CHAPTER 2

PLANT ASSETS, NATURAL RESOURCES AND INTANGIBLE ASSETS

Topics
1. Accounting for plant assets-Acquisition and Cost determination for major types of plant
assets, Depreciation, Costs incurred subsequent to acquisition, and Disposal through
retirement, sale, and exchange
2. Natural resource accounting and depletion concepts
3. Intangible asset accounting and amortization concepts
1. Accounting for Plant Assets
- The accounting issues related to plant assets are important since they constitute the largest single asset
category for companies. Further, the recorded value of plant assets is the basis for subsequent
depreciation.
Nature of Plant Assets
- Assets used in operations may be divided into tangible and intangible categories as follows:
o Tangible assets have physical substance. They are classified as property, plant, and equipment
(plant assets), and natural resources.
a) Plant Assets: Plant assets are tangible assets used by business enterprises in their operation
over time (indefinite or limited). Examples are :
– Land used in operations (underlying the plant).
– Buildings, fixtures, furniture, machinery, and equipment used in operations. These are
properties having a limited economic life and are subject to depreciation.
Characteristics of plant assets
– The asset must be tangible in nature
– The asset must be held for use and not resale
– The asset must have an expected life of more than one year
Note that:
 Land held for speculation and Undeveloped land (land not yet put in to service) are long-term
investments
 Stand by equipment’s held for use in case of a breakdown or during peak periods of production
is a plant asset because the equipment is used in operation and is not bough for resale.
However, when equipment is removed from service and held for sale, it is no longer considered
a plant asset
b) Natural Resources– include such things as standing timber, mineral deposits, and oil
reserves. Because they are physically consumed when they are used, they are known as
wasting assets. In their natural state, they represent inventories of raw materials that will be
converted into a product by cutting, mining, or pumping. However, until the conversion takes
place, they are noncurrent assets and appear on a balance sheet under captions such as
“Timberlands,” “Mineral deposits,” or “Oil reserves.” Sometimes, this caption appears under
the property, plant, and equipment category of assets and sometimes it is shown as a separate
category.
o Intangible Assets are without physical substance. Intangible assets with a limited life (such as
a patent) are amortized over their useful life. Some intangible assets, such as goodwill,

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 trademarks and trade names, have a potentially indefinite life and are not amortized (until
their life is no longer considered to be indefinite), but is reviewed for impairment annually.
Accountable Events under accounting for Plant Assets
- These are events requiring accounting activities like recording, summarizing etc and are depicted
below

1 Acquisition of Plant Assets

- Operational assets can be acquired through purchase, exchange, etc. The major accounting problem is
determining the cost of the asset.
- General approach: Costs of plant assets include all necessary costs incurred to bring it to the
condition and location necessary for it intended use.
- Note that unnecessary costs such as; expenditures resulting from carelessness, accidents, errors in
installing the asset, vandalism/damage, theft ,etc do not increase the usefulness of the asset and should
be expensed.
Application
Land:
- If a land is acquired as building site, the entire cost of bringing the land into suitable conditions as a
building site are associated to land.
- These include: Purchase price(invoice price), legal costs (title transfer costs), general land preparation
costs (eg grading, filling, draining, surveying, clearing) to make the land suitable for the desired use,
delinquent (past due) taxes assumed, brokers’ commissions, escrow fees, and additional improvements
with an indefinite life, cost of removing old houses (if land is acquired for redevelopment or use as a
building site) or existing structures less any salvage recovered (proceeds from salvaged materials).
Land Improvements:
- Improvements with limited lives are recorded as Land Improvements (not as cost of Land). Example
include: driveways, sidewalks, streets, parking lots, fencing, lighting systems, temporary landscaping
etc. They are depreciated over their estimated lives.
- Land improvements such as landscaping and drainage, which have indefinite economic lives, are added
to land cost.
Buildings:
- All expenditures related directly to acquisition or construction is capitalized. This includes attorneys’
and architects’ fees, building permits, and all costs incurred beginning with excavation and ending with
completion of the building.

Equipment

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 - All expenditures incurred in acquiring the equipment and preparing it for use are included. This
includes freight charges, insurance while in transit, assembly costs, and the cost of conducting trial
runs.

