Chapter 9 Long-Term Assets Skyline College Lecture Notes

Long-Term Assets 
Useful life of more than one year
Used in the operation of a business Not intended for resale

Long-term assets might include:  Equipment  Vehicles  Property  Trademarks
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Carrying Value
The unexpired cost of an asset (also called book value) Unexpired Cost = Cost ± Accumulated Depreciation

On the Balance Sheet:

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Classification of Long-Term Assets and Methods of Accounting for Them

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Asset Impairment
When is an asset deemed impaired? When a long-term asset loses some or all of its potential to generate revenue before the end of its useful life Asset Impairment

The carrying value of a long-term asset exceeds its fair value

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9±6 . and disposal price Copyright © Houghton Mifflin Company.Acquiring Long-Term Assets How do companies make the decision to acquire long-term assets? Capital Budgeting Method of Evaluation Net Present Value Method Evaluates the purchase based on the net present value of acquisition cost. net annual savings in cash flows. All rights reserved.

the usual life of the software.000 ($30.000) $20.Net Present Value Method Apple Computer is considering the purchase of a $50. The interest rate is 10 percent compounded annually.000 in net cash flows per year for four years.000 20x7 $20.000 $30. The software should be worth $10.000 $20.000 at the end of that period.000) 20x6 $20. 9±7 .000 customer relations software package.000 10. Management estimates that the company will save $20.000 20x8 $20.000 $20. All rights reserved.000 Acquisition cost Net annual savings in cash flows Disposal price Net cash flows Present value Tables 3 and 4 can now be used to place the cash flows on a comparable basis. Cash flows related to the purchase of the computer would be as follows: 20x5 ($50. Copyright © Houghton Mifflin Company.

000 Present value factor = .000 ($30. 9±8 .000) $20.000 ($50.000 10.683 x $10. The return is greater than 10 percent on the investment.Example of Net Present Value Method (cont¶d) 20 5 ($50.000 20 8 $20.000 x $50.000 $20. 10% .000 Present value factor = 3.683 Table 3: 4 periods.000 $20.000 $30. Apple will earn a return of at least 10 percent.000) 63.000 Acquisition cost et annual savings in cash lo s isposal price et cash lo s Acquisition cost Net annual savings in cash flows Disposal price Present value factor = 1. Copyright © Houghton Mifflin Company. Apple should purchase the software. Based on this analysis. 10% 3.000 1.170 Table 4: 4 periods.000) 20 6 $20.000 20 7 $20. All rights reserved.400 6.170 x $20.230 As long as the net present value is positive.830 Net present value $20.

Free cash flow is cash that remains after deducting funds committed to operations at current levels Copyright © Houghton Mifflin Company. 9±9 . All rights reserved.Financing Long-Term Assets ‡ Financing alternatives: Use cash flow from operations Issue common stock Issue long-term notes Issue bonds Investors may investigate whether a company has free cash flow to finance long-term assets.

9±10 . it may choose to capitalize it. All rights reserved. thus deferring an expense to a later period Favorably impacts profitability for that current period Management uses ethical judgments in resolving two issues: 1. How much of the cost of a long-term asset should be allocated to expense in the current period? 2. How much should be retained on the balance sheet as an asset that will benefit future periods? Copyright © Houghton Mifflin Company.The Matching Rule and Long-Term Assets When a company purchases an asset.

What is the cost of the long-term asset? 2. All rights reserved. How should subsequent expenditures. be treated? 4. 9±11 . How should the expired portion of the cost of the asset be allocated against revenues over time? 3. How should disposal of the long-term asset be recorded? Copyright © Houghton Mifflin Company.Long-Term Asset Accounting Policies Each company must determine how it will treat long-term assets: 1. such as repairs and additions.

Is this decision ethical? What must the accountant base his decision on? Copyright © Houghton Mifflin Company.Discussion: Ethics on the Job Brattman Company purchases a building and the land on which it is located for a lump sum. The accountant decides to allocate a larger portion of the price to the land since this will improve net income. 9±12 . All rights reserved.) Q. (If he allocated more of the price to the building. The accountant must allocate the purchase price between the building and the land. depreciation expense would be higher. thus decreasing net income.

9±13 . and operation of a long-term asset Copyright © Houghton Mifflin Company. maintenance. All rights reserved.What Are Expenditures? Payments or obligations to make a future payment for an asset or for a service Capital Expenditure Expenditure for the purchase or expansion of a longterm asset Revenue Expenditure Expenditure for the repair.

