Once you have completed this chapter, you should be able to:

  1. Describe the major types of long-term assets, their purposes, and the measurement basis that GAAP requires that businesses use to record these assets.
  2. Use the proper rules to record the acquisition, depreciation, and disposal of fixed assets.
  3. Apply GAAP to the purchase and use of natural resources.
  4. Apply GAAP to the purchase, valuation, and sale of long-term and short-term investments.
  5. Identify accounting issues associated with intangible and other long-term assets.
  6. Explain the effects of investing activities on a company’s financial statements.

Investing Activities

Types of Assets

Investing activities supply the resources that an organization needs to operate. Most of these resources are reported as assets, although some – for example, the value of management expertise, are not. On its balance sheet, a company reports those assets for which it can reasonably identify costs and that are important to its operations.

Most companies divide their assets into two major categories: current and long-term. Current assets are those that management expects to convert to cash or consume during the coming fiscal year. Most current assets are created or used as part of a company’s operating activities. The company uses these assets to produce and sell goods and services. Long-term assets include assets a company uses to produce and sell its products. These assets provide benefits to a company that extend beyond the coming fiscal year or operating cycle. Long-term assets usually are divided into four categories.

  1. Long-term Investments are investments in financial securities. These securities ae debt or equity issued by other organizations.
  2. Plant, property, and equipment includes investments in tangible assets, such as land, buildings, and equipment that a company intends to use in the future to produce or sell its products. The purchase price plus any additional costs to ready the asset for its intended use is reported on the balance sheet. Also, the amount of depreciation recorded on the assets since acquisition is reported as accumulated depreciation. The difference between the cost of these assets and their accumulated depreciation – book value – is the amount actually used to compute total assets on the balance sheet.
  3. Intangible assets are those that confer a right or benefit to a company. Examples include patents, copyrights, trademarks, and goodwill. A company benefits from these assets because it controls rights to certain property, processes, brands, or markets that give the company an advantage relative to its competitors.
  4. Other assets include miscellaneous resources that are important to a particular company, such as long-term receivables and long-term prepaid assets.

Property, Plant, and Equipment

Plant assets include the land, buildings, and equipment a company uses in its operations. The transactions associated with plant assets include their acquisition, disposition, and valuation on the balance sheet at the end of each reporting period. The purchase of plant assets is recorded at cost, the amount paid for the asset, and includes all other costs necessary to ready the asset for its intended use. The disposal of plant assets usually results in an inflow of cash and recognition of a gain or loss.

Expenditures made to acquire new plant, property, and equipment or to extend the life or enhance the value of existing plant, property, and equipment are called capital expenditures. Capital expenditures are recorded as assets because they create future benefits. Expenditures to repair or maintain plant asses that do not extend the life or enhance the value of the assets are called operating expenditures. Operating expenditures are recorded as expenses because they are costs associated with the use or consumption of a resource.

In addition to purchase and renovation costs, interest on debt used to finance the construction of assets may be included as part of the cost of these assets. This interest is capitalized (recorded as an asset) because it is part of the cost of constructing the asset. The total cost of the asset, including interest, is depreciated over the asset’s useful life.

Depreciation

Depreciation is the process of allocating the cost of plant, property, and equipment to expense over the fiscal periods that benefit from their use. As the actual consumption of plant assets is impossible to determine, depreciation involves arbitrary allocation of costs. These allocations attempt to match the cost of consuming plant assets with the periods that benefit from their use. A variety of depreciation methods exist; most methods fall into one of three general categories:

  1. Straight-line depreciation, which allocates an equal amount of the cost of a fixed (plant) asset to expense during each fiscal period of the asset’s expected useful life.
  2. Accelerated depreciation, which allocates a larger portion of the cost of a plant asset to expense early in the asset’s life.
  3. Units-of-production depreciation, which produces a level amount of depreciation expense per unit of output (rather than per fiscal period).

Straight-line depreciation (S-L) is equal to the cost of the asset minus residual (salvage) value, which is the amount management expects to receive for the asset at the end of the asset’s useful life divided by the expected useful life of the asset. We record depreciation with the following journal entry at year-end:

Depreciation Expense (debit)

Accumulated Depreciation (credit)

Accumulated depreciation is a contra-asset account that offsets the plant asset account. The book value or carrying value of a plant asset is equal to the cost minus accumulated depreciation. When we use straight-line depreciation, we record an equal amount of depreciation each fiscal period, and we never depreciate below residual value. Therefore, at the end of an asset’s useful life, the book value will be equal to residual value.

Because depreciation is an estimation process, some amounts may change, specifically residual value and useful life, as new information comes to light. Revised depreciation expense is equal to remaining book value minus (revised) residual value divided by (revised) useful life. A change in an estimate affects depreciation in the period of the change and in periods after the change is made. Amounts recorded in previous periods are not changed.

Straight-line depreciation is easy to compute and provides a reasonable estimate of the consumption of most plant assets. Therefore, it is the most commonly used method for determining depreciation for financial reporting of major corporations.

Accelerated Depreciation

Accelerated depreciation allocates more depreciation expense to the earlier years of an asset’s estimated useful life than to the later years. One frequently used method is called double-declining balance (DDB). DDB depreciation allocates to depreciation expense twice the straight-line rate times the book value of an asset at the beginning of the year. The straight-line rate is equal to one divided by the estimated useful life of the asset. An asset with an estimated useful life of four years has a straight-line rate of ¼ or 25%. Double this rate would be 2/4 or 50%. DDB depreciation expense is equal to the book value of the asset at the beginning of the year x (2 divided by the asset’s expected useful life). Remember that the asset cannot be depreciated below residual value; therefore, the amount of depreciation expense recorded in the last year of the asset’s useful life is equal to book value of the asset at the beginning of the year minus residual value.

