LECTURE NOTES: Plant Assets, Natural Resources, and Intangible Assets

Chapter Objectives:

1.Describe the application of the cost principle 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 these expenditures.

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 reported and analyzed.

10. Explain how to account for the exchange of plant assets (Appendix).

INTRODUCTION: Take the following Quiz on Plant Assets and then check the answers on the last page of the lecture notes after you have studied this chapter:

1. T or F: Depreciation is a valuation process.

2. T or F: When land and buildings are purchased for a lump sum, the Buildings account is debited for the total cost.

3. T or F: All costs of getting a plant asset in place and ready for use are debited to the Plant Asset account.

4. T or F: When disposing of a plant asset, first update depreciation.

5. T or F: Maintenance expenditures are capital expenditures.

6. T or F: When selling a plant asset at a gain, do not recognize the gain.

7. T or F: Gains on the exchange of similar plants should be recognized if have commercial substance.

Name the depreciation method in which each occurs:

8. Salvage is ignored in the calculation.______

9. A rate per hour or some other measure of the asset’s output is calculated.

______

10. A constant amount of depreciation exists ______

I. Types of Long-Term Assets.

  1. Distinguish between current and long-term assets
  2. Current assets consist of cash and assets that will be sold (merchandise inventory), realized (collected or turned into cash, such as receivables), or consumed (supplies, prepaid insurance, etc.) within one accounting period, usually a year.
  3. Long-term assets will provide benefit to the company beyond one year.
  4. Define and give examples of plant assets.
  5. Plant assets (also called fixed assets; capital assets; property, plant, and equipment; or plant and equipment) are assets that:

a)have a useful life of more than one year;

b)are acquired for use in the operation of the business;

c)are not intended for resale to customers in the normal course of business such as merchandise inventory; and

d)are tangible (capable of being touched, physical).

  1. Plant assets are usually subdivided into four:

a)Land, such as a building site.

b)Land improvements—the title of an account to which the cost of improvements to real estate are debitedsuch as driveways; parking lots, fences, sidewalks, and underground sprinkler systems (all of which have a limited life).

c)Buildings such as stores, offices, factories, and warehouses.

d)Equipment such as store check-out counters, cash registers, coolers, office furniture, factory machinery, automobiles, computers, and delivery equipment.

  1. Define and give examples of natural resources.
  2. Natural resources (also called wasting assets) are long-term assets that are acquired to extract or remove resources from land or from the ground.
  3. Natural resources consist of standing timber and underground deposits of oil (where oil wells are used to extract it), gas, coal (mined), and minerals such as gold, silver, copper, etc which are mined as well.
  4. Define and give examples of intangible assets.
  5. Intangible assets are long-term assets used in the business that lack physical substance. To help understand the concept of intangible can be difficult to understand but think of an insurance policy (which will probably be a current asset) as that has value despite the fact that you cannot see it or feel it.
  6. Intangible assets consist of legal rights, privileges, and competitive advantages and are listed as:

a)Patents—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.

b)Copyrights—an exclusive grant from the federal government that allows the owner to reproduce and sell an artistic or published work for the life of the creator + 70 years.

c)Trademarks (trade names)—a word, phrase, jingle, or symbol that identifies a particular enterprise or product.

d)Franchises(licenses)—a contractual arrangement under which the franchisor grants the franchisee the right to sell certain products, render specific services, or use certain trademarks or trade names, usually within a designated geographical area.

e)Goodwill—the value of all favorable attributes that relate to a business enterprise such as exceptional management, desirable location, good customer relations, skilled employees, high-quality products, and harmonious relations with labor unions. Since the measurement of goodwill is a subjective valuation (what dollar value can be put on this asset), it is only recorded only by the acquiring company when there is a transaction that involves the purchase of an entire business. In that case goodwill is the excess of cost over the fair market value of the net assets (assets less liabilities) acquired.