All rights reserved.Capital Expenditures  Outlays for plant assets. which are repairs that significantly enhance a plant asset¶s estimated useful life or residual value Copyright © Houghton Mifflin Company. which are enlargements to the physical layout of a plant asset  Betterments. 9±14 . natural resources. and intangible assets  Additions. which are improvements to a plant asset but that do not add to the plant¶s physical layout  Extraordinary repairs.

Acquisition Costs Includes all expenditures reasonable and necessary to get an asset in place and ready for use Installation costs Freight Insurance while in transit Testing and setup Are these items considered acquisition costs? Repair costs No Interest charges on purchase No Copyright © Houghton Mifflin Company. 9±15 . All rights reserved.

All rights reserved. not the Land account.000 $185. 9±16 . or parking lots have a limited life. They should be recorded in an account called Land Improvements.000 1. Copyright © Houghton Mifflin Company.Acquiring Land Costs that should be debited to the Land account include: Purchase price Agent commissions Legal fees Accrued taxes paid by purchaser Grading Land preparation fees Assessments for local improvements Landscaping Sample Acquisition of Land Net purchase price Brokerage fees Legal fees Tearing down old building Less salvage Grading Total cost $170.000 6. driveways.000 $10.000 4.000 6.000 Improvements to real estate like fences.000 2.

9±17 .Acquiring Buildings Acquisition costs include:  Purchase price  Repairs and other expenditures required to put it in usable condition Buildings are subject to depreciation because they have a limited useful life Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company.Leasehold Improvements Improvements to leased property that become the property of the lessor at the end of the lease  Classified as tangible assets in property. plant. and equipment section of the balance sheet  Costs of leasehold improvements are depreciated or amortized over the remaining term of the lease or the useful life of the improvement. 9±18 . All rights reserved. whichever is shorter.

All rights reserved. 9±19 .Acquiring Equipment ‡ Acquisition costs include: Purchase price (less cash discounts) All expenditures connected with purchasing the equipment and preparing it for use ‡ ‡ ‡ ‡ ‡ ‡ Freight Insurance in transit Excise taxes and tariffs Buying expenses Installation costs Cost of test runs Equipment is subject to depreciation because it has a limited useful life Copyright © Houghton Mifflin Company.

( 8 . All rights reserved. 9 8 .000. ÷ Copyright © Houghton Mifflin Company. . 9±20 . Assume that appraisals yield estimates of $10. buys a building and the land on which it is situated for a lump sum of $85. Allocate as follows: . . ) ) Apportionment 8.Group Purchases Land and other assets may sometimes be purchased for a lump sum Because buildings are depreciable and land is not.000 for the building if purchased separately. ÷ ( 9 . ( 8 . 9 . the purchase price must be allocated to each asset ABC Co. 9 Percentage ( . ) ) L B il i T t ls Appraisal . .000 for the land and $90.

9±21 . All rights reserved.What Is Depreciation? The periodic allocation of the cost of a tangible asset (other than land and natural resources) over the asset¶s estimated useful life  All tangible assets except land have a limited useful life (physical deterioration and obsolescence limit useful life)  Depreciation refers to the allocation of the cost of a plant asset to the periods that benefit from the asset. not to the asset¶s physical deterioration or decrease in market value  Depreciation is not a process of valuation. it is a process of allocation Copyright © Houghton Mifflin Company.

9±22 . salvage. Depreciable cost 4. Estimated useful life Net purchase price of an asset plus all reasonable and necessary expenditures to get it in place and ready for use Estimated scrap. All rights reserved.Four Factors That Affect the Computation of Depreciation 1. or trade-in value on the estimated date of its disposal Cost less residual value Total number of service units expected from a long-term asset Copyright © Houghton Mifflin Company. Residual value 3. Cost 2.

All rights reserved.Accounting for Depreciation Depreciation is recorded at the end of the accounting period by an adjusting entry Depreciation Expense. Asset Name To record depreciation for the period xxx xxx Copyright © Houghton Mifflin Company. 9±23 . Asset Name Accumulated Depreciation.

. All rights reserved.Methods of Accounting for Depreciation Straight-line method Production method Spreads the depreciable cost evenly over the estimated useful life of the asset Based on the assumption that depreciation is solely the result of use and that passage of time plays no role in the depreciation process Accelerated method of depreciation that results in larger amounts of depreciation in earlier years of the asset¶s life and smaller amounts in later years 9±24 Declining-balance method Copyright © Houghton Mifflin Company.

