Financial Accounting Fourth Edition

Long-Term Assets

CHAPTER

7 Spiceland Thomas Herrmann

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Long-Term Assets

Tangible assets Intangible assets

Land Patents
Land improvements Trademarks
Buildings Copyrights
Equipment Franchises
Natural resources Goodwill

- Physical substance - Lack of physical substance

- Existence often based on
legal contract
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Illustration 71
Balance Sheet for Darden Restaurants
DARDEN RESTAURANTS
Balance Sheet (partial)
($ in thousands)

Cash $ 98,300
Receivables 207,800
Inventory 196,800
Other current assets 1,473,500
Total current assets 1,976,400
Property, plant, and equipment 3,381,000
Intangible assets 1,447,100
Other long-term assets and investments 296,200
Total assets $7,100,700

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Part A
ACQUISITIONS

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Learning Objective 1

LO71 Identify the major types of property, plant, and

equipment.

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Property, Plant, and Equipment
Recorded at:

The original cost of the asset

+
All expenditures necessary
to get the asset ready for use

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Land
Land includes the cost of the land and all
expenditures necessary to get the land ready
for its intended use
Costs to get the land ready for use include
items such as:
Real estate commissions and fees
Back property taxes or other obligations
Clearing, filling, and leveling the land

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Illustration 72
Computation of the Cost of Land
Purchase price of land (and existing building) $500,000
Commissions 30,000
Back property taxes 6,000
Title insurance 3,000
Cost of removing existing building 50,000
Less: Salvaged materials from existing building (5,000)
Cost of leveling the land 6,000
Total cost of land $590,000

Land includes the initial purchase price plus all

expenditures (net of salvaged materials) necessary to get
the land ready for use.
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Land Improvements
Land improvements are amounts spent to
improve the land
Examples:
Parking lots, sidewalks, driveways, landscaping,
lighting systems, fences, and sprinklers

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Buildings
Buildings: administrative offices, retail stores,
manufacturing facilities, and storage
warehouses
Costs of getting a building ready for use
include items such as:
Real estate commissions and fees
Inspection costs
Remodeling costs
Recurring costs such as utilities and insurance
are expensed as incurred
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Equipment
Equipment: machinery used in manufacturing,
computers and other office equipment,
vehicles, furniture, and fixtures
The cost of equipment might include sales tax,
shipping, assembly, and any other costs to
prepare the asset for use
Recurring costs such as maintenance are
expensed as incurred

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Illustration 73
Computation of the Cost of
Equipment
Purchase price $82,000
Sales tax 6,500
Transportation 800
Shipping insurance 200
Installation 1,500
Total cost of equipment $91,000

Total cost of equipment includes the initial purchase

price plus all expenditures necessary to get the
equipment ready for use.
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Basket Purchases
Purchase of more than one asset at the same
time for one purchase price
Allocate the total purchase price based on the
relative fair values of the individual assets

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Illustration 74
Allocation of Cost in a Basket Purchase
Purchase of land, building, and equipment = $900,000
Estimated fair value of: Land $ 200,000
Building $ 700,000
Equipment $ 100,000
$1,000,000
Determine amount to record for each asset.
Estimated Allocation Amount of Recorded
Fair Value Percentage Basket Purchase Amount
Land $ 200,000 $200,000/$1,000,000 = 20% $900,000 $180,000
Building 700,000 $700,000/$1,000,000 = 70% $900,000 630,000
Equipment 100,000 $100,000/$1,000,000 = 10% $900,000 90,000
Total $1,000,000 100% $900,000

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Concept Check 71
A company makes a basket purchase of land,
buildings, and equipment with estimated fair values
of $70,000, $150,000, and $30,000, respectively.
The purchase price is $210,000. How much should
be recorded to the Land account?
a. $ 126,000 The purchase price of $210,000 is allocated
b. $ 70,000 to the separate accounts for Land, Buildings,
and Equipment based on their relative fair
c. $ 58,800 values. The total fair value of the three
d. $ 25,200 assets is $250,000. Lands relative fair value
is $70,000/$250,000 (or 28%). Therefore,
the land would be recorded for $210,000
28% = $58,800.
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Natural Resources
Natural resources: oil, natural gas, timber, and
salt
Distinguished from other assets by the fact
that they are physically used up, or depleted
Recorded at cost plus all other costs necessary
to get the natural resource ready for its
intended use

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Key Point
Tangible assets such as land, land
improvements, buildings, equipment, and
natural resources are recorded at cost plus all
costs necessary to get the asset ready for its
intended use.