Lump-sum (Group) Acquisition - Special Method of Acquisition

- When a company purchases a group of plant assets at a single lump sum price, an allocation of costs
must be made to each individual asset.
- The best way to allocate the purchase price of the assets to the individual items is the relative fair
market values of the assets acquired. To determine fair market value, an appraisal for insurance
purposes, the assessed valuation for property taxes, or simply an independent appraisal by a qualified
appraiser might be used.
Example:
A building, Equipment, and the Land on which they are situated /located are purchased for a lump-
sum payment of $900,000. Appraisals yield estimates of $300,000 for the land, $200,000 for the
Equipment, and $500,000 for the building, if purchased separately.
Required: Determine the cost allocated to each asset acquired and record the acquisition.
Solution
Each asset in the group receives a valuation based on the proportions of its appraisal value to the total
appraisal value of the group.
Asset Appraisal value Percentage Cost
Lang $ 300,000 300,000/1,000,000= 30% 900,000*.3= 270,000
Building 500,000 500,000/1,000,000= 50% 900,000*.5= 450,000
Equipment 200,000 200,000/1,000,000= 20% 900,000*.2= 180,000
Total $ 1,000,000 $ 900,000
Land ………………… 270,000
Building ……………… 450,000
Equipment ……………. 180,000
Cash ……………………………….. 900,000

Note that under the historical cost principle, the sum of the individual asset account balances at
acquisitions is limited to the lump-sum price.

2 Accounting for Depreciation

- As time passes all plant assets with the exception of land lose their capacity to yield service. We
recognize this fact through depreciation.
- Depreciation is a systematic and rational process of distributing the cost of plant assets over the life of
assets. An awareness of the similarity between plant assets and prepaid expenses is essential to the
understanding of the accounting process by which the cost of plant assets is allocated to the years in
which the benefits of ownership are received.
Misunderstandings
Deprecation has been one of the most misunderstood concepts of accounting:
a) Deprecation as a value measurement technique: Depreciation is a process of allocation not a process of valuation
(an attempt to approximate market value). The book value of the asset represents only the un-depreciated
acquisition cost of the asset, not its market value.
b) Depreciation as a means of setting aside /accumulating something for replacement purpose: Accumulated
depreciation does not represent money accumulated for the purpose of buying new
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plant asset. It represents the portion of the assets' cost which has already been recognized as an expense.
Replacement is another management decision.
c) Depreciation as an expense that affects cash flow. Depreciation is a noncash operating expense. It
differs from most expense in that it doesn't require cash payment.

Factors to Be Considered for Computing Depreciation:

a) Cost of the Asset Acquisition cost discussed above
b) Estimated Residual Value (salvage value or scrap value) equals the value, if any, that a company
expects to receive by selling or exchanging an asset at the end of its useful life. Estimated salvage
value should be adjusted for dismantling, and restoring and disposal costs. The residual value is not
matched against revenue through depreciation.
c) Depreciable Base (Cost) it is the amount subject to depreciation.
Depreciable cost = Original cost of the asset – Estimated net residual value
d) Useful life The useful life (service life) of a plant asset refers to the length of time it will be used in
the operations of the business. The service life of an asset should not be confused with its physical
life. Causes that affect the service life of a plant asset include:
o Physical factors Includes wear and tear from operation and deterioration and decay from forces of
nature with passage of time. Unusual events such as accidents, floods, and earthquakes also serve to
terminate or reduce the useful life of plant assets.
o Functions or Economic factors:
Inadequacy is a result of growth which leads to inability to meet the demands of increased
production. For example, the need for a larger building to handle increased production.
Obsolescence new inventions and improvements can cause existing assets to become obsolete and
the company may simply discard it long before it wears out. For example, computers have made
typewriters obsolete.

Service life may be expressed or stated on either time or output basis (e.g total months, years, total
output, total hours of operating time etc). The useful life of an asset must be finite to justify
deprecation recognition. Land is not depreciated, for example, because useful life is considered
indefinite. The choice of an appropriate unit of economic life for a plant asset also requires a
determination of the causes of depreciation.
e) Depreciation Methods
- Among the factors, the method of depreciation chosen usually has the greatest effect on periodic
depreciation expense. The depreciation method selected for a particular asset should be systematic and
rational. The different types of depreciation methods are discussed in the following section.
- Note that it is not unusual for a company to use different depreciation methods for different classes of
asset simultaneously.
i) Straight-Line Method
- Equal amount of the depreciation cost is allocated to each period of
use. Annual depreciation =
Depreciable base
Estimated useful life in years

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- Another way to describe this calculation is to say that the asset's depreciable cost is multiplied by the
straight-line rate, which equals one divided by the number of years in the asset's useful life.
SL Rate = 1
Estimated useful life in
years
Annual depreciation = SL Rate × Depreciable cost
- It is appropriate when:
o The asset provides an even amount of service throughout its useful life.
o Time (rather than obsolescence) is the most important factor causing depreciation. This method
relates depreciation directly to the passage of time rather than to the asset's use
- It is the most widely used method because
o Many companies consider the benefits derived from the majority of plant assets to be
approximately even over the assets’ useful lives.
o It is the easiest method to understand and apply.
o It has also a positive effect on reported income than accelerated methods in the early years of
an asset’s life making it more attractive particularly for compensations (e.g bonus).
Example:
Suppose a company purchases a $90,000 truck and expects the truck to have a salvage value of
$10,000 after five years.
Required: Compute yearly depreciation under the SL method
Solution:
Cost $90,000
Less: Salvage Value -10,000
Depreciable Cost $80,000

- The following table summarizes the application of straight-line depreciation during the truck's five-
year useful life.

