© The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin

Accounting for Long-Term Operational

Assets

Chapter Nine

9-2

LO 1

Identify different types of long-term

operational assets.

LO 1

9-3

Tangible versus Intangible Assets

Tangible assets have a physical presence; they can be seen and touched.

Intangible assets are rights or privileges. They cannot be seen or touched.

9-4

Tangible Long-Term Assets

1.1. Property, Plant, and EquipmentProperty, Plant, and Equipment – Sometimes called plant assets or fixed assets. We depreciate these assets over their useful life.

2.2. Natural ResourcesNatural Resources – Mineral deposits, oil and gas reserves, timber stands, coal mines, and stone quarries are some examples of natural resources. We deplete these assets over their useful life.

3.3. LandLand – Has an infinite life and is not subject to depreciation.

9-5

Intangible Assets

1.1. Intangible Assets with Intangible Assets with IdentifiableIdentifiable Useful Useful LivesLives – patents and copyrights.

• amortize the cost of each over its useful life.

2.2. Intangible Assets with Intangible Assets with IndefiniteIndefinite Useful Useful LivesLives - renewable franchises, trademarks, and goodwill.

• The cost of these assets is not expensed unless it can be shown that there has been an impairment in value.

9-6

LO 1

Determine the cost of long-term

operational assets.

LO 2

9-7

Cost of Long-Term Assets

BuildingsBuildings •Purchase pricePurchase price•Sales taxesSales taxes•Title search and transfer document Title search and transfer document costscosts•Realtor’s and attorney’s feesRealtor’s and attorney’s fees•Remodeling costsRemodeling costs

BuildingsBuildings •Purchase pricePurchase price•Sales taxesSales taxes•Title search and transfer document Title search and transfer document costscosts•Realtor’s and attorney’s feesRealtor’s and attorney’s fees•Remodeling costsRemodeling costs

EquipmentEquipment •Purchase price (less Purchase price (less discounts)discounts)•Sales taxesSales taxes•Delivery costsDelivery costs•Installation costsInstallation costs•Costs to adapt to intended Costs to adapt to intended useuse

EquipmentEquipment •Purchase price (less Purchase price (less discounts)discounts)•Sales taxesSales taxes•Delivery costsDelivery costs•Installation costsInstallation costs•Costs to adapt to intended Costs to adapt to intended useuse

9-8

Cost of Long-Term Assets

Land Land •Purchase pricePurchase price•Sales taxesSales taxes•Title search and transfer document Title search and transfer document costscosts•Realtor’s and attorney’s feesRealtor’s and attorney’s fees•Costs of removal of old buildingsCosts of removal of old buildings•Grading costsGrading costs

Land Land •Purchase pricePurchase price•Sales taxesSales taxes•Title search and transfer document Title search and transfer document costscosts•Realtor’s and attorney’s feesRealtor’s and attorney’s fees•Costs of removal of old buildingsCosts of removal of old buildings•Grading costsGrading costs

9-9

Basket Purchase Allocation

Beatty Co. purchased land and a building for $240,000 cash. An appraiser estimated that the land has a fair market value of $90,000, and the building has a fair market value of $270,000. How will we assign the $240,000 cost between the land and building? Amount %

Fair market value of building 270,000$ 75%

Fair market value of land 90,000 25%

Total fair market value 360,000$ 100%

Cost % AllocationAssign to building 240,000$ 75% 180,000$ Assign to land 240,000 25% 60,000

100% 240,000$

270000/360000

90000/360000

9-10

Life Cycle of Operational Assets

9-11

LO 1

Explain how different

depreciation methods affect

financial statements.

LO 3

9-12

Depreciation Methods

1.1. Straight-line methodStraight-line method - the same amount - the same amount is depreciated each accounting period.is depreciated each accounting period.

2.2. Double-declining-balance Double-declining-balance – produces – produces more depreciation expense in the early more depreciation expense in the early years of an asset’s life, with a declining years of an asset’s life, with a declining amount of expense in later years.amount of expense in later years.

3.3. Units-of-ProductionUnits-of-Production – produces varying – produces varying amounts of depreciation in different amounts of depreciation in different accounting periods depending upon the accounting periods depending upon the number of units produced.number of units produced.

1.1. Straight-line methodStraight-line method - the same amount - the same amount is depreciated each accounting period.is depreciated each accounting period.

2.2. Double-declining-balance Double-declining-balance – produces – produces more depreciation expense in the early more depreciation expense in the early years of an asset’s life, with a declining years of an asset’s life, with a declining amount of expense in later years.amount of expense in later years.

