CHAPTER four

FIXED ASSETS AND INTANGIBLE ASSETS

Nature of Fixed Assets

Businesses purchase and use a variety of fixed assets, such as equipment,
furniture, tools, machinery, buildings, and land. Fixed assets are long-term or
relatively permanent assets. They are tangible assets because they exist
physically. They are owned and used by the business and are not offered for sale
as part of normal operations. Other descriptive titles for these assets are plant
assets or property, plant, and equipment. The fixed assets of a business can be a
significant part of the total assets.
CLASSIFYING COSTS
If the purchased item is long-lived, then it should be capitalized, which means it
should appear on the balance sheet as an asset. Otherwise, the cost should be
reported as an expense on the income statement. Capitalized costs are normally
expected to last more than a year. If the asset is also used for a productive
purpose, which involves a repeated use or benefit, then it should be classified as a
fixed asset, such as land, buildings, or equipment. An asset does not need to be
used regularly to be a fixed asset. For example, standby equipment for use in the
event of a breakdown of regular equipment or for use only during peak periods is
included in fixed assets. Fixed assets that have been abandoned or are no longer
used should not be classified as fixed assets.
Fixed assets are owned and used by the business and are not offered for resale.
Long-lived assets held for resale are not classified as fixed assets, but should be
listed on the balance sheet in a section entitled Investments. For example,
undeveloped land acquired as an investment for resale would be classified as an
investment, not land.
THE COST OF FIXED ASSETS
The costs of acquiring fixed assets include all amounts spent to get the asset in
place and ready for use. For example, freight costs and the costs of installing
equipment are included as part of the asset’s total cost. The direct costs
associated with new construction, such as labor and materials, should be debited to
a “construction in progress” asset account. When the construction is complete, the
costs should be reclassified by crediting the construction in progress account and
debiting the appropriate fixed asset account. For growing companies, construction
in progress can be significant.
 The types of costs differ for the various plant assets, so we discuss each asset
individually.
Cost of an asset = Sum of all the costs incurred to bring the asset to its intended
purpose, net of all discounts.
Land and Land Improvements
The cost of land includes its purchase price, brokerage commission, survey and
legal fees, and any back property taxes the purchaser pays. The cost also includes
the cost of clearing the land and removing any unwanted buildings. The cost of land
is not depreciated.
The cost does not include fencing, paving, sprinkler systems, and lighting. These
separate plant assets called land improvements are subject to depreciation.
EXAMPLE
Suppose American Airlines signs a $500,000 note payable to purchase land.
American also pays $40,000 in back property taxes, $8,000 in transfer taxes,
$5,000 to remove an old building, and a $1,000 survey fee. What is the cost of this
land?
Buildings
The cost of a building includes
 Architectural fees
 Building permits,
 Contractors’ charges and
 Payments for material, labor, and overhead.
If the company constructs its own assets, the cost of the building may include the
cost of interest on borrowed money. When an existing building is purchased, its
cost includes all the usual items, plus all costs to repair and renovate the building
for its intended use.
Machinery and Equipment
The cost of machinery and equipment includes its
 Purchase price (less any discounts) plus transportation charges
 Insurance while in transit
 sales and other taxes
 Purchase commission
 Installation costs, and
 The cost of testing the asset before it is used.
After the asset is up and running, we no longer capitalize these costs to the
Equipment account. Thereafter, insurance, taxes, and maintenance costs are
recorded as expenses.
Furniture and Fixtures
Furniture and fixtures include desks, chairs, file cabinets, and display racks. The
cost of furniture and fixtures includes the basic cost of each asset (less any
discounts), plus all other costs to get the assets ready for use.
Only costs necessary for preparing a long-lived asset for use should be included as
a cost of the asset. Unnecessary costs that do not increase the asset’s usefulness
are recorded as an expense. For example, the following costs are included as an
expense:
 Vandalism
 Mistakes in installation
 Uninsured theft
 Damage during unpacking and installing
 Fines for not obtaining proper permits from governmental agencies

