Plant and Intangible Assets

Plant and Intangible Assets
Chapter 9 Plant and Intangible Assets

Plant Assets Plant assets represent a bundle of future services and, thus, can be thought of as long- term prepaid expenses. Plant and equipment items are classified into three groups: Tangible plant assets have physical substance. This category is further divided into two classifications: Property subject to depreciation such as buildings and equipment. Land. Generally, the only plant asset not subject to depreciation is land, which has an unlimited term of existence and whose usefulness does not decline over time. Intangible assets. The term intangible assets is used to describe assets that are used in the operation of the business but have no physical qualities and are noncurrent. Examples include patents, copyrights, trademarks, franchises, and goodwill. Current assets such as accounts receivable or prepaid rent are not included in the intangible classification, even though they also have value and are lacking in physical substance. Natural resources. A site acquired for the purpose of extracting or removing some valuable resource such as oil, minerals, or timber is classified as a natural resource, not as land. This type of plant asset is gradually converted into inventory as the natural resource is extracted from the site.

Plant Assets (concluded)
Land, which is not subject to depreciation due to its unlimited term of existence and utility that does not decline over time. Intangible assets describe assets that are used in the operation of the business but have no physical qualities and are noncurrent. Examples include patents, copyrights, trademarks, franchises, and goodwill. Natural resources include oil, minerals, and timber. Land. Generally, the only plant asset not subject to depreciation is land, which has an unlimited term of existence and whose usefulness does not decline over time. Intangible assets. The term intangible assets is used to describe assets that are used in the operation of the business but have no physical qualities and are noncurrent. Examples include patents, copyrights, trademarks, franchises, and goodwill. Current assets such as accounts receivable or prepaid rent are not included in the intangible classification, even though they also have value and are lacking in physical substance. Natural resources. A site acquired for the purpose of extracting or removing some valuable resource such as oil, minerals, or timber is classified as a natural resource, not as land. This type of plant asset is gradually converted into inventory as the natural resource is extracted from the site.

Accountable Events For all categories of plant assets, there are three primary accountable events: Acquisition Allocation of the acquisition cost to expense (with the exception of land) over the asset’s useful life (called depreciation) Sale or disposal For all categories of plant assets, there are three primary accountable events: (1) acquisition, (2) with the exception of land, allocation of the acquisition cost to expense over the asset’s useful life (depreciation), and (3) sale or disposal.

Acquisitions of Plant Assets
The cost of a plant asset includes all expenditures that are reasonable and necessary for getting the asset to the desired location and ready for use. In addition to the basic cost of the asset, other incidental costs may be included in the cost assigned to a plant asset. These include: Sales taxes on the purchase price Delivery costs Installation costs The cost of a plant asset includes all expenditures that are reasonable and necessary for getting the asset to the desired location and ready for use. In addition to the basic cost of the asset, other incidental costs may be included in the cost assigned to a plant asset. These include, for example, sales taxes on the purchase price, delivery costs, and installation costs.

Acquisition Cost: Example 1
Only reasonable and necessary costs should be included. Assume, for example, that a machine is dropped and damaged while it is being unloaded. The cost of repairing this damage should be recognized as an expense of the current period, not added to the cost of the machine. Although it is necessary to repair the machine, it was not necessary to drop it—and that’s what brought about the need for the repairs. Only reasonable and necessary costs should be included. Assume, for example, that a machine is dropped and damaged while it is being unloaded. The cost of repairing this damage should be recognized as an expense of the current period, not added to the cost of the machine. Although it is necessary to repair the machine, it was not necessary to drop it—and that’s what brought about the need for the repairs.

Acquisition Cost: Example 2
Companies often purchase plant assets on an installment plan or by issuing a note payable. Interest charges after the asset is ready for use are recorded as interest expense, not as part of the cost of the asset. But if a company constructs a plant asset for its own use, the interest charges during the construction period are considered part of the asset’s cost. Companies often purchase plant assets on an installment plan or by issuing a note payable. Interest charges after the asset is ready for use are recorded as interest expense, not as part of the cost of the asset. But if a company constructs a plant asset for its own use, the interest charges during the construction period are considered part of the asset’s cost.

Determining Cost: Example 1
A factory in Mississippi orders a machine from a Colorado tool manufacturer at a list price of $10,000. Payment will be made in 48 monthly installments of $250, which include $2,000 in interest charges. Sales taxes of $600 must be paid, as well as freight charges of $1,350. Installation and other set- up costs amount to $500. The cost of this machine to be established in the Machinery account of the purchasing company is computed as follows: List price: $10,000 Sales taxes: $600 Transportation charges: $1,350 Cost of installation and set-up: $500 Total: $12,450

Land When land is purchased, various incidental costs may be incurred in addition to the purchase price. These additional costs may include: Commissions to real estate brokers Escrow fees Legal fees for examining and insuring the title Delinquent taxes paid by the purchaser Fees for surveying, draining, clearing, and grading the property All these expenditures become part of the cost of the land. When land is purchased, various incidental costs may be incurred in addition to the purchase price. These additional costs may include commissions to real estate brokers, escrow fees, legal fees for examining and insuring the title, delinquent taxes paid by the purchaser, and fees for surveying, draining, clearing, and grading the property. All these expenditures become part of the cost of the land.

Land (concluded) Sometimes land purchased as a building site has a building on it that is not suitable for the buyer’s use. In this case, the only useful asset being acquired is the land. Therefore, the entire purchase price is charged to the Land account, as well as the costs of tearing down and removing the unusable building. Sometimes land purchased as a building site has a building on it that is not suitable for the buyer’s use. In this case, the only useful asset being acquired is the land. Therefore, the entire purchase price is charged to the Land account, as well as the costs of tearing down and removing the unusable building.

Land Improvements Land improvements have limited lives separate from the land and are subject to depreciation. For this reason, they should be recorded in a separate account entitled Land Improvements. Examples include: Driveways Fences Parking lots Landscaping Sprinkler systems Improvements to real estate such as driveways, fences, parking lots, landscaping, and sprinkler systems have limited lives separate from the land and are subject to depreciation. For this reason, they should be recorded in a separate account entitled Land Improvements.

