Chapter 9

Chapter 9

Reporting and InterpretingLong-Lived Tangible and

Intangible Assets

Learning Objectives1. Define, classify, and explain the nature of long-lived

assets. 2. Apply the cost principle to the acquisition of long-lived

assets. 3. Apply various depreciation methods as economic benefits

are used up over time. 4. Explain the effect of asset impairment on the financial

statements. 5. Analyze the disposal of long-lived tangible assets. 6. Analyze the acquisition, use, and disposal of long-lived

intangible assets. 7. Interpret the fixed asset turnover ratio. 8. Describe factors to consider when comparing companies’

long-lived assets.

Tangible

PhysicalSubstance

Intangible

No PhysicalSubstance

Will not be used up within the next year

Actively Used in Operations

Definition and Classification

Land Assets subject to depreciation

Buildings and equipment Furniture and fixtures

Examples

Value represented by rights that produce benefits.

Intangibles with a limited life, such as patents and copyrights, are subject to amortization.

Intangibles with an unlimited (or indefinite) life, such as goodwill and trademarks, are not amortized.

Decline in asset value over its useful life

Use2. Allocate cost to periods benefited.3. Account for subsequent expenditures.

Use2. Allocate cost to periods benefited.3. Account for subsequent expenditures.

Disposal 4. Record disposal. Disposal 4. Record disposal.

Acquisition1. Compute cost. Acquisition1. Compute cost.

Long-term Tangible Assets

Acquisition cost includes:

1. purchase price; and

2. all necessary expenditures needed to prepare the asset for its intended use.

Recording costs as assets is calledcapitalizing the costs.

Acquisition cost includes:

1. purchase price; and

2. all necessary expenditures needed to prepare the asset for its intended use.

Recording costs as assets is calledcapitalizing the costs.

Acquisition of Tangible Assets

PrincipleHistorical cost: Cash equivalent cost given up

is the basis for the initial recording of elements.

PrincipleHistorical cost: Cash equivalent cost given up

is the basis for the initial recording of elements.

Acquisition of Tangible Assets

Purchase cost Legal fees Surveying fees Broker’s commissions

Land

Purchase/construction cost Sales taxes Transportation costs Installation costs

Equipment

Purchase/construction cost Legal fees Appraisal fees Architectural fees

Buildings

Cash PurchaseCedar Fair purchased a new ride for $26,000,000 less a

$1,000,000 discount. Cedar Fair paid $125,000 for transportation and $625,000 for installation of the ride.

Prepare the journal entry for the acquisition assuming Cedar Fair paid cash for the new ride.

2 Record

1 Analyze

Credit PurchaseInstead of paying cash, assume that Cedar Fair issued

a note for the new ride, but paid cash for the transportation and installation of the ride.

Prepare the journal entry for the acquisition.

1 Analyze

2 Record

Martin Co. purchased land as a factory site for $400,000. The process of tearing down an old building on the site and constructing the factory required 6 months. The company paid $42,000 to raze the old building and $1,850 for legal fees. It also paid $68,000 for drawing the factory plan. The construction of factory costs Martin $28,000,000.

Land purchase price 400,000 Land preparation 42,000 Legal fees 1,850 Total Land value 443,850

Construction costs 28,000,000 Architectural fees 68,000 Total Building value 28,068,000

Land value to be capitalized

Building value to be capitalized

Acquisition Cost of Realty

Debit CreditLand (+A) 443,850 Building (+A) 28,068,000

Cash (-A) 28,511,850

Accounts

Acquisition Cost of Realty

Total Land value = $443,850Total Building value = $28,068,000

Quick check1. Starbucks paid

1) $150,000 cash to acquire land for a retail store.2) This land had an old service garage that was removed at

a cost of $15,000, and salvaged materials were sold for $2,000.

3) Additional closing cost (brokerage fee and transfer fee) total $10,000.

Calculate the cost of this land to Starbucks.

2. S Co. purchased a machine for $32,000 with terms 2/15, n/60, and paid $400 in shipping charges. Experts were hired to install the machine at a cost of $1,000; In moving the machine, paid $500 in damages occurred. Once the machine was installed several test runs were made to calibrate the settings – material and labor associated with the testing totaled $600. Assuming the firm paid within the discount period, what cost should be recorded for the machine?

