Chapter 7Chapter 7

Long-Lived Non-monetary Long-Lived Non-monetary Assets andAssets and

Their AmortizationTheir Amortization

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved.

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Nature of Long-Lived AssetsNature of Long-Lived Assets

Benefits obtained from expenditures on goods or Benefits obtained from expenditures on goods or services are eitherservices are either Obtained in current period (expenses) orObtained in current period (expenses) or Expected to be obtained in future periods Expected to be obtained in future periods

(capitalized).(capitalized).

Capital assets provide benefits to future periods.Capital assets provide benefits to future periods. Amortization is the process of matching costs Amortization is the process of matching costs

incurred for capital assets with the revenues incurred for capital assets with the revenues obtained from their use.obtained from their use.

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Types of Long-Lived AssetsTypes of Long-Lived Assets

Tangible asset Tangible asset Asset with physical substanceAsset with physical substance Property, plant, and equipment = fixed asset.Property, plant, and equipment = fixed asset.

Intangible assetIntangible asset Intellectual property.Intellectual property. No physical substanceNo physical substance

Examples are patent rights, copyrightsExamples are patent rights, copyrights

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AmortizationAmortization

View capital asset as bundle of services.View capital asset as bundle of services. Similar to prepaid expenses, cost is Similar to prepaid expenses, cost is

expensed as company benefits from the expensed as company benefits from the services.services. Land - no depreciationLand - no depreciation Plant and equipment - depreciation.Plant and equipment - depreciation. Natural resources - depletionNatural resources - depletion Intangible assets - amortizationIntangible assets - amortization

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Asset versus expenseAsset versus expense

Expenditures:either expensed or capitalized.Expenditures:either expensed or capitalized. Small items may be expensed (materiality).Small items may be expensed (materiality).

Capitalize large purchases of small items.Capitalize large purchases of small items. Replacement items charged as an expense.Replacement items charged as an expense.

Repairs and maintenance are expensed.Repairs and maintenance are expensed. Betterments are capitalized.Betterments are capitalized.

Makes the asset better than when purchased.Makes the asset better than when purchased.

Replacements: assets or expenses depending Replacements: assets or expenses depending on how the asset unit is defined.on how the asset unit is defined.

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What is Included in Cost?What is Included in Cost?

All expenditures necessary to make asset All expenditures necessary to make asset ready for its intended use.ready for its intended use.

Self constructed assets:Self constructed assets: All construction costs (materials, direct labor, All construction costs (materials, direct labor,

overhead).overhead). Capital asset acquired for other than cash:Capital asset acquired for other than cash:

Record at fair market value (FMV) of consideration Record at fair market value (FMV) of consideration given or received. given or received.

Basket purchase:Basket purchase: Allocate cost based on FMV of acquired assets.Allocate cost based on FMV of acquired assets.

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DepreciationDepreciation

Gradual conversion of cost into expense.Gradual conversion of cost into expense. Depreciation is a cost consumed by an Depreciation is a cost consumed by an

entity during an accounting period.entity during an accounting period. Definition:Definition:

The systematic allocation of the original The systematic allocation of the original cost of an asset to the periods in which the cost of an asset to the periods in which the asset provides benefit to the entity.asset provides benefit to the entity.

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DefinitionsDefinitions

Deterioration = physical process of wearing Deterioration = physical process of wearing out.out.

Obsolescence = loss of usefulness because Obsolescence = loss of usefulness because of change in technology or tastes.of change in technology or tastes.

Physical life = time until asset wears out.Physical life = time until asset wears out. Service life = shorter of either time until asset Service life = shorter of either time until asset

becomes obsolete or time until asset wears becomes obsolete or time until asset wears out.out.

Book value = net book value = original cost - Book value = net book value = original cost - accumulated depreciation to date.accumulated depreciation to date.

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Judgments RequiredJudgments Required

Service life of asset.Service life of asset. Residual value at the end of its service life. Residual value at the end of its service life.

Net cost = original cost - residual value.Net cost = original cost - residual value. Method of depreciation used to allocate Method of depreciation used to allocate

cost over useful life of asset.cost over useful life of asset.

