FINANCIAL ACCOUNTING
CHAPTER 9
Long-term
assets are resources owned by a business and employed for more than one
year. They assets support daily
operations and are not held for sale to customers. Long-term assets include:
1.
Plant assets: long-lived, tangible
assets used in the operations of the business (land, land improvements,
buildings, equipment, furniture, fixtures), and natural resources (ore
deposits, timbers.)
2.
Intangible assets: Long-lived
resources without physical form that represents rights, such as patents,
copyrights, trademarks, trade names, and franchises.
Long-term
assets may either be donated to or purchased by a business. As the asset is used, a portion of its cost
is expensed against the revenues earned from its use. The following expenses relate to long-term
assets:
1.
Depreciation is the allocation of the cost of assets to expense over
their useful life.
2.
Depletion is the allocation of the cost of natural resources to expense
over their useful life.
3.
Amortization is the allocation of the cost of intangible assets to
expense over their useful life.
Businesses
may decide to dispose of a long-term asset before, or at the end of its useful
life. To determine whether the disposal
of an asset generates a gain or loss and thus affects net income, the cash or
trade-in value received is compared to the book value of the asset. The book value is the portion of the asset’s
original cost that has not been used or expensed; it is the cost of the asset
less its accumulated depreciation.
Business
managers are responsible for developing internal controls for long-term
assets. These assets are often
expensive, and some are easy to steal.
The following internal controls are important:
1.
Tag or otherwise label each newly purchased plant asset with an identification
number.
2.
Create a subsidiary ledger for long-term assets, listing each asset and
its identification number, date of purchase, location, and person responsible
for it.
3.
In each plant asset’s account in the subsidiary ledger, record the
cost, depreciation data, and subsequent disposal date, and amount of the asset.
4.
Periodically make sure the total balance of all asset subsidiary
accounts agrees with the general ledger account balances shown on the balance
sheet.
5.
Inspect each asset at least once a year, noting its condition and
whether it remains in use.
Cost
of equipment/machinery – all normal and reasonable expenditures to get the
asset in place and ready for its intended use.
1.
Purchase price, less discount
2.
Transportation costs
3.
Sales Tax
4.
Commission
5.
Installing and testing the asset (concrete base, electricity,
adjustments to the asset)
6.
Cost of insurance while machine is in transit
Costs
to include if construct your own plant asset
1.
Direct labor
2.
Direct material
3.
Overhead
4.
Architectural fees
5.
Building permits
Costs
if purchase building
1.
Brokerage commission
2.
Legal fees
3.
unpaid Taxes
4.
Renovation and repair costs
Cost
of land
1.
Purchase price
2.
Brokerage commission
3.
survey and legal fees
4.
unpaid taxes
5.
costs to clear land
6.
costs to remove buildings
Cost
of land improvements (fencing, paving, sprinkler systems, lighting, signs)
1.
purchase price
Cost
of furniture/fixtures
1.
purchase price less discounts
2.
transportation costs
3.
sales tax
The
land improvements are recorded separately from the land account because land is
never depreciated, but the land improvements are depreciated.
Example
of land purchase
Example
of land improvements
Plant
assets sometimes are purchased as a group in a single transaction for a
lump-sum price. This transaction is
called a basket purchase. If land, building, and land improvements are
purchased in a single transaction for a lump-sum price, the cost of the
purchase must be allocated among the accounts based on their relative fair
market value. This allocation technique
is called the relative-sales-value method.
Example
Even
after an asset has been purchased, it may be necessary to spend money on
it. These expenditures may be consumed
over more than one period and treated as an asset; or they may be consumed in
the current period and treated as an expense.
Expenditures
that increase the asset’s capacity or efficiency or that expend the asset’s
useful life are called capital expenditures because they result in the
capitalization, or increase, of an asset.
The cost of a major overhaul that makes an asset’s useful life longer is
a capital expenditure. Repair work that
generates a capital expenditure is called an extraordinary repair. Capital expenditures and extraordinary
repairs are both recorded by increasing assets.
Other
expenditures do not extend as asset’s efficiency, life, or capacity, but merely
maintain the asset in working order.
These costs are recorded as expenses and immediately subtracted from the
revenue they produced. These costs of ordinary
repairs are debited to an expense
account.
Depreciation
is the allocation of an asset’s cost to expense over its useful life. Recognizing depreciation expense matches the
portion of the asset cost in the period against the revenue earned by the asset
in that period.
Depreciation
is an expense that reflects the wear and tear or the obsolescence of plant
assets. An asset is obsolete when
another asset can do the job much more efficiently. An asset’s useful life may be shorter than
its physical life.
Depreciation
of a plant asset is based on three factors:
1.
Cost is the amount paid to acquire the asset and get it ready for use.
2.
Useful life is the estimated length of service of an asset. Useful life may be expressed in years, units
of output, miles, or another measure of productivity.
3.
Residual value, also called salvage value, is the estimated cash
value of a plant asset at the end of its useful life. The estimated residual value of the asset is
excluded from the amount of cost depreciated because the business expects to
receive this amount at the end. If the
asset has no residual value, then the business depreciated the full cost of the
asset. Cost minus residual value is
called depreciable cost.