Buildings Buildings are sometimes purchased with the intention of remodeling them prior to placing them in use. Costs incurred under these circumstances are charged to the Buildings account. After the building has been placed in use, however, ordinary repairs are considered to be maintenance expense when incurred. Buildings are sometimes purchased with the intention of remodeling them prior to placing them in use. Costs incurred under these circumstances are charged to the Buildings account. After the building has been placed in use, however, ordinary repairs are considered to be maintenance expense when incurred.

Equipment When equipment is purchased, all of the sales taxes, delivery costs, and costs of getting the equipment in good operating order are treated as part of the cost of the equipment. Once the equipment has been placed in operation, maintenance costs (including interest, insurance, and property taxes) are treated as expenses of the current period. When equipment is purchased, all of the sales taxes, delivery costs, and costs of getting the equipment in good operating order are treated as part of the cost of the equipment. Once the equipment has been placed in operation, maintenance costs (including interest, insurance, and property taxes) are treated as expenses of the current period.

Allocation of a Lump-Sum Purchase
Several different types of plant assets may be purchased at one time. Separate asset accounts are maintained for each type of plant asset, such as land, buildings, and equipment. When land and buildings (and perhaps other assets) are purchased for a lump sum, the purchase price must be allocated among the types of assets acquired. An appraisal may be needed for this purpose. Several different types of plant assets may be purchased at one time. Separate asset accounts are maintained for each type of plant asset, such as land, buildings, and equipment.1 When land and buildings (and perhaps other assets) are purchased for a lump sum, the purchase price must be allocated among the types of assets acquired. An appraisal may be needed for this purpose.

Lump-Sum Purchase: Example
Assume, for example, that Exercise-for-Health, Inc., purchases a complete fitness center from Golden Health Spas. Exercise- for-Health purchases the entire facility at a bargain price of $800,000. The allocation of this cost on the basis of an appraisal is illustrated as follows.

Lump-Sum Purchase: Example (concluded)
Assuming that Exercise-for-Health purchased this facility for cash, the journal entry to record this acquisition would be as follows.

Your Turn: Facility Manager
Assume you have been hired as manager of the new Golden Health Spas facility that was recently purchased by Exercise-for-Health. One of your responsibilities as manager is to show that the facility is profitable. In fact, your contract specifies a bonus for you if the profits are at least 10 percent above the budgeted amount each year. In a recent conversation with the appraiser, it became clear to you that some of the items classified as land in the appraisal were really building improvements. No one at Exercise-for-Health is aware of this misclassification. As a result, the appraised value for the building asset account should be $350,000 instead of $300,000. When budgeted profits for the Golden Health Spas facility are computed each year, a charge for depreciation on the building is deducted in determining the amount of profit. What impact does the improper appraisal have on your ability to achieve the bonus? What should you do?

Capital and Revenue Expenditures
Capital Expenditures Recorded in asset accounts. Include the purchase or expansion of plant assets. Revenue Expenditures Recorded in expense accounts. Include ordinary repairs, maintenance, fuel, and other items necessary to the ownership and use of plant and equipment. Expenditures for the purchase or expansion of plant assets are called capital expenditures and are recorded in asset accounts. Accountants often use the word capitalize to mean charging an expenditure to an asset account rather than to an expense account. Expenditures for ordinary repairs, maintenance, fuel, and other items necessary to the ownership and use of plant and equipment are called revenue expenditures and are recorded in expense accounts. The charge to an expense account is based on the assumption that the benefits from the expenditure will be used up in the current period, and therefore the cost should be deducted from the revenue of the period in determining the net income. Charging an expenditure directly to an expense account is often called “expensing” the item. A business may purchase many small items that will benefit several accounting periods but that have a relatively low cost. Examples of such items include auto batteries, hand tools, wastebaskets, and pencil sharpeners. Such items are theoretically capital expenditures, but if they are recorded as assets in the accounting records, it will be necessary to compute and record the related depreciation expense in future periods. We have previously mentioned the idea that the extra work involved in developing more precise accounting information should be weighed against the benefits that result. For reasons of convenience and economy, expenditures that are not material in dollar amount are treated in the accounting records as expenses of the current period. In brief, any material expenditure that will benefit several accounting periods is considered a capital expenditure. Any expenditure that will benefit only the current period or that is not material in amount is treated as a revenue expenditure. Many companies develop formal policies defining capital and revenue expenditures as a guide toward consistent accounting practice from year to year. These policy statements often set a minimum dollar amount (such as $500) for expenditures that are to be capitalized, regardless of the expected useful life of the asset.

The Depreciation Process
The allocation of the cost of a plant asset to expense in the periods in which services are received from the asset. EXHIBIT 9–1 The Depreciation Process Depreciation is a process of cost allocation. The cost of an asset is allocated to expense over its useful life in some rational and systematic manner. Do not confuse asset valuation, an economic concept, with allocation. The unused portion of the asset’s cost appears on the balance sheet. A portion of the cost is allocated to expense on the income statement each accounting period. The journal entry to record depreciation expense consists of a debit to Depreciation Expense and a credit to Accumulated Depreciation. The credit portion of the entry removes from the balance sheet that portion of the asset’s cost estimated to have been used up during the current period. The debit portion of the entry allocates this expired cost to expense. Separate Depreciation Expense and Accumulated Depreciation accounts are maintained for different types of depreciable assets, such as factory buildings, delivery equipment, and office equipment. These separate accounts help accountants to measure separately the costs of different business activities, such as manufacturing, sales, and administration.

