chapter 6 Plant Assets Copyright Barbara Chase/Corbis/AP Images Learning Goals waL80144_06_c06_135-154.indd 1 • Apply the principles of ordinary and necessary cost, along with other special rules related to capitalization of expenditures. • Understand conceptual and applied issues pertaining to alternative depreciation methods. • Know the principles that govern the accounting for asset-related expenditures subsequent to acquisition. • Record transactions related to the disposal of assets. • Understand the basic elements of accounting for natural resources and related depletion. • Understand the basic elements of accounting for intangibles and related amortization. 8/29/12 2:44 PM CHAPTER 6 Chapter Outline Chapter Outline 6.1 Ordinary and Necessary Costs Special Rules Materiality Issues Depreciation 6.2 Depreciation Methods The Straight-Line Method of Depreciation The Double-Declining-Balance Method of Depreciation The Units-of-Output Method of Depreciation Revisions in Depreciation Two Sets of Books? 6.3 Asset-Related Costs Subsequent to Acquisition Sale or Abandonment of Property, Plant, and Equipment Impairment Taking a “Big Bath” Natural Resources Intangible Assets Research and Development Costs Goodwill R emember that a classified balance sheet includes a separate category entitled Property, Plant, and Equipment. This section typically follows the Long-Term Investments section. Property, Plant, and Equipment (PP&E) should reflect only the physical assets that are used in the business’s production activities. This would include land, buildings, and equipment. Idle facilities or assets acquired for speculative purposes should be shown in long-term investments. Within the PP&E section, assets are usually listed according to their useful lives. Land is listed first because it has a permanent life and is followed by buildings, then equipment. Table 6.1 shows a typical balance sheet disclosure. Table 6.1: A typical balance sheet disclosure Land Buildings $ 250,000 $ 600,000 Less: Accumulated depreciation (150,000) Equipment $850,000 Less: Accumulated depreciation (550,000) 450,000 300,000 $1,000,000 This balance sheet section would appear within a company’s balance sheet, similar to Exhibit 6.1. 136 waL80144_06_c06_135-154.indd 2 8/29/12 2:44 PM waL80144_06_c06_135-154.indd 3 (150,000) $ 850,000 (550,000) Less: Accumulated depreciation Equipment Less: Accumulated depreciation Total Assets Receivable from employee Other Assets Goodwill Intangible Assets $ 600,000 Building and equipment Land Property, Plant, & Equip. Cash value of insurance Stock investments Long-term Investments 300,000 450,000 $ 250,000 40,000 $100,000 10,000 140,000 Inventories Prepaid insurance 250,000 Accounts receivable $ 100,000 10,000 350,000 1,000,000 140,000 500,000 $ 2,000,000 $ Total Liabilities and Equity Total stockholder’s Equity Retained earnings Capital stock Stockholder’s equity Total Liabilites Mortgage liabity Note payable Long-term Liabilities Current portion of note Taxes payable Interest payable Accounts payable Current Liabilities Current Assets Cash Liabilities Assets Mega Company Balance Sheet December 31, 20XX 980,000 $ 400,000 135,000 $ 235,000 119,000 12,000 5,000 $ 114,000 2,000,000 1,380,000 $ 620,000 370,000 $ 250,000 Section 6.1 Ordinary and Necessary Costs CHAPTER 6 Exhibit 6.1: Mega Company balance sheet 6.1 Ordinary and Necessary Costs T he amount of cost reported for an item of PP&E is the ordinary and necessary cost to get the item in place and in condition for its intended use. These costs are referred to as capital expenditures. Capital expenditures include the direct purchase price and the cost of permits, sales tax, freight, installation, and other usual costs to prepare the item for use. Costs that are not ordinary and necessary, such as repairing damage caused by an accident during installation of equipment, would be expensed. Sometimes, new 137 8/29/12 2:44 PM CHAPTER 6 Section 6.1 Ordinary and Necessary Costs machinery requires employee training on its use. Although there are a few exceptions, such costs are normally expensed as incurred. Equipment often has a list price, but the actual negotiated purchase price may be reduced by discounts and rebates. Perhaps you have purchased a car at less than the amount listed on the window sticker. Accountants use the negotiated price as the basis for accounting measurement, as will be apparent in the following example. The following journal entry illustrates the recording of a purchase of a new item of equipment. The equipment had a list price of $500,000 but a negotiated purchase price of $425,000. Sales tax was $3,000. Freight and normal installation costs totaled $25,000. The item was dropped during installation, and an additional $10,000 was spent to repair damage. 