Straight-Line Depreciation
Depreciable Cost Annu.Depr. Acc.Depr. Book Value
Cost $90,000
Year 1 20% × $80,000 = $16,000 $16,000 74,000
Year 2 20% × 80,000 = 16,000 32,000 58,000
Year 3 20% × 80,000 = 16,000 48,000 42,000
Year 4 20% × 80,000 = 16,000 64,000 26,000
Year 5 20% × 80,000 = 16,000 80,000 10,000
- At the end of year five, the $80,000 shown as accumulated depreciation equals the asset's depreciable
cost, and the $10,000 net book value represents its estimated salvage value. The residual value is not
matched against revenue through depreciation.

- To record depreciation expense on the truck each year, the company debits depreciation expense–
vehicles for $16,000 and credits accumulated depreciation–vehicles for $16,000.

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 Dec. 31 Depreciation Expense--------------------------16,000
of each year Accumulated Depr.-Truck ---------------- 16,000
To record annual depreciation on Truck
- Companies use separate accumulated depreciation accounts for buildings, equipment, and other types
of depreciable assets. Companies with a large number of depreciable assets may even create subsidiary
ledger accounts to track the individual assets and the accumulated depreciation on each asset.
ii) Units-of-Production(Output) Method
- This technique involves calculations that are quite similar to the straight-line method, but it allocates
the depreciable cost of an asset based on its usage rather than years of use.

- The useful life of some assets, particularly vehicles and equipment, is frequently determined by usage
(not with passage of time). So length of life of the asset is expressed in terms of productive capacity
such as machine hours, miles driven, or number of units produced.
- This method is appropriate when:
o Usage of a plant asset changes from year to year. The higher the usage of the asset in a period
the higher the deterioration (i.e, depreciation expense)
o Total number of units of output(usage) can be reasonably estimated
Example: Continuing with the above example, assume that the truck is expected to be driven 400,000
miles during its service life.
Required: Compute the annual depreciation if the truck is actually driven for 110,000; 70,000; 90,
000; 80,000; and 50,000 in the first five years respectively.
Solution:

- The following table shows how depreciation expense is assigned to the truck based on the number of
miles driven each year.
Units-of-Activity Depreciation
Per-Unit Depreciation r. Acc.Depr. Book Value
Cost $90,000
Year 1 110,000 × $0.20 = $22,000 $22,000 68,000
Year 2 70,000 × 0.2 = 14,000 36,000 54,000
Year 3 90,000 × 0.2 = 18,000 54,000 36,000
Year 4 80,000 × 0.2 = 16,000 70,000 20,000
Year 5 50,000 × 0.2 = 10,000 80,000 10,000
iii) Accelerated Depreciation Methods
- These methods are designed to recognize greater amount of depreciation early in the useful life of plant
assets and lesser amounts later. Thus they accelerate the recognition of depreciation.
- The justifications for an accelerated method of depreciation include:
o The expected service for the asset declines with age.
o The asset is high technology asset subject to rapid obsolescence (e.g computers).

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 o Services are constant (i.e., revenues is constant) but repairs and maintenance costs increase
with age of the asset. The related amount of depreciation in later years are therefore offset to
some extent by increased maintenance expense
- Two most widely used accelerated methods are discussed below:

Double-Declining-Balance Depreciation
- Declining-balance depreciation is found by applying constant depreciation rate to the declining book
value of the asset as a result periodic depreciation declines with age. The depreciation rate is some
multiple of the straight-line rate for the asset. Companies typically use twice (200%) the straight-line
rate, which is called the double-declining-balance rate, but rates of 125%, 150%, or 175% of the
straight-line rate are also used.
- Note that declining balance ignores residual value in its computation. Declining-balance depreciation
is calculated as follows:

Example:
Compute the annual depreciation for the truck under the double-declining-balance method

Solution:
The SL rate for the Truck is 20% (1 ÷ 5 = 20%), so the double-declining-balance rate, which uses the
200% multiple, is 40% (20% × 200% = 40%).
The following table shows how the double-declining-balance method allocates depreciation expense to
the truck.
Double-Declining-Balance Depreciation
Begin-of-Year Book Value Annu.Depr. Acc.Depr. End-of-yr Book Value
Year 1 40% × $90,000 = $36,000 $36,000 $54,000
Year 2 40% × 54,000 = 21,600 57,600 32,400
Year 3 40% × 32,400 = 12,960 70,560 19,440
Year 4 40% × 19,440 = 7,776 78,336 11,664
Year 5 11664 − 10,000 = 1,664 80,000 10,000
- At the end of an asset's useful life, the asset's net book value should equal its salvage value. Although
40% of $11,664 is $4,666, the truck depreciates only $1,664 during year five because net book value
must never drop below salvage value. If the truck's salvage value were $5,000, depreciation expense
during year five would have been $6,664. If the truck's salvage value were $20,000, then depreciation
expense would have been limited to $12,400 during year three, and no depreciation expense would be
recorded during year four or year five.

