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Financial_Accounting_7e_Ch09 (1).pdf

Resource: Ch. 9 of Financial Accounting

Complete Exercises E9-7 & E9-12.

Complete Problem P9-7A.

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JWCL165_c09_396-443.qxd 8/4/09 9:39 PM Page 396 9 Plant Assets, Natural Resources, and Intangible Assets Chapter STUDY OBJECTIVES After studying this chapter, you should be able to: 1 Describe how the cost principle applies to plant assets. 2 Explain the concept of depreciation. 3 Compute periodic depreciation using different methods. 4 Describe the procedure for revising periodic depreciation. 5 Distinguish between revenue and capital expenditures, and explain the entries for each. 6 Explain how to account for the disposal of a plant asset. 7 Compute periodic depletion of natural resources. 8 Explain the basic issues related to accounting for intangible assets. 9 Indicate how plant assets, natural resources, and intangible assets are The Navigator reported. ✓ The Navigator Scan Study Objectives ■ Read Feature Story ■ Read Preview ■ Read text and answer p. 402 ■ p. 409 ■ Work Comprehensive Do it! p. 412 Do it! ■ p. 417 p. 421 p. 422 ■ ■ ■ Review Summary of Study Objectives ■ Answer Self-Study Questions ■ Complete Assignments ■ ✓ Feature Story HOW MUCH FOR A RIDE TO THE BEACH? It’s spring break. Your plane has landed, you’ve finally found your bags, and you’re dying to hit the beach—but first you need a “vehicular unit” to get 396 JWCL165_c09_396-443.qxd 7/31/09 4:20 PM Page 397 you there. As you turn away from baggage claim you see a long row of rental agency booths. Many are names you are familiar with—Hertz, Avis, and Budget. But a booth at the far end catches your eye—Rent-A-Wreck (www.rent-a-wreck.com). Now there’s a company making a clear statement! Any company that relies on equipment to generate revenues must make decisions about what kind of equipment to buy, how long to keep it, and how vigorously to maintain it. Rent-A-Wreck has decided to rent used rather than new cars and trucks. It rents these vehicles across the United States, Europe, and Asia. While the big-name agencies push vehicles with that “new car smell,” Rent-A-Wreck competes on price. The message is simple: Rent a used car and save some cash. It’s not a message that appeals to everyone. If you’re a marketing executive wanting to impress a big client, you probably don’t want to pull up in a Rent-A-Wreck car. But if you want to get from point A to point B for the minimum cash per mile, then they are playing your tune. The company’s message seems to be getting across to the right clientele. Revenues have increased significantly. When you rent a car from Rent-A-Wreck, you are renting from an independent business person who has paid a “franchise fee” for the right to use the Rent-A-Wreck name. In order to gain a franchise, he or she must meet financial and other criteria, and must agree to run the rental agency according to rules prescribed by Rent-A-Wreck. Some of these rules require that each franchise maintain its cars in a reasonable fashion. This ensures that, though you won’t be cruising down Daytona Beach’s Atlantic Avenue in a Mercedes convertible, you can be reasonably assured that you won’t be calling a towtruck. ✓ The Navigator Inside Chapter 9… • Many U.S. Firms Use Leases (p. 401) • ESPN Wins Monday Night Football Franchise (p. 416) • All About You: Buying a Wreck of Your Own (p. 420) 397 JWCL165_c09_396-443.qxd 8/4/09 9:39 PM Page 398 Preview of Chapter 9 The accounting for long-term assets has important implications for a company’s reported results. In this chapter, we explain the application of the cost principle of accounting to property, plant, and equipment, such as Rent-A-Wreck vehicles, as well as to natural resources and intangible assets such as the “Rent-A-Wreck” trademark. We also describe the methods that companies may use to allocate an asset’s cost over its useful life. In addition, we discuss the accounting for expenditures incurred during the useful life of assets, such as the cost of replacing tires and brake pads on rental cars. The content and organization of Chapter 9 are as follows. Plant Assets, Natural Resources, and Intangible Assets Plant Assets • Determining the cost of plant assets • Depreciation • Expenditures during useful life • Plant asset disposals Natural Resources • Accounting for natural resources • Financial statement presentation Intangible Assets • Accounting for intangibles • Types of intangibles • Research and development costs Statement Presentation and Analysis • Presentation • Analysis ✓ SECTION 1 The Navigator Plant Assets Plant assets are resources that have three characteristics: they have a physical substance (a definite size and shape), are used in the operations of a business, and are not intended for sale to customers. They are also called property, plant, and equipment; plant and equipment; and fixed assets. These assets are expected to provide services to the company for a number of years. Except for land, plant assets decline in service potential over their useful lives. Because plant assets play a key role in ongoing operations, companies keep plant assets in good operating condition. They also replace worn-out or outdated plant assets, and expand productive resources as needed. Many companies have substantial investments in plant assets. Illustration 9-1 shows the percentages of plant assets in relation to total assets of companies in a number of industries. Illustration 9-1 Percentages of plant assets in relation to total assets Southwest Airlines 75% Wendy's 70% Wal-Mart 56% Nordstrom 36% Caterpillar Microsoft Corporation 18% 7% 10 20 30 40 50 60 70 80 90 Plant assets as a percentage of total assets 398 JWCL165_c09_396-443.qxd 7/31/09 4:20 PM Page 399 Determining the Cost of Plant Assets 399 DETERMINING THE COST OF PLANT ASSETS The cost principle requires that companies record plant assets at cost. Thus STUDY OBJECTIVE 1 Rent-A-Wreck records its vehicles at cost. Cost consists of all expendi- Describe how the cost principle tures necessary to acquire the asset and make it ready for its intended use. applies to plant assets. For example, the cost of factory machinery includes the purchase price, freight costs paid by the purchaser, and installation costs. Once cost is established, the company uses that amount as the basis of accounting for the plant asset over its useful life. In the following sections, we explain the application of the cost principle to each of the major classes of plant assets. Land Companies acquire land for use as a site upon which to build a manufacturing plant or office.The cost of land includes (1) the cash purchase price, (2) closing costs such as title and attorney’s fees, (3) real estate brokers’ commissions, and (4) accrued property taxes and other liens assumed by the purchaser. For example, if the cash price is $50,000 and the purchaser agrees to pay accrued taxes of $5,000, the cost of the land is $55,000. Companies record as debits (increases) to the Land account all necessary costs incurred to make land ready for its intended use. When a company acquires vacant land, these costs include expenditures for clearing, draining, filling, and grading. Sometimes the land has a building on it that must be removed before construction of a new building. In this case, the company debits to the Land account all demolition and removal costs, less any proceeds from salvaged materials. To illustrate, assume that Hayes Manufacturing Company acquires real estate at a cash cost of $100,000. The property contains an old warehouse that is razed at a net cost of $6,000 ($7,500 in costs less $1,500 proceeds from salvaged materials). Additional expenditures are the attorney’s fee, $1,000, and the real estate broker’s commission, $8,000. The cost of the land is $115,000, computed as follows. HELPFUL HINT Management’s intended use is important in applying the cost principle. Illustration 9-2 Computation of cost of land Land Cash price of property Net removal cost of warehouse Attorney’s fee Real estate broker’s commission $100,000 6,000 1,000 8,000 Cost of land $115,000 When Hayes records the acquisition, it debits Land for $115,000 and credits Cash for $115,000. Land Improvements Land improvements are structural additions made to land. Examples are driveways, parking lots, fences, landscaping, and underground sprinklers. The cost of land improvements includes all expenditures necessary to make the improvements ready for their intended use. For example, the cost of a new parking lot for Home Depot JWCL165_c09_396-443.qxd 400 7/31/09 4:20 PM Page 400 Chapter 9 Plant Assets, Natural Resources, and Intangible Assets includes the amount paid for paving, fencing, and lighting. Thus Home Depot debits to Land Improvements the total of all of these costs. Land improvements have limited useful lives, and their maintenance and replacement are the responsibility of the company. Because of their limited useful life, companies expense (depreciate) the cost of land improvements over their useful lives. Buildings Buildings are facilities used in operations, such as stores, offices, factories, warehouses, and airplane hangars. Companies debit to the Buildings account all necessary expenditures related to the purchase or construction of a building. When a building is purchased, such costs include the purchase price, closing costs (attorney’s fees, title insurance, etc.) and real estate broker’s commission. Costs to make the building ready for its intended use include expenditures for remodeling and replacing or repairing the roof, floors, electrical wiring, and plumbing. When a new building is constructed, cost consists of the contract price plus payments for architects’ fees, building permits, and excavation costs. In addition, companies charge certain interest costs to the Buildings account: Interest costs incurred to finance the project are included in the cost of the building when a significant period of time is required to get the building ready for use. In these circumstances, interest costs are considered as necessary as materials and labor. However, the inclusion of interest costs in the cost of a constructed building is limited to the construction period. When construction has been completed, the company records subsequent interest payments on funds borrowed to finance the construction as debits (increases) to Interest Expense. Equipment Equipment includes assets used in operations, such as store check-out counters, office furniture, factory machinery, delivery trucks, and airplanes.The cost of equipment, such as Rent-A-Wreck vehicles, consists of the cash purchase price, sales taxes, freight charges, and insurance during transit paid by the purchaser. It also includes expenditures required in assembling, installing, and testing the unit. However, Rent-A-Wreck does not include motor vehicle licenses and accident insurance on company vehicles in the cost of equipment. These costs represent annual recurring expenditures and do not benefit future periods. Thus, they are treated as expenses as they are incurred. To illustrate, assume Merten Company purchases factory machinery at a cash price of $50,000. Related expenditures are for sales taxes $3,000, insurance during shipping $500, and installation and testing $1,000. The cost of the factory machinery is $54,500, computed as follows. Illustration 9-3 Computation of cost of factory machinery Factory Machinery Cash price Sales taxes Insurance during shipping Installation and testing $50,000 3,000 500 1,000 Cost of factory machinery $54,500 JWCL165_c09_396-443.qxd 7/31/09 4:20 PM Page 401 401 Determining the Cost of Plant Assets Merten makes the following summary entry to record the purchase and related expenditures: Factory Machinery Cash (To record purchase of factory machine) 54,500 54,500  L  SE 54,500 54,500 Cash Flows For another example, assume that Lenard Company purchases a delivery truck at a cash price of $22,000. Related expenditures consist of sales taxes $1,320, painting and lettering $500, motor vehicle license $80, and a three-year accident insurance policy $1,600. The cost of the delivery truck is $23,820, computed as follows. Cash price Sales taxes Painting and lettering $22,000 1,320 500 Cost of delivery truck $23,820 54,500 Illustration 9-4 Computation of cost of delivery truck Delivery Truck Lenard treats the cost of the motor vehicle license as an expense, and the cost of the insurance policy as a prepaid asset. Thus, Lenard makes the following entry to record the purchase of the truck and related expenditures: Delivery Truck License Expense Prepaid Insurance Cash (To record purchase of delivery truck and related expenditures) A A  L  SE 23,820 23,820 80 1,600 80 Exp 25,500 ACCOUNTING ACROSS THE ORGANIZATION Many U.S. Firms Use Leases Leasing is big business for U.S. companies. For example, business investment in equipment in a recent year totaled $709 billion. Leasing accounted for about 31% of all business investment ($218 billion). Who does the most leasing? Interestingly major banks, such as Continental Bank, J.P. Morgan Leasing, and US Bancorp Equipment Finance, are the major lessors. Also, many companies have established separate leasing companies, such as Boeing Capital Corporation, Dell Financial Services, and John Deere Capital Corporation. And, as an excellent example of the magnitude of leasing, leased planes account for nearly 40% of the U.S. fleet of commercial airlines. In addition, leasing is becoming increasingly common in the hotel industry. Marriott, Hilton, and InterContinental are increasingly choosing to lease hotels that are owned by someone else. Why might airline managers choose to lease rather than purchase their planes? 