Needles Powers Crosson Principles of Accounting 12e Long-Term Assets 10 C H A P T E R ©...

NeedlesPowersCrosson

Principles of Accounting

12e

Long-Term Assets10C H A P T E R

© human/iStockphoto

LEARNING OBJECTIVES

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LO1: Identify the classifications of long-term assets, and describe how they are valued by allocating their costs to the periods that they benefit.

LO2: Account for the acquisition costs of property, plant, and equipment.

LO3: Compute depreciation under the straight-line, production, and declining-balance methods.

LO4: Account for the disposal of depreciable assets. LO5: Identify the issues related to accounting for natural

resources, and compute depletion. LO6: Identify the issues related to accounting for

intangible assets, including research and development costs and goodwill.

LO7: Describe the disclosure of acquiring and financing long-term assets, and calculate free cash flow.

SECTION 1: CONCEPTS


Valuation: the process of assigning a monetary value to a business transaction and the resulting assets and liabilities

Classification: the process of assigning transactions to the appropriate accounts

Accrual accounting (matching rule): recording transactions in the periods in which they occur, rather than in the periods in which cash is received or paid

Disclosure: presenting all information relevant to users’ understanding of the financial statements

Recognition: the determination of when a business transaction should be recorded

Concepts Underlying Long-Term Assets

Long-term assets have the following characteristics:– They have a useful life of more than one year.– They are used in the operation of a business.

For an asset to be classified as property, plant, and equipment, it must be “put in use,” which means it is available for its intended purpose.

Assets not used in the normal course of business, such as land held for speculative reasons or buildings no longer used in ordinary operations, should be classified as investments.

– They are not intended for resale to customers. An asset that a company intends to resell to

customers should be classified as inventory, not as a long-term plant asset.


Long-Term Assets as a Percentage of Total Assets for Selected Industries


Classification, Accrual Accounting, and Disclosure of Long-Term Assets

Long-term assets are classified as– property, plant, and equipment—land

and other long-term assets that have physical substance

– natural resources—assets purchased for the economic value that can be extracted from them, like oil and gas

– intangible assets—long-term assets that have no physical substance, such as copyrights and patents


Classification, Accrual Accounting, and Disclosure of Long-Term Assets

Under accrual accounting, the cost of these assets, with the exception of land and some intangible assets, is allocated to the periods they benefit.– The periodic allocation of the costs of plant

and equipment over their estimated useful lives is called depreciation. (Land is not depreciated because it has an unlimited life.)

– The allocation of the cost of natural resources is called depletion.

– The allocation of the costs of most long-term intangible assets is called amortization.


Classification of Long-Term Assets and Methods of Accounting for Them


Valuation and Disclosure of Long-Term Assets

Long-term assets are generally reported and valued at carrying value. – Carrying value (or book value) is the

unexpired part of an asset’s cost, computed as shown below.


Valuation and Disclosure of Long-Term Assets

If a long-term asset loses some or all of its potential to generate revenue before the end of its useful life, it is impaired, and its carrying value is reduced. – Asset impairment occurs when the

carrying value of a long-term asset exceeds its fair value. Fair value is the amount for which the asset

could be bought or sold in a current transaction.


Recognition of the Acquisition Cost of Long-Term Assets (slide 1 of 3)

An expenditure is a payment or an obligation to make a future payment for an asset or a service. Expenditures are classified as capital expenditures or revenue expenditures.– A capital expenditure is for the purchase or

expansion of a long-term asset. Capital expenditures are recorded in asset accounts.

– A revenue expenditure is for the ordinary repairs and maintenance needed to keep a long-term asset in good operating condition. Revenue expenditures are recorded in expense

accounts.



Capital expenditures include:– outlays for plant assets, natural resources,

and intangible assets– additions—enlargements to the physical

layout of a plant asset– betterments—improvements to a plant

asset but not an addition to the plant’s physical layout

– extraordinary repairs—repairs that significantly enhance a plant asset’s estimated useful life or residual value; recorded by reducing the Accumulated Depreciation account



The distinction between capital and revenue expenditures is important in applying accrual accounting, as shown in the examples below.


SECTION 2: ACCOUNTING APPLICATIONS

Computing acquisition cost Computing depreciation

– Straight-line method– Production method– Declining-balance method

Accounting for the disposition of depreciable assets

Accounting for natural resources Accounting for intangible assets


Acquisition Cost of Property, Plant, and Equipment

The acquisition cost of property, plant, and equipment includes all expenditures reasonable and necessary to get an asset in place and ready for use.