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 Sum-of-the-Years'-Digits Depreciation.
- It is so called because the consecutive digits for each year of an asset's estimated life are added
together and used as a denominator of a fraction.
- Under this method, depreciation expense is calculated using the following equation.

- The equation's denominator (the sum of the years' digits) can be found by adding each integer from one
through the number of years in the asset's useful life (1 + 2 + 3…) or by substituting the number of
years in the asset's useful life for x in the following equation.

- The sum of the years' digits for an asset with a five-year useful life is 15.

- The following table shows how the sum-of-the-years'-digits method allocates depreciation expense to
the truck, which has a depreciable cost of $80,000 ($90,000 cost less $10,000 expected salvage value)
and a useful life of five years
Sum-of-the-Years'-Digits Depreciation
Depreciable Cost Annu.Depr. Acc.Depr. Book Value
Cost $90,000
Year 1 5/15 × $80,000 = $26,667 $26,667 63,333
Year 2 4/15 × 80,000 = 21,333 48,000 42,000
Year 3 3/15 × 80,000 = 16,000 64,000 26,000
Year 4 2/15 × 80,000 = 10,667 74,667 15,333
Year 5 1/15 × 80,000 = 5,333 80,000 10,000
- The periodic charge for depreciation declines steadily over the estimated life of the asset because a
successively smaller fraction is applied each year to the depreciable cost of the asset (a constant
amount)
- In the later life of the asset no depreciation may be reported if the asset has been reduced already to
residual value even though the asset is still producing benefits.

Partial-Year Depreciation Calculations

- Partial-year depreciation expense calculations are necessary when depreciable assets are purchased,
retired, or sold in the middle of an annual accounting period or when the company produces quarterly
or monthly financial statements. The units-of-activity method is unaffected by partial-year depreciation
calculations because the per-unit depreciation expense is simply multiplied by the number of units
actually used during the period in question.
- For all other depreciation methods, however, annual depreciation expense is multiplied by a fraction
that has the number of months the asset depreciates as its numerator and twelve as its denominator.
Since depreciation expense calculations are estimates to begin with, rounding the time period to the
nearest month is acceptable for financial reporting purposes.

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 Example:
Suppose the truck is purchased on July 26, year 1, instead of January 1, year 1 and the company's
annual accounting period ends on December 31.

Required: Compute the depreciation expense for all the fiscal years in which the truck is used under
each of the depreciation methods discussed above.

Solution:
Straight-Line Method-Partial year deprecation
Straight-Line Depreciation
Depreciable Cost Depr. Exp. Acc.Depr. Book Val.
Cost $90,000
Year 1 (5 5/12 × 20% × $80,000 = $6,667 $6,667 83,333
months)
Year 2 20% × 80,000 = 16,000 22,667 67,333
Year 3 20% × 80,000 = 16,000 38,667 51,333
Year 4 20% × 80,000 = 16,000 54,667 35,333
Year 5 20% × 80,000 = 16,000 70,667 19,333
Year 6 (7 7/12 × 20% × 80,000 = 9,333 80,000 10,000
months)
Declining-balance method (double) - Partial year depreciation
- Under the declining-balance method, the first full year's annual depreciation expense of $36,000 is
multiplied by five-twelfths to calculate depreciation expense for the truck's first five months of use. In
subsequent years, the truck's net book value is higher than it would have been if a full year's
depreciation expense had been assigned during the first year, but the declining-balance method's
calculation of depreciation expense is otherwise unchanged.

Double-Declining-Balance Depreciation
Beg.-of-Year BV Depr. Exp. Accum. Depr. End-of-yr BV
Year 1 (5 5/12 × 40% × $90,000 = $15,000 $15,000 $75,000
months)
Year 2 40% × 75,000 = 30,000 45,000 45,000
Year 3 40% × 45,000 = 18,000 63,000 27,000
Year 4 40% × 27,000 = 10,800 73,800 16,200
Year 5 40% × 16,200 = 6,200 80,000 10,000
Year 6 (7 0 80,000 10,000
months)

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 Sum-of-the-years'-digits method- Partial year deprecation
- We use a two-step calculation between the first year and final year of use of the truck.

Revising Depreciation Estimates

- Depreciation expense calculations depend upon estimates of an asset's useful life and expected salvage
value. As time passes, a number of factors may cause these estimates to change. Prior financial
statements are not changed when useful life or salvage value estimates change, but subsequent
depreciation expense calculations must be computed using the revised depreciation rate based upon
the new estimates of the truck's useful life and depreciable cost. The revised annual depreciation is
computed assuming a straight line method is computed using the following equation.

