Fixed Assets and Intangible Assets 10 Fixed Assets and Intangible Assets

Describe the nature of the adjusting process. Learning Objective 1 Learning Objective 1 Fixed Assets and Intangible Assets 3-1 3-1 After studying this chapter, you should be able to: 1 Define, classify, and account for the cost of fixed assets. Insert Chapter Objectives Describe the nature of the adjusting process. Describe the nature of the adjusting process. 2 Compute depreciation, using the following methods: straight-line method, units-of-production method, and double-declining-balance method. 3 Journalize entries for the disposal of fixed assets. 10-2

4 5 6 Compute depletion and journalize the entry for depletion. Fixed Assets and Intangible Assets (continued) 4 Compute depletion and journalize the entry for depletion. 5 Describe the accounting for intangible assets, such as patents, copyrights, and goodwill. 6 Describe how depreciation expense is reported in an income statement and prepare a balance sheet that includes fixed assets and intangible assets. 10-3

Describe, classify, and account for the cost of fixed assets. 1 Describe, classify, and account for the cost of fixed assets. 10-4

1 Nature of Fixed Assets Fixed assets are long-term or relatively permanent assets, such as equipment, machinery, buildings, and land. Other descriptive titles for fixed assets are plant and equipment.

1 Fixed assets have the following characteristics: They exist physically and, thus, are tangible assets. They are owned and used by the company in its normal operations. They are not offered for sale as part of normal operations.

1 Fixed Assets as a Percent of Total Assets—Selected Companies Exhibit 1

1 Exhibit 2 Classifying Costs

1 Exhibit 3 Costs of Acquiring Fixed Assets (continued)

1 Exhibit 3 Costs of Acquiring Fixed Assets (continued) (continued)

1 Exhibit 3 Costs of Acquiring Fixed Assets (continued) (continued)

1 Exhibit 3 Costs of Acquiring Fixed Assets (continued)

Cost of Acquiring Fixed Assets Excludes: These costs are expenses. 1 Cost of Acquiring Fixed Assets Excludes: Vandalism Mistakes in installation Uninsured theft Damage during unpacking and installing Fines for not obtaining proper permits from government agencies These costs are expenses.

Capital and Revenue Expenditures 1 Capital and Revenue Expenditures Expenditures that benefit only the current period are called revenue expenditures. Expenditures that improve the asset or extend its useful life are capital expenditures.

Normal and ordinary repairs and maintenance 1 REVENUE EXPENDITURES CAPITAL EXPENDITURES Additions, improvements, and extraordinary repairs Normal and ordinary repairs and maintenance

Ordinary Maintenance and Repairs This is a revenue expenditure. 1 Ordinary Maintenance and Repairs On April 9, the firm paid $300 for a tune-up of a delivery truck. This is a revenue expenditure.

This is a capital expenditure. 1 Asset Improvements On May 4, a $5,500 hydraulic lift was installed on the delivery truck to allow for easier and quicker loading of heavy cargo. This is a capital expenditure.

Extraordinary Repairs This is a capital expenditure. 1 Extraordinary Repairs The engine of a forklift that is near the end of its useful life is overhauled at a cost of $4,500, which extends its useful life eight years. Work on the forklift was completed on October 14. This is a capital expenditure.

Capital and Revenue Expenditures 1 Capital and Revenue Expenditures

1 Example Exercise 10-1 Example Exercise 10-1 Follow My Example 10-1 Capital and Revenue Expenditures On June 18, GTS Co. paid $1,200 to upgrade a hydraulic lift and $45 for an oil change for one of its delivery trucks. Journalize the entries for the hydraulic lift upgrade and oil change expenditures. Follow My Example 10-1 June 18 Delivery Truck…………………........ 1,200 Cash……………………………... 1,200 Follow My Example 6-1 18 Repairs and Maintenance Exp…… 45 Cash…………………………......... 45 For Practice: PE 10-1A, PE 10-1B 10-20

1 Leasing Fixed Assets A capital lease is accounted for as if the lessee has, in fact, purchased the asset. The asset is then amortized over the life of the capital lease.

1 Leasing Fixed Assets A lease that is not classified as a capital lease for accounting purposes is classified as an operating lease (an operating lease is treated as an expense).

2 Compute depreciation, using the following methods: straight-line method, units-of-production method, and double-declining balance method. 10-23

2 Depreciation Over time, fixed assets such as equipment, buildings, and land improvements lose their ability to provide services. The periodic recording of the cost of fixed assets to expense is called depreciation.