05-14-X3 Equipment 453,000.00 Repair Expense 10,000.00 Cash 463,000.00 Purchased equipment Special Rules If the preceding transaction was financed with debt rather than cash (i.e., credit Notes Payable), none of the interest cost would be added to the asset. Instead, interest is usually charged to Interest Expense as incurred. There is an exception for interest costs associated with debt that is used to finance construction of a particular asset; interest incurred during the active period of construction is added to the cost of the account (it is deemed to be an ordinary and necessary cost associated with the asset’s acquisition). The interest capitalization rules can be quite complex and are usually covered in advanced accounting courses. Certain costs normally accompany the acquisition of land, like title fees, legal fees, and surveys. Additional costs may be needed to ready the land for its intended use. Examples include zoning costs, drainage, and grading. Because these costs are ordinary and necessary, they may be added to the Land account. To illustrate, assume that Quantum Realty acquired a tract of land that it intended to develop into land for commercial use. A creek that meandered across the property adversely impacted the land. Quantum paid $1,000,000 for the land and incurred surveying costs of $40,000. It was necessary to obtain a floodplain permit costing $10,000, and an additional $150,000 was spent rerouting the creek into a channel. All these costs are considered to be ordinary and necessary to get the land in condition for its intended use, and the land should be recorded into the Land account as follows: 138 waL80144_06_c06_135-154.indd 4 8/29/12 2:44 PM CHAPTER 6 Section 6.2 Depreciation Methods 04-15-X5 Land 1,200,000.00 Cash 1,200,000.00 To record cost of land, including costs associated with surveys, permits, and grading Materiality Issues Look around your room and consider how many expenditures were for long-lived assets that were relatively minor in value—perhaps a trashcan, a telephone, a picture on the wall, and so forth. If your room were a business, would you capitalize those expenditures and depreciate them over their useful life? Or would you decide that the cost of record keeping exceeded the benefit? If so, you might choose to simply expense the cost as incurred (as many businesses do). The reason is materiality; no matter which way that you account for the cost, it is not apt to bear on anyone’s process about the company. Depreciation Once an asset’s cost has been appropriately determined, recorded, and appropriately posted to the ledger, it becomes necessary to depreciate the asset. As you may recall from Chapter 3, depreciation is not intended to value or revalue the asset. Instead, depreciation is the process of allocating an asset’s cost to all accounting periods benefited by the asset’s use (i.e., spread the cost over the asset’s service life). The number of periods benefited is known as the service life of the asset. Your determination of the service life of an asset will depend on professional judgment, taking into account facets such as the rate of the asset’s physical deterioration and the possibility of obsolescence. You should observe that service life might be completely different from physical life. For example, how many computers have you owned, and why did you replace an old one? In all likelihood, its service life to you had been exhausted, even though it was still physically functional. Some assets like land have a permanent life and are rarely depreciated. 6.2 Depreciation Methods R ecall from Chapter 5 that companies can use different inventory methods. This is also true for depreciation. The cost of an asset and its service life are important factors that will drive the depreciation amount, but you must also select a specific depreciation method. The method reflects the pattern by which the cost is allocated to specific periods. We will look at three specific techniques: (1) straight line, (2) double-declining balance, and (3) units of output. Before looking at the unique features of these methods, it is first necessary to learn a few more terms. You have already been made familiar with the concepts of cost and service life. You also need to know about salvage value. Salvage value is also called residual value and is the amount one expects to receive when selling or trading at the end of an asset’s service life. Salvage value is excluded from the amount to be depreciated. As such, the 139 waL80144_06_c06_135-154.indd 5 8/29/12 2:44 PM CHAPTER 6 Section 6.2 Depreciation Methods depreciable base is equal to cost minus the salvage value. At any point in time, an asset’s total cost minus accumulated depreciation to date can be referred to as the remaining net book value. The Straight-Line Method of Depreciation The straight-line method spreads the depreciable base over the service life, with an equal amount of depreciation assigned to each period. Each accounting period should bear an appropriate amount of depreciation. If the business produces monthly financial statements, this means that 1/12th of the annual amount should be allocated to each month for purposes of calculating business income. The following examples illustrate calculations of the annual depreciation expense, assuming the asset is acquired on the first day of the year. For assets not acquired on the first day of a year (i.e., most assets), a convention must be adopted. Thus, some business treat all assets acquired in the first half of the year as being acquired on the first day of the year (and assets acquired in the last half of the year as not being acquired until the last moment of the year). Other businesses are far more precise and allocate depreciation down to the number of days in use in a particular period. The annual charge for depreciation is determined by dividing the depreciable base by the service life. If an asset has a $550,000 cost, $50,000 salvage value, and a 5-year life, then annual depreciation would be equal to $100,000 [($550,000 2 $50,000)/5 years 5 $100,000]. Table 6.2 lists the amounts reported