Plant Assets, Intangible Assets, & Natural Resources

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LEARNING OBJECTIVES Distinguish between capital expenditures and revenue expenditures.

Understand what costs should be capitalized as a part of the cost of plant assets, including buildings, equipment, land, land improvements and leasehold improvements.

Understand accounting and reporting for leasehold improvement costs.

Understand the nature of depreciation as cost allocation (not asset valuation) and the depreciation methods available for use (straight-line method, accelerated methods, units-of-output method, half-year convention).

Understand federal tax implications of different depreciation methods.

Be aware of the relationship between the consistency principle and depreciation methods used.

Understand the impact of changes in estimated asset service lives or salvage values on depreciation.

Understand the impact of changes in depreciation methods used on fi nancial reporting.

Understand basic reporting rules regarding plant asset impairment.

Be aware of major differences between U.S. GAAP and international fi nancial reporting standards (IFRS) regarding plant assets, intangible assets, research and development costs, and organization costs.

Understand accounting for disposal of plant assets when scrapped, sold, or exchanged.

Be aware of the nature and types of intangible assets that exist.

Understand basic accounting and reporting rules for intangible assets.

Understand U.S. GAAP for research and development costs.

Understand basic accounting and reporting for natural resources.

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6.1 Plant Assets6.1a Capital Expenditures versus Revenue ExpendituresPlant assets include buildings, equipment, land, land improvements, and leasehold improvements. In previ-ous chapters, we discussed certain plant assets such as buildings and equipment with related depreciation, as well as land that is not subject to depreciation. Now, we’ll discuss plant asset acquisition, depreciation, and disposal in greater depth. First, let’s differentiate capital expenditures from revenue expenditures.

Capital expenditures are material expenditures that will benefit future accounting periods, and are there-fore initially recorded as assets. Revenue expenditures are expenditures that either benefit only the current period or are immaterial, and are therefore initially recorded as expenses. Acquisitions of buildings or equip-ment are capital expenditures. Major improvements or betterments of plant assets extending their life or output, such as building additions or major equipment renovations, are capital expenditures. Expenditures for routine repairs and maintenance of plant assets or for fuel to operate plant assets are revenue expenditures. Some expenditures may meet the “future period benefit” requirement of capital expenditures but may be too small (immaterial) to be worth capitalizing as assets when purchased. For example, an electronic pencil sharpener purchase for $30 is an expenditure for an item that will benefit future accounting periods; however, it is so small (immaterial) a purchase that the cost of recording it as an asset and depreciating it over say 10 years at $3 per year outweighs any benefit that might be gained in terms of financial statement accuracy. For this reason, some companies create policy making all expenditures under certain minimum dollar amounts revenue expenditures. This amount will vary in terms of what is considered to be material for a company. A larger company may have a $5,000 dollar threshold while a smaller company may have a $500 threshold.

6.1b Plant Asset Acquisition CostsAll normal costs to get plant assets into condition and position for use are capital expenditures repre-senting a part of the asset’s cost, referred to as reasonable and necessary costs. Obviously, a plant asset’s purchase price is a capital expenditure but so are costs that one may otherwise view as expenses in a different context such as installation costs (labor, material, etc.), sales taxes, and delivery costs.

Interest on borrowing to purchase a plant asset after the plant asset has been placed in service is not part of the asset’s cost but rather it is interest expense. However, under U.S. generally accepted accounting principles, interest during an asset’s construction period prior to its use is a part of the cost of the asset (see Financial Accounting Standards Board Statement No. 34, Capitalization of Interest Costs, 1979).

When acquiring land, all of the following costs are capitalized as a part of the land cost: purchase price of the land, real estate or legal fees associated with the purchase, accrued taxes that must be paid, net cost of removing old buildings from the land, and costs of grading and landscaping. Note that these are all normal costs to get the land in condition and position for use. If, after land is purchased and placed in service, addi-tional improvements are made such as the additions of driveways, fences, or parking areas, these costs are generally part of the cost of an asset called land improvements, rather than the account land. And, unlike land, land improvements are subject to depreciation.

List prices are only relevant to the extent they represent the actual plant asset’s cost. If a discount is given off the list price, then the discounted price, not the list price, is the asset’s cost.

Example: ABC Manufacturing Co. purchased factory equipment with a list price of $100,000 on June 1, 20X7. As a regular customer of the seller of the equipment, the manufacturer qualified for a 4% discount off the list price. The manufacturer paid $36,000 down to the seller and signed a 3 month note payable at a 5% annual rate due to the vendor, with interest of $250 due to the vendor at the end of each of the next three months and the note principal of $60,000 due on September 1, 20X7. In addition, the manufacturer paid the follow-ing costs in cash: sales tax on the equipment purchase of $4,800, equipment delivery costs of $1,200, and installation labor and material costs of $3,000. When the equipment was delivered, it fell off the delivery truck and cost the manufacturer an added $500 for repairs. As a result, the manufacturer’s factory equipment cost would be determined as follows:

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List price …………………………………………………… $100,000Less: 4% discount off list price …………………………… 4,000Subtotal ……………………………………………………… $96,000 Sales tax ……………………………………………………… 4,800Delivery costs ……………………………………………… 1,200Installation costs …………………………………………… 3,000Total cost of equipment …………………………………… $105,000

Note: The $500 paid to repair the equipment after it fell off the delivery truck is an expense and not part of the asset cost since it is clearly not a normal cost of getting the plant asset into position and condition for use.

The entry to record the plant asset acquisition would have been as follows:6/1/X7 Factory equipment ……………………………………………………105,000 Cash ………………………………………………………………………… 45,000* Note payable …………………………………………………………… 60,000**To record acquisition of factory equipment.

* Down payment to seller of equipment of $36,000 plus sales tax of $4,800 plus delivery costs of $1,200 plus installation costs of $3,000 equal $45,000.

** Net amount due to seller after 4% discount of $96,000 less $36,000 down payment equals $60,000 note payable.

Note: (a) The factory equipment will be depreciated using one of the methods that will be described shortly. (b) Interest on the note payable of $250 per month ($60,000 principal × 5% interest × 1 month/12 months) will paid on June 30, July 31, and August 31 and will be recorded as inter-est expense (not as part of the plant asset cost). The $60,000 principal will be paid on September 1, 20X7.

Example: Custom Designs, Inc. purchased land for $300,000 and paid real estate fees of $18,000, legal fees of $2,000, $30,000 to have an old building on the land removed, and $5,000 for grading and clearing the land. As a result of the sale of antique staircases and woodwork from the old building before demolition, Custom designs, Inc. received $9,000 in salvage value. The cost of the land would be determined as follows:

Purchase price …………………………………………………$300,000Real estate fees ………………………………………………… 18,000Legal fees ……………………………………………………… 2,000Old building demolition costs ……………… $30,000Less: Salvage value ………………………… 9,000 21,000Grading and clearing costs …………………………………… 5,000Total land cost …………………………………………………$346,000

Allocation of Plant Asset Acquisition Costs in Lump-Sum PurchasesSometimes plant assets are acquired in bundles or groups. For example, land, building, and equipment housed in the building might be purchased for a single price. If the price paid equals the fair value of the plant assets acquired, then the recording of the acquisition will be straight forward, involving the recording of the assets at their individual fair values in consideration of the purchase price. But if the price paid for the plant asset group differs from the sum of the fair values of those assets, then the purchase price should be allocated among the plant assets acquired based on their fair values.

Example: Custom Designs, Inc. purchased land, building, and equipment with fair market values on the pur-chase date of $150,000, $800,000, and $50,000 respectively and paid a total price of $950,000 for these assets. The $950,000 price paid will be allocated among the assets acquired as follows:

% to Total Price Paid Fair Values Fair Value Allocation

Land ………………… $150,000 15% $142,500 Building ……………… 800,000 80% 760,000Equipment …………… 50,000 5% 47,500Totals ………………… $1,000,000 100% $950,000

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The entry to record the acquisition of these plant assets is as follows:Land ………………………………………………………… 142,500Building ……………………………………………………… 760,000Equipment ……………………………………………………… 47,500

Cash ……………………………………………………………… 950,000

6.1c Leasehold ImprovementsSometimes a lessee of property will make improvements to leased property such as adding new carpets, lights fixtures, or even walls which will become the property of the lessor (property owner) at the end of the lease. Therefore, the lessee of the property should amortize leasehold improvement costs over the shorter of their estimated service life or the lease life.

Example: Davis Co. leased building space for an 8 year period on January 1, 20X1, from BIG Leases, Inc. Davis Co. invested $80,000 in improvements to the office space, including carpets, light fixtures, and dry wall. These leasehold improvements are estimated to have a 10 year service life and no salvage value. The entries Davis Co. would make relative to the leasehold improvements are:

During 20X1: Leasehold improvements ………………………… 80,000 Cash …………………………………………………………… 80,000 To record cost of leasehold improvements.