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Learning Objective 2

LO72 Identify the major types of intangible assets.

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Intangible Assets
Intangible assets: patents, copyrights,
trademarks, franchises, and goodwill
Lack physical substance but can be very
valuable
Existence often based on legal contract
Acquired in two ways:
Purchased
Developed internally

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Illustration 75
Worlds Top 10 Brands
Brand Value ($ in billions)
#1 Apple 118.9
#2 Google 107.4
#3 The Coca-Cola Company 81.6
#4 IBM 72.2
#5 Microsoft 61.1
#6 General Electric 45.5
#7 Samsung 45.4
#8 Toyota 42.4
#9 McDonalds 42.2
#10 Mercedes-Benz 34.3
| | | | | | | | | | | | | |
0 10 20 30 40 50 60 70 80 90 100 110 120 130

Source: Interbrand, www.Interbrand.com (2015)

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Patents
Exclusive right to manufacture a product or to
use a process
Granted for a period of 20 years
When purchased:
Capitalize the purchase price plus legal and filing
fees
When developed internally:
Capitalize legal and filing fees only (Research and
Development costs are expensed as incurred)

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Copyrights
Exclusive right of protection given to the
creator of a published work
Granted for the life of the creator plus 70
years
Allows holder to pursue legal action against
anyone who attempts to infringe the copyright
Accounting is virtually identical to that of
patents

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Trademarks
Word, slogan, or symbol that distinctively
identifies a company, product, or service
Renewed for an indefinite number of 10-year
periods
Capitalize legal, registration, and design fees
Advertising costs expensed as incurred

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Franchises
Local outlets that pay for the exclusive right to
use the franchisors name and to sell its
products within a specified geographical area
The franchisee records the initial fee as an
intangible asset
Additional periodic payments to the franchisor
are usually expensed as incurred

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Goodwill
Recorded only when one company acquires
another company

Fair value of the

Purchase
Goodwill = identifiable net
Price
assets acquired

Net assets = assets acquired less liabilities assumed

Goodwill is portion of purchase price that exceeds
the fair value of identifiable net assets

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Illustration 76
Business Acquisition with Goodwill
One company acquires another for $36 million.
The following information is known for the acquired company:
Fair value of the identifiable assets = $50 million
Fair value of the identifiable liabilities = $24 million
For how much will the acquiring company record goodwill?
($ in millions)
Purchase price $36
Less:
Fair value of assets acquired $ 50
Less: Fair value of liabilities assumed (24)
Fair value of identifiable net assets (26)
Goodwill $10
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Key Point
Intangible assets include patents, copyrights,
trademarks, franchises, and goodwill.

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Concept Check 72
Which of the following is an exclusive right to
manufacture a product or to use a process?
a. Trademark
b. Patent
c. Copyright
d. Goodwill
A patent is an exclusive right to manufacture a product or
to use a process. The U.S. Patent and Trademark Office
grants this right for a period of 20 years.

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Learning Objective 3

LO73 Describe the accounting treatment of

expenditures after acquisition.

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Expenditures After Acquisition
Repairs and maintenance
Additions
Improvements
Litigation costs
For all expenditures after acquisition:
If they benefit only
Expense
the current period
or
If they benefit
Capitalize
future periods
Capitalize = record an asset
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Illustration 77
Expenditures after Acquisition
Type of Period Usual Accounting
Expenditure Definition Benefited Treatment

Repairs and Maintaining a given level of Current Expense

maintenance benefits

Repairs and Making major repairs that Future Capitalize

maintenance increase future benefits

Additions Adding a new major Future Capitalize

component

Improvements Replacing a major component Future Capitalize

Legal defense Incurring litigation costs to

of intangible defend the legal right to the Future Capitalize
assets asset (Expense if defense
is unsuccessful)

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Key Point
We capitalize (record as an asset) expenditures
that benefit future periods. We expense items
that benefit only the current period.

