Chapter 8 – Operating Assets: Property, Plant, and

Equipment, and Intangibles

Operating Assets: Property, Plant, and Equipment
• Operating assets constitute the major productive assets of many companies.
• Current assets are important to a company’s short-term liquidity, but operating assets are
absolutely essential to its long-term future. These assets must be used to produce the goods or
services the company sells to customers.
• Users of financial statements must assess the operating assets to make important decisions.
• The dollar amount invested in operating assets may be very large, as is the case with most
manufacturing companies. On the other hand, operating assets on the balance sheet may be
insignificant to a company’s value, as is the case with a computer software fi rm and many of the
so-called Internet fi rms.
• Operating assets are generally presented in two categories on the balance sheet: (1) Property,
Plant and Equipment and (2) Intangible Assets.
• Some firms refer to this category of assets as fixed or plant assets. Other firms present operating
assets in two categories: tangible assets and intangible assets.

Acquisition of Property, Plant, and Equipment

• Assets classified as property, plant, and equipment are initially recorded at acquisition cost (also
referred to as historical cost).
• Acquisition cost: the amount that includes all of the cost normally necessary to acquire an asset
and prepare it for its intended use, such as purchase price, taxed paid at the time of purchase,
transportation charges, and installation costs (also called Historical Cost and Original Cost).
• These assets are normally presented on the balance sheet at original acquisition cost minus
accumulated depreciation.
• Acquisition cost should not include expenditures unrelated to the acquisition (e.g., repair costs if
an asset is damaged during installation) or costs incurred after the asset was installed and use
begun.
• Quite often a firm purchases several assets as a group and pays a lump-sum amount. This is most
common when a company purchases land and a building situated on it and pays a lump-sum
amount for both.
 It is important to measure the acquisition cost of the land and the building separately.
 Land is not a depreciable asset, but the amount allocated to the building is subject to
depreciation.
 The purchase price should be allocated between land and building on the basis of the
proportion of the fair market value of each.
• Market value is best established by an independent appraisal of the property. If such appraisal is
not possible, the accountant must rely on the market value of other similar assets, on the value of
the assets in tax records, or on other available evidence.
• Generally, the interest on borrowed money should be treated as an expense of the period.
• If a company buys an asset and borrows money to finance the purchase, the interest on the
borrowed money is not considered part of the asset’s cost.
• Financial statements generally treat investing and financing as separate decisions.
• Purchase of an asset, an investing activity, is treated as a business decision that is separate from
the decision concerning the financing of the asset. Therefore, interest is treated as a period cost
and should appear on the income statement as interest expense in the period incurred.
• Exception to the rule stated above: If a company constructs an asset over a period of time and
borrows money to finance the construction, the interest incurred during the construction period
is not treated as interest expense. Instead, the interest must be included as part of the acquisition
cost of the asset.
• Capitalization of interest: interest on constructed assets is added to the asset account.
• Depreciation of an asset should be based on the capitalization of interest value less any residual
value.
• Land improvements: costs that are related to land but that have a limited life.
• The acquisition cost of land should be kept in a separate account because land has an unlimited
life and is not subject to depreciation. Other costs associated with land should be recorded in an
account such as Land Improvements.
• The acquisition costs of land improvements should be depreciated over their useful lives.

Use and Depreciation of Property, Plant, and Equipment

• All property, plant, and equipment, except land, have a limited life and decline in usefulness over
time.
• The accrual accounting process requires a proper matching of expenses and revenue to measure
income accurately.
• Depreciation: the allocation of the original cost of an asset to the periods benefited by its use.
• Proper matching for operating assets is not easy because of the many factors involved. An asset’s
decline in usefulness is related to:
1. Physical deterioration from usage or from the passage of time.
2. Obsolescence factors such as changes in technology.
3. The company’s repair and maintenance policies.
• Because the decline in an asset’s usefulness is related to a variety of factors, several depreciation
methods have been developed.
• A company should use a depreciation method that allocates the original cost of the asset to the
periods benefited and that allows the company to accurately match the expense to the revenue
generated by the asset.
• Three methods of depreciation: straight line, units of production, and double declining balance.
• All depreciation methods are based on the asset’s original acquisition cost.
• All methods require an estimate of two additional factors: the asset’s life and its residual value.
• The residual value (also referred to as salvage value) should represent the amount that could be
obtained from selling or disposing of the asset at the end of its useful life. Often, this amount may
be small or even zero.