2 Physical depreciation factors include wear and tear during use or from exposure to the weather. Functional depreciation factors include obsolescence and changes in customer needs that cause the asset to no longer provide services for which it was intended.

2 Depreciation does not measure a decline in the market value of a fixed asset. Depreciation does not provide cash to replace fixed assets as they wear out.

Factors in Computing Depreciation 2 Factors in Computing Depreciation The asset’s initial cost. The asset’s expected useful life. The asset’s estimated residual value.

2 Residual Value The expected useful life of a fixed asset is estimated at the time the asset is placed into service. The residual value of a fixed asset at the end of its useful life is estimated at the time the asset is placed into service.

2 Exhibit 4 Depreciation Expense Factors

2 Exhibit 5 Use of Depreciation Methods

Cost – estimated residual value 2 Straight-Line Method The straight-line method provides for the same amount of depreciation expense for each year of the asset’s useful life. Annual depreciation Cost – estimated residual value Estimated life =

2 A depreciable asset cost $24,000. Its estimated residual value is $2,000 and its estimated useful life is five years. Annual depreciation Cost – estimated residual value Estimated life = Annual depreciation $24,000 – $2,000 5 years expected useful life = Annual depreciation = $4,400

2 If the preceding equipment was purchased and placed into service on October 1, the depreciation would be $1,100, computed as follows: $4,400 × 3/12 = $1,100

2 Example Exercise 10-2 Example Exercise 10-2 Follow My Example 10-2 Straight-Line Depreciation Equipment acquired at the beginning of the year at a cost of $125,000 has an estimated residual value of $5,000 and an estimated useful life of 10 years. Determine the (a) depreciable cost, (b) straight-line rate, and (c) annual straight-line depreciation. Follow My Example 10-2 $120,000 ($125,000 – $5,000) 10% = 1/10 Follow My Example 6-1 $12,000 ($120,000 × 10%) or ($120,000 ÷ 10 years) 10-34 For Practice: PE 10-2A, PE 10-2B

Total Units of Production 2 2 Units-of-Production Method The units-of-production method provides for the same amount of depreciation expense for each unit produced or each unit of capacity used by the asset. Depreciation per unit Cost – Residual Value Total Units of Production =

2 A depreciable asset cost $24,000. Its estimated residual value is $2,000 and it is expected to have an estimated life of 10,000 operating hours. Depreciation per unit Cost – Residual Value Total units of production = Depreciation per unit $24,000 – $2,000 10,000 hours expected useful life = Depreciation per unit = $2.20 per hour

Depreciation per Unit × Total Units of Production Used 2 A depreciable asset cost $24,000. Its estimated residual value is $2,000 and it is expected to have an estimated life of 10,000 operating hours. During the year the asset was operated 2,100 hours. Depreciation Depreciation per Unit × Total Units of Production Used = Depreciation ($2.20 per hour) × (2,100 hours) = Depreciation $4,620 =

2 Example Exercise 10-3 Example Exercise 10-3 Example Exercise 10-2 Units-of-Production Depreciation Equipment acquired at a cost of $180,000 has an estimated residual value of $10,000, an estimated useful life of 40,000 hours, and was operated 3,600 hours during the year. Determine the (a) depreciable cost, (b) depreciation rate, and (c) the units-of-production depreciation for the year. Follow My Example 10-3 $170,000 ($180,000 – $10,000) $4.25 per hour ($170,000 ÷ 40,000 hours) $15,300 (3,600 hours × $4.25) For Practice: PE 10-3A, PE 10-3B 10-38

Double-Declining-Balance Method 2 Double-Declining-Balance Method The double-declining-balance method provides for a declining periodic expense over the estimated useful life of the asset.

2 A double-declining balance rate is determined by doubling the straight-line rate. A shortcut to determining the straight-line rate is to divide one by the number of years (1/5 = .20). Hence, using the double-declining- balance method, a five-year life results in a 40 percent rate (.20 × 2). (continued)

2 For the first year, the cost of the asset is multiplied by 40 percent. After the first year, the declining book value of the asset is multiplied 40 percent. Continuing with the example where the fixed asset cost $24,000 and has an expected residual value of $2,000, a table can be built.