for each of the 5 years. Table 6.2: Annual depreciation expense and accumulated depreciation for 5 years Annual Depreciation Expense Accumulated Depreciation Year 1 $100,000 $100,000 Year 2 100,000 200,000 Year 3 100,000 300,000 Year 4 100,000 400,000 Year 5 100,000 500,000 The appropriate journal entry for each year would be as follows: 12-31-XX Depreciation Expense 100,000.00 Accumulated Depreciation 100,000.00 To record annual depreciation expense As a general rule, the annual depreciation would be included in each period’s income determination. Remember that Depreciation Expense is a temporary account that is closed each year. In contrast, Accumulated Depreciation is a real account appearing on the balance sheet. Its value builds over time (because the account is not closed), and the appropriate balance sheet presentation would be as follows at the end of year 4: 140 waL80144_06_c06_135-154.indd 6 8/29/12 2:44 PM CHAPTER 6 Section 6.2 Depreciation Methods Equipment $550,000 Less: Accumulated depreciation 400,000 $150,000 The Double-Declining-Balance Method of Depreciation The double-declining-balance (DDB) method “front loads” depreciation to the early periods of an asset’s service life. It is sometimes used when the service quality produced by an asset declines over time or if repair and maintenance costs tend to rise as an asset ages (i.e., the reducing depreciation charge is offset with a rising maintenance charge). Annual depreciation under the DDB method is determined by multiplying the beginningof-year net book value of an asset by twice the straight-line rate. Because net book value is decreasing, so is the annual depreciation charge. The mechanics of the DDB method is best shown with a simple example. Let’s return to our $550,000 asset with a 5-year life. First, the straight-line rate is 20% per year (one fifth each year), and twice that rate is 40%. Thus, the first year’s double-declining depreciation is 40% of $550,000 (we initially ignore salvage value with the DDB method), or $220,000. This leaves a remaining net book value of $330,000 ($550,000 2 $220,000), and the second year’s depreciation expense is only $132,000 ($330,000 3 40%). Table 6.3 lists the entire pattern of depreciation. Table 6.3: Entire pattern of depreciation Annual Depreciation Expense Accumulated Depreciation Illustrative Calculation Year 1 $220,000 $220,000 Year 2 132,000 352,000 ($550,000 2 $220,000) 3 40% Year 3 79,200 431,200 ($550,000 2 $352,000) 3 40% Year 4 47,520 478,720 ($550,000 2 $431,200) 3 40% Year 5 21,280 500,000 See text. $550,000 3 40% You probably noted how salvage was not reduced against the balance each year in the fundamental calculation of the DDB method. However, it is not ignored completely. In the year when calculated accumulated depreciation begins to exceed the depreciable base, depreciation is discontinued. In our example, this did not occur until the final year 5. Only $21,280 of depreciation was recorded in the final year (despite the fact that the DDB calculations return a higher value). The suspension of the recording of depreciation would occur anytime the accumulated amount of depreciation equals the depreciable base. This could occur well before the last year of use. 141 waL80144_06_c06_135-154.indd 7 8/29/12 2:44 PM CHAPTER 6 Section 6.2 Depreciation Methods The Units-of-Output Method of Depreciation In a limited number of circumstances, an asset’s consumption may be associated with a specific measure of use or output. Such would the case for an aircraft engine that might deliver a fixed number of flight hours before a mandatory replacement schedule. When this type of situation is encountered, accountants may resort to the units-of-output method of depreciation. To illustrate, assume that Sky Air uses a jet engine with a 50,000-hour life and $5,000,000 cost (and no salvage value). Sky Air’s hourly engine cost is $100 ($5,000,000450,000 hours). Table 6.4 shows the amount of depreciation to be recorded over the life of the engine (hours flown are assumed). Table 6.4: Depreciation over the life of an engine Hours Flown Hourly Rate Total Depreciation Year 1 10,000 $100 $1,000,000 Year 2 5,000 $100 500,000 Year 3 8,000 $100 800,000 Year 4 12,000 $100 1,200,000 Year 5 5,000 $100 500,000 Year 6 5,000 $100 500,000 Year 7 5,000 $100 500,000 50,000 $100 $5,000,000 During a month in which the engine is flown for 200 hours, the depreciation would be reported at $20,000 (200 hours 3 $100 per hour). The units-of-output method is like the straight-line method, but the unit of allocation is units of use rather than units of time. A simple method, it seems to produce a very systematic and rational cost allocation. Unfortunately, the cases in which it can be used are limited. Few assets have such a readily fixed and determinable life. Revisions in Depreciation The initial assumptions about useful life and residual value are subject to change. When this happens, accountants have to decide if the effects are sufficiently material to justify a revision in periodic depreciation. Perhaps after completing 5 years of use of an asset with an estimated life of 10 years, someone concludes that the asset will continue in use for 7 more years (bringing the total life to 12 years). This suggests that the annual expense for depreciation is less than originally thought. You may be thinking that you need to restate prior and future years’ depreciation. However, accounting rules take a simpler approach and deal with changes in estimates prospectively. This means that the accountant will revise accounting to adjust only current and future periods. In the case of depreciation, this occurs rather simply as shown in the following example. 