Straight-Line Method
• Straight-line method: a method by which the same dollar amount of depreciation is recorded in
each year of asset use (cost is allocated evenly).
• Book value: the original cost of an asset minus the amount of accumulated depreciation.
Acquisition Cost - Residual Value
• Depreciation =
Life
• The most attractive features of the straight-line method are its ease and its simplicity.
• The most popular method for presenting depreciation in the annual report to stockholders.
Units-of-Production Method
• Units-of-production method: depreciation is determined as a function of the number of units the
asset produces.
• In this method, the asset’s life is expressed in terms of the number of units that the asset can
produce.
Acquisition Cost - Residual Value
• Depreciation per Unit =
Total Number of Units in Asset's Life
• The annual depreciation for a given year can be calculated based on the number of units produced
during that year, as follows:
Annual Depreciation = Depreciation per Unit x Units Produced in Current Year
• Depreciation will only be recorded till the total number of units in the asset’s life.
• The units-of-production method is most appropriate when the accountant is able to estimate the
total number of units that will be produced over the asset’s life.
• The units produced must be related to particular time periods so that depreciation expense can
be matched accurately with the related revenue.
• A variation of the units-of-production method can be used when the life of the asset is expensed
in other factors, such as miles driven or hours of use.

Accelerated Depreciation Method

• Accelerated depreciation: a higher amount of depreciation is recorded in the early years and a
lower amount in the later years.
• One form of accelerated depreciation is the double-declining-balance method.
• Double-declining-balance method: depreciation is recorded at twice the straight-line rate, but the
balance is reduced each period.
• Steps for calculating depreciation with the double-declining method:
1. The first step is to calculate the straight-line rate as a percentage. For example, if the life of the
asset is 5 years, then the straight-line rate as a percentage would be:
100%/5 = 20%
2. The second step is to double the straight-line percentage: 20% x 2 = 40%
3. This rate will be applied in all years to the asset’s book value at the beginning of each year, till
the value reaches its residual value, below which depreciation will not be applied.
4. This constant rate is applied to the full cost or initial book value, not to cost minus residual value
as in the other methods.
5. The formula for the first year would be:
Depreciation = Beginning Book Value x Rate
6. The formula for the second year would be:
Depreciation = (Beginning Book Value – Accumulated Depreciation) x Rate
• Double-declining-balance depreciation is not widely used for financial statement purposes but
may be appropriate for certain assets.
• Most companies use straight-line depreciation for financial statement purposes because it
generally produces the highest net income, especially in growing companies that have a stable or
expanding base of assets.
Comparison of Depreciation Methods
• Both straight-line and double-declining methods result in the same accumulated depreciation
amount over a certain period.
• Accountants consider depreciation to be a process of cost allocation. The purpose is to allocate
the original acquisition cost to the periods benefited by the asset.
• The depreciation method chosen should be based on the decline in the asset’s usefulness.
• A company can choose a different depreciation method for each individual fixed asset or for each
class or category of fixed assets.
• The choice of depreciation method can have a significant impact on the bottom line, given the
companies are identical in every other respect.
• A company that uses accelerated depreciation for one year can find that its otherwise declining
earnings are no longer declining if it switches to straight-line depreciation.
• Investors should pay some attention to depreciation methods when comparing companies.
• Statement users must be aware of the different depreciation methods to understand the
calculation of income and to compare companies that may not use the same methods.

Depreciation and Income Taxes

• When depreciating an asset for financial accounting purposes, the accountant should choose a
depreciation method that is consistent with the asset’s decline in usefulness and that properly
allocates its cost to the periods that benefit from its use.
• Depreciation is also deducted for income tax purposes.
• Sometimes depreciation is referred to as a tax shield because it reduces (as do other expenses)
the amount of income tax that would otherwise have to be paid.
• When depreciating an asset for tax purposes, a company should generally choose a depreciation
method that reduces the present value of its tax burden to the lowest possible amount over the
life of the asset. Normally, this is best accomplished with an accelerated depreciation method,
which allows a company to save more income tax in the early years of the asset.
• The method allowed for tax purposes is referred to as the Modified Accelerated Cost Recovery
System (MACRS).
• As a form of accelerated depreciation, it results in a larger amount of depreciation in the asset’s
early years and a smaller amount in later years.