Straight-Line Method Illustrated A delivery truck costs $10.800 per year 5 years Copyright © Houghton Mifflin Company.000 at the end of its estimated useful life of 5 years. All rights reserved. Cost ± esidual alue Yearly epreciation ! stimated Useful ife $10.000 ! ! $1. 9±25 .000 and has an estimated residual value of $1.000 ± $1.

800 1. All rights reserved.000 Yearly Depreciation ² $1.200 9.800 3. 9±26 .200 6.600 2.800 1.000 10.600 5.000 Carrying Value $10.000 The amount of depreciation is the same each year Accumulated depreciation increases uniformly The carrying value decreases uniformly until it reaches the estimated residual value Copyright © Houghton Mifflin Company.000 10.400 4.800 1. Straight-Line Method Date of purchase End of first year End of second year End of third year End of fourth year End of fifth year Cost $10.000 10.800 1.000 10.000 10.800 Accumulated Depreciation ² $1.400 7.Depreciation Schedule.800 1.000 8.

and 10.10 per mile appropriate for 90.Production Method A delivery truck costs $10. 10. Cost ± esidual alue stimated Units of Useful ife epreciation Cost ! The unit of output or use should be $10.000 ! ! $0. 20.000 and has an estimated residual value of $1.000 miles that asset Copyright © Houghton Mifflin Company. All rights reserved. Assume the truck was driven 20.000 miles during year 3. 9±27 .000 miles during year 5.000 miles during year 1.000 ± $1.000 miles during year 2.000 at the end of its estimated useful life of five years.000 miles during year 4. 30.

000 10.000 Accumulated Depreciation ² $2.000 10.000 3.000 10. Accumulated depreciation increases each year in direct relation to units of output or use. 9±28 .000 8.000 Miles ² 20.000 2.000 10.000 10. Production Method Date of purc ase End of first year End of second year End of third year End of fourth year End of fifth year Cost $10.000 9.000 8.000 6.000 Carrying Value $10. All rights reserved.000 30.000 10.000 Yearly Depreciation ² $2.000 1.000 5.000 There is a direct relation between the amount of depreciation each year and the units of output or use.000 5.000 4.000 2. The carrying value decreases each year in direct relation to units of output or use until the estimated residual value is reached.000 1. Copyright © Houghton Mifflin Company.000 1.000 20.Depreciation Schedule.000 10.

Declining-Balance Method  Based on the passage of time  Assumes that many kinds of plant assets are most efficient when new  Is consistent with the matching rule  Any fixed rate can be used  Most common rate is twice the straightline depreciation percentage (called double-declining-balance method) Copyright © Houghton Mifflin Company. 9±29 . All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Its estimated useful life is 5 years. Under the straight-line method.Double-Declining-Balance Method Illustrated A delivery truck costs $10. the depreciation rate for each year is 20 percent: 100 percent z 5 years ! 20 percent Under the double-declining-balance method.000. the depreciation rate for each year is 40 percent: 2 v 20 percent ! 40 percent This fixed rate is applied to the remaining carrying value at the end of each year. 9±30 .000 and has an estimated residual value of $1.

9 . . . The depreciation in the last year is limited to the amount necessary to reduce the carrying value to the residual value. .8 8. . 8 9 * ($1. . .Depreciation Schedule. . . . Accumulated Depreciation ² . 9±31 . All rights reserved. . * 9. ($1. Double-Declining-Balance Method Yearly Depreciation D t E E E E E f rc s f first y r fs c y r f t ir y r f f rt y r f fift y r Cost . .000 = $296) Copyright © Houghton Mifflin Company. ( ( ( ( . ) ) ) ) . .$1. Carrying Value . . .296 ± $1. Depreciation is greatest in the first year and declines each year after that.000 = $296) Note that the fixed rate is always applied to the carrying value at the end of the previous year. .296 . .

9±32 .Graphic Comparison of Three Methods of Determining Depreciation Copyright © Houghton Mifflin Company. All rights reserved.

9±33 . All rights reserved.Revising Depreciation Rates Sometimes a company must revise its estimate of an asset¶s useful life or its residual value  The periodic depreciation expense will increase or decrease depending on the adjustment  The remaining depreciable cost of the asset should be spread over the remaining years of useful life Copyright © Houghton Mifflin Company.

