copyright © cengage learning. all rights reserved. chapter 9 long-term assets
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Chapter 9
Long-Term Assets
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Management Issues Related to Long-Term Assets
• Objective 1– Define long-term assets, and explain the management
issues related to them.
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Information about long-term acquisitions can be found under investing activities in the
statement of cash flows
Long-Term Assets
• Assets have a useful life greater than one year• Used in operation of a business• Are not intended for resale to customers
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Long-Term Assets for Selected Industries
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Long-Term Assets and Corresponding Expenses
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Carrying ValueThe unexpired cost of an asset
Unexpired Cost = Cost – Accumulated Depreciation
• Also called book value• Carrying value is reduced if a long-term asset loses some or
all of its revenue generating potential before the end of its useful life– Called asset impairment
• PV of Expected Cash Flows from Asset < Carrying Value– Carrying value is reduced to fair value (present value of future cash
flows)• Is an application of conservatism
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Carrying Value of Long-Term Assets on Balance Sheet
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Favorably impacts profitability for that current period
Management must use ethical judgments when resolving two issues:
1. How much of the total cost of a long-term asset should be allocated to expense in the current period?
2. How much should be retained on the balance sheet as an asset that will benefit future period?
Applying the Matching Rule When a company purchases an asset, it may choose to capitalize it, thus deferring an expense to a later period
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Long-Term Assets
1. How is the cost of the long-term asset determined?
2. How should the expired portion of the cost of the long-term asset be allocated against revenues over time?
3. How should subsequent expenditures, such as repairs and additions, be treated?
4. How should disposal of the long-term asset be recorded?
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Issues in Accounting for Long-Term Assets
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Acquisition Cost of Property, Plant, and Equipment
• Objective 2– Distinguish between capital expenditures and revenue
expenditures, and account for the cost of property, plant, and equipment.
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Expenditures
Payments or obligations to make future payments for assets or services
• Capital expenditure– An expenditure for the purchase or expansion of a long-
term asset
• Revenue expenditure– An expenditure for the repair, maintenance, and
operation of a long-term asset
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Capital Expenditures
• Outlays for plant assets, natural resources, and intangible assets
• Additions to the physical layout of a plant asset like a building (debit asset account)
• Betterments, or improvements, to a plant asset (debit asset account)
• Extraordinary repairs that significantly enhance a plant asset’s estimated useful life or residual value (debit accumulated depreciation)
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General Approach to Acquisition Costs
• Include all expenditures reasonable and necessary to get the asset in place and ready for use
• Include costs of installing and testing a machine; freight, insurance while in transit, and installation
• Interest charges are not included in the acquisition cost
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Specific Applications: Land
Costs that should be debited to the Land account include:
Purchase price Agent commissionsLegal feesAccrued taxes paid by
purchaserDraining Land preparation feesAssessments for local
improvements Landscaping
SampleAcquisition of Land
Net purchase price $170,000Brokerage fees 6,000Legal fees 2,000Tearing down old barn $10,000Less salvage 4,000 6,000Grading 1,000Total cost $185,000
Improvements to real estate like fences, driveways, or parking lots have a limited life. They should be recorded in an account called Land Improvements, not the Land account.
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Buildings
• Acquisition costs include:– Purchase price
– Repairs and other expenditures required to put it in usable condition
• Buildings are subject to depreciation because they have a limited useful life.
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Costs of Building Construction
• Materials• Labor• Overhead and other indirect costs• Architects’ fees• Insurance during construction• Interest on construction loans• Lawyers’ fees• Building permits• Outside contractors
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Equipment• Acquisition costs:
– Purchase price (less cash discounts)– All expenditures connected with purchasing the
equipment and preparing it for use.• Freight• Insurance in transit• Excise taxes and tariffs• Buying expenses• Installation costs• Cost of test runs
• Equipment is subject to depreciation because it has a limited useful life.
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Stop & Review
Q. Dyeing a carpet may make it look almost new. Why isn’t this a capital expenditure?
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Depreciation
• Objective 3– Compute depreciation under the straight-line, production,
and declining-balance methods.