Cost of Asset = Purchase Price + Additional Expenditures (freight, installation, etc.)– Interest charges incurred in purchasing an

asset are not a cost of the asset, but an operating expense.

– Small expenditures for long-term assets may be treated as expenses if they are not material.


Determining the Acquisition Cost of Property, Plant, and Equipment: Land

Expenditures that should be debited to the Land account include:– Purchase price of the land– Commissions to real estate agents– Lawyer’s fees– Accrued taxes paid by the purchaser– Costs of preparing the land to build on, such as

costs of tearing down old buildings and grading the land

– Assessments for local improvements– Landscaping


Determining the Acquisition Cost of Property, Plant, and Equipment: Land

– Assume that a company pays $340,000 for land, $16,000 in brokerage and legal fees, $20,000 to have an old building on the site torn down, and $2,000 to have the site graded. It receives $8,000 in salvage from the old building. The cost of the land is $370,000, calculated as follows.


Determining the Acquisition Cost of Property, Plant, and Equipment: Land Improvements

Some improvements to real estate, such as driveways, parking lots, and fences have a limited life and are subject to depreciation.

They are recorded in an account called Land Improvements.


Determining the Acquisition Cost of Property, Plant, and Equipment: Buildings

When a company buys a building, the cost includes the purchase price and all expenditures required to put the building in usable condition.

When a company constructs its own building, the cost includes:– Costs of materials, labor, and overhead– Architects’ fees and lawyers’ fees– Insurance during construction– Interest on construction loans during construction– Building permits


Determining the Acquisition Cost of Property, Plant, and Equipment: Leasehold Improvements

Improvements to leased property, such as the installation of carpet or walls, on the books of the lessee that become the property of the lessor (the owner of the property) at the end of the lease are called leasehold improvements. – These are usually classified in the property, plant,

and equipment section of the balance sheet.– The cost of these improvements is depreciated

over the remaining term of the lease or the useful life of the improvement, whichever is shorter.


Determining the Acquisition Cost of Property, Plant, and Equipment: Equipment

The cost of equipment includes all expenditures connected with purchasing the equipment and preparing it for use. These expenditures include:– Invoice price less cash discounts– Freight, including insurance– Excise taxes and tariffs– Buying expenses– Installation costs– Test runs to ready the equipment for operation


Determining the Acquisition Cost of Property, Plant, and Equipment: Group Purchases

Companies sometimes purchase land and other assets for a lump sum. The purchase price must be apportioned between the land and other assets.– For example, suppose a company buys a

building and land for $170,000. If appraisals yield estimates of $20,000 for the land and $180,000 for the building, the lump-sum price would be allocated as follows.


Depreciation

Depreciation refers to the allocation of the cost of a plant asset over its estimated useful life, not to the asset’s physical deterioration or to its decrease in market value.– The major factors that limit a depreciable

asset’s useful life are: Physical deterioration—the result of use or

exposure to the elements, such as sun or wind Obsolescence—the process of becoming out of date

– Depreciation is recorded even if an asset increases in value.


Factors in Computing Depreciation

Factors in computing depreciation include:– Cost—the net purchase price of an asset plus all

expenditures to get it in place and ready for use

– Residual value (or salvage, disposal, or trade-in value)—the portion of an asset’s cost that a company expects to recover when it disposes of the asset

– Depreciable cost—an asset’s cost less its residual value

– Estimated useful life—the total number of service units expected from a long-term asset (may be years used, units produced, or miles driven)


Recording Depreciation

At the end of a period, depreciation is recorded with an adjusting entry that takes the following form:


Computing Depreciation: Straight-Line Method (slide 1 of 2)


Computing Depreciation:Straight-Line Method (slide 2 of 2)

The table below shows the depreciation schedule for the five years of the delivery truck’s useful life. Note that in addition to annual depreciation being the same each year, the accumulated depreciation increases uniformly and the carrying value decreases uniformly until it reaches the estimated residual value.


Computing Depreciation:Production Method (slide 1 of 2)


Computing Depreciation:Production Method (slide 2 of 2)

If the truck were driven 20,000 miles in the first year, 30,000 miles in the second, 10,000 miles in the third, 20,000 miles in the fourth, and 10,000 miles in the fifth, the depreciation schedule for the truck would be as shown below.


Computing Depreciation:Declining-Balance Method (slide 1 of 3)

An accelerated method of depreciation results in larger amounts of depreciation in the early years of an asset’s life than in later years.– Thus, depreciation charges will be highest

in years when the asset is newest and when revenue generation from the asset is likely to be highest.



This rate is applied to the carrying value at the end of the previous year. With this method, the depreciation schedule would be as shown below.


