8-1

FINANCIAL ACCOUNTINGAN INTRODUCTION TO CONCEPTS,

METHODS, AND USES10th Edition

Chapter 8 – Long-Lived Tangibleand Intangible Assets: The Source of

Operating Capacity

Clyde P. Stickney and Roman L. Weil

8-2 Learning Objectives

1. Understand the concepts distinguishing expenditures capitalized as assets from expenditures expensed.

2. Understand the concepts of measurement of cost.3. Understand depreciation and amortization as a process

of cost allocation, not one of valuation.4. Develop the skills to compute depreciation or

amortization under various commonly used methods.5. Develop the skills to re-compute depreciation or

amortization for changes in estimates.6. Develop the skills to compute an impairment loss on

long-lived assets.7. Develop the skills to record the retirement of assets.

8-3Chapter Outline

1. Capitalization versus expensing.2. Acquisition costs.3. Depreciation and amortization.4. Depreciation methods.5. Impact of new information.6. Retirement of assets.7. Intangible assets.8. International perspective.Chapter Summary9. Appendix 8.1: Effects of Transactions Involv-

ing Plant and Intangible Assets on Cash Flows

8-4 1. Capitalization versus Immediate Expensing

Should firms treat expenditures as:1. Expenses in the period incurred, or2. Assets (that is, capitalize the cost).

An expenditure is an asset if the firm:1. has acquired rights to future use as the

result of a past transaction, and2. can measure or quantify the future

benefits.

8-5 1.a. Patterns of Expiration of Costs

Recognizing the expiration of the cost of an asset need not be linear. There are many other patterns each with some advantages and disadvantages. The following summarized the possibilities:

A. accelerated depreciation

S. straight-line depreciation

D. decelerated depreciation

E. expense immediately

N. no depreciation

8-6 2. Acquisition Costs

The acquisition value of an asset is either: The fair value of what was given up in exchange

for the asset (such as cash), or The fair value of what was received Which ever is more easily determined.

The acquisition value is all inclusive, that is, it includes all costs of acquiring and putting the asset in to use.

8-7 3. Depreciation and Amortization

Depreciation Purpose of depreciation

Allocation of costProcess of cost allocation

Return of capital Conceptual discussion Depreciation is not a decline in value

The causes of the process requiring depreciation Issues in depreciation accounting

1. Measuring the depreciable basis of the asset

2. Estimating its useful service life

3. Deciding on the pattern of expiration of asset cost

8-8 3.a. Measuring the Depreciable Basis of Plant Assets

Cost less salvage value Measuring cost -- all inclusive basis

Assets acquired in a swap for other assets may be difficult to value,

Asset value includes all costs necessary to acquire and put the asset into use,

Assets that are constructed by the firm may be difficult to measure but do include certain financing charges.

Estimating salvage value -- estimate of a market price into the distant future. Rarely, salvage values may be negative if disposal costs are very high.

8-9 3.b. Useful Service Life

Most difficult task in depreciation Because obsolescence typically results from forces outside the

firm Accountants reconsider assets’ estimated service lives every

few years Tax reporting dictates useful lives for classes of assets for tax

filing purposes but not for financial reporting purposes

8-10 4. Depreciation Methods

Depreciation methods systematically allocate the cost of the asset (less its estimated salvage value) over the useful service life of the asset. Not all patterns of expiration costs are used.

The expense immediately pattern is used in cases where the future benefit is uncertain.

The no-depreciation option is used almost exclusively to value land.

Most firms are currently using straight-line for financial reporting purposes.

The U.S. income tax code requires a version of accelerated expiration called modified accelerated cost recovers system (MACRS).

8-11 4. Depreciation Methods (Cont.)

Common methods used in financial reporting are:

1. Straight-line (time) method, pattern S.

2. Units-of-production method, straight line against production rather than time, pattern S.

3. Accelerated methods, pattern A.

a. Declining-balance methods (typically double declining balance)

b. Sum-of-the-years’-digits methods

c. Modified accelerated cost recovery system (income tax reporting).