2 $24,000 × .40 Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End 1 $24,000 40% $9,600 $24,000 × .40

2 Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End 1 $24,000 40% $9,600 $9,600 $14,400 2 14,400 40% 5,760 $14,400 × .40

2 Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End 1 $24,000 40% $9,600 $9,600 $14,400 2 14,400 40% 5,760 15,360 8,640

2 Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End 1 $24,000 40% $9,600 $9,600 $14,400 2 14,400 40% 5,760 15,360 8,640 3 8,640 40% 3,456 18,816 5,184

2 Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End 1 $24,000 40% $9,600 $9,600 $14,400 2 14,400 40% 5,760 15,360 8,640 3 8,640 40% 3,456 18,816 5,184 4 5,184 40% 2,074 20,890 3,110

2 STOP Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End 1 $24,000 40% $9,600 $9,600 $14,400 2 14,400 40% 5,760 15,360 8,640 3 8,640 40% 3,456 18,816 5,184 4 5,184 40% 2,074 20,890 3,110 5 3,110 40% 1,244 22,134 1,866 DEPRECIATION STOPS WHEN BOOK VALUE EQUALS RESIDUAL VALUE! STOP

“Forced” annual depreciation Desired ending book value 2 Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End 1 $24,000 40% $9,600 $9,600 $14,400 2 14,400 40% 5,760 15,360 8,640 3 8,640 40% 3,456 18,816 5,184 4 5,184 40% 2,074 20,890 3,110 5 3,110 – $2,000 1,110 22,000 2,000 “Forced” annual depreciation Desired ending book value

2 If the preceding equipment was purchased and placed into service on October 1, depreciation for the year ending December 31 would be $2,400, computed as follows: $9,600 × 3/12 = $2,400

2 The depreciation for the second year would then be $8,640, computed as follows: $8,640 = [40% × ($24,000 – $2,400)]

2 Example Exercise 10-4 Example Exercise 10-4 Follow My Example 10-4 Double-Declining-Balance Depreciation Equipment acquired at the beginning of the year at a cost of $125,000 has an estimated residual value of $5,000 and an estimated useful life of 10 years. Determine the (b) double-declining-balance rate, and (c) double-declining balance depreciation for the first year. Follow My Example 10-4 a. 20% [(1/10) × 2] b. $25,000 ($125,000 × 20%) For Practice: PE 10-4A, PE 10-4B 10-51

2 Exhibit 6 Summary of Depreciation Methods

2 Exhibit 7 Comparing Depreciation Methods

Depreciation for Federal Income Tax 2 Depreciation for Federal Income Tax The Internal Revenue Code specifies the Modified Accelerated Cost Recovery System (MACRS) for use by businesses in computing depreciation for tax purposes.

2 MACRS specifies eight classes of useful life and depreciation rates for each of the eight classes. The two most common classes are the 5-year class (includes automobiles and light duty trucks) and the 7-year class (includes most machinery and equipment).

2 For the five-year-class assets, depreciation is spread over six years, as shown below.

Revising Depreciation Estimates 2 Revising Depreciation Estimates A machine purchased on January 1, 2009, for $140,000 was originally estimated to have a useful life of five years and a residual value of $10,000. The asset has been depreciated for two years using the straight-line method. $140,000 – $10,000 5 years Annual Depreciation (S/L) = $26,000 per year Annual Depreciation (S/L) = (continued)

Less accumulated depreciation ($26,000 per year × 2 years) 52,000 At the end of 2011, the asset’s book value is $88,000, determined as follows: Asset cost $140,000 Less accumulated depreciation ($26,000 per year × 2 years) 52,000 Book value, end of second year $ 88,000 (continued)

2 During 2012, the company estimates that the remaining useful life is eight years (instead of three) and that the residual value is $8,000 (instead of $10,000). Depreciation expense for each of the remaining eight years is determined as follows: Book value, end of second year $88,000 Less revised estimated residual value 8,000 Revised remaining depreciation cost $80,000 Revised annual depreciation expense [($88,000 – $8,000) ÷ 8 years] $10,000

2 Exhibit 8 Book Value of Asset with Change in Estimate

2 Example Exercise 10-5 Revision of Depreciation A warehouse with a cost of $500,000 has an estimated residual value of $120,000, an estimated useful life of 40 years, and is depreciated by the straight-line method. (a) Determine the amount of annual depreciation. (b) Determine the book value at the end of the 20th year of use. (c) If at the start of the 21st year it is estimated that the remaining life is 25 years and that the residual value is $150,000, determine the depreciation expense for each of the remaining 25 years. 10-61

2 Follow My Example 10-5 $9,500 [($500,000 – $120,000) ÷ 40] Example Exercise 10-5 (continued) 2 Follow My Example 10-5 $9,500 [($500,000 – $120,000) ÷ 40] $310,000 [$500,000 – ($9,500 × 20)] $6,400 [310,000 – $150,000) ÷ 25] For Practice: PE 10-5A, PE10-5B 10-62

Journalize entries for the disposal of fixed assets. 3 Journalize entries for the disposal of fixed assets. 10-63

Discarding Fixed Assets 3 Discarding Fixed Assets A piece of equipment acquired at a cost of $25,000 is fully depreciation at December 31, 2009. On February 14, 2010, the equipment is discarded.