Graphic Comparison of Three Methods of Determining Depreciation

The graphs below compare yearly depreciation and carrying value under the three methods.


Special Issues in Determining Depreciation(slide 1 of 3)

Group Depreciation: Large companies group similar assets, such as machines, to calculate depreciation.

Depreciation for partial years: It is often necessary to calculate depreciation for partial years because assets are often purchased mid-year.

Special rules for tax purposes: The tax law allows rapid write-offs of plant assets, which differs from the depreciation methods most companies use for financial reporting.– A a result of the Economic Stimulus Act of 2008, the

tax law allows a small company to expense the first $250,000 of equipment expenditures.



Revision of depreciation rates: Sometimes the estimate of useful life is revised, so that the depreciation expense changes over the asset’s remaining useful life.– Suppose a delivery truck cost $14,000 and has a

residual value of $2,000. The truck was expected to last six years, but after two years, it is determined that the truck will last only two more years. At the end of the second year, the asset and accumulated depreciation accounts would be as follows.



– The remaining depreciable cost is computed as follows:

Cost − Depreciation Already Taken − Residual Value =

Depreciable Cost $14,000 − $4,000 − $2,000 = $8,000– The new annual depreciation charge is computed by

dividing the remaining depreciable cost of $8,000 by the remaining useful life of two years. Therefore, the new periodic depreciation charge is $4,000.


Disposal of Depreciable Assets

When plant assets, like buildings and equipment, are no longer useful because they have physically deteriorated or become obsolete, a company can:– Discard them– Sell them– Trade them in on the purchase of a new asset

Regardless of how a company disposes of a plant asset, it must record depreciation expense for the partial year up to the date of disposal.


Discarded Plant Assets

If an asset remains in use beyond the end of its estimated life, its cost and accumulated depreciation remain in the ledger accounts.– If the residual value is zero, the carrying

value of a fully depreciated asset is zero. When the asset is discarded, no gain or loss results.

– For assets with a carrying value, a loss equal to the carrying value should be recorded.


Discarding Assets with a Carrying Value(slide 1 of 2)


Discarding Assets with a Carrying Value(slide 2 of 2)


Plant Assets Sold for Cash: Cash Received Equal to Carrying Value (slide 1 of 2)


Plant Assets Sold for Cash: Cash Received Equal to Carrying Value (slide 2 of 2)


Plant Assets Sold for Cash: Cash Received Less Than Carrying Value (slide 1 of 2)


Plant Assets Sold for Cash: Cash Received Less Than Carrying Value (slide 2 of 2)


Plant Assets Sold for Cash: Cash Received More Than Carrying Value (slide 1 of 2)


Plant Assets Sold for Cash: Cash Received More Than Carrying Value (slide 2 of 2)


Exchanges of Plant Assets

Exchanges may involve similar assets, such as an old machine traded in on a newer model, or dissimilar assets, such as a cement mixer traded in on a truck.– In both cases, the purchase price is reduced

by the amount of the trade-in allowance. If the trade-in allowance is greater than the

asset’s carrying value, the company realizes a gain.

If the allowance is less, it suffers a loss.


Natural Resources

Natural resources are long-term assets that are converted to inventory by cutting, pumping, mining, or other extraction methods.– They are recorded at acquisition cost, which

may include some development.– As these resources are converted to

inventory, their asset accounts must be proportionately reduced.


Depletion

Depletion refers not only to the exhaustion of a natural resource but also to the proportional allocation of the cost of a natural resource to the units extracted.– When a natural resource is purchased or

developed, the total units that will be available, such as tons of coal, must be estimated.

– The depletion cost per unit is computed as follows:Depletion Cost per Unit = Cost − Residual Value

Estimated Number of Units


Depletion of a Natural Resource(slide 1 of 2)


Depletion of a Natural Resource(slide 2 of 2)


Depreciation of Plant Assets Related to Natural Resources

The extraction of natural resources generally requires special on-site buildings and equipment.

The useful life of these plant assets may be longer than the estimated time it will take to deplete the resources.

If a company plans to abandon these assets after all the resources have been extracted, they should be depreciated on the same basis as depletion.


Development and Exploration Costs in the Oil and Gas Industry

Successful efforts accounting—Under this method, the cost of successful exploration is a cost of the resource. – It is recorded as an asset

and depleted over the resource’s estimated life. The cost of unsuccessful exploration is written off immediately as a loss.

Full-costing method—Under this method, all costs of exploration are recorded as assets and depleted over the estimated life of the resources.– This includes the costs

of unsuccessful exploration, such as the cost of dry wells.


