Professional Documents
Culture Documents
Notes06 3
Notes06 3
Plant Assets
Plant Assets are also called fixed assets; property, plant and equipment; plant and equipment; long-term assets; operational assets; and long-lived assets. They are characterized by: have a useful life of more than one year; used in the operation of the business; and are not intended for resale to customers (not inventory).
Plant assets are tangible assets. "Tangible assets" are assets that you can touch. Plant assets include land, buildings, equipment, and natural resources.
Land Improvements Land improvements, such as driveways, parking lots, fences and signs, are subject to depreciation and require a separate Land Improvements account. Buildings The cost of buildings purchased includes the applicable items described above and the cost of any repairs made in order to make the building usable. If a building is construction, the construction costs are added to the cost of the building. Interest incurred during the construction of a building or other plant asset is included in the cost of the asset (capitalized interest). This is true even if the loan was not directly used to construct the asset. Interest incurred for the purchase of a plant asset is expensed when incurred. Equipment The cost of equipment includes the price paid, sales taxes, freight charges, and insurance during transit paid by the purchaser. It also includes expenditures required in assembling, installing, and testing the unit.
When an asset is purchased for cash, the general journal entry is as follows: D. Equipment Cr. Cash $5,000 $5,000
When an asset is purchased for debt, the general journal entry is as follows: D. Equipment (cost) Cr. Cash (down payment) Notes Payable (amount borrowed) $5,000 $1,000 4,000
When an asset is acquired for equity, the general journal entry is as follows: D. Equipment (cost) Cr. Common Stock (par value) APIC (cost in excess of par) $5,000 $1,000 4,000
To Buy or Lease?
A lease is a contract that allows a business or an individual to use an asset for a specific length of time in return for periodic payments. There are two types of leases: (i) operating leases; and (ii) capital leases. Capital leases are financing transactions. The lessee (renter) is treated as having acquired the leased property through the use of financing (the Capital Lease). An operating lease is a lease that does not meet the criteria for Capital Leases. There are advantages for leasing plant assets: Reduced Risk of Obsolescence. The lease may allow the lessee to exchange the leased asset for a more modern one if it becomes outdated. Little or No Down Payment. In order to purchase an asset, the purchaser must usually pay a material portion of the purchase price in cash (e.g., 20%). Leases require little or no down payment. Shared Tax Advantages. With some leases (e.g., operating leases), the lessor (rather than the lessee) receives the depreciation tax deduction. The lessee may not need the tax deduction, and the lessor is willing to accept lower rental payments in exchange for receiving the tax deduction. Assets and Liabilities Not Reported. In the case of operating leases, the lessee is not treated as the owner of the asset, and therefore does not report the assets and the associated liabilities on their balance sheet.
Capital leases are not really leases. They are financing transactions. You are really buying an asset; not leasing it. Many car leases are, in fact, financing transactions. A capital lease (as determined by certain criteria) is in substance a sale and should be recorded as an asset (to be depreciated) and a related liability by the lessee. When the capital lease is signed, the lessee makes journal entries that record the acquisition of an asset and liability. The purchase price and the amount of the liability is the present value of all of the payments under the lease: D. Equipment Under Capital Lease (present value of lease payments) Cr. Obligations Under Capital Lease (present value of lease payments) At the end of each year, the lessee depreciates the leased asset: D. Depreciation Expense Cr. Accumulated Depreciation, Equipment Under Capital Lease $1,000 $1,000 $5,000 $5,000
Each payment under the lease is treated as a payment on the debt. A portion is treated as interest and a portion is treated as principal: D. Interest Expense (amount paid over present value) Obligations Under Capital Lease (amount related to present value) Cr. Cash $200 800 $1,000
Depreciation
In dealing with long-term assets, the major accounting problem is to determine how much of the asset has benefited the current period (e.g., expenses) and how much should be carried forward as an asset to benefit future periods (e.g., assets).
This allocation of costs to different accounting periods is called: depreciation in the case of plant and equipment (property, plant and equipment); depletion in the case of natural resources, and amortization in the case of intangible assets.
Because land has an unlimited useful life, its cost is never converted into an expense. The unexpired cost of an asset is called the carrying value (also book value), and is equal to the cost less accumulated depreciation. Equipment (cost of asset) Less: Acc. Depr. (All Depr to date) Book Value or Carrying Value $10,000 -4,000 $6,000
Depreciation, as used in accounting, refers to the allocation of the cost (less the residual value) of a plant asset to the periods benefited by the asset. It does not refer to the physical deterioration or the decrease in market value of the asset; it is a process of allocation, not valuation. Your book notes that the useful life of an asset is limited by physical depreciation (e.g., as you drive your car, it deteriorates and breaks down) and functional depreciation (e.g., as your computer gets older it can't handle newer computer programs). A plant asset should be depreciated over its estimated useful life in a systematic, rational manner. Depreciation can be computed once the cost, salvage value, and estimated useful life have been determined. Cost is the cost of the asset calculated in the manner described above. Salvage Value is the estimated value at the disposal date; it is often referred to as "residual value" or "disposal value". Estimated useful life is the period in which the company will use the plant asset. It is measured in time or in units.