December 31, 20X1: Amortization expense: leasehold improvements 10,000 Leasehold improvements ……………………………………………………………… 10,000 To record amortization of leasehold improvements as follows: $80,000 divided by 8 year lease life = $10,000 per year. This entry will be repeated

each year from 20X1 through 20X8, the end of the lease life.

Note that it did not matter that the leasehold improvement life was estimated at 10 years since the lessee will no longer have access to the leased property or related improvements when the lease end in 8 years. In short, the leasehold improvement costs should be amortized over their useful life to the lessee.

6.1d Plant Asset Depreciation MethodsAs mentioned in an earlier chapter, depreciation is the allocation of the cost of plant assets to the future periods benefiting from their use. It is not valuation of plant assets. We will discuss straight-line depreciation, units-of-output (or production) depreciation, and accelerated depreciation methods. All examples will be based on the following information:

Equipment cost (acquired January 1, 20X1) …………… $19,000Salvage value …………………………………………………… $1,000Estimated useful life ……………………………………… 3 years

Straight-line Depreciation The straight-line method of depreciation provides the same total dollar amount of deprecation each year as follows:

Asset Cost – Salvage Value

Estimated useful life = Annual depreciation expense

$19,000 – $1,000

3 years = $6,000 annual decpreciation expense

(or, if monthly, $500 per month)

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Depreciation may be expressed as a fraction (or as a percentage) and in this case depreciation would be 1/3 (or thirty-three and one-third percent) of the asset’s cost less salvage value. Over the equipment’s life, depreciation will be determined as follows:

Straight-Line Depreciation Method Cost less Annual Rate Annual Accumulated Book Year Salvage Value of Depreciation Depreciation Expense Depreciation Value* 20X1 $18,000 × 1/3 = $6,000 $6,000 $13,000 20X2 $18,000 × 1/3 = $6,000 $12,000 $7,000 20X3 $18,000 × 1/3 = $6,000 $18,000 $1,000

*Book value = $19,000 original cost less accumulated depreciation.

The annual entry for depreciation expense is: Depreciation expense – equipment ………………………… $6,000 Accumulated depreciation – equipment ……………………… $6,000So, for example, at the end of year 20X2, the statement of financial position would appear as follows:

Equipment ……………………………………………………… $19,000Less: Accumulated depreciation ……………………………… 12,000Equipment (net) ……………………………………………… $7,000

Straight-line Depreciation for Partial YearSuppose, however, that the equipment described in the previous example had been acquired on March 20, 20X1 (not January 1, 20X1). In this case, depreciation need not be calculated on a daily basis since this would imply more accuracy than actually exists. In fact, any systematic and rational approach to depreciation is acceptable under generally accepted accounting principles and depreciation could be based on: a) rounding to the nearest whole month or, b) the half-year convention.

a) Straight-Line Method Rounding to the Nearest Whole Month (April 1 to December 31, 20X1 = 9 Months/12 Months; January 1 to March 31, 20X4 = 3 Months/12 Months)

Cost less Annual Rate Partial Annual Accumulated Book Year Salvage Value of Depreciation Year Depreciation Expense Depreciation Value* 20X1 $18,000 × 1/3 × 9/12 = $4,500 $4,500 $14,500 20X2 $18,000 × 1/3 = $6,000 $10,500 $8,500 20X3 $18,000 × 1/3 = $6,000 $16,500 $2,500 20X4 $18,000 × 1/3 × 3/12 = $1,500 $18,000 $1,000


b) Straight-Line Method Applying the Half-Year Convention (depreciate for one-half year in year of acquisition)

Cost less Annual Rate Partial Annual Accumulated Book Year Salvage Value of Depreciation Year Depreciation Expense Depreciation Value* 20X1 $18,000 × 1/3 × 1/2 = $3,000 $3,000 $16,000 20X2 $18,000 × 1/3 = $6,000 $9,000 $10,000 20X3 $18,000 × 1/3 = $6,000 $15,000 $4,000 20X4 $18,000 × 1/3 × 1/2 = $3,000 $18,000 $1,000


When the half-year convention is used, accounting efficiencies may be gained since all plant assets of equal life acquired during any given year may be depreciated as a group, rather than being depreciated separately based on different months of purchase.

Note: Under any depreciation method (straight-line or accelerated), when the half-year convention is used, it applies to all plant assets acquired, regardless of the date during the year on which they were acquired.

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Accelerated DepreciationAccelerated depreciation provides for a larger total dollar amount of deprecation in the early years of an asset’s life and a lower total amount of depreciation in the later years of an asset’s life. One of the ways in which accelerated depreciation may be implemented is by developing an accelerated depreciation rate and multiplying that rate by the asset’s declining balance (or book value). The accelerated depreciation rate is a specified percentage of the straight-line depreciation rate, such as 200% or 150%. For example, if the specified percentage is 200% for an asset with an estimated three-year life and therefore a straight-line depreciation rate of 1/3, then the accelerated depreciation rate is 2/3 (or 200% times 1/3). Or, if the specified percentage is 150% for an asset with estimated three-year life and therefore a straight-line depreciation rate of 1/3, then the accelerated depreciation rate is 1/2 (or 150% times 1/3). This accelerated depreciation rate is multiplied by the asset’s declining balance (or book value) to determine depreciation expense. The declining balance (book value) will begin at the asset’s full cost, not reduced by an estimated salvage value. However, unless using an accelerated depreciation method for federal income tax purposes as will be demonstrated, the book value of the asset should not fall below its salvage value. The 200% and 150% declining balance accelerated depreciation methods will be illustrated shortly. While there are other accelerated depreciation methods that will not be illustrated here, these other methods are either variants of the declining balance methods that will be illustrated or they are methods not heavily used in financial or tax accounting.

Accelerated Depreciation Using the Double-Declining-Balance (DDB) Method (also called the 200% DDB method)The DDB method involves doubling the straight-line rate of depreciation and multiplying the resulting accel-erated depreciation rate times the asset’s declining balance (or book value). The declining balance initially equals the asset’s cost but is reduced each year by that year’s depreciation. There is no reduction for salvage value when the depreciation process begins but the asset’s book value (cost less accumulated depreciation) may not fall below salvage value. Using our original case facts (equipment cost $19,000, estimated 3 year-life, $1,000 salvage value), the equipment will be depreciated as follows:

200% DDB Method Declining Annual Rate of Annual Accumulated Book Year Balance Depreciation* Depreciation Expense Depreciation Value** 20X1 $19,000*** × 2/3 = $12,667 $12,667 $6,333 20X2 $6,333 × 2/3 = $4,222 $16,889 $2,111 20X3 $2,111 – $1,000 salvage value = $1,111**** $18,000 $1,000

* DDB rate = 2 × straight-line rate = 2 × 1/3 = 2/3 (this is the accelerated depreciation rate). ** Book value = $19,000 original cost less accumulated depreciation. *** Original cost. **** Note: While there is no initial reduction for salvage value, do not bring the declining balance (book value) below salvage value. That is, 2/3 of

$2,111 or $1,407 would have been too much depreciation.

200% DDB Depreciation for Partial Year Again, if the equipment described in the previous example had been acquired on March 20, 20X1 (not January 1, 20X1), any systematic and rational approach to depreciation is acceptable under generally accepted accounting principles. Depreciation could be based on: a) rounding to the nearest whole month or, b) the half-year convention.

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a) 200% DDB Depreciation Method Rounding to the Nearest Whole Month (April 1 to December 31, 20X1 = 9 Months/12 Months)

Declining Annual Rate of Annual Accumulated Book Year Balance Depreciation* Depreciation Expense Depreciation Value** 20X1 $19,000*** × 1/2**** = $9,500 $9,500 $9,500 20X2 $9,500 × 2/3 = $6,333 $15,833 $3,167 20X3 $3,167 × 2/3 = $2,111 $17,944 $1,056 20X4 $1,056 – $1,000 salvage value = $56***** $18,000 $1,000

* DDB rate = 2 × straight-line rate = 2 × 1/3 = 2/3 (this is the accelerated depreciation rate). ** Book value = $19,000 original cost less accumulated depreciation. *** Original cost. **** 20X1 (first year) rate = 2/3 accelerated depreciation rate × 9 months/12 months = 1/2. ***** Note: While there is no initial reduction for salvage value, do not bring the declining balance (book value) below salvage value. That is,

2/3 of $1,056 or $704 would have been too much depreciation.