Choice of Depreciation Method

• Usually, the most important factor in choosing a depreciation method is whether depreciation is
calculated for presentation on the financial statements to stockholders or whether it is calculated
for income tax purposes.
• When depreciation is calculated for financial statement purposes, a company generally wants to
present the most favorable impression (the highest income) possible.
• More than 90% of large companies use the straight-line method for financial statement purposes.
• If management’s objective is to minimize the company’s income tax liability, the company will
generally not choose the straight-line method for tax purposes and will use the accelerated
depreciation method as it allows the company to save more on income taxes because depreciation
is a tax shield.
• Therefore, it is not unusual for a company to use two depreciation methods for the same asset,
one for financial reporting purposes and another for tax purposes.
Change in Depreciation Estimate
• An asset’s acquisition cost is known at the time it is purchased, but its life and residual value must
be estimated.
• These estimates are then used as the basis for depreciating it.
• Occasionally, an estimate of the asset’s life or residual value must be altered after the depreciation
process has begun.
• Change in estimate: a change in the life of the asset or in its residual value.
• A change in estimate should be recorded prospectively – the depreciation recorded in prior years
is not corrected or restated; the new estimate should affect the current year and future years.
• A change in the choice of depreciation method for an asset should be mentioned in the notes to
the financial statements.
• The company’s auditors have to be very careful that management’s decision to change its estimate
of the depreciable life of the asset is not an attempt to manipulate earnings.

Capital versus Revenue Expenditures

• Accountants often must decide whether certain expenditures related to operating assets should
be treated as an addition to the cost of the asset or as an expense.
• Capital expenditure: a cost that improves the asset and is added to the asset account. Alternate
term: Item treated as asset.
• Revenue expenditure: a cost that keeps an asset in its normal operating condition and is treated
as an expense. Alternate term: Item treated as an expense of the period.
• When an expenditure increases the life of the asset or its productivity, it should be treated as a
capital expenditure and added to the asset account.
• When an expenditure simply maintains an asset in its normal operating condition, however, it
should be treated as an expense.
• When a company is capitalizing rather than expensing certain items to artificially boost earnings,
that revelation can be very damaging to the stock price.
• An item treated as a capital expenditure affects the amount of depreciation that should be
recorded over the asset’s remaining life.
Environmental Aspects of Operating Assets
• As the government’s environmental regulations have increased, businesses have been required to
expend more money complying with them.
• A common example involves costs to comply with federal requirements to clean up contaminated
soil surrounding plant facilities.
• In some cases, the costs are high and may exceed the value of the property.
• If there is a legal obligation to clean up the property or restore it to its original condition,
companies are required to record the cost of asset retirement obligations as part of the asset’s
cost.
• Sometimes, it is difficult to determine whether a legal obligation exists.
• Companies should at least conduct a thorough investigation to determine the potential
environmental considerations that may affect the value of operating assets and to ponder carefully
the accounting implications of new environmental regulations.

Disposal of Property, Plant and Equipment

• Disposal of an asset occurs when the asset is sold, traded, or discarded.
• At the time of disposal, the company must update depreciation to the date of sale and must
calculate a gain or loss on the disposal.
• A gain occurs when the selling price of the asset exceeds its book value. The Gain on Sale of Asset
account is an income statement account and should appear in the Other Income/Expense category
of the statement.
• A loss occurs when the selling price of the asset is less than its book value. The Loss on Sale of
Asset account is an income statement account and should appear in the Other Income/Expense
category of the income statement.
• When an asset is sold, all accounts related to it must be removed.

IFRS and Property, Plant, and Equipment

• Generally, the Financial Accounting Standards Board’s (FASB) standards concerning property,
plant, and equipment are similar to the international accounting standards, and conversion to
those standards should not impose great difficulties for U.S. companies.
• There are two important differences:
1. When depreciation is calculated, the international standards require that estimates of residual
value and the life of the asset be reviewed at least annually and revised if necessary. If the
estimate is revised, it should be treated as a change in estimate. The FASB standards do not
have a specific rule that requires residual value and asset life to be reviewed annually.
2. The FASB generally requires operating assets to be recorded at acquisition cost, less
depreciation, and the assets’ values are not changed to reflect their fair market values or selling
prices. International accounting standards allow but do not require companies to revalue their
property, plant, and equipment to reflect fair market values. This gives fi rms additional
flexibility in portraying their assets but may also cause difficulties in comparing one company
with another.
Operating Assets: Intangible Assets
• Intangible assets are long-term assets and should be shown separately from property, plant, and
equipment.
• Intangible assets: assets with no physical properties; that are long-lived and provide rights or
privileges (provide future economic benefit to the company).
• Intangible assets are recorded at their acquisition cost.
• Research and development costs are not considered to be an intangible asset and are treated as
an expense instead.
• Goodwill: the excess of the purchase price to acquire a business over the value of the individual
net assets acquired. Alternate term: Purchase price in excess of the market value of the assets.
• Goodwill is recorded only when a business is purchased. It is not recorded when a company
engages in activities that do not involve the purchase of another business entity.
• The balance sheet includes the intangible assets that meet the accounting definition of assets,
which are patents, copyrights, and brand names.
• The balance sheet, however, would indicate only the acquisition cost of those assets, not the value
of the assets to the company or the sales value of the assets.