A Lump-Sum (Basket) Purchase of Assets

A company may purchase several assets as a group in a “basket purchase” for a
single price. For example, Delta Airlines may pay one price for land and a building.
For accounting purposes, Delta must identify the cost of each asset. The total cost
(100%) is divided among the assets according to their relative sales values. This
allocation technique is called the relative-sales-value method.
Example
Suppose Ethiopian Airlines purchases land and a building in Addis Ababa City for a
marketing center. The combined purchase price of land and building is $2,800,000.
An appraisal indicates that the land’s market (sales) value is $300,000 and that
the building’s market (sales) value is $2,700,000.
Exercise
How would Kinko’s divide a $120,000 lump-sum purchase price for land, building,
and equipment with estimated market values of $40,000, $95,000, and $15,000,
respectively?

CAPITAL AND REVENUE EXPENDITURES

Once a fixed asset has been acquired and placed in service, expenditures may be
incurred for ordinary maintenance and repairs. In addition, expenditures may be
incurred for improving an asset or for extraordinary repairs that extend the
asset’s useful life. Expenditures that benefit only the current period are called
revenue expenditures. Expenditures that improve the asset or extend its useful
life are capital expenditures.
Ordinary Maintenance and Repairs Expenditures related to the ordinary
maintenance and repairs of a fixed asset are recorded as an expense of the
current period. Such expenditures are revenue expenditures and are recorded as
increases to Repairs and Maintenance Expense.
Example
A$300 paid for maintenance of a delivery truck
Asset Improvements After a fixed asset has been placed in service, expenditures
may be incurred to improve an asset. Such expenditures are capital expenditures
and are recorded as increases to the fixed asset account. Because the cost of the
delivery truck has increased, depreciation for the truck would also change over its
remaining useful life.
Example
The service value of a delivery truck might be improved by adding a $5,500
hydraulic lift to allow for easier and quicker loading of heavy cargo.
Extraordinary Repairs After a fixed asset has been placed in service,
expenditures may be incurred to extend the asset’s useful life.
Example
The engine of a forklift that is near the end of its useful life may be overhauled
at a cost of $45,500, which would extend its useful life by eight years. Such
expenditures are capital expenditures and are recorded as a decrease in an
accumulated depreciation account. Because the forklift’s remaining useful life has
changed, depreciation for the forklift would also change based upon the new book
value of the forklift.
Exercise
On June 18, GTS Co. paid $15,200 to upgrade a hydraulic lift and $450 for an oil
change for one of its delivery trucks. Journalize the entries for the hydraulic lift
upgrade and oil change expenditures.
Measuring Plant Asset Depreciation
Depreciation is the allocation of a plant asset’s cost to expense over its useful life.
Depreciation matches the asset’s cost (expense) against the revenue earned by the
asset. The adjusting entry to record depreciation is usually made at the end of
each month or at the end of the year. This entry debits Depreciation Expense and
credits a contra asset account entitled Accumulated Depreciation or Allowance for
Depreciation. The use of a contra asset account allows the original cost to remain
unchanged in the fixed asset account.
Factors that cause a decline in the ability of a fixed asset to provide services may
be identified as physical depreciation or functional depreciation.
Physical depreciation occurs from wear and tear while in use and from the action
of the weather.
Functional depreciation occurs when a fixed asset is no longer able to provide
services at the level for which it was intended.
Example
A personal computer made in the 1980s would not be able to provide an Internet
connection. Such advances in technology during this century have made functional
depreciation an increasingly important cause of depreciation.
 Type writing machine due the development Computer technology
FACTORS IN COMPUTING DEPRECIATION EXPENSE
Three factors are considered in determining the amount of depreciation expense
to be recognized each period. These three factors are
a) The fixed asset’s initial cost,
b) Its expected useful life, and
c) Its estimated value at the end of its useful life.
Estimated useful life is the length of the service period expected from the asset.
Useful life may be expressed in years, units of output, miles, or another measure.
For example, a building’s life is stated in years, a bookbinding machine in the
number of books it can bind, and a delivery truck in miles.
A fixed asset’s expected useful life must also be estimated at the time the asset
is placed in service. Estimates of expected useful lives are available from various
trade associations and other publications.
Estimated residual value also called salvage value—is the expected cash value of
an asset at the end of its useful life. A machine’s useful life may be seven years.
After seven years, the company expects to sell the machine as scrap metal. The
expected cash receipt is the machine’s estimated residual value. Estimated residual
value is not depreciated because the business expects to receive this amount at
the end. If there’s no residual value, then the business depreciates the full cost of
the asset. Cost minus residual value is called depreciable cost.
In practice, many businesses use the guideline that all assets placed in or taken out
of service during the first half of a month are treated as if the event occurred on
the first day of that month. That is, these businesses compute depreciation on
these assets for the entire month. Likewise, all fixed asset additions and
deductions during the second half of a month are treated as if the event occurred
on the first day of the next month. We will follow this practice in this chapter.
Depreciation Methods
The four methods used most often are
1. Straight line
2. Units of production,
3. Double declining balance and
4. Sum of year’s digit