On January 1, Jones purchased land and building for $400,000 cash. The appraised

values are building, $325,000, and land, $175,000.

How much of the $400,000 purchase price will be charged to the building and land

accounts?

On January 1, Jones purchased land and building for $400,000 cash. The appraised

values are building, $325,000, and land, $175,000.

How much of the $400,000 purchase price will be charged to the building and land

accounts?

The total cost of a combined purchase of land and building is allocated in proportion to their

relative market values.

The total cost of a combined purchase of land and building is allocated in proportion to their

relative market values.

Acquisition Cost - Basket Purchase

Appraised % of Purchase ApportionedAsset Value Value Price Cost

a b* c b × c

Land 175,000$ 35% × 400,000$ = 140,000$ Building 325,000 65% × 400,000 = 260,000 Total 500,000$ 100% 400,000$

* $175,000 ÷ $500,000 = 35%

$325,000 ÷ $500,000 = 65%

Acquisition Cost - Basket Purchase

After a company acquires a plant asset and puts it into service, it often makes additional expenditures for that asset’s operation: General maintenance Repair Upgrade and improvement

Capitalize them or Expense them? Capitalize: charge the amount to an asset

account Expense: charged to current period income as

an expense

Additional Expenditures

Type of AccountingExpenditure Identifying Characteristics Treatment

Ordinary 1. Maintains normal operating condition Expenserepairs and 2. Does not increase productivity

maintenance 3. Does not extend life beyond original estimate

Extraordinary 1. Major overhauls or partial Capitalizerepairs replacements

2. Extends life beyond original estimate

Additions 1. Increases productivity Capitalize2. May extend useful life3. Improvements or expansions


If the amounts involved are not material, most companies expense the item.

If the amounts involved are not material, most companies expense the item.

Financial Statement EffectCurrent Current

Treatment Statement Expense Income TaxesCapitalize Balance sheet

account debited Deferred Higher HigherExpense Income statement Currently

account debited recognized Lower Lower


Kelly Co. owns machine that has net book value of 30,000. In Mar. 2007, Kelly paid $13,000 to rearrange and reinstall machinery, which will enhance productivity of the machine. In Apr. 2007, it paid $200 for regular maintenance of the machine. Prepare journal entries for the above transactions.

Dr. Cr.Machine (+A) 13,000

Cash (-A) 13,000 Maintenance Expense (+E,-SE) 200

Cash (-A) 200


Depreciation is the process of allocating the cost of a plant asset to expense in the accounting periods benefiting from its use.

Depreciation is the process of allocating the cost of a plant asset to expense in the accounting periods benefiting from its use.

Cost

AllocationAcquisition

CostAcquisition

Cost

(Unused)

Balance Sheet

(Used)

Income Statement

ExpenseExpense

Depreciation

Rules of the Game As depreciation is recognized it is charged

to income as depreciation expense and aggregated as the contra asset account “accumulated depreciation”

The book value (or net book value) of a depreciable asset equals the historical cost minus the accumulated depreciation

The depreciation method selected determines the periodic expense amount.

Book Values

Depreciation on Delta’s2000 Balance Sheet

Property and Equipment:

Flight equipment 27,000$ Less: Accumulated depreciation 5,000 22,000$

Ground property and equipment 4,500 Less: Accumulated depreciation 2,300$ 2,200

Total property and equipment, net 24,200$

Book value = Market valueBook value = Market value/

The calculation of depreciation requires three amounts for each asset: Cost Salvage Value Useful Life

Do we know these with absolute certainty?

Factors in Computing Depreciation

Straight-line

Units-of-production

Accelerated Method: Double-Declining balance

Straight-line

Units-of-production

Accelerated Method: Double-Declining balance

Alternative Depreciation Methods

Straight-line

Units-of-production

Declining balance

Depreciation Methods

At the beginning of the year, Cedar Fair purchased a new Go-Cart Ride for $62,500 cash. The ride has an estimated useful life of 3 years and an

estimated residual value of $2,500.