3 Equipment costing $6,000, with no residual value, is depreciated at an annual straight-line rate of 10%. After the December 31, 2009, adjusting entry, Accumulated Depreciation—Equipment has a $4,750 balance. On March 24, 2010, the asset is removed from service and discarded. $600 × 3/12

3 The discarding of the equipment is then recorded as follows (note that this is the second of two entries on March 24):

3 Selling Fixed Assets Equipment was purchased at a cost of $10,000. It had no estimated residual value and was depreciated at a straight-line rate of 10%. The equipment is sold for cash on October 12 of the eighth year of its use. The balance of the accumulated depreciation account as of the preceding December 31 is $7,000.

3 The entry to update the depreciation for the nine months of the current year is as follows:

The equipment is sold on October 12 for $2,250. No gain or loss. 3 Assumption 1 The equipment is sold on October 12 for $2,250. No gain or loss.

The equipment is sold on October 12 for $1,000; a loss of $1,250. 3 Assumption 2 The equipment is sold on October 12 for $1,000; a loss of $1,250.

The equipment is sold on October 12 for $2,800; a gain of $550. 3 Assumption 3 The equipment is sold on October 12 for $2,800; a gain of $550.

3 Example Exercise 10-6 Sale of Equipment Equipment was acquired at the beginning of the year at a cost of $91,000. The equipment was depreciated using the straight-line method based upon an estimated useful life of 9 years and an estimated residual value of $10,000. What was the depreciation for the first year? Assuming the equipment was sold at the end of the second year for $78,000, determine the gain or loss on sale of the equipment. Journalize the entry to record the sale. 10-72

3 Follow My Example 10-6 $9,000 [($91,000 – $10,000) ÷ 9] Example Exercise 10-6 (continued) 3 Follow My Example 10-6 $9,000 [($91,000 – $10,000) ÷ 9] $5,000 gain: $78,000 – [$91,000 – ($9,000 × 2)] Cash…………………………………………… 78,000 Accum. Depreciation—Equipment............ 18,000 Equipment……………………………….. 91,000 Gain on Disposal of Fixed Assets…… 5,000 For Practice: PE 10-6A, PE 10-6B 10-73

Compute depletion and journalize the entry for depletion. 4 Compute depletion and journalize the entry for depletion. 10-74

4 Natural Resources The process of transferring the cost of natural resources to an expense account is called depletion.

Estimated Total Units of Resources 4 A business paid $400,000 for the mining rights to a mineral deposit estimated at 1,000,000 tons of ore. Step 1: Determine the depletion rate per ton. Cost of Resources Estimated Total Units of Resources Depletion Rate =

4 A business paid $400,000 for the mining rights to a mineral deposit estimated at 1,000,000 tons of ore. Step 1: Determine the depletion rate per ton. $400,000 1,000,000 $.40 per ton =

4 A business paid $400,000 for the mining rights to a mineral deposit estimated at 1,000,000 tons of ore. Step 2: Multiply the depletion rate by the quantity extracted during period. $0.40 per ton × $90,000 tons = $36,000

The adjusting entry to record the depletion is shown below. 4 The adjusting entry to record the depletion is shown below.

4 Example Exercise 10-7 Depletion Earth’s Treasures Mining Co. acquired mineral rights for $45,000,000. The mineral deposit is estimated at 50,000,000 tons. During the current year, 12,600,000 tons were mined and sold. Determine the depletion rate. Determine the amount of depletion expense for the current year. Journalize the adjusting entry on December 31 to recognize the depletion expense. 10-80

4 Follow My Example 10-7 $0.90 per ton = $45,000,000 ÷ 50,000,000 tons Example Exercise 10-7 (continued) 4 Follow My Example 10-7 $0.90 per ton = $45,000,000 ÷ 50,000,000 tons $11,340,000 = (12,600,000 tons × $0.90 per ton) Depletion Expense……………….. 11,340,000 Accumulated Depletion.......... 11,340,000 Depletion of mineral deposit. For Practice: PE 10-7A, PE 10-7B 10-81

5 Describe the accounting for intangible assets, such as patents, copyrights, and goodwill. 10-82

5 Intangible Assets Patents, copyrights, trademarks, and goodwill are long-lived assets that are useful in the operations of a business and not held for sale. These assets are called intangible assets because they do not exist physically.