1,600 25,500 Cash Flows 25,500 JWCL165_c09_396-443.qxd 402 8/4/09 9:39 PM Page 402 Chapter 9 Plant Assets, Natural Resources, and Intangible Assets before you go on... Cost of Plant Assets Action Plan • Identify expenditures made in order to get delivery equipment ready for its intended use. • Treat operating costs as expenses. Do it! Assume that Drummond Heating and Cooling Co. purchases a delivery truck for $15,000 cash, plus sales taxes of $900 and delivery costs of $500. The buyer also pays $200 for painting and lettering, $600 for an annual insurance policy, and $80 for a motor vehicle license. Explain how each of these costs would be accounted for. Solution The first four payments ($15,000, $900, $500, and $200) are expenditures necessary to make the truck ready for its intended use. Thus, the cost of the truck is $16,600. The payments for insurance and the license are operating costs and therefore are expensed. Related exercise material: BE9-1, BE9-2, E9-1, E9-2, E9-3, and Do it! 9-1. ✓ The Navigator DEPRECIATION STUDY OBJECTIVE 2 Explain the concept of depreciation. As explained in Chapter 3, depreciation is the process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systematic manner. Cost allocation enables companies to properly match expenses with revenues in accordance with the expense recognition principle (see Illustration 9-5). Illustration 9-5 Depreciation as a cost allocation concept Depreciation allocation Year Year Year 1 2 3 Year Year Year 4 5 6 It is important to understand that depreciation is a process of cost allocation. It is not a process of asset valuation. No attempt is made to measure the change in an asset’s market value during ownership. So, the book value (cost less accumulated depreciation) of a plant asset may be quite different from its market value. Depreciation applies to three classes of plant assets: land improvements, buildings, and equipment. Each asset in these classes is considered to be a depreciable asset. Why? Because the usefulness to the company and revenue-producing ability of each asset will decline over the asset’s useful life. Depreciation does not apply to land because its usefulness and revenue-producing ability generally remain intact over time. In fact, in many cases, the usefulness of land is ETHICS NOTE greater over time because of the scarcity of good land sites. Thus, land is When a business is not a depreciable asset. acquired, proper allocation of During a depreciable asset’s useful life, its revenue-producing ability the purchase price to various asset classes is important, since declines because of wear and tear. A delivery truck that has been driven different depreciation treatment 100,000 miles will be less useful to a company than one driven only 800 miles. can materially affect income. Revenue-producing ability may also decline because of obsolescence. For example, buildings are Obsolescence is the process of becoming out of date before the asset physdepreciated, but land is not. ically wears out. For example, major airlines moved from Chicago’s JWCL165_c09_396-443.qxd 7/31/09 4:20 PM Page 403 Depreciation 403 Midway Airport to Chicago-O’Hare International Airport because Midway’s runways were too short for jumbo jets. Similarly, many companies replace their computers long before they originally planned to do so because improvements in new computing technology make the old computers obsolete. Recognizing depreciation on an asset does not result in an accumulation of cash for replacement of the asset. The balance in Accumulated Depreciation represents the total amount of the asset’s cost that the company has charged to expense. It is not a cash fund. Note that the concept of depreciation is consistent with the going-concern assumption. The going-concern assumption states that the company will continue in operation for the foreseeable future. If a company does not use a going-concern assumption, then plant assets should be stated at their market value. In that case, depreciation of these assets is not needed. Factors in Computing Depreciation Three factors affect the computation of depreciation: 1. Cost. Earlier, we explained the issues affecting the cost of a depreciable asset. Recall that companies record plant assets at cost, in accordance with the cost principle. 2. Useful life. Useful life is an estimate of the expected productive life, also called service life, of the asset. Useful life may be expressed in terms of time, units of activity (such as machine hours), or units of output. Useful life is an estimate. In making the estimate, management considers such factors as the intended use of the asset, its expected repair and maintenance, and its vulnerability to obsolescence. Past experience with similar assets is often helpful in deciding on expected useful life. We might reasonably expect Rent-A-Wreck and Avis to use different estimated useful lives for their vehicles. 3. Salvage value. Salvage value is an estimate of the asset’s value at the end of its useful life. This value may be based on the asset’s worth as scrap or on its expected trade-in value. Like useful life, salvage value is an estimate. In making the estimate, management considers how it plans to dispose of the asset and its experience with similar assets. Illustration 9-6 summarizes the three factors used in computing depreciation. A LT E R N AT I V E TERMINOLOGY Another term sometimes used for salvage value is residual value. Illustration 9-6 Three factors in computing depreciation Cost: all expenditures necessary to acquire the asset and make it ready for intended use Useful life: estimate of the expected life based on need for repair, service life, and vulnerability to obsolescence Salvage value: estimate of , the asset s value at the end of its useful life HELPFUL HINT Depreciation expense is reported on the income statement. Accumulated depreciation is reported on the balance sheet as a deduction from plant assets. Depreciation Methods Depreciation is generally computed using one of the following methods: 1. Straight-line 2. Units-of-activity 3. Declining-balance STUDY OBJECTIVE 3 Compute periodic depreciation using different methods. JWCL165_c09_396-443.qxd 404 8/4/09 9:39 PM Page 404 Chapter 9 Plant Assets, Natural Resources, and Intangible Assets Each method is acceptable under generally accepted accounting principles. Management selects the method(s) it believes to be appropriate. The objective is to select the method that best measures an asset’s contribution to revenue over its useful life. Once a company chooses a method, it should apply it consistently over the useful life of the asset. Consistency enhances the comparability of financial statements. Depreciation affects the balance sheet through accumulated depreciation and the income statement through depreciation expense. We will compare the three depreciation methods using the following data for a small delivery truck purchased by Barb’s Florists on January 1, 2011. Illustration 9-7 Delivery truck data Cost Expected salvage value Estimated useful life in years Estimated useful life in miles $13,000 $ 1,000 5 100,000 Illustration 9-8 (in the margin) shows the use of the primary depreciation methods in 600 of the largest companies in the United States. 88% Straight-line 2% Declining-balance 3% Units-of-activity 7% Other Illustration 9-8 Use of depreciation methods in 600 large U.S. companies Illustration 9-9 Formula for straight-line method STRAIGHT-LINE Under the straight-line method, companies expense the same amount of depreciation for each year of the asset’s useful life. It is measured solely by the passage of time. In order to compute depreciation expense under the straight-line method, companies need to determine depreciable cost. Depreciable cost is the cost of the asset less its salvage value. It represents the total amount subject to depreciation. Under the straight-line method, to determine annual depreciation expense, we divide depreciable cost by the asset’s useful life. Illustration 9-9 shows the computation of the first year’s depreciation expense for Barb’s Florists. Cost ⴚ $13,000  Salvage Value $1,000 ⴝ  Depreciable Cost $12,000 Annual Depreciable ⴜ Useful Life ⴝ Depreciation Cost (in years) Expense $12,000  5  $2,400 Alternatively, we also can compute an annual rate of depreciation. In this case, the rate is 20% (100%  5 years). When a company uses an annual straight-line rate, it applies the percentage rate to the depreciable cost of the asset. Illustration 9-10 (page 405) shows a depreciation schedule using an annual rate. This illustration indicates that the depreciation expense of $2,400 is the same each year. The book value (computed as cost minus accumulated depreciation) at the end of the useful life is equal to the expected $1,000 salvage value. 4:20 PM Page 405 Depreciation $12,000 12,000 12,000 12,000 12,000 ⴝ Accumulated Depreciation Book Value $2,400 2,400 2,400 2,400 2,400 $ 2,400 4,800 7,200 9,600 12,000 $10,600* 8,200 5,800 3,400 1,000 20% 20 20 20 20 *Book value  Cost  Accumulated depreciation  ($13,000  $2,400). $2,400 2013 2011 2012 2013 2014 2015 ⴛ End of Year Annual Depreciation Expense 2012 Year Depreciation Rate 2011 Computation Depreciable Cost Illustration 9-10 Straight-line depreciation schedule Depreciation Expense BARB’S FLORISTS 405 2015 7/31/09 2014 JWCL165_c09_396-443.qxd Year What happens to these computations for an asset purchased during the year, rather than on January 1? In that case, it is necessary to prorate the annual depreciation on a time basis. If Barb’s Florists had purchased the delivery truck on April 1, 2011, the company would own the truck for nine months of the first year (April–December). Thus, depreciation for 2011 would be $1,800 ($12,000  20%  9/12 of a year). The straight-line method predominates in practice. Such large companies as Campbell Soup, Marriott, and General Mills use the straight-line method. It is simple to apply, and it matches expenses with revenues when the use of the asset is reasonably uniform throughout the service life. For simplicity, Rent-A-Wreck is probably using the straight-line method of depreciation for its vehicles. UNITS-OF-ACTIVITY Under the units-of-activity method, useful life is expressed in terms of the total units of production or use expected from the asset, rather than as a time period. The units-of-activity method is ideally suited to factory machinery. Manufacturing companies can measure production in units of output or in machine hours. This method can also be used for such assets as delivery equipment (miles driven) and airplanes (hours in use). The units-of-activity method is generally not suitable for buildings or furniture, because depreciation for these assets is more a