3.3. Units-of-ProductionUnits-of-Production – produces varying – produces varying amounts of depreciation in different amounts of depreciation in different accounting periods depending upon the accounting periods depending upon the number of units produced.number of units produced.

9-13

Asset to be Depreciated

List price of van 23,500$ Cash discount (2,350) Transportation cost 250 Cost of customization 2,600 Cost of van 24,000$

The van has a salvage value of $4,000, and an estimated useful life of four years.

9-14

Straight-Line Depreciation

Life Cycle Phase 1Acquire $25,000 cash from the sale of common stock to purchase the van.

= Rev. – Exp. = Net Inc. Cash Flow

Cash + Van AccDep = Com. Stk. Ret. Earn.25,000 NA = NA = 25,000 NA NA – NA = NA 25,000 FA

EquityAssets

Cash $25,000

Common Stock $25,000

9-15

Straight-Line Depreciation

Life Cycle Phase 2Purchase the van on January 1, 2008, for a net cost of $24,000.

= Rev. – Exp. = Net Inc. Cash Flow

Cash + Van AccDep = Com. Stk. Ret. Earn.(24,000) 24,000 = NA = NA NA NA – NA = NA (24,000) IA

EquityAssets

Van $24,000

Cash $24,000

9-16

Straight-Line Depreciation

Life Cycle Phase 3Use the van to generate $8,000 revenue for the period. Depreciation expense calculated under straight-line is determined as followed:

(Asset Cost – Salvage Value) (Asset Cost – Salvage Value) ÷ Useful Life÷ Useful Life(Asset Cost – Salvage Value) (Asset Cost – Salvage Value) ÷ Useful Life÷ Useful Life

($24,000 – $4,000) ($24,000 – $4,000) ÷ 4 = $5,000 depreciation÷ 4 = $5,000 depreciation($24,000 – $4,000) ($24,000 – $4,000) ÷ 4 = $5,000 depreciation÷ 4 = $5,000 depreciation

= Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

Cash + Truck - A. Dep.8,000 NA NA = NA + 8,000 8,000 – NA = 8,000 8,000 OANA NA 5,000 NA (5,000) NA – 5,000 (5,000) NA

Assets

Journal Entries

Cash $8,000

Revenue $8,000

Depreciation Expense $5,000

Accumulated Dep. Van $5000

Accumulated Depreciation is a Contra Asset Account used to track the total loss of value of the attached asset so far. The Asset account in this case the VAN always shows the historical cost. $24,000. After one year the book value is $19,000.

9-18

LO 1Determine how gains and losses on disposals of

long-term operational assets

affect financial statements.

LO 4

9-19

Straight-Line Depreciation

= Liab. + Equity Gain – Exp. = Net Inc. Cash Flow

Cash + Van - A. Depr Ret. Earn.4,500 (24,000) (20,000) = NA + 500 500 – - = 500 4,500 IA

Assets

Life Cycle Phase 4On January 1, 2012, the van is sold for $4,500 cash. The van was purchased on January 1, 2008.

Cost of Asset 24,000$ Accumulated Depreciation 20,000 ($5,000 × 4 years)Book Value 4,000 Cash Proceeds 4,500 Gain on disposal 500$

Cash $4,500

Accumulated Dep. $20,000

Gain on sale $500

Van $24,000

9-20

Straight-Line Depreciation Journal Entries

9-21

Double-Declining-Balance Method

The double-declining-balance method is called an accelerated depreciation method because more depreciation expense is recorded in the early years than in later years. Determining the amount of depreciation expense in any year is the result of a three-step process.

1. Determine the straight-line rate of depreciation.

2. Multiply the straight-line rate times two.

3. Multiply the double-declining rate by the book value of the asset at the beginning of the period.

1. Determine the straight-line rate of depreciation.

2. Multiply the straight-line rate times two.

3. Multiply the double-declining rate by the book value of the asset at the beginning of the period.

Divide 1 by the assets useful life = straight line rate

9-22

Double-Declining-Balance Method

See how double-declining-balance depreciation works

(1 ÷ 4) = (25% straight-line rate × 2) = 50%(1 ÷ 4) = (25% straight-line rate × 2) = 50%

YearBook Value at

Beginning of Year

Double the Straight-Line

Rate

Annual Depreciation

Expense2008 ($24,000 – $ 0) 50% 12,000$ 2009 ($24,000 – $12,000) 50% 6,000 2010 ($24,000 – $18,000) 50% 3,000 2,0002011 ($24,000 - $20,000) 50% 2,000 0