142 waL80144_06_c06_135-154.indd 8 8/29/12 2:44 PM Section 6.3 Asset-Related Costs Subsequent to Acquisition CHAPTER 6 Assume that an asset costing $200,000 and having no salvage value was initially depreciated over 10 years. The annual charge for the first 5 years was $20,000 per year ($200,000/ 10 years), and totaled $100,000 ($20,000 per year 3 5 years). Early in the sixth year, the total life of the asset was concluded to be 12 years (in other words, 7 remaining years). Further, it was additionally concluded that the asset would now have a $30,000 salvage value. The revised annual depreciation would be $10,000 per year for the last 7 years of useful life. This amount is calculated by taking the remaining depreciable base of $70,000 ($200,000 cost minus accumulated depreciation of $100,000 and salvage value of $30,000) and spreading it evenly over the last 7 years of useful life. Two Sets of Books? You may have heard something about “keeping two sets of books.” Generally, this has a pejorative connotation and implies some form of deception. However, tax laws tend to be rather “friendly” by allowing companies to depreciate assets quickly—much faster than under generally accepted accounting principles (GAAP). The depreciation under the tax rules reduces taxable income and taxes due. Governments are usually pleased to grant this accelerated benefit in efforts to stimulate asset purchases and economic activity. Thus, it is not uncommon for a company’s tax depreciation to initially exceed the amounts allowed under GAAP. This necessarily entails a company keeping two sets of books—one for tax and one for accounting. This is not only not wrong but also absolutely necessary. If you continue to study accounting, you will discover that there are significant complexities associated with measuring and reporting assets and liabilities that have different tax and accounting treatments. For now, you just need to know that accounting and tax rules are not always the same. 6.3 Asset-Related Costs Subsequent to Acquisition Y ou probably know that the purchase price of an asset is not the only cost of ownership. In some cases, it is only the beginning. Consider your car. It must be fueled, insured, and maintained. Maintenance can include a variety of services like lubrication, tune-ups, shock absorbers, body work, and engine overhaul. Many business assets require such support, and that support can be very costly. Accountants need to account for such costs, and it becomes important to know whether such costs are capital expenditures or not. Remember that a capital expenditure would be recorded as an asset (i.e., debit the asset and credit Cash); if the cost is not a viewed as a capital expenditure, then it is recorded as an expense (i.e., debit the expense and credit Cash). Thus, assessing the nature of an assetrelated expenditure (capital in nature or not) becomes highly significant. Accountants have developed principles that should form the foundation for deciding if an asset-related expenditure is capital in nature. Simply stated, if an expenditure results in the extension of the service life of an asset or the quantity/quality of services expected from an asset are increased, then the cost is viewed as capital in nature. By default, if one or more of these criteria are not met, then the cost would be expensed as incurred. You must be careful not to conclude that routine operating costs meet these conditions. If an expenditure is intended to merely maintain normal operating condition (e.g., lubrication), it is not a capital expenditure; it is instead termed a revenue expenditure. 143 waL80144_06_c06_135-154.indd 9 8/29/12 2:44 PM Section 6.3 Asset-Related Costs Subsequent to Acquisition CHAPTER 6 The reason for the different treatment relates primarily to the number of periods benefited by an expenditure. The former (capital expenditure) generally describes costs that are regarded as attributable to multiple accounting periods, and the latter (revenue expenditure) is usually for benefits that are quickly consumed during the period in which the cost is incurred. Generalizing about all costs and all businesses is very difficult. For instance, new tires on a farmer’s tractor might last 20 years, but new tires on the farmer’s truck might last only 1 year. Thus, it is impossible to develop a uniform capitalization/expensing protocol. Judgment is always required, but Table 6.5 helps frame the concept with specific examples. Table 6.5: Examples of expenditures Capital Expenditure Revenue Expenditure Buying a new motor Tuning up a vehicle Replacing a parking lot Painting stripes in a parking lot Installing fire sprinkler system Test checking valves on a sprinkler system Buying new windows Cleaning windows Changing out faucets Replacing washers Installing new duct work for air conditioning Cleaning air filters Replacing carpet Cleaning carpet The manner in which capital expenditures are actually recorded in the journal can vary based on the nature of the outlay. Sometimes, a cost is designed to restore an asset to its original condition—for example, replacing a motor in a vehicle. In some ways, this can be seen as partially returning the asset to its new