Depreciation Terms Book Value Cost – Accumulated Depreciation
Contra-asset Represents the portion of an asset’s cost that has already been allocated to expense Causes of Depreciation Physical deterioration Obsolescence Plant assets are shown in the balance sheet at their book values (or carrying values). The book value of a plant asset is its cost minus the related accumulated depreciation. Accumulated Depreciation is a contra-asset account, representing that portion of the asset’s cost that has already been allocated to expense. Book value represents the portion of the asset’s cost that remains to be allocated to expense in future periods. CAUSES OF DEPRECIATION The need to systematically spread or allocate plant asset costs over multiple accounting periods arises from two major causes: (1) physical deterioration and (2) obsolescence. Physical Deterioration Physical deterioration of a plant asset results from use, as well as from exposure to sun, wind, and other climatic factors. When a plant asset has been carefully maintained, it is not uncommon for the owner to claim that the asset is as “good as new.” Such statements are not literally true. Although a good repair policy may lengthen the useful life of a machine, every machine eventually reaches the point at which it must be discarded. Making repairs does not eliminate the need for recognition of depreciation. Obsolescence The term obsolescence refers to the process of an asset’s becoming out of date as a result of improved, more efficient assets becoming available. An airplane, for example, may become obsolete even though it is in excellent physical condition; it becomes obsolete because better planes of superior design and performance become available. Now, let’s look at some common methods of calculating depreciation expense.

Straight-Line Depreciation
The straight-line method allocates an equal portion of depreciation expense to each period of the asset’s expected useful life. Most of the other depreciation methods are various forms of accelerated depreciation. Cost − Residual Value Years of Useful Life Depreciation Expense per Year = Regardless of the method used to calculate depreciation expense, three variables must be known: (1) the asset’s cost, (2) the estimated residual value expected to be received at the end of its useful life, and (3) the estimated useful life of the asset. When using the straight-line method, depreciation expense is calculated by taking cost minus residual value and dividing by the years of useful life. Let’s see how this works.

Straight-Line Vs. Accelerated
Over the entire life of the asset, however, both the straight-line method and accelerated methods recognize the same total amount of depreciation. EXHIBIT 9–2 Straight-Line and Accelerated Depreciation Methods There are several accelerated methods, each producing slightly different results. Different depreciation methods may be used for different assets. The depreciation methods in use should be disclosed in notes accompanying the financial statements. In this section, we illustrate and explain straight-line depreciation and one variation of the most widely used accelerated method, which is called fixed-percentage-of-declining-balance, or simply the declining-balance method. Other depreciation methods are discussed briefly in the section that follows.

Straight-Line Depreciation: Example
On January 2, S&G Wholesale Grocery acquires a new delivery truck. The truck cost $17,000, has an estimated residual value of $2,000, and an estimated useful life of five years. Compute annual depreciation using the straight-line method. On January 2, S&G Wholesale Grocery acquires a new delivery truck. The truck cost $17,000, has an estimated residual value of $2,000, and an estimated useful life of 5 years. Compute annual depreciation using the straight-line method. This calculation was relatively easy. Did you get the annual depreciation of $3,000? Now let’s look at a schedule of the annual depreciation over the life of the asset.

Straight-Line Depreciation: Example (cont.)
S&G will record $3,000 depreciation each year for five years. Total depreciation over the estimated useful life of the equipment is: Notice that depreciation expense is the same amount in each of the 5 years. If this amount was plotted on a graph, it would be a straight-line. That is how the name for this method was determined. Accumulated depreciation increases by $3,000 each year. The cost of the asset less accumulated depreciation at the end of any year is called book value. Book value decreases by $4,200 each year. At the end of the asset’s useful life, the book value is equal to the estimated residual value. This should be true regardless of the method used. The book value (cost less accumulated depreciation) is presented as an asset in the statement of financial position (balance sheet). Notice that the depreciation expense over the life of the truck totals $15,000—the cost of the truck minus the estimated residual value. The residual value is not part of the cost “used up” in business operations. Instead, the residual value is expected to be recovered in cash upon disposal of the asset. In practice, residual values may be ignored if they are not expected to be material in amount. Office equipment, furniture, fixtures, and special-purpose equipment seldom are considered to have significant residual values. Assets such as vehicles, aircraft, and construction equipment, in contrast, often do have residual values that are material in amount. Salvage Value

Depreciation for Fractional Periods
When an asset is acquired during the year, depreciation in the year of acquisition must be prorated. Half-Year Convention In the year of acquisition, record six months of depreciation. Thus far, this chapter has covered the depreciation of an asset purchased on January 1. However, relatively few assets will actually be purchased on January 1. One way to determine depreciation for assets purchased throughout the year is to use the half-year convention. Using this convention, in the year of acquisition, a company would record half a year, or six months, of depreciation.

Half-Year Convention Using the half-year convention, assume that an insurance company purchases hundreds of desktop computers throughout the current year at a total cost of $600,000. The company depreciates these computers by the straight-line method, assuming a three-year life and no residual value. Using the half-year convention, assume that an insurance company purchases hundreds of desktop computers throughout the current year at a total cost of $600,000. The company depreciates these computers by the straight-line method, assuming a three-year life and no residual value. Using straight-line depreciation, the depreciation expense for an entire year would be $200,000. This amount is determined by taking cost less residual value and dividing it by the useful life. Since the company uses the half-year convention, divide the annual depreciation in half for the first year. The depreciation expense for current period would be $100,000. If the company did not use the half-year convention, depreciation would have to be computed separately for computers purchased in different months. Depreciation = ($600,000 − $0) ÷ 3 = $200,000 for a full year Depreciation = $200,000 × 1/2 = $100,000

Declining-Balance Method
Depreciation in the early years of an asset’s estimated useful life is higher than in later years. There are several appealing reasons to use a declining-balance method for depreciation. One reason to consider the declining-balance method is to better match depreciation expense with revenue generated. The idea is that a newer asset will generate more revenue in early years rather than later years, so depreciation expense should be higher in the early years of ownership and less in later years. Another reason that the declining-balance method is appealing to use for financial statement reporting is that it is similar to the depreciation method used for tax purposes. Calculating depreciation expense under the double-declining-balance method is a three-step process. The first step is to calculate the straight-line depreciation rate. Do this by dividing 100 percent by the asset’s useful life. The second step is to calculate the double-declining-balance rate, which is done by multiplying the straight-line rate times two. The third and final step is to determine depreciation expense. Multiply the double-declining rate times the book value of the asset at the beginning of the period. Under the double-declining-balance method, estimated residual value is ignored. Let’s look at an example. The double-declining-balance depreciation rate is 200 percent of the straight-line depreciation rate of (1 ÷ Useful Life).

