PowerPoint PresentationMcGraw-Hill/Irwin
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In this chapter, we will study the acquisition and depreciation of productive assets used in a business. In addition, we will take a quick look at accounting for natural resources and intangibles. This chapter contains some challenging accounting procedures, so let us get started.
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Conceptual Learning Objectives
C1: Describe property, plant and equipment and issues in accounting for them
C2: Explain depreciation and the factors affecting its computation
C3: Explain depreciation for partial years and changes in estimates
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A1: Compare and analyze alternative depreciation methods
A2: Compute total asset turnover and apply it to analyze a company’s use of assets
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Procedural Learning Objectives
P1: Apply the cost principle to compute the cost of property, plant and equipment.
P2: Compute and record depreciation using the straight-line, units-of-production, and declining-balance methods.
P3: Distinguish between revenue and capital expenditures, and account for them.
P4: Account for asset disposal through discarding or selling an asset.
P5: Account for natural resource assets and their depletion.
P6: Account for intangible assets.
P7: Appendix 8A: Account for asset exchanges
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Actively Used in Operations
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Property, plant and equipment are tangible assets that are used actively in the operations of the entity. We fully expect these assets, sometimes referred to as plant assets or fixed assets to benefit future periods.
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Use
benefited.
Disposal
*
When we acquire property, plant and equipment, they are recorded at historical cost. We will see how cost is determined on the next slide.
Once the asset is placed in service, we will allocate a portion of the asset’s cost to depreciation expense as the asset becomes older.
Finally, at the end of the asset’s useful life, we will dispose of it and remove it from our books and records. The accounting for property, plant and equipment usually covers several accounting periods.
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Acquisition
Cost
cash discounts.
Cost Determination
P1
All expenditures needed to prepare the asset for its intended use
Purchase
price
*
The cost includes the purchase price as well as all costs necessary to get the asset in place and ready for its intended use. We record the purchase price net of any cash discounts available.
Finance charges are not included in the cost of an asset. If we elect to finance the purchase over a period of time, the interest cost is charged as an expense when incurred.
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Land
P1
*
Land is not a depreciable asset. In addition to the purchase price, there are many costs generally incurred in connection with the acquisition. Many of these costs are related to obtaining legal title to the land.
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Depreciate over useful life of improvements.
P1
Land improvements are depreciated over their useful life. Land improvements include parking lots, driveways, fences, sidewalks, landscaping, and any outdoor lighting systems.
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Brokerage
fees
Taxes
*
Whether we purchase or construct a building, the cost should include the purchase price plus any attorney fees or title fees. If we construct the building, the cost will include all the necessary construction costs as well as the costs we have just mentioned.
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Purchase
price
Installing,
*
Machinery and equipment is recorded at its purchase price less any available cash discount. The company may have to pay delivery charges on the truck; these costs are included in the cost of the truck. If we need to install any special parts to make the machinery or equipment ready for its intended use, we will include these costs in the price of the assets.
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On January 1, Matrix, Inc. purchased land and building for $200,000 cash. The appraised values are building, $162,500, and land, $87,500.
How much of the $200,000 purchase price will be charged to the building and land accounts?
Lump-Sum Asset Purchase
The total cost of a combined purchase of land and building is separated on the basis of their relative market values.
P1
*
It is not uncommon to have a lump-sum purchase of assets. The most common example may be when purchasing a building and land. Remember, the land is not depreciable but the building is. We must assign a portion of the purchase price separately to the building and to the land. When faced with this type of problem, accountants normally divide the cost between the assets on the basis of relative fair market values. Let’s see how this works.
Matrix, Incorporated purchased land with a building for two hundred thousand dollars cash. The building was appraised at one hundred sixty-two thousand five hundred dollars, and the land was appraised at eighty-seven thousand five hundred dollars.
We must determine how to divide the two hundred thousand dollar purchase price between the land and building.
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Begin by calculating the relative fair value as a percent of the total fair value. The total fair value is two hundred fifty thousand dollars. The land has an appraised value of eighty-seven thousand five hundred dollars. So, land is valued at thirty-five percent of the total. We get the percent by dividing eighty-seven thousand five hundred dollars by the total fair value of two hundred fifty thousand dollars. We do a similar calculation for the building. Next, multiply the percentages we just calculated times the purchase price of two hundred thousand dollars to determine the amount assigned to each asset. In the case of land, we multiply thirty-five percent times two hundred thousand dollars and assign seventy thousand dollars to the land account. The remainder, or one hundred thirty thousand dollars, is assigned to the building account.