Note: Other systematic and rational approaches could be used. For example, in this case, depreciation expense could have calculated by taking:

• 9/12ofafullfirstyear$12,667DDBdepreciationexpensein20X1($9,500), • 3/12ofafullfirstyear$12,667DDBdepreciationexpenseplus9/12ofafullsecondyear$4,222DDBdepreciationexpensein

20X2 ($6,334), • 3/12ofafullsecondyear$4,222DDBdepreciationexpenseplus9/12ofafullthirdyear$1,111DDBdepreciationexpensein

20X3 ($1,888), and • 3/12ofafullthirdyear$1,111DDBdepreciationexpensein20X4($278),equalingaccumulateddepreciationof$18,000($9,500

+ $6,334 + $1,888 + $278).

b) 200% DDB Method Applying the Half-Year Convention

Declining Annual Rate of Annual Accumulated Book Year Balance Depreciation* Depreciation Expense Depreciation Value** 20X1 $19,000*** × 1/3**** = $6,333 $6,333 $12,667 20X2 $12,667 × 2/3 = $8,445 $14,778 $4,222 20X3 $4,222 × 2/3 = $2,815 $17,593 $1,407 20X4 $1,407 – $1,000 salvage value = $407***** $18,000 $1,000

* DDB rate = 2 x straight-line rate = 2 x 1/3 = 2/3 (this is the accelerated depreciation rate). ** Book value = $19,000 original cost less accumulated depreciation. *** Original cost. **** 20X1 (first year) rate = 2/3 accelerated depreciation rate x 1/2 (for half-year convention) = 1/3. ***** Note: While there is no initial reduction for salvage value, do not bring the declining balance (book value) below salvage value. That is, 2/3 of

$1,407 or $938 would have been too much depreciation.

Accelerated Depreciation Using the 150% Declining-Balance Method (1.5 DB Method)The 1.5 DB method involves multiplying the straight-line rate of depreciation by 1.5 and then multiplying the resulting accelerated depreciation rate times the asset’s declining balance (or book value). As stated earlier, the declining balance initially equals the asset’s cost but is reduced each year by that year’s depreciation. Also, recall that there is no reduction for salvage value when the depreciation process begins but the asset’s book value (cost less accumulated depreciation) may not fall below salvage value. Again using the original informa-tion, 150% declining-balance depreciation would be as follows:

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150% DB Depreciation Method

Declining Annual Rate of Annual Accumulated Book Year Balance Depreciation* Depreciation Expense Depreciation Value** 20X1 $19,000*** × 1/2 = $9,500 $9,500 $9,500 20X2 $9,500 × 1/2 = $4,750 $14,250 $4,750 20X3 $4,750 – $1,000 salvage value = $3,750**** $18,000 $1,000

* 1.5 DB rate = 1.5 × straight-line rate = 1.5 × 1/3 = 1/2 (this is the accelerated depreciation rate). ** Book value = $19,000 original cost less accumulated depreciation. *** Original cost. **** Note: While there is no initial reduction for salvage value, bring the declining balance (book value) to salvage value.

150% DB Depreciation for Partial YearAgain, if the equipment described in the previous example had been acquired on March 20, 20X1 (not January 1, 20X1), any systematic and rational approach to depreciation is acceptable under generally accepted accounting principles. Depreciation could be based on: a) rounding to the nearest whole month or, b) the half-year convention.

a) 150% DB Depreciation Method Rounding to the Nearest Whole Month (April 1 to December 31, 20X1 = 9 Months/12 Months)

Declining Annual Rate of Annual Accumulated Book Year Balance Depreciation* Depreciation Expense Depreciation Value** 20X1 $19,000*** × 3/8**** = $7,125 $7,125 $11,875 20X2 $11,875 × 1/2 = $5,938 $13,063 $5,937 20X3 $5,937 × 1/2 = $2,969 $16,032 $2,968 20X4 $2,968 – $1,000 salvage value = $1,968***** $18,000 $1,000

* 1.5 DB rate = 1.5 × straight-line rate = 1.5 × 1/3 = 1/2 (this is the accelerated depreciation rate). ** Book value = $19,000 original cost less accumulated depreciation. *** Original cost. **** 20X1 (first year) rate = 1/2 accelerated depreciation rate × 9 months/12 months = 3/8. ***** Note: While there is no initial reduction for salvage value, bring the declining balance (book value) to salvage value.

Note: Other systematic and rational approaches could be used. For example, in this case, deprecia-tion expense could have been calculated by taking:

• 9/12ofafullfirstyear$9,500150%DBdepreciationexpensein20X1($7,125), • 3/12ofafullfirstyear$9,500150%DBdepreciationexpenseplus9/12ofafullsecondyear$4,750150%DBdepreciation

expense in 20X2 ($5,938), • 3/12ofafullsecondyear$4,750150%DBdepreciationexpenseplus9/12ofafullthirdyear$3,750150%DBdepreciation

expense in 20X3 ($4,000), and • 3/12ofafullthirdyear$3,750150%DBdepreciationexpensein20X4($937),equalingaccumulateddepreciationof$18,000

($7,125 + $5,938 + $4,000 + $937).

b) 150% DB Depreciation Method Applying the Half-Year Convention Declining Annual Rate of Annual Accumulated Book Year Balance Depreciation* Depreciation Expense Depreciation Value** 20X1 $19,000*** × 1/4**** = $4,750 $4,750 $14,250 20X2 $14,250 × 1/2 = $7,125 $11,875 $7,125 20X3 $7,125 × 1/2 = $3,563 $15,438 $3,562 20X4 $3,562 – $1,000 salvage value = $2,562***** $18,000 $1,000

* 1.5 DB rate = 1.5 × straight-line rate = 1.5 × 1/3 = 1/2 (this is the accelerated depreciation rate). ** Book value = $19,000 original cost less accumulated depreciation. *** Original cost. **** 20X1 (first year) rate = 1/2 accelerated depreciation rate × 1/2 (for half-year convention) = 1/4. ***** Note: While there is no initial reduction for salvage value, bring the declining balance (book value) to salvage value.

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Special Point: Accelerated Depreciation Adjustment Sometimes when declining balance accelerated depreciation methods are used, a special adjustment is needed involving a switch from the accelerated method to the straight-line method.

Example: On April 18, 20X3, equipment was purchased for $100,000 with a salvage value of $8,000 and a useful life of 5 years. The 150% DB depreciation method is used as follows: Declining Annual Rate of Annual Accumulated Book Year Balance Depreciation* Depreciation Expense Depreciation Value** 20X3 $100,000*** × 3/20**** = $15,000 $15,000 $85,000 20X4 $85,000 × 3/10 = $25,500 $40,500 $59,500 20X5 $59,500 × 3/10 = $17,850 $58,350 $41,650 20X6 $41,650 × 3/10 = $12,495 $70,845 $29,155 20X7 Switch to straight-line***** $10,578 $81,423 $18,577 20X8 Switch to straight-line***** $10,577 $92,000 $8,000

* 1.5 DB rate = 1.5 × straight-line rate = 1.5 × 1/5 = 3/10 (this is the accelerated depreciation rate). ** Book value = $100,000 original cost less accumulated depreciation. *** Original cost. **** 20X3 (first year) rate = 3/10 accelerated depreciation rate × 1/2 (for half-year convention) = 3/20. ***** The remaining depreciable amount at January 1, 20X7 is $21,155 ($29,155 book value at December 31, 20X6 less $8,000 salvage). Using

a switch to straight line depreciation for 20X7 and 20X8, depreciation expense each year is $10,577.50 (rounded to $10, 578 for 20X7 and $10,577 for 20X8).

Note: If the switch to straight-line depreciation had not been made, 20X7 depreciation expense would have been $8,747 (3/10 × $29,155) and the 20X8 depreciation would have been higher at $12,408. To avoid a situ-ation in which an accelerated depreciation method results in higher depreciation expense in a later year than in a previous year, a switch to the straight-line method is made. This change to the straight-line method is not considered to be an accounting change since the goal of accelerated depreciation is maintained – earlier years have higher depreciation expense and later years have lower depreciation expense.

Straight-line Depreciation versus Accelerated DepreciationThe straight-line method, which results in a constant dollar amount of depreciation each year over the life of the asset, makes sense particularly when an asset has equal utility over its life, that is, when it provides net cash flows that are roughly equal each year, has equal annual productive capacity over its life, and has relatively constant maintenance costs over its life. The accelerated method, which results in a higher dollar amount of depreciation in the early years and in a lower dollar amount of depreciation in the later years of an asset’s life, makes sense particularly when an asset has declining utility over its life, that is, when it provides net cash flows that are higher in the early years of its life and lower in the later years of its life, has greater productive capacity in its early years than in its later years, and has rising maintenance costs. So, for example, if straight line depreciation is used for an asset that has equal utility and maintenance costs over its life, con-stant annual depreciation expense and constant annual maintenance expense may be viewed as follows:

$ Depreciation expense/year

$ Maintenance expense/year

$ Total depreciation & maintenance expenses/year

1 2 3Years

1 2 3Years

1 2 3Years




1 2 3Years

1 2 3Years

1 2 3Years

If accelerated depreciation is used for an asset that has declining utility and rising maintenance costs over its life, decreasing depreciation expense and increasing maintenance expense may be viewed as follows:

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1 2 3Years

1 2 3Years

1 2 3Years




1 2 3Years

1 2 3Years

1 2 3Years

Note that, in theory, because the straight-line method yields relatively lower depreciation expense and higher maintenance expense than the accelerated method in the early years of the asset’s life while the reverse is true for the later years of the asset’s life, total annual depreciation and maintenance expenses are relatively similar under straight-line and accelerated methods as depicted in the graphs above, resulting in a “leveling” of total annual expenses. As a practical matter, however, a firm may simply wish to use accelerated depreciation, for all depreciable assets for tax purposes to lower current tax burden as described previously. Also, an argu-ment can be made in favor of the use of accelerated depreciation in any case for financial reporting purposes since it results in lower net income and therefore is in conformity with the principle of conservatism described in an earlier chapter.

