CHAPTER 9

Long-Term Assets
0REVIEWING THE CHAPTER
Objective 1: Define long-term assets, and explain the management issues related to them. 10. Long-term assets (once called fixed assets) are assets that (a) have a useful life of more than one year, (b) are acquired for use in the operation of a business, and (c) are not intended for resale to customers. Assets that are not being used in the normal course of business, such as land held for speculative purposes, should be classified as long-term investments rather than as long-term assets. 20. roperty, plant, and equipment is the balance sheet classification for tangible assets, !hich are long-term assets that have physical substance, and for natural resources, !hich are long-term assets in the form of valuable substances, such as standing timber, oil and gas fields, and mineral deposits. Intangible assets is the balance sheet classification for longterm assets !ithout physical substance !hose value is based on rights or advantages accruing to the o!ners" e#amples are patents, copyrights, trademar$s, franchises, licenses, and good!ill. %he allocation of costs to different accounting periods is called depreciation in the case of plant and equipment (plant assets), depletion in the case of natural resources, and amorti ation in the case of intangible assets. &ecause land has an unlimited useful life, its cost is not converted into an e#pense.

'0. (ong-term assets are generally reported at carr!ing value (also called book value), !hich is the une#pired part of a plant asset)s cost. *arrying value is calculated by deducting accumulated depreciation from original cost. +f asset impairment (loss of revenuegenerating potential) occurs, the long-term asset)s carrying value is reduced to reflect its current fair value (an application of conservatism). A loss for the amount of the !rite-do!n !ould also be recorded. %a$ing a large !rite-do!n in a bad year is often called ,ta$ing a bath,- because it presumably !ill reduce future depreciation or amorti.ation and, thus, raise the li$elihood of profit reali.ation. /0. *apital budgeting is the process of evaluating a decision to acquire a long-term asset. 0ne common capital budgeting technique compares the amount and timing of cash inflo!s and outflo!s over the life of the asset under consideration. +f the net present value of those cash flo!s is positive, the asset should probably be purchased. +nformation about long-term asset acquisitions may be found in the investing activities section of the statement of cash flo!s. 10. (ong-term assets not purchased for cash must be financed. *ommon financing techniques include issuing stoc$, bonds, and long-term notes. "ree cash flo# is a good measure of a business)s ability to finance long-term assets. 2pecifically, it is the amount of cash that remains after deducting the funds a company must commit to continue operating at its planned level, and is computed as follo!s3 4ree *ash 4lo! 5 6et *ash 4lo!s from 0perating Activities 7 8ividends 7 ( urchases of lant Assets 7 2ales of lant Assets)

90. %he ma:or problem in accounting for long-term assets is to figure out ho! much of the asset has benefited the current period and ho! much should be carried for!ard as an asset that !ill benefit future periods. %o resolve these issues, one must determine (a) the cost of the asset" (b) the method of matching the cost !ith revenues" (c) the treatment of subsequent e#penditures, such as repairs and additions" and (d) the treatment of the asset at the time of disposal. Objective $: Distinguish bet#een capital expenditures and revenue expenditures, and account for the cost of propert!, plant, and e%uipment. ;0. &efore recording an expenditure (a payment or the incurrence of liability) for a long-term asset, one must determine !hether it !as a capital e#penditure or a revenue e#penditure. A capital expenditure is an e#penditure for the purchase or e#pansion of long-term assets. *apital e#penditures are recorded in the asset accounts because they !ill benefit several future accounting periods. A revenue expenditure is an e#penditure for ordinary repairs, maintenance, and anything else necessary to enable the asset to fulfill its originally estimated useful life. A revenue e#penditure is charged as an e#pense in the period in !hich it is incurred because it benefits only the current accounting period. <0. &usinesses ma$e capital e#penditures not only for plant assets, natural resources, and intangible assets, but also for additions (such as a building !ing) and betterments (such as the installation of an air-conditioning system). &xtraordinar! repairs (such as the complete overhaul of a heating system) are e#penditures that either increase an asset)s residual value or lengthen its useful life. %hey are recorded by reducing Accumulated 8epreciation, thereby increasing the asset)s carrying value. =0. %reating a capital e#penditure as a revenue e#penditure, or vice versa, can result in a mismatching of revenues and e#penses. >reat care must therefore be ta$en to dra! the appropriate distinction. 100. %he acquisition cost of a long-term asset includes the purchase price, freight charges, insurance !hile in transit, installation, and other costs involved in acquiring the asset and getting it ready for use. %hese costs are allocated to the useful life of the asset rather than charged as e#penses in the current period. Also included in the acquisition cost is interest incurred during the construction of a plant asset. ?o!ever, interest incurred in the purchase of an asset is e#pensed !hen incurred. 2mall e#penditures for such items as office supplies are also often e#pensed immediately because the amounts involved are immaterial.0 a0. @hen land is purchased, the (and account should be debited not only for the price paid for the land, but also for such e#penses as real estate commissions, la!yers) fees, bac$ ta#es paid by the buyer" the cost (less salvage value) of ra.ing buildings on the land" draining, clearing, and grading costs" assessments for local improvements" and (usually) the cost of landscaping. (and is not sub:ect to depreciation because of its unlimited useful life.