Depreciable cost equals the cost less the salvage value. It represents the net cost of the assets use by the. For example, if a company buys a computer for $1,000 and intends to sell it for $100 after it is finished using the computer, the companys use of computer costs the company $900. The depreciation expense may not exceed the depreciable cost of the asset. The following journal entry is used in connection with depreciation. D. Depreciation Expense, Asset Name Cr. Accumulated Depreciation, Asset Name $1,000 $1,000
The most common methods of depreciation are: The straight-line method (based on the passage of time) The declining-balance method (an accelerated method), and The units-of-activity method (based on units produced, miles driven, and the like)
Straight-Line Method
Under the straight-line method, the depreciable cost is spread uniformly over the estimated useful life of the asset. Depreciation for each year is computed as follows: Cost - Salvage Value -------------------------------------Estimated useful life in years For example, if you had an asset with a cost of $10,000, a salvage value of $1,000, and a useful life of 10 years, each year you would take $900 of depreciation ($10,000 - $1,000)/10.
Declining-Balance Method
Accelerated methods of depreciation result in larger depreciation in the early years of an asset's life. Under the declining-balance method, depreciation is computed by multiplying the existing carrying value of the asset by a fixed percentage. The double-declining-balance method is a form of the decliningbalance method; it uses a fixed percentage that is twice the straight-line percentage. Under the double-declining-balance method, the fixed percentage is double the percentage used in the straight line calculation. For example, if the useful life is 10 years, then the straight-line depreciation would be 1/10 (10%) of the depreciable cost. With the double declining balance method, you would use twice the straight-line rate (20%). This percentage is then multiplied against the existing book value of the asset for the year in question. Note that the declining-balance method does not use residual value in figuring the rate. Despite this, you are not allowed to depreciate the asset below the residual vale. In other words, depreciation is limited to the amount necessary to bring the carrying value down to the estimated residual value.
Units-of-Activity Method
This is often referred to as the units-of-production method or the production method. This method is similar to the straight-line method. Under the straightline method, the cost of the asset is spread out evenly over the period in which the asset is used. Under the units-of-production method, the cost is spread evenly over the units produced by the asset. Depreciation for each year is computed as follows: Cost - Salvage Value ------------------------------------Estimated units of useful life Units of production method is a good application of the matching principle but can only be used if output over useful life can be estimated with reasonable accuracy.
Ordinary repairs are expenditures necessary to maintain an asset in good operating condition; they are charged as an expense in the period incurred. Your book refers to capital expenditures as additions and improvements. They are described as costs that increase the operating efficiency, productive capacity or expected useful life of existing plant assets.
An addition adds a new feature to an existing building. An example of an addition would be adding a new room to a building. The cost is capitalized and then depreciated (expensed) over the useful life of the room or the building, whichever is shorter. A new asset is created by the expenditure A betterment improves a fixed asset's operating efficiency or capacity for its remaining useful life. It is added to the cost of the original asset. An example would be exchanging the hard drive of a computer for a newer one with more capacity. The cost of the new drive is added to the computers cost, and the cost
and any accumulated depreciation related to the old hard drive should be removed from the computers cost. Extraordinary repairs are expenditures that either increase an asset's residual value or lengthen its useful life (e.g., a major overhaul of a car engine). Extraordinary repairs are recorded by debiting Accumulated Depreciation and crediting Cash. This has the effect of increasing the book value of the asset, but makes it appear less depreciated. The thought is that by making the extraordinary repair, you have undone the previous depreciation. D. Accumulated Depreciation, Asset Name Cr. Depreciation Expense, Asset Name $2,000 $2,000
If a capital expenditure is recorded mistakenly as a revenue expenditure, current period expense is overstated and net income is understated. In future periods, net income will be overstated since it was all expensed in the first period. The opposite effects would be true for a revenue expenditure recorded mistakenly as a capital expenditure.