Units of Output (Production Based) Depreciation MethodSo far, the straight-line and accelerated depreciation methods we have discussed have resulted in the recording of depreciation expense based simply on the passage of time. That is, once determined by these methods, depreciation cost is a fixed cost which will occur no matter what the level of output or production. The units of output depreciation method is fundamentally different since depreciation is not based on the passage of time but rather on the level of output or production, such that units of output depreciation is a variable cost. Units of output depreciation is calculated as follows:

Asset Cost – Salvage ValueEstimated units of output/production*

= Depreciation expense per output/production unit

* Output/production units could represent units of product, machine hours, labor hours, miles driven, etc.

Using our original case facts (equipment cost $19,000 with a $1,000 estimated salvage value) and the addi-tional assumption that the estimated units of output from this equipment total 9,000 units, depreciation expense would be determined as follows:

$19,000 – $1,0009,000 estimated units of output

= $2.00 depreciation expense per unit of output

So, if in 20X1, the equipment’s output was 3,000 units, then the 20X1 depreciation expense would be $6,000 (3,000 units of output x $2.00 per unit depreciation expense).

Depreciation and Federal Taxation The U.S. Congress has often revised federal income tax law in ways that encourage investment in property, plant, and equipment. For example, the Economic Stimulus Act of 2008 allows the first $250,000 of equipment cost to be expensed immediately for tax purposes rather than recording these expenditures as assets. This is not permissible under generally accepted accounting principles (GAAP), but it is not only perfectly alright to use various forms of accelerated depreciation on tax returns that differ from the depreciation methods used in financial reporting to the public, it makes good business sense to do so since a firm can reduce its current tax burden. Congress adopted the modified accelerated cost recovery system (MACRS) in 1986 which provides taxpayers with an option to use accelerated depreciation on tax returns rather than straight-line depreciation. MACRS provides for accelerated depreciation that approximates 200% DDB and 150% DB methods. MACRS assigns “class lives” and related annual depreciation rates to assets and so, for example, an asset with a 3 year class life that cost $19,000 with a $1,000 salvage value could be depreciated on a straight-line basis for tax purposes or, alternatively, on an accelerated basis over 4 years under the tax law as follows:

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MACRS Accelerated Depreciation under U.S. Tax Law MACRS Depreciation Annual Accumulated Book Year Cost Rate Depreciation Expense Depreciation Value** 20X1 $19,000 × 33.33% = $6,333 $6,333 $12,667 20X2 $19,000 × 44.45% = $8,445 $14,778 $4,222 20X3 $19,000 × 14.81% = $2,814 $17,592 $1,408 20X4 $19,000 × 7.41% = $1,408 $19,000 $0

Note that in this case MACRS closely approximates the 200% DDB method applying the half-year conven-tion, except that under MACRS the full cost of the asset is depreciated without consideration for salvage value, resulting in higher depreciation in the fourth and final year.

Both the tax laws on methods of depreciating or expensing the cost of plant assets, and the accounting and reporting requirements under GAAP when different depreciation methods are used for financial reporting and tax purposes, are complex and beyond the scope of this presentation. Suffice it to say that different reporting methods may be and often are used for financial reporting versus tax reporting purposes. A study done by the American Institute of CPAs in 2007 entitled “Depreciation Methods Used By 600 Large Companies” showed that a majority used straight-line depreciation in financial reporting. But a majority also used an accelerated depre-ciation method for tax purposes. This stands to reason since the accelerated methods will lower taxable income currently while the straight-line method will produce a higher net income for financial reporting purposes.

Consistency PrincipleThere are numerous depreciation methods that are systematic and rational and which are therefore accept-able under generally accepted accounting principles for financial reporting purposes. However, under the con-sistency principle, a firm should generally not change its method of depreciating a given plant asset from one year to the next, although different depreciation methods may be selected for different plant assets. In the unusual case in which a given method can be shown to be preferred over another method, such as when a new accounting standard indicates a preference, a change may be made to the preferred method with full disclo-sure in the financial statements and related notes. A change from one depreciation method to another, while viewed as a change in accounting principle inseparable from a change in estimate, would be accounted for as a change in estimate (described below). (Note: This is a Financial Accounting Standards Board Statement on Financial Accounting Standards No. 154 change from previous GAAP which had accounted for changes in depreciation methods very differently as changes in accounting principle.)

Changes in EstimatesChanges in accounting estimate are a natural part of business and financial reporting. There are numerous examples. Examples relevant to this discussion include changes in estimated plant asset lives and salvage values. Changes in accounting estimate will simply be reported in the financial statements of current and future periods affected, with footnote disclosure of the change. No adjustments are made for any prior year depreciation expense. As mentioned previously, changes in estimate inseparable from changes in accounting principle, such as changes in the method of depreciating an asset, are also accounted for as changes in estimate.

Changes in Accounting Estimate Example 1 (Change in Estimated Plant Asset Life and Salvage Value) On January 1, 20X1, ABC Co. purchased equipment with a useful life of 10 years and $0 salvage value for $100,000. ABC Co. uses straight line depreciation. On January 1, 20X4, it was determined that the remaining equipment life would be only 3 more years due to the introduction of newer more efficient equipment (total 6 year life). It was also determined that the equipment would have a salvage value of $10,000 at the end of year 6. No adjustment would be made to any prior year depreciation. Current and future year depreciation will change as follows.

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January 1, 20X1 Original cost …………………………………………… $100,000 Less: Accumulated depreciation through December 31, 20X3: ($100,000/10 years) = $10,000/year × 3 years ………… (30,000) January 1, 20X4 Book value …………………………………………… 70,000 Less: Estimated salvage value ………………………………………… (10,000) Depreciable amount for remaining asset life …………………………… 60,000 Divide asset life years remaining at January 1, 20X4 ………………… 3 yrs. Depreciation expense/year (each year 20X4, 20X5, & 20X6) ………… $20,000

Note: Original equipment cost of $100,000 less accumulated depreciation at December 31, 20X6 of $90,000 (based on $30,000 for the first 3 years plus $60,000 for last 3 years), results in a book value of $10,000 which is the salvage value.

Changes in Accounting Estimate Example 2 (Change in Estimate Inseparable from Change in Principle):Suppose the following original and revised information is available regarding a piece of equipment:

Original information at January 1, 20X1: January 1, 20X1 Equipment cost ……………………………………… $90,000 Estimated life at January 1, 20X1 ……………………………………… 6 years Double declining balance (DDB) depreciation method is used. Revised information at January 1, 20X3: Estimated life (total from January 1, 20X1) …………………………… 8 years (that is, 6 year life remaining at January 1, 20X3) Estimated salvage value ………………………………………………… $4,000 Switch to straight-line depreciation method is made.

If a change to straight line (SL) depreciation for years 20X3 through 20X8 is made based on a longer asset life expectation than originally estimated, we need to first determine the remaining asset book value as of December 31, 20X2. Then, this remaining book value at December 31, 20X2 less salvage value will be depreciated over the next six years (20X3 through 20X8) using the SL depreciation method. No prior year adjustments are needed since a change in estimate is accounted for in the current and future years only.

So, to determine book value on December 31, 20X2, we have the equipment’s original cost of $90,000 and need to subtract accumulated depreciation through December 31, 20X2 which is determined as follows:

Year 20X1 and 20X2 DDB depreciation (2 × SL rate of 1/6 = 1/3): 20X1 DDB Depreciation expense = $90,000 × 1/3 = $30,000 20X2 DDB Depreciation expense = $60,000 × 1/3 = $20,000 December 31, 20X2 Accumulated depreciation … $50,000

The equipment’s book value at December 31, 20X2, is $40,000 (based on the original cost of $90,000 less accumulated depreciation of $50,000). Now, the 20X3 through 20X8 SL depreciation can be determined as follows:

($40,000 book value less $4,000 salvage)/6 years = $36,000/6 = $6,000/year depreciation expense for last 6 years.

Accumulated depreciation through December 31, 20X8, equals $86,000 (based on $50,000 for 20X1 and 20X2 plus $36,000 for 20X3 through 20X8). The equipment cost of $90,000 less accumulated depreciation of $86,000 equals the equipment’s book value of $4,000, which is also its salvage value.