23,000$

=12,000=6,000

=4,000

$20,000Total Depreciation can only be

Cost – Salvage Value = Total Depreciation

9-23

Units-of-Production Depreciation

Cost – Salvage valueTotal estimated units of production

=Depreciation charge per unitof production

Depreciation charge per unitof production

×Units of production in current accounting period

=PeriodicDepreciation Expense

9-24

Units-of-Production Depreciation

Here is the depreciation charge per mile driven in our van:

$24,000 – $4,000100,000 miles

= $0.20 per mile

Here is the calculation of depreciation expense based on miles driven:

Depreciation Charge Per

MileMiles

DrivenDepreciation

Expense0.20$ × 40,000 = 8,000$ 0.20 × 20,000 = 4,000 0.20 × 30,000 = 6,000 0.20 × 15,000 = 3,000 2,000

105,000 21,000$

Can’t depreciate below the salvage value of $20,000

9-25

Graph of Depreciation Expense

9-26

LO 1

Identify some of the tax issues

which affect long-term operational

assets.

LO 5

9-27

Income Tax Considerations

The maximum depreciation currently allowed by tax law is computed using the modified modified accelerated cost recovery systemaccelerated cost recovery system (MACRS). The rate of depreciation depends on the class life of the asset and the period in which we are calculating depreciation. There are currently six categories for property, excluding real estate. They are 3-year, 5-year, 7-year, 10-year, 15-year, and 20-year property.

9-28

Income Tax Considerations

Here are the tax rates for 5-year and 7-year property:

Year5-Year

Property %7-Year

Property %1 20.00% 14.29%2 32.00% 24.49%3 19.20% 17.49%

4 11.52% 12.49%5 11.52% 8.93%6 5.76% 8.92%7 8.93%8 4.46%

100.00% 100.00%

Let’s assume our van is classified as 5-year property and calculate depreciation for our tax return.

9-29

Income Tax Considerations

Year5-Year

Property % Cost of VanDepreciation

Expense1 20.00% 24,000$ 4,800$ 2 32.00% 24,000 7,680 3 19.20% 24,000 4,608

4 11.52% 24,000 2,765 5 11.52% 24,000 2,765 6 5.76% 24,000 1,382

100.00% 24,000$

Let’s assume our van is classified as 5-year property and calculate depreciation for our tax return.

9-30

LO 1

Show how revising estimates affects

financial statements.

LO 6

9-31

Revision of Estimates

Estimates are revised when new information surfaces. Assume we purchased equipment on January 1, 2008, for $50,000 cash and estimated salvage value was $3,000. The equipment has an estimated useful life of eight years, and we use straight-line depreciation.

($26,500 – $3,000) ($26,500 – $3,000) ÷ 10 = $2,350 depreciation per year÷ 10 = $2,350 depreciation per year($26,500 – $3,000) ($26,500 – $3,000) ÷ 10 = $2,350 depreciation per year÷ 10 = $2,350 depreciation per year

On January 1, 2012, after four years of depreciation, it was determined that the machine has a useful life of 14.

($50,000 – $3,000) ($50,000 – $3,000) ÷ 8 = $5,875 depreciation per year÷ 8 = $5,875 depreciation per year($50,000 – $3,000) ($50,000 – $3,000) ÷ 8 = $5,875 depreciation per year÷ 8 = $5,875 depreciation per year

Prior Reports are not corrected!!!

Revision of Estimates

At the beginning of the 5th year the machine had Accumulated Depreciation of $23,500. ($5,875 x 4) The machines book value was $26,500. ($50,000-$23,500).

At this point it was determined a revision in the life of the machine is expected to be 14 years instead of 8 year. This means the life of the machine now has 10 more years. (14-4) If we assume the salvage value stays at $3,000 the following would be the new depreciation for each year will be $2,350. ($26,500 BV - $3,000 salvage value / 10)

OR

At this point it was determined the salvage value was changed. The salvage value is now estimated to be $6,000 with the original 4 years remaining. The new depreciation would be $5,125 ($26,500 BV - $6,000 Salvage value / 4)

9-33

LO 1

Explain how continuing

expenditures for operational assets

affect financial statements.

LO 7

9-34

Continuing Expenditures for Plant Assets

Costs that Are ExpensedCosts that Are ExpensedThe cost of routine maintenance and minor repairs that are incurred to keep an asset in good working order are expensed as incurred. Assume the company spent $200 cash for routine maintenance on machinery.

