PRINCIPLES OF ACCOUNTING II Fixed Assets and Intangible Assets CHAPTER E – 3, 4, 13, 18, 19, 20, 23, 26; P - 2A PRINCIPLES OF ACCOUNTING II Fixed Assets and Intangible Assets

1 Learning Objective Number Describe, classify, and account for the cost of fixed assets.

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.

Nature of Fixed Assets 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.

Nature of Fixed Assets Classifying Costs

Building a Restaurant Location What do you need? Most important Rent, lease, buy, or build Location Land Building Equipment Fixtures Land Improvements

Nature of Fixed Assets Costs of Acquiring Fixed Assets

Nature of Fixed Assets Costs of Acquiring Fixed Assets

Nature of Fixed Assets Costs of Acquiring Fixed Assets

Nature of Fixed Assets Costs of Acquiring Fixed Assets

These costs are expenses. Nature of Fixed Assets 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.

Exercise 10-3

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.

Capital and Revenue Expenditures CAPITAL EXPENDITURES Additions, improvements, and extraordinary repairs Normal and ordinary repairs and maintenance

Ordinary Maintenance and Repairs This is a revenue expenditure. 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. 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. 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 Used in normal operations

Exercise 10-4

Internal Revenue Service STORY The Real World Internal Revenue Service STORY The following is a true story, the names have been changed to protect the innocent

The Real World

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.

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).

Learning Objective Number Compute depreciation, using the following methods: straight-line method, units-of-production method, and double-declining balance method. 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.

Depreciation 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.

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

Depreciation 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.

Depreciation Depreciation Expense Factors

Depreciation Use of Depreciation Methods

Cost – Estimated residual value 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 =

Straight-Line Method 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

Straight-Line Method 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 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 366 367 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

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 =

Units-of-Production Method 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

Units-of-Production Method 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 =

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

Double-Declining-Balance Method 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)

Double-Declining-Balance Method 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.

Double-Declining-Balance Method 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 Fixed asset cost $24,000 and has an expected residual value of $2,000.

Double-Declining-Balance Method 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 Fixed asset cost $24,000 and has an expected residual value of $2,000.

Double-Declining-Balance Method 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 Fixed asset cost $24,000 and has an expected residual value of $2,000.

Double-Declining-Balance Method 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 Fixed asset cost $24,000 and has an expected residual value of $2,000.

Double-Declining-Balance Method 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 Fixed asset cost $24,000 and has an expected residual value of $2,000.

Double-Declining-Balance Method 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 Fixed asset cost $24,000 and has an expected residual value of $2,000.

Double-Declining-Balance Method 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 Desired ending book value “Forced” annual depreciation Fixed asset cost $24,000 and has an expected residual value of $2,000.

Double-Declining-Balance Method 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 Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End $24,000 40% $2,400 $2,400 $ 21,600

Double-Declining-Balance Method The depreciation for the second year would then be $8,640, computed as follows: $8,640 = [40% × ($24,000 – $2,400)] Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End $24,000 40% $2,400 $2,400 $ 21,600 21,600 40% 8,640 11,040 12,960 $24,000 40% $2,400 $2,400 $ 21,600

Summary of Depreciation Methods

Comparing Depreciation Methods

Exercise 10-13

Problem 10-2A

Problem 10-2A

Problem 10-2A * Book value should not be reduced below the residual value of $36,000.

Problem 10-2A

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.

Depreciation for Federal Income Tax 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).

Depreciation for Federal Income Tax For the five-year-class assets, depreciation is spread over six years, as shown below.

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)

Revising Depreciation Estimates 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)

Revising Depreciation Estimates 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

Book Value of Asset with Change in Estimate

3 Learning Objective Number Journalize entries for the disposal of fixed assets.

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.

Discarding Fixed Assets 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

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

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.

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

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

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

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

Exercise 10-18

4 Learning Objective Number Compute depletion and journalize the entry for depletion.

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

Estimated Total Units of Resources Natural Resources 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 =

Natural Resources 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 =

Natural Resources 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

Natural Resources The adjusting entry to record the depletion is shown below.

Exercise 10-19

Learning Objective Number Describe the accounting for intangible assets, such as patents, copyrights, and goodwill. 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.

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. Scotch Tape and Dollar Store

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.

Amortizing a Patent 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.

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.

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.

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.

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

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

Frequency of Intangible Asset Exhibit 9 Disclosures for 600 Firms

Comparison of Intangible Assets Exhibit 10

Exercise 10-20

Learning Objective Number Describe how depreciation expense is reported in an income statement and prepare a balance sheet 6

Balance Sheet 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 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) 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

Learning Objective Number Sum-of-the-Years-Digits Depreciation

Sum-of-the-Years-Digits Method 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.

Exercise 10-23

Learning Objective Number Exchanging Similar Fixed Assets 101

Exchanging Similar Fixed Assets

Exchanging Similar Fixed Assets Per footnote, different according to the IRS: Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031. If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized. Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets.

Exchanging Similar Fixed Assets 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

Exchanging Similar Fixed Assets 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.

Exchanging Similar Fixed Assets

Exercise 10-26

CHAPTER 10 THE END