II. Purchasing Plant Assets.

  1. Identify the costs to be included in the cost of plant assets. All normal costs to acquire the asset and prepare it for use are included.Plant assets are recorded at cost in accordance with the cost principle (GAAP) of accounting.
  2. Cost consists of all normal expenditures necessary to acquire the asset and make it ready for its intended use and includes the list or invoice price, delivery charges, installation charges, sales taxes, insurance charges while in transit, testing costs, painting and lettering on a new delivery truck, etc. For example if a delivery truck was purchased for $21,400, has air conditioning installed at a cost of $600, pays sales taxes of $1,320, and has painting and lettering done at a cost of $500, the Delivery Truck will be debited on the books at $23,820. The cost of motor vehicle license and insurance paid on the truck (for several months in advance) would be debited to an expense and prepaid insurance accounts.
  3. The key word to remember when determining the cost of the plant asset is the word, “normal.” Costs from carelessness, vandalism, and other abnormal causes are debited to expense accounts such as Repairs Expense account because the expenditure did not add to the usefulness of the asset—it simply restored the asset to a usable condition. For example to determine the cost of a newly acquired piece of equipment given the following information: purchase price, $2,000; installation charges, $300; sales tax, $100, initial testing of the asset, $150; and repairs for breakage due to dropping the equipment while unloading off the truck, $300—the Equipmentwill be debited for $2,550and Repairs Expense will be debited for $300.
  1. Determine the costs of land, buildings, and land improvements.
  1. Group purchase of assets—when land and buildings are purchased in a package deal, an apportionment needs to be made between the value of the land and the value of the buildings for two reasons (1) so that asset values can be reflected properly in the accounting records and on the financial statements, and (2) to allow a determination of depreciationon the buildings, since land does not depreciate. The following example illustrates how this apportionment is done with a group or basket purchase:

Group Purchase Example
Purchase Building with Land @ Total Price / $100,000
Appraisal shows the following values:
FMV (Fair Market Value) Building / $75,000 / 60%
FMV Land / $50,000 / 40%
Total Appraised Value / $125,000 / 100%
To allocate the purchase price in fair proportion:
Building: / $75,000 / x / $100,000 / = / $60,000
$125,000
Land: / $50,000 / x / $100,000 / = / $40,000
$125,000

If the building requires any other costs to make the building ready for use such as remodeling, and replacing or repairing the roof, floors, electrical wiring, plumbing, etc., these costs would then be added and debitedto the Building account. If the land needs additional costs (see LAND below), and then these costs would be added and debited to the Land account.

  1. LAND costs includes the purchase price; closing costs such as real estate brokers’ commissions, title and attorney’s fees (legal fees); accrued property taxes (delinquent by the seller but paid by the buyer) and other liens on the land assumed by the buyer; amounts spent on draining, clearing, grading, etc. to get the land ready for use; and net costs of razing and removing of unwanted buildings already existing on the land. For example, assume a piece of land was purchased for $100,000 which included an old warehouse that is razed at a net cost of $6,000 ($7,500 in costs less $1,500 proceeds from salvaged materials) with $1,000 in attorney and $8,000 in real estate broker’s commission, the cost of the Land would be calculated as follows:

Amount to Debit to Land account
Cash price of the property / $100,000
Net removal cost of warehouse / 6,000
Attorney’s fees / 1,000
Real Estate broker’s commission / 8,000
Cost of land / $115,000
  1. BUILDING costs for a newly constructed building includes all construction (contract price) costs, architect’s fees, building permits, excavation costs, insurance and interest costs during construction. The inclusion of interest costs is limited to the construction period as after the building has been placed in use, the cost of interest on borrowed funds to finance the constructions are debited to Interest Expense.
  1. LAND IMPROVEMENTS that were listed above are debited to this asset account because these improvements have limited useful lives and their maintenance and replacement are the responsibility of the company and they are depreciated over their useful lives.

III. The Terminology of Depreciation.

  1. Define depreciation and depreciation expense.Depreciation is an allocation process, not a valuation one.
  1. Depreciation is the process of allocating the cost of a plant asset to expense over its useful (service) life in a rational and systematic manner. Cost allocation provides for the proper matching of expenses and revenues in accordance with the matching (GAAP) principle.
  2. Depreciation expense is the expense that results from the allocation of this cost.
  3. TYPICAL STUDENT MISCONCEPTION: Students tend to think of depreciation as a process to determine the market value of an asset. Plant assets are purchased for use, not for resale. Thus depreciation has nothing to do with market value. The objective of depreciation is to allocate the cost of a plant asset over the years that the asset will be used in the production of revenue. In other words, we are trying to match the cost of a plant asset against the revenue it produces.
  4. Adjusting entry for depreciation involves a debit to Depreciation Expense and a credit to Accumulated Depreciation. Recall from early chapters that the Accumulated Depreciation is a contra asset account with a normal credit balance. Depreciation is recorded in the Accumulated Depreciation account, rather than directly in the asset account, so as to maintain both the asset account showing the original or historical cost of the asset and the accumulated depreciation account showing how much the asset has depreciated (as this information will be needed when filing tax returns to determine the amount of gain or loss on the sale of the asset). The entry:

General Journal / Page 1
Date / Account Title / P.R / Debit / Credit
20-- / Adjusting Entries
Dec / 31 / Depreciation Expense—name of asset / 1,000.00
Accumulated Depreciation—name of asset / 1,000.00

The depreciation expense is reported on the income statement and accumulated depreciation is reported as a deduction from plant assets on the balance sheet.