Example
Assume that the company purchased the truck at the beginning of an annual accounting period. After
recording three years of depreciation expense on the truck, suppose the company decides the truck
should be useful until it is seven rather than five years old and that its salvage value will be $14,000
instead of $10,000. Under the straight-line method, compute depreciation expense for years four
through seven.
Solution
The truck's net book value of $42,000 at the end of year three is reduced by the new, $14,000 estimate
of salvage value to produce a revised depreciable cost of $28,000. The revised depreciable cost is
divided by the four years now estimated to remain in the truck's useful life, yielding annual
depreciation expense of $7,000.

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- Similar revisions are made for each of the other depreciation methods. The asset's net book value when
the revision is made along with new estimates of salvage value and useful life—measured in years or
units—are used to calculate depreciation expense in subsequent years.
Depreciation for Income Tax Purposes
- For financial reporting purposes, companies often select a depreciation method that apportions an
asset's depreciable cost to expense in accordance with the matching principle. For income tax purposes,
companies usually select a depreciation method that reduces or postpones taxable income and,
therefore, tax payments. In the United States, straight-line depreciation is the method companies most
frequently use for financial reporting purposes, and a special type of accelerated depreciation designed
for income tax returns is the method they most frequently use for income tax purposes.
3 Expenditures after Plant Asset Acquisition
- After acquisition, many costs related to plant assets are incurred. Examples include repairs,
maintenance, betterments, and replacements. The accounting dispositions of these expenditures affect
balance sheet classification and subsequent depreciation calculations if they are material.
- Expenses relating to depreciable assets fall into two broad categories:
i) Ordinary (Revenue) Expenditures-- These are ordinary repairs and maintenance required to
keep the assets in a normal operating condition but that neither add materially to the value of the
asset nor materially prolong its economic life. They merely enable the asset to provide the
benefits originally expected of it. Thus they benefit current period only. They are recurring in
nature and usually involve relatively small expenditure. Examples are: lubrication, cleaning,
paintings, grease, outlays for replacement of minor parts, labor, and related supplies.
Accounting treatment:
The costs associated with these items are considered normal operating expenses, and they are
recorded by debiting expense accounts and crediting cash or another appropriate account.
ii) Capital Expenditures-- Capital expenditures increase an asset's usefulness (quantity or quality
of units/ service produced) or service life. They benefit future periods.
Accounting treatment:
They should be capitalized by increasing the asset's net book value and then expensed in future
periods through depreciation, depletion, or amortization. This permits the matching of the
expenditure with the future benefits.
There are two ways to increase an asset's net book value:
i) the asset account can be debited, thus increasing the recognized cost of the asset

This treatment is used for expenditure that serves primarily to increase the asset's usefulness or value.
Additions and Improvements are usually handled in this way.
 Additions-- involve adding a new major component to an existing asset. By definition,
any addition to plant assets is capitalized because a new asset has been created. For
example, adding a refrigeration unit to a delivery tuck, construction of a new wing on a
building and the addition of a security system to an existing building.
 Replacements and Betterments-- represent the substitution of a new part of an asset
for an existing part. If the new part of the asset is similar in nature to the part being
eliminated, the substitution is called a replacement. If the new part represents an
improvement in quality over the part being eliminated, the substitution is called a
betterment.
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 ii) the asset's corresponding accumulated depreciation account can be debited, thus decreasing
the amount of depreciation previously allocated to the asset.

[[[

This treatment is used for capital expenditure that serves primarily to increase the asset's
useful life or salvage value, without bringing visible change in quantity or quality.
Replacements and extraordinary repairs are usually handled in this manner.
 Extraordinary Repairs are major, high-cost, nonrecurring long-term repairs that
increase the economic usefulness of the asset in terms of greater efficiency or longer
life.
Note that capital expenditures recorded in either the asset account or the asset's accumulated
depreciation account have the same effect on the asset's net book value. Judging whether the
expenditure increases utility or life is not always clear cut.
Example:
Assume that the truck was acquired at the beginning of year 1 and has been depreciated using the SL
method. Consider a $10,000 capital expenditure was made at the beginning of year 4.
Required:
1) Record the expenditure if:
i) it improves the efficiency of the truck only
ii) it prolong the useful life of the truck by two years only.
2) Compute revised annual depreciation expense after the expenditure under each case
Solution:
1) i) Vehicles--------------------------------------10,000
Cash (other resources) --------------- 10,000
ii) Accumulated depr.-------------------------10,000
Cash (other resources) --------------- 10,000
2)
After Capital After Capital
Expenditure Expenditure
Before Capital Asset Account Accum. Depre.
Expenditure Debited Debited
Cost $90,000 100,000 90,000
Accum. Depr. -48,000 -48,000 -38,000
Net Book Value $42,000 52,000 52,000
Revised Annual $52,000 - 10,000 $52,000 - 10,000
Expense-SL method 2 years 4 years
$21,000 $10,500

- When capital expenditures are made, the revised net book value must be used to calculate depreciation
expense in subsequent accounting periods over the revised useful life of the asset (if revised). The
revised depreciation is computed in a similar technique used under revision of depreciation estimates

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- Materiality is an important factor in the treatment of post-acquisition expenditures. For expediency,
many companies set materiality thresholds for the capitalization of any expenditure. Small
expenditures such as waste baskets and pencil sharpeners are expensed immediately even if they are
capital expenditures in nature for materiality reason.