Account Title Debit CreditMaintenance Expense 200 Cash 200

Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

Cash Ret. Earn.(200) = NA + (200) NA – 200 = (200) (200) OA

9-35

Continuing Expenditures for Plant Assets

Costs that Are CapitalizedCosts that Are CapitalizedExpenditures that improve the quality of an asset are capitalized as part of the cost of that asset. Assume the company spent $5,000 cash for a major overall of equipment to improve efficiency.

= Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

Cash + Equip. - A. Depr(5,000) 5,000 NA = NA + NA NA – NA = NA (5,000) IA

Assets

Account Title Debit CreditEquipment 5,000 Cash 5,000

Depreciation Calculation for Capitalization when a plant asset is improved

EX: An asset which originally cost $50,000 and has a salvage value of $3,000 with a life expectancy of 8 years will have its depreciation expense altered if at the beginning of the fifth year the company spends $4,000 money is spent to improve its efficiency.

The first four years of depreciation would be $5,875 using the straight line method. ($50,000 - $3000 = $47,000/8 = $5,875

At the end of the fourth year the book value would be $26,500.

4 X $5,875 = $23,500 $50,000 - $23,500 = $26,500.

Since the $4,000 improves the efficiency you add the $4,000 to the asset. This would give the asset a new book value of $30,500. $26,500 + $4,000 = $30,500

The new depreciation would be $6,875. ($30,500 - $3,000 salvage / 4 remaining years = $6,875)

9-37

Continuing Expenditures for Plant Assets

Costs that Extend the Life of an AssetCosts that Extend the Life of an AssetThe amount of the expenditure should reduce the balance in the accumulated depreciation account. Assume the company spent $8,000 cash for improvements that extended the life of equipment four years.

= Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

Cash + Equip. - A. Depr(8,000) NA (8,000) = NA + NA NA – NA = NA (8,000) IA

Assets

Account Title Debit CreditAccumulated Depreciation - Equipment 8,000 Cash 8,000

Depreciation Calculation for Capitalization when a plant assets life is extended.

When the cost extends the life but does not improve the productivity you reduce the Accumulated Depreciation for that asset.

Ex: The company spends $4,000 which will extend the life of the asset two more years.

Using the same problem as before. You can use one of two methods.

So far the assets accumulated depreciation was $23,500. 4 x $5,875 You now subtract the $4,000 from this to get an adjusted accumulated depreciation of $19,500. The new book value would be $30,500 ($50,000 - $19,500 AD) Then $30,500 Book value - $3,000 salvage value / 6 years (4 remaining + 2 extra) = $4,583.33 depreciation

OR Original book value $26,500 + $4,000 = New BV $30,500 - $3,000 salvage value / 6 = $4,583.33

9-39

LO 1Explain how

expense recognition for

natural resources (depletion) affects

financial statements.

LO 8

9-40

Natural Resources

Cost – Salvage valueTotal estimated units recoverable

=Depletion charge per unitof resource

Depletion charge per unitof resource

×Number of units extracted and sold this period

=PeriodicDepletion Expense

9-41

Natural Resources

Apex Coal Mining paid $4,000,000 cash to purchase a mine expected to yield 16,000,000 tons of coal. After all coal is extracted the mine is not expected to have any salvage value. During the year, the company extracted and sold 360,000 tons of coal.

$4,000,000 – $016,000,000 tons

= $0.25 per ton extracted and sold

9-42

Natural Resources

= Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

Cash + Coal Mine(4,000,000) 4,000,000 = NA + NA NA – NA = NA (4,000,000) IANA (90,000) NA (90,000) NA – (90,000) (90,000) NA

Assets

Apex Coal Mining paid $4,000,000 cash to purchase a mine expected to yield 16,000,000 tons of coal. After all coal is extracted the mine is not expected to have any salvage value. During the year, the company extracted and sold 360,000 tons of coal.

Account Title Debit CreditCoal Mine 4,000,000 Cash 4,000,000

Depletion Expense 90,000 Coal Mine 90,000

.25 x 360,000 = $90,000

9-43

LO 1Explain how

expense recognition for

intangible assets (amortization)

affects financial statements.

LO 9

9-44

Intangible Assets

TrademarksA name or symbol that

identifies a company or a product. The cost of a trademark may include design, purchase, or

defense of the trademark.

TrademarksA name or symbol that

identifies a company or a product. The cost of a trademark may include design, purchase, or

defense of the trademark.Patents

The exclusive legal right to produce and sell a product

that has one or more unique features. The legal life of a patent is 20 years.