Sheet1
Appraised
% of
Purchase
Apportioned
Asset
Value
Value
Price
Cost
a
b*
c
McGraw-Hill/Irwin
Depreciation is the process of allocating the cost of an item of property, plant and equipment to expense in the accounting periods benefiting from its use.
Depreciation
C2
Cost
Allocation
Acquisition
Cost
(Unused)
*
Depreciation is a process of cost allocation. We allocate the cost of the asset to expense over its useful life in some rational and systematic manner. We do not want to confuse asset valuation, an economic concept, with allocation.
The unused portion of the asset’s cost appears on the balance sheet. We allocate a portion of the cost to expense on the income statement each accounting period. Let’s look at some very common methods of calculating depreciation expense.
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The calculation of depreciation requires three amounts for each asset:
Cost
*
Regardless of the method used to calculate depreciation expense, we must know three variables: the asset’s cost; the estimated salvage value we expect to receive at the end of its useful life, and the estimated useful life of the asset. Once these three amounts are known, we select the depreciation method that we will use to calculate depreciation expense.
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Straight-line
Units-of-production
Declining-balance
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There are three popular methods of calculating depreciation expense. The easiest and most widely used method is called straight-line depreciation. In special circumstances, we may wish to use the units-of-productions method. We would elect this method if the life of the asset is generally measured in terms of units of production. For example, airplanes keep highly detailed tracking of the number of hours the engines run. The unit of production may be the hours run by an aircraft. The third method is called the declining-balance method. Under this method, we take more depreciation expense in the early years of the asset’s life and lower amounts of depreciation in later years. Several income-tax depreciation calculations are based on the declining balance method. Let’s begin by looking at straight-line depreciation.
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On January 1, 2007, equipment was purchased for $50,000 cash. The equipment has an estimated useful life of five years and an estimated residual value of $5,000.
Straight-Line Method
=
*
Depreciation expense for any given period is determined by taking the asset’s cost less its estimated salvage value and dividing this amount by the asset’s estimated useful life. If we calculate annual depreciation, we would express the useful life in years. Or we may want to calculate monthly depreciation. We will see how to do this on a later slide. Here is our specific depreciation example. On January first, 2007, a company purchased equipment for fifty thousand dollars. The estimated useful life is five years and the estimated salvage value is five thousand dollars. Can you calculate the amount of annual depreciation?
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=
*
This calculation was relatively easy. Did you get the annual depreciation of nine thousand dollars? Now let us make the journal entry on December thirty first, to record depreciation expense for the year. The proper adjusting journal entry is to debit, or increase, depreciation expense and credit, or increase, the contra account, accumulated depreciation dash equipment for nine thousand dollars. Now let us look at depreciation for this asset for its five-year life.
Larson
Dr.
Cr.
3,000
$ 275,000
Matrix, Inc.
1
30
90
McGraw-Hill/Irwin
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Notice that depreciation expense is the same amount in each of the five years. If we plot this amount on a graph, it would be a straight line. That is how we got the name of the method. Accumulated depreciation increases by nine thousand dollars each year. The cost of the asset (fifty thousand dollars) less accumulated depreciation at the end of any year is called book value. Book value decreases by nine thousand dollars each year. The ending book value is equal to the estimated salvage value at the end of the asset’s useful life. We want this to be true regardless of the method we use. It’s easy to calculate the rate of depreciation—just divide one hundred percent by the useful life. In this case the rate of depreciation is twenty percent. If we multiply the asset’s cost less its salvage value of forty-five thousand dollars times twenty percent, we get the annual depreciation of nine thousand dollars.
Sheet1
Depreciation
Accumulated
Expense
Depreciation
Accumulated
Book
Year
(debit)
(credit)
Depreciation
Value
$ 50,000
2007
$ 9,000
$ 9,000
$ 9,000
41,000
2008
9,000
9,000
18,000
32,000
2009
9,000
9,000
27,000
23,000
2010
9,000
9,000
36,000
14,000
2011
9,000
9,000
45,000
5,000
$ 45,000
$ 45,000
Sheet2
Sheet3
McGraw-Hill/Irwin
P2
Income Statement.
Book Value
Book Value
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In this graph of each year’s depreciation expense, you can clearly see the straight-line nature of the method. Now we have a graph of the asset’s book value at the end of each year. Once again, we have a straight line that slopes down and to the left.
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*
Under the units-of-production method, the first step is to calculate the depreciation expense per unit of production. Take the asset’s cost less its salvage value and divide this amount by the total estimated number of units that will be produced by the assets. Once we complete the first step, we may calculate depreciation expense for the period. Multiply the depreciation expense per unit that we determined in step one by the number of units produced in the current period. Let’s look at a specific example.