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Depreciation: Limited Life of Tangible Assets
1. All tangible assets except land have a limited useful life, because of physical deterioration and obsolescence.
– Physical deterioration• Results from use and exposure to the elements
– Obsolescence• Process of becoming out of date
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Allocation of Cost
Depreciation means the allocation of the cost of a plant asset to the periods that benefit from the service of that asset. – Does not refer to an asset’s
• Physical deterioration
• Decrease in market value over time
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Not a Process of Valuation
• Depreciation is a process of allocation • Accounting records are not indicators of changing
price levels • As an asset wears out or becomes obsolete,
depreciation must be recorded
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Factors in Computing Depreciation
1. Cost– Net purchase price
– All reasonable and necessary expenditures to get the asset in place and ready for use
2. Residual value (Salvage value)– An asset’s estimated scrap, salvage, or trade-in value as
of the estimated date of disposal
– Also called salvage value or disposal value
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Factors in Computing Depreciation (cont’d)
3. Depreciable cost– Cost less residual value
– Depreciable cost is allocated over the useful life of an asset
4. Estimated useful life– Total number of service units expected from a long-
term asset
– May be measured in years, miles, units, or similar measures
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Depreciation Expense, Asset Name xxx Accumulated Depreciation, Asset Name xxx To record depreciation for the period
Accounting for Depreciation
• Depreciation is recorded at the end of the accounting period by an adjusting entry.
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Methods of Computing Depreciation
• The most common methods– Straight-line method (based upon usable life)
– Production method (based upon number of usable units asset is expected to provide)
– Declining-balance method
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Life UsefulEstimated
Value Residual -Cost on DepreciatiYearly
yearper $3,600 years 5
$2,000 - $20,000
A delivery truck costs $20,000 and has an estimated residual value of $2,000 at the end of its estimated useful life of 5 years.
Straight-Line Method
Asset’s depreciable cost is spread evenly over its estimated useful life.
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The amount of depreciation is the
same each year
Accumulated depreciation increases
uniformly
The carrying value decreases uniformly until it reaches the estimated
residual value
Depreciation ScheduleStraight-Line Method
Cost
Yearly Depreciation
Accumulated Depreciation
Carrying Value
Date of purchase $20,000 — — $20,000 End of first year 20,000 $3,600 $3,600 16,400 End of second year 20,000 3,600 7,200 12,800 End of third year 20,000 3,600 10,800 9,200 End of fourth year 20,000 3,600 14,400 5,600 End of fifth year 20,000 3,600 18,000 2,000
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A delivery truck costs $20,000 and has an estimated residual value of $2,000 at the end of its estimated useful life of five years. Assume the truck was used 20,000 miles during year 1; 30,000 miles during year 2; 10,000 miles during year 3; 20,000 miles during year 4; and 10,000 miles during the fifth year.
Life UsefulEstimated
Value Residual -Cost Cost on Depreciati
mileper $.20 miles 90,000
$2,000 - $20,000
The unit of output or use should be appropriate for
that asset
Production MethodBased on the assumption that depreciation is solely the result of use and that passage of time plays no role in the depreciation process.
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Declining-Balance Method
An accelerated method of depreciation that results in large amounts of depreciation in earlier years of the
asset’s life and smaller amounts in later years.• Is based on the passage of time.• Assumes that many kinds of plant assets are most
efficient when new.• Is consistent with matching rule
– Allocates more depreciation to earlier years if benefits received in earlier years are greater.
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A delivery truck costs $20,000 and has an estimated residual value of $2,000 at the end of its estimated useful life of 5 years.
Under the straight-line method, the depreciation rate for each year is 20 percent.
percent 20 years 5 percent 100
Under the double-declining-balance method, the depreciation rate for each year is 40 percent.
percent 40 percent 20 2
This fixed rate is applied to the remaining carrying value at the end of each year.
