assets

for the period as shown in the formula below using Proctor & Gamble Company:

Net Sales ÷ Average Total Assets = Assets Turnover Ratio$56,741 ÷ $61,527 + $57,048 = 0.96 Times2

Retake opening Quiz and then check your answers as follows:1. False. It is an allocation process.2. False. The cost is divided between the Land account and the

Buildings account.3. False. Only normal and necessary costs.4. True.5. False. They are revenue expenditures.6. False. You recognize both gains and losses on a sale.7. True.8. Double declining-balance9. Units-of-production10. Straight-line

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