Declining-Balance Method: Example
On January 2 , S&G buys a new delivery truck paying $17,000 cash. The truck has an estimated residual value of $2,000 and an estimated useful life of five years. Compute depreciation for the first year using the double-declining-balance method. On January 2, S&G Wholesale Grocery purchased a truck for $17,000. The estimated useful life is five years and the estimated residual value is $2,000. The first step is to calculate the straight-line depreciation rate. Recall that this is done by dividing 100 percent by the asset’s useful life. In this case divide 100 percent by the five-year useful life to get a straight-line rate of 20 percent. The second step is to calculate the double-declining-balance rate. Do this by multiplying the straight-line rate times two. In this case that would be 20 percent times two, or 40 percent. The third and final step is to determine depreciation expense. Multiply the double-declining rate times the book value of the asset at the beginning of the period. In this case, multiply the beginning book value (cost less accumulated depreciation) of $17,000 by 40 percent. Depreciation expense for the first year is $6,800. Remember, under the double-declining-balance method, ignore estimated salvage value in calculations.

Declining-Balance Method: Example (cont.)
Total depreciation over the estimated useful life of an asset is the same using either the straight-line method or the declining-balance method. While book value should always be equal to the estimated salvage value at the end of an asset’s useful life, it just will not work properly using the double-declining-balance method. In this case, the book value at the end of the fifth year needs to be equal to $2,000, the estimated residual value. The only way that can work is to force depreciation expense in the last year to be the amount needed to bring book value down to residual value. Depreciation expense will be recorded at $203 in the fifth year. This amount is determined by subtracting the salvage value of $2,000 from the book value at the end of fourth year, $2,203. Notice that no matter which depreciation method is used, the total depreciation taken at the end of an asset’s life will be the same. In this case, for both the straight-line method and the double-declining-balance method, total depreciation taken is $15,000.

Which Depreciation Methods Do Most Businesses Use?
The majority of publicly owned companies use straight-line depreciation in their financial statements. Accounting principles and income tax laws both permit companies to use different depreciation methods in their financial statements and their income tax returns. Many companies use straight-line depreciation in their financial statements and accelerated methods in their income tax returns. Many businesses use the straight-line method of depreciation in their financial statements and accelerated methods in their income tax returns. The reasons for these choices are easy to understand. Accelerated depreciation methods result in higher charges to depreciation expense early in the asset’s life and, therefore, lower reported net income than straight-line depreciation. Most publicly owned companies want to appear as profitable as possible—certainly as profitable as their competitors. Therefore, the majority of publicly owned companies use straight-line depreciation in their financial statements. For income tax purposes, it’s a different story. Management wants to report the lowest possible taxable income in the company’s income tax returns. Accelerated depreciation methods can substantially reduce both taxable income and tax payments for a period of years.4 Accounting principles and income tax laws both permit companies to use different depreciation methods in their financial statements and their income tax returns. Therefore, many companies use straight-line depreciation in their financial statements and accelerated methods (variations of the declining-balance method) in their income tax returns.

Financial Statement Disclosures
Estimates of Useful Life and Residual Value May differ from company to company. The reasonableness of management’s estimates is evaluated by external auditors. Principle of Consistency Companies should avoid switching depreciation methods from period to period. Auditors review management’s estimates for useful lives and residual values for reasonableness. The principle of consistency ensures that companies avoid switching depreciation methods from period to period, unless there is a compelling reason for the change.

Revision of Estimated Useful Lives
Q: What should be done if, after a few years of using a plant asset, management decides that the asset actually is going to last for a longer or shorter period than was originally estimated? A: When this situation arises, a revised estimate of useful life should be made and the periodic depreciation expense decreased or increased accordingly.

Revising Depreciation Rates: Example
Assume that a company acquires a $10,000 asset estimated to have a five-year useful life and no residual value. At the beginning of the fourth year, management decides that the asset will last for five more years. The revised estimate of useful life is, therefore, a total of eight years. Calculate depreciation expense for the fourth year and for each of the remaining years. In this example, a company purchased an asset on January 1, for $10,000. The asset is estimated to have a five-year useful life and no salvage value at the end of its useful life. The company uses the straight-line method and begins recording depreciation on this asset. At the beginning of the fourth year, management decides that the asset will last for five more years. The revised estimate of useful life is, therefore, a total of eight years. Depreciation expense for three years has already been recorded, so there are five years remaining in the equipment’s useful life. In this case, accountants take the book value at the date of revision of the estimate, which is $4,000. 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 year four.

Revising Depreciation Rates: Example (cont.)
Book Value at Date of Change Salvage Value at Date of Change Remaining useful life at date of change – The asset had a cost of $10,000 and a five-year useful life with no salvage value. Under straight-line depreciation, $2,000 of expense is recorded in each of the first three years. The original cost of the asset was $10,000. Accumulated depreciation has a balance of $6,000 at the beginning of the fourth year. The remaining book value is $4,000 and the remaining useful life of the asset is five years, so depreciation for each of those five years will be $800.

Impairment of Plant Assets
If the carrying amount of an asset cannot be recovered through future use or sale, the asset should be written down to its fair value and an impairment loss recognized. For example, a computer manufacturer may have paid a high price to acquire specialized production equipment. If new technology renders the equipment obsolete, however, it may become apparent that the equipment is worth less than the amount it is carried in the accounting records. A company may determine that it cannot reasonably expect to recover the carrying amount of certain plant assets, either through use or through sale. For example, a computer manufacturer may have paid a high price to acquire specialized production equipment. If new technology renders the equipment obsolete, however, it may become apparent that the equipment is worth less than the amount it is carried in the accounting records. If the carrying amount of an asset cannot be recovered through future use or sale, the asset should be written down to its fair value and an impairment loss recognized.

