Chap009 notes

Editor's Notes

• #2: In this chapter we will study the acquisition and depreciation of productive assets used in a business. In addition, we will take a quick look at accounting for natural resources and intangibles. This chapter contains some challenging accounting procedures, so let’s get started.
• #3: Plant assets are tangible assets that are used actively in the operations of the entity. We fully expect these assets, sometimes referred to as property, plant, and equipment, to benefit future periods. When we acquire a plant asset, it is recorded at its historical cost. Once the asset is placed in service, we will allocate a portion of the asset’s cost to depreciation expense as the asset becomes older.
• #4: There are three major categories of plant assets. Tangible plant assets are long-term assets that have physical substance. Examples include land, buildings, equipment, furniture and fixtures. Intangible assets are noncurrent assets with no physical substance. Examples include patents, copyrights, trademarks, franchises and goodwill. Natural resources are acquired for extracting valuable resources that will be used in the business. Examples include oil reserves, timber, and other minerals. We will review the accounting issues related to all three of these categories.
• #5: There are three accountable events we need to discuss. When we acquire a plant asset, it is recorded at its historical cost. We will see how cost is determined on the next slide. Once the asset is placed in service, we will allocate a portion of the asset’s cost to depreciation expense as the asset becomes older. Finally, at the end of the asset’s useful life, we will dispose of it and remove it from our books and records. The accounting for plant assets usually covers several accounting periods.
• #6: The cost of a plant asset includes the purchase price as well as all costs necessary to get the asset in place and ready for its intended use. We record the purchase price net of any cash discounts available. Finance charges are not included in the cost of an asset. If we elect to finance the purchase over a period of time, the interest cost is charged as an expense when incurred. Let’s see how to determine the cost of a plant asset on the next slide.
• #7: On May 4th, Heat Company buys a new machine for fifty two thousand dollars. Sales tax is eight percent. Heat Company also pays five hundred dollars in shipping costs, one thousand three hundred dollars in set-up costs, and four thousand dollars in testing costs. What is the cost of the machine?
• #8: Part I Remember that the cost of an asset includes the purchase price plus any cost that is necessary to get the asset to you and ready for use. The cost of the new machine is sixty one thousand nine hundred sixty dollars. Part II The entry to record the purchase includes a debit to the asset account and a credit to Cash.
• #9: When purchasing land, the cost includes the purchase price and other costs generally incurred in connection with land acquisitions. Many of these costs are related to obtaining legal title to the land. Also remember that land is not a depreciable plant asset. Land improvements include parking lots, driveways, fences, sidewalks, landscaping, and any outdoor lighting systems. Land improvements are depreciated over their useful life.
• #10: Whether we purchase or construct a building, the cost should include the purchase price plus any attorney fees, title fees, and repairs made prior to using the building. If we construct the building, the cost will include all the necessary construction costs as well as the costs we have just mentioned. Machinery and equipment is recorded at its purchase price less any available cash discount. If the company pays delivery charges on the truck, these costs are included in the cost of the truck. If we need to install any special parts to make the machinery or equipment ready for its intended use, we will include these costs in the price of the assets. Other costs included are insurance and property taxes of the current period.
• #11: It is not uncommon to have a lump-sum purchase of assets. The most common example may be when purchasing a building and land. Remember, the land is not depreciable but the building is. We must assign a portion of the purchase price separately to the building and to the land. When faced with this type of problem, accountants normally divide the cost between the assets on the basis of relative fair market values.
• #12: After a plant asset is purchased, the company may incur additional expenditures on that asset. These expenditures may be for repairs and maintenance, overhauls, upgrading the asset, and similar expenditures.One way to handle these types of expenditures is to treat them as a Capital Expenditure and charge the amount to a balance sheet account like the asset or accumulated depreciation. In some cases, the expenditures may be treated as Revenue Expenditures and charged to current period income as an expense. For each expenditure subsequent to acquisition of a plant asset we must decide if the expenditure is to be treated as a Capital or Revenue expenditure. Generally, subsequent expenditures for ordinary repairs are treated as revenue expenditures and charged to current period income as an expense. Subsequent expenditures that are for betterments are classified as extraordinary repairs. These should be treated as capital expenditures and charged to the asset account.