4. Decelerated methods are very rare.

8-12 4.a. Straight-Line (Time) Depreciation

Probably the most common method for financial reporting.

Intuitive and long history of use Ease of computation Reduces expense to a minimum (assuming decelerated methods

are not allowed) thus increasing reported income Not consistent with a discounted cash flow (or present value)

assumption

8-13 4.b. Straight Line Depreciation:An Example

Problem for self study 8.2

Markam Corp acquires a new machine costing $20,000 of year 3. The firm expects to use the machine for 5 years and that the salvage value will be $2,000.

1. The straight line rate would be 1/( 5 years) or 20%

2. The basis to be depreciated is cost minus salvage or $18,000

beginning depreciation endingnet book charge accum.depr. net book

year balance basis 20% of basis after charge balance1 $20,000 $18,000 $3,600 $3,600 $16,4002 16,400 18,000 3,600 7,200 12,8003 12,800 18,000 3,600 10,800 9,2004 9,200 18,000 3,600 14,400 5,6005 5,600 18,000 3,600 18,000 2,000

8-14 4.c. Units of Production Depreciation

The exhaustion of some assets can be measured by units of output or production. This may serve as a better measure than time.

For example, a delivery truck may be good for 200,000 miles before wear and tear make it uneconomically useful. It may matter little whether the miles are driven in a few years or many.

In these cases, depreciation based on units may be useful.

annual cost - salvage value units used depreciation service life (in units) in year

= *

8-15 4.d. Units of Production Depreciation:An Example

Markam Corp acquires a new machine costing $20,000. Engineers say the machine should run for 24,000 hours and that the salvage value will be $2,000. The firm expects to run the machine for 5,000 hours for the first 4 years and for 4,000 hours during the last.

1. The basis to be depreciated is cost minus salvage or $18,000

2. The per hour unit rate would be $18,000/( 24,000 hours) or $0.75 per hour

beginning depreciation endingnet book charge accum.depr. net book

year balance hours $0.75*hours after charge balance1 $20,000 5,000 $3,750 $3,750 $16,2502 16,250 5,000 3,750 7,500 12,5003 12,500 5,000 3,750 11,250 8,7504 8,750 5,000 3,750 15,000 5,0005 5,000 4,000 3,000 18,000 2,000

8-16 4.e. Accelerated Methods

The earning power of some assets declines as they age. In these cases, accelerated depreciation methods may be useful. Some of the accelerated methods such as a present value computation

are computationally intense; that is, they require a lot of calculations. For this reason as well as some historical reasons, three methods are

generally used which produce accelerated depreciation but are relatively easy to compute:

a. Declining-balance methods (typically double declining balance)

b. Sum-of-the-years’-digits methods

c. Modified accelerated cost recovery system (income tax reporting)

8-17 4.f. Declining-Balance Methods

Depreciation charge is calculated as a fixed rate times the net book value of the asset

Net book value is cost reduced by accumulated depreciation but not reduced by salvage value

This is one of the very rare methods that does not subtract salvage value

The reason is that the method produces declining depreciation charges and when the net book value is equal to salvage, no further depreciation is taken.

So this method does reduce the net book value to salvage The fixed rate must be greater than the straight line rate for the

depreciation to be accelerated Depreciation charges are greater in early years

8-18 4.g. Declining Balance Method:An Example

Markam Corp acquires a new machine costing $20,000. The firm expects to use the machine for 5 years and that the salvage value will be $2,000.

1. The straight line rate would be 1/( 5 years) or 20%

2. Double declining balance uses a fixed rate of twice the straight line rate, or 40%

beginning endingnet book depreciation accum.depr. net book

year balance charge after charge balance1 $20,000 $8,000 * $8,000 $12,0002 12,000 4,800 * 12,800 7,2003 7,200 2,880 * 15,680 4,3204 4,320 1,160 ** 16,840 3,1605 3,160 1,160 ** 18,000 2,000

* 40% of net book value** switch to straight line, one half of $4,320 per year

8-19 4.h. Sum of Years’ Digits Methods

Depreciation charge is calculated as a variable rate times the basis of the asset The basis of the asset is cost less salvage value and

it is constant The variable rate is equal to the number of years

remaining (including the current year) divided by the sum of the years’ digits

The sum of the years’ digits is the sum of the numbers 1, 2, 3, …, up to and including the last year of useful life

For a 5 year useful life, the sum is 1+2+3+4+5 = 15

8-20 4.i. Sum of Years’ Digits Methods:An Example

Markam Corp acquires a new machine costing $20,000. The firm expects to use the machine for 5 years and that the salvage value will be $2,000.