STRAIGHT-LINE METHOD
The straight-line method provides for the same amount of depreciation expense
for each year of the asset’s useful life. Depreciable cost is divided by useful life in
years to determine annual depreciation.
Example
Assume that the cost of a depreciable asset is $24,000, its estimated residual
value is $2,000, and its estimated life is five years.
Exercise
Equipment acquired at the beginning of the year at a cost of $125,000 has an
estimated residual value of $5,000 and an estimated useful life of 10 years.
Determine (a) the depreciable cost, (b) the straight-line rate, and (c) the annual
straight-line depreciation.
UNITS-OF-PRODUCTION METHOD
The units-of-production (UOP) method allocates a fixed amount of depreciation
to each unit of output produced by the asset. When the amount of use of a fixed
asset varies from year to year, the units-of production method is more appropriate
than the straight-line method. In such cases, the units-of-production method
better matches the depreciation expense with the related revenue.
The units-of-production method provides for the same amount of depreciation
expense for each unit produced or each unit of capacity used by the asset.
Example
Assume that a machine with a cost of $24,000 and an estimated residual value of
$2,000 is expected to have an estimated life of 10,000 operating hours, and also
assuming that the machine was in operation for 2,100 hours during a year.
Exercise
Equipment acquired at a cost of $180,000 has an estimated residual value of
$10,000, has an estimated useful life of 40,000 hours, and was operated 3,600
hours during the year. Determine (a) the depreciable cost, (b) the depreciation
rate, and (c) the units-of-production depreciation for the year.
DOUBLE-DECLINING-BALANCE METHOD
The double declining balance method provides for a declining periodic expense
over the estimated useful life of the asset. In using this method, a double declining
balance rate is determined by doubling the straight line rate.
For the first year of use, the cost of the asset is multiplied by the double
declining balance rate. After the first year, the declining book value (cost minus
accumulated depreciation) of the asset is multiplied by this rate.
Example
Assume that the cost of a depreciable asset is $24,000, its estimated residual
value is $2,000, and its estimated life is five years.
You should note that when the double-declining-balance method is used, the
estimated residual value is not considered in determining the depreciation rate. It
is also ignored in computing the periodic depreciation. However, the asset should
not be depreciated below its estimated residual value.
Exercise
Equipment acquired at the beginning of the year at a cost of $125,000 has an
estimated residual value of $5,000 and an estimated useful life of 10 years.
Determine (a) the depreciable cost, (b) the double declining balance rate, and (c)
the double declining balance depreciation for the first year.