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6.1e Plant Asset ImpairmentIf a plant asset’s book value cannot be expected to be recovered either through use or sale, then all or a portion of the asset must be written off to an income statement impairment loss account. For example, if computer equipment was purchased but became of no value prior to the end of it’s originally estimated life due to the availability of new and superior technology, the book value of the computer equipment would be written off to impairment loss as follows:

Impairment loss ……………………………………………………………… $X Accumulated depreciation – computer equipment ………………………… $X Computer equipment …………………………………………………………… $X

International Accounting Standards Board (IASB) Notes

Under U.S. GAAP, historical cost must be used to report plant assets. There are several arguments in favor of the use of historical cost. The objectivity principle discussed in an earlier chapter favors the use of historical costs since historical costs are objectively verifiable by an auditor using invoices, contracts, payment records, price lists, and so on. If fair market value were used rather than historical cost, audit costs would increase since the auditor would instead have to rely on outside expert appraisals to determine if plant assets were fairly presented. Also, the going concern principle favors the use of historical cost since this principle assumes that a business will remain in existence for a period of time sufficiently long to permit recovery of the historical cost of plant assets through depreciation expenses that will be matched against future revenues. However, International Financial Reporting Standards (IFRS) allow the use of either historical cost or fair market value in accounting and reporting plant assets. A strong argument in favor of the use of fair market value is simply that, over time, historical costs become less meaningful in the presentation of a firm’s financial position. It is obvious that land or buildings, for example, purchased many years ago will not be fairly reflected in terms of value in today’s statement of financial position if historical costs (less accumulated depreciation in most cases) are used. If a plant asset is increased to fair market value under IFRS, the unrealized gain is not reported as income but is treated as an adjustment to equity through accumulated other comprehensive income.

6.1f Plant Asset DisposalAt the time plant assets are disposed of, whether scrapped, sold, or exchanged (traded-in), depreciation should first be brought up to date as of the date of the sale. If the half-year convention is used, the deprecia-tion expense should be recorded for one-half a year in the year of sale. If the half-year convention is not used, then depreciation should be taken for a portion of the year up to the sale date.

Scrapping of Plant Assets Suppose a piece of equipment that cost $10,000 and which is fully depreciated is no longer useful and must therefore be scrapped. The entry to record scrapping of the equipment is:

Accumulated depreciation – equipment ……………………………… 10,000 Equipment …………………………………………………………………… 10,000

Suppose a piece of equipment that cost $10,000 is no longer useful and must therefore be scrapped. Further assume that accumulated depreciation through the date the equipment was scrapped was $$8,500. The entry to record scrapping of the equipment is:

Accumulated depreciation – equipment …………………………………8,500 Loss on disposal of equipment ……………………………………………1,500 Equipment …………………………………………………………………… 10,000

Of course, it is possible that a plant asset may continue to be useful for a long time after it has been fully depreciated. The process of depreciating an asset is done to spread the cost of the asset across all years expected to benefit from its use but it is only an estimate. So, when an asset outlives its estimated life, no additional depreciation can be taken since the historical cost principle limits depreciation to the original cost.

Sale of Plant Assets When a plant asset is sold for a price that differs from its book value, a gain or a loss on sale will occur. Recall that the equipment we discussed in our earlier examples was purchased on January 1, 20X1, for $19,000,

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had an estimated salvage value of $1,000, and a three-year life. Suppose this equipment was sold on April 20, 20X3, for $4,000. To determine the gain or loss on sale, we will compare the selling price of $4,000 with the April 20, 20X3, book value. So, we need to determine April 20, 20X3, book value which will depend on the depreciation method used. Assuming the half-year convention was used, let’s determine book value on the sale date assuming three different but commonly used depreciation methods—the straight-line method, the DDB method, and the 1.5 DB method.

Using the Half Year Convention Straight-Line DDB 1.5 DB. Year 20X3 depreciation expense (see earlier schedule) … $6,000 $2,815 $3,563 Multiply by 50% for one-half year …………………………… × 50% × 50% × 50% Additional depreciation needed for 20X3 sale year* ……… $3,000 $1,408 $1,782 Plus: Accumulated depreciation through December 31, 20X2 (see earlier schedule) ……………… 9,000 14,778 11,875 Accumulated depreciation through April, 20, 20X3 ……… $12,000 $16,186 $13,657

* An entry would be made debiting depreciation expense and crediting accumulated depreciation for this additional depreciation, bringing accumu-lated depreciation up to date as of April 20, 20X3 under each of the three methods.

Using the Half Year Convention Straight-Line DDB 1.5 DB. As of April 20, 20X3 sale date: Equipment (original cost) …………………………………… $19,000 $19,000 $19,000 Less: Accumulated depreciation through April, 20, 20X3 (see previous schedule above) ………… 12,000 16,186 13,657 Equipment (net) (book value on sale date) ………………… $7,000 $2,814 $5,343 Selling price …………………………………………………… $4,000 $4,000 $4,000 Gain (loss) on sale …………………………………………… ($3,000) $1,186 ($1,343)

The entry to record the sale if the straight-line method were used would be:

Cash ……………………………………………………………………4,000 Accumulated depreciation – equipment ……………………………… 12,000 Loss on equipment sale ……………………………………………………3,000 Equipment …………………………………………………………………… 19,000

The entry to record the sale if the DDB method were used would be:

Cash ……………………………………………………………………4,000 Accumulated depreciation – equipment ……………………………… 16,186 Equipment …………………………………………………………………… 19,000 Gain on equipment sale ……………………………………………………… 1,186

The entry to record the sale if the 1.5 DB method was used would be:

Cash ……………………………………………………………………4,000 Accumulated depreciation – equipment ……………………………… 13,657 Loss on equipment sale ……………………………………………………1,343 Equipment …………………………………………………………………… 19,000

These entries to record the sale of a plant asset demonstrate the idea that depreciation is the allocation of an asset’s cost to future years benefited and not asset valuation. If depreciation provided asset valuation, there should be no gain or loss on sale but the DDB and 1.5 DB methods produced a gain and a loss respectively. It so happened that there was no gain or loss on the sale under the straight-line method but this was not because the straight-line method is designed to provide for valuation. Note also that since the DDB method recorded relatively higher depreciation expenses in the early years which brought the asset’s book value to a lower level than the other methods, the DDB method was the only method that resulted in a gain on sale.

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Exchange of Plant AssetsSometimes, a firm will trade-in one asset in the purchase of another asset. The trade-in could be for similar (car for car) or dissimilar (car for factory equipment) assets. Generally, if a trade-in allowance on the pur-chase of an asset exceeds the traded in asset’s book value, a gain is recognized, but if the traded in asset’s book value exceeds the trade-in allowance, a loss is recognized. However, because special rules apply here and because financial accounting and federal tax rules differ in some ways, this subject is covered in more detail in more advanced courses.

6.2 Intangible Assets6.2a Nature and Types of Intangible AssetsIntangible assets are long-lived assets with no physical substance. All intangible assets should be tested for impairment and should be written down to their fair value or to zero if their book value is impaired, that is, if their book value exceeds their fair value. All intangible assets, except for goodwill, should be amortized to expense over the shorter of their legal lives or their economically useful lives. (Trademarks, brands, and fran-chise licenses are amortized over a reasonable life, which may be interpreted as their economic lives.) Often, as you will see, the legal lives of intangible assets far exceed their economic lives. Generally, internally gener-ated costs to develop intangible assets are treated as revenue expenditures (see research and development cost discussion shortly), with the exception being certain software development costs after a working model or prototype is developed.

Examples of intangible assets include:Software: Costs to develop computer programs for sale, lease, or internal use after a working model is

developed are capital expenditures.Patents: A patent is an exclusive right granted by the federal government to make a product or use a process

for a period of 20 years (design patents are granted for 14 years). The cost of a patent is its purchase price, including any associated legal and registration fees, plus any costs to successfully defend it.

Copyrights: A copyright, recorded at its acquisition cost including any associated legal and registration fees, is an exclusive right granted by the federal government to sell and reproduce artistic materials (books, musical scores, and other artistic works) and computer programs for a period equal to the author’s life plus 70 years.

Noncompete covenant: Noncompete covenants, recorded at acquisition cost, limit someone’s right to compete in a given business for a specific period of time.

Goodwill: The excess of the price paid for a business over the fair market value of the net assets (assets less liabilities) of that business (additional discussion of goodwill follows below).

Other intangible assets include leaseholds (rights to land or buildings), customer lists, trademarks and trade names, franchises, and licenses.

Example: Davis Co. purchased a patent for $40,000 from an inventor of a new product 8 years after the patent was registered with the federal government. The estimated useful life of the patent for Davis Co.’s pur-poses is 5 years. The legal life of this patent is 12 years, based on the original 20 year life minus 8 years since registration. Therefore, the shorter of the economic life (5 years) or the legal life (12 years) is 5 years. The patent should be amortized over 5 years.