Double-Declining-Balance Method Illustrated
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Note that the fixed rate is always applied to the carrying value
at the end of the previous year
Depreciation is greatest in the first year and declines
each year after that
The depreciation in the last year is limited to the amount
necessary to reduce the carrying value to the residual
value ($2,592 - $2,000 = $592)
Cost
Yearly Depreciation Accumulated Depreciation
Carrying Value
Date of purchase $20,000 — — $20,000 End of first year 20,000 (40% x $20,000) $8,000 $8,000 12,000 End of second year 20,000 (40% x $12,000) 4,800 12,800 7,200 End of third year 20,000 (40% x $7,200) 2,880 15,680 4,320 End of fourth year 20,000 (40% x $4,320) 1,728 17,408 2,592 End of fifth year 20,000 592 9,000 2,000
Depreciation ScheduleDouble-Declining-Balance
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Comparison of Depreciation Methods
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Depreciation for Partial Years
• Businesses often purchase assets during the year, thus depreciation is calculated for a partial year.
• Can be computed to the nearest month• Can use the half-year convention
One-half year’s depreciation is taken if the asset is purchased in the first half of the year.
A full year’s depreciation is taken if the asset is purchased in the last half of the year.
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Accelerated Cost Recovery for Tax Purposes
• Rapid write-offs of plant assets is encouraged by federal income tax law .
• Depreciation allowed for tax purposes differs from depreciation calculated for the financial statements.
• A small company can expense the first $250,000 of equipment expenditures rather than recording them as assets.
• Allows an accelerated method of writing off expenditures that are recorded as assets.
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Disposal of Depreciable Assets
• Objective 4– Account for the disposal of depreciable assets.
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Disposal of Depreciable Assets
• Discarded• Sold for cash
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KOT Company purchased a machine on January 2, 2009, for $13,000 and planned to depreciate it on a straight-line basis over its estimated useful life of 8 years. Its residual value at the end of 8 years was estimated to be $600. Depreciation Expense = (13,000-600)/8 = 1550; Acc Dep = 1550x6 = 9,300
On December 31, 2014, the balances of the relevant accounts were as follows:
Machinery Accum. Depreciation, Machinery
13,000 9,300
On January 2, 2015, management disposed of the asset.
Disposal of a Plant Asset
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Machinery Accum. Depreciation, Machinery
13,000
9,300
•Remove the carrying value of the asset.Carrying value is computed by subtracting accumulated
depreciation from the acquisition cost of the asset.If the asset is fully depreciated, the carrying value is zero.If the asset is not fully depreciated, a loss is recorded.Jan. 2 Accumulated Depreciation, Machinery 9,300
Loss on Disposal of Machinery 3,700 Machinery 13,000 Discarded machine no longer
used in business
9,300
13,000
Bal. -0-
Bal. -0-Gains and losses on disposal of plant assets are classified as other revenues and expenses on the income statement.
Discarded Plant Asset
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Plant Assets Sold for Cash
• The entry to record plant assets sold for cash is similar to that of discarding of a plant asset.– The receipt of cash is also recorded.
• If cash received = carrying value, no gain or loss is recorded.
• If cash received < carrying value, loss is recorded.
• If cash received > carrying value, gain is recorded.
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Received $3,700 cash for sale of machinery.
Remove the carrying value of the asset:Jan. 2 Cash 3,700 Accumulated Depreciation, Machinery 9,300 Machinery 13,000 Sale of machinery for carrying
value; no gain or loss
Selling an Asset for CashCash Received = Carrying Value
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Received $2,000 cash for sale of machinery.
Remove the carrying value of the asset:
Jan. 2 Cash 2,000 Accumulated Depreciation, Machinery 9,300 Loss on Sale of Machinery 1,700 Machinery 13,000 Sale of machinery at less than carrying
value; loss of $1,700 recorded ($3,700 - $2,000)
Selling an Asset for CashCash Received < Carrying Value
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Received $4,000 cash for sale of machinery.
Remove the carrying value of the asset:
Jan. 2 Cash 4,000 Accumulated Depreciation, Machinery 9,300 Gain on Sale of Machinery 300 Machinery 13,000 Sale of machinery at more than carrying
value; gain of $300 recorded ($4,000 - $3,700)
Selling an Asset for CashCash Received > Carrying Value
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Natural Resources
• Objective 5– Identify the issues related to accounting for natural
resources, and compute depletion.
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• Shown on the balance sheet as long-term assets
• Are recorded at acquisition cost
• As the asset is converted to inventory, the asset account must be proportionally reduced
Examples: • Timberlands • Oil and Gas
Reserves • Mineral Deposits
Natural Resources
Are converted to inventory by cutting, pumping, mining, or other extraction methods
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Available UnitsofNumber Estimated
Value Residual - Resource Natural ofCost per Unit Cost Depletion
Depletion
1. The exhaustion of a natural resource, and
2. the proportional allocation of the cost of a natural resource to the units extracted.