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Concept Check 73
Which of the following costs would be expensed?
a. Adding a refrigeration unit to a delivery truck
b. Adding a new suspension system to a delivery
truck that will allow for heavier loads
c. Adding a new transmission to a delivery truck,
which will increase its life and future benefits
d. Performing a tune-up on the delivery truck
Tune-ups are necessary to maintain the truck and are
regularly required. The cost of a tune-up should be
expensed. All of the other items benefit future periods
and should be capitalized.
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Part B
COST ALLOCATION

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Learning Objective 4

LO74 Calculate depreciation of property, plant, and

equipment.

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Depreciation
Dictionary definition
Decrease in value of an asset
Accounting definition
Allocation of an assets cost to expense over time

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Illustration 78
Depreciation of Long-Term Assets

Cost incurred to purchase Depreciation = Allocation of a portion of

an asset (future benefit) the assets cost to an
expense over all periods
benefited.
$ Cost

$ Benefit $ Benefit $ Benefit $ Benefit

Time Periods

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 Recording Depreciation
A local Starbucks pays $1,200 for equipmentsay, an
espresso machine, with a useful life of four years.
Record depreciation expense for the first year.
December 31 Debit Credit
Depreciation Expense 300
Accumulated Depreciation .. 300
(Depreciate equipment; $300 = $1,200 4 years)

Balance Sheet Presentation Asset account

Equipment (cost) $1,200
Less: Accumulated depreciation ($300 1 year) (300)
= Book value $ 900

Contra asset account

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Common Mistake
Students sometimes mistake accounting
depreciation as recording the decrease in
value of an asset. Depreciation in accounting
is not a valuation process. Rather,
depreciation in accounting is an allocation of
an assets cost to expense over time.
Some students want to depreciate land. Land
is not depreciated, because its service life
never ends.

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Depreciation Methods
How much of an assets original cost is
allocated to each year of the assets
useful life?
Three common methods:
Straight-line
Declining-balance
Activity-based

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Key Point
Depreciation refers to the allocation of the
assets original cost to an expense during the
periods benefited. Depreciation does not refer
to the change in value or selling price.

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 Illustrations 79 and 7-10
Straight-Line Depreciation

Cost of the new truck $40,000

Estimated residual value $5,000
Estimated service life 5 years or 100,000 miles

Depreciation expense = Assets cost Residual value = Depreciable cost

Service life Service life

$40,000 $5,000
Depreciation expense = = $7,000 per year
5 years

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Illustration 711
Straight-Line Depreciation Schedule
Same amount Original
each year cost
LITTLE KING SANDWICHES
Depreciation ScheduleStraight-Line

Calculation End-of-Year Amounts

Depreciable Depreciation Depreciation Accumulated Book
Year Cost Rate = Expense Depreciation Value*
$40,000
1 $35,000 0.20 $ 7,000 $ 7,000 33,000
2 35,000 0.20 7,000 14,000 26,000
3 35,000 0.20 7,000 21,000 19,000
4 35,000 0.20 7,000 28,000 12,000
5 35,000 0.20 7,000 35,000 5,000
Total $35,000

*Book value is the cost of the asset ($40,000) minus accumulated depreciation. Book value of $33,000 at the end of year 1,
for example, is $40,000 minus $7,000 in accumulated depreciation.
Residual value

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Partial-Year Depreciation
What if the delivery truck was purchased during
the year, say on March 1, and then used for five
years? (Recall annual depreciation = $7,000)
Depreciate for portion of the year held
Year 1: $7,000 10/12 = $ 5,833
Years 25: $7,000 per year = $28,000
Year 6: $7,000 x 2/12 = $ 1,167
Total depreciation over life = $35,000

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Concept Check 74
How much depreciation should be recorded in the
first year for a delivery truck purchased on April 1
with a cost of $30,000, an expected life of five years,
and an estimated residual value of $5,000? Assume
the straight-line method is used.
a. $ 5,000
b. $ 3,750 Annual depreciation would be:
$5,000 = ($30,000 $5,000) 5 years
c. $ 4,500
d. $ 6,000 Therefore, depreciation from April 1 through
December 31 (9 months) in the first year
would be:
$3,750 = $5,000 9/12
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Illustration 712
Change in Depreciation Estimate
Assume that after three years Little King Sandwiches
estimates the remaining service life of the delivery truck
to be four more years, for a total service life of seven years
rather than the original five. Little King also changes the
estimated residual value to $3,000 from the original
estimate of $5,000.
How much is depreciation in years 4 to 7?
Book value, end of year 3 $19,000
New residual value (3,000)
New depreciable cost 16,000
New remaining service life 4
Annual depreciation in years 4 to 7 $ 4,000
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Illustration 713
Double-Declining-Balance
Depreciation Schedule each year
Declining amount