Remove the carrying value of the asset Copyright © Houghton Mifflin Company. Record depreciation for the partial year up to the date of disposal 2. All rights reserved. 9±34 .Methods of Disposal  Discard  Sell for cash  Exchange for another asset When plant assets are no longer usefu« 1.

Copyright © Houghton Mifflin Company. 20x2.650 On January 2.500 4. On December 31. management disposed of the asset. the balances of the relevant accounts were: Machi ry ccumulat r ciati . 9±35 . 20x7. All rights reserved. Its residual value at the end of 8 years was estimated to be $500. Machi ry 6. for $6. 20x8.500 and planned to depreciate it on a straight-line basis over its estimated useful life (8 years).Disposal of a Depreciable Asset MGC Company purchased a machine on January 2.

the carrying value is zero ‡ If the asset is not fully depreciated.500 al. 9±36 .650 1. Machiner oss on isposal of Machiner Machiner iscarded machine no longer used in business Machi ry Accum. a loss is recorded Jan.Disposal of a Plant Asset Remove the carrying value of the asset ‡ Carrying value is computed by subtracting accumulated depreciation from the acquisition cost of the asset ‡ If the asset is fully depreciated.500 r ciati .500 4. 4. 50 6. 4. Machi ry 6. -0- 6.650 al. All rights reserved.650 -0- Gains and losses on disposal of plant assets are classified as other revenues and expenses on the income statement. Copyright © Houghton Mifflin Company. 2 Accumulated epreciation.

Selling a Plant Asset for Cash In addition to removing the carrying value of the asset. 9±37 . gain is recorded Copyright © Houghton Mifflin Company. you will also record the cash received  If cash received = carrying value. no gain or loss is recorded  If cash received < carrying value. All rights reserved. loss is recorded  If cash received > carrying value.

850 cash for sale of machinery. Copyright © Houghton Mifflin Company.8 . ac inery ac inery Sale f ac inery f r carrying al e. Remove the carrying value of the asset and record receipt of cash: Jan. All rights reserved.Selling an Asset for Cash Cash Received = Carrying Value Received $1. 9±38 . Cas Acc lat D r ciati n. no gain or loss . .

9±39 . loss of 8 recorded . ac inery .Selling an Asset for Cash Cash Received < Carrying Value Received $1. Loss on Sale of ac inery 8 ac inery Sale of ac inery at less t an carrying al e.000 cash for sale of machinery.8 ± . Copyright © Houghton Mifflin Company. ) ( . Cas . Acc lated Depreciation. All rights reserved. Remove the carrying value of the asset and record receipt of cash: Jan.

gain of $150 recorded ($2. Remove the carrying value of the asset and record receipt of cash: Jan.500 Copyright © Houghton Mifflin Company. 50) 150 6.650 Gain on ale of Machiner Machiner ale of machiner at more than carr ing value. All rights reserved.Selling an Asset for Cash Cash Received > Carrying Value Received $2.000 ± $1.000 Accumulated epreciation.000 cash for sale of machinery. 9±40 . 2 ash 2. Machiner 4.

9±41 .Exchanges of Plant Assets  May involve similar assets Old machine traded in for newer model  May involve dissimilar assets Cement mixer traded in for truck Purchase price is reduced by the amount of the trade-in allowance  If trade allowance is greater than asset¶s carrying value. loss realized. gain realized.  If trade allowance is less than asset¶s carrying value. All rights reserved. Copyright © Houghton Mifflin Company.

or other extraction methods Timberlands Oil and Gas Reserves Mineral Deposits Record at acquisition cost and show on the balance sheet as long-term assets Copyright © Houghton Mifflin Company. mining. All rights reserved. pumping.What Are Natural Resources? Assets that are converted to inventory by cutting. 9±42 .

All rights reserved.Depletion of Natural Resources (1) The exhaustion of a natural resource and (2) The proportional allocation of the cost of a natural resource to the units extracted Costs are allocated much like the production method of depreciation epletion Cost per Unit ! Cost of atural esource .esidual alue stimated umber of Units Available 9±43 Copyright © Houghton Mifflin Company. .

