1 chapter 7 plant assets, intangible assets, and related expenses

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Chapter 7Chapter 7

Plant Assets, Intangible Plant Assets, Intangible Assets, and Related Assets, and Related

ExpensesExpenses

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Learning Objective 1Learning Objective 1

Determine the cost of a plant asset.

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Types of AssetsTypes of Assets

• Long-lived assets used in operations– Plant Assets (a.k.a. known in practice as

“Property, Plant, and Equipment”)– Intangible Assets

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Plant Assets: Terminology for Plant Assets: Terminology for Expensing of Plant and Intangible Expensing of Plant and Intangible

AssetsAssets

• Plant Assets - Depreciation

• Natural Resources - Depletion

• Intangibles - Amortization

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What is Included in the Cost Basis What is Included in the Cost Basis of Plant Assets and Intangibles?of Plant Assets and Intangibles?

All ordinary and necessary costs incurred to bring the asset to its useable state are included in the cost basis

Following are examples of this principle [slide no. 6, etc.]

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Determining the Cost of LandDetermining the Cost of Land

A business signs a $300,000 note payable to purchase land for a new store site. It pays: – $10,000 in back property tax – $8,000 in transfer taxes – $5,000 for removal of an old building– $1,000 survey fee– $260,000 to pave the parking lot.

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What is the Cost of the Land?What is the Cost of the Land?

Purchase price of land $300,000Add related costs: Back property taxes $10,000 Transfer taxes 8,000 Removal of existing buildings 5,000 Survey fees 1,000 24,000Total cost of land $324,000

Note that cost of paving the parking lot is not included in above.

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Why are Parking Lot Costs not Why are Parking Lot Costs not Included in the Cost Basis of the Included in the Cost Basis of the

Land?Land?• The land has an indefinite life and is not

depreciated, unless there has been an impairment in value, though that is rare

• However, the parking lot ($260,000 cost) will have a finite life, and therefore depreciated over its estimated useful life [till it has to be replaced]

• Thus, land improvements would be accounted for in a separate “Land Improvements “ plant asset account

• These land improvement costs would be depreciated over their useful lives

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Land Improvements Account Would Land Improvements Account Would IncludeInclude

• Cost of fencing

• Paving

• Security systems

• Lighting in parking lot

• Sprinkler systems

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Determining the Cost ofDetermining the Cost ofBuildings: Self Constructed by Buildings: Self Constructed by

the Entitythe Entity• Architectural fees• Building permits• Contractor’s charges• Materials• Direct Labor on this project• An allocation of Overhead• Cost of construction loan interest

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Determining the Cost ofDetermining the Cost ofBuildings: Purchased by the Buildings: Purchased by the

EntityEntity

• Purchase price

• Brokerage commissions

• Sales and other taxes

• Repairing or renovating building for its intended purpose

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Determining the Cost ofDetermining the Cost ofMachinery and EquipmentMachinery and Equipment

• Purchase price less discounts, if any• Transportation charges• Insurance in transit• Sales and other taxes pursuant to the transaction• Purchase commission• Installation costs• Expenditures to test the asset• Special platforms or other modifications

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Determining the Cost of Land Determining the Cost of Land and Leasehold Improvementsand Leasehold Improvements

• Land improvements – Paving– Fences– Sprinkler systems– Lights in parking lot

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Lump-Sum (or Basket)Lump-Sum (or Basket)Purchases of AssetsPurchases of Assets

Xerox Corporation paid $2,800,000 for a combined purchase of land and a building.

The land is appraised at $300,000 and the building at $2,700,000.

The purchase price ($2,800,000) is allocated to land and building based upon proportionate appraisal (fair) values

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Lump-Sum (or Basket)Lump-Sum (or Basket)Purchases of AssetsPurchases of Assets

Total appraised value = $3,000,000

• Land: $300,000 ÷ $3,000,000 = 10%$2,800,000 × 10% = $280,000

• Building: $2,700,000 ÷ $3,000,000 = 90%$2,800,000 × 90% = $2,520,000

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Does expenditure increase capacity or

efficiency or extend useful life?

CapitalRecord an asset

ExpensesRecord an expense

YES

Capital Expenditure versusCapital Expenditure versusPeriod ExpensePeriod Expense

NO

Does expenditure increase capacity or

efficiency or extend useful life?