function of time than of use. To use this method, companies estimate the total units of activity for the entire useful life, and then divide these units into depreciable cost.The resulting number represents the depreciation cost per unit.The depreciation cost per unit is then applied to the units of activity during the year to determine the annual depreciation expense. To illustrate, assume that Barb’s Florists drives its delivery truck 15,000 miles in the first year. Illustration 9-11 shows the units-of-activity formula and the computation of the first year’s depreciation expense. Depreciable ⴜ Cost $12,000  Total Units of Activity 100,000 miles Depreciation ⴝ Cost per Unit  $0.12 Depreciable Units of Annual Cost per ⴛ Activity during ⴝ Depreciation Unit the Year Expense $0.12  15,000 miles  $1,800 A LT E R N AT I V E TERMINOLOGY Another term often used is the units-of-production method. HELPFUL HINT Under any method, depreciation stops when the asset’s book value equals expected salvage value. Illustration 9-11 Formula for units-of-activity method JWCL165_c09_396-443.qxd 406 7/31/09 4:20 PM Page 406 Chapter 9 Plant Assets, Natural Resources, and Intangible Assets The units-of-activity depreciation schedule, using assumed mileage, is as follows. Year BARB’S FLORISTS 2015 Computation 2014 2013 2012 $5,000 $4,000 $3,000 $2,000 $1,000 0 2011 Depreciation Expense Illustration 9-12 Units-of-activity depreciation schedule Year Units of Activity 2011 2012 2013 2014 2015 15,000 30,000 20,000 25,000 10,000 ⴛ Depreciation Cost/Unit $0.12 0.12 0.12 0.12 0.12 ⴝ End of Year Annual Depreciation Expense Accumulated Depreciation Book Value $1,800 3,600 2,400 3,000 1,200 $ 1,800 5,400 7,800 10,800 12,000 $11,200* 7,600 5,200 2,200 1,000 *($13,000  $1,800). This method is easy to apply for assets purchased mid-year. In such a case, the company computes the depreciation using the productivity of the asset for the partial year. The units-of-activity method is not nearly as popular as the straight-line method (see Illustration 9-8, page 404), primarily because it is often difficult for companies to reasonably estimate total activity. However, some very large companies, such as Chevron and Boise Cascade (a forestry company), do use this method. When the productivity of an asset varies significantly from one period to another, the units-of-activity method results in the best matching of expenses with revenues. DECLINING-BALANCE The declining-balance method produces a decreasing annual depreciation expense over the asset’s useful life. The method is so named because the periodic depreciation is based on a declining book value (cost less accumulated depreciation) of the asset. With this method, companies compute annual depreciation expense by multiplying the book value at the beginning of the year by the declining-balance depreciation rate. The depreciation rate remains constant from year to year, but the book value to which the rate is applied declines each year. At the beginning of the first year, book value is the cost of the asset. This is so because the balance in accumulated depreciation at the beginning of the asset’s useful life is zero. In subsequent years, book value is the difference between cost and accumulated depreciation to date. Unlike the other depreciation methods, the declining-balance method does not use depreciable cost. That is, it ignores salvage value in determining the amount to which the declining-balance rate is applied. Salvage value, however, does limit the total depreciation that can be taken. Depreciation stops when the asset’s book value equals expected salvage value. A common declining-balance rate is double the straight-line rate. The method is often called the double-declining-balance method. If Barb’s Florists uses the double-declining-balance method, it uses a depreciation rate of 40% (2  the straight-line rate of 20%). Illustration 9-13 shows the declining-balance formula and the computation of the first year’s depreciation on the delivery truck. Illustration 9-13 Formula for decliningbalance method Book Value DecliningAnnual at Beginning ⴛ Balance ⴝ Depreciation of Year Rate Expense $13,000  40%  $5,200 JWCL165_c09_396-443.qxd 7/31/09 4:20 PM Page 407 Depreciation 407 The depreciation schedule under this method is as follows. $5,200 3,120 1,872 1,123 685* $ 5,200 8,320 10,192 11,315 12,000 $7,800 4,680 2,808 1,685 1,000 40% 40 40 40 40 *Computation of $674 ($1,685  40%) is adjusted to $685 in order for book value to equal salvage value. $5,000 $4,000 $3,000 $2,000 $1,000 0 2015 Book Value 2014 $13,000 7,800 4,680 2,808 1,685 ⴝ Accumulated Depreciation 2013 2011 2012 2013 2014 2015 ⴛ End of Year Annual Depreciation Expense 2012 Year Depreciation Rate 2011 Computation Book Value Beginning of Year Illustration 9-14 Double-declining-balance depreciation schedule Depreciation Expense BARB’S FLORISTS Year The delivery equipment is 69% depreciated ($8,320  $12,000) at the end of the second year. Under the straight-line method, the truck would be depreciated 40% ($4,800  $12,000) at that time. Because the declining-balance method produces higher depreciation expense in the early years than in the later years, it is considered an accelerated-depreciation method. The declining-balance method is compatible with the expense recognition principle. It matches the higher depreciation expense in early years with the higher benefits received in these years. It also recognizes lower depreciation expense in later years, when the asset’s contribution to revenue is less. Some assets lose usefulness rapidly because of obsolescence. In these cases, the declining-balance method provides the most appropriate depreciation amount. When a company purchases an asset during the year, it must prorate the first year’s declining-balance depreciation on a time basis. For example, if Barb’s Florists had purchased the truck on April 1, 2011, depreciation for 2011 would become $3,900 ($13,000  40%  9/12). The book value at the beginning of 2012 is then $9,100 ($13,000  $3,900), and the 2012 depreciation is $3,640 ($9,100  40%). Subsequent computations would follow from those amounts. HELPFUL HINT The method recommended for an asset that is expected to be significantly more productive in the first half of its useful life is the decliningbalance method. COMPARISON OF METHODS Illustration 9-15 compares annual and total depreciation expense under each of the three methods for Barb’s Florists. Year 2011 2012 2013 2014 2015 StraightLine $ 2,400 2,400 2,400 2,400 2,400 $12,000 Units-ofActivity $ 1,800 3,600 2,400 3,000 1,200 $12,000 DecliningBalance $ 5,200 3,120 1,872 1,123 685 $12,000 Annual depreciation varies considerably among the methods, but total depreciation is the same for the five-year period under all three methods. Each method is acceptable in accounting, because each recognizes in a rational and systematic manner the decline in service potential of the asset. Illustration 9-16 (page 408) graphs the depreciation expense pattern under each method. Illustration 9-15 Comparison of depreciation methods JWCL165_c09_396-443.qxd 408 7/31/09 4:20 PM Page 408 Chapter 9 Plant Assets, Natural Resources, and Intangible Assets Illustration 9-16 Patterns of depreciation Depreciation Expense Key: Straight-line Declining-balance Units-of-activity $5,000 $4,000 $3,000 $2,000 $1,000 0 2011 2012 2013 2014 2015 Year Depreciation and Income Taxes The Internal Revenue Service (IRS) allows corporate taxpayers to deduct depreciation expense when they compute taxable income. However, the IRS does not require the taxpayer to use the same depreciation method on the tax return that is used in preparing financial statements. Many corporations use straight-line in their financial statements to maximize net income. At the same time, they use a special accelerated-depreciation method on their tax returns to minimize their income taxes. Taxpayers must use on their tax returns either the straight-line method or a special accelerated-depreciation method called the Modified Accelerated Cost Recovery System (MACRS). Revising Periodic Depreciation Depreciation is one example of the use of estimation in the accounting process. Management should periodically review annual depreciation Describe the procedure for expense. If wear and tear or obsolescence indicate that annual depreciarevising periodic depreciation. tion estimates are inadequate or excessive, the company should change the amount of depreciation expense. When a change in an estimate is required, the company makes the change in current and future years. It does not change depreciation in prior periods. The rationale is that continual restatement of prior periods would adversely affect confidence in financial statements. To determine the new annual depreciation expense, the company first comHELPFUL HINT putes the asset’s depreciable cost at the time of the revision. It then allocates the reUse a step-by-step vised depreciable cost to the remaining useful life. approach: (1) determine To illustrate, assume that Barb’s Florists decides on January 1, 2014, to extend the new depreciable cost; (2) divide by remaining useful life of the truck one year because of its excellent condition. The company has useful life. used the straight-line method to depreciate the asset to date, and book value is $5,800 ($13,000  $7,200). The new annual depreciation is $1,600, computed as follows. STUDY OBJECTIVE 4 Illustration 9-17 Revised depreciation computation Book value, 1/1/14 Less: Salvage value $5,800 1,000 Depreciable cost $4,800 Remaining useful life 3 years Revised annual depreciation ($4,800 ⴜ 3) $1,600 (2014–2016) JWCL165_c09_396-443.qxd 8/4/09 9:39 PM Page 409 Expenditures During Useful Life 409 Barb’s Florists makes no entry for the change in estimate. On December 31, 2014, during the preparation of adjusting entries, it records depreciation expense of $1,600. Companies must describe in the financial statements significant changes in estimates. before you go on... Do it! On January 1, 2011, Iron Mountain Ski Corporation purchased a new snowgrooming machine for $50,000. The machine is estimated to have a 10-year life with a $2,000 salvage value. What journal entry would Iron Mountain Ski Corporation make at December 31, 2011, if it uses the straight-line method of depreciation? Solution Depreciation expense  Cost  Salvage value $50,000  $2,000   $4,800 Useful life 10 The entry to record the first year’s depreciation would be: Dec. 31 Depreciation Expense Accumulated Depreciation (To record annual depreciation on snowgrooming machine) Straight-Line Depreciation Action Plan • Calculate depreciable cost (CostSalvage value). • Divide the depreciable cost by the estimated useful life. 4,800 4,800 Related exercise material: BE9-3, BE9-4, BE9-5, BE9-6, BE9-7, E9-5, E9-6, E9-7, E9-8, and Do it! 9-2. ✓ The Navigator EXPENDITURES DURING USEFUL LIFE During the useful life of a plant asset, a company may incur costs for ordiSTUDY OBJECTIVE 5 nary repairs, additions, or improvements. Ordinary repairs are expendi- Distinguish between revenue and tures to maintain the operating efficiency and productive life of the unit. capital expenditures, and explain They usually are fairly small amounts that occur frequently. Examples are the entries for each. motor tune-ups and oil changes, the painting of buildings, and the replacing of worn-out gears on machinery. Companies record such repairs as debits to Repair (or Maintenance) Expense as they are incurred. Because they are immediately charged as an expense against revenues, these costs are often referred to as revenue expenditures. Additions and improvements are costs incurred to increase the operETHICS NOTE ating efficiency, productive capacity, or useful life of a plant asset. They are WorldCom perpetrated usually material in amount and occur infrequently. Additions and imthe largest accounting fraud in provements increase the company’s investment in productive facilities. history by treating $7 billion Companies generally debit these amounts to the plant asset affected. They of “line costs” as capital are often referred to as capital expenditures. Most major U.S. corporations expenditures. Line costs are disclose annual capital expenditures. rental payments to access