The entry to acquire this patent is:

Patent ………………………………………………………………… 40,000 Cash …………………………………………………………………………… 40,000

The entry to record patent amortization expense each year for the next 5 years is:

Patent amortization expense ………………………………………………8,000 Patent ………………………………………………………………………… 8,000

This entry is based on the $40,000 patent cost divided by 5 years.

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Example: XYZ Co. purchased patent #1 for $90,000 and patent #2 for $100,000. In addition, registration fees were paid in the amounts of $10,000 for patent #1 and 15,000 for patent #2. Finally, XYZ Co. paid $40,000 to successfully defend patent #1 and $50,000 to unsuccessfully defend patent #2. Costs associated with patent #1 are capital expenditures that will be reported as the cost of the patent since it has been successfully defended. But the costs associated with patent #2 are revenue expenditures with no future benefit since the patent was not successfully defended and must therefore be charged to expense immediately. A summary of the expenditures follows.

Patent #1 Patent #2 Acquisition costs …………………………… $90,000 $100,000 Registration costs …………………………… 10,000 15,000 Legal defense was …………………………… Successful Unsuccessful Legal defense costs ………………………… 40,000 50,000 Expense immediately (unsuccessful) …… $165,000 Patent cost (capitalized) ………………… $140,000

6.2b GoodwillSome special discussion of goodwill is necessary. Recall that goodwill is the excess of the price paid for a busi-ness over the fair market value of the net assets (assets less liabilities) of that business. It is a price paid for the excess earnings potential of a business. Goodwill can only be recorded when one company buys another company at a price above the fair value of the net assets of the other company. When an actual purchase is made, objective evidence of the existence of goodwill becomes available. Companies cannot simply record goodwill they may have created for themselves. Only a purchase transaction provides the necessary objective evidence for the existence of goodwill.

Example: ABC Company is for sale. With the help of appraisers for the purpose of selling the business, ABC Company’s statement of financial position, including both book values and fair market values, is as follows:

ABC CompanyStatement of Financial Position

June 30, 20X5 ASSETS LIABILITIES & STOCKHOLDERS’ EQUITY Book Value Fair Value Book Value Fair Value Current assets: Current liabilities: Cash ………………… $1,000,000 $1,000,000 Accounts payable ……… $5,000,000 $5,000.000 Accounts receivable (net) 3,000,000 3,000,000 Long-term debt: Inventory ……………… 4,000,000 3,500,000 Mortgage payable ……… 4,500,000 4,500,000 Total current assets …… 8,000,000 7,500,000 Total liabilities …………… 9,500,000 9,500,000 Plant assets (net) ……… 7,000,000 8,000,000 Stockholders’ equity: Total assets …………… $15,000,000 $15,500,000 Common stock ………… 3,000,000 Retained earnings ……… 2,500,000 Total stockholders’ equity … 5,500,000 Total liabilities & stockholders’ equity …… $15,000.000

Note that while the book value of the business is $5,500,000 (assets $15,000,000 less liabilities $9,500,000), the fair of the business is $6,000,000 (assets $15,500,000 less liabilities $9,500,000). The fair value of the busi-ness is $500,000 greater than the book value since inventory is overvalued by $500,000 and plant assets are undervalued by $1,000,000.

Suppose XYZ Company purchased all of the net assets of ABC Co. for $6,500,000 on July 1, 20X5. The result would be that XYZ Company would record goodwill of $500,000 on the purchase (price paid $6,500,000 less fair value of net assets $6,000,000).

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The entry to record the purchase on the books of XYZ Company on July 1, 20X5, appropriately ignoring ABC Company’s book values, would be based on fair values as follows:

July 1, 20X5 Cash …………………………………………………… 1,000,000 Accounts receivable ………………………………………… 3,000,000 Inventory ………………………………………… 3,500,000 Plant assets ………………………………………… 8,000,000 Goodwill ………………………………………… 500,000 Accounts payable ………………………………………5,000,000 Mortgage payable ………………………………………4,500,000 Cash ………………………………………………………6,500,000 To record acquisition of net assets of ABC Company.

Why was XYZ Company willing to pay $500,000 in goodwill, above the fair value of the net assets acquired? The simple answer is excess earnings potential. For example, XYZ Company may have determined that ABC Company’s annual earnings were $100,000 above the norm for the industry. XYZ Company was willing to pay for these excess earnings for a 5 year period ($100,000 annual excess earnings times 5 years). XYZ Company may be trying to increase its market share in a given industry and if it can continue to provide the level of products or services that had been provided by ABC Company beyond 5 years, XYZ Company will begin to benefit even more heavily from the purchase.

Under GAAP, since goodwill of many businesses tends to rise in value over time, it is not amortized. Also, like some other intangible assets such as trademarks and trade names, goodwill has an indefinite life. But under GAAP, goodwill must be tested for impairment annually and must be written down if its value is impaired (Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets”, 2001, par. 11 to 17).

6.2c Impairment of Intangible AssetsIf an intangible asset declines in value it must be written down. This value decline is called impairment. Once written down, the intangible asset cannot be written up in the future if it increases in value.

Example: Suppose the goodwill from the previous example of $500,000 is tested for impairment at the end of XYZ Company’s fiscal year on June 30, 20X6, and is determined to be worth only $450,000. The following entry would be necessary on XYZ Company’s books:

June 30, 20X6 Impairment loss ……………………………… 50,000 Goodwill ……………………………………………………… 50,000

The goodwill will now appear on the statement of financial position at $450,000 (original $500,000 less impairment loss $50,000). Since it may not be written back up again in the event the value of goodwill increases in the future, goodwill will remain at $450,000 unless it is further impaired.

6.2d Research and Development (R&D) CostsIn many industries (pharmaceuticals, chemicals, aircraft, computer and computer software development, etc.), R&D costs represent a significant cost, in some cases in the billions of dollars annually for some compa-nies. The general rule under U.S. GAAP is that R&D costs must be expensed as they are incurred with only minor exceptions, such as expenditures for the purchase of assets with alternative future uses. In developing the general rule that R&D costs should be expensed as incurred, the Financial Accounting Standards Board argued that R&D costs should be expensed due to the uncertainty of future benefit from R&D work.

6.2e Organization CostsOrganization or start-up costs are costs of forming a corporation such as legal fees to develop articles of incor-poration, state registration fees, accounting fees, costs of printing stock, underwriter’s fees, etc. Arguably, organization costs could be viewed as an intangible asset amortizable over the entire life of the firm but since this life is not known, organization costs are generally expensed as incurred.

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International Accounting Standards Board (IASB) Notes

Some big differences exist between U.S. GAAP and International Financial Reporting Standards (IFRS) on the treat-ment of: (I) some intangible asset costs, and (II) research and development costs as follows:

(I) Under IFRS, internally-generated costs to develop an intangible asset such as patents or trade names may be capitalized as part of the cost of the intangible asset as long as it is probable that future benefit will be received from these assets. Under U.S. GAAP, internally-generated costs to develop intangible assets must be expensed and only external costs of intangible assets may be capitalized, such as acquisition prices, legal fees, registra-tion costs, and costs to legally defend intangible assets such as patents.

(II) Under U.S. GAAP, research and development costs are generally expensed as they are incurred with the exception of expenditures for assets that have alternative future uses, with little distinction made between research and development costs. Under IFRS, research costs are also generally expensed as incurred, how-ever development costs may result in the recording of an intangible asset if certain criteria are met, such as:

• anintenttocompletetheintangibleassetwithadequate,available,andreliablymeasurableresources,

• technicalfeasibilityofcompletionoftheintangibleasset,and

• economicusefulnessoftheintangibleasset,suchasanabilitytosellitoruseit.

On these and other issues, the FASB and the IASB are continuing the work of convergence, attempting to eliminate differences.

6.3 Natural Resources6.3a Nature and Types of Natural ResourcesNatural resources are long-term assets that are converted into inventory through some extractive process such as drilling, pumping, mining, or cutting. Developed through these extractive processes are assets such as oil, gas, coal, and timber. The statement of financial position may label these natural resource assets in a descriptive way such as Mining Properties, Oil Reserves, or Timberlands.

The cost of natural resources includes acquisition costs, development costs, and in some cases estimated property restoration costs, such as a requirement that a lumber company engage in reforestation techniques after extraction of timber. As the natural resource is extracted, the long-term natural resource asset account balance is decreased (referred to as depletion) and the current asset inventory account is increased. When the natural resources are sold, the inventory account balance is decreased and cost of goods sold is increased.

6.3b Depletion and Its Effect on Financial StatementsDepletion refers to both a decrease in the natural resource and an increase in depletion cost which is either an expense (cost of goods sold) or inventory until the natural resources are sold. The depletion rate is determined as follows:

Acquisition price of natural resource – Salvage value + Restoration costs, if anyEstimated resource output (barrels, tons, feet, yards, etc.)