b0. Anli$e land, land improvements, such as fences, drive!ays, and par$ing lots, have a limited life and are therefore sub:ect to depreciation. %hey are recorded in a (and +mprovements account rather than in the (and account. c0. @hen a business constructs a building for its o!n use, it debits the &uildings account for such costs as materials, labor, overhead, architects) fees, insurance during construction, interest on construction loans, legal fees, and building permits. &ecause they have a limited useful life, buildings are considered depreciable assets.

d0. Leasehold improvements are improvements to leased property that become the property of the lessor !hen the lease e#pires. B#amples are light fi#tures and carpeting. e0. %he cost of equipment includes the invoice price less cash discounts, freight charges (including insurance), e#cise ta#es and tariffs, buying e#penses, installation costs, and test runs. (i$e land improvements and buildings, equipment is sub:ect to depreciation. @hen long-term assets are purchased for a lump sum, the cost should be divided among the assets acquired in proportion to their appraised values.

f0.

Objective ': (ompute depreciation under the straight-line, production, and decliningbalance methods. 110. Depreciation, as the term is used in accounting, refers to the allocation of the cost (less the residual value) of a tangible asset to the periods benefited by the asset. +t does not refer to the asset)s physical deterioration or to a decrease in its mar$et value. %hus, depreciation is not a process of valuation but of allocating the cost of the asset over the asset)s estimated useful life. All tangible assets e#cept land have limited useful lives, generally because of ph!sical deterioration (resulting from use and e#posure to the elements) and obsolescence (the process of becoming out of date). 120. 8epreciation is computed after the asset)s cost, residual value, depreciable cost, and estimated useful life have been determined. )esidual value (often called salvage value or disposal value) is the estimated value of the asset at the estimated disposal date . Depreciable cost is the asset)s cost less its residual value. &stimated useful life can be measured in time or in units and requires the accountant)s careful consideration. 1'0. %he most common depreciation methods are the straight-line, production, and decliningbalance methods. %he last is described as an accelerated method. 0 a0. Ander the straight-line method, the depreciable cost is spread evenly over the life of the asset. 8epreciation for each year is computed as follo!s3 *ost C Desidual Ealue Bstimated Aseful (ife (Fears) b0. Ander the production method, depreciation is based not on time, but on use of the asset in units. Ander this method, depreciation for each year is computed as follo!s3 *ost C Desidual Ealue Bstimated Anits of Aseful (ife c0. G Actual Anits of 0utput