other Companies must use good judgment in deciding between a revenue ex- companies’ networks. Like any penditure and capital expenditure. For example, assume that Rodriguez Co. other rental payment, they purchases a number of wastepaper baskets.Although the proper accounting should have been expensed as would appear to be to capitalize and then depreciate these wastepaper bas- incurred. Instead, capitalization kets over their useful life, it would be more usual for Rodriguez to expense delayed expense recognition to them immediately. This practice is justified on the basis of materiality. future periods and thus boosted Materiality refers to the impact of an item’s size on a company’s financial current-period profits. JWCL165_c09_396-443.qxd 410 7/31/09 4:20 PM Page 410 Chapter 9 Plant Assets, Natural Resources, and Intangible Assets operations. The materiality principle states that if an item would not make a difference in decision making, the company does not have to follow GAAP in reporting that item. PLANT ASSET DISPOSALS Companies dispose of plant assets in three ways—retirement, sale, or exchange—as Illustration 9-18 shows. Whatever the method, at the time of Explain how to account for the disposal the company must determine the book value of the plant asset. disposal of a plant asset. As noted earlier, book value is the difference between the cost of a plant asset and the accumulated depreciation to date. STUDY OBJECTIVE 6 Piper Co. Lowy Co. Piper Co. Lowy Co. Retirement Sale Exchange Equipment is scrapped or discarded. Equipment is sold to another party. Existing equipment is traded for new equipment. Illustration 9-18 Methods of plant asset disposal At the time of disposal, the company records depreciation for the fraction of the year to the date of disposal. The book value is then eliminated by (1) debiting (decreasing) Accumulated Depreciation for the total depreciation to date, and (2) crediting (decreasing) the asset account for the cost of the asset. In this chapter we examine the accounting for the retirement and sale of plant assets. In the appendix to the chapter we discuss and illustrate the accounting for exchanges of plant assets. Retirement of Plant Assets A  L  SE 32,000 32,000 Cash Flows no effect HELPFUL HINT When a company disposes of a plant asset, the company must remove from the accounts all amounts related to the asset. This includes the original cost in the asset account and the total depreciation to date in the accumulated depreciation account. To illustrate the retirement of plant assets, assume that Hobart Enterprises retires its computer printers, which cost $32,000. The accumulated depreciation on these printers is $32,000. The equipment, therefore, is fully depreciated (zero book value). The entry to record this retirement is as follows. Accumulated Depreciation—Printing Equipment Printing Equipment (To record retirement of fully depreciated equipment) 32,000 32,000 What happens if a fully depreciated plant asset is still useful to the company? In this case, the asset and its accumulated depreciation continue to be reported on the balance sheet, without further depreciation adjustment, until the company retires the asset. Reporting the asset and related accumulated depreciation on the balance sheet informs the financial statement reader that the asset is still in use. Once fully depreciated, no additional depreciation should be taken, even if an asset is still being used. In no situation can the accumulated depreciation on a plant asset exceed its cost. If a company retires a plant asset before it is fully depreciated, and no cash is received for scrap or salvage value, a loss on disposal occurs. For example, assume JWCL165_c09_396-443.qxd 8/4/09 9:39 PM Page 411 Plant Asset Disposals 411 that Sunset Company discards delivery equipment that cost $18,000 and has accumulated depreciation of $14,000. The entry is as follows. A Accumulated Depreciation—Delivery Equipment Loss on Disposal Delivery Equipment (To record retirement of delivery equipment at a loss)  L  SE 14,000 14,000 4,000 4,000 Exp 18,000 18,000 Cash Flows no effect Companies report a loss on disposal in the “Other expenses and losses” section of the income statement. Sale of Plant Assets In a disposal by sale, the company compares the book value of the asset with the proceeds received from the sale. If the proceeds of the sale exceed the book value of the plant asset, a gain on disposal occurs. If the proceeds of the sale are less than the book value of the plant asset sold, a loss on disposal occurs. Only by coincidence will the book value and the fair market value of the asset be the same when the asset is sold. Gains and losses on sales of plant assets are therefore quite common. For example, Delta Airlines reported a $94,343,000 gain on the sale of five Boeing B727-200 aircraft and five Lockheed L-1011-1 aircraft. GAIN ON DISPOSAL To illustrate a gain, assume that on July 1, 2011, Wright Company sells office furniture for $16,000 cash. The office furniture originally cost $60,000. As of January 1, 2011, it had accumulated depreciation of $41,000. Depreciation for the first six months of 2011 is $8,000. Wright records depreciation expense and updates accumulated depreciation to July 1 with the following entry. A July 1 Depreciation Expense Accumulated Depreciation—Office Furniture (To record depreciation expense for the first 6 months of 2011)  L  SE 8,000 Exp 8,000 8,000 8,000 Cash Flows no effect After the accumulated depreciation balance is updated, the company computes the gain or loss. Illustration 9-19 shows this computation for Wright Company, which has a gain on disposal of $5,000. Cost of office furniture Less: Accumulated depreciation ($41,000  $8,000) Book value at date of disposal Proceeds from sale Gain on disposal $60,000 49,000 11,000 16,000 $ 5,000 Illustration 9-19 Computation of gain on disposal JWCL165_c09_396-443.qxd 412 8/4/09 9:39 PM Page 412 Chapter 9 Plant Assets, Natural Resources, and Intangible Assets Wright records the sale and the gain on disposal as follows. A  L  SE July 1 16,000 49,000 60,000 5,000 Rev Cash Flows Cash Accumulated Depreciation—Office Furniture Office Furniture Gain on Disposal (To record sale of office furniture at a gain) 16,000 49,000 60,000 5,000 16,000 Companies report a gain on disposal in the “Other revenues and gains” section of the income statement. LOSS ON DISPOSAL Assume that instead of selling the office furniture for $16,000, Wright sells it for $9,000. In this case, Wright computes a loss of $2,000 as follows. Illustration 9-20 Computation of loss on disposal Cost of office furniture Less: Accumulated depreciation Book value at date of disposal Proceeds from sale Loss on disposal $60,000 49,000 11,000 9,000 $ 2,000 Wright records the sale and the loss on disposal as follows. A  L  SE July 1 9,000 49,000 2,000 Exp 60,000 Cash Accumulated Depreciation—Office Furniture Loss on Disposal Office Furniture (To record sale of office furniture at a loss) 9,000 49,000 2,000 60,000 Cash Flows 9,000 Companies report a loss on disposal in the “Other expenses and losses” section of the income statement. before you go on... Plant Asset Disposal Action Plan • At the time of disposal, determine the book value of the asset. • Compare the asset’s book value with the proceeds received to determine whether a gain or loss has occurred. Do it! Overland Trucking has an old truck that cost $30,000, and it has accumulated depreciation of $16,000 on this truck. Overland has decided to sell the truck. (a) What entry would Overland Trucking make to record the sale of the truck for $17,000 cash? (b) What entry would Overland Trucking make to record the sale of the truck for $10,000 cash? Solution (a) Sale of truck for cash at a gain: Cash Accumulated Depreciation—Truck Truck Gain on Disposal [$17,000  ($30,000  $16,000)] (To record sale of truck at a gain) 17,000 16,000 30,000 3,000 JWCL165_c09_396-443.qxd 8/4/09 9:39 PM Page 413 Accounting for Natural Resources (b) Sale of truck for cash at a loss: Cash Loss on Disposal [$10,000  ($30,000  $16,000)] Accumulated Depreciation—Truck Truck (To record sale of truck at a loss) 10,000 4,000 16,000 30,000 Related exercise material: BE9-9, BE9-10, E9-9, E9-10, and Do it! 9-3. SECTION 2 413 ✓ Natural ResourcesH E L P F U L The Navigator HINT Natural resources consist of standing timber and underground deposits of oil, gas, and minerals.These long-lived productive assets have two distinguishing characteristics: (1) They are physically extracted in operations (such as mining, cutting, or pumping). (2) They are replaceable only by an act of nature. HELPFUL HINT On a balance sheet, natural resources may be described more specifically as timberlands, mineral deposits, oil reserves, and so on. ACCOUNTING FOR NATURAL RESOURCES The acquisition cost of a natural resource is the price needed to acquire STUDY OBJECTIVE 7 the resource and prepare it for its intended use. For an already-discovered Compute periodic depletion of resource, such as an existing coal mine, cost is the price paid for the property. natural resources. The allocation of the cost of natural resources to expense in a rational and systematic manner over the resource’s useful life is called depletion. (That is, depletion is to natural resources as depreciation is to plant assets.) Companies generally use the units-of-activity method (learned earlier in the chapter) to compute depletion. The reason is that depletion generally is a function of the units extracted during the year. Under the units-of-activity method, companies divide the total cost of the natural resource minus salvage value by the number of units estimated to be in the resource. The result is a depletion cost per unit of product.They then multiply the depletion cost per unit by the number of units extracted and sold.The result is the annual depletion expense. Illustration 9-21 shows the formula to compute depletion expense. Total Cost minus Salvage ⴜ Value Depletion Cost per Unit Total Estimated Units Depletion ⴝ Cost per Unit Illustration 9-21 Formula to compute depletion expense Number of Annual ⴛ Units Extracted ⴝ Depletion and Sold Expense To illustrate, assume that Lane Coal Company invests $5 million in a mine estimated to have 10 million tons of coal and no salvage value. In the first year, Lane extracts and sells 800,000 tons of coal. Using the formulas above, Lane computes the depletion expense as follows: $5,000,000  10,000,000  $0.50 depletion cost per ton $0.50  800,000  $400,000 annual depletion expense ETHICS NOTE Investors were stunned at news that Royal Dutch/Shell Group had significantly overstated its reported oil reserves—and perhaps had done so intentionally. JWCL165_c09_396-443.qxd 414 A 7/31/09 4:20 PM Page 414 Chapter 9 Plant Assets, Natural Resources, and Intangible Assets  L  SE 400,000 Exp Lane records depletion expense for the first year of operation as follows. Dec. 31 400,000 Cash Flows no effect Depletion Expense Accumulated Depletion (To record depletion expense on coal deposits) 400,000 400,000 FINANCIAL STATEMENT PRESENTATION The company reports the account Depletion Expense as a part of the cost of producing the product. Accumulated Depletion is a contra-asset account, similar to accumulated depreciation. It is deducted from the cost of the natural resource in the balance sheet, as Illustration 9-22 shows. Illustration 9-22 Statement presentation of accumulated depletion LANE COAL COMPANY Balance Sheet (partial) Coal mine Less: Accumulated depletion $5,000,000 400,000 $4,600,000 Many companies do not use an Accumulated Depletion account. In such cases, the company credits the amount of depletion directly to the natural resources account. Sometimes, a company will extract natural resources in one accounting period but not sell them until a later period. In this case, the company does not expense the depletion until it sells the resource. It reports the amount not sold as inventory in the current assets section. SECTION 3 Intangible Assets Intangible assets are rights, privileges, and competitive advantages that result from the ownership of long-lived assets that do not possess physical substance. Evidence of intangibles may exist in the form of contracts or licenses. Intangibles may arise from the following sources: 1. Government grants, such as patents, copyrights, and trademarks. 