• #13: Depreciation is a process of cost allocation. We allocate the cost of the asset to expense over its useful life in some rational and systematic manner. We do not want to confuse asset valuation, an economic concept, with allocation. The unused portion of the asset’s cost appears on the balance sheet. We allocate a portion of the cost to expense on the income statement each accounting period.
• #14: When dealing with depreciation, there are several terms and concepts we need to understand. Book value is calculated as the historical cost of the asset minus the accumulated depreciation. Book value is the undepreciated cost of the asset. Accumulated depreciation represents the depreciation taken on the asset since its purchase. Accumulated depreciation is a contra-asset account and is subtracted from the asset account to determine book value. We depreciate assets as we use them to help earn revenue. As assets are used, they incur physical deterioration and obsolescence. Now, let’s look at some common methods of calculating depreciation expense.
• #15: Regardless of the method used to calculate depreciation expense, we must know three variables: (1) the asset’s cost; (2) the estimated residual value we expect to receive at the end of its useful life, and (3) the estimated useful life of the asset. When using the straight line method, depreciation expense is calculated by taking cost minus residual value and dividing by the years of useful life. Let’s see how this works.
• #16: Part I On January 1, 2005, Bass Company purchased a boat for twenty four thousand dollars. The estimated useful life is five years and the estimated residual value is three thousand dollars. Can you calculate the amount of annual depreciation? Part II This calculation was relatively easy. Did you get the annual depreciation of four thousand two hundred dollars? Now let’s look at a schedule of the annual depreciation for over the life of the asset.
• #17: Notice that depreciation expense is the same amount in each of the five years. If we plot this amount on a graph, it would be a straight-line. That is how we got the name of the method. Accumulated depreciation increases by four thousand two hundred dollars each year. The cost of the asset less accumulated depreciation at the end of any year is called book value. Book value decreases by four thousand two hundred dollars each year. At the end of the asset’s useful life, the book value is equal to the estimated residual value. We want this to be true regardless of the method we use.
• #18: To this point we have discussed depreciation of an asset that was purchased on January first of the year. We realize that relative few assets will actually be purchase on January 1st. One way to determine depreciation for assets purchased throughout the year is to use the half-year convention. Using this convention, in the year of acquisition, a company would record half a year, or six months, of depreciation. Let’s see how how this works.
• #19: Part I In our example, a company purchased equipment for seventy five thousand dollars on some date in two thousand five. The equipment has a useful life of ten years and estimated residual value of five thousand dollars. This company uses straight-line depreciation for all its plant assets. Let’s calculate depreciation expense for 2005 using the half-year convention. Part II Using straight-line depreciation, the depreciation expense for an entire year would be seven thousand dollars. We determine this amount by taking cost less residual value and dividing it by the useful life. Since the company uses the half-year convention, we divide the annual depreciation in half for the first year. The depreciation expense for 2005 would be three thousand five hundred dollars.
• #20: There are several appealing reasons to use a declining-balance method for depreciation. One reason to consider the declining-balance method is to better match depreciation expense and with revenue generated. The idea is that a newer asset will generate more revenue in early years rather than later years so depreciation expense should be higher in the early years of ownership and less in later years. Another reason that the declining-balance method is appealing to use for financial statement reporting is that it is similar to the depreciation method used for tax purposes. Calculating depreciation expense under the double-declining-balance method is a three step process. The first step is to calculate the straight line depreciation rate. We do this by dividing one hundred percent by the asset’s useful life. The second step is to calculate the double declining balance rate. We do this by multiplying the straight-line rate times two. The third, and final step is to determine depreciation expense. We multiply the double declining rate times the book value of the asset at the beginning of the period. Under the double declining balance method we ignore estimated residual value. Let’s look at an example.