%he declining-balance method is called an accelerated method because depreciation is greatest in the first year and decreases each year thereafter. %his method is consistent !ith the matching rule because the highest depreciation is charged in the most productive years, !hen the asset is ne!, and because of the smoothing effect that results !hen annual depreciation and repair e#pense are combined (i.e., over the years, depreciation charges decrease, !hile repair costs increase). @ith the decliningbalance method, depreciation is computed by multiplying the remaining carrying value (the une#pired part of the cost) of the asset by a fi#ed percentage. %he doubledeclining-balance method is a form of the declining-balance method" it uses a fi#ed

percentage that is t!ice the straight-line percentage. Ander the double-decliningbalance method, depreciation for each year is computed as follo!s3 100H Demaining G *arrying Ealue Aseful (ife in Fears Ander the declining-balance or double-declining-balance method, as under the other methods, an asset should not be depreciated belo! its residual value. 2 G 1/0. @hen a company has a number of plant assets that are similar in nature, such as truc$s or pieces of office equipment, it may use a method $no!n as group depreciation rather than individual depreciation. Ander group depreciation, the original costs of all similar assets are lumped together in one summary account. 8epreciation is then figured for the group of assets as a !hole. 110. @hen an asset is purchased after the beginning of the year or discarded before the end of the year, depreciation should be recorded for only part of the year. %he accountant figures the year)s depreciation and multiplies this figure by the fraction of the year that the asset !as in use. As a matter of convenience, some companies compute depreciation to the nearest month or use the half-year convention. 190. 0ften, the estimated useful life or residual value of an asset is found to be significantly over- or understated after some depreciation has been ta$en. +n that case, the accountant must produce a revised figure for the asset)s remaining useful life or remaining depreciable cost. 4uture depreciation is then calculated by spreading the remaining depreciable cost over the remaining useful life, leaving previous depreciation unchanged. 1;0. 8epreciation for federal income ta# purposes differs considerably from depreciation for financial reporting purposes. %a# la!, for e#ample, disregards estimated useful life and residual value, and allo!s rapid !rite-offs of e#penditures recorded as assets. 2mall businesses can e#pense the first I100,000 of equipment on their ta#es, and most property (other than real estate) is depreciated using a 200 percent declining balance !ith a half-year convention. +ncome ta# depreciation is not normally acceptable for financial reporting because the recovery period is typically shorter than the asset)s useful life. Objective *: +ccount for the disposal of depreciable assets. 1<0. @hen an asset is still in use after it has been fully depreciated, no more depreciation should be recorded, but the asset should not be !ritten off until its disposal. 8isposal occurs !hen the asset is discarded, sold, or traded in for another asset. 1=0. @hen a business disposes of an asset, depreciation should be recorded for the partial period up to the date of the disposal. %his brings the asset)s Accumulated 8epreciation account up to that date. 4or e#ample, !hen a machine is discarded (thro!n out), Accumulated 8epreciation, Jachinery is debited and Jachinery is credited for the present balance in the Accumulated 8epreciation account. +f the machine has not been fully depreciated, then to balance the entry, (oss on 8isposal of Jachinery must be debited for the carrying value. 200. @hen a machine is sold for cash, both the *ash and the Accumulated 8epreciation, Jachinery accounts are debited, and the Jachinery account is credited. +f the cash received is less than the carrying value of the machine, then (oss on 2ale of Jachinery is debited. +f the cash received is greater than the carrying value, >ain on 2ale of Jachinery is credited to balance the entry. 210. B#changes (trade-ins) of plant assets may involve similar assets or dissimilar ones. +n either case, the purchase price is reduced by the amount of the trade-in allo!ance. 4urther, if the

trade-in allo!ance is greater than the asset)s carrying value, the company reali.es a gain. +f the allo!ance is less, it reali.es a loss.

Objective ,: Identif! the issues related to accounting for natural resources, and compute depletion. 220. Depletion refers both to the e#haustion of a natural resource and to the allocation of its cost to accounting periods, !hich is based on the amount of the resource e#tracted in each period. 8epletion for each period is computed as follo!s3 *ost C Desidual Ealue Bstimated Anits Available G Anits B#tracted and 2old 8uring eriod