Acquisition Cost of Intangible Assets

• The acquisition cost of an intangible asset includes all of the costs to acquire the asset and prepare
it for its intended use.
• Acquisition cost also should include those costs that are incurred after acquisition and that are
necessary to the existence of the asset.
• Research and development costs: expenditures incurred in the discovery of new knowledge and
the translation of research into a design or plan for a new product or service or in a significant
improvement to an existing product or service (it is similar to intangible assets but is not on the
balance sheet).
• Firms that engage in research and development do so because they believe such activities provide
future benefit to the company.
• Because of the difficulty in predicting future benefits, the FASB has ruled that firms are not allowed
to treat research and development costs as assets; all such expenditures must be treated as
expenses in the period incurred.
• Difference between patent costs and R&D costs: Patent costs include legal and filing fees
necessary to acquire a patent. Such costs are capitalized as an intangible asset. However, the
Patent account should not include the costs of R&D of a new product. Those costs are not
capitalized but are treated as an expense.
Amortization of Intangibles
• The term amortization is very similar to depreciation of property, plant, and equipment.
• Amortization involves allocating the acquisition cost of an intangible asset to the periods benefited
by the use of the asset.
• When an intangible asset is amortized, most companies use the straight-line method of
amortization.
• If an intangible asset has a finite life, amortization must be recognized.
• A finite life exists when an intangible asset is legally valid for only a certain length of time
(examples: patents and copyrights).
• A finite life also exists when there is no legal life, but company management knows for certain that
it will be able to use the intangible asset for only a specified period of time.
• An intangible asset with a limited life should be amortized over the shorter of its legal/useful life.
• Rather than use an accumulated amortization account, some companies decrease the intangible
asset account directly.
• The asset should be reported on the balance sheet at acquisition cost less accumulated
amortization.
• If an intangible asset has an indefinite life, amortization should not be recognized (examples:
renewable licenses and trademarks).
• While companies should not record amortization of intangible assets with an indefinite life, they
are required each year to determine whether the asset has been impaired (loss should be recorded
when the value of the asset has declined).
• Goodwill is an intangible asset. It is not amortized, but must be evaluated every year to determine
any impairment in value.
• It requires a great deal of judgment to determine when intangible assets have been impaired
because the true value of an intangible asset is often difficult to determine.

IFRS and Intangible Assets

• The international standards are more flexible in allowing the use of fair market values for
intangible assets. However, such values can only be used for those assets where an “active market”
exists and it is possible to determine fair value.
• FASB standards require all research and development costs to be treated as an expense.
• The international standards make a distinction between research costs and development costs.
All research costs must be treated as an expense, but development costs can be capitalized as an
asset if certain criteria are met.
How Long-Term Assets Affect the Statement of Cash Flows
• The acquisition of a long-term asset is an investing activity and should be reflected in the Investing
Activities category of the statement of cash flows. The acquisition should appear as a deduction,
or negative item, in that section because it requires the use of cash to purchase the asset.
• The depreciation or amortization of a long-term asset is not a cash item, but it must be presented
on the statement of cash flows (if the indirect method is used for the statement).
• Depreciation and amortization should be presented in the Operating Activities category of the
statement of cash flows as an addition to net income.
• The sale or disposition of long-term assets is an investing activity. When an asset is sold, the
amount of cash received should be reflected as an additional amount in the Investing Activities
category of the statement of cash flows.
• If the asset was sold at a gain or loss, however, one additional aspect should be reflected. Because
the gain or loss was reflected on the income statement, it should be eliminated from the net
income amount presented in the Operating Activities category (if the indirect method is used).
• A sale of an asset is not an activity related to normal ongoing operations, and all amounts involved
with the sale should be removed from the Operating Activities category.

Analyzing Long-Term Assets for Average Life and Asset Turnover

• Because long-term assets constitute the major productive assets of most companies, the age and
composition of these assets should be analyzed.
Property, Plant & Equipment
• Average Life =
Depreciation Expense
Accumulated Depreciation
• Average Age =
Depreciation Expense
Net Sales
• Asset Turnover =
Average Total Assets
• The asset turnover ratio is a measure of how productive the assets are in generating sales. If a
company is using its assets efficiently, each dollar of assets will create a high amount of sales. A
company with less productive assets will generate fewer sales from its dollar of assets.
• The company’s age, composition, and productivity of operating assets should be compared to
those of prior years and to those of companies in the same industry.