4 Disposal of Plant Assets

- Depreciable assets are disposed of by retiring, selling, or exchanging them.
- When a depreciable asset is disposed of, there are three procedures to be performed
i) Update accumulated depreciation account – record depreciation up to the date of disposal.
Under the matching rule, the accounting period should receive the proper allocation of
depreciation expense
ii) Remove the PA and its corresponding accumulated depreciation account from the book
iii) Record other events if any e.g. cash paid or received, new PA, gains or losses. Any recognized
losses or gains associated with the disposition appear in the portion of the income statement
named other income/(expense), net.
Disposal Methods:
a) Plant Asset disposal through discarding(Retirement):
- This involves abandoning the asset(taken out of service) without receiving anything in return
- A gain never occurs when an asset is retired. If the entire cost of an asset has been depreciated before it
is retired, however, there is no loss. But if the asset is not fully depreciated, loss results to the extent of
the assets book value.
Example:
Suppose the $90,000 truck reaches the end of its useful life with a net book value of $10,000, but the
truck is in such poor condition that a another company simply agrees to take it away for free.

Required: Record the retirement of the truck.

b) Plant Asset Disposal for Selling

- The asset is given out and cash is received
- There are three possibilities: gain /loss/neither of the two: if cash proceed is greater than book value,
there is gain; if cash proceed is less than book value, there is loss; is cash proceed is equal to book
value, there is neither gain nor loss.

Example:
Suppose the truck sells for $7,000 when its net book value is $10,000, resulting in a loss of $3,000.
Required: Record the sale of the truck.

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 c) Disposal through Exchange
- The valuation of the acquired asset is the substantive accounting issue in nonmonetary asset exchange.
This valuation determines whether a gain or loss is recognized.
- The general rule in accounting states that fair value is the proper measure of exchanges of
nonmonetary assets and any gain or loss should be immediately recognized. This general rule is
summarized below:

Recorded value of the acquired asset

Market value of asset Market value of transferred asset + Cash paid(boot)
transferred is known Market value of transferred asset – Cash received(boot)
Market value of asset
acquired (only) is known Market value of acquired asset(whether cash is received or paid)

There are two circumstances (exceptions), however, in which the general guideline does not apply:
Recorded value of the acquired asset
Market value of neither the asset surrendered Recorded value (book value) of the asset
nor acquired is determinable surrendered and no gain or loss is recognized

When the exchange lack commercial Book value + Cash paid + Gain recognized*
substance with indicated gain – Cash received

- *the recognition of gain under this condition is covered in advanced courses

- Note that, a gain or loss on the exchange is determined as follows:

- In the exchange, trade-in allowance is the money value attached to the asset being given up. It may or
may not be the fair value of the asset. It is used to compute the cash boot involved to make the
exchange even, not to compute gain or loss.
- Boot is additional cash paid or received to make the exchange even and is computed as follows:

Exchange with Commercial Substance

- A nonmonetary exchange has commercial substance if the entity’s future cash flows are expected to
significantly change as a result of the exchange. In other words the economic position of the parties has
changed. For example, ABC Co. exchanged its fleet of company cars for a plot of land held by XYZ
Corp. It is likely that the timing of the cash flows from the land will be significantly different from the
cash flows from the company cars. Therefore, the economic positions of both parties have changed and
the transaction has commercial substance. An exchange of trucks with different useful lives might have
commercial substance while an exchange of trucks with no significant difference in useful lives would
probably not.
- These exchanges have to be accounted for at fair value (same as the general rule), recognizing any gain
or loss as long as fair value is determinable within reasonable limits.