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On December 31, 2007, equipment was purchased for $50,000 cash. The equipment is expected to produce 100,000 units during its useful life and has an estimated salvage value of $5,000.
If 22,000 units were produced in 2008, what
is the amount of depreciation expense?
Units-of-Production Method
*
At the end of December 2007, the company purchased equipment that had a cost of fifty thousand dollars and estimated salvage value of five thousand dollars. The equipment is expected to produce one hundred thousand units during its useful life. During 2008, the equipment was used to produce twenty-two thousand units. Let’s follow our two-step method of calculating depreciation expense for 2008.
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Depreciation
*
First we calculate the depreciation expense per unit of production of forty-five cents per unit. During 2008, the company produced twenty-two thousand units, so we determine depreciation expense of ninety-nine hundred dollars. Just multiply the twenty-two thousand units times the forty-five cents per unit depreciation charge. Let’s look at a table of depreciation expense for this equipment over its five-year life. Remember that we need to know the units produced in each year.
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Units-of-Production Method
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In the second column we show the units produced in each of the five years. In 2010, no units were produced, so there is no depreciation. The depreciation expense amounts are all determined by multiplying the units produced by forty-five cents per unit. Finally, notice that the book value is equal to the estimated salvage value of five thousand dollars at the end of the asset’s estimated useful life. Now let us move on to the declining-balance method.
Sheet1
Depreciation
Accumulated
Book
Year
Units
Expense
Depreciation
Value
$ 50,000
2008
22,000
$ 9,900
$ 9,900
40,100
2009
28,000
12,600
22,500
27,500
2010
- 0
- 0
22,500
27,500
2011
32,000
14,400
36,900
13,100
2012
18,000
8,100
45,000
5,000
100,000
$ 45,000
Sheet2
Sheet3
McGraw-Hill/Irwin
later years’ total expense.
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One of the reasons to consider the declining-balance method is that it is an attempt to match depreciation expense and repairs expense to focus on the overall cost of ownership. In the early years of the asset’s life, depreciation under the declining-balance method is high and generally repair expenses are low. Conversely, in the later years of an asset’s life, we take less depreciation expense but repairs expense is usually higher. So, over the life of the asset we attempt to smooth the total cost of ownership.
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Calculating depreciation expense under the double-declining-balance method is a three-step process. The first step is the calculate the straight-line depreciation rate. Recall that we do this by dividing one hundred percent by the asset’s useful life. In our specific case we divide one hundred percent by the five-year useful life to get a straight-line rate of twenty percent. The second step is to calculate the double-declining-balance rate. We do this by multiplying the straight-line rate times two. In our case that would be twenty percent times two, or forty percent. The third, and final step is to determine depreciation expense. We multiply the double-declining rate times the book value of the asset at the beginning of the period. Under the double-declining-balance method we ignore estimated salvage value. The beginning book value (cost less accumulated depreciation), is fifty thousand dollars. Depreciation expense for 2008 is twenty thousand dollars, forty percent times fifty thousand dollars.
Don’t forget that salvage value is not used in the double-declining-balance method.
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At the start of the second year the book value of the asset was thirty thousand dollars (cost of fifty thousand dollars less accumulated depreciation of twenty thousand dollars). To determine depreciation expense, we multiply the book value of thirty thousand dollars times our rate of forty percent to yield twelve thousand dollars. Let’s look at a depreciation table for our asset.
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While we always want the book value to be equal to estimated salvage value at the end of the asset’s useful life, it just will not work properly using the double-declining-balance method. As you can see, the book value of the asset is three thousand eight hundred and eighty-eight dollars. We need for it to be equal to five thousand dollars, the estimated salvage value. The only way we can make this work is to force depreciation expense in the last year to be the amount needed to bring book value down to salvage value. In 2012, if we go by the table, we would record depreciation expense of two thousand five hundred ninety-two dollars. But this can’t be right since the book value can’t go below the salvage value of five thousand dollars. Let’s look at a corrected schedule.
Sheet1
Depreciation
Accumulated
Book
Year
Expense
Depreciation
Value
$ 50,000
2008
$ 20,000
$ 20,000
30,000
2009
12,000
32,000
18,000
2010
7,200
39,200
10,800
2011
4,320
43,520
6,480
2012
2,592
46,112
3,888
$ 46,112
Sheet2
Sheet3
McGraw-Hill/Irwin
last year so that book value equals salvage value.