LITTLE KING SANDWICHES

Depreciation ScheduleDouble-Declining-Balance

Calculation End-of-Year Amounts

Beginning Depreciation Depreciation Accumulated Book
Year Book Value Rate = Expense Depreciation Value*
$40,000
1 $40,000 0.40 $16,000 $16,000 24,000
2 24,000 0.40 9,600 25,600 14,400
3 14,400 0.40 5,760 31,360 8,640
4 8,640 0.40 3,456 34,816 5,184
5 5,184 Double 184** 35,000 5,000
Total straight-line $35,000
rate
*Book value is the cost of the asset minus accumulated depreciation. Book value at the end of year 1 is $24,000, equal to the cost of $40,000
minus accumulated depreciation of $16,000. Book value at the end of year 1 in the last column is equal to book value at the beginning of year 2
in the second column of the schedule.
**Amount necessary to reduce book value to residual value. Remaining Residual value
depreciation
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Common Mistake
When using the declining-balance method, mistakes are
commonly made in the first and last year of the calculation. In
the first year, students sometimes calculate depreciation
incorrectly as cost minus residual value times the depreciation
rate. The correct way in the first year is to simply multiply cost
times the depreciation rate. In the final year, some students
incorrectly calculate depreciation expense in the same manner
as in earlier years, multiplying book value by the depreciation
rate. However, under the declining-balance method,
depreciation expense in the final year is the amount necessary
to reduce book value down to residual value.

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Concept Check 75
How much depreciation should be recorded for the
first year for a delivery truck with a cost of $30,000,
an expected life of six years, and an estimated
residual value of $6,000? Assume the double-
declining-balance method is used.
a. $ 12,000
The straight-line rate for a six-year
b. $ 10,000 asset is 1/6. This rate would be
c. $ 8,000 doubled to 2/6 (or 33.33%).
d. $ 5,000
Depreciation the first year (rounded):
$10,000 = $30,000 33.33%.

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Illustration 714
Activity-Based Depreciation

Cost of the new truck $40,000

Estimated residual value $5,000
Estimated service life 5 years or 100,000 miles

Depreciation rate Depreciable cost

=
per unit Total units expected to be produced
$40,000 $5,000
Depreciation rate = = $0.35 per mile
100,000 expected miles

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Illustration 715
Activity-Based Depreciation
Schedule
LITTLE KING SANDWICHES
Depreciation ScheduleActivity-Based

Calculation End-of-Year Amounts

Miles Depreciation Depreciation Accumulated Book
Year Driven x Rate = Expense Depreciation Value*
$40,000
1 30,000 $0.35 $10,500 $10,500 29,500
2 22,000 0.35 7,700 18,200 21,800
3 15,000 0.35 5,250 23,450 16,550
4 20,000 0.35 7,000 30,450 9,550
5 13,000 0.35 4,550 35,000 5,000
Total $35,000

*Book value is the cost of the asset ($40,000) minus accumulated depreciation. Book value of $29,500 in year 1 is $40,000 minus $10,500 in
accumulated depreciation.
Cost allocated Residual value
Actual miles per mile
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Illustration 716
Comparison of Depreciation
Methods
Double-Declining-
Year Straight-Line Balance Activity-Based
1 $ 7,000 $16,000 $10,500
2 7,000 9,600 7,700
3 7,000 5,760 5,250
4 7,000 3,456 7,000
5 7,000 184 4,550
Total $35,000 $35,000 $35,000

Total depreciation is the same

under each method

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Illustration 717
Depreciation Expense Over Time

16,000
14,000
Depreciation expense

12,000
10,000
8,000
6,000
4,000
2,000
0 | | | | |
Year 1 Year 2 Year 3 Year 4 Year 5
Time

Straight-line Activity-based Double-declining balance

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Illustration 718
Use of Various Depreciation Methods
Other (1%)
Activity-Based (3%)

Declining-Balance (4%)

Straight-Line (92%)

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Tax Depreciation
Accelerated methods reduce taxable income
more in the earlier years of an assets life
Most companies use:
Straight-line for financial reporting
Accelerated for tax reporting
- called MACRS

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Key Point
Straight-line, declining-balance, and activity-
based depreciation are all acceptable
depreciation methods for financial reporting.
Most companies use straight-line depreciation
for financial reporting and an accelerated
method called MACRS for tax reporting.