Sum of the Years’ Digits

Under the sum-of-the-years-digits method, depreciation expense is determined by
multiplying the original cost of the asset less its estimated residual value by a
smaller fraction each year. Thus, the sum-of-the-years-digits method is similar to
the double declining- balance method in that the depreciation expense declines
each year.
The denominator of the fraction used in determining the depreciation expense is
the sum of the digits of the years of the asset’s useful life. For example, an asset
with a useful life of five years would have a denominator of 15 (5 + 4 + 3 +2 + 1).
The numerator of the fraction is the number of years of useful life remaining at
the beginning of each year for which depreciation is being computed. Thus, the
numerator decreases each year by 1. For a useful life of five years, the numerator
is 5 the first year, 4 the second year, 3 the third year, and so on.
Example
Assume that the cost of a depreciable asset is $24,000, its estimated residual
value is $2,000, and its estimated life is five years.
What if the fixed asset is not placed in service at the beginning of the year?
When the date an asset is first put into service is not the beginning of a fiscal
year, each full year’s depreciation must be allocated between the two fiscal years
benefited.
Example
To illustrate, assume that the asset in the above example was put into service at
the beginning of the fourth month of the first fiscal year.
Exercise
Sandblasting equipment acquired at a cost of $68,000 has an estimated residual
value of $18,000 and an estimated useful life of 10 years. It was placed in service
on October 1 of the current fiscal year, which ends on December 31. Determine
the depreciation for the current fiscal year and for the following fiscal year by (a)
the straight-line method (b) the double-declining-balance method and SYD
methods.
REVISING DEPRECIATION ESTIMATES
Revising the estimates of the residual value and the useful life is normal. When
these estimates are revised, they are used to determine the depreciation expense
in future periods. They do not affect the amounts of depreciation expense
recorded in earlier years.
Example
Assume that a fixed asset purchased for $140,000 was originally estimated to
have a useful life of five years and a residual value of $10,000. During the third
year, the company estimates that the remaining useful life is eight years (instead
of three) and that the residual value is $8,000 (instead of $10,000).
Exercise
A warehouse with a cost of $500,000 has an estimated residual value of $120,000,
has an estimated useful life of 40 years, and is depreciated by the straight-line
method. (a) Determine the amount of the annual depreciation. (b) Determine the
book value at the end of the twentieth year of use. (c) Assuming that at the start
of the twenty-first year the remaining life is estimated to be 25 years and the
residual value is estimated to be $150,000, determine the depreciation expense
for each of the remaining 25 years.
Disposal of Fixed Assets
Fixed assets that are no longer useful may be discarded, sold, or traded for other
fixed assets. The details of the entry to record a disposal will vary. In all cases,
however, the book value of the asset must be removed from the accounts. The
entry for this purpose debits the asset’s accumulated depreciation account for its
balance on the date of disposal and credits the asset account for the cost of the
asset.
A fixed asset should not be removed from the accounts only because it has been
fully depreciated. If the asset is still used by the business, the cost and
accumulated depreciation should remain in the ledger. This maintains accountability
for the asset in the ledger. If the book value of the asset was removed from the
ledger, the accounts would contain no evidence of the continued existence of the
asset. In addition, the cost and the accumulated depreciation data on such assets
are often needed for property tax and income tax reports .
DISCARDING FIXED ASSETS
When fixed assets are no longer useful to the business and have no residual or
market value, they are discarded.
Example
Assume that an item of equipment acquired at a cost of $25,000 is fully
depreciated at December 31, the end of the preceding fiscal year. On February 14,
the equipment is discarded.
If an asset has not been fully depreciated, depreciation should be recorded prior
to removing it from service and from the accounting records.
Example
To illustrate, assume that equipment costing $6,000 with no estimated residual
value is depreciated at an annual straight-line rate of 10%. In addition, assume that
on December 31 of the preceding fiscal year, the accumulated depreciation
balance, after adjusting entries, is $4,750. Finally, assume that the asset is
removed from service on the following March 24.
Losses on the discarding of fixed assets are non operating items and are
normally reported in the Other Expense section of the income statement.