*
If we force depreciation expense to be one thousand four hundred and eighty dollars in 2012, accumulated depreciation will be forty-five thousand dollars, and book value will be equal to salvage value of five thousand dollars. Let’s summarize our three depreciation methods by looking at some graphs.
Sheet1
Depreciation
Accumulated
Book
Year
Expense
Depreciation
Value
$ 50,000
2008
$ 20,000
$ 20,000
30,000
2009
12,000
32,000
18,000
2010
7,200
39,200
10,800
2011
4,320
43,520
6,480
2012
1,480
45,000
5,000
$ 45,000
Sheet2
Sheet3
McGraw-Hill/Irwin
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The graph in the upper left corner is depreciation expense using the straight-line method. We have a constant nine thousand dollar expense each year.
In the upper right corner we have the graph of units-of-production depreciation expense. This method does not follow any pattern because it is dependent on the number of units produced each period. Notice that in year three the equipment was idle so no depreciation expense was recorded.
At the bottom of the screen is the depreciation expense under the double-declining-balance method. Depreciation expense decreases each year of the asset’s life.
The choice of the depreciation method to use is one that should be carefully made by management. Depreciation expense impacts net income in each period of the asset’s useful life.
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When an item of property, plant or equipment is acquired during the year, depreciation is calculated for the fraction of the year the asset is owned.
Partial-Year Depreciation
C 3
*
To this point we have discussed depreciation of an asset that was purchased at the beginning of the year. Let’s see how we handle depreciation expense for partial periods, that is, assets that are purchased during the year.
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Calculate the straight-line depreciation on December 31, 2010, for equipment purchased on June 30, 2010. The equipment cost $75,000, has a useful life of 10 years, and an estimated salvage value of $5,000.
Depreciation = ($75,000 - $5,000) ÷ 10
= $7,000 for all 2007
Depreciation = $7,000 × 6/12 = $3,500
*
In our example, a company purchased equipment for seventy-five thousand dollars on June thirtieth, 2010. The equipment has a useful life of ten years and estimated salvage value of five thousand dollars. This company uses straight-line depreciation for all its property, plant and equipment.
Let’s calculate depreciation expense for 2010. The depreciation expense for the entire year 2010 would be seven thousand dollars. We determine this amount by taking cost less salvage value of seventy thousand dollars and dividing it by ten. The company had the equipment in service for one-half of the year, so we multiply the annual depreciation of seven thousand dollars times one-half, or six twelfths. We use the same procedure for other partial periods.
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useful life
Over the life of an asset, new information may come to light that indicates the
original estimates were inaccurate.
C 3
*
You know that the salvage value and useful life of an item of property, plant and equipment are both estimates. Like all estimates, new information may come to light that will cause us to revise our previous estimate. Let’s see how accountants handle the revision of previous estimates.
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On January 1, 2008, equipment was purchased that cost $30,000, has a useful life of 10 years, and no salvage value. During 2011, the useful life was revised to eight years total (five years remaining).
Calculate depreciation expense for the year
ended December 31, 2008, using the
straight-line method.
C 3
–
*
In our example, a company purchased equipment on January first, 2008 for thirty thousand cash. The equipment is estimated to have a ten-year useful life and no salvage value at the end of its useful life. The company uses the straight-line method for all plant assets and begins recording depreciation on this equipment in 2008. We continue our original computations for 2009 and 2010. During 2011, we learn new information about the equipment. This new information causes us to revise our estimate of the equipment’s useful life. We now believe the equipment will have a total useful life of eight years. We already recorded depreciation expense for three years (2008, 2009, and 2010), so there are five years remaining in the equipment’s useful life. In this case, accountants would take the book value at the date of revision of our estimate, that is, 2011, and subtract any estimated salvage value at the time of revision. This total is to be divided by the remaining useful life of the asset at the date of revision. Let’s calculate the proper depreciation expense for 2011.
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C 3
*
The asset had a cost of thirty thousand dollars and a ten-year useful life with no salvage value. Under straight-line depreciation we record three thousand dollars of expense in each of the years 2008, 2009, and 2010. Accumulated depreciation has a balance of nine thousand dollars at the beginning of 2011. The remaining book value is twenty-one thousand dollars and the remaining useful life of the asset is five years, so depreciation for each of those five years will be four thousand two hundred dollars. Let’s record depreciation expense at December thirtieth, 2011.
We debit depreciation expense for forty-two hundred dollars and credit accumulated depreciation dash equipment for the same amount.