= Depletion rate per unit of output

Example: Land Minerals, Inc. acquired the Ridgeview Mines for $80,000,000 on January 15, 20X6, which were believed to contain an estimated 25,000,000 tons of coal. After all of the coal is mined, the salvage value of the property is expected to be $5,000,000. The depletion rate is determined as follows:

$80,000,000 cost – $5,000,000 salvage value25,000,000 estimated tons of coal

= $3 per ton mined depletion rate

If 6,000,000 tons were mined during 20X6, of which 4,000,000 tons were sold and 2,000,000 tons remained in ending inventory, entries for 20X6 on the books of Land Minerals, Inc. would be as follows:

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January 15, 20X6 Coal Mines: Ridgeview …………………………… 80,000,000 Cash ………………………………………………………… 80,000,000 To record purchase of mining property.

During 20X6 Inventory …………………………………………… 18,000,000 Accumulated depletion …………………………………… 18,000,000 To record depletion for the period (6,000,000 tons mined at $3 cost per ton).

Note: Accumulated depletion is a contra-asset account similar to accumulated depreciation, which will offset the natural resource asset account Coal Mines.

During 20X6 Cost of goods sold ………………………………… 12,000,000 Inventory …………………………………………………… 12,000,000 To record cost of goods sold for the period (4,000,000 tons sold at $3 cost per ton).

The income statement for the year ended December 31, 20X6, will include $12,000,000 in cost of goods sold from the Ridgeview Mine and the Statement of Financial Position as of December 31, 20X6, will include the following items:

Current asset: Inventory …… $6,000,000 (2,000,000 tons unsold at $3 cost per ton)Property, plant, and equipment: Coal mines ……………………………………… $80,000,000 Less: Accumulated depletion …………………… 18,000,000 Coal mines (net) ………………………………… $62,000,000

Special Point on Buildings and Equipment Related to Natural Resources If buildings and equipment are acquired for use at the natural resource extraction site, they should generally be depreciated over the shorter of their normal useful life or the life of the natural resource. Also, the units-of-output method of depreciation works well in this context since depreciation would then be proportional to depletion. Of course, if after completion of the extraction process at one site the intent is to continuously move plant assets acquired to new sites, then depreciation can be done over the estimated normal useful life of the asset, possibly using other depreciation methods such as straight-line or accelerated methods.

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Chapter 6 ExercisesE6.1 Distinguish between capital expenditures and revenue expenditures.

E6.2 Identify the items that follow as capital expenditures or revenue expenditures.

a) Paid $80,000 for an elevator in a converted offi ce building.b) Paid $45 for a new battery in a 4 year old delivery truck.c) Paid $3,000 for a new engine for a 4 year old delivery truck.d) Paid $3,500 for installation materials and labor to place a new piece of equipment in a factory.e) Paid $30 for an electronic pencil sharpener.f) Paid a total of $2,700 during the year for fuel to operate a business vehicle.

E6.3 ABC Designs, Inc purchased equipment with a list price of $60,000 on June 1, 20X9. ABC Designs, Inc. qualifi ed for a 3% discount off the list price. ABC Designs, Inc. paid $28,200 down to the seller and signed a 3 month note payable at a 4% annual rate due to the vendor, with interest of $100 due to the vendor at the end of each of the next three months and the note principal of $30,000 due on September 1, 20X9. In addition, the ABC Designs, Inc. paid the following costs in cash: sales tax on the equipment purchase of $3,492, equipment delivery costs of $308, and installation labor and material costs of $2,000. When the equipment was delivered, it fell off the delivery truck and cost the ABC Designs, Inc. an added $400 for repairs. a) At what total cost will the equipment be recorded? b) Prepare the entry on June 1, 20X9, to record the purchase.

E6.4 Mechanical Engineers, Inc. purchased a parcel of land to be used as a parking lot for $260,000 and also made the following payments:

• $2,100foraccruedtaxesatthetimeofthepurchase.• $10,900forgradingandclearingoftheland.• $1,000forlegalfees.• $8,000forrealestateandsettlementfees.• $50,000forremovalofanoldbuildingfromtheland.• $75,000forconstructionofdrivewaysandaparkinglot.

Before the old building was demolished, Mechanical Engineers, Inc. removed and sold copper pipe and antique stairwells and fi xtures from the old building for $10,000. Based on this information, at what amount should Mechanical Engineers, Inc. record the land acquisition in the land account?

E6.5 On January 15, 20X7, Davis Fashions Co. paid $1,000,000 ($400,000 down payment and a note payable for the balance) to acquire the following assets from a competitor that was going out of business:

Fair Market Value @ Purchase DateLand ………………………………………………………$110,000Building …………………………………………………… 600,000Equipment ………………………………………………… 260,000Inventory …………………………………………………… 80,000

Prepare the journal entry to record the purchase of these assets.

E6.6 On January 1, 20X4, The Fashion Store, Inc. leased retail store space for a 10 year period and immediately engaged in leasehold improvements that cost a total of $36,000 in 20X4, paid in cash. The leasehold improvements have an expected 12 year life. The Fashion Store, Inc. records an entry to amortize leasehold improvements at the end of its fi scal year on December 31 each year and takes a full year’s worth of amortization in the year leasehold improvements are made. The Fashion Store, Inc. is planning to move the store to a more up-scale shopping district at the end of the lease. Prepare the entries The Fashion Store, Inc. made in 20X4 to account for the payment of the leasehold improvement costs and for their subsequent amortization.

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E6.7 Davis Enterprises, Inc. has a December 31 year end. On January 11, 20X4, Davis Enterprises, Inc. purchased a truck for heavy duty hauling for $40,000. The truck is expected to be used for 5 years and it has an estimated salvage value of $5,000. If the straight-line method of depreciation is used (with a full month’s depreciation taken in the month of acquisition and none in the month of sale or disposal), determine the following:

a) Depreciation expense for 20X4 and 20X5.b) Presentation of the truck on the statement of fi nancial position as of

December 31, 20X5.c) Assuming the truck was sold on October 15, 20X5, for $27,000, prepare the journal entry

to record the sale. (Reminder: No depreciation expense in month of sale.)

E6.8 Davis Enterprises, Inc. has a December 31 year end. On January 11, 20X4, Davis Enterprises, Inc. purchased a truck for heavy duty hauling for $40,000. The truck is expected to be used for 5 years and it has an estimated salvage value of $5,000. If the straight-line method of depreciation is used (with the half-year convention), determine the following:

a) Depreciation expense for 20X4 and 20X5.b) Presentation of the truck on the statement of fi nancial position as of December 31, 20X5.c) Assuming the truck was sold on October 15, 20X5, for $27,000, prepare the journal entry

to record the sale. (Reminder: When the half-year convention is used, depreciation should be taken for one-half of a year in the year of sale.)

E6.9 Davis Enterprises, Inc. has a December 31 year end. On January 11, 20X4, Davis Enterprises, Inc. purchased a truck for heavy duty hauling for $40,000. The truck is expected to be used for 5 years and it has an estimated salvage value of $5,000. If the double-declining-balance (DDB) method of depreciation is used (with the half-year convention), determine the following:



E6.10 Davis Enterprises, Inc. has a December 31 year end. On January 11, 20X4, Davis Enterprises, Inc. purchased a truck for heavy duty hauling for $40,000. The truck is expected to be used for 5 years and it has an estimated salvage value of $5,000. If the 150% declining-balance (1.5 DB) method of depreciation is used (with the half-year convention), determine the following:



E6.11 Davis Enterprises, Inc. has a December 31 year end. On January 11, 20X4, Davis Enterprises, Inc. purchased a truck for heavy duty hauling for $40,000. The truck is expected to be used for 5 years and be driven an estimated 100,000 miles in total. It has an estimated salvage value of $5,000. The truck was actually driven 24,000 miles in 20X4 and 25,000 miles in 20X5. If the units-of-output method of depreciation is used (based on mileage), determine the following:

a) Depreciation expense for 20X4 and 20X5.b) Presentation of the truck on the statement of fi nancial position as of December 31, 20X5.c) Assume the truck was sold on October 15, 20X5 for $27,000. During 20X4, 24,000 actual

miles were driven, however only 19,800 actual miles were driven in 20X5 through the October 15, 20X5 sale date. Prepare the journal entry to record the sale.

164

E6.12 a) What are some justifi cations for the use of the straight-line depreciation method in fi nancial reporting? b) What are some justifi cations for the use of an accelerated depreciation method in fi nancial reporting? c) What are some justifi cations for the use of the units-of-output depreciation method in fi nancial reporting? d) What are the reasons a fi rm might use straight-line depreciation for fi nancial reporting purposes and accelerated depreciation (termed the modifi ed accelerated cost recovery system or MACRS) for tax reporting purposes?

E6.13 Explain why it is (or it is not) appropriate for a fi rm to change from one depreciation method to another from one reporting year to the next.