CapitalRecord an asset

ExpensesRecord an expense

YES NO

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Learning Objective 2Learning Objective 2

Accounting for depreciation of plant assets

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What Depreciation is (and isn’t)What Depreciation is (and isn’t)

• The allocation of the cost of a plant asset as expense to future periods benefited by the use of the fixed asset

• Depreciation is not intended to be a valuation technique, i.e…

• It would be sheer coincidence if the fair market value of an asset at any time was the same as its book value (asset cost minus accumulated depreciation to date)

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• Straight-line (SL)

• Units-of-production (UOP)

• Double-declining balance (DDB)

Depreciation MethodsDepreciation Methods

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Depreciation MethodsDepreciation Methods

Data Items Amount

Cost of truck $41,000Estimated residual value ( 1,000)Depreciable cost $40,000

Estimated useful life 5 years

Est’d units of production 100,000 miles

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(Cost – Residual value) ÷ Years of useful life

($41,000 – $1,000) ÷ 5 = $8,000

Year 1 depreciation: $ 8,000Year 2 depreciation: 8,000Year 3 depreciation: 8,000Year 4 depreciation: 8,000Year 5 depreciation: 8,000 Total depreciation: $40,000

Straight-Line MethodStraight-Line Method

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($41,000 – $1,000) ÷ 100,000 = $.40/mile

Year 1: 20,000 miles × $.40 = $ 8,000Year 2: 30,000 miles × $.40 = 12,000Year 3: 25,000 miles × $.40 = 10,000Year 4: 15,000 miles × $.40 = 6,000Year 5: 10,000 miles × $.40 = 4,000

$40,000

Units-of-Production MethodUnits-of-Production Method

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Double-Declining-Balance MethodDouble-Declining-Balance Method

• Straight-line rate per year: 100% ÷ 5 = 20%• Multiply the straight-line rate times 2, e.g.: • 20% x 2 = 40%• Multiply 40% times book value at beginning

of each period, ignoring residual (salvage) value

• In last year, depreciation is amount needed to reduce book value to salvage value

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Double-Declining-Balance Double-Declining-Balance MethodMethod

Book value of truck at the end of the first year:$41,000 × 40% = $16,400

$41,000 – $16,400 = $24,600

(40% is multiplied by $24,600 for depreciation in next period, etc.)

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Comparing Depreciation Comparing Depreciation MethodsMethods

Year12345

Total

SL$ 8,000 8,000 8,000 8,000 8,000$40,000

UOP $ 8,000 12,000 10,000 6,000 4,000$40,000

DDB$16,400 9,840 5,904 3,542 4,314$40,000

Amount of Depreciation per Year

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Depreciation Methods UsedDepreciation Methods Usedby 600 Public Companiesby 600 Public Companies

84% Straight-line

5% Units-of-production

10% Accelerated

1% Other

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Learning Objective 3Learning Objective 3

Select the best depreciation method.

Relationship BetweenRelationship BetweenDepreciation and TaxesDepreciation and Taxes

Cash revenues $400,000 $400,000Cash operating expenses 300,000 300,000Cash provided by operations before tax $100,000 $100,000Depreciation expense 8,000 16,400Income before income tax $ 92,000 $ 83,600Income tax expense (30%) 27,600 25,080Net income $ 64,400 $ 58,520

Straight-line Accelerated

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Relationship BetweenRelationship BetweenDepreciation and TaxesDepreciation and Taxes

Cash-flow analysis $100,000 $100,000Income tax expense 27,600 25,080Cash provided by operations before taxes $ 72,400 $ 74,920Extra cash available for investment if DDB is used ($74,920 – $72,400) $ 2,520

Straight-line Accelerated

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

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Companies Can Use Differing Companies Can Use Differing Methods for Book and Tax Methods for Book and Tax

DepreciationDepreciation• St. line depreciation can be used for book

(reporting) purposes• While using DDB for tax purposes, reducing

taxes• This is an acceptable practice, but creates a

difference between book and tax income, causing deferred income tax liabilities

• Accounting majors will learn about this in ACCT 3312

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Modified Accelerated CostModified Accelerated CostRecovery System (MACRS)Recovery System (MACRS)

Assets are grouped into one of eight classes identified by asset life: 3 yr. lives, 5 yr. lives, 7 yr. lives…39 yr. lives.

This framework can only be used for tax purposes

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Depreciation for Partial YearsDepreciation for Partial Years

• Suppose a calendar-year closing business purchases a building on April 1 for $500,000 with an estimated life of 20 years and an estimated residual value of $80,000.

• What is the current year’s depreciation using the straight-line method?

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Partial-year depreciation:$21,000 × 9/12 = $15,750

Depreciation for Partial YearsDepreciation for Partial Years

Full-year depreciation:($500,000 – $80,000) ÷ 20 = $21,000

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• Assume an asset cost of $50,000, an ten-year useful life with no residual value, and the straight-line method.

$50,000 ÷ 10 = $5,000 depreciation per year

Changing the Useful LifeChanging the Useful Lifeof a Depreciable Assetof a Depreciable Asset

What is the book value after four years?

$50,000 – $20,000 = $30,000

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Changing the Useful LifeChanging the Useful Lifeof a Depreciable Assetof a Depreciable Asset

• Management determines that the asset will be useful for an additional ten years. How much depreciation expense would be recognized each year starting in year five?

$30,000 / 10 years = $3,000

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Learning Objective 4Learning Objective 4

Analyze the effect of a plant asset disposal.