5 Patent The exclusive right granted by the federal government to manufacturers to produce and sell goods with one or more unique features is a patent. These rights continue in effect for 20 years.

5 Amortizing a Patent At the beginning of its fiscal year, a business acquires a patent right for $100,000. Its remaining useful life is estimated at 5 years.

5 Because a patent (and other intangible assets) does not exist physically, it is acceptable to credit the asset. This approach is different from physical fixed assets that require the use of a contra asset account.

5 Copyright The exclusive right granted by the federal government to publish and sell a literary, artistic, or musical composition is a copyright. A copyright extends for 70 years beyond the author’s death.

5 Trademark A trademark is a unique name, term, or symbol used to identify a business and its products. Most businesses identify their trademarks with ® in their advertisements and on their products. Trademarks can be registered for 10 years and can be renewed every 10-year period thereafter.

5 Goodwill In business, goodwill refers to an intangible asset of a business that is created from such favorable factors as location, product quality, reputation, and managerial skill.

5 Generally accepted accounting principles permit goodwill to be recorded in the accounts only if it is objectively determined by a transaction.

5 Impaired Goodwill A loss should be recorded if the business prospects of the acquired firm (and the acquired goodwill) become significantly impaired.

5 Frequency of Intangible Asset Disclosures for 600 Firms Exhibit 9

5 Exhibit 10 Comparison of Intangible Assets

5 Example Exercise 10-8 Impaired Goodwill and Amortization of Patent On December 31 it was estimated that goodwill of $40,000 was impaired. In addition, a patent with an estimated useful economic life of 12 years was acquired for $84,000 on July 1. Journalize the adjusting entry on December 31 for the impaired goodwill. Journalize the adjusting entry on December 31 for the amortization of the patent rights. 10-94

Example Exercise 10-8 (continued) 5 Follow My Example 10-8 a. Dec. 31 Loss from Impaired Goodwill……… 40,000 Goodwill……………………………. 40,000 Impaired goodwill. b. Dec. 31 Amortization Expense—Patent……. 3,500 Patents……………………………… 3,500 Amortized patent rights [($84,000/12] × (6/12]. For Practice: PE 10-8A, PE 10-8B 10-95

6 Describe how depreciation expense is reported in an income statement and prepare a balance sheet that includes fixed assets and intangible assets. 10-96

6

6 Intangible assets are usually reported in the balance sheet, supported by a note with a separate listing. The balance in each class of intangible assets should be disclosed net of any amortization. The cost and related accumulated depletion of mineral rights are normally shown as part of the Fixed Assets section of the balance sheet.

Fixed Asset Turnover Ratio 6 Fixed Asset Turnover Ratio One measure of the revenue-generating efficiency of fixed assets is the fixed asset turnover ratio. It measures the number of dollars of revenue earned per dollar of fixed assets and is computed as follows: Fixed Asset Turnover Ratio Revenue Average Book Value of Fixed Assets =

For Marriott International, Inc. (in millions) 6 For Marriott International, Inc. (in millions) Fixed Asset Turnover Ratio Revenue Average Book Value of Fixed Assets = Fixed Asset Turnover Ratio $12,160 ($1,238 + 2,341)/2 = Fixed Asset Turnover Ratio = 6.79

Sum-of-the-Years-Digits Depreciation Appendix 1: Sum-of-the-Years-Digits Depreciation 10-101

An asset costs $24,000, has a five-year life, and an estimated salvage value of $2,000. Annual depreciation using sum-of-the-years-digits method is shown in the column shaded in yellow.

Exchanging Similar Fixed Assets Appendix 2: Exchanging Similar Fixed Assets 10-103

(see Slide 105)

Calculating the Gain Price (fair market value) of new equipment $5,000 Less assets given up in exchange: Book value of old equipment ($4,000 – $3,200) $ 800 Cash paid on the exchange 3,900 4,700 Gain on exchange of assets $ 300

Loss on Exchange of Similar Assets This time assume that only a $675 trade-in allowance was allowed towards the purchase of the new equipment. Because the market value of the new equipment is $5,000, the cash paid on the exchange amounts to $4,325.