We will use the following information to illustratethe three methods of depreciation:

Straight-Line Method

= $20,000 per year ($62,500 - $2,500) × 13

Depreciation Accumulated Accumulated UndepreciatedExpense Depreciation Depreciation Balance

Year (debit) (credit) (credit balance) (book value)62,500$

1 20,000$ 20,000$ 20,000$ 42,500 2 20,000 20,000 40,000 22,500 3 20,000 20,000 60,000 2,500

60,000$ 60,000$

Units-of-Production Method

= $18,000 ($62,500 - $2,500) × 30,000100,000

The ride has a 100,000-mile estimated useful life. If the ride is used 30,000 miles

in the first year, what is the amount of depreciation expense?

Accumulated UndepreciatedDepreciation Depreciation Balance

Year Miles Expense Balance (book value)62,500$

1 30,000 18,000$ 18,000$ 44,500 2 50,000 3 20,000

100,000

Units-of-Production Method

Depreciation Accumulated UndepreciatedExpense Depreciation Balance

Year Miles (debit) (credit balance) (book value)62,500$

1 30,000 18,000$ 18,000$ 44,500 2 50,000 30,000 48,000 14,500 3 20,000 12,000 60,000 2,500

100,000 60,000$

DepreciationExpense

Early Years High

Later Years Low

The declining-balance method matches higher depreciation expense with higher revenuesin the early years of an asset’s useful life

when the asset is more efficient.

Declining-Balance Method

Double-Declining-Balance Method

AnnualDepreciation

Expense

NetBookValue

( )Useful Life in Years 2

= ×

Cost – Accumulated Depreciation

Declining balance rate of 2 isdouble-declining-balance (DDB) rate.

Annual computation ignores residual value.Annual computation ignores residual value.

At the beginning of the year, Cedar Fair purchased a new Go-Cart Ride for $62,500

cash. The ride has an estimated useful life of 3 years and an estimated residual

value of $2,500.

Calculate the depreciation expense for the first two years.


AnnualDepreciation

expense

NetBookValue

( )Useful Life in Years 2

= ×

( ) $62,500 × 3 years 2

= $41,667

( ) ($62,500 – $41,667) × 3 years 2

= $13,889

Year 1 Depreciation:

Year 2 Depreciation:



Year (debit) Balance (book value)62,500$

1 41,667$ 41,667$ 20,833 2 13,889 55,556 6,944 3 4,629 60,185 2,315

60,185$

( ) ($62,500 – $55,556) × 3 years 2

= $4,629

Below residual value


We usually must force depreciation expense in thelast year so that book value equals salvage value.Depreciation expense is limited to the amount thatreduces book value to the estimated residual value.


Year (debit) Balance (book value)62,500$

1 41,667$ 41,667$ 20,833 2 13,889 55,556 6,944 3 4,444 60,000 2,500

60,000$


When a plant asset is acquired during the year, depreciation is calculated for the fraction of the year the asset is owned.

When a plant asset is acquired during the year, depreciation is calculated for the fraction of the year the asset is owned.

Partial-Year Depreciation

Calculate the straight-line depreciation on December 31, 2007, for equipment purchased on June 30, 2007. The equipment cost $75,000, has a useful life of 10 years, and an estimated salvage value of $5,000. (Straight-Line method)

Calculate the straight-line depreciation on December 31, 2007, for equipment purchased on June 30, 2007. The equipment cost $75,000, has a useful life of 10 years, and an estimated salvage value of $5,000. (Straight-Line method)

Depreciation = ($75,000 - $5,000) ÷ 10

= $7,000 for all 2007

Depreciation = $7,000 × 6/12 = $3,500

Depreciation = ($75,000 - $5,000) ÷ 10

= $7,000 for all 2007

Depreciation = $7,000 × 6/12 = $3,500

Summary of Depreciation Methods

For tax purposes, most corporations use the Modified Accelerated Cost

Recovery System (MACRS).

MACRS depreciation provides for rapid write-off of an asset’s cost in order to

stimulate new investment.

Tax Depreciation

Asset Impairment Losses

Cedar Fair recorded a write-down of $3,200,000 on equipment.