Depreciation
is not a process of adjusting the recorded value of the asset to its market
value. Depreciation does not mean that
the business sets aside cash to replace an asset when it is used up. Depreciation has nothing to do with
establishing a cash fund.
1. Straight-line method allocates an equal amount of depreciation
to each year of a plant asset’s use. A
two-step process is used. First compute
the depreciable cost of the asset; this amount is also called the cost
to be depreciated. It is computed by
subtracting the asset’s residual value from its total cost. Second, the depreciable cost is divided by
the number of accounting periods in the asset’s useful life.
Example
Book value declines each period until it equals
salvage value at the end of its useful life.
Accumulated depreciation is the sum of current and prior periods’
depreciation expense. Total accumulated
depreciation increases each period.
2. Units of production method allocates
a fixed amount of depreciation to each unit of output produced by a plant
asset. Units of production may be units
of product, hours of use, or miles driven.
A two-step process is used to compute units-of-production
depreciation. First compute depreciation
per unit by subtracting the asset’s residual value from its total cost and then
dividing by the total number of units expected to be produced during its useful
life. The second step is to compute
depreciation expense for the period by multiplying the units produced in the
period by the depreciation per unit.
Example
3. Double-declining balance method is an accelerated
depreciation method because it records more depreciation near the start of a
plant asset’s life than at the end of its life.
double-declining balance method
1.
Calculate straight-line depreciation rate for the asset
2.
Double it
3.
Calculate depreciation expense by applying this rate to the asset’s
book value at the beginning of that period.
4.
Residual value is not used
5.
Final year depreciation is the amount needed to bring the asset to
residual value.
Example
If a
plant asset is purchased or disposed of during the year, depreciation must be
recorded for part of a year. Record no
depreciation for the month on assets purchased after the 15th of the
month. Record a full month’s
depreciation on assets bought on or before the 15th.
Example
Revising
depreciation
Estimating
the useful life of a plant asset poses a challenge because it involves guessing
at the future of an asset. The business
may change its estimated useful life based on experience and new information. When a company makes such a change, GAAP
requires the business to report the nature, reason, and effect of the
change. The remaining book value of the
asset is spread over the asset’s remaining life.
Example
A
fully depreciated asset is one that has reached the end of its estimated useful
life. The company may continue using the
asset, but no more depreciation is recorded for the asset. The asset account and its accumulated
depreciation remain on the books.
Plant
assets can be disposed of in one of three ways:
1.
Sold
2.
Exchanged
3.
Retired
To
account for each of these types of disposal:
Selling
plant assets
Example
one – sell at book value
Example
two – sale above book value
Example
three – sale below book value
Exchanging
plant assets
1.
Exchanging dissimilar assets (trading land for a truck) – if a company
exchanges a plant asset that is dissimilar in use or purpose, any gain or loss
must be recognized. Treat like selling
the asset and then buying another asset.
2.
Exchanging similar assets
A. Recognize loss
B. Non-recognition of gain –
gains are not recognized because the business still
owns the same type of asset that is owned before the trade.
Receiving less in exchange – a loss
Receiving more in exchange – a gain
A
plant asset is retired when it is no longer useful to the company and it has no
market value.
Example
Natural resources are plant assets and are usually listed below Property, Plant, and Equipment on the balance sheet. Examples are iron ore, natural gas, standing timber, and oil reserves. They are recorded at cost. As the natural resources are extracted and sold, a portion of their cost is expensed through depletion. Depletion expense is that portion of the cost of natural resources that is used in a particular period. Account for depletion as follows:
1. Compute depletion over the asset’s estimated useful life using the units-of-production method. Natural resources usually have no residual value.
2.
Record depletion in Depletion Expense and
Accumulated Depletion, a contra-asset account similar to Accumulated
Depreciation.
Example
Intangible assets have
no physical existence but they provide benefit to their owners because they
convey special rights.
1. Patents
2. Copyrights
3. Trademarks and Trade Names
4. Franchises and Licenses
5. Goodwill
Intangible assets are recorded at cost and written off over their useful life through the process of amortization. A separate contra account is usually not used for intangible assets. The straight-line method is normally used to determine the periodic amortization. The residual value of most intangibles is zero.
1. Patent is a federal government grant giving the holder the exclusive right to manufacture and sell a patented machine or device, or to use a process, for 20 years. Patents can be amortized for 20 years or their useful life, whichever is less. When patents are purchased, an account called patents is debited.
Example
2. Copyrights are the exclusive right to reproduce and sell music, literature, or art work during the life of the composer, author, or artist plus 70 years.
3. Trademarks and Trade Names are assets that represent distinctive products or services. The cost of a trademark or trade name is amortized over its useful life.
4. Franchises and Licenses are privileges granted by a private business or a government to sell products or services under specified conditions. The acquisition cost of a franchise or license is amortized over its useful life.
5. Goodwill is the excess of the cost to purchase another company over the market value of the net assets purchased, where net assets are equal to total assets minus total liabilities. Good will is recorded only by a company that purchases another company. Goodwill is recorded as an asset, and it is not amortized. The company measures the current value of its purchased goodwill each year. If goodwill’s value decreases, then the company records a loss and reduces the value of goodwill.
Example
Footnotes to the financial statements will describe the methods used to compute depreciation, depletion, and amortization.