The method of depreciation does not change the total amount of depreciation recorded; it only changes the amount allocated to each fiscal year.

Reasons for Using Accelerated Depreciation

Accelerated depreciation methods are used for two primary reasons. Sometimes, an asset is more useful earlier in its life rather than later, and the useful life may be difficult to estimate. For example, since computer equipment becomes obsolete quickly, a company may accelerate the depreciation of computer equipment to ensure that most of the cost has been depreciated when the equipment is replaced.

A second and more common reason for using accelerated depreciation is for tax purposes as a way of postponing the tax obligation. Companies typically report the maximum amount of depreciation permitted by law for tax purposes. Larger amounts of depreciation expense reduce tax payments for the current fiscal period, thereby reducing cash outflows for tax purposes. For financial reporting purposes, companies prefer to report higher amounts of net income in earlier years. Therefore, they generally use straight-line depreciation in preparing their financial statements. Companies may use straight-line depreciation when preparing their financial statements and accelerated depreciation when preparing their tax returns. Note that over the life of the asset, the same total amount of depreciation expense is recognized under the straight-line method as under the accelerated methods, and the same amount of total income tax is paid under those methods.

The difference between straight-line and accelerated depreciation is a major source of deferred taxes. Deferred taxes are taxes that a company would owe if it used the same methods for preparing its tax return that it used in preparing its financial statements.

Units-of-Production Depreciation

Units-of-Production Depreciation Rate=(Cost of Fixed Asset minus Residual value) divided by the Total Expected Units of Production.

Units-of-Production Depreciation Rate x Number of Units Used in Reporting Period = Depreciation Expense

This method is an activity-based method, not a time-based method like straight-line or double-declining balance.

Long-term and Short-term Investments

Types of Securities

Companies often invest in securities issued by other organizations. Securities include common and preferred stocks, bonds, certificates of deposit, and notes. Stocks are called equity securities; other securities are debt securities. Securities that are readily exchangeable for cash are called marketable securities.

Companies invest in marketable securities for many reasons. When there is a temporary surplus of cash, this cash may be invested on a short-term basis to earn a return until cash is needed. Long-term investments meet different needs. They may be used to fund the future repurchase or repayment of a company’s own debt or to provide for future retirement and other employee benefits. Investments in other companies may be made to gain access to new markets, resources, and technology controlled by these companies.

GAAP distinguishes between two types of investments, investments that give the investor significant influence or control over the company issuing the securities, and investments that do not.

Investments That Yield Significant Influence/Control

These investments are always reported as a long-term asset. Significant influence over another company is established when one company holds between 20% and 50% of the outstanding common stock of the other company. When significant influence exists, the equity method of accounting is used. When a company has control of another (generally this means ownership of greater than 50% of the other company’s outstanding common stock), the two companies will prepare consolidated financial statements.

Investments That Do Not Yield Significant Influence/Control

There are three categories of investments that do not yield significant influence or control. Each type is treated differently in the financial statements. The three categories are:

  1. Held-to-Maturity Securities: These are investments in debt securities that the investor has the intent and ability to hold until the debt’s maturity date. They are reported on the balance sheet as a long-term asset except during the year just prior to maturity when they should be reported as a current asset.
  2. Trading Securities: These are investments in either debt or equity securities that a company buys and sells on a regular basis. They are reported on the balance sheet as a current asset.
  3. Available-for-Sale Securities: These are investments in securities that a company could sell but that it does not sell regularly. These are reported as a current asset or a non-current asset depending on management’s intention and expectation regarding when the investments will be sold.

Held-to-maturity (debt) securities are reported on the balance sheet at amortized cost (original cost adjusted for amortization of premium or discount). Trading securities and Available-for-Sale securities are reported on the balance sheet at current market value. This is referred to as mark-to-market accounting. Held-to-maturity securities are debt securities that management intends to hold for the long term. They are reported on the balance sheet at amortized cost. If debt securities are held as trading securities or available-for-sale securities, they are reported on the balance sheet at current market value. When the investment’s amortized cost is different from its current market value, an unrealized holding gain or loss is recognized. The holding gain or loss is unrealized because actual sale of the investment has not yet occurred. Unrealized holding gains or losses are an indication of the gain or loss that would occur if the investment were sold at the balance sheet date.

The only difference in accounting for trading securities and available-for-sale securities is in how the unrealized holding gain or loss is reported in the financial statements. Trading securities are expected to be sold in the near future. Therefore, for trading securities, the unrealized holding gain or loss is reported on the income statement as part of net income. This gives an early signal to readers as to the likely outcome when the securities are sold. Available-for-sale securities are not expected to be sold in the near future. Therefore, the unrealized holding gain or loss is reported as part of Other Comprehensive Income in the stockholders’ equity section of the balance sheet.

Trading Securities and Available-for-Sale Securities (AFS) – Investments in Equity

The accounting for trading securities and available-for-sale (AFS) securities is very similar. Both are recorded initially at cost and are reported on the balance sheet at current market value. Unrealized holding gains and losses for AFS securities are reported on the balance sheet as a component of stockholders’ equity. They are not part of net income. If the securities had been trading securities, the unrealized holding gains and losses would be reported on the income statement as part of net income. The long-term investment will be reported on the balance sheet at current market value. When an investment is sold, the business will record a realized gain or loss that is reported in computing net income on the income statement. As noted previously, the rules above do not apply when a company owns a significant or controlling interest in another company.

Intangible Assets

Intangible assets include legal rights such as copyrights, patents, brand names, and trademarks that a company owns. The purchase price and/or legal fees associated with acquiring those rights are recorded as assets, and with the exception of goodwill, are amortized over the life of the asset, usually on a straight-line basis.