1. Basis is $20,000 - $2,000 = $18,000

2. The sum of the years’ digits is 1+2+3+4+5 = 15

3. The rate is the remaining years / the sum of the years’ digitsaccum.depr. ending

remaining after charge net bookyear years rate basis (rate * basis) balance

1 5 5/15 $18,000 $6,000 $14,0002 4 4/15 18,000 4,800 9,2003 3 3/15 18,000 3,600 5,6004 2 2/15 18,000 2,400 3,2005 1 1/15 18,000 1,200 2,000

8-21 4.j. Modified Asset Cost Recovery Method

This method is used for U.S. income tax reporting and not for financial reporting.

The rates for each year are given by statue for each class of assets.

The method is based on accelerated declining balance methods with only partial depreciation recognized in the first year.

Basically, the IRS specifies the depreciation schedule and the tax payer has little control over the method, the rate or the useful life.

MACRS ignores salvage values. When the asset is disposed, any proceeds are taxed as a gain.

8-22 4.j. Modified Asset Cost Recovery Method:An Example

Markam Corp acquires a new machine costing $20,000. The IRS classified the machine as a 5-year asset.

1. Basis is $20,0002. The rates are given in IRS publications3. Notice that the first year of depreciation only gets a part of the

year of a charge and that the missing half is made up in the sixth calendar year

rate from depreciation accum.depr. endingIRS charge after charge net book

year schedule basis rate*basis (rate * basis) balance1 20.0% $20,000 $4,000 $4,000 $16,0002 32.0% 20,000 $6,400 10,400 9,6003 19.2% 20,000 $3,840 14,240 5,7604 11.5% 20,000 $2,300 16,540 3,4605 11.5% 20,000 $2,300 18,840 1,1606 5.8% 20,000 $1,160 20,000 0

8-23 5. Impact of New Information

Depreciation and amortization are based on knowledge at the time of the initial acquisition, however, these methods should be updated when new information becomes available.

Changes in expected service lives or salvage values.

Additional expenditures to maintain or improve the assets.

Changes in the market value of assets.

8-24 6. Retirement of Assets

When the asset is removed from service, either sold or disposed, the accounts need to reflect this change. There are three adjustments:

The asset account must be closed (removed) The accumulated depreciation account for that asset must also

be closed (removed) And any gain or loss on retirement needs to be recognized.

If the depreciation schedule was perfect, the asset value less the accumulated depreciation would equal exactly the salvage value.

Differences give rise to a gain (if a credit) or a loss (if a debit).

cash (received or asset)* $1,500accum.depr (to remove the account) 3,000loss on retirement (plug) 300 equipment (to remove the asset) 5,000

8-25 7. Intangible Assets and Amortization

Assets may provide future benefits without having physical form; for example, a patent or copyright.

Such assets are called intangible assets. Intangible assets may have a limited life. Patents expire after 20 years

in the U.S. Intangible assets are reduced in value in recognition of this limited life.

The revaluation is similar to depreciation but is called amortization. Specific examples of intangibles are

a. Research and developmentb. Patentsc. Advertisingd. Goodwill

8-26 7. Intangible Assets (Cont.)

Accountants face two key issues with regards to intangible assets: Have the expenditures made to acquire or develop the

intangible asset generated sufficient future benefits that the expenditures should be capitalized?

Have the expenditures produced no future benefit for the firm or benefits so hard to quantify or measure that the the expenditures should be expensed.