000 ! ! $1 per ton 1.000 .000. All rights reserved. During the first year. The estimated residual value of the mine is $300.500.000 tons of coal are mined and sold.800. Depletion Cost per Unit ! Cost of atural esource .Recording Depletion Expense A mine that cost $1. Coal Deposits To record depletion of coal mine: $1 per ton.000 tons of coal.000 Natural resources that have been extracted but not sold are considered inventory and are not recorded as an expense until the year sold. 115. 31 Depletion Expense. 9±44 . Coal Deposits Accumulated Depletion.500.$300.000 tons 115.800.000 Dec.000 tons mined and sold 115.esidual alue stimated umber of Units Available $1. Copyright © Houghton Mifflin Company.000 has an estimated 1. 115.

Improves earnings performance in the early years. All costs. 9±45 . Copyright © Houghton Mifflin Company. are recorded as assets and depleted over the estimated life of the producing resources. All rights reserved.Development and Exploration Costs in the Oil and Gas Industry Use one of these two accounting methods: Successful efforts method Full-costing method Cost recorded as an asset and depleted over the estimated life of the resource. For an unsuccessful effort. write off immediately as a loss. including costs of dry wells.

nonphysical asset whose value comes from the rights or advantages afforded its owner  Goodwill  Trademarks  Brand names  Copyrights  Patents  Leaseholds  Software  Customer Lists 9±46 Copyright © Houghton Mifflin Company.What Is an Intangible Asset? Long-term. All rights reserved. .

Importance of Intangibles For some companies. 9±47 . intangible assets make up a substantial portion of total assets Copyright © Houghton Mifflin Company. All rights reserved.

Accounting for Intangible Assets Intangibles developed by a firm for its own benefit Record as expense Intangibles acquired from others Record as asset. amortize over the shorter of useful life or legal life (not to exceed 40 years) Copyright © Houghton Mifflin Company. All rights reserved. 9±48 .

Difficult Issues When Accounting for Intangibles  How to account for the initial carrying value?  How to account for that amount under normal business conditions (periodic write-off or amortization)?  How to account for the amount if the value declines substantially and permanently?  How to estimate an intangible asset¶s value and useful life? Copyright © Houghton Mifflin Company. All rights reserved. 9±49 .

but the product using the cap will be sold only for the next six years. Copyright © Houghton Mifflin Company.000. All rights reserved. The patent will last for 20 years.000 3.000 ÷ 6 years) 3. Record the purchase of the patent: Patents ash ecord patent rchase of ottle cap 8.000 Record the annual amortization expense: Amortization xpense Patents o record amortization expense for patent ($ 8.Intangible Assets Illustrated Soda Bottling Company purchases a patent on a unique bottle cap for $18.000 8. whereas depreciation or depletion is accumulated in separate contra accounts for other long-term assets. 9±50 .000 Notice that the Patents account is directly reduced y the amount of amortization expense.

000 If the patent becomes worthless before it is fully amortized. All rights reserved. 9±51 .000 15. the remaining carrying value is written off as a loss by removing it from the Patents account. Copyright © Houghton Mifflin Company.Intangible Assets Illustrated (cont¶d) The patent becomes worthless after only 1 year.000 ± $3.000) 15. Record the write-off: Loss on Patent Patents To record the write -off of a worthless patent ($18.

Why?  Too difficult to trace specific costs to specific profitable developments  Costs of R&D are continuous and necessary for the success of a business and are treated as current expenses  Studies show that 30 to 90 percent of all new products fail and 75 percent of new-product expenses are unsuccessful Copyright © Houghton Mifflin Company. All rights reserved. 9±52 .Research and Development Costs The FASB requires that all R&D costs be treated as revenue expenditures and charged to expense in the period in which they are incurred.

Amortize over the estimated economic life using the straight-line method 9±53 . all costs are recorded proved technologically feasible as assets Costs incurred before technologically feasible should be charged to expense as incurred Copyright © Houghton Mifflin Company. All rights reserved.Computer Software Costs Costs incurred in developing computer software for sale or lease or for a firm¶s internal use are research and development Once a working program is costs until the product has ready.

All rights reserved.Goodwill A company¶s good reputation Customer satisfaction Good management Manufacturing efficiency Good location Goodwill exists when a purchaser pays more for a business than the fair market value of the business¶s net assets  Goodwill should not be recorded unless it is paid for in connection with the purchase of a whole business  Goodwill = Purchase price ± FMV of identifiable net assets Copyright © Houghton Mifflin Company. 9±54 .

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