• #21: Part I On January 1, 2005, Bass Company purchased a boat for twenty four thousand dollars. The estimated useful life is five years and the estimated residual value is three thousand dollars. Can you calculate the amount of annual depreciation using the double-declining balance method? Part II The first step is to calculate the straight line depreciation rate. Recall that we do this by dividing one hundred percent by the asset’s useful life. In our specific case we divide one hundred percent by the five-year useful life to get a straight-line rate of twenty percent. The second step is to calculate the double declining balance rate. We do this by multiplying the straight-line rate times two. In our case that would be twenty percent times two, or forty percent. The third, and final step is to determine depreciation expense. We multiply the double declining rate times the book value of the asset at the beginning of the period. In our case we would multiply the beginning book value (cost less accumulated depreciation) of twenty four thousand dollars by forty percent. Depreciation expense for 2005 is nine thousand six hundred dollars. Remember, under the double declining balance method we ignore estimated salvage value.
• #22: Part I While we always want the book value to be equal to estimated salvage value at the end of the asset’s useful life, it just will not work properly using the double declining balance method. In this case, we need for the book value at the end of 2009 to be equal to three thousand dollars, the estimated residual value. The only way we can make this work is to force depreciation expense in the last year to be the amount needed to bring book value down to residual value. In 2009, we will record depreciation expense of one hundred ten dollars. We determine this amount by subtracting the salvage value of three thousand dollars from the book value at the end of 2008, three thousand one hundred ten dollars. Part II Notice that no matter which depreciation method we use, total depreciation taken at the end of the asset’s life will be the same. In this case, for both the straight line method and the double declining balance method, total depreciation taken is twenty one thousand dollars.
• #23: Auditors review management’s estimates for useful lives and residual values for reasonableness. The principle of consistency ensures that companies avoid switching depreciation methods from period to period, unless there is a compelling reason for the change.
• #24: You know that the salvage value and useful life of a plant asset are both estimates. Like all estimates, new information may come to light that will cause us to revise our previous estimate.Let’s see how accountants handle the revision of previous estimates.
• #25: In our example, a company purchased equipment on January 1, 2002 for thirty thousand dollars. The equipment is estimated to have a ten year useful life and no salvage value at the end of its useful life. The company uses the straight-line method for all plant assets and begins recording depreciation on this equipment in 2002. We continue our original computations for 2002 through 2004. During 2005, we learn new information about the equipment. This new information causes us to revise our estimate of the equipment’s useful life. We now believe the equipment will have a total useful life of eight years. We already recorded depreciation expense for three years (2002, 2003, and 2004), so there are five years remaining in the equipment’s useful life.In this case, accountants would take the book value at the date of revision of our estimate, that is, 2005, and subtract any estimated salvage value at the time of revision. This total is to be divided by the remaining useful life of the asset at the date of revision.Let’s calculate the proper depreciation expense for 2005.
• #26: Part I The asset had a cost of thirty thousand dollars and a ten year useful life with no salvage value. Under straight line depreciation we record three thousand dollars of expense in each of the years 2002, 2003, and 2004. Let’s calculate the depreciation expense at December 31, 2005. Part II The original cost of the asset was thirty thousand dollars. Accumulated depreciation has a balance of nine thousand dollars at the beginning of 2005. The remaining book value is twenty one thousand dollars and the remaining useful life of the asset is five years, so depreciation for each of those five years will be four thousand two hundred dollars.
• #27: If an asset’s value decreases and cannot be recovered through future use or sale, the asset is considered to be impaired and it should be written down to its net realizable value.
• #28: Whenever we dispose of a plant asset, the first thing we do is update depreciation to the date of disposal. After completing the update we can begin on the journal entry.We start the journal entry by recording a debit to the cash account, if cash was received, or credit the cash account, if cash was paid by the company. In addition, we must determine whether a gain or loss is associated with the disposal. A gain is recorded with a credit, just like revenue, and a loss is recorded with a debit, just like an expense account.We complete the entry by removing the plant asset’s cost from our books with a credit, and remove the related accumulated depreciation with a debit.Let’s see how we calculate the gain or loss associated with the disposal.