Impairment is the loss of a significant portion of the utility of an asset through . . .

Casualty. Obsolescence. Lack of demand for the asset’s services.

A loss should be recognized when an asset suffers a permanent impairment.

1 Analyze

2 Record

1. Recognize any unrecorded depreciation expense

2. Remove the historical cost of the asset and the accumulated depreciation associated with the asset from books

3. Record the cash receipts (or payment)

4. Recognize any difference between value of asset received and book value of asset given up as a gain or loss

Accounting for Asset Disposals

Update depreciation to the date of disposal.

If Cash > BV, record a gain (credit).

If Cash < BV, record a loss (debit).

If Cash = BV, no gain or loss.

Disposal of Tangible Assets

Recording again (credit)

or loss (debit).

Recording again (credit)

or loss (debit).

BV is equal to cost less accumulated depreciation.

On December 31, 2007, Evans Company sells a machine that originally cost $100,000 for $60,000 cash. The machine was placed in service on January 1, 2004. It was depreciated using the straight-line method with an estimated salvage value of $20,000 and a useful life of 10 years.

Disposal of Tangible Assets

Annual Depreciation:($100,000 - $20,000) ÷ 10 Yrs. = $8,000Annual Depreciation:($100,000 - $20,000) ÷ 10 Yrs. = $8,000

Update Depreciation to Date of Disposal

Dr. Cr.Dec. 31 Depreciation expense 8,000

Accumulated Depreciation - Machine 8,000 To update depreciation to date of disposal

Cost 100,000$ Accumulated Depreciation: 4 yrs. × $8,000 = 32,000

Book Value 68,000$

Determine Gain or Loss on Disposal

Cost 100,000$ Accumulated depreciation 32,000

Book Value 68,000 Cash Received 60,000

Loss on disposal (8,000)$

If Cash > BV, record a gain (credit).

If Cash < BV, record a loss (debit).

If Cash = BV, no gain or loss.

Record the Disposal in the Journal

Dr. Cr.Dec. 31 Cash 60,000

Loss on Disposal of Asset 8,000 Accumulated Depreciation - Machine 32,000

Machine 100,000 To record disposal of equipment

Question: what if the company sells the machine for $80,000

Dr. Cr.Dec. 31 Cash 80,000

Accumulated Depreciation - Machine 32,000 Machine 100,000 Gain on Disposal of Asset 12,000

To record disposal of equipment

BV

BV

Tangible

PhysicalSubstance

Intangible

No PhysicalSubstance

Expected to Benefit Future Periods

Actively Used in Operations

Value represented by rights that produce benefits

PatentsCopyrightsTrademarksFranchisesGoodwill Subject to amortization

Examples

Classifying Long-Lived Assets

Noncurrent assetswithout physicalsubstance.

Noncurrent assetswithout physicalsubstance.

Useful life isoften difficultto determine.

Useful life isoften difficultto determine.

Usually acquired for operational use.

Usually acquired for operational use.

IntangibleAssets

IntangibleAssets

Often provideexclusive rightsor privileges.

Often provideexclusive rightsor privileges.

Intangible Assets

Patents Copyrights Franchises Trademarks Goodwill

Record at current cash equivalent cost, including purchase price, legal fees, and

filing fees.

Cost Determination and Amortization

Trademarks and Copyrights A trademark is a symbol, design,or logo associated with a business.

Internally developedtrademarks have norecorded asset cost.

Purchased trademarksare recorded at cost.

Amortize costover the period

benefited.

Legal life islife of creatorplus 70 years.

A copyright is an exclusive right granted by the federalgovernment to protect artistic or intellectual properties.

Cost is purchaseprice plus legalcost to defend.

Amortize costover the shorter of

useful life or 20 years.

Patents and Licensing Rights

A patent is an exclusive right granted by the federalgovernment to sell or manufacture an invention.

You may be using computersoftware that is made

available to you through a

campus licensing agreement.

Licensing rights grant limited permission to use a productor service according to specific terms and conditions.

Franchises

A franchise provides legally protected rightsto sell products or provide services purchased

by a franchisee from the franchisor.