Intangibles are generally amortized on a straight line basis based on time.

8-27 7.a. Research and Development (R&D)

Research and development are expenditures for knowledge that may increase the competitiveness of the firm in the future.

Examples include the development of new pharmaceuticals, new technologies, new manufacturing methods, and general scientific endeavors.

GAAP is very conservative on the question of R&D. Such expenditures are considered so difficult to measure and future benefits are generally so uncertain that U.S. GAAP requires expensing of the expenditure in the year of the expenditure.

This requirement is quite controversial and some managers argue that forcing them to expense R&D discourages them from investing in R&D.

8-28 7.b. Patents

A patent is a right granted by a government for exclusive use and benefits for and invention for a limited time.

The U.S. has been extending the definition of what qualifies as an invention to include what are called intellectual property rights. U.S. Patents may now cover ideas, mathematical formulas and (in one case at least) a very large prime number.

Copyrights are similar but are not inventions, rather they are rights given for exclusive use of an artistic design or words. Music, photographs, and famous people are sometimes copyrighted.

Trademarks, TM, are similar but are specific identifiers for firms.

Patents in the U.S. are generally amortized over 20 years using a straight line method.

8-29 7.c. Advertising

Advertising is expenditures to inform potential customers about the product or services of the firm.

It is hoped that an informed potential customer will be more likely to purchase from the firm.

The benefits of successful advertising may extend for many periods into the future, however, any such benefits are very difficult to measure.

GAAP requires immediate expensing of most advertising costs because: This is more conservative than capitalization Any future benefits are difficult to measure For many firms, advertising costs are fairly stable

8-30 8. An International Perspective

Accounting for plant assets around the world is similar to U.S. accounting. Some countries allow for inflation adjustments to the value of the asset. Rarely the adjustment may be to a market value.

Depreciation accounting is similar for most countries. Where financial reporting is more closely linked to tax accounting, accelerated depreciation is common.

The IASC allows capitalization of development costs under some conditions.

Specific laws relating to length of time for patents, trademarks, copyrights may vary as to what is recognized and how long any benefits last.

8-31 Chapter Summary

Long lived assets include plant assets, natural resources (or wasting assets) and intangibles.

Each class presents similar accounting problems: How to determine the amount to be capitalized including

whether to capitalize or expense, How to estimate any future benefit, How to amortize the capitalized amount over the expected

time of benefits. Intangible assets have value even though they may lack a

physical presence. This value and the length of time of any future benefits may be very difficult to measure.

8-32 Appendix 8.1: Effects of Transactions Involv-ing Plant and Intangible Assets on Cash Flows

Retirement entries -- retirement may result in cash inflows or even cash outflows if the assets have a high disposal cost. These cash flows along with removing the asset account show up in the investing section of the cash flow statement; removing the accumulated depreciation account along with any gain or loss appear in the operating cash flow section. Net cash flows is unchanged but amounts may be moved from one section of the cash flow statement to another.

Depreciation and amortization charges -- because both are noncash expenses, they are added back and appear in the operating section of the cash flow statement.

Noncash acquisition of assets -- barter trade would not show in the cash flow statement because the amount given would cancel the amount received.

8-33 1. Plant Assets

Plant assets and fixed assets are sometimes used interchangeably.

Both are long-lived assets and include land, buildings, machinery and equipment.

Plant assets includes more than just the manufacturing building.

Fixed assets includes more than just immobile assets. Also, fixed in this usage does not mean non-variable.

Two main issues with plant assets are

1. How to measure the acquisition value of the asset

2. How to measure the assets utilization over time

8-34 5. Repairs and Improvements

Repairs and improvements both require expenditures. Repairs generally restore usefulness. As such, repairs are

expensed in the period they occur. Improvements generally increase usefulness. As such,

improvements can either Increase the useful life of the asset in which case the offset to

the expenditure (a credit) would be a debit to accumulated depreciation (a debit) which allows the asset to be depreciated for a longer time.

Increase the output of the asset in which case the offset could be to the cost of the asset and a new depreciation schedule would have to be determined.