SELLING FIXED ASSETS

The entry to record the sale of a fixed asset is similar to the entries illustrated
above, except that the cash or other asset received must also be recorded. If the
selling price is more than the book value of the asset, the transaction results in a
gain. If the selling price is less than the book value, there is a loss.
Example
To illustrate, assume that equipment is acquired at a cost of $10,000 with no
estimated residual value and is depreciated at an annual straight-line rate of 10%.
The equipment is sold for cash on October 12 of the eighth year of its use.
Exercise
Equipment was acquired at the beginning of the year at a cost of $91,000. The
equipment was depreciated using the straight-line method based upon an estimated
useful life of nine years and an estimated residual value of $10,000.
a. What was the depreciation for the first year?
b. Assuming the equipment was sold at the end of the second year for
$78,000; determine the gain or loss on sale of the equipment.
c. Journalize the entry to record the sale.

EXCHANGING SIMILAR FIXED ASSETS

Old equipment is often traded in for new equipment having a similar use. In such
cases, the seller allows the buyer an amount for the old equipment traded in. This
amount, called the trade-in allowance, may be either greater or less than the book
value of the old equipment. The remaining balance the amount owed is either paid in
cash or recorded as a liability. It is normally called boot, which is its tax name.
Gains on Exchanges:- Gains on exchanges of similar fixed assets are not
recognized for financial reporting purposes. This is based on the theory that
revenue occurs from the production and sale of goods produced by fixed assets
and not from the exchange of similar fixed assets.
When the trade-in allowance exceeds the book value of an asset traded in and no
gain is recognized, the cost recorded for the new asset can be determined in
either of two ways:
1. Cost of new asset = List price of new asset - unrecognized gain
2. Cost of new asset =Cash given (or liability assumed) + Book value of old asset
Losses on Exchanges For financial reporting purposes, losses are recognized on
exchanges of similar fixed assets if the trade-in allowance is less than the book
value of the old equipment. When there is a loss, the cost recorded for the new
asset should be the market (list) price.
Example
On the first day of the fiscal year, a delivery truck with a list price of $75,000
was acquired in exchange for an old delivery truck and $63,000 cash. The old truck
had a cost of $50,000 and accumulated depreciation of $39,500.
a. Determine the cost of the new truck for financial reporting purposes.
b. Journalize the entry to record the exchange.
Natural Resources
The fixed assets of some businesses include timber, metal ores, minerals, or other
natural resources. As these businesses harvest or mine and then sell these
resources, a portion of the cost of acquiring them must be debited to an expense
account. This process of transferring the cost of natural resources to an expense
account is called depletion.
The amount of depletion is determined by multiplying the quantity extracted
during the period by the depletion rate. This rate is computed by dividing the cost
of the mineral deposit by its estimated size.
Computing depletion is similar to computing units-of-production depreciation.
Example
To illustrate, assume that a business paid $400,000 for the mining rights to a
mineral deposit estimated at 1,000,000 tons of ore . If 90,000 tons are mined
during the year, the periodic depletion is…
Like the accumulated depreciation account, Accumulated Depletion is a contra
asset account. It is reported on the balance sheet as a deduction from the cost of
the mineral deposit.
Exercise
Earth’s Treasures Mining Co. acquired mineral rights for $45,000,000. The mineral
deposit is estimated at 50,000,000 tons. During the current year, 12,600,000 tons
were mined and sold.
a. Determine the depletion rate.
b. Determine the amount of depletion expense for the current year.
c. Journalize the adjusting entry on December 31 to recognize the depletion
expense.
Intangible Assets
Patents, copyrights, trademarks, and goodwill are long-lived assets that are useful
in the operations of a business and are not held for sale. These assets are called
intangible assets because they do not exist physically.
The basic principles of accounting for intangible assets are like those described
earlier for fixed assets. The major concerns are determining (1) the initial cost
and (2) the amortization the amount of cost to transfer to expense. Amortization
results from the passage of time or a decline in the usefulness of the intangible
asset.
PATENTS
Manufacturers may acquire exclusive rights to produce and sell goods with one or
more unique features. Such rights are granted by patents, which the federal
government issues to inventors. These rights continue in effect for 20 years. A
business may purchase patent rights from others, or it may obtain patents
developed by its own research and development efforts.
The initial cost of a purchased patent, including any related legal fees, is debited
to an asset account. This cost is written off, or amortized, over the years of the
patent’s expected usefulness. This period of time may be less than the remaining
legal life of the patent. The estimated useful life of the patent may also change as
technology or consumer tastes change.
The straight-line method is normally used to determine the periodic amortization.
When the amortization is recorded, it is debited to an expense account and
credited directly to the patents account. A separate contra asset account is
usually not used for intangible assets.
To illustrate, assume that at the beginning of its fiscal year, a business acquires
patent rights for $100,000. The patent had been granted six years earlier by the
Federal Patent Office. Although the patent will not expire for 14 years, its
remaining useful life is estimated as five years.