• Costs are allocated much like the production method of depreciation
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Dec 31 Depletion Expense, Coal Deposits 230,000 Accumulated Depletion, Coal Deposits 230,000 To record depletion of coal mine: $1
per ton for 230,000 tons mined and sold
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A mine that cost $3,600,000 has an estimated 3,000,000 tons of coal. The estimated residual value of the coal is $600,000. During the first year, 230,000 tons of coal are mined and sold.
Available UnitsofNumber Estimated
Value Residual - Resource Natural ofCost per Unit Cost Depletion
per ton $1 tons3,000,000
$600,000 - $3,600,000
Natural resources that have been extracted but not sold are considered inventory and are not recorded as an expense until the year sold.
Recording Depletion Expense
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Development and Exploration Costs in the Oil and Gas Industry
• Accounted for under one of two methods– Successful efforts accounting
• Cost recorded as an asset and depleted over the estimated life of the resource
• For an unsuccessful exploration, written off immediately as a loss
• More conservative method– Full-costing method
• All costs, including costs of dry wells, are recorded as assets and depleted over the estimated life of the producing resources.
• Improves earnings performance in the early years
• Either method is allowed under GAAP.
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Intangible Assets
• Objective 6– Identify the issues related to accounting for intangible
assets, including research and development costs and goodwill.
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Intangible Assets• Long-term assets with no physical substance
• Have a value based on rights, privileges, or advantages coming to or belonging to the owner
• Accounted for at acquisition cost – Patents
– Copyrights
– Leaseholds and leasehold improvements
– Franchises
– Licenses
– Trademarks and brand names and goodwill
• Goodwill and trademarks should not appear on the balance sheet unless they have been purchased from another party at a price established in the marketplace.
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Accounting Issues forIntangible Assets
• Accounting issues are similar to other long-term assets.
• Issues include:– Determining an initial carrying amount
– Accounting for periodic write-off or amortization
– Accounting for that amount if the value declines substantially and permanently
• Because of its intangibility, its value and useful life may be difficult to estimate.
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Accounting for Intangible Assets
• Record as expenses– Intangible assets developed by a company for its own
benefit.
• Record as assets– Intangible assets acquired from others
• Amortize over the shorter of their useful life or their legal life (not to exceed 40 years).
• If an intangible asset becomes worthless before it is fully amortized, the remaining carrying value should be written off as a loss.
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Amortization Expense 6,000 Patents 6,000 To record amortization expense for
patent ($36,000 ÷ 6 years)
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WATER Bottling Company purchases a patent on a unique bottle cap for $36,000. The patent will last for 20 years, but the product using the cap will be sold only for the next six years.
Patents 36,000 Cash 36,000 To record purchase of bottle cap
patent
Record the purchase of the patent:
Record the annual amortization expense:
Notice that the Patents account is directly reduced by the amount of amortization expense, whereas depreciation or depletion is accumulated in separate contra accounts for other long-term assets.
Intangible Assets Illustrated
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Research and Development Costs
• Expenses of funding development of new products, testing of existing and proposed products, and pure research.
• Treat as revenue expenditures and charged to expense in the period when incurred.
• Are continuous and necessary for the success of a business and should be treated as current expenses.
• Do not necessarily result in future benefits (assets).
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Goodwill
• Exists when a purchaser pays more for a business than the fair market value of the net assets if purchased separately.
• Should not be recorded unless it is paid for in connection with the purchase of a whole business.
Goodwill = Purchase price - FMV of identifiable assets
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Chapter Review
1. Define long-term assets, and explain the management issues related to them.
2. Distinguish between capital expenditures and revenue expenditures, and account for the cost of property, plant, and equipment.
3. Compute depreciation under the straight-line, production, and declining-balance methods.
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Chapter Review (cont’d)
4. Account for the disposal of depreciable assets.
5. Identify the issues related to accounting for natural resources, and compute depletion.
6. Identify the issues related to accounting for intangible assets, including research and development costs and goodwill.