• #29: If the amount of cash received is greater than the book value of the asset (cost less accumulated depreciation), a gain is associated with the disposal. If the cash received is less than the book value of the asset, a loss will be recorded. When the amount of cash is exactly equal to the book value of the asset, there will be no gain or loss in connection with the disposal. Now let’s look at a specific example of disposal of a plant asset.
• #30: On September 30, 2005, Evans Map Company sells a machine for sixty thousand dollars. The machine was purchased on January 1, 2000, for one hundred thousand dollars, had an estimated salvage value of twenty thousand dollars and a useful life of ten years. Evans’ uses straight-line deprecation. Let’s answer the following questions.
• #31: Part I What is the amount of depreciation to be recorded on September 30, 2005, to bring the depreciation up to date? Part II Annual depreciation is eight thousand dollars. For the nine months ending September 30, 2005, Evans will record six thousand dollars in depreciation.
• #32: Part I After updating the depreciation, what is the machine’s book value? Part II Book value is calculated as cost of one hundred thousand dollars minus the accumulated depreciation of forty six thousand dollars. So, for Evans’ machine, the book value is fifty four thousand dollars.
• #33: Part I Did the sale of the machine result in a gain or a loss? Part II To determine a gain or loss, compare the cash received of sixty thousand with the book value of fifty four thousand. Since Evans received more cash than the book value, Evans has a gain of six thousand dollars.
• #34: Part I Now, you have all the pieces of information necessary to record the sale. Part II We record the disposal with a debit to Cash for sixty thousand dollars, a debit to Accumulated Depreciation for forty six thousand dollars, a credit to Gain on Sale for six thousand dollars, and a credit to Machinery for one hundred thousand dollars.
• #35: Instead of selling assets, some transactions involve exchanging one plant asset for another asset. Sometimes these transactions are an exchange of similar assets and sometimes the exchange involves dissimilar assets. Let’s look at some basic information about exchanging assets.
• #36: If the exchange involves dissimilar assets, then any gain or loss on the transaction is immediately recorded. However, we have special accounting rules that apply when we trade one plant asset for a similar plant asset. The particular accounting rule we will follow depends on whether there is a gain or loss involved in the transaction. If the exchange if for similar assets and there is a loss on the exchange, then the loss is recorded immediately. However, if the exchange involves similar assets, some cash is paid, and there is a gain on the exchange, then none of the gain can be recorded immediately. Instead, we record the asset received at the book value of the asset given up. We do not recognize the gain because most accountants believe that the earnings process is not complete. Let’s look at an example of a similar exchange.
• #37: On May 30, 2005, Essex Company exchanges a used airplane and thirty five thousand dollars cash for a new similar airplane. The old airplane given up has a historical cost of forty thousand dollars, accumulated deprecation to the date of exchange of thirty thousand dollars, and a fair value of four thousand dollars.The first thing we need to determine is whether a gain or loss will result. Remember that our accounting depends upon whether a gain or a loss is indicated on the transaction.
• #38: Part I Does this exchange of similar airplanes result in a gain or a loss? Part II The book value of the airplane given up is ten thousand dollars and the fair value of the airplane given up is four thousand dollars. By comparing the ten thousand dollar book value with the four thousand dollar fair value, Essex has a six thousand dollar loss on the exchange. The general rule is that when we exchange similar productive assets and a loss in indicated, the loss is recognized in full.
• #39: Part I Let’s prepare the journal entry to record the exchange. Part II We begin by recording the parts of the journal entry that we know. We know we are giving up the old airplane, so we debit Accumulated Depreciation and credit the old Airplane account for their respective amounts. We also know we are giving up cash of thirty five thousand dollars and have a loss on the transaction of six thousand. Now all we need is to debit the new Airplane account for thirty-nine thousand dollars. This amount represents the fair value of the assets given up in the exchange: Cash of thirty five thousand dollars and the old Airplane of four thousand dollars.