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 Exchange that Lacks Commercial Substance
- An exchange transaction lacks commercial substance if the entity’s future cash flows are expected to
remain substantially the same after the exchange. For example, two car rental companies may
exchange cars (equivalent models) to increase variety of cars available. This exchange lacks
commercial substance because the cash flows generated by rental activities will be substantially the
same.
- These exchanges are valued using the exception to the general rule under which no gain is recognized
(with some exception) but any loss is recognized.
- To summarize these concepts, when a transaction involves an exchange of nonmonetary assets,
losses are always recognized. Gains are recognized if the exchange has commercial substance.
However, gains are deferred (not immediately recognized) if the exchange has no commercial
substance(with some exception). This is application of the conservatism principle. To preclude the
possibility of companies engaging in exchanges of appreciated assets solely to be able to
recognize gains, fair value can only be used in legitimate exchanges that have commercial
substance.
- The examples shown below are designed to demonstrate the various situations where exchanges of
nonmonetary assets are included.
Examples: Exchange with and without commercial substance
ABC Co. has a fleet of cars: with original cost of $140,000 and accumulated depreciation of
$90,000. Answer the following cases independently.
a) Current fair value of the cars is $40,000 and they were exchanged for land; no cash is
involved. The indicated loss is = $10,000
Commercial substance No commercial substance
Land 40,000
Accum. Depr.-Veh. ---------- 90,000 the same
Loss on exchange of Veh. ---10,000
Vehicles 140,000
b) The cars have market value of $45,000 & were exchanged for land with a list price of $70,000, and
the seller has allowed a trade-in allowance of $60,000 on the cars.
The indicated loss is = $5,000
Commercial substance No commercial substance
Land 55000
Accum. Depr----------------------90,000
Loss on exchange of PA ---------5000 the same
Plant asset (old)---------------------140,000
Cash 10,000
c) The cars were exchanged for other cars with a fair value of $40,000; cash of $6,000 is
received. The indicated loss is = $4000
Commercial substance No commercial substance
Vehicles(new)---------------------40,000
Accum. Depr----------------------90,000
Cash ------------------------------- 6000 the same
Loss on exchange of PA----------4000
Plant asset (old)---------------------140,000
15 Fundamental of Accounting II , Chapter 2: PPE, Intangibles & Natural Resources
d) Current fair value of the cars is $57,000 and they were exchanged for land; no cash is involved
Indicated gain is = $7000
Commercial substance No commercial substance

Land -----------------------57000 Land-------------------50,000

Accum. Depr. ------------ 90,000 Accum. Depr-----------90,000
Vehicles------------------------ 140,000 Vehicles-----------------------140,000
Gain on exchange of PA--------7000
e) The cars were exchanged for other cars with a fair value of $65,000; cash of $5,000 is
paid. Indicated gain is = $10,000
Commercial substance No commercial substance
Vehicles(new)----------65,000 Vechicles(new)------------55,000
Accum. Depr------------90,000 Accum. Depr--------------90,000
Cash ---------------- 5000 Cash ----------------- 5000
Vehicles (old)------- 140,000 Vehicles (old)------- 140,000
Gain on exchange ------ 10,000
Exchanges of Nonmonetary Assets—Old GAAP
- There are two types of exchanges: similar exchanges and dissimilar exchanges. A similar exchange
involves the exchange of one asset for another asset that performs the same type of function. Trading
in an old delivery truck to purchase a new delivery truck is an example of a similar exchange. A
dissimilar exchange involves the exchange of one asset for another asset that performs a different
function. Trading in an old truck for a forklift is an example of a dissimilar exchange.
- For exchanges with dissimilar assets and exchanges with similar assets with indicated loss, the general
rule is used. For exchanges involving similar assets with indicated gain, we use the modified rule
which defers the gain and reduce the cost of the new asset.

Natural Resources and Depletion

- Timber, fossil, mineral deposits, and other natural resources are different from depreciable assets
because they are physically extracted during company operations and they are replaceable only through
natural processes. Natural resources can be reported as property, plant, and equipment. But because of
their unique features they can be reported separately.
- The issues in accounting for natural resources are similar to those for depreciable assets:
1. Which costs should be included in the cost of natural resource?
2. How do we allocate the cost of natural resources?

1. Cost of natural resources. The cost of natural resources includes all costs necessary to acquire the
resource and prepare it for extraction. These include: Purchase price, Exploration costs, and
Development costs. If the property must be restored after the natural resources are removed, the
restoration costs are also considered to be part of the cost.
2. Depletion-- Depletion is the process of allocating the depletable cost of natural resources as the
resource is mined, pumped, or cut.
 Depletable cost = Cost of natural resources  Anticipated residual value.
The depletable cost is similar to the depreciable cost of plant assets. Residual value could be
significant if cost includes land that has a value after the natural resource has been extracted.
 Depletion method: because the usefulness of natural resources generally is directly related
to the amount of the resources extracted, the activity-based units-of-production method is

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 widely used to calculate periodic depletion. Service life is therefore the estimated amount of
natural resource to be extracted (for example, tons of mineral or barrels of oil).

Example:
Suppose a company pays $50,000,000 for an existing gold mine estimated to contain 1,000,000 ounces
of gold. The mine has no salvage value. If the company extracts and then sells 100,000 ounces of gold
during the first year, how much is depletion expense? Show the journal entry to record depletion.
Solution:

- Depletion is a product cost and is included in the cost of the inventory of gold. The inventory should
also include production costs such as material, labor and overhead costs which include depreciation of
equipments used in the extraction. The depletion is then included in cost of goods sold in the income
statement when the gold is sold.
- Note that the unit depletion rate is revised frequently due to the uncertainties surrounding the recovery
of natural resources. Like depreciation, the revision is made prospectively; the remaining un-depleted
cost is allocated over the remaining recoverable units.