COPYRIGHTS AND TRADEMARKS

The exclusive right to publish and sell a literary, artistic, or musical composition is
granted by a copyright. Copyrights are issued by the federal government and
extend for 70 years beyond the author’s death. The costs of a copyright include all
costs of creating the work plus any administrative or legal costs of obtaining the
copyright. A copyright that is purchased from another should be recorded at the
price paid for it. Copyrights are amortized over their estimated useful lives.

Trademark is a name, term, or symbol used to identify a business and its products.
For example, The Coca Cola Company’s distinctive red and white Coke logo is an
example of a trademark. Under federal law, businesses can protect against others
using their trademarks by registering them for 10 years and renewing the
registration for 10 year periods thereafter. Like a copyright, the legal costs of
registering a trademark with the federal government are recorded as an asset.
If, however, a trademark is purchased from another business, the cost of its
purchase is recorded as an asset. The cost of a trademark is in most cases
considered to have an indefinite useful life. Thus, trademarks are not amortized
over a useful life, as are the previously discussed intangible assets. Rather,
trademarks should be tested periodically for impaired value. When a trademark is
impaired from competitive threats or other circumstances, the trademark should
be written down and a loss recognized.
GOODWILL
In business, goodwill refers to an intangible asset of a business that is created
from such favorable factors as location, product quality, reputation, and managerial
skill. Goodwill allows a business to earn a rate of return on its investment that is
often in excess of the normal rate for other firms in the same business.
Generally accepted accounting principles permit goodwill to be recorded in the
accounts only if it is objectively determined by a transaction. An example of such a
transaction is the purchase of a business at a price in excess of the net assets
(assets - liabilities) of the acquired business. The excess is recorded as goodwill
and reported as an intangible asset. Unlike patents and copyrights, goodwill is not
amortized. However, a loss should be recorded if the business prospects of the
acquired firm become significantly impaired. This loss would normally be disclosed
in the Other Expense section of the income statement.
Patents and copyrights are examples of intangible assets with finite lives and are
thus subject to periodic amortization based upon their estimated useful lives.
Trademarks and goodwill are examples of intangible assets with indefinite lives and
are thus not subject to periodic amortization. Rather, intangible assets with
indefinite lives are tested periodically for impairment. If the intangible asset is
impaired, then the intangible asset’s carrying value is written down, and an
impairment loss is recognized for the period.
Example
On December 31, it was estimated that goodwill of $40,000 was impaired. In
addition, a patent with an estimated useful economic life of 12 years was acquired
for $84,000 on July 1.
a. Journalize the adjusting entry on December 31 for the impaired goodwill.
b. Journalize the adjusting entry on December 31 for the amortization of the
patent rights.