2. Acquisition of another business, in which the purchase price includes a payment for the company’s favorable attributes (called goodwill). 3. Private monopolistic arrangements arising from contractual agreements, such as franchises and leases. Some widely known intangibles are Microsoft’s patents, McDonald’s franchises, Apple’s trade name iPod, J.K. Rowlings’ copyrights on the Harry Potter books, and the trademark Rent-A-Wreck in the Feature Story. ACCOUNTING FOR INTANGIBLE ASSETS Companies record intangible assets at cost. Intangibles are categorized as having either a limited life or an indefinite life. If an intangible has a Explain the basic issues related to limited life, the company allocates its cost over the asset’s useful life using accounting for intangible assets. a process similar to depreciation. The process of allocating the cost of intangibles is referred to as amortization. The cost of intangible assets with indefinite lives should not be amortized. STUDY OBJECTIVE 8 JWCL165_c09_396-443.qxd 7/31/09 4:20 PM Page 415 Types of Intangible Assets To record amortization of an intangible asset, a company increases (debits) Amortization Expense, and decreases (credits) the specific intangible asset. (Unlike depreciation, no contra account, such as Accumulated Amortization, is usually used.) Intangible assets are typically amortized on a straight-line basis. For example, the legal life of a patent is 20 years. Companies amortize the cost of a patent over its 20-year life or its useful life, whichever is shorter. To illustrate the computation of patent amortization, assume that National Labs purchases a patent at a cost of $60,000. If National estimates the useful life of the patent to be eight years, the annual amortization expense is $7,500 ($60,000  8). National records the annual amortization as follows. HELPFUL HINT Amortization is to intangibles what depreciation is to plant assets and depletion is to natural resources. A Dec. 31 Amortization Expense—Patent Patent (To record patent amortization) 415  L  SE 7,500 Exp 7,500 7,500 Companies classify Amortization Expense—Patents as an operating expense in the income statement. There is a difference between intangible assets and plant assets in determining cost. For plant assets, cost includes both the purchase price of the asset and the costs incurred in designing and constructing the asset. In contrast, cost for an intangible asset includes only the purchase price. Companies expense any costs incurred in developing an intangible asset. TYPES OF INTANGIBLE ASSETS Patents A patent is an exclusive right issued by the U.S. Patent Office that enables the recipient to manufacture, sell, or otherwise control an invention for a period of 20 years from the date of the grant. A patent is nonrenewable. But companies can extend the legal life of a patent by obtaining new patents for improvements or other changes in the basic design. The initial cost of a patent is the cash or cash equivalent price paid to acquire the patent. The saying, “A patent is only as good as the money you’re prepared to spend defending it” is very true. Many patents are subject to litigation. Any legal costs an owner incurs in successfully defending a patent in an infringement suit are considered necessary to establish the patent’s validity. The owner adds those costs to the Patent account and amortizes them over the remaining life of the patent. The patent holder amortizes the cost of a patent over its 20-year legal life or its useful life, whichever is shorter. Companies consider obsolescence and inadequacy in determining useful life. These factors may cause a patent to become economically ineffective before the end of its legal life. Copyrights The federal government grants copyrights which give the owner the exclusive right to reproduce and sell an artistic or published work. Copyrights extend for the life of the creator plus 70 years. The cost of a copyright is the cost of acquiring and defending it. The cost may be only the $10 fee paid to the U.S. Copyright Office. Or it may amount to much more if an infringement suit is involved. The useful life of a copyright generally is significantly shorter than its legal life. Therefore, copyrights usually are amortized over a relatively short period of time. 7,500 Cash Flows no effect JWCL165_c09_396-443.qxd 416 7/31/09 4:20 PM Page 416 Chapter 9 Plant Assets, Natural Resources, and Intangible Assets Trademarks and Trade Names A trademark or trade name is a word, phrase, jingle, or symbol that identifies a particular enterprise or product. Trade names like Wheaties, Game Boy, Frappuccino, Kleenex, Windows, Coca-Cola, and Jeep create immediate product identification. They also generally enhance the sale of the product.The creator or original user may obtain exclusive legal right to the trademark or trade name by registering it with the U.S. Patent Office. Such registration provides 20 years of protection. The registration may be renewed indefinitely as long as the trademark or trade name is in use. If a company purchases the trademark or trade name, its cost is the purchase price. If a company develops and maintains the trademark or trade name, any costs related to these activities are expensed as incurred. Because trademarks and trade names have indefinite lives, they are not amortized. Franchises and Licenses When you fill up your tank at the corner Shell station, eat lunch at Taco Bell, or rent a car from Rent-A-Wreck, you are dealing with franchises. A franchise is a contractual arrangement between a franchisor and a franchisee. The franchisor grants the franchisee the right to sell certain products, provide specific services, or use certain trademarks or trade names, usually within a designated geographical area. Another type of franchise is that entered into between a governmental body (commonly municipalities) and a company.This franchise permits the company to use public property in performing its services. Examples are the use of city streets for a bus line or taxi service, use of public land for telephone and electric lines, and the use of airwaves for radio or TV broadcasting. Such operating rights are referred to as licenses. When a company can identify costs with the purchase of a franchise or license, it should recognize an intangible asset. Companies should amortize the cost of a limited-life franchise (or license) over its useful life. If the life is indefinite, the cost is not amortized. Annual payments made under a franchise agreement are recorded as operating expenses in the period in which they are incurred. ACCOUNTING ACROSS THE ORGANIZATION ESPN Wins Monday Night Football Franchise What is a well-known franchise worth? Recently ESPN outbid its rivals for the right to broadcast Monday Night Football. At a price of $1.1 billion per year— nearly twice what rival ABC paid in previous years—it isn’t clear who won and who lost. When bidding for a unique franchise like Monday Night Football, management must consider many factors to determine a price. As part of the deal, ESPN also got wireless rights and Spanish-language telecasts. By its estimation, ESPN will generate a profit of $200 million per year from Monday Night Football. ABC was losing $150 million per year. Another factor in the decision was ESPN management’s concern that if ESPN didn’t win the bid, a buyer would emerge that would use Monday Night Football as a launching pad for a new sports network. ESPN doesn’t want any more competitors than it already has. It is hard to put a price tag on the value of keeping the competition to a minimum. Source: Ronald Grover and Tom Lowry, “A Ball ESPN Couldn’t Afford to Drop,” BusinessWeek, May 2, 2005, p. 42. How should ESPN account for the $1.1 billion per year franchise fee? JWCL165_c09_396-443.qxd 8/4/09 9:39 PM Page 417 Research and Development Costs 417 Goodwill Usually, the largest intangible asset that appears on a company’s balance sheet is goodwill. Goodwill represents the value of all favorable attributes that relate to a company. These include exceptional management, desirable location, good customer relations, skilled employees, high-quality products, and harmonious relations with labor unions. Goodwill is unique: Unlike assets such as investments and plant assets, which can be sold individually in the marketplace, goodwill can be identified only with the business as a whole. If goodwill can be identified only with the business as a whole, how can its amount be determined? One could try to put a dollar value on the factors listed above (exceptional management, desirable location, and so on). But the results would be very subjective, and such subjective valuations would not contribute to the reliability of financial statements. Therefore, companies record goodwill only when an entire business is purchased. In that case, goodwill is the excess of cost over the fair market value of the net assets (assets less liabilities) acquired. In recording the purchase of a business, the company debits (increases) the net assets at their fair market values, credits (decreases) cash for the purchase price, and debits goodwill for the difference. Goodwill is not amortized (because it is considered to have an indefinite life). Companies report goodwill in the balance sheet under intangible assets. RESEARCH AND DEVELOPMENT COSTS Research and development costs are expenditures that may lead to patents, copyrights, new processes, and new products. Many companies spend considerable sums of money on research and development (R&D). For example, in a recent year IBM spent over $6.15 billion on R&D. Research and development costs present accounting problems. For one thing, it is sometimes difficult to assign the costs to specific projects. Also, there are uncertainties in identifying the extent and timing of future benefits. As a result, companies usually record R&D costs as an expense when incurred, whether the research and development is successful or not. To illustrate, assume that Laser Scanner Company spent $3 million on R&D. This expenditure resulted in two highly successful patents, obtained with $20,000 in lawyers’ fees. The company would add the lawyers’ fees to the patent account. The R&D costs, however, cannot be included in the cost of the patent. Instead, the company would record the R&D costs as an expense when incurred. Many disagree with this accounting approach. They argue that expensing R&D costs leads to understated assets and net income. Others, however, argue that capitalizing these costs will lead to highly speculative assets on the balance sheet. It is difficult to determine who is right.The controversy illustrates how difficult it can be to establish proper guidelines for financial reporting. HELPFUL HINT Research and development (R&D) costs are not intangible assets. But because they may lead to patents and copyrights, we discuss them in this section. before you go on... Do it! Match the statement with the term most directly associated with it. Copyright Intangible assets Research and development costs Depletion Franchise 1. _______ The allocation of the cost of a natural resource to expense in a rational and systematic manner. 2. _______ Rights, privileges, and competitive advantages that result from the ownership of long-lived assets that do not possess physical substance. Classification Concepts JWCL165_c09_396-443.qxd 418 7/31/09 4:20 PM Page 418 Chapter 9 Plant Assets, Natural Resources, and Intangible Assets Action Plan • Know that the accounting for intangibles often depends on whether the item has a finite or indefinite life. • Recognize the many similarities and differences between the accounting for natural resources, plant assets, and intangible assets. 