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Depreciation Methods:Depreciation Methods:

Straight line method:Straight line method: (original cost - residual value) /service life(original cost - residual value) /service life

Accelerated methods:Accelerated methods: Declining balance methods.Declining balance methods. Sum of the years’ or years’ digits methods.Sum of the years’ or years’ digits methods.

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Declining Balance MethodDeclining Balance Method

Depreciation = book value * depreciation Depreciation = book value * depreciation rate.rate. Double declining balance method = book Double declining balance method = book

value * 2 * straight line rate.value * 2 * straight line rate. Straight line rate = 1/(life of asset in years).Straight line rate = 1/(life of asset in years).

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Years Digits MethodYears Digits Method

Depreciation for first year = (cost - residual Depreciation for first year = (cost - residual value) * n / SYD.value) * n / SYD. SYD = n(n+1)/2 where n is estimated years of SYD = n(n+1)/2 where n is estimated years of

useful life.useful life. Depreciation for second year = (cost - Depreciation for second year = (cost -

residual value) * (n - 1) / SYD.residual value) * (n - 1) / SYD.

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Units of Production MethodUnits of Production Method

Depreciation = (cost / estimated units of Depreciation = (cost / estimated units of production over life of asset) * units production over life of asset) * units produced in periodproduced in period

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Depreciation AccountingDepreciation Accounting

Acquire an asset for $1,000 and Acquire an asset for $1,000 and depreciate straight line over 5 years.depreciate straight line over 5 years.

First year’s depreciation:First year’s depreciation: Depreciation expense 200Depreciation expense 200 Accumulated depreciation 200Accumulated depreciation 200

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Depreciation MiscellanyDepreciation Miscellany

Theoretically selection by management results in best Theoretically selection by management results in best matching.matching.

Changes in estimate:Changes in estimate: Not unusual.Not unusual. Affect future, not past depreciation.Affect future, not past depreciation.

Fully depreciated assets on BS until disposal. Fully depreciated assets on BS until disposal. Half year convention: record a half year’s depreciation in Half year convention: record a half year’s depreciation in

year of acquisition and disposition.year of acquisition and disposition. Disclosure: amount of depreciation expensed in year, & Disclosure: amount of depreciation expensed in year, &

original cost, accumulated depreciation by category.original cost, accumulated depreciation by category.

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Plant and Equipment: DisposalPlant and Equipment: Disposal

Sale of building:Sale of building: Remove cost and accumulated depreciation.Remove cost and accumulated depreciation.

Reminder: book value = cost - accumulated Reminder: book value = cost - accumulated depreciation.depreciation.

Gain or (loss) = Selling price of asset - book Gain or (loss) = Selling price of asset - book value.value. Gain or loss in current period income statement.Gain or loss in current period income statement.

Cost = market value at time of purchase.Cost = market value at time of purchase.

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Impaired AssetsImpaired Assets

An asset for which its remaining benefits, as An asset for which its remaining benefits, as measured by the sum of future cash flows the measured by the sum of future cash flows the asset’s use will generate, is less than its book asset’s use will generate, is less than its book value.value.

If entity expects to hold asset:If entity expects to hold asset: Write asset down to fair valueWrite asset down to fair value

If entity expects to sell asset:If entity expects to sell asset: Write asset down to lower of cost or fair value less Write asset down to lower of cost or fair value less

cost of disposal.cost of disposal.

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Exchange and Trade-InsExchange and Trade-Ins

Trade is for a similar asset if if the asset Trade is for a similar asset if if the asset received is of the same general type of received is of the same general type of performing the same function. Otherwise, it is performing the same function. Otherwise, it is dissimilar.dissimilar.

If exchange is for a similar asset, value of the If exchange is for a similar asset, value of the asset received is recorded at additional amount asset received is recorded at additional amount paid + book value of old asset. No gain or loss paid + book value of old asset. No gain or loss is recorded.is recorded.

If exchange is between dissimilar assets, record If exchange is between dissimilar assets, record asset received at fair value and recognize gain asset received at fair value and recognize gain or loss on disposal of old asset.or loss on disposal of old asset.