Factors Needed to Calculate Depreciation.

  1. Cost—recall from above that plant assets are recorded at cost, in accordance to the cost principle which is the invoice price plus all of the normal and necessary expenditures of getting it ready for use.
  2. Estimated salvage value(SV) (scrap value, trade-in value, residual value)—the amount that an asset is expected to be worth at the end of its productive life. The amount is an estimate and in making the estimate, management considers how it plans to dispose of the asset and its experiences with similar assets. Also, the federal government and some trade associations publish guidelines for determining the salvage value of many assets.
  3. Estimated useful life(EUL)of an asset is the number of years the asset is expected to remain useful. Useful life can be expressed in time (years of life) or in terms of output (hours of operation, miles driven, number of pages, etc.). TYPICAL STUDENT MISCONCEPTION: Students often think the estimated useful like (EUL) of a plant asset is the actual period of time the asset will last. For example, your car may last 12 years. However, the key word is useful. If a business intends to use that car for only three years, then three years becomes the EUL on which depreciation will be computed.

IV. Traditional Depreciation Methods—each method is acceptable under GAAP. The objective is to select the method that best measures an asset’s contribution to revenue over the useful life. Once a method is chosen, it should be applied consistently over the useful life of the asset. Consistency enhances the comparability of financial statements.

  1. The straight-line method.
  2. Formula:(Cost minus salvage) divided by estimated useful life(life in years) equals depreciation per year (annual depreciation). The straight-line depreciation method gets its name from the fact that if annual depreciation charges under this under this method were plotted on graph paper, the result would be straight line.
  3. Preparing the depreciation schedule—a table that lists for a plant asset the amount of depreciation for each year and the accumulated depreciation and book value(BV) (cost – accumulated depreciation or the undepreciated cost of the asset) of that plant asset at the end of the year. CAUTION: Book value should NOT be confused with market value which is what the asset could be sold for on a given date; it has no relationship to the calculations for depreciation. Book value is what an asset is worth on the books of the firm at a certain date (cost not yet allocated to expense).
  4. Straight-line rate—the annual percent of depreciation in the straight-line method. It is calculated by dividing 100% by the estimated life in years (100% ÷ estimated life in years) or can also be calculated by 1 ÷ estimated life in years. Refer to the following depreciation schedule that has the column for depreciation rate and rather than cost, the column is showing “Depreciable Cost” (Cost – Salvage): NOTE: the book value(BV) at the end of the schedule, $1,000, is the estimated salvage value(SV) which you CANNOT depreciate beyond as DEPRECIATION STOPS WHEN THE BV REACHES SV:

Year / Deprec.
Cost x / Depr.
Rate = / Depr.
Expense / Accum Depr.
End of Year / Book Value
End of Year
2014 / $12,000 / 20% / $2,400 / $2,400 / $10,600
2015 / 12,000 / 20% / 2,400 / 4,800 / 8,200
2016 / 12,000 / 20% / 2,400 / 7,200 / 5,800
2017 / 12,000 / 20% / 2,400 / 9,600 / 3,400
2018 / 12,000 / 20% / 2,400 / 12,000 / 1,000
  1. How to prorate for part of a year. When as asset is owned for less than a whole year, depreciation is prorated for the partial year. However, depreciation is usually not prorated for less than half a month known as the half-month convention. The half-month convention means to figure depreciation to the nearest whole month.If an asset is purchased from the 1st – 15th of the month, the accountant counts the whole month as if purchased on the 1st of the month. If an asset is purchased on the 16th to the end of the month is considered to be purchased on the first day of the next month. TO PRORATE FOR PART OF A YEAR, multiply annual depreciation times the months used that year. Below is the calculation of the first year’s depreciation for a truck acquired on April 12. Since the asset was purchased on the 12th, the full month of April is considered therefore the annual depreciation of $24,000 x 9/12 (as used the asset for 9 months) = $18,000. For an exercise to test your understanding of prorating for part of a year, determine the portion of $2,400 annual depreciation charge to be recorded as of December 31 for an asset purchased on:

a)May 2 ($2,400 x 8/12 = $1600.

b)October 18 ($2,400 x 2/12 = $400.

c)April 28 ($2,400 x 8/12 = $1,600.

d)January 14 ($2,400).

e)December 16 ($0).