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Learning Objective 5

LO75 Calculate amortization of intangible assets.

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Amortization of Intangible Assets
Allocating the cost of most tangible assets to
expense is called
Depreciation
Allocating the cost of intangible assets to
expense is called
Amortization

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Amortization of a Franchise
In early January, Little King Sandwiches acquires franchise rights from
University Hero for $800,000. The franchise agreement is for a period of
20 years. Record amortization for the first year.

December 31 Debit Credit

Amortization Expense 40,000
Franchises .......................... 40,000
(Amortize franchise; $40,000 = $800,000 / 20 years)

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Amortization of a Patent
In addition, Little King purchases a patent for a meat-slicing process for
$72,000. The original legal life of the patent was 20 years, and there are
12 years remaining. However, due to expected technological
obsolescence, the company estimates that the useful life of the patent is
only 8 more years. Little King uses straight-line amortization for all
intangible assets. Record amortization for the first year.

December 31 Debit Credit

Amortization Expense 9,000
Patents ............................... 9,000
(Amortize patent; $9,000 = $72,000 / 8 years)

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Illustration 719
Amortization Treatment of
Intangible Assets
Intangible Assets Intangible Assets
Subject to Amortization Not Subject to Amortization
(those with finite useful life) (those with indefinite useful life)
Patents
Copyrights Goodwill
Trademarks (with finite life) Trademarks (with indefinite life)
Franchises

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Key Point
Amortization is a process, similar to
depreciation, in which we allocate the cost of
intangible assets over their estimated service
lives. Intangible assets with an indefinite useful
life (goodwill and most trademarks) are not
amortized.

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Concept Check 76
Which of the following intangible assets would not
be subject to amortization?
a. Patents
b. Trademarks with an indefinite life
c. Copyrights
d. Franchises

We do not amortize intangible assets with indefinite lives

(unknown or not determinable). So if a trademark has an
indefinite life, we would not amortize it.

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Part C
ASSET DISPOSITION: SALE, RETIREMENT,
OR EXCHANGE

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Learning Objective 6

LO76 Account for the disposal of long-term assets.

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Illustration 720
Three Methods of Asset Disposal
Disposal of Long-Term Assets

Most common Occurs when a long- Occurs when

method to term asset is no two companies
dispose of a longer useful but trade long-term
long-term asset cannot be sold assets
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Illustration 721
Data to Illustrate Long-Term Asset
Disposals
Original cost of the truck $40,000
Estimated residual value $5,000
Estimated service life 5 years
Assume straight-line depreciation

What if the truck is:

Sold after three years for $22,000
Sold after three years for $17,000
Retired after three years
Exchanged for a new truck worth $45,000 and a $22,000
cash payment
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Illustration 722
Gain on Sale
Sell truck after three years for $22,000 (Depr. = $7,000/year)

Sale amount $22,000

Less:
Original cost of the truck $40,000
Less: Accumulated depreciation (3 years $7,000/year) (21,000)
Book value at the end of year 3 19,000
Gain $ 3,000

Debit Credit
Cash 22,000
Accumulated Depreciation .. 21,000
Equipment .. 40,000
Gain .. 3,000
(Sell equipment for a gain)
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Common Mistake
Be careful not to combine the delivery truck
($40,000) and accumulated depreciation
($21,000) and credit the $19,000 difference to
the Equipment account. Instead, remove the
delivery truck and accumulated depreciation
from the accounting records separately.
Otherwise, the Equipment and the Accumulated
Depreciation accounts will incorrectly have a
remaining balance after the asset has been sold.