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Group DepreciationGroup Depreciation

Treats all similar assets as a “pool” or Treats all similar assets as a “pool” or group rather than calculating for each item group rather than calculating for each item separately.separately.

No gain or loss recognized when an No gain or loss recognized when an individual item is disposed.individual item is disposed. Credit asset account for original cost.Credit asset account for original cost. Debit cash for amount of proceeds.Debit cash for amount of proceeds. Debit accumulated depreciation for difference.Debit accumulated depreciation for difference.

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Accumulated DepreciationAccumulated Depreciation

Does not represent the accumulation of Does not represent the accumulation of any tangible thing.any tangible thing.

Sum of the original cost that has been Sum of the original cost that has been expensed.expensed.

Funding the purchase of new assets is Funding the purchase of new assets is usually unrelated to depreciation.usually unrelated to depreciation.

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Income Tax ConsiderationsIncome Tax Considerations

Modified accelerated cost recovery system Modified accelerated cost recovery system (MACRS).(MACRS). Rapid depreciation, lower taxes to encourage Rapid depreciation, lower taxes to encourage

investment.investment. Investment tax credit (ITC)Investment tax credit (ITC)

Tax credit as a percent of cost of capital Tax credit as a percent of cost of capital assets.assets.

Encourages investment. Encourages investment. Currently not in tax code.Currently not in tax code.

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Modified Accelerated Cost Modified Accelerated Cost Recovery System (MACRS)Recovery System (MACRS)

Tax code allows rapidly accelerated depreciation Tax code allows rapidly accelerated depreciation for tax purposes to encourage investment in for tax purposes to encourage investment in capital assets.capital assets.

Ignores estimated residual values.Ignores estimated residual values. Combination of declining balance method, half-Combination of declining balance method, half-

year convention, and switch to straight-line year convention, and switch to straight-line depreciation for the latter portion of the recovery depreciation for the latter portion of the recovery period.period.

IRS provides a table to look up percentage to IRS provides a table to look up percentage to multiply against original cost.multiply against original cost.

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Natural ResourcesNatural Resources Measure cost same as other assets.Measure cost same as other assets. 2 methods of handling oil exploration costs:2 methods of handling oil exploration costs:

Full cost method: Full cost method: All costs of exploration allocated to and capitalized All costs of exploration allocated to and capitalized

as the value of reserves discovered during the year.as the value of reserves discovered during the year. Successful efforts method: Successful efforts method:

Only capitalize costs involved with successful Only capitalize costs involved with successful efforts (oil reserves that are discovered). efforts (oil reserves that are discovered).

Both allowed under GAAP. Both allowed under GAAP.

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DepletionDepletion

Amortizing costs of natural resources.Amortizing costs of natural resources. Units of production method ordinarily used. Units of production method ordinarily used.

Depletion for a period = (Cost of reserve / estimated Depletion for a period = (Cost of reserve / estimated units, say barrels) * number of barrels extracted units, say barrels) * number of barrels extracted during the period.during the period.

Accretion = increase in value arising from Accretion = increase in value arising from natural growth (e.g., timber, agricultural natural growth (e.g., timber, agricultural products)products)

Not recognized in accounts until sold.Not recognized in accounts until sold. Costs incurred are capitalized.Costs incurred are capitalized.

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Intangible AssetsIntangible Assets

Long-lived.Long-lived. Usually converted to expenses over a number of Usually converted to expenses over a number of

accounting periods.accounting periods. Amortization is the systematic allocation of cost Amortization is the systematic allocation of cost

to period of which benefits are provided.to period of which benefits are provided. Amortization should reflect the pattern in which the Amortization should reflect the pattern in which the

economic benefits are consumed.economic benefits are consumed. Straight line amortization, if that pattern cannot be Straight line amortization, if that pattern cannot be

determined.determined.

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Internally Developed or Internally Developed or AcquiredAcquired

Internally developed are expensed as Internally developed are expensed as incurred.incurred.

Acquired are capitalized.Acquired are capitalized.