Sheet1
Depreciation
Accumulated
Undepreciated
Expense
Depreciation
Balance
Year
(debit)
Balance
9,000
Jul. 30
3,000
$ 275,000
2007
1
30
90
McGraw-Hill/Irwin
*
Total accumulated depreciation is subtracted for the total cost of property, plant, and equipment.
Sheet1
Depreciation
Accumulated
Undepreciated
Expense
Depreciation
Balance
Year
(debit)
Balance
9,000
$ 453,000
McGraw-Hill/Irwin
Additional Expenditures
If the amounts involved are not material, most companies expense the item.
P3
*
After a plant asset is purchased, the company may incur additional expenditures on that asset. These expenditures may be for repairs and maintenance, overhauls, upgrading the asset, and similar expenditures.
One way to handle these types of expenditures is to treat them as a Capital Expenditure and charge the amount to a balance sheet account like the asset or accumulated depreciation. In some cases, the expenditures may be treated as Revenue Expenditures and charged to current period income as an expense. For each expenditure subsequent to acquisition of a plant asset we must decide if the expenditure is to be treated as a Capital or Revenue expenditure.
Sheet1
$ 90,000
$ 40,000
$ (24,000)
26,000
Proceeds from issuance of debt
13,000
$ 15,000
$ 15,000
$ 15,000
Sheet2
McGraw-Hill/Irwin
*
Generally, subsequent expenditures for ordinary repairs are treated as revenue expenditures and charged to current period income as an expense. Subsequent expenditures that are for betterments are classified as extraordinary repairs. These should be treated as capital expenditures and charged to the asset account. Let’s look at the proper accounting for the disposal of plant assets.
Sheet1
$ 90,000
$ 40,000
$ (24,000)
26,000
Proceeds from issuance of debt
13,000
$ 15,000
$ 15,000
$ 15,000
Sheet2
Repairs
3. Does not extend life beyond original
estimate.
replacements.
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Journalize disposal by:
P4
*
Whenever we dispose of an item of property, plant and equipment, the first thing we do is update depreciation to the date of disposal. After completing the update we can begin on the journal entry. We start the journal entry by recording a debit to the cash account, if cash was received, or credit the cash account, if cash was paid by the company. In addition, we must determine whether a gain or loss is associated with the disposal. A gain is recorded with a credit, just like revenue, and a loss is recorded with a debit, just like an expense account.
We complete the entry by removing the asset’s cost from our books with a credit, and remove the related accumulated depreciation with a debit.
Let’s see how we calculate the gain or loss associated with the disposal.
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Journalize disposal by:
Recording cash
received (debit)
Recording a
gain (credit)
*
If the amount of cash received is greater than the book value of the asset (cost less accumulated depreciation), a gain is associated with the disposal.
If the cash received is less than the book value of the asset, a loss will be recorded. When the amount of cash is exactly equal to the book value of the asset, there will be no gain or loss in connection with the disposal. Now let us look at a specific example of disposal of a plant asset.
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On September 30, 2011, Evans Company sells a machine that originally cost $100,000 for $60,000 cash. The machine was placed in service on January 1, 2008. It was depreciated using the straight-line method with an estimated salvage value of $20,000 and a useful life of 10 years.
Selling Property, Plant and Equipment
P4
*
On September thirtieth, 2011, Evans Company sells a machine for sixty thousand dollars cash. The machine was purchased on January first, 2008, for one hundred thousand dollars, had an estimated salvage value of twenty thousand dollars, and a useful life of ten years. Evans uses straight-line depreciation.
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Annual Depreciation:
9/12 × $8,000 = $6,000
*
Annual depreciation is eight thousand dollars. For the nine months ending September thirtieth, Evans will record six thousand dollars in depreciation.
Next, we make the journal entry to bring the depreciation up-to-date. The required journal entry is to debit depreciation expense and credit accumulated depreciation dash machine. Now we need to make the journal entry to record the disposal.
Larson
Dr.
Cr.
Jul. 30
3,000
$ 275,000
2007
1
30
90
McGraw-Hill/Irwin
P4
*
The balance in the accumulated depreciation account is thirty thousand dollars at the date of disposal. We recorded three years of depreciation at eight thousand dollars and the partial year depreciation of six thousand dollars. Once we determine the book value of the asset, we can calculate any gain or loss involved with the disposal.
Sheet1
Cost
$ 100,000
McGraw-Hill/Irwin
P4
*
The book value of seventy thousand dollars is less than the cash received of sixty thousand dollars, so this disposal involves a loss of ten thousand dollars. Let’s record the journal entry.