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Illustration 723
Loss on Sale
Sell truck after three years for $17,000 (Depr. = $7,000/year)
Sale amount $17,000
Less:
Original cost of the truck $40,000
Less: Accumulated depreciation (3 years $7,000/year) (21,000)
Book value at the end of year 3 19,000
Loss $ (2,000)

Debit Credit
Cash . 17,000
Accumulated Depreciation 21,000
Loss .. 2,000
Equipment 40,000
(Sell equipment for a loss)
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Illustration 724
Loss on Retirement
Sale amount $ 0
Less:
Original cost of the truck $40,000
Less: Accumulated depreciation (3 years $7,000/year) (21,000)
Book value at the end of year 3 19,000
Loss $(19,000)

Debit Credit
Accumulated Depreciation . 21,000
Loss .. 19,000
Equipment ..... 40,000
(Retire equipment for a loss)

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Concept Check 77
If an asset is sold at the end of its first year of use,
which depreciation method would result in the
highest amount of gain (or lowest amount of loss)
assuming the asset is used fairly evenly over its life?
a. Straight-line
b. Double-declining-balance
c. Activity-based
d. Not enough information to determine
Assuming that the asset is used uniformly means that approximately the same
amount of depreciation would be recorded for each year of the assets life. The
double-declining-balance would result in the most depreciation in the first year
and therefore the lowest book value. A low book value results in the highest
amount of gain (or lowest amount of loss).
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Illustration 725
Gain on Exchange
Trade-in Allowance (new truck = $45,000 less $22,000 paid in cash) $23,000
Less:
Original cost of the truck $40,000
Less: Accumulated depreciation (3 years $7,000/year) (21,000)
Book value at the end of year 3 19,000
Gain $ 4,000

Debit Credit
Equipment (new) ............................. 45,000
Accumulated Depreciation 21,000
Cash .. 22,000
Equipment (old) 40,000
Gain 4,000
(Exchange equipment for a gain)
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Key Point
If we dispose of an asset for more than book
value, we record a gain. If we dispose of an asset
for less than book value, we record a loss.

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Analysis

ASSET ANALYSIS

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Learning Objective 7

LO77 Describe the links among return on assets,

profit margin, and asset turnover.

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Illustration 726
Selected Financial Data

($ in millions)
Walmart
Net sales $485,651 Walmart is
Net income 16,363 larger.
Total assets, beginning 204,751 Is it also more
Total assets, ending 203,706 profitable?
Costco
Net sales $112,640
Net income 2,058
Total assets, beginning 30,283
Total assets 33,024

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Return on Assets
Indicates the amount of net income generated
for each dollar invested in assets

Net income
Return on Assets =
Average total assets

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Illustration 727
Return on Assets for Walmart and
Costco

($ in millions) Net Income Average Total Assets = Return on Assets

Walmart $16,363 ($204,751 + $203,706)/2 = 8.0%
Costco $ 2,058 ($30,283 + $33,024)/2 = 6.5%

Walmart is more profitable

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Illustration 728
Components of Return on Assets

Return on assets = Profit margin Asset turnover

Net income = Net income Net sales
Average total assets Net sales Average total assets

Profit margin: indicates the earnings per

dollar of sales
Asset turnover: measures the sales per
dollar of assets invested

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Illustration 729
Profit Margin
for Walmart and Costco
($ in millions) Net Income Net Sales = Profit Margin
Walmart $16,363 $485,651 = 3.4%
Costco $ 2,058 $112,640 = 1.8%

Walmarts profit margin is higher than Costcos

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Illustration 730
Asset Turnover
for Walmart and Costco

($ in millions) Net Sales Average Total Assets = Asset Turnover

Walmart $485,651 ($204,751 + $203,706)/2 = 2.4 times
Costco $112,640 ($30,283 + $33,024)/2 = 3.6 times

Costcos asset turnover is higher than Walmarts

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Concept Check 78
Papas Pizza has the following items for the past
year: Net sales are $24,128, net income is $2,223,
total assets at the beginning of year are $14,898,
and total assets at the end of year are $15,465.
What is the profit margin?
a. 9.2%
b. 61.7%
c. 14.6%
d. 14.9% The profit margin is computed by taking net
income and dividing by net sales. Net income
of $2,223 divided by net sales of $24,128
results in a profit margin of 9.2%.
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End of Chapter 7

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