3. _______ An exclusive right granted by the federal government to reproduce and sell an artistic or published work. 4. ________ A right to sell certain products or services or to use certain trademarks or trade names within a designated geographic area. 5. ________ Costs incurred by a company that often lead to patents or new products. These costs must be expensed as incurred. Solution 1. Depletion 2. Intangible assets 3. Copyright 4. Franchise 5. Research and development costs Related exercise material: BE9-11, BE9-12, E9-11, E9-12, E9-13, and Do it! 9-4. ✓ The Navigator STATEMENT PRESENTATION AND ANALYSIS Presentation Usually companies combine plant assets and natural resources under “Property, plant, and equipment” in the balance sheet. They show intangiIndicate how plant assets, natural bles separately. Companies disclose either in the balance sheet or the resources, and intangible assets notes the balances of the major classes of assets, such as land, buildings, are reported. and equipment, and accumulated depreciation by major classes or in total. In addition, they should describe the depreciation and amortization methods that were used, as well as disclose the amount of depreciation and amortization expense for the period. Illustration 9-23 shows the financial statement presentation of property, plant, and equipment and intangibles by The Procter & Gamble Company (P&G) in its 2008 balance sheet.The notes to P&G’s financial statements present greater details about the accounting for its long-term tangible and intangible assets. STUDY OBJECTIVE 9 Illustration 9-23 P&G’s presentation of property, plant, and equipment, and intangible assets THE PROCTER & GAMBLE COMPANY Balance Sheet (partial) (in millions) June 30 2008 2007 Property, plant, and equipment Buildings Machinery and equipment Land $ 7,052 30,145 889 $ 6,380 27,492 849 Accumulated depreciation 38,086 (17,446) 34,721 (15,181) 20,640 19,540 59,767 34,233 56,552 33,626 $94,000 $90,178 Net property, plant, and equipment Goodwill and other intangible assets Goodwill Trademarks and other intangible assets, net Net goodwill and other intangible assets JWCL165_c09_396-443.qxd 8/4/09 9:39 PM Page 419 Statement Presentation and Analysis 419 Illustration 9-24 shows another comprehensive presentation of property, plant, and equipment, from the balance sheet of Owens-Illinois. The notes to the financial statements of Owens-Illinois identify the major classes of property, plant, and equipment. They also indicate that depreciation and amortization are by the straight-line method, and depletion is by the units-of-activity method. Illustration 9-24 Owens-Illinois’ presentation of property, plant, and equipment, and intangible assets OWENS-ILLINOIS, INC. Balance Sheet (partial) (in millions) Property, plant, and equipment Timberlands, at cost, less accumulated depletion Buildings and equipment, at cost Less: Accumulated depreciation $ 95.4 $2,207.1 1,229.0 978.1 Total property, plant, and equipment Intangibles Patents $1,073.5 410.0 Total $1,483.5 Analysis Using ratios, we can analyze how efficiently a company uses its assets to generate sales. The asset turnover ratio analyzes the productivity of a company’s assets. It tells us how many dollars of sales a company generates for each dollar invested in assets. This ratio is computed by dividing net sales by average total assets for the period. The formula in Illustration 9-25 shows the computation of the asset turnover ratio for The Procter & Gamble Company. P&G’s net sales for 2008 were $83,503 million. Its total ending assets were $143,992 million, and beginning assets were $138,014 million. Net Sales ⴜ $83,503  Average Total Assets Asset Turnover ⴝ Ratio $143,992  $138,014  2 .59 times Thus, each dollar invested in assets produced $0.59 in sales for P&G. If a company is using its assets efficiently, each dollar of assets will create a high amount of sales. This ratio varies greatly among different industries—from those that are asset intensive (utilities) to those that are not (services). Be sure to read all about Y *U Buying a Wreck of Your Own on page 420 for information on how topics in this chapter apply to your personal life. Illustration 9-25 Asset turnover formula and computation JWCL165_c09_396-443.qxd 7/31/09 4:20 PM all about Y Page 420 *U Buying a Wreck of Your Own T The opening story to this chapter discusses car rental company Rent-A-Wreck. Recall that Rent-A-Wreck determined it can maximize its profitability by buying and renting used, rather than new, cars. What about you? Could you maximize your economic wellbeing by buying a used car rather than a new one? * *About the Numbers There are many costs to consider in deciding whether to buy a new or used car. These costs include the down payment, monthly loan payments, insurance, maintenance and repair costs, and state (department of motor vehicle) fees. The graph below compares the total costs over five years for the typical new versus used car. Cost of Car Ownership Some Facts * There are approximately 250 million vehicles in operation in the U.S. Around the world, there were 806 million cars and light trucks on the road in 2007. Currently, these vehicles burn over 260 billion gallons of fuel yearly. * In the U.S., the 2008 car and light-truck market dropped diamatically, to approximately 13.2 million units, down by about 2.9 million from 2007. First-Year Expenses $30k Total Five-Year Expenses Adjusted Five-Year Expenses (Allowing for equity in owned vehicle) $25k $20k $15k * The cost of an average new car is about $22,000. The price of the average used car is now about $13,900. * Financial institutions typically require a down payment of at least 10% of the value of a vehicle on a vehicle loan. Thus, the average new car will require a much higher down payment. However, interest rates on used-car loans are higher than on new-car loans. * To stimulate car sales, individuals can generally deduct fees and taxes on the purchase price of a qualified new car, light truck, motor home, or motorcycle. * A new car typically loses at least 30% of its value during the first two years, and about 40 to 50% after three years. Some brands maintain their value better than others. * To keep monthly car payments down, car companies will now provide financing for up to six years. (It used to be two or three years.) With such a long loan, you might end up “upside down on the loan”—that is, you might actually owe more money than the car is worth if you decide to sell the car before the end of the loan. $10k $5k New Used Source for graph: Phillip Reed, “Compare the Costs: Buying vs. Leasing vs. Buying a Used Car,” www.edmunds.com/advice/buying/articles/47079/article.html (accessed May 2006). *What Do You Think? Should you buy a new car? YES: I have enough stress in my life. I don’t want to worry about my car breaking down—and if it does break down, I want it to be covered by a warranty. Besides, I have an image to maintain—I don’t want to be seen in anything less than the latest styling and the latest technology. NO: I’m a college student, and I need to keep my costs down. Also, used cars are a lot more dependable than they used to be. In addition, my selfimage is strong enough that I don’t need a fancy new car to feel good about myself (despite what the car advertisements say). Source: Michelle Krebs, “Should You Buy New or Used?” www.cars.com/go/advice, May 3, 2005. 420 * The authors’ comments on this situation appear on page 443. JWCL165_c09_396-443.qxd 8/4/09 9:39 PM Page 421 Comprehensive Do it! Comprehensive Do it! 421 1 DuPage Company purchases a factory machine at a cost of $18,000 on January 1, 2011. DuPage expects the machine to have a salvage value of $2,000 at the end of its 4-year useful life. During its useful life, the machine is expected to be used 160,000 hours.Actual annual hourly use was: 2011, 40,000; 2012, 60,000; 2013, 35,000; and 2014, 25,000. Instructions Prepare depreciation schedules for the following methods: (a) straight-line, (b) units-of-activity, and (c) declining-balance using double the straight-line rate. Solution to Comprehensive Do it! 1 (a) Straight-Line Method Computation Year Depreciable Cost* 2011 2012 2013 2014 $16,000 16,000 16,000 16,000 Depreciation Rate ⴛ ⴝ 25% 25% 25% 25% End of Year Annual Depreciation Expense Accumulated Depreciation $4,000 4,000 4,000 4,000 $ 4,000 8,000 12,000 16,000 Book Value $14,000** 10,000 6,000 2,000 *$18,000  $2,000. **$18,000  $4,000. (b) Units-of-Activity Method Computation Year Units of Activity 2011 2012 2013 2014 40,000 60,000 35,000 25,000 Depreciation Cost/Unit ⴛ ⴝ $0.10* 0.10 0.10 0.10 End of Year Annual Depreciation Expense Accumulated Depreciation Book Value $4,000 6,000 3,500 2,500 $ 4,000 10,000 13,500 16,000 $14,000 8,000 4,500 2,000 *($18,000  $2,000)  160,000. (c) Declining-Balance Method Computation Year Book Value Beginning of Year 2011 2012 2013 2014 $18,000 9,000 4,500 2,250 ⴛ Depreciation Rate* 50% 50% 50% 50% ⴝ Annual Depreciation Expense $9,000 4,500 2,250 250** End of Year Accumulated Depreciation Book Value $ 9,000 13,500 15,750 16,000 $9,000 4,500 2,250 2,000 *1⁄4  2. **Adjusted to $250 because ending book value should not be less than expected salvage value. ✓ The Navigator Action Plan • Under the straight-line method, apply the depreciation rate to depreciable cost. • Under the units-of-activity method, compute the depreciation cost per unit by dividing depreciable cost by total units of activity. • Under the declining-balance method, apply the depreciation rate to the book value at the beginning of the year. JWCL165_c09_396-443.qxd 422 7/31/09 4:20 PM Page 422 Chapter 9 Plant Assets, Natural Resources, and Intangible Assets Comprehensive Do it! 2 On January 1, 2011, Skyline Limousine Co. purchased a limo at an acquisition cost of $28,000. The vehicle has been depreciated by the straight-line method using a 4-year service life and a $4,000 salvage value. The company’s fiscal year ends on December 31. Instructions Action Plan • At the time of disposal, determine the book value of the asset. • Recognize any gain or loss from disposal of the asset. • Remove the book value of the asset from the records by debiting Accumulated Depreciation for the total depreciation to date of disposal and crediting the asset account for the cost of the asset. Prepare the journal entry or entries to record the disposal of the limousine assuming that it was: (a) Retired and scrapped with no salvage value on January 1, 2015. (b) Sold for $5,000 on July 1, 2014. Solution to Comprehensive (a) (b) 1/1/15 7/1/14 Do it! 2 Accumulated Depreciation—Limousine Loss on Disposal Limousine (To record retirement of limousine) Depreciation Expense Accumulated Depreciation—Limousine (To record depreciation to date of disposal) Cash Accumulated Depreciation—Limousine Loss on Disposal Limousine (To record sale of limousine) 24,000 4,000 28,000 3,000 3,000 5,000 21,000 2,000 28,000 ✓ The Navigator SUMMARY OF STUDY OBJECTIVES 1 Describe how the cost principle applies to plant assets. The cost of plant assets includes all expenditures necessary to acquire the asset and make it ready for its intended use. Cost is measured by the cash or cash equivalent price paid. 2 Explain the concept of depreciation. Depreciation is the allocation of the cost of a plant asset to expense over its useful (service) life in a rational and systematic manner. Depreciation is not a process of valuation, nor is it a process that results in an accumulation of cash. 3 Compute periodic depreciation using different methods. Three depreciation methods are: Method Straight-line Effect on Annual Depreciation Units-ofactivity Constant amount Varying amount Decliningbalance Decreasing amount Formula Depreciable cost  Useful life (in years) Depreciation cost per unit  Units of activity during the year Book value at beginning of year  Decliningbalance rate 4 Describe the procedure for revising periodic depreciation. Companies make revisions of periodic depreciation in present and future periods, not retroactively. They determine the new annual depreciation by dividing the depreciable cost at the time of the revision by the remaining useful life. 5 Distinguish between revenue and capital expenditures, and explain the entries for each. Companies incur revenue expenditures to maintain the operating efficiency and productive life of an asset. They debit these expenditures to Repair Expense as incurred. Capital expenditures increase the operating efficiency, productive capacity, or expected useful life of the asset. Companies generally debit these expenditures to the plant asset affected. 