Case in Point A recent balance sheet of JCPenney includes $5,148 million of property and equipment. This represents approximately 49 percent of the company’s reported assets. A note to the financial statements indicates that the company evaluates long-lived assets, such as store property and equipment and other corporate assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of those assets may not be recoverable. Factors that may trigger an impairment review include significant underperformance relative to historical or projected operating results, significant changes in the manner of use of the assets, and changes in the company’s overall business strategies. The amount of the impairment loss represents the excess of the carrying value (i.e., book value) of the asset over its fair value.

Units-of-Output Depreciation Method
Under the units-of-output method, depreciation is based on some measure of output rather than on the passage of time. When depreciation is based on units of output, more depreciation is recognized in the periods in which the assets are most heavily used.

Units-of-Output: Example
Consider Marpole Company’s delivery truck, which cost $35,000 and has an estimated salvage value of $5,000. Assume that Marpole’s management plans to retire this truck after it has been driven 60,000 miles. The depreciation rate per mile of operation is 50 cents, computed as follows.

Units-of-Output: Example (cont.)
At the end of each year, the amount of depreciation to be recorded is determined by multiplying the 50-cent rate by the number of miles the truck was actually driven during the year. After the truck has gone 60,000 miles, it is fully depreciated, and the depreciation process is stopped. For example if the truck is driven 17,000 miles in a year, $8,500 depreciation expense is recognized (17,000 miles × $0.50 = $8,500). KEY POINT This method provides an excellent matching of expense with revenue when the total units of output can be determined with reasonable accuracy. This method is used only for assets such as vehicles and certain types of machinery whose use can be measured in miles, machine hours, or some other measure of use.

MACRS Most businesses use MACRS (Modified Accelerated Cost Recovery System) in their federal income tax returns. Some small businesses also use this method in their financial statements, so they do not have to compute depreciation in several different ways. KEY POINT For publicly traded companies, the use of MACRS in financial statements is usually not considered to be in conformity with generally accepted accounting principles.

Sum-of-the-Years’ Digits Method
Sum-of-the-years’ digits, or SYD, is a form of accelerated depreciation that generally produces results that lie between the double-declining- balance and 150 percent declining-balance methods. SYD is rarely used in today’s business world. Because of its complexity, it is even less frequently used in small businesses. SYD is seldom used for income tax purposes. For these reasons, we defer coverage of the mechanics of this method to later accounting courses.

Disposal of Plant and Equipment
Update depreciation to the date of disposal. Journalize disposal by: Recording cash received (debit). Recording a gain (credit) or loss (debit). When a plant asset is disposed of, the first thing to do is update depreciation to the date of disposal. After completing the update, the journal entry can be created. The journal entry begins by the recording of a debit to the Cash account, if cash was received, or credit to the Cash account, if cash was paid by the company. In addition, it must be determined 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. The entry is completed by removing the plant asset’s cost from the books with a credit, and removing the related accumulated depreciation with a debit. Let’s see how to calculate the gain or loss associated with the disposal. Removing accumulated depreciation (debit). Removing the asset cost (credit).

Disposal of Plant and Equipment (cont.)
If Cash > BV, record a gain (credit). If Cash < BV, record a loss (debit). If Cash = BV, no gain or loss. Recording cash received (debit). Recording a gain (credit) or loss (debit). 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’s look at a specific example of disposal of a plant asset. Removing accumulated depreciation (debit). Removing the asset cost (credit).

Disposal: Example Assume that a machine costing $10,000 had accumulated depreciation of $8,000 and book value of $2,000 (10,000 − $8,000) at the time it was sold for $3,000 cash. Determine the gain or loss on sale of this machine. Assume that a machine costing $10,000 had accumulated depreciation of $8,000 and book value of $2,000 (10,000 − $8,000) at the time it was sold for $3,000 cash. Determine the gain or loss on sale of this machine. Remember that to determine gain or loss on disposal of an asset we compare the asset’s book value to the proceeds from the disposal. In this case, the cash received was more than the book value of the asset, so we have a gain on the sale of this machine of $1,000. Now, let’s look at the entry to record the sale of the assets. Cost of machine $ 10,000 Accumulated depreciation (8,000) Book value at time of sale 2,000 Cash received 3,000 Gain on sale of machine $ 1,000

Disposal: Example (cont.)
Assume that a machine costing $10,000 had accumulated depreciation of $8,000 and book value of $2,000 (10,000 − $8,000) at the time it was sold for $3,000 cash. Determine the gain or loss on sale of this machine. To record the disposal of the machine we debit Cash for $3,000, debit to Accumulated Depreciation on the machine for $8,000, a credit to Machinery for $10,000, and a credit to Gain on Disposal of Plant Asset for $1,000. Whenever we dispose of a depreciable asset, the entry to record the disposal will always have a debit to accumulated depreciation and a credit to the asset.

Trading in Used Assets for New Ones
Assume that Rancho Landscape exchanges an old truck for a new truck costing $25,000. They received $3,500 trade-in allowance on the old truck, which had a book value of $2,000. Rancho pays the remaining $21,500 cost of the new truck in cash. Assume that Rancho Landscape exchanges an old truck and $21,500 cash for a new truck. They received $3,500 trade-in allowance on the old truck, which had a book value of $2,000. The new truck has a cost of $25,000. The first thing we need to determine is whether a gain or loss will result.

Trading in Used Assets for New Ones: Example
Because there were no cash proceeds from the disposal of the old truck, we determine the gain or loss by comparing the asset’s book value to its fair market value. In this case, the old truck has a book value of $2,000 and a fair market value of $3,500. Because fair market value is greater than the book value, we have a $1,500 gain on the disposal of the old truck. Begin by recording the parts of the journal entry that are known. The old truck is being given up, so we debit Accumulated Depreciation for $8,000, and credit the old Vehicles account for $10,000. Next, we credit Cash for $21,500 because it is being given up in the exchange, and we credit Gain on Disposal of Asset for $1,500. Now, just debit the new Vehicles account for $25,000. This $25,000 represents the fair value of the assets given up in the exchange: Cash of $21,500 plus the fair market value of the old truck trade-in value of $3,500.