Accounting for DisposalAccounting for Disposalof Plant Assets: Exampleof Plant Assets: Example

Fixtures cost: $4,000Accumulated depreciation: $3,000Book value $1,000

General Journal

Date Accounts and Explanations PR Debit Credit

Accumulated Depreciation 3,000Loss of Disposal of Asset 1,000 Store Fixtures 4,000To dispose of store fixtures

General Journal

Date Accounts and Explanations PR Debit Credit

Accumulated Depreciation 3,000Loss of Disposal of Asset 1,000 Store Fixtures 4,000To dispose of store fixtures

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

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Selling a Plant Asset: ExampleSelling a Plant Asset: Example

Equipment which cost $10,000 on 1/1/2002 is sold on 9/30/2005 for $5,000. It has been depreciated on a straight-line basis over its 10 years’ estimated useful life. There is no residual value.

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Selling a Plant Asset: ExampleSelling a Plant Asset: Example

• What is the accumulated depreciation on September 30, 2005?

$10,000 ÷ 10 = $1,000/year$1,000 × 3 years = $3,000$1,000 × 9/12 = $750$3,000 + $750 = $3,750

Selling a Plant Asset: ExampleSelling a Plant Asset: Example

General Journal

Date Accounts and Explanations PR Debit Credit

Sep 30 Cash 5,000Accumulated Depreciation 3,750Loss of Sale of Equipment 1,250 Equipment 10,000To record sale of equipment.

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

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Exchanging Plant AssetsExchanging Plant Assets

Assume than an old delivery car with a cost of $9,000 and accumulated depreciation of $8,000 (book value of $1,000) is exchanged for a new car. Cash payment is $10,000. What is the cost of the new car?

$10,000 + $1,000 = $11,000

Exchanging Plant AssetsExchanging Plant Assets

General Journal

Date Accounts and Explanations PR Debit Credit

Delivery Auto (new) 11,000Accumulated Depreciation (old) 8,000

Delivery Auto (old) 9,000 Cash 10,000To record exchange of auto.

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

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Learning Objective 5Learning Objective 5

Account for natural resources and depletion.

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• Natural gas and oil

• Precious metals and gems

• Timber, coal, and iron ore

(Cost – Residual value)÷

Estimated units of natural resource=

Depletion per unit

Accounting for Natural Accounting for Natural Resources and DepletionResources and Depletion

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Accounting for Natural Accounting for Natural Resources and DepletionResources and Depletion

Assume an oil lease cost $100,000 and contains an estimated 10,000 barrels of oil.

If 3,000 barrels are extracted during the year,depletion expense is $30,000.

Accumulated Depletion is a contra accountsimilar to Accumulated Depreciation

Depletion rate:$100,000 ÷ 10,000 = $10 per barrel.

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Learning Objective 6Learning Objective 6

Account for intangible assets and amortization

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Intangible AssetsIntangible Assets

• Have no physical form– Patents– Copyrights– Trademarks– Franchises– Leaseholds– Goodwill

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Intangible AssetsIntangible Assets

• Amortization expense - can be written off directly as credits against the intangible asset account

• That is, no “accumulated amortization” is ordinarily recorded

• Assets with an indefinite useful life are not amortized.

• All intangible assets are subject to impairment

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Intangible Assets: PatentsIntangible Assets: Patents

• Federal government grants giving holder the right to produce and sell an invention.

• Suppose a company pays $170,000 to acquire a patent on January 1. The company believes that its expected useful life is 5 years.

Intangible Assets: PatetsIntangible Assets: Patets

General Journal

Date Accounts and Explanations PR Debit Credit

Jan 1 Patents 170,000 Cash 170,000To record acquisition of patent.

Dec 31 Amortization Expense 34,000Patents 34,000

To amortize cost of patent

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

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• Literary compositions (novels)• Musical compositions• Films (movies)• Software• Other works of art• Extend 50 years beyond author’s life.

Intangible Assets: CopyrightsIntangible Assets: Copyrights

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• Trademarks, Trade Names, or Brand Names - assets that represent distinctive identifications of a product or service

Intangible Assets: TrademarksIntangible Assets: Trademarks

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Intangible Assets: FranchisesIntangible Assets: Franchises

• Privileges granted by private business or government to sell a product or service

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Intangible Assets: GoodwillIntangible Assets: Goodwill

• An intangible asset created by purchasing a business and paying more than the fair value of the net assets (assets minus liabilities) acquired

• This excess of purchase price over fair value is for factors causing unusual earnings power, e.g. market or locational competitive advantages, reputation

• Goodwill is not amortized, unless there has been an impairment in its value

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Purchase price paid for Mexana Company $10 millionAssets at fair market value $9 millionLess: Mexana’s liabilities $1 millionMarket value of Mexana’s net assets 8 millionGoodwill $ 2 million

Intangible Assets: GoodwillIntangible Assets: Goodwill

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Research and DevelopmentResearch and Development

• Ordinarily expensed (in the U.S.) as it is incurred, for reasons of financial statement comparability

• Only capitalized as an asset if a contract guarantees that the R&D costs incurred will be recovered from a customer who has requested the research and development activity

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End of Chapter 7End of Chapter 7