6 Explain how to account for the disposal of a plant asset. The accounting for disposal of a plant asset through retirement or sale is as follows: (a) Eliminate the book value of the plant asset at the date of disposal. (b) Record cash proceeds, if any. (c) Account for the difference between the book value and the cash proceeds as a gain or loss on disposal. 7 Compute periodic depletion of natural resources. Companies compute depletion cost per unit by dividing the JWCL165_c09_396-443.qxd 7/31/09 4:20 PM Page 423 Glossary total cost of the natural resource minus salvage value by the number of units estimated to be in the resource. They then multiply the depletion cost per unit by the number of units extracted and sold. 8 Explain the basic issues related to accounting for intangible assets. The process of allocating the cost of an intangible asset is referred to as amortization. The cost of intangible assets with indefinite lives are not amortized. Companies normally use the straight-line method for amortizing intangible assets. 9 Indicate how plant assets, natural resources, and intangible assets are reported. Companies usually 423 combine plant assets and natural resources under property, plant, and equipment; they show intangibles separately under intangible assets. Either within the balance sheet or in the notes, companies should disclose the balances of the major classes of assets, such as land, buildings, and equipment, and accumulated depreciation by major classes or in total. They also should describe the depreciation and amortization methods used, and should disclose the amount of depreciation and amortization expense for the period. The asset turnover ratio measures the productivity of a company’s assets in generating sales. ✓ The Navigator GLOSSARY Accelerated-depreciation method Depreciation method that produces higher depreciation expense in the early years than in the later years. (p. 407). Additions and improvements Costs incurred to increase the operating efficiency, productive capacity, or useful life of a plant asset. (p. 409). Amortization The allocation of the cost of an intangible asset to expense over its useful life in a systematic and rational manner. (p. 414). Asset turnover ratio A measure of how efficiently a company uses its assets to generate sales; calculated as net sales divided by average total assets. (p. 419). Capital expenditures Expenditures that increase the company’s investment in productive facilities. (p. 409). Copyright Exclusive grant from the federal government that allows the owner to reproduce and sell an artistic or published work. (p. 415). Declining-balance method Depreciation method that applies a constant rate to the declining book value of the asset and produces a decreasing annual depreciation expense over the useful life of the asset. (p. 406). Depletion The allocation of the cost of a natural resource to expense in a rational and systematic manner over the resource’s useful life. (p. 413). Depreciation The process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systematic manner. (p. 402). Depreciable cost The cost of a plant asset less its salvage value. (p. 404). Franchise (license) A contractual arrangement under which the franchisor grants the franchisee the right to sell certain products, provide specific services, or use certain trademarks or trade names, usually within a designated geographical area. (p. 416). Going-concern assumption States that the company will continue in operation for the foreseeable future. (p. 403). Goodwill The value of all favorable attributes that relate to a business enterprise. (p. 417). Intangible assets Rights, privileges, and competitive advantages that result from the ownership of long-lived assets that do not possess physical substance. (p. 414). Licenses Operating rights to use public property, granted to a business enterprise by a governmental agency. (p. 416). Materiality principle If an item would not make a difference in decision making, a company does not have to follow GAAP in reporting it. (p. 410). Natural resources Assets that consist of standing timber and underground deposits of oil, gas, or minerals. (p. 413). Ordinary repairs Expenditures to maintain the operating efficiency and productive life of the unit. (p. 409). Patent An exclusive right issued by the U.S. Patent Office that enables the recipient to manufacture, sell, or otherwise control an invention for a period of 20 years from the date of the grant. (p. 415). Plant assets Tangible resources that are used in the operations of the business and are not intended for sale to customers. (p. 398). Research and development (R&D) costs Expenditures that may lead to patents, copyrights, new processes, or new products. (p. 417). Revenue expenditures Expenditures that are immediately charged against revenues as an expense. (p. 409). Salvage value An estimate of an asset’s value at the end of its useful life. (p. 403). Straight-line method Depreciation method in which periodic depreciation is the same for each year of the asset’s useful life. (p. 404). Trademark (trade name) A word, phrase, jingle, or symbol that identifies a particular enterprise or product. (p. 416). Units-of-activity method Depreciation method in which useful life is expressed in terms of the total units of production or use expected from an asset. (p. 405). Useful life An estimate of the expected productive life, also called service life, of an asset. (p. 403). JWCL165_c09_396-443.qxd 424 7/31/09 4:20 PM Page 424 Chapter 9 Plant Assets, Natural Resources, and Intangible Assets Exchange of Plant Assets APPENDIX Ordinarily, companies record a gain or loss on the exchange of plant assets. The rationale for recognizing a gain or loss is that most exchanges Explain how to account for the have commercial substance. An exchange has commercial substance if the exchange of plant assets. future cash flows change as a result of the exchange. To illustrate, Ramos Co. exchanges some of its equipment for land held by Brodhead Inc. It is likely that the timing and amount of the cash flows arising from the land will differ significantly from the cash flows arising from the equipment. As a result, both Ramos and Brodhead are in different economic positions. Therefore the exchange has commercial substance, and the companies recognize a gain or loss in the exchange. Because most exchanges have commercial substance (even when similar assets are exchanged), we illustrate only this type of situation, for both a loss and a gain. STUDY OBJECTIVE 10 Loss Treatment To illustrate an exchange that results in a loss, assume that Roland Company exchanged a set of used trucks plus cash for a new semi-truck.The used trucks have a combined book value of $42,000 (cost $64,000 less $22,000 accumulated depreciation). Roland’s purchasing agent, experienced in the second-hand market, indicates that the used trucks have a fair market value of $26,000. In addition to the trucks, Roland must pay $17,000 for the semi-truck. Roland computes the cost of the semi-truck as follows. Illustration 9A-1 Cost of semi-truck Fair value of used trucks Cash paid Cost of semi-truck $26,000 17,000 $43,000 Roland incurs a loss on disposal of $16,000 on this exchange. The reason is that the book value of the used trucks is greater than the fair market value of these trucks. The computation is as follows. Illustration 9A-2 Computation of loss on disposal A  L  SE 43,000 22,000 16,000 Exp 64,000 17,000 Cash Flows 17,000 Book value of used trucks ($64,000  $22,000) Fair market value of used trucks Loss on disposal $42,000 26,000 $16,000 In recording an exchange at a loss, three steps are required: (1) Eliminate the book value of the asset given up, (2) record the cost of the asset acquired, and (3) recognize the loss on disposal. Roland Company thus records the exchange on the loss as follows. Semi-truck Accumulated Depreciation—Used Trucks Loss on Disposal Used Trucks Cash (To record exchange of used trucks for semi-truck) 43,000 22,000 16,000 64,000 17,000 Gain Treatment To illustrate a gain situation, assume that Mark Express Delivery decides to exchange its old delivery equipment plus cash of $3,000 for new delivery equipment. The book JWCL165_c09_396-443.qxd 8/4/09 9:39 PM Page 425 Self-Study Questions 425 value of the old delivery equipment is $12,000 (cost $40,000 less accumulated depreciation $28,000). The fair market value of the old delivery equipment is $19,000. The cost of the new asset is the fair market value of the old asset exchanged plus any cash paid (or other consideration given up). The cost of the new delivery equipment is $22,000 computed as follows. Fair market value of old delivery equipment Cash paid Cost of new delivery equipment Illustration 9A-3 Cost of new delivery equipment $19,000 3,000 $22,000 A gain results when the fair market value of the old delivery equipment is greater than its book value. For Mark Express there is a gain of $7,000 on disposal, computed as follows. Fair market value of old delivery equipment Book value of old delivery equipment ($40,000  $28,000) Gain on disposal Illustration 9A-4 Computation of gain on disposal $19,000 12,000 $ 7,000 Mark Express Delivery records the exchange as follows. Delivery Equipment (new) Accumulated Depreciation—Delivery Equipment (old) Delivery Equipment (old) Gain on Disposal Cash (To record exchange of old delivery equipment for new delivery equipment) 22,000 28,000 A 40,000 7,000 3,000  L  SE 22,000 28,000 40,000 7,000 Rev 3,000 Cash Flows In recording an exchange at a gain, the following three steps are involved: (1) Eliminate the book value of the asset given up, (2) record the cost of the asset acquired, and (3) recognize the gain on disposal. Accounting for exchanges of plant assets becomes more complex if the transaction does not have commercial substance. This issue is discussed in more advanced accounting classes. 3,000 SUMMARY OF STUDY OBJECTIVE FOR APPENDIX 10 Explain how to account for the exchange of plant assets. Ordinarily companies record a gain or loss on the exchange of plant assets. The rationale for recognizing a gain or loss is that most exchanges have commercial substance. An exchange has commercial substance if the future cash flows change as a result of the exchange. *Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter. SELF-STUDY QUESTIONS (SO 1) Answers are at the end of the chapter. 1. Erin Danielle Company purchased equipment and incurred the following costs. Cash price $24,000 Sales taxes 1,200 Insurance during transit 200 Installation and testing 400 Total costs $25,800 What amount should be recorded as the cost of the equipment? a. $24,000. c. $25,400. b. $25,200. d. $25,800. 2. Depreciation is a process of: (SO 2) a. valuation. b. cost allocation. c. cash accumulation. d. appraisal. JWCL165_c09_396-443.qxd 426 (SO 3) (SO 3) (SO 3) (SO 4) (SO 4) (SO 5) (SO 6) 7/31/09 4:20 PM Page 426 Chapter 9 Plant Assets, Natural Resources, and Intangible Assets 3. Micah Bartlett Company purchased equipment on January 1, 2010, at a total invoice cost of $400,000. The equipment has an estimated salvage value of $10,000 and an estimated useful life of 5 years. The amount of accumulated depreciation at December 31, 2011, if the straightline method of depreciation is used, is: a. $80,000. b. $160,000. c. $78,000. d. $156,000. 4. Ann Torbert purchased a truck for $11,000 on January 1, 2010. The truck will have an estimated salvage value of $1,000 at the end of 5 years. Using the units-of-activity method, the balance in accumulated depreciation at December 31, 2011, can be computed by the following formula: a. ($11,000  Total estimated activity)  Units of activity for 2011. b. ($10,000  Total estimated activity)  Units of activity for 2011. c. ($11,000  Total estimated activity)  Units of activity for 2010 and 2011. d. ($10,000  Total estimated activity)  Units of activity for 2010 and 2011. 5. Jefferson Company purchased a piece of equipment on January 1, 2011. The equipment cost $60,000 and had an estimated life of 8 years and a salvage value of $8,000. What was the depreciation expense for the asset for 2012 under the double-declining-balance method? a. $6,500. b. $11,250. c. $15,000. d. $6,562. 