Exploring and developing oil and gas resources can be accounted for under one of two methods:

Intangible Assets(slide 1 of 2)

An intangible asset’s value comes from the long-term rights it affords its owner.– The most common types of intangible

assets and their accounting treatment are described below and on the next slide.


Intangible Assets(slide 2 of 2)


Assets Reported by Large Companies

The graph below shows the percentage of companies (out of those surveyed) that report various intangible assets.


Purchase of Intangible Assets

Intangible assets are accounted for at the amount that a company paid for them and should be included on a company’s balance sheet only if purchased from another party at a price established in the marketplace.– The useful life of an intangible asset is the period

over which the asset is expected to contribute to the company’s future cash flows. It may be: Definite—subject to a legal limit or can be reasonably

estimated Indefinite—not limited by legal, regulatory, contractual,

competitive, economic, or other factors (and not amortized)


Accounting for Intangible Assets with Limited Useful Lives

Suppose Soda Bottling Company purchases a patent for a unique bottle cap for $36,000. – The purchase is recorded with an entry of $36,000 in

the asset Patents.– Although the patent will last for 20 years, Soda

determines that it will sell the cap for only six years.– The annual amortization expense is $6,000 ($36,000

÷ 6 years), and the Patents account is reduced directly.


Research and Development Costs

Most successful companies carry out research and development (R&D) activities, often within a separate department.– These activities include development of

new products, testing of existing and proposed products, and pure research.

– The Financial Accounting Standards Board requires that all R&D costs be charged to expense in the period in which they are incurred.


Computer Software Costs

The costs that companies incur in developing computer software for sale or lease or for their own internal use are considered research and development costs until the product has proved feasible. Thus, they are charged to expense as they are incurred.

Once a product is deemed feasible, all software production costs are recorded as assets and amortized over the software’s estimated useful life, using the straight-line method.


Goodwill

From an accounting standpoint, goodwill exists when a purchaser pays more for a business than the fair market value of the business’s net assets.– Goodwill reflects several factors, including:

Customer satisfaction Good management Manufacturing efficiency The advantages of having a monopoly Good locations Good employee relations


Goodwill

The FASB requires that purchased goodwill be reported as a separate line item on the balance sheet and that it be reviewed annually for impairment.

A company should record goodwill only when it acquires a controlling interest in another business.– The amount to be recorded as goodwill can

be determined by writing the identifiable net assets up to their fair market values at the time of purchase and subtracting the total from the purchase price.


Long-Term Assets and the Financial Statements

The graphic below shows that purchase, use, and disposal of long-term assets affect all financial statements.


SECTION 3: BUSINESS APPLICATIONS

Acquiring and financing long-term assets

Free cash flow Ethics


Management Decisions Relating to Long-Term Assets

Although some companies are profitable enough to pay for long-term assets out of cash flows from operations, for major acquisitions of long-term assets, a company may need to finance them with the issue of stock, long-term notes, or bonds.– Information about acquisitions of long-term

assets appears in the investing activities section of the statement of cash flows.

– A measure of a company’s success in funding these acquisitions is free cash flow.


Free Cash Flow(slide 1 of 2)

Free cash flow is the amount of cash that remains after deducting the funds a company must commit to continue operating at its planned level. The commitments include:– Current or continuing operations– Interest– Income taxes– Dividends– Net capital expenditures (purchases of plant

assets minus sales of plant assets)


Free Cash Flow (slide 2 of 2)

Free cash flow is computed as follows:

Free Cash Flow = Net Cash Flows from Operating Activities − Dividends − Purchases of Plant Assets + Sales of Plant Assets

A positive free cash flow means that a company has met all its cash commitments and has cash available to reduce debt or to expand operations.

A negative free cash flow means that it will have to sell investments, borrow money, or issue stock to continue at its planned level.


Ethics in Acquiring and Financing Long-Term Assets

When a company acquires a long-term asset, it defers some of the asset’s cost to later periods.– Thus, the current period’s profitability looks

better than it would if the asset’s total cost had been expensed.

To avoid fraudulent reporting of long-term assets, a company’s management must apply accrual accounting in resolving two important issues:– The amount of the total cost of a long-term asset

to allocate to expense in the current period.– The amount to retain on the balance sheet as an

asset.


Ethics in Acquiring and Financing Long-Term Assets

– To resolve these issues, management must answer four important questions:

1. How is the cost of the long-term asset determined?2. How should the expired portion of the cost of the long-term asset be allocated against revenues over time?3. How should subsequent expenditures, such as repairs and additions, be treated?4. How should disposal of the long-term asset be recorded?


Needles Powers Crosson Principles of Accounting 12e Long-Term Assets 10 C H A P T E R ©...

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