International Financial Reporting Standards
Under international accounting standards, companies have an option to follow a revaluation process rather than continuing to use historical cost throughout the asset’s useful life. This revaluation alternative requires that an asset’s fair value can be reliably measured and it must be applied to an entire class of plant assets. Under international accounting standards, companies have an option to follow a revaluation process rather than continuing to use historical cost throughout the asset’s useful life. This revaluation alternative requires that an asset’s fair value can be reliably measured and it must be applied to an entire class of plant assets. If an asset’s carrying amount is increased as a result of a revaluation, the increase is recorded in other comprehensive income and accumulated equity. If an asset’s carrying amount is increased as a result of a revaluation, the increase is recorded in other comprehensive income and accumulated equity.

Intangible Assets: Characteristics
Intangible assets are long-term assets with no physical substance. They are used in the operation of the business to generate income. The valuation basis is cost. Common examples include: Patents Trademarks Goodwill As the word intangible suggests, assets of this type have no physical characteristics. Common examples are patents, trademarks, and goodwill. Intangible assets are classified in the balance sheet as a subgroup of plant assets. However, not all assets that lack physical substance are regarded as intangible assets. An account receivable, for example, has no physical attributes but is classified as a current asset and is not regarded as an intangible. Intangible assets are assets that are used in the operation of the business but that have no physical substance and are noncurrent. The basis of valuation for intangible assets is cost. In some companies, however, certain intangible assets such as trademarks may be of great importance but may have been acquired without incurring any significant cost. These intangible assets appear in the balance sheet at their cost, regardless of their value to the company. Intangible assets are listed only if significant costs are incurred in their acquisition or development. If these costs are insignificant, they are treated as revenue expenditures (ordinary expenses).

Operating Expenses Vs. Intangible Assets
For an expenditure to qualify as an intangible asset, there must be reasonable evidence of future benefits. Many expenditures offer some prospects of yielding benefits in subsequent years, but the existence and life span of these benefits are so uncertain that most companies treat these expenditures as operating expenses. For an expenditure to qualify as an intangible asset, there must be reasonable evidence of future benefits. Many expenditures offer some prospects of yielding benefits in subsequent years, but the existence and life span of these benefits are so uncertain that most companies treat these expenditures as operating expenses. Examples are the expenditures required to reorganize a business and the expense of training employees to work with new types of machinery or office equipment. There is little doubt that some benefits from these outlays continue beyond the current period, but because of the uncertain duration of the benefits, it is almost universal practice to treat expenditures of this nature as an expense of the current period.

Amortization The term amortization describes the systematic write-off to expense of the cost of an intangible asset over its useful life. Amortization of an intangible asset is essentially the same as depreciation for a tangible asset. The usual accounting entry for amortization consists of a debit to Amortization Expense and a credit to the intangible asset account. The term amortization describes the systematic write-off to expense of the cost of an intangible asset over its useful life. Amortization of an intangible asset is essentially the same as depreciation for a tangible asset. The usual accounting entry for amortization consists of a debit to Amortization Expense and a credit to the intangible asset account. There is no theoretical objection to crediting an accumulated amortization account rather than the intangible asset account, but this method is seldom encountered in practice.

Amortization (concluded)
Although it is difficult to estimate the useful life of an intangible such as a trademark, like most plant assets it is probable that such an asset will not contribute to future earnings on a permanent basis. The cost of the intangible asset should, therefore, be deducted from revenue during the years in which it may be expected to aid in producing revenue. The straight-line method normally is used for amortizing intangible assets. Although it is difficult to estimate the useful life of an intangible such as a trademark, like most plant assets it is probable that such an asset will not contribute to future earnings on a permanent basis. The cost of the intangible asset should, therefore, be deducted from revenue during the years in which it may be expected to aid in producing revenue. The straight-line method normally is used for amortizing intangible assets.

Goodwill Goodwill represents an amount that a company has paid to acquire certain favorable intangible attributes as part of an acquisition of another company. Positive attributes often included in goodwill are: Favorable reputation Positive market share Positive advertising image Reputation for high quality and loyal employees Superior management Manufacturing and other operating efficiency The intangible asset goodwill is often found in corporate balance sheets. While this word has a variety of meanings in our general vocabulary, it has a specific and specialized meaning in financial reporting. Goodwill represents an amount that a company has paid to acquire certain favorable intangible attributes as part of an acquisition of another company. For example, assume a company purchases another company that has a favorable reputation for high-quality customer service. The purchasing company might be willing to pay a premium price to acquire this favorable attribute because of the positive impact this customer service is expected to have on future profitability. Even though an intangible asset such as a favorable reputation for customer service lacks the physical qualities of land, buildings, and equipment, such service may be just as important for the future success of a company. Goodwill is a general term that encompasses a wide variety of favorable attributes expected to permit the acquiring company to operate at a greater-than-normal level of profitability. Positive attributes often included in goodwill are: Favorable reputation. Positive market share. Positive advertising image. Reputation for high quality and loyal employees. Superior management. Manufacturing and other operating efficiency. All of these attributes can be expected to contribute to positive future cash flows of the acquiring company. The present value of future cash flows is the amount that a knowledgeable investor would pay today for the right to receive those future cash flows. (The present value concept is discussed further in later chapters and in Appendix B.) Goodwill is sometimes described and measured as the price paid to receive an above-normal return on the purchase of another company’s net identifiable assets. Net assets refers to assets minus liabilities, or owners’ equity. Goodwill is not a separately identifiable asset, however, and the existence of goodwill is implied by the ability of the entire business to earn an above-average return. The term net identifiable assets is used to mean all assets except goodwill, minus liabilities. A normal return on net identifiable assets is the rate of return that investors demand in a particular industry to justify purchasing a business at the fair value of its net identifiable assets. A business has goodwill when investors pay an even higher price because the business is expected to earn more than the normal rate of return.