  1. The units-of-production method (units-of-activity depreciation)is based on the assumption that depreciation results solely from using the asset, not from the passage of time. That is, there is a direct relationship between the amount of depreciation each year and the actual output of the asset. The unit of output used to measure an asset’s life should be appropriate for that asset (hours of operation for a tractor, miles driven for a truck, number of copies for a copy machine, etc.). The following two step process to determine the depreciation:
  2. Step1: Determine depreciation per unit: (Cost minus salvage) divided by estimated units of output equals depreciation per unit.
  3. Step 2: Determine the current year’s depreciation: Depreciation per unit times actual output for the year equals depreciation expense. The following depreciation schedule shows a column for the Units of Activity and Depreciation Cost/Unit (NOTE: Regardless of how many miles the truck is driven the last year or succeeding years, the final year can only show 10,000 for the total depreciable cost of $120,000 as you CANNOT depreciate beyond that amount and that the final book value is the estimated salvage value of $20,000 (DEPRECIATION STOPS WHEN BV REACHES SV):

Year / Units of
Activity x / Depr.
Cost/Unit = / Depr.
Expense / Accum. Depr.
End of Year / Book Value
End of Year
2014 / 12,000 / $1.00 / $12,000 / $12,000 / $128,000
2015 / 36,000 / 1.00 / 36,000 / 48,000 / 92,000
2016 / 30,000 / 1.00 / 30,000 / 78,000 / 62,000
2017 / 32,000 / 1.00 / 32,000 / 110,000 / 30,000
2018 / 10,000 / 1.00 / 10,000 / 120,000 / 20,000
  1. TYPICAL STUDENT MISCONCEPTION: When using the units of production method, students often think that they are finished after calculating the depreciation per unit. This calculation is Step 1 of the calculation process and only gives part of the answer. Step 2 must also be done to multiply the depreciation per unit times the number of units used to arrive at the final answer.
  1. The declining-balance method—a depreciation method that allows greater depreciation in the early years of the life of a plant asset and less depreciation in later years. This is achieved by applying a constant rate to each year’s decreasing book value. The declining-balance methodis the most common accelerated depreciation method (a depreciation method that allows greater depreciation in early years and smaller amounts in later years). The sum-of-the-years’ digits method is rarely used but is tested on the Certified Bookkeeper Exam. An ADVANTAGE of using an accelerated depreciation method, such as the double declining-balance method, is that depreciation will be higher in early years when repairs are lower, and lower in later years when repairs are higher. Thus expenses will be evened out over the years. The following two step process is the formula to determine the depreciation:
  2. Step 1: Determine the constant rate (2 times the straight-line rate). Cost times rate (double the straight-line rate) equals depreciation for the first year. Accelerated methods of depreciation permit more depreciation in early years and less in later years. Salvage is not deducted in this method, but depreciation always STOPS AT THE POINT OF SALVAGE as with the other depreciation methods.
  3. Step 2: Determine the year’s depreciation: Book value at the beginning of the yeartimesthe constant rate equals depreciation for later years.
  4. Calculation for partial year. For partial first year, apply fraction of year to product of cost times the constant rate. For later years, fraction is not required.The following example is showing the two step process of the formula in the first year when the asset was purchased on April 12 (40% x $140,000 (cost) = $56,000 x 9/12 months used = $42,000) and then the second year (40% x $98,000 (BV at the beginning of the year) = $39,200. The following depreciation schedule shows how the BV at the beginning of the year is multiplied times the constant rate to equal the annual depreciation. NOTE how DEPRECIATION STOPS WHEN BV REACHES SV(an asset CANNOT be depreciated beyond its SV) so the last year is whatever is needed to complete to SV:

Year / BV @ beg.
of year x / Depr.
Rate = / Depr.
Expense / Accum. Depr.
End of Year / Book Value
End of Year
2014 / 140,000 / 40% x 9/12 / $42,000 / $42,000 / $98,000
2015 / 98,000 / 40% / 39,200 / 81,200 / 58,800
2016 / 58,800 / 40% / 23,520 / 104,720 / 35,280
2017 / 35,280 / 40% / 14,112 / 118,832 / 21,168
2018 / 21,168 / 40% / 1,168 / 120,000 / 20,000

CAUTION: If an asset has a large salvage value, the asset could be fully depreciated BEFORE it reaches the last year of depreciation. In that case the last year or years shows zero on the depreciation schedule.