Sheet1
Cost
$ 100,000
McGraw-Hill/Irwin
P4
*
We record the disposal with a debit to the cash account for sixty thousand dollars, a debit to accumulated depreciation dash machine for thirty thousand dollars (this eliminates the account balance), and a debit to the loss on disposal account for ten thousand dollars. Finally, we credit the asset account, machine, for one hundred thousand dollars, the historical cost of the machine.
Larson
Dr.
Cr.
10,000
2005
3,000
$ 275,000
2006
Inventory
2007
1
30
90
McGraw-Hill/Irwin
P5
*
Let’s change the subject away from disposals of plant assets and discuss natural resources.
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*
Natural resources abound. We have accounting issues with oil, coal, timber, gold, gravel, and a wide variety of other natural resources. In general, natural resources can be thought of as anything extracted from our natural environment. As accountants, we report natural resources at their cost less accumulated depletion. The depletion we will study in this text is very similar to units-of-production depreciation. The cost of any natural resource must include all exploration and development costs as well as extraction costs. A portion of these total costs will be charged to income each period through the depletion expense account. Let’s see how this works.
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Step 2:
*
We begin the process of calculating depletion expense by determining the depletion expense per unit of natural resource. The numerator of the equation contains the resource cost less any estimated salvage value. The denominator of the equation is our estimated total capacity of the natural resource we expect to extract. For oil we express the denominator in terms of barrels, for coal we use tons, for timber we use board feet, and the like for other resources. The current period depletion expense is determined by multiplying the depletion expense per unit, determined in the first step, by the number of extracted units sold during the period. Depletion expense is based on the number of units sold, not the number of units extracted. Let’s go over a specific example.
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Apex Mining acquired a tract of land containing ore deposits. Total costs of acquisition and development were $1,000,000 and Apex estimates the land contained 40,000 tons of ore. During the first year of operations Apex extracted and sold 13,000 tons of ore.
Depletion of Natural Resources
*
Apex Mining paid one million dollars cash to acquire and develop an ore site. The engineers at Apex estimate that the site will eventually produce forty thousand tons of ore. During the first year of operation, the company extracted and sold thirteen thousand tons of ore. Let’s start by calculating the depletion charge per ton of ore.
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Step 1:
Depletion Expense
*
The depletion charge per ton of ore is twenty-five dollars. The site has no residual value so we divide one million dollars by forty thousand tons to get the twenty-five dollar per ton depletion charge. Depletion expense for the first year will be three hundred twenty-five thousand dollars. We extracted and sold thirteen thousand tons of ore at twenty-five dollars per ton.
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Property, Plant and Equipment Used in Extracting Natural Resources
Specialized property, plant and equipment may be required to extract the natural resource.
These assets are recorded in a separate account and depreciated.
P5
*
The development and extraction of many types of natural resources require highly specialized plant assets. Just think of the use of off-shore drilling platforms for oil and gas production. These specialized assets are recorded in a separate account from the natural resource and depreciated over their useful lives.
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McGraw-Hill/Irwin
P6
*
Now let us turn to the last major subject we will cover in the presentations…intangible assets.
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McGraw-Hill/Irwin
*
Intangible assets lack physical substance and that makes it difficult to determine the asset’s useful life or any residual value. Many intangible assets involve exclusive rights or privileges. We will review the major types of intangible assets and related accounting on the remaining screens.
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McGraw-Hill/Irwin
Patents
Copyrights
Leaseholds
Trademarks & Trade Names
Record at current cash equivalent cost, including purchase price, legal fees, and filing fees.
Cost Determination and Amortization
*
We have provided you with a list of intangible assets that will be discussed. Intangible assets are normally recorded at the purchase price plus any legal or related fees.
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McGraw-Hill/Irwin
Patents
The exclusive right granted to its owner to manufacture and sell a patented item or use a process for 20 years. A patent is generally amortized, using the straight-line method, over its useful life not to exceed 20 years.
P6
*
A patent gives the holder the exclusive right to manufacture and sell an item or process for twenty years. A patent is amortized (a process just like depreciation) using the straight-line method over its useful life, but never more than twenty years. Most companies amortize patents over a very short period of time.
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Patents
Matrix, Inc. purchased a patent for $10,000. The patent is expected to have a useful life of 10 years.
P6
Part One
In our example, Matrix purchased a patent for ten thousand dollars cash. The useful life of the patent is estimated at ten years. Let’s prepare the journal entry to record the annual amortization expense.
Part Two
We will debit amortization expense dash patents for one thousand dollars (one-tenth of the ten thousand dollar cost), and credit accumulated amortization dash patents for the same amount. This entry will be made each year for the next nine years.