International Case in Point
Goodwill was identified as a topic for harmonization efforts when the FASB and the International Accounting Standards Board (IASB) agreed to work toward convergence of reporting requirements in 2002, an effort that continues today and will undoubtedly continue for years to come. U.S. GAAP requires capitalization of goodwill but no amortization. Instead, goodwill is reviewed annually and its value is adjusted if subject to impairment. Until March 2004, international standards required goodwill to be capitalized and amortized over its estimated useful life (20 years or less). In 2004, the IASB changed international standards for goodwill to be consistent with the U.S. GAAP approach by requiring an impairment test rather than amortization for goodwill.

Patents A patent is an exclusive right granted by the federal government for manufacture, use, and sale of a particular product. The purpose of this exclusive grant is to encourage the invention of new products and processes. When a company acquires a patent by purchase from the inventor or other holder, the purchase price is recorded in an intangible asset account Patents. Patents are granted for 20 years, and the period of amortization should not exceed that period. However, if the patent is likely to lose its usefulness in less than 20 years, amortization is based on the shorter estimated useful life. A patent is an exclusive right granted by the federal government for manufacture, use, and sale of a particular product. The purpose of this exclusive grant is to encourage the invention of new products and processes. When a company acquires a patent by purchase from the inventor or other holder, the purchase price is recorded in an intangible asset account Patents. Patents are granted for 20 years, and the period of amortization should not exceed that period. However, if the patent is likely to lose its usefulness in less than 20 years, amortization is based on the shorter estimated useful life.

Patent: Example Assume that a patent is purchased from the inventor at a cost of $100,000 after five years of the legal life have expired. The remaining legal life is, therefore, 15 years. But if the estimated useful life is only eight years, amortization is based on this shorter period. The entry to record the annual amortization expense would be as follows.

Trademarks and Brand Names
Coca-Cola’s famous name, usually printed in a distinctive typeface, is a classic example of a trademark known around the world. A trademark is a name, symbol, or design that identifies a product or group of products. A permanent exclusive right to use a trademark, brand name, or commercial symbol may be obtained by registering it with the federal government.

Trademarks and Brand Names (cont.)
The costs of developing a trademark or brand name often consist of advertising campaigns, which should be treated as expenses when incurred. KEY POINT If a trademark or brand name is purchased, however, the cost may be substantial. Such cost is capitalized and amortized to expense over the time period the trademark or brand name is expected to be used. If the use of the trademark is discontinued or its contribution to earnings becomes doubtful, any unamortized cost is written off immediately.

Franchises A franchise is a right granted by a company or a governmental unit to conduct a certain type of business in a specific geographical area. An example of a franchise is the right to operate a McDonald’s restaurant in a specific geographic region. The cost of franchises varies greatly and often is quite substantial.

Franchises (cont.) When the cost of a franchise is small, it may be charged immediately to expense or amortized over a short period such as five years. When the cost is material, amortization is based on the life of the franchise (if defined by the franchise agreement); the amortization period, however, should not exceed the period the franchise is expected to generate revenue.

Copyrights A copyright is an exclusive right granted by the federal government to protect the production and sale of literary or artistic materials for the life of the creator plus 70 years. The cost of obtaining a copyright may be minor and therefore is chargeable to expense when paid. Only when a copyright is purchased from an existing owner will the expenditure be material enough to warrant its being capitalized and spread over the useful life. A copyright is an exclusive right granted by the federal government to protect the production and sale of literary or artistic materials for the life of the creator plus 70 years. The cost of obtaining a copyright may be minor and therefore is chargeable to expense when paid. Only when a copyright is purchased from an existing owner will the expenditure be material enough to warrant its being capitalized and spread over the useful life. The revenue from copyrights is usually limited to only a few years, and the purchase cost is amortized over the years in which the revenue is expected.

Research and Development (R&D) Costs
Companies spend billions of dollars each year on research and development of new products. The annual research and development expenditures of some companies often exceed $1 billion and account for a substantial percentage of their total costs and expenses. Companies spend billions of dollars each year on research and development of new products. In fact, R&D is a defining characteristic of U.S. industry. The annual research and development expenditures of some companies often exceed $1 billion and account for a substantial percentage of their total costs and expenses. In the past, some companies treated all research and development costs as expenses in the year incurred; other companies recorded these costs as intangible assets and amortized them over future years. This diversity of practice prevented financial statements of different companies from being comparable. The Financial Accounting Standards Board standardized accounting for R&D when it ruled that as a general rule research and development expenditures are required to be charged to expense when incurred. This action by the FASB had the beneficial effect of reducing the number of alternative accounting practices and helping to make financial statements of different companies more comparable. KEY POINT The Financial Accounting Standards Board standardized accounting for R&D when it ruled that as a general rule research and development expenditures are required to be charged to expense when incurred.

Your Turn: Financial Analyst
You are working as an equity analyst on Wall Street and a college intern asks you to explain why companies can differ greatly in the R&D expense to net sales ratio. How do you respond?

Accounting for Natural Resources
The distinguishing characteristic of natural resources is that they are physically removed from their natural environment and converted into inventory. Examples include: Mining properties Oil Gas reserves Tracts of timber Mining properties, oil and gas reserves, and tracts of standing timber are examples of natural resources. The distinguishing characteristic of these assets is that they are physically removed from their natural environment and are converted into inventory.

Natural Resource: Example
Theoretically, a coal mine might be regarded as an underground inventory of coal; however, such an inventory is certainly not a current asset. In the balance sheet, mining property and other natural resources are classified as property, plant, and equipment. Once the coal is removed from the ground, however, this coal does represent inventory. Theoretically, a coal mine might be regarded as an underground inventory of coal; however, such an inventory is certainly not a current asset. In the balance sheet, mining property and other natural resources are classified as property, plant, and equipment. Once the coal is removed from the ground, however, this coal does represent inventory.