Impairments
As noted above, the historical cost of a plant asset is used in a companys balance sheet. The balance sheet is also governed by the principle of conservatism. When the market value of an asset falls below the book value of the asset, the asset is impaired. A company is required to write down the book value of the impaired asset to its fair market value in the year that the decline in value occurs. The journal entry to reflect the impairment loss is reflected below: D. Impairment Loss Cr. Asset Name $10,000 $10,000
If the machine is fully depreciated: D. Accumulated Depreciation, Machinery Cr. Machinery $10,000 $10,000
If the machine has not been fully depreciated, then Loss on Disposal of Machinery must be debited for the carrying value to balance the entry. D. Accumulated Depreciation, Machinery Loss on Disposal of Machinery Cr. Machinery $7,000 3,000
$10,000
When a machine is sold for cash, Accumulated Depreciation, Machinery is debited, Cash is debited, and Machinery is credited. If a machine is sold for its book value: D. Cash Accumulated Depreciation, Machinery Cr. Machinery $3,000 7,000
$10,000
If the cash received is less than the carrying value of the machine, then Loss on Sale of Machinery would also be debited. On the other hand, if the cash received is greater than the carrying value, then Gain on Sale of Machinery would be credited to balance the entry. $2,000 D. Cash Accumulated Depreciation, Machinery 7,000 Loss on Sale Machinery 1,000 Cr. Machinery (Sale of machine at less than carrying value; loss recorded) D. Cash Accumulated Depreciation, Machinery Cr. Machinery Gain on Sale of Machinery (Sale of machine at more than carrying value) $4,000 7,000
$10,000
$10,000 1,000
$10,000 9,000
If a gain was recognized on the above transaction, then the new machine would be recorded at its fair market value and a gain of $3,000 would be recognized on the receipt of a credit of $6,000 for the old machine with the book value of $3,000. D. Machinery (New) Accumulated Depreciation, Machinery (Old) Cr. Machinery (Old) Cash Gain on Exchange of Machine $15,000 7,000
The following journal entry relates to depletion: D. Depletion Expense, Coal Deposits Cr. Accumulated Depletion, Coal Deposits $1,000 $1,000
Return on Assets Ratio Financial Analysts often look at the profit earned on the companys assets. The Return on Assets Ratio is calculated as follows: Net Income -----------------------Average Total Assets Asset Turnover Ratio The Asset Turnover Ratio looks at the productivity of a companys assets (rather than their profitability). This ratio is calculated as follows: Net Sales ---------------------------Average Total Assets Profit Margin Ratio Revisited The Profit Margin and the Asset Turnover Ratio are components of the Return on Assets: Profit Margin Net Income Net Sales X X Asset Turnover Ratio Net Sales Average Total Assets = = Return On Assets Net Income Average Total Assets
Net Sales in the Profit Margin and the Asset Turnover Ratio cancel out and leave you with the Return on Assets. This relationship demonstrates the fact that if a company wishes to increase its profitability, it can either: increase its profit margin (earn more income on its given revenue), or increase its asset turnover ratio (make its assets more productive).
Intangible Assets
Intangible assets are long-term assets that have no physical substance; they represent certain legal rights and advantages extended to their owner. Examples of intangible assets are patents, copyrights, trademarks, goodwill, leaseholds, leasehold improvements, franchises, licenses, brand names, formulas, and processes. An intangible asset should be written off over its useful life through a process called amortization in accordance with the matching principle. Assets with an
indefinite useful life should not be amortized. These assets however still must be written down as impaired assets if their fair market value declines below their book value. Rather than using a contra account to reduce the asset being amortized (as was the case with Accumulated Depreciation and Accumulated Depletion), the intangible asset is reduced by its Amortization expense. There is no contra account. The journal entry for amortization is as follows: D. Amortization Expense, Patent Cr. Patent Patents A patent is an exclusive legal right to use an invention for 20 years. The cost of a patent should be amortized over the shorter of its useful life or its legal life. If a company incurs legal costs in successfully defending its patent, these costs are added to the cost of the patent and amortized over its remaining life. Research and Development Costs Research and development encompass the development of new products, the testing of existing and proposed products, and pure research. According to GAAP, research and development costs normally should be expensed in the period incurred. The cost of developing computer software should be treated as research and development up to the point where a product is deemed technologically feasible. From that point on, software production costs should be capitalized and amortized over their useful lives using the straight-line method. Copyrights A copyright is an exclusive legal right to publish literary, musical, and other artistic materials and software. For individuals, the copyright period is the creators life plus 50 years. The cost of a copyright should be amortized over the shorter of its useful life or its legal life. If a company incurs legal costs in successfully defending its copyright, these costs are added to the cost of the copyright and amortized over its remaining life. Trademarks and Trade Names Trademarks and trade names are the exclusive rights to use registered symbols and names to identify a product or service. Trademarks and trade names are $1,000 $1,000
registered with the U.S. Patent Office. Such registration provides 20 years protection and may be renewed indefinitely as long as the trademark or trade name is in use. Because trademarks and trade names have an indefinite life, they are not amortized. Franchises and Licenses A franchise grants the franchisee the exclusive right to operate a business in a given territory (e.g., a Wendys). A license grants the licensee the right to use property or a process (e.g., formula, technique, process, or design) of another person, company or government. Annual payments on a franchise or license are an operating expense. The cost of acquiring a franchise or license should be amortized over its useful life. If the useful life is indefinite, then there should be no amortization. Goodwill Goodwill, as the term is used in accounting, refers to a company's ability to earn more than is normal for its particular industry or for the amount of its capitalization (net assets). Goodwill is recorded only when a company is purchased and equals the excess of the purchase cost over the fair market value of the net assets. Goodwill is considered to have an indefinite useful life, and therefore is not amortized. However, a company is required to examine whether its Goodwill is impaired on an annual basis. Leasehold (Not In Book) A leasehold is the purchased right to rent property for a long period of time. Leasehold improvements are improvements made to leased property that revert to the lessor at the end of the lease. They are amortized over the shorter of: (i) the useful life of the improvements or (ii) the remaining term of the lease.