• #40: Let’s change the subject away from disposals of plant assets and discuss intangible assets. Intangible assets lack physical substance and that makes it difficult to determine the asset’s useful life or any residual value. Many intangible assets involve exclusive rights or privileges. We will review the major types of intangible assets and related accounting on the remaining screens.
• #41: We have provided you with a list of intangible assets that will be discussed. Intangible assets are normally recorded at the purchase price plus any legal or related fees.
• #42: Amortization is the systematic write-off of the cost of an intangible over its useful or legal life, whichever is shorter. Amortization is the same concept as depreciation only we call it a different name because it refers to intangible assets. The entry to record amortization includes a debit to Amortization Expense and a credit to the specific intangible asset account involved.
• #43: An intangible asset called goodwill can be created when one company buys another company. If the purchase price of the company is greater than the fair value of the net assets and liabilities acquired, we have goodwill associated with the transaction.Goodwill is not amortized. Each year we must test to see if there has been any impairment in the carrying value of the goodwill. If an impairment is determined to exist, we will reduce the goodwill account and recognize the loss in value.
• #44: A patent gives the holder the exclusive right to manufacture and sell an item or process for twenty years. Patents are amortized (a process just like depreciation) using the straight-line method of its useful life, but never more than twenty years. Most companies amortized patents over a very short period of time.
• #45: A trademark or trade name is any symbol, name, phrase, or jingle the is identified with a company, product or service. No other party may use the trademark or trade name without the permission of the holder. Many trade marks are extremely valuable. The name “Mercedes-Benz” is quite valuable, or the name “Harley-Davidson.” How about the phrase, “Coke is it.”We normally amortize the cost of trademarks over a short period of time using the straight-line method.
• #46: The holder of a franchise has the right to deliver a product or service under conditions granted by the franchisor. You really can’t drive down any major street without finding a number of franchise operations. The accounting for franchises can become quite complex. At this point it is sufficient to be able to define the nature of a franchise.
• #47: A copyright grants to the holder the exclusive right to publish and sell musical, literary, or artistic work for the life of the creator plus seventy years. Most copyrights are amortized over a short period of time using the straight-line method.
• #48: According the generally accepted accounting principles, research and development costs should be expensed as incurred.
• #49: Now let’s turn to the last major subject we will cover in the presentations . . . . natural resources. Natural resources abound. We have accounting issues with oil, coal, timber, gold, gravel, and a wide variety of other natural resources. In general, natural resources can be thought of as anything extracted from our natural environment. As accountants, we report natural resources at their cost less accumulated depletion. Depletion is the allocation of the cost of a natural resource over its useful life. The depletion we will study in this text is very similar to straight-line depreciation. The cost of any natural resource must include all exploration and development costs as well as extraction costs. A portion of these total costs will be charged to income each period through the depletion expense account. Let’s see how the accounting rules for natural resources work.
• #50: We begin the process of calculating depletion expense by determining the depletion expense per unit of natural resource. The numerator of the equation contains the resource cost less any estimated residual value. The denominator of the equation is our estimated total capacity of the natural resource we expected to extract. For oil we express the denominator in terms of barrels, for coal we use tons, for timber we use board feet, and the like for other resources.
• #51: The second step to determine the current period’s depletion expense is calculated by multiplying the depletion expense per unit, determine on the previous slide, by the number of extracted units sold during the period. Depletion expense, which becomes part of cost of goods sold, is based on the number of units sold not the number of units extracted. To determine the unsold inventory balance at the end of the current period, multiply the depletion expense per unit by the number of units on hand at the end of the period.
• #52: The development and extraction of many types of natural resources require highly specialized plant assets. Just think of the use of off-shore drilling platforms for oil and gas production. These specialized assets are recorded in a separate account from the natural resource and depreciation over their useful life.
• #53: As this slide indicates, the straight-line method is used by the majority of companies. This is because of the simplicity of the calculation and ease of use.
• #54: This chapter covered a great deal of new material related to plant asset acquisition, depreciation and disposal. We also covered accounting issues for intangible assets and natural resources. In the next chapter, you will learn about liabilities.