Goodwill

Occurs when onecompany buys

another company.

Purchase Price > Fair Market Value of Net Assets Acquired

Only purchased goodwill is an

intangible asset.

Is not amortized.Is impairment

tested and may bewritten down.

Amortization of Limited Life Intangible Asset

Assume Cedar Fair purchased a patent for an uphill water-coaster for $800,000 and intends to use it for 20 years. Each

year, the company would record $40,000 in Amortization Expense ($800,000 ÷ 20 years).

Assets = Liabilities + Stockholders' EquityPatent (-A) $40,000 Amortization Expense

(+E, -SE) -40,000

1 Analyze

2 Recorddr Amortization Expense (+E, -SE) 40,000

cr Patent (-A) 40,000

Summary of Accounting Rulesfor Long-Lived Assets

Stage Subject Tangible Assets Intangible AssetsAcquisition Purchased Asset Capitalize all related costs Capitalize all related costs

Use Repairs/maintenance Ordinary Expense related costs Not applicable Extraordinary Capitalize related costs Not applicable

Depreciation/ amortization Limited life straight-line Typically use straight line only

units-of-productiondeclining-balance

Unlimited life Do not depreciate land Do not amortize

Impairment test Write-down if necessary Write-down if necessary

Disposal Report gain or (loss) when . . . Receive more (less) on Receive more (less) on disposal than book value disposal than book value

This ratio measures the sales dollars generated by each dollar

invested in fixed assets.

For the year 2008, Cedar Fair had $1,000,000 ofrevenue. End-of-year fixed assets were $1,800,000and beginning-of-year fixed assets were $1,940,000.

(All numbers in millions.)

Turnover AnalysisFixedAsset

Turnover

Net Sales RevenueAverage Net Fixed Assets

=

Turnover Analysis

FixedAsset

Turnover

$1,000,000($1,800,000 + $1,940,000) ÷ 2

= = 0.53

FixedAsset

TurnoverNet Sales Revenue

Average Net Fixed Assets=

Yahoo! Six Flags Cedar Fair5.68 0.64 0.53

2008 Fixed Asset Turnover Comparisons

Impact of Depreciation Differences

Accelerated depreciation, in the early years of an asset’s useful life, results in higher depreciation expense, lower

net income, and lower book value than would result using straight-line depreciation.

Selling an asset with a low book value, resulting from accelerated depreciation, might result in a gain.

Selling the same asset with a higher book value, resulting from straight-line depreciation, might result in

a loss.

In-class exercise problem #1 On January 1, Manning Co. purchases a new

knitting machine costing $300,000, the shipping cost was 1,000 and installs it at a cost of $23,000.

Estimates The useful life of the equipment is 5 years Salvage value of $24,000 at the end of 5 years Total production of 1,500,000 pairs of socks

Actual production is as follows: Year 1 350,000 Year 2 320,000 Year 3 300,000

How much depreciation will be recognized in each year using (a) straight-line depreciation and (b) units of production depreciation

In-class exercise problem #2 City Corp. owns machinery that cost

$20,000 when purchased on January 1, 2004. It sold the machinery on July 31, 2008 for $10,500 cash. On the day of sale, the updated accumulated depreciation for the machinery was $10,000. Determine gain (loss) from the sale and prepare a journal entry for the sale transaction.

In-class exercise problem #3On December 31, 2007, Travis Inc. had a machine with a book

value of $940,000. The original cost and related accumulated depreciation at this date are as follows:

12/31/2007Machine $1,300,000Accumulated depreciation 360,000Book Value $ 940,000

The machine has expected useful life of 10 years and will have $100,000 salvage value at the end of its useful life. Travis has been depreciating the machine using a straight-line method.

Required: Assume that Travis Inc. sold the machine for $920,000 on

January 1, 2008. Determine Gain (Loss) from the sale of the machine and prepare journal entries to record the disposal transaction.

Assume that Travis Inc. sold the machine on Dec 31, 2008 for $920,000. Determine Gain (Loss) from the sale of the machine and prepare journal entries to record the disposal transaction.

Business

Chapter 9