condition. These replacement outlays are usually “capitalized” by debiting Accumulated Depreciation (and crediting Cash), which has the effect of increasing the asset’s net book value. At other times, the capital expenditures may actually improve the asset beyond its original condition. For instance, adding a satellite navigation system to a ship that was previously only piloted by a human is actually a betterment beyond the original condition. Accordingly, the expenditure is normally added to the gross cost of the asset directly (debit Ship and credit Cash). Under some accounting systems, asset accounts are unitized. In other words, the cost of a building can be split between the building’s shell and the many improvements within (e.g., ventilation systems). For those systems, any betterment expenditures would likely be recorded into a separate account (e.g., Satellite Navigation System, rather than Ship). Sale or Abandonment of Property, Plant, and Equipment An item of property, plant, and equipment may be sold or abandoned. If the asset is abandoned for no consideration (e.g., taking it to the junk yard), the accounting process would be to record any unrecognized depreciation up to the date of abandonment and then remove the asset and accumulated depreciation from the accounts. For instance, assume that an asset costing $90,000, with a 90-month life, straight-line depreciation, and no salvage value is abandoned on April 30, 20X4. Further assume the asset is 80 months old and depreciation was last recorded on December 31, 20X3: 144 waL80144_06_c06_135-154.indd 10 8/29/12 2:44 PM CHAPTER 6 Section 6.3 Asset-Related Costs Subsequent to Acquisition 4-30-X4 Depreciation Expense 4,000.00 Accumulated Depreciation 4,000.00 To record depreciation for first 4 months of the year 04-30-X4 Accumulated Depreciation 80,000.00 Loss 10,000.00 Equipment 90,000.00 Abandoned equipment costing $90,000 and having accumulated depreciation of $80,000 Alternatively, if the same asset were instead sold for $25,000 cash, then a $15,000 gain would result. The following journal entries reveal how this occurs: 4-30-X4 Depreciation Expense 4,000.00 Accumulated Depreciation 4,000.00 To record depreciation for first 4 months of the year 04-30-X4 Accumulated Depreciation 80,000.00 Cash 25,000.00 Gain 15,000.00 Equipment 90,000.00 Sold equipment costing $90,000 and having accumulated depreciation of $80,000 for $25,000. It bears repeating that the preceding entries to dispose of an asset would only be recorded subsequent to a separate entry to update the depreciation accounting through the April 30 disposal date. Impairment An asset’s value may be diminished but not to the point of triggering an abandonment. In other words, the owner does not expect to generate cash flows from the asset sufficient to recover the recorded net book value. Very simply, the fair value of the asset is below its reported value. Accountants tend toward conservatism and try to avoid reporting assets at more than they are worth. Specific accounting rules provide a framework for measuring the amount of impairment. The amount of impairment is recorded as a loss (debit the loss and credit the asset). This approach results in reducing the asset’s reported value down to an amount that bears closer proximity to its value/recoverable amount. 145 waL80144_06_c06_135-154.indd 11 8/29/12 2:44 PM CHAPTER 6 Section 6.3 Asset-Related Costs Subsequent to Acquisition Taking a “Big Bath” This terminology is sometimes used to characterize significant one-time impairment losses. You may see this occur when a business has gone through a significant down period and is struggling to regain its footing. Coincident with such efforts, a business may evaluate all assets in use and conclude that some assets are impaired. This requires that the carrying value (i.e., the amount reported on the balance sheet) be reduced. Management has some degree of incentive to engage in this “bath.” Why? Given that this reduction in carrying value will produce an offsetting loss, isn’t this something that management might wish to avoid? The logic goes like this: Things are already bad, so where is the harm? And, more to the point, future periods’ income will be buoyed by this action because the reduction in carrying value will leave fewer assets that will need to be depreciated in the future. The reduction in future expenses increases the odds of an eventual return to profitability. Memories are short and management may hope that the “bath” will be forgotten once profitability is restored. Natural Resources So far, you may have envisioned productive assets as consisting primarily of buildings and machinery, but there are other categories to consider. An energy company may have a significant investment in oil and gas reserves, for example. Such natural resources can pertain to mineral deposits, timber, and countless other assets. There are many industryspecific accounting rules for unique natural resources, making it difficult to generalize about the accounting treatment. However, you should know that natural resources tend to be established in the accounting records at their acquisition cost, plus selected exploration and development costs. This recorded cost pool is then allocated to future accounting periods via periodic depletion charges. Depletion is like depreciation but relates to natural resources instead of buildings and equipment. The process of measuring depletion