Anits e#tracted but not sold !ithin an accounting period are recorded as inventory, to be charged as an e#pense in the period in !hich they are sold. 2'0. Assets acquired in con:unction !ith a natural resource that have no useful purpose after the natural resource is depleted (e.g., drills and pumps) should be depreciated on the same basis as the depletion. 2/0. %!o methods are used to account for the e#ploration and development of oil and gas resources. Ander the successful efforts method, the cost of a dry !ell is !ritten off immediately as a loss. %he full-costing method, on the other hand, capitali.es and depletes the costs of both productive and dry !ells. &oth methods are in accordance !ith >AA . Objective -: Identif! the issues related to accounting for intangible assets, including research and development costs and good#ill. 210. +ntangible assets acquired from others should initially be recorded as assets. %hose !ith determinable useful lives (such as patents, copyrights, and leaseholds) should be !ritten off over their useful lives through periodic amorti.ation. %his is normally accomplished by a direct reduction of the asset account and an increase in amorti.ation e#pense. Any substantial and permanent decline (impairment) in value must also be recogni.ed. ?o!ever, a business must e#pense the costs of developing its intangible assets.0 a0. .ood#ill is the e#cess of the cost of a group of assets (usually a business) over the fair mar$et value of the individual assets.

b0. A trademar/ or brand name is a registered symbol or name that gives the o!ner the e#clusive right to use it to identify a product or service. c0. A cop!right is an e#clusive right granted by the federal government to reproduce and sell literary, musical, and other artistic materials and computer programs for a period of the author)s life plus ;0 years.

d0. A patent is an e#clusive right granted by the federal government for a period of 20 years (1/ years for a design) to ma$e a particular product or use a specific process. e0. f0. A license or franchise is the right to an e#clusive territory or mar$et, or the right to use a formula, technique, process, or design. A leasehold is a right to occupy land or buildings under a long-term rental contract.

g0. 0oft#are is the capitali.ed cost of computer programs developed for sale or lease or for use !ithin the firm. h0. A noncompete covenant is a contract that limits the rights of others to compete in a specific industry or line of business for a specified time. i0. (ustomer lists are lists of customers or of subscribers.

290. Research and development (R&D) refers to developing ne! products, testing e#isting ones, and doing pure research. %he costs associated !ith these activities should be charged as e#penses in the period in !hich they are incurred. 2;0. %he costs of developing computer soft!are should be treated as DK8 costs until the product is deemed technologically feasible (i.e., !hen a detailed !or$ing program has been designed). At that point, the costs should be recorded as assets and amorti.ed over the estimated economic life of the product using the straight-line method. 2<0. Goodwill, as the term is used in accounting, equals the e#cess of the purchase cost of a business over the fair mar$et value of the net assets purchased. +t should be recorded only !hen a controlling interest in another company has been acquired. >ood!ill is reported as a separate line item on the balance sheet. 0nce recorded, it is sub:ect to annual impairment revie!s. @hen its fair value drops belo! its carrying value, an impairment loss is reported on the income statement, and good!ill is reduced on the balance sheet. 0ummar! of 1ournal &ntries Introduced in (hapter 11 A. ((0') 8epreciation B#pense, Asset 6ame Accumulated 8epreciation, Asset 6ame %o record depreciation for the period (revie! of entry introduced in *hapter ') Accumulated 8epreciation, Jachinery (oss on 8isposal of Jachinery Jachinery 8iscarded machine no longer used in the business *ash Accumulated 8epreciation, Jachinery Jachinery 2ale of machine for carrying value" no gain or loss *ash Accumulated 8epreciation, Jachinery (oss on 2ale of Jachinery Jachinery 2ale of machine at less than carrying value (*E)" loss recorded *ash Accumulated 8epreciation, Jachinery >ain on 2ale of Jachinery Jachinery 2ale of machine at more than carrying value (*E)" gain recorded 8epletion B#pense, *oal 8eposits Accumulated 8epletion, *oal 8eposits %o record depletion of coal mine LL (amount allocated) LL (amount allocated)

&.

((0/)

LL (e#isting balance) LL (carrying value) LL (purchase price) LL (proceeds on sale) LL (e#isting balance) LL (purchase price) LL (proceeds on sale) LL (e#isting balance) LL (*E minus cash) LL (purchase price)

*.

((0/)

8.

((0/)

B.

((0/)

LL (proceeds on sale) LL (e#isting balance) LL (cash minus *E) LL (purchase price)

4.

((01)

LL (amount allocated) LL (amount allocated)