INTANGIBLE ASSETS
- Characteristics
1) They lack physical existence.
2) They have useful life of more than one year. Thus, normally classified as long-term asset.
- Intangibles can be either purchased or internally developed.
o Purchased Intangibles are capitalized (recorded as asset at cost). Cost includes all costs
necessary to make the intangible asset ready for its intended use.
o Internally Created Intangibles are generally not capitalized (generally expensed). They are
capitalized to the extent of direct costs incurred in developing the intangible asset, such as legal
costs
- Like plant assets and natural resources, the cost of limited-life intangible assets is systematically
allocated to expense during the asset's useful life or legal life, whichever is shorter, and this life is
never allowed to exceed forty years. This process is called amortization. Examples are patents,
copyrights, franchise (may or may not have limited life).

- Companies almost always use the straight-line method to amortize intangible assets.

17 Fundamental of Accounting II , Chapter 2: PPE, Intangibles & Natural Resources

- No amortization is allowed for indefinite-life Intangibles. Instead, they are periodically evaluated for
impairment. For example, Trademark or trade name has legal protection for indefinite number of 10
year renewal periods, and Goodwill.
- If they are never found to be impaired, they will permanently remain on the balance sheet. If there is
any impairment, it is recorded as follows:

Some Specific Intangibles:

Patents:
- Patents provide exclusive rights to produce or sell new inventions.
- Cost of patent: if purchased from another company (externally acquired), the cost of the patent is the
purchase price. If a company invents a new product and receives a patent for it (internally developed),
the cost includes only registration, documentation, and legal fees associated with acquiring the patent
and defending it against unlawful use by other companies. Research and development costs, which are
spent to improve existing products or create new ones, are never included in the cost of a patent; such
costs are recorded as operating expenses when they are incurred because of the uncertainty
surrounding the benefits they will provide.
- The cost of a patent should be amortized over its useful life (not to exceed its legal life of 20 years).
The legal life of a patent is twenty years, which often exceeds the patent's useful life.

Example:
Suppose a company buys an existing, eight-year-old patent for $100,000. The patent's remaining legal
life is twelve years. The company believes the patent's remaining useful life is only ten years.
Required:
1. Record the acquisition of the patent

2. Compute the yearly amortization expense and show the journal entry.

- Most companies decrease the balance of the intangible asset directly. But it is possible to use
Accumulated amortization― a contra-asset account to record the amortization.
- Note that the Partial year amortization is also applicable here if the intangible assets are acquired in the
middle of the year.

18 Fundamental of Accounting II , Chapter 2: PPE, Intangibles & Natural Resources

 Copyrights:
- Copyrights provide their owner with the exclusive right to reproduce and sell artistic works, such as
books, songs, or movies. It is granted for the life of the creator plus 70 years.
- Cost of copyrights: If purchased, cost is the purchase price and other necessary costs. If internally
generated it includes a nominal registration fee and any expenditures associated with defending the
copyright.
- Although the legal life of a copyright is extensive, copyrights are often fully amortized within a
relatively short period of time which will not exceed 40 years.

Goodwill:
- Goodwill equals the amount paid to acquire a company in excess of its net assets at fair market value.
The excess payment may result from the value of the company's reputation, location, customer list,
management team, or other intangible factors.
- Internally generated goodwill is never capitalized.

Example:
Suppose at the beginning of the year XYZ Co. purchases ABC Co. for $750,000. When the purchase
takes place, ABC Co. has assets with a fair market value of $770,000 and liabilities of$100,000, so
the company would seem to be worth only $670,000. At the end of the year the test for impairment
showed that the value of the goodwill has decreased by $30,000.
Requires: Record the acquisition of goodwill and the impairment at the end of the period.

19 Fundamental of Accounting II , Chapter 2: PPE, Intangibles & Natural Resources

 Financial Statement Presentations- Balance sheet
Total currrent assets -------------------------------------------- $xxx
Property, plant, and equipment:
Land ---------------------- $xxx
Buildings ------------------- $xxx
Less: Accmu. Depr. ------------- xxx xxx
Factory Equipment --------- xxx
Less: Accmu. Depr. -------------- xxx xxx
Office Equipment ----------- xxx
Less: Accmu. Depr. -------------- xxx xxx $xxxx
Mineral Deposits:
Coal deposit --------------- $xxx
Less: Accmu.depletion ----------- xxx xxx xxxx
Total prop.,plant, & eqt. $xxxx
Intangible assets:
Patents --------------------------------- $xxx
Goodwill -------------------------------- xxx
Total Intangible asses xxxx
Total Assets $xxxx

- In the income statement the amount of depreciation and amortization expense of a period should be
reported separately or disclosed in a note. A general description of the method used in computing
depreciation should also be reported

END

20 Fundamental of Accounting II , Chapter 2: PPE, Intangibles & Natural Resources