Depletion of Natural Resources
A mine or an oil reserve does not depreciate, but it is gradually depleted as the natural resource is removed from the ground. Once all of the coal has been removed from a coal mine, for example, the mine is fully depleted and will be abandoned or sold for its residual value. We have explained that plant assets such as buildings and equipment depreciate because of physical deterioration or obsolescence. A mine or an oil reserve does not depreciate for these reasons, but it is gradually depleted as the natural resource is removed from the ground. Once all of the coal has been removed from a coal mine, for example, the mine is fully depleted and will be abandoned or sold for its residual value.

Depletion: Example Rainbow Minerals pays $48 million to acquire the Red Valley Mine, which is believed to contain 5 million tons of coal. The residual value of the mine after all of the coal is removed is estimated to be $8 million. The depletion that will occur over the life of the mine is the original cost minus the residual value, or $40 million. This depletion will occur at the rate of $8 per ton ($40 million ÷ 5 million tons) as the coal is removed from the mine. If we assume that 2 million tons are mined during the first year of operations, the entry to record the depletion of the mine would be as follows.

Depletion: Example (concluded)
As the coal is sold, this cost is transferred from the Inventory account to the Cost of Goods Sold account. Accumulated Depletion is a contra-asset account similar to the Accumulated Depreciation account; it represents the portion of the mine that has been used up (depleted) to date. In Rainbow Minerals’s balance sheet, the Red Valley Mine now appears as follows.

Plant Transactions and the Statement of Cash Flows
Cash flows relating to acquisitions and disposals of plant assets appear in the statement of cash flows, classified as investing activities. Depreciation and amortization expense both reduce net income, but they have no effect on cash flows. As a result, both tend to make net income less than the net cash flows from operating activities. Likewise, the write-down of impaired assets is another example of a noncash charge or expense against income having no immediate effect on cash flows.

Noncash Investing Activities
Not all purchases and sales of plant assets result in cash payments or cash receipts during the current accounting period. For example, a company may finance the purchase of plant assets by issuing notes payable, or it may sell plant assets in exchange for notes receivable. The noncash aspects of investing and financing activities are summarized in a special schedule that accompanies a statement of cash flows.

Ethics, Fraud, & Corporate Governance
The largest instance of fraudulent financial reporting in U.S. history was primarily due to improper capitalization of operating expenditures. WorldCom Inc. (WorldCom) from as early as through the first quarter of 2002 overstated its reported income by approximately $11 billion, including approximately $7 billion of ordinary operating expenses that were improperly capitalized. The revelation of the fraud led to WorldCom’s filing for protection from its creditors under the provisions of the U.S. Bankruptcy Code. Although the fraud at Enron had prompted congressional interest in auditing, financial reporting, and corporate governance, by the spring of 2002 congressional efforts to draft a law in response to the Enron fraud had stalled due to disagreements between the two houses of Congress. The fraud at WorldCom broke this congressional logjam and resulted in the passage of the Sarbanes- Oxley Act less than two months after the revelation of the WorldCom fraud.

Learning Objective Summary LO9-1
LO9-1: Determine the cost of plant assets. Plant assets are long-lived assets acquired for use in the business and not for resale to customers. The matching principle requires that we include in the plant and equipment accounts those costs that will provide services over a period of years. During these years, the use of the plant assets contributes to the earning of revenue. The cost of a plant asset includes all expenditures reasonable and necessary in acquiring the asset and placing it in a position and condition for use in the operations of the business.

LO9-2: Distinguish between capital expenditures and revenue expenditures. Capital expenditures include all material expenditures that will benefit several accounting periods. These expenditures are charged to asset accounts (capitalized) and are recognized as expense in future periods. Revenue expenditures are charged directly to expense accounts because either (1) there is no objective evidence of future benefits or (2) the amounts are immaterial.

LO9-3: Compute depreciation by the straight-line and declining-balance methods. Straight-line depreciation assigns an equal portion of an asset’s cost to expense in each period of the asset’s life. Declining-balance depreciation is an accelerated method. Each year, a fixed (and relatively high) depreciation rate is applied to the remaining book value of the asset. There are several variations of declining-balance depreciation.

LO9-4: Account for depreciation using methods other than straight-line or declining-balance. Most companies that prepare financial statements in conformity with generally accepted accounting principles use the straight-line method of depreciation. Other accepted methods include the units-of-output method, sum- of-the-years’ digits, and, in rare circumstances, decelerated depreciation methods.

LO9-5: Account for the disposal of plant assets. When plant assets are disposed of, depreciation is first recorded to the date of disposal. The cost is then removed from the asset account and the total recorded depreciation is removed from the Accumulated Depreciation account. The sale of a plant asset at a price above or below book value results in a gain or loss that is reported in the income statement. Because different depreciation methods are used for income tax purposes, the gain or loss reported in income tax returns may differ from that shown in the income statement. The gain or loss shown in the financial statement is recorded in the company’s general ledger accounts.

LO9-6: Explain the nature of intangible assets, including goodwill. Intangible assets are assets owned by the business that have no physical substance, are noncurrent, and are used in business operations. Examples include trademarks and patents. Among the most interesting intangible assets is goodwill. Goodwill is the expected future earnings in excess of a normal return on net identifiable assets. It stems from such factors as a good reputation, loyal customers, and superior management. Any business that earns significantly more than a normal rate of return actually has goodwill. But goodwill is recorded in the accounts only if it is purchased by acquiring another business at a price higher than the fair market value of its net identifiable assets.

LO9-7: Account for the depletion of natural resources. Natural resources (or wasting assets) include mines, oil fields, and standing timber. Their cost is converted into inventory as the resource is mined, pumped, or cut. This allocation of the cost of a natural resource to inventories is called depletion. The depletion rate per unit extracted equals the cost of the resource (less residual value) divided by the estimated number of units it contains.

LO9-8: Explain the cash effects of transactions involving plant assets. Depreciation is a noncash expense; cash expenditures for the acquisition of plant assets are independent of the amount of depreciation for the period. Cash payments to acquire plant assets (and cash receipts from disposals) appear in the statement of cash flows, classified as investing activities. Write-downs of plant assets also are noncash charges, which do not involve cash payments.

End of Chapter 9 End of Chapter 9.

Plant and Intangible Assets

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