PatentsThe exclusive legal right to produce and sell a product

that has one or more unique features. The legal life of a patent is 20 years.

9-45

Intangible Assets

CopyrightsCopyrightsProtection of writings, Protection of writings,

musical composition, work musical composition, work of art, or other intellectual of art, or other intellectual property. The protection property. The protection extends for the life of the extends for the life of the

creator plus 70 years.creator plus 70 years.

CopyrightsCopyrightsProtection of writings, Protection of writings,

musical composition, work musical composition, work of art, or other intellectual of art, or other intellectual property. The protection property. The protection extends for the life of the extends for the life of the

creator plus 70 years.creator plus 70 years.

FranchiseThe exclusive right to sell

products or perform services in certain geographic areas.

FranchiseThe exclusive right to sell

products or perform services in certain geographic areas.

9-46

Intangible Assets

GoodwillGoodwillThe excess of cost over fair The excess of cost over fair value of net tangible assets value of net tangible assets

acquired in a business acquired in a business acquisition.acquisition.

GoodwillGoodwillThe excess of cost over fair The excess of cost over fair value of net tangible assets value of net tangible assets

acquired in a business acquired in a business acquisition.acquisition.

Assets 500,000$

Liabilities 100,000$ Stockholders' Equity 400,000

Total 500,000$

Seller CompanyBalance Sheet

At December 31, 2009

Assume that your company is willing to pay $450,000 cash to acquire

Seller Company. Let’s look at the accounting.

9-47

Goodwill

= Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

Cash + Seller Assets Goodwill Seller Liab.(450,000) 500,000 50,000 = 100,000 + NA NA – NA = NA (450,000) IA

Assets

Assets 500,000$

Liabilities 100,000$ Stockholders' Equity 400,000

Total 500,000$

Seller CompanyBalance Sheet

At December 31, 2009

Assume that your company is willing to pay $450,000 cash to acquire Seller Company. Let’s look at the accounting.

$500,000 -$100,000 = $400,000

$400,000 equity and you paid $450,000 = $50,000 more than it is worth. This is

$50,000 Goodwill

A-L=E

9-48

Goodwill

Assets 500,000$

Liabilities 100,000$ Stockholders' Equity 400,000

Total 500,000$

Seller CompanyBalance Sheet

At December 31, 2009

Assume that your company is willing to pay $450,000 cash to acquire Seller Company. Let’s look at the accounting.

Account Title Debit CreditSeller Assets 500,000 Goodwill 50,000 Seller Liabilities 100,000 Cash 450,000

9-49

Expensing Intangible Assets

An asset with an identifiable useful life is amortized using the straight-line method over the intangible’s legal life or its useful life. Assume we purchased a patent that has a 20-year legal and useful life for $20,000 cash.

= Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

Cash + Patent(20,000) 20,000 = NA + NA NA – NA = NA (20,000) IA

NA (1,000) NA (1,000) NA – 1,000 (1,000) NA

Assets

Account Title Debit CreditPatent 20,000 Cash 20,000

Amortization Expense - Patent 1,000 Patent 1,000

$20,000 / 20 = $1,000

9-50

Impairment of Intangible Asset

Intangible assets with indefinite useful lives must be tested for Intangible assets with indefinite useful lives must be tested for impairment annually. If the fair value of the intangible asset is impairment annually. If the fair value of the intangible asset is

less than its book value, an impairment loss is recognized.less than its book value, an impairment loss is recognized.

Intangible assets with indefinite useful lives must be tested for Intangible assets with indefinite useful lives must be tested for impairment annually. If the fair value of the intangible asset is impairment annually. If the fair value of the intangible asset is

less than its book value, an impairment loss is recognized.less than its book value, an impairment loss is recognized.

Assume that at the end of 2008, we determine that goodwill has suffered a $10,000 impairment in value.

Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

Goodwill(10,000) = NA + (10,000) NA – 10,000 = (10,000) NA

Account Title Debit CreditImpairment Loss 10,000 Goodwill 10,000

9-51

Balance Sheet Presentation

9-52

LO 1Understand how expense

recognition choices and

industry characteristics affect financial performance measures.

LO 10

9-53

Effect of Judgment and Estimates

Assume that Alpha Company uses straight-line depreciation and Zeta Company uses the double-declining-balance method. Let’s look at their partial financial statements.

9-54

Effect of Judgment and Estimates

Assume that Alpha Company uses straight-line depreciation and Zeta Company uses the double-declining-balance method. Let’s look at their partial financial statements.

9-55

End of Chapter Nine