6. When there is a change in estimated depreciation: a. previous depreciation should be corrected. b. current and future years’ depreciation should be revised. c. only future years’ depreciation should be revised. d. None of the above. 7. Able Towing Company purchased a tow truck for $60,000 on January 1, 2011. It was originally depreciated on a straight-line basis over 10 years with an assumed salvage value of $12,000. On December 31, 2013, before adjusting entries had been made, the company decided to change the remaining estimated life to 4 years (including 2013) and the salvage value to $2,000. What was the depreciation expense for 2013? a. $6,000. b. $4,800. c. $15,000. d. $12,100. 8. Additions to plant assets are: a. revenue expenditures. b. debited to a Repair Expense account. c. debited to a Purchases account. d. capital expenditures. 9. Bennie Razor Company has decided to sell one of its old manufacturing machines on June 30, 2011. The machine was purchased for $80,000 on January 1, 2007, and was de- preciated on a straight-line basis for 10 years assuming no salvage value. If the machine was sold for $26,000, what was the amount of the gain or loss recorded at the time of the sale? a. $18,000. b. $54,000. c. $22,000. d. $46,000. 10. Maggie Sharrer Company expects to extract 20 million (SO 7) tons of coal from a mine that cost $12 million. If no salvage value is expected, and 2 million tons are mined and sold in the first year, the entry to record depletion will include a: a. debit to Accumulated Depletion of $2,000,000. b. credit to Depletion Expense of $1,200,000. c. debit to Depletion Expense of $1,200,000. d. credit to Accumulated Depletion of $2,000,000. 11. Which of the following statements is false? (SO 8) a. If an intangible asset has a finite life, it should be amortized. b. The amortization period of an intangible asset can exceed 20 years. c. Goodwill is recorded only when a business is purchased. d. Research and development costs are expensed when incurred, except when the research and development expenditures result in a successful patent. 12. Martha Beyerlein Company incurred $150,000 of research (SO 8) and development costs in its laboratory to develop a patent granted on January 2, 2011. On July 31, 2011, Beyerlein paid $35,000 for legal fees in a successful defense of the patent. The total amount debited to Patents through July 31, 2011, should be: a. $150,000. b. $35,000. c. $185,000. d. $170,000. (SO 9) 13. Indicate which of the following statements is true. a. Since intangible assets lack physical substance, they need be disclosed only in the notes to the financial statements. b. Goodwill should be reported as a contra-account in the owner’s equity section. c. Totals of major classes of assets can be shown in the balance sheet, with asset details disclosed in the notes to the financial statements. d. Intangible assets are typically combined with plant assets and natural resources and shown in the property, plant, and equipment section. 14. Lake Coffee Company reported net sales of $180,000, net (SO 9) income of $54,000, beginning total assets of $200,000, and ending total assets of $300,000. What was the company’s asset turnover ratio? a. 0.90 b. 0.20 c. 0.72 d. 1.39 JWCL165_c09_396-443.qxd 7/31/09 4:20 PM Page 427 Questions 427 (SO 10) *15. Schopenhauer Company exchanged an old machine, with *16. In exchanges of assets in which the exchange has commer- (SO 10) a book value of $39,000 and a fair market value of $35,000, and paid $10,000 cash for a similar new machine. The transaction has commercial substance. At what amount should the machine acquired in the exchange be recorded on Schopenhauer’s books? a. $45,000. b. $46,000. c. $49,000. d. $50,000. cial substance: a. neither gains nor losses are recognized immediately. b. gains, but not losses, are recognized immediately. c. losses, but not gains, are recognized immediately. d. both gains and losses are recognized immediately. Go to the book’s companion website, www.wiley.com/college/weygandt, for Additional Self-Study Questions. ✓ The Navigator QUESTIONS 1. Tim Hoover is uncertain about the applicability of the cost principle to plant assets. Explain the principle to Tim. 2. What are some examples of land improvements? 3. Dain Company acquires the land and building owned by Corrs Company. What types of costs may be incurred to make the asset ready for its intended use if Dain Company wants to use (a) only the land, and (b) both the land and the building? 4. In a recent newspaper release, the president of Keene Company asserted that something has to be done about depreciation. The president said, “Depreciation does not come close to accumulating the cash needed to replace the asset at the end of its useful life.” What is your response to the president? 5. Robert is studying for the next accounting examination. He asks your help on two questions: (a) What is salvage value? (b) Is salvage value used in determining periodic depreciation under each depreciation method? Answer Robert’s questions. 6. Contrast the straight-line method and the units-of-activity method as to (a) useful life, and (b) the pattern of periodic depreciation over useful life. 7. Contrast the effects of the three depreciation methods on annual depreciation expense. 8. In the fourth year of an asset’s 5-year useful life, the company decides that the asset will have a 6-year service life. How should the revision of depreciation be recorded? Why? 9. Distinguish between revenue expenditures and capital expenditures during useful life. 10. How is a gain or loss on the sale of a plant asset computed? 11. Mendez Corporation owns a machine that is fully depreciated but is still being used. How should Mendez account for this asset and report it in the financial statements? 12. What are natural resources, and what are their distinguishing characteristics? 13. Explain what depletion is and how it is computed. 14. What are the similarities and differences between the terms depreciation, depletion, and amortization? 15. Pendergrass Company hires an accounting intern who says that intangible assets should always be amortized over their legal lives. Is the intern correct? Explain. 16. Goodwill has been defined as the value of all favorable attributes that relate to a business enterprise. What types of attributes could result in goodwill? 17. Kenny Sain, a business major, is working on a case problem for one of his classes. In the case problem, the company needs to raise cash to market a new product it developed. Joe Morris, an engineering major, takes one look at the company’s balance sheet and says, “This company has an awful lot of goodwill. Why don’t you recommend that they sell some of it to raise cash?” How should Kenny respond to Joe? 18. Under what conditions is goodwill recorded? 19. Often research and development costs provide companies with benefits that last a number of years. (For example, these costs can lead to the development of a patent that will increase the company’s income for many years.) However, generally accepted accounting principles require that such costs be recorded as an expense when incurred. Why? 20. McDonald’s Corporation reports total average assets of $28.9 billion and net sales of $20.5 billion. What is the company’s asset turnover ratio? 21. Resco Corporation and Yapan Corporation operate in the same industry. Resco uses the straight-line method to account for depreciation; Yapan uses an accelerated method. Explain what complications might arise in trying to compare the results of these two companies. 22. Lopez Corporation uses straight-line depreciation for financial reporting purposes but an accelerated method for tax purposes. Is it acceptable to use different methods for the two purposes? What is Lopez’s motivation for doing this? 23. You are comparing two companies in the same industry. You have determined that May Corp. depreciates its plant assets over a 40-year life, whereas Won Corp. depreciates its plant assets over a 20-year life. Discuss the implications this has for comparing the results of the two companies. 24. Wade Company is doing significant work to revitalize its warehouses. It is not sure whether it should capitalize these costs or expense them. What are the implications for current-year net income and future net income of expensing versus capitalizing these costs? JWCL165_c09_396-443.qxd 428 7/31/09 4:20 PM Page 428 Chapter 9 Plant Assets, Natural Resources, and Intangible Assets 25. What classifications and amounts are shown in *27. Tatum Refrigeration Company trades in an old machine PepsiCo’s Note 4 to explain its total property, plant, and on a new model when the fair market value of the old equipment (net) of $11,663 million? machine is greater than its book value. The transaction has commercial substance. Should Tatum recognize a gain on dis*26. When assets are exchanged in a transaction involving posal? If the fair market value of the old machine is less than commercial substance, how is the gain or loss on disposal its book value, should Tatum recognize a loss on disposal? computed? BRIEF EXERCISES Determine the cost of land. (SO 1) Determine the cost of a truck. (SO 1) Compute straight-line depreciation. (SO 3) Compute depreciation and evaluate treatment. (SO 3) Compute declining-balance depreciation. (SO 3) Compute depreciation using the units-of-activity method. (SO 3) Compute revised depreciation. (SO 4) Prepare entries for delivery truck costs. (SO 5) BE9-1 The following expenditures were incurred by Obermeyer Company in purchasing land: cash price $70,000, accrued taxes $3,000, attorneys’ fees $2,500, real estate broker’s commission $2,000, and clearing and grading $3,500. What is the cost of the land? BE9-2 Neeley Company incurs the following expenditures in purchasing a truck: cash price $30,000, accident insurance $2,000, sales taxes $1,500, motor vehicle license $100, and painting and lettering $400. What is the cost of the truck? BE9-3 Conlin Company acquires a delivery truck at a cost of $42,000. The truck is expected to have a salvage value of $6,000 at the end of its 4-year useful life. Compute annual depreciation for the first and second years using the straight-line method. BE9-4 Ecklund Company purchased land and a building on January 1, 2011. Management’s best estimate of the value of the land was $100,000 and of the building $200,000. But management told the accounting department to record the land at $220,000 and the building at $80,000. The building is being depreciated on a straight-line basis over 20 years with no salvage value. Why do you suppose management requested this accounting treatment? Is it ethical? BE9-5 Depreciation information for Conlin Company is given in BE9-3. Assuming the declining-balance depreciation rate is double the straight-line rate, compute annual depreciation for the first and second years under the declining-balance method. BE9-6 Speedy Taxi Service uses the units-of-activity method in computing depreciation on its taxicabs. Each cab is expected to be driven 150,000 miles. Taxi no. 10 cost $33,500 and is expected to have a salvage value of $500. Taxi no. 10 is driven 30,000 miles in year 1 and 20,000 miles in year 2. Compute the depreciation for each year. BE9-7 On January 1, 2011, the Ramirez Company ledger shows Equipment $29,000 and Accumulated Depreciation $9,000. The depreciation resulted from using the straight-line method with a useful life of 10 years and salvage value of $2,000. On this date, the company concludes that the equipment has a remaining useful life of only 4 years with the same salvage value. Compute the revised annual depreciation. BE9-8 Firefly Company had the following two transactions related to its delivery truck. 1. Paid $45 for an oil change. 2. Paid $400 to install special shelving units, which increase the operating efficiency of the truck. Prepare Firefly’s journal entries to record these two transactions. Prepare entries for disposal by retirement. (SO 6) Prepare entries for disposal by sale. (SO 6) Prepare depletion expense entry and balance sheet presentation for natural resources. (SO 7) BE9-9 Prepare journal entries to record the following. (a) Gomez Company retires its delivery equipment, which cost $41,000. Accumulated depreciation is a...
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