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Categories of IntangiblesCategories of Intangibles

Intangible assets with limited lives.Intangible assets with limited lives. Intangible assets with indefinite lives.Intangible assets with indefinite lives. Goodwill.Goodwill.

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Intangibles with Indefinite Useful Intangibles with Indefinite Useful LivesLives

Example: renewable broadcast license.Example: renewable broadcast license. Considered indefinite if no legal, regulatory, Considered indefinite if no legal, regulatory,

contractual, competitive or other limiting factors.contractual, competitive or other limiting factors. Not amortized.Not amortized. Tested for impairment.Tested for impairment. If determined to be impaired, it is written down to If determined to be impaired, it is written down to

realizable value and charged against income.realizable value and charged against income.

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GoodwillGoodwill

When one company buys another.When one company buys another. Goodwill = Purchase price of company – fair Goodwill = Purchase price of company – fair

value of net assets.value of net assets. Net assets include tangible assets and recognized Net assets include tangible assets and recognized

intangible assets net of liabilities assumed by the intangible assets net of liabilities assumed by the purchaser.purchaser.

Recorded as an asset upon acquisition.Recorded as an asset upon acquisition. Not amortized.Not amortized. Annual impairment test.Annual impairment test. Any write down is charged against income.Any write down is charged against income.

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Intangible Assets with Limited LivesIntangible Assets with Limited Lives

Examples: patents and copyrights.Examples: patents and copyrights. If purchased, recorded at cost.If purchased, recorded at cost.

Amortized over useful life.Amortized over useful life. Useful life can equal or be shorter than legal Useful life can equal or be shorter than legal

life.life. If developed internally, expense as If developed internally, expense as

incurred.incurred.

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Leasehold ImprovementsLeasehold Improvements

Improvements made to leased property.Improvements made to leased property. Revert to owner at end of lease.Revert to owner at end of lease. Amortized over the shorter of useful life or Amortized over the shorter of useful life or

length of lease. (If renewal is likely length of lease. (If renewal is likely amortize through renewed period.)amortize through renewed period.)

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Start-up CostsStart-up Costs

Deferred Charges.Deferred Charges. Pre-operating period.Pre-operating period.

Expense or Expense or Capitalize and amortize over a short period Capitalize and amortize over a short period

(rarely more than 5 years).(rarely more than 5 years).

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Research & Development CostsResearch & Development Costs(R&D)(R&D)

Costs incurred to:Costs incurred to: Develop new knowledge, products or improve Develop new knowledge, products or improve

goods, processes, or services.goods, processes, or services. GAAP: GAAP:

Expense since future benefits uncertain.Expense since future benefits uncertain. Argument for capitalizing:Argument for capitalizing:

Matching concept.Matching concept. Argument for immediate expensing:Argument for immediate expensing:

Conservatism, objectivity.Conservatism, objectivity.

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Other R&DOther R&D

R&D for customer under contract:R&D for customer under contract: Inventory until sold. Inventory until sold.

Software development: Software development: Costs are expensed until technological feasibility Costs are expensed until technological feasibility

of product has been established.of product has been established. Costs after feasibility established until product is Costs after feasibility established until product is

available for release to customer are capitalized.available for release to customer are capitalized. Amount of amortization for year is the greater of:Amount of amortization for year is the greater of:

Straight line or ratio of year’s revenues to total Straight line or ratio of year’s revenues to total anticipated revenuesanticipated revenues

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Analysis of Non-monetary Analysis of Non-monetary AssetsAssets

To estimate:To estimate: Average age of depreciable assets = Average age of depreciable assets =

(accumulated depreciation)/(annual (accumulated depreciation)/(annual depreciation expense)depreciation expense)

An asset’s depreciation period in years = An asset’s depreciation period in years = (Original cost)/(annual depreciation expense)(Original cost)/(annual depreciation expense)

Annual expenditure for a particular intangible Annual expenditure for a particular intangible asset = annual amortization expense asset = annual amortization expense +increase in asset’s balance or – a decrease +increase in asset’s balance or – a decrease in balancein balance