generally consists of dividing the resource’s total cost, less residual value, by the total expected units of output. This results in a per-unit depletion charge that is either assigned to depletion expense or inventory (if the extracted resource has not been delivered to an end customer). You can think of the depletion as a “first cousin” of units-of-output depreciation. To illustrate, assume that Copper River Mines invested a total of $1,000,000 in a mineral deposit and that amount is initially recorded into a Copper Ore account on its balance sheet. The deposit contained 500,000 tons of ore. Thus, the ore has a per-unit depletion cost of $2 ($1,000,0004500,000 tons). During 20X5, 100,000 tons of ore were extracted. Of this amount, 75,000 tons were sold, and 25,000 tons were loaded on a barge, awaiting sale to a customer. The total depletion amounts to $200,000 (100,000 tons  $2 per ton). Of the depletion, $150,000 would be expensed (75,000 tons  $2) and $50,000 (25,000  $2) would be carried as inventory. The following entry shows this allocation: 12-31-X5 Depletion Expense 150,000.00 Copper Inventory 50,000.00 Copper Ore 200,000.00 To reduce Copper Ore and allocate depletion to expense and inventory 146 waL80144_06_c06_135-154.indd 12 8/29/12 2:44 PM CHAPTER 6 Section 6.3 Asset-Related Costs Subsequent to Acquisition Intangible Assets Remember that a classified balance sheet also contains an area for reporting intangible assets. Recall that intangibles are resources that do not physically exist. Examples include patents, copyrights, trademarks, brands, franchises, and similar items. Some intangibles are internally developed, and some are purchased from others. As you would imagine, some of a company’s most important intangibles are ones that are not directly purchased from another party. Brands, trademarks, internally discovered concepts that result in patents, trade secrets, and so forth are significant assets that may take years to build up and often have very little specifically identified cost. Despite their tremendous value, these intangibles may not appear on a balance sheet. The cost principle generally requires that a recorded amount on a balance sheet be tied to the asset’s cost. Because the cost is negligible or hard to pinpoint, the result is that much of this value remains invisible. On the other hand, a company may acquire intangible rights from others. For example, one company may buy a copyright to an artist’s song. Such purchased intangibles are recorded at their cost. This cost is to be expensed over the shorter of its legal life or useful life. For instance, a patent has a 20-year legal life. But, in many cases, the economic value of a patent may benefit a shorter amount of time. The accountant must exercise considerable judgment to reach a conclusion on the accounting life of such assets. The process of expensing an intangible over time is called amortization. Amortization is not much different than depreciation or depletion; it is just the process of allocating cost to the benefited time periods. If an intangible has an indefinite life, the cost is not amortized at all, but the recorded cost will be periodically evaluated for impairment. To illustrate the accounting for intangibles, assume that Tremonton Medical purchased a patent for $100,000 and estimated the useful life to equal the 20-year legal life. The appropriate entries are as follows: 01-1-X5 Patent 100,000.00 Cash 100,000.00 Paid $100,000 to purchase a patent 12-31-X5 Amortization Expense 5,000.00 Patent 5,000.00 To record annual amortization expense ($100,000/20 years) Notice that the annual amortization entry credits the asset account directly. Intangibles are usually reported net of their accumulated amortization. Unlike with buildings and equipment, no accumulated amortization account is necessary. 147 waL80144_06_c06_135-154.indd 13 8/29/12 2:44 PM CHAPTER 6 Concept Check Research and Development Costs As noted, a company’s internally developed intangibles are not shown as assets. Under GAAP applicable in the United States, this concept is carried far. All costs that are classified as research and development (R&D) are to be expensed as incurred. These costs pertain to activities related to a planned search for new knowledge, product, or processes. You are probably aware, for instance, that pharmaceutical companies spend heavily in pursuit of new drugs. Many of these costs are likely to generate substantial future benefits. Nevertheless, their R&D costs are expensed each year, regardless of the likelihood of success of failure for a project. Thus, balance sheets are often void of some very significant intangible assets. You might find it interesting to note that the global accounting approach often varies from the U.S. approach, and some international companies do in fact report an R&D asset! Goodwill One way in which intangible business values are realized is when a business is sold. Then the purchaser will record the assets and liabilities of the acquired company at their fair value. The purchaser may, however, pay far more for the business than just the identifiable pieces are worth. In such case, the excess purchase price is recorded as unique intangible asset called goodwill. Simply, goodwill is the excess of the fair value of a company over the fair value of the identifiable elements. A buyer may be willing to pay the goodwill premium because of the acquired business’s favorable operating results over time, good reputation, location advantages, established customer base, and similar value propositions. When you see goodwill on a corporate balance sheet, it means that the company has purchased one or more businesses in the past and willingly paid a premium. Although goodwill is not amortized, accountants are required to evaluate it for impairment at least once each year. In other words, if the acquired business’s value has declined, it can become necessary to remove the goodwill from the balance sheet. Concept Check The following questions relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The answers appear on p. 236.) 