E6.14 On January 2, 20X3, Davis Co. purchased equipment for $180,000 that had an estimated 8 year useful life and an estimated salvage value of $20,000. Davis Co. uses straight-line depreciation. As of January 1, 20X5, due to the development of new technologies, it was determined that the remaining useful life of the equipment was only 4 years and the revised estimated salvage value projected for December 31, 20X8, was only $10,000. Davis Co. records depreciation expense at the end of its fi scal year on December 31 each year. a) Determine the depreciation expense that will appear on the income statement for the year ended December 31, 20X5. b) Show how the equipment will be presented in the statement of fi nancial position on December 31, 20X5.

E6.15 The following original and revised information is available regarding a piece of equipment:

Original information at January 1, 20X2: January 1, 20X2 Equipment cost ………………………………………… $60,000 Estimated life at January 1, 20X2 ………………………………………… 4 years Estimated salvage value ………………………………………………………… $0 Dou ble declining balance (DDB) depreciation method is used (the half-year

convention does not apply here).Revised information at January 1, 20X4: Estimated life (total from January 1, 20X2) ……………………………… 6 years (that is, 4 year life remaining at January 1, 20X4) Estimated salvage value …………………………………………………… $3,000 Swit ch to straight-line depreciation method is made (the half-year convention

does not apply here).

What is the depreciation expense for the year ended December 31, 20X4?

E6.16 Custom Designs, Inc. has the following computer equipment on its books:

Computer equipment …………………………………………………………… $48,000Less: Accumulated depreciation ……………………………………………… 18,000Computer equipment (net) …………………………………………………… $30,000

As a result of the development of new and superior technology, this computer equipment cannot be expected to be used or sold in the future. What recording in the books of Custom Designs, Inc., if any, is necessary?

E6.17 What major difference currently exists between U.S. generally accepted accounting principles (GAAP) and international fi nancial reporting standards (IFRS) regarding the reporting of property, plant, and equipment? What justifi cations are made for the U.S. GAAP approach versus the IFRS approach to this difference?

E6.18 Henley Co. developed a patent with a 20 year federally granted legal life on a product. Six years later, Davis Co. purchased the patent on January 2, 20X1, from Henley Co. for $25,000. Davis also paid legal fees during 20X1 to successfully defend the patent of $15,000. Davis Co. estimates that the patent’s economic life is 5 years. Prepare entries necessary on the books of Davis Co. to acquire the patent and to record patent amortization expense for the year ended December 31, 20X1. (Davis Co. takes a full year’s amortization in the year of patent acquisition and none in the year of disposition.)

165

E6.19 Refer to exercise 6.18. How would your answer differ if Davis Co. had been unable to successfully defend the sole right to the patent?

E6.20 Defi ne goodwill.

E6.21 What major difference currently exists between U.S. generally accepted accounting principles (GAAP) and international fi nancial reporting standards (IFRS) regarding the treatment of internally-generated costs to develop an intangible asset?

E6.22 What major difference currently exists between U.S. generally accepted accounting principles (GAAP) and international fi nancial reporting standards (IFRS) regarding the treatment of research and development costs?

E6.23 On February 18, 20X8, Everett Mining Company acquired the Western Mountain mining property for $60,000,000 which was estimated to contain 14,000,000 tons of ore. The property’s estimated salvage value after extraction of the ore is $4,000,000. During 20X8, 3,000,000 tons of ore were mined of which 2,500,000 tons were sold. a) What is the depletion rate per ton of ore? b) Prepare the journal entries made by Everett Mining Company to record the purchase of the mine on February 18, 20X8, depletion during 20X8, and the cost of goods (ore) sold during 20X8. c) Demonstrate the presentation as of December 31, 20X8, on Everett Mining Company’s Statement of Financial Position of all assets related to the mine acquisition and its depletion. d) Over what period should buildings and equipment acquired for use at the Western Mountain property be depreciated and what depreciation method would you recommend?

166

Chapter 6 ProblemsProblem 6.1

On October 1, 20X2, Custom Designs, Inc. purchased equipment with a list price of $75,000 from ABC Equipment Co. The equipment qualifi es for a 4% discount off the list price. The equipment has an estimated life of 10 years, an estimated salvage value of $5,000, and will be depreciated using the straight-line depreciation method rounding to the nearest whole month. On October 1, 20X2, Custom Designs, Inc. gave ABC Equipment Co. a $22,000 down payment on the equipment purchase and signed a 5% (annual rate) note payable for the balance. Principal and interest on the note payable are due in 4 months on January 31, 20X3.

Sales tax on the equipment was $4,320 and delivery cost was $180. Equipment installation labor costs of $2,500 and installation materials costs of $1,000 were incurred and paid. Cost of $6,000 were paid to advertise a new product that the equipment would be used to manufacture.

Custom Designs, Inc. makes adjusting journal entries at the end of its fi scal year on December 31 each year.

a) What was the total cost of the new equipment?b) Record the journal entry made on October 1, 20X2, to record the equipment

acquisition.c) Record any adjusting entry (entries) needed on December 31, 20X2, relative to the

equipment purchase.d) How will the equipment be presented in the December 31, 20X3, statement of

fi nancial position of Custom Designs, Inc.?

Problem 6.2On May 6, 20X3, Custom Designs, Inc. purchased equipment for $93,000 which had an estimated salvage value of $5,000 and an estimated life of 5 years. Custom Designs, Inc. uses the half-year convention in all depreciation expense calculations.

a) Complete the schedule below for all years of the equipment’s life:

Straight-line method applying the half-year convention Cost less Annual Rate Partial Annual Accumulated Book Year Salvage Value of Depreciation Year Depreciation Expense Depreciation Value

b) Complete the schedule below for all years of the equipment’s life:

200% DDB Method Applying the Half-Year Convention Declining Annual Rate of Annual Accumulated Book Year Balance Depreciation Depreciation Expense Depreciation Value

c) Complete the schedule below for all years of the equipment’s life:

150% DB Depreciation Method Applying the Half-Year Convention Declining Annual Rate of Annual Accumulated Book Year Balance Depreciation Depreciation Expense Depreciation Value

d) Show the presentation in the statement of fi nancial position as of December 31, 20X5, of the equipment when (1) the straight-line method is used, (2) the double-declining-balance method is used, and (3) the 150% declining balance method is used.

e) Suppose the equipment was sold on April 25, 20X6, by Custom Designs, Inc. for $35,000. Determine gain or loss on sale and prepare journal entries to record the sale assuming (1) the straight-line method is used, (2) the double-declining-balance method is used, and (3) the 150% declining balance method is used.

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Problem 6.3Mechanical Engineers, Inc., largely an east coast fi rm, wishes to expand its operations and market share through acquisition of a mid-western fi rm, BCT Consulting Engineers, Inc., which is currently interested in negotiating a sale. With the help of business valuation experts, Mechanical Engineers, Inc. has gathered the following information regarding the statement of fi nancial position of BCT Consulting Engineers, Inc. in terms of both book values and fair market values:

BCT Consulting Engineers, Inc.Statement of Financial Position

May 31, 20X7 ASSETS LIABILITIES & STOCKHOLDERS’ EQUITY

Book Value Fair Value Book Value Fair Value Current assets: Current liabilities: Cash ………………………… $500,000 $500,000 Accounts payable ………… $5,400,000 $5,400.000 Accounts receivable (net) …… 4,200,000 4,200,000 Long-term debt: Inventory …………………… 3,000,000 3,600,000 Mortgage payable ……… 4,500,000 4,500,000Total current assets …………… 7,700,000 8,300,000 Total liabilities …………… 9,900,000 9,900,000 Plant assets (net) ……………… 8,200,000 8,500,000 Stockholders’ equity:Total assets …………………… $15,900,000 $16,800,000 Common stock …………… 3,200,000 Retained earnings ………… 2,800,000 Total stockholders’ equity … 6,000,000 Total liabilities & stockholders’ equity ……… $15,900.000

Mechanical Engineers, Inc. purchased all of the net assets of BCT Consulting Engineers, Inc. for $7,300,000 on June 1, 20X7.

a) What is the amount of goodwill included in the purchase price paid by Mechanical Engineers, Inc. in the purchase of BCT Consulting Engineers, Inc. on June 1, 20X7?

b) Prepare the entry made on the books of Mechanical Engineers, Inc. to record the acquisition of the net assets of BCT Consulting Engineers, Inc.

c) At the end of its fi scal year on December 31, 20X9, Mechanical Engineers, Inc. determined that the goodwill that had been recorded over two years earlier in the purchase of BCT Consulting Engineers, Inc. now had a value of $210,000. No adjustment to goodwill from this purchase had ever been made prior to December 31, 20X9. What adjusting entry, if any, is needed on the books of Mechanical Engineers, Inc., based on its valuation of goodwill, on December 31, 20X9?

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Plant Assets, Intangible Assets, & Natural Resources