Larson
Dr.
Cr.
3,000
$ 275,000
2006
Inventory
2007
1
30
90
McGraw-Hill/Irwin
Copyrights
The exclusive right to publish and sell a musical, literary, or artistic work during the life of the creator plus 70 years.
P6
Leaseholds
*
A copyright grants to the holder the exclusive right to publish and sell musical, literary, or artistic work for the life of the creator plus seventy years. Most copyrights are amortized over a short period of time using the straight-line method. A leasehold is the right to the beneficial use of property owned by a lessor. The lessee does not own the property but gets to use it over some extended period of time.
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Leasehold Improvements
A lessee may pay for alterations or improvements to the leased property such as partitions, painting, and storefronts. These costs are usually amortized over the term of the lease.
P6
Franchises and Licenses
*
Leasehold improvements are any alterations or improvements to leased property. Leasehold improvements are normally amortized using the straight-line method over the term of the lease.
The holder of a franchise has the right to deliver a product or service under conditions granted by the franchisor. You really can’t drive down any major street without finding a number of franchise operations. The accounting for franchises can become quite complex. At this point it is sufficient to be able to define the nature of a franchise.
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McGraw-Hill/Irwin
Trademarks and Trade Names
A symbol, name, phrase, or jingle identified with a company, product, or service.
P6
*
A trademark or trade name is any symbol, name, phrase, or jingle that is identified with a company, product or service. No other party may use the trademark or trade name without the permission of the holder. Many trademarks are extremely valuable. The name “Mercedes-Benz” is quite valuable, or the name “Harley-Davidson.” How about the phrase, “Coke is it.”
We normally amortize the cost of trademarks over a short period of time using the straight-line method.
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each year to determine if there has been
any impairment in carrying value.
Goodwill
*
An intangible asset called goodwill can be created when one company buys another company. If the purchase price of the company is greater than the fair value of the net assets and liabilities acquired, we have goodwill associated with the transaction. Goodwill is not amortized. Each year we must test to see if there has been any impairment in the carrying value of the goodwill. If an impairment is determined to exist, we will reduce the goodwill account and recognize the loss in value.
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efficiency in using its assets.
Total Asset Turnover
*
Total asset turnover is equal to the net sales for the period divided by the average total assets. The average total assets is computed by taking the beginning balance of total assets, adding the ending balance, and dividing the result by two. Total asset turnover provides us with information about how efficiently a company uses its assets. For example, Dragon had an asset turnover in 2010 of point 92. This means that for every dollar of assets invested, the company generated ninety two cents in sales. You can see that two companies in the same industry, like Dragon and Phoenix, can have significantly different measures of total asset turnover. The ratio should be interpreted in comparison to prior years and also to its competitors.
Larson
3,000
$ 275,000
Inventory
1
30
90
McGraw-Hill/Irwin
Exchanging Property, Plant and Equipment
Many property, plant and equipment are disposed of by exchanging them for newer assets. The next few slides will explain how exchanges are recorded.
P7
*
Many property, plant and equipment such as machinery, automobiles, and office equipment, are disposed of by exchanging them for newer assets. In a typical exchange of property, plant and equipment, a trade-in allowance is received on the old asset and any remaining balance is either paid in cash or financed. In the next few slides, we will discuss how these exchanges are accounted for using generally accepted accounting principles.
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McGraw-Hill/Irwin
SIMILAR
Accounting for exchanges of similar assets depends on whether the book value of the asset(s) given up is less or more than the market value of the asset(s) received.
P7
*
We have special rules in accounting when we trade one plant asset for a similar plant asset. The particular accounting we will follow depends on whether there is a gain or loss involved in the transaction.
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McGraw-Hill/Irwin
Exchanging Property, Plant and Equipment
Accounting for exchanges of similar assets depends on whether the transaction has commercial substance (i.e. whether company’s future cash flows change).
A loss is recognized when the book value given up is more than the market value received.
A gain is recognized when the book value given up is less than the market value received.
P7
*
We know that a loss occurs when the book value of the asset or assets given up is more than the market value of the asset or assets received.
A gain exists when the book value of the asset given up is less than the market value of the asset received.
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McGraw-Hill/Irwin
On May 30, 2010, Matrix, Inc. exchanged a used bus and $35,000 cash for a new European-style bus. The old bus originally cost $40,000, had up-to-date accumulated depreciation of $30,000. The new bus had a market value of $39,000.