1. A  company financed a land purchase by paying $120,000 cash and assuming a $100,000 mortgage payable. County fees to record the transfer of the land to the buyer totaled $150. Costs to clear the land of rocks and trees amounted to $850. What is the recorded cost of the land? a. $120,000 b. $220,000 c. $220,850 d. $221,000 2. Depreciation is a. a system of cost allocation, not valuation. b. a system of valuation. 148 waL80144_06_c06_135-154.indd 14 8/29/12 2:44 PM CHAPTER 6 Key Terms c. recorded in an effort to reduce assets to their fair market value. d. based on an asset’s cost and residual value but not service life. 3. A  machine that was purchased 4 years ago for $45,000 has an accumulated depreciation balance of $8,000 and a residual value of $5,000. Assuming use of straight-line depreciation, what is the machine’s estimated service life? a. 4 years b. 8 years c. 20 years d. Cannot be determined from the stated facts. 4. Tiger  Lines purchased and began depreciating a new truck on April 1, 20X4. The truck, which cost $60,000, had a 5-year service life and a $12,000 residual value. Assuming use of the double-declining-balance method, what is the 20X5 depreciation expense? a. $13,440 b. $14,400 c. $16,800 d. $18,000 5. Revising a depreciation rate because of a change in a service life estimate a. requires the correction of prior years’ financial statements. b. involves allocating the remaining depreciable base over the future years of use. c. requires that sufficient cash be available to replace the asset at the end of the new service life. d. is permitted only if the service life is shortened. Key Terms amortization The process of allocating cost to the benefited time periods. betterment A capital expenditure for an improvement. capital expenditures Ordinary and necessary costs such as direct purchase price and the cost of permits, sales tax, freight, installation, and other usual costs to prepare an item for use. changes in estimates To revise the accounting to adjust only current and future periods. DDB See double-declining-balance method. depletion Similar to depreciation but relates to natural resources instead of buildings and equipment. depreciable base The cost of an item of plant and equipment minus any residual value. double-declining-balance (DDB) method A method of depreciation that “front loads” depreciation to the early periods of an asset’s service life. goodwill The excess of the fair value of a company over the fair value of the identifiable elements. 149 waL80144_06_c06_135-154.indd 15 8/29/12 2:44 PM CHAPTER 6 Critical Thinking Questions materiality A concept dictating that an accountant must judge the impact and importance of a transaction to determine its proper handling in the accounting records. natural resources Materials—such as mineral deposits and timber—that are assets. net book value An asset’s total cost minus accumulated depreciation to date. R&D See research and development. replacement An outlay expenditure designed to restore an asset to its original condition. salvage value Also called residual value, the amount a business expects to receive when selling or trading at the end of an asset’s service life. service life The number of periods benefited in the life of an asset. straight-line method A method of depreciation that spreads the depreciable base over the service life, with an equal amount of depreciation assigned to each period. units-of-output method A method of depreciation when an asset’s consumption may be associated with a specific measure of use or output. research and development (R&D) Internally developed intangibles that are not assets. Critical Thinking Questions 1. Do all items of property, plant, and equipment have a useful life? Explain. 2. How is the acquisition cost of a machine determined? Which of the following items are included in the cost of an asset: purchase price, freight charges, cost of installation, medical costs of injured installer, special electrical wiring? 3. Explain the proper treatment of interest costs related to the purchase of a new automobile. 5. Contrast the accounting treatments for land and land improvements. 6. What does the term depreciation mean in accounting? Is the term used differently by others? Explain. 7. Define the term depreciable base. 8. Is  the units-of-output method of depreciation more appropriate to use for some items of plant and equipment than for others? Why? 9. How  does a change in the estimated remaining service life of a piece of equipment affect past and future depreciation amounts? 