Exchanging Property, Plant and Equipment
COMMERCIAL SUBSTANCE
*
Let’s look at a specific example of the exchange of similar plant assets. On May thirtieth, 2010, Matrix exchanges a used bus and thirty-five thousand dollars cash for a new similar bus that has a fair market value of thirty-nine thousand dollars. The old bus given up has a historical cost of forty thousand dollars and accumulated depreciation to the date of exchange of thirty thousand dollars.
The first thing we need to determine is whether a gain or loss will result. Assume that this transaction has commercial substance.
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McGraw-Hill/Irwin
P7
*
The book value of the bus given up is ten thousand dollars and the cash paid is thirty-five thousand dollars, so Matrix gave up assets with a book value of forty-five thousand dollars. We compare the book value of the assets given up to the thirty-nine thousand dollar market value of the bus received and see that this transaction indicates a loss of six thousand dollars.
Let us prepare the journal entry to record the exchange.
We debit the Bus account for thirty-nine thousand dollars, the fair value of the bus received. Next, we debit Accumulated Depreciation dash Bus for thirty thousand dollars and Loss on Exchange for six thousand dollars. The credits are to the old Bus asset account for forty thousand dollars and to Cash for thirty-five thousand dollars.
Sheet1
$ 39,000
10,000
Cash
35,000
45,000
3,000
$ 275,000
2006
Inventory
2007
1
30
90
McGraw-Hill/Irwin
On May 30, 2010, Matrix, Inc. exchanged a used bus and $35,000 cash for a new European-style bus. The old bus originally cost $40,000, had up-to-date accumulated depreciation of $30,000. The new bus had a market value of $49,000.
COMMERCIAL SUBSTANCE
P7
*
Now let us look at an example very similar to the one we just completed. Once again we are exchanging similar plant assets. The old bus has a cost basis of forty thousand dollars and accumulated depreciation to the date of exchange of thirty thousand dollars. In addition to exchanging the old bus, we are paying thirty-five thousand dollars cash. In exchange we are receiving a new bus that has a market value of forty-nine thousand dollars. Let’s look at the accounting of this exchange.
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McGraw-Hill/Irwin
P7
*
Unlike our last example, this transaction indicates that a gain exists. Let us prepare the journal entry for this exchange. We record the new bus at the market value. Next, we remove the old bus and its accumulated depreciation from our books. To accomplish this, we will debit the accumulated depreciation account and credit the Bus asset account. Finally, we credit the Cash account for the cash payment made in connection with the exchange, and record the gain.
Sheet1
$ 49,000
10,000
Cash
35,000
45,000
3,000
$ 275,000
Gain
4,000
2006
Inventory
2007
1
30
90
McGraw-Hill/Irwin
On May 30, 2010, Matrix, Inc. exchanged a used bus and $35,000 cash for a new European-style bus. The old bus originally cost $40,000, had up-to-date accumulated depreciation of $30,000. The new bus had a market value of $49,000.
NO COMMERCIAL SUBSTANCE
P7
*
If we just change the assumption and treat this transaction with no commercial substance, then the journal entry would be different.
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McGraw-Hill/Irwin
P7
$49,000 - $4,000 = $45,000
*
If the exchange transaction has no commercial substance, the gain is not recognized. Instead, we record the asset received at the book value of the asset given up. Let us prepare the journal entry for this exchange. We record the new bus at the book value of the assets given up. In our exchange, we gave up a bus with a book value of ten thousand dollars and cash of thirty-five thousand dollars. The cost basis of the new bus will be forty-five thousand dollars. Next, we remove the old bus and its accumulated depreciation from our books. To accomplish this, we will debit the accumulated depreciation account and credit the Bus asset account. Finally, we credit the Cash account for the cash payment made in connection with the exchange. The same analysis and approach is taken for a loss on an asset exchange with commercial substance.
Sheet1
$ 49,000
10,000
Cash
35,000
45,000
3,000
$ 275,000
2006
Inventory
2007
1
30
90
McGraw-Hill/Irwin
*
This chapter covered a great deal of new material related to property, plant and equipment acquisition, depreciation and disposal. We also covered accounting issues for intangible assets and natural resources.
Appraised% ofPurchaseApportioned
Remaining book value21,000$
Revised annual depreciation4,200$
Property, plant, and equipment:
Financial Statement Effect
3. Does not extend life beyond original
estimate.
replacements.
Betterments
and
Extraordinary
Repairs
Dr.Cr.
Cost100,000$
Book Value70,000$
Machine100,000
Dr.Cr.
Cost of old bus40,000$
Cash35,000 45,000
Cost of old bus40,000$
Cash35,000 45,000