150 waL80144_06_c06_135-154.indd 16 8/29/12 2:44 PM CHAPTER 6 Exercises Exercises 1. Determining  acquisition cost. Well-Made Fabricating Company recently purchased a state-of-the-art metal-cutting tool. The invoice price was $300,000, which reflected a 25% trade discount from the $400,000 list price. Other data related to the machine were as follows: Freight and installation costs Cash discount for prompt payment of invoice Materials used during setup and initial testing Finger guards installed around cutting head Property taxes paid for first year of ownership Advertising brochure to inform customers of new cutting capabilities $9,500 3,000 800 2,500 4,500 1,500 a. Determine the cost at which the machine should be recorded. b. Briefly describe and justify the proper treatment of the items that you excluded in part (a). 2. Depreciation  methods. Betsy Ross Enterprises purchased a delivery van for $30,000 in January 20X7. The van was estimated to have a service life of 5 years and a residual value of $6,000. The company is planning to drive the van 20,000 miles annually. Compute depreciation expense for 20X8 by using each of the following methods: a. Units-of-output, assuming 17,000 miles were driven during 20X8 b. Straight-line c. Double-declining-balance 3. Depreciation  computations. Alpha Alpha Alpha, a college fraternity, purchased a new heavy-duty washing machine on January 1, 20X3. The machine, which cost $1,000, had an estimated residual value of $100 and an estimated service life of 4 years (1,800 washing cycles). Calculate the following: a. The machine’s book value on December 31, 20X5, assuming use of the straightline depreciation method b. Depreciation expense for 20X4, assuming use of the units-of-output depreciation method. Actual washing cycles in 20X4 totaled 500. c. Accumulated depreciation on December 31, 20X5, assuming use of the doubledeclining-balance depreciation method. 4. Depreciation  concepts. Evaluate the following comments as true or false. If the comment is false, briefly explain why. a. Depreciation is recorded over the years so that a company’s asset valuations are reduced to reflect lower market values. b. A depreciable asset’s cost, minus accumulated depreciation, equals book value. 151 waL80144_06_c06_135-154.indd 17 8/29/12 2:44 PM CHAPTER 6 Problems c. An asset’s depreciable base and book value are identical at the end of the asset’s service life. d. Straight-line depreciation is probably the most popular accelerated depreciation method used by businesses. Problems 1. Cost treatment. Consider the following costs of Shamrock Company: • • • • • • • • • • • • • • • • Cost of grading land prior to construction Cost of material used during trial runs of new machinery Delinquent property taxes on newly acquired land Damage to equipment, which occurred during installation Fine for fire code violation in building Freight charges on newly acquired equipment Cost of parking lot constructed on property Cost of three wastebaskets purchased for office use Cost of clearing land prior to construction Cost of purchasing used equipment Interest incurred to purchase machinery on credit Current property taxes on land and building Attorney’s fees for land and building purchase Construction costs of fence at company headquarters Construction costs of new building Cost of sprinkling system for landscaping Instructions a. Identify which of the preceding costs should be charged to asset accounts? b. For the costs that you identified in part (a), indicate which asset account(s) should be increased. 2. D  epreciation computations: change in estimate. Aussie Imports purchased a specialized piece of machinery for $50,000 on January 1, 20X3. At the time of acquisition, the machine was estimated to have a service life of 5 years (25,000 operating hours) and a residual value of $5,000. During the 5 years of operations (20X3220X7), the machine was used for 5,100, 4,800, 3,200, 6,000, and 5,900 hours, respectively. Instructions a. Compute depreciation for 20X3220X7 by using the following methods: straight line, units of output, and double-declining-balance. b. On January 1, 20X5, management shortened the remaining service life of the machine to 20 months. Assuming use of the straight-line method, compute the company’s depreciation expense for 20X5. c. Briefly describe what you would have done differently in part (a) if Aussie Imports had paid $47,800 for the machinery rather than $50,000 In addition, assume that the company incurred $800 of freight charges $1,400 for machine setup and testing, and $300 for insurance during the first year of use. 152 waL80144_06_c06_135-154.indd 18 8/29/12 2:44 PM CHAPTER 6 Problems 3. Depreciation  methods, changes in rates, and partial periods. Ridgemar Inc. purchased a bus for $200,000 on April 1, 20X1. The bus had a residual value of $50,000 and a 10-year (150,000-mile) service life. On January 1, 20X2, the service life was decreased to recognize 8 years (or 120,000 miles) of remaining service from that date. Miles driven during 20X1 and the first quarter of 20X2 totaled 16,400 and 4,700, respectively. Accumulated Depreciation accounts based on the straight-line, units-of-output, and double-declining-balance depreciation methods follow. a. Accumulated Depreciation 12/31/X1: ? 3/31/X2: 4,336 b. Accumulated Depreciation 12/31/X1: ? 3/31/X2: 5,233 c. Accumulated Depreciation 12/31/X1: ? 3/31/X2: 10,625 Instructions Determine which Accumulated Depreciation account corresponds to each of the depreciation methods. Ridgemar rounds final depreciation computations to the nearest dollar. 153 waL80144_06_c06_135-154.indd 19 8/29/12 2:44 PM
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