CHAPTER 10
Plant Assets and Intangible Assets
Chapter Overview
This chapter begins by explaining which assets are included in three categories of plant assets and the related expenses for each. Students learn how to determine the cost of various plant assets. The relative-sales-value method is used to divide a lump-sum purchase of assets into component parts (land, building, and so on) in order to identify the cost of each asset. Capital expenditures are compared to ordinary repairs.
A detailed discussion of depreciation begins by explaining that depreciation is a method of matching expenses against revenue and not a valuation process nor a fund of cash for replacing assets. Estimated useful life and residual value are explained. Three depreciation methods are presented, including straight-line, units-of-production, and double-declining balance. The methods are illustrated and compared, showing that an equal amount of depreciation is taken over the total useful life of the asset. A mid-chapter summary problem allows the student to practice using the different depreciation methods.
A discussion of depreciation and income taxes follows, explaining how the accelerated method has a cash-flow advantage over the straight-line method. Partial-year depreciation and changing the useful life of an asset are illustrated. Next, students learn about the gains and losses on disposal of plant assets. Disposals are illustrated, including junked assets, selling assets and exchanging plant assets.
The chapter continues with coverage of depletion of natural resources and amortization of intangible assets. Research and development costs are mentioned, followed by ethical issues in accounting for plant assets. Decision Guidelines related to plant assets and related expenses, an Excel Application problem, and a final summary problem covering tax considerations in depreciation, partial-year calculations, and sale of plant assets, conclude the chapter.
Learning Objectives
After studying Chapter 10, your students should be able to:
1. Measure the cost of a plant asset
2. Account for depreciation
3. Select the best depreciation method for tax purposes
4. Account for the disposal of a plant asset
5. Account for natural resources
6. Account for intangible assets
Chapter Outline
Objective 1: Measure the cost of a plant asset
A. Plant assets (fixed assets) are those long-lived assets that are tangible in nature and are used in the operation of the business. Exhibit 10-1 lists three categories of plant and intangible assets and the related expenses.
B. Tangible assets (plant assets) are generally useful for more than one year. Intangible assets do not have a physical form.
1. The cost of the asset includes all amounts paid to acquire the asset and prepare it for its intended use in the business, including purchase price (net of all discounts), taxes, fees, installation cost, and so on. Measuring the cost of a plant asset is illustrated in Exhibit
10-2.
2. Types of tangible assets and related costs include:
a. Land and land improvements –
(1) Land cost includes its purchase price, brokerage commission, survey and legal fees, back property taxes, and the cost of clearing the land and removing unwanted buildings. Land is not depreciated.
(2) Land improvements include fencing, paving, sprinkler systems, and lighting. Land improvements are depreciated.
b. Buildings – cost includes architectural fees, building permits, contractors’ charges, cost of material, labor and overhead for constructed buildings, and cost of renovation and repairs for existing buildings. Buildings are subject to depreciation.
c. Machinery and equipment – cost includes purchase price less discounts, plus transportation charges, insurance while in transit, sales and other taxes, purchase commissions, installation costs, and cost to test the machine before use.
1) After the asset is up and running, these costs are no longer capitalized (added to the asset account); instead, these costs (and others related to the machine) are recorded as expenses.
2) Machinery and equipment are subject to depreciation.
d. Furniture and fixtures – cost begins with the basic cost of the asset (such as desks, chairs, display racks); additionally, all other costs to get the asset ready for use are included in the asset account.
3. For a lump-sum (or basket) purchase of several assets, the relative-sales-value method is used to allocate that cost among the various assets acquired. The allocation is based on the assets’ appraised or market values.
C. Expenditures relating to an asset can be classified as either capital expenditures or ordinary repairs. Refer to Exhibit 10-3 for a comparison.
1. A capital expenditure is one made to increase the capacity or efficiency of an asset or to extend its useful life. Examples are: the cost of a new engine that is put into a truck or a major overhaul.
a. Repair work that generates a major repair is an extraordinary repair.
b. Record this type of expenditure with a debit to the asset account.
2. An ordinary repair maintains the asset or restores it to good working order.
a. This type of repair does not extend the useful life of the asset.
b. Examples are: the cost of new tires for the truck or the cost of replacing a dead battery on the truck.
c. Debit an expense account, such as Repair and Maintenance Expense.
3. It is important to record capital expenditures and ordinary repair and maintenance expenses correctly, as an error in recording causes errors on both the income statement and the balance sheet.
D. Depreciation is the process of allocating a plant asset’s cost to expense over the asset’s useful life. Depreciation is based on the matching principle. It matches the cost of an asset with the revenue generated by the use of that asset. (Refer to Exhibit 10-4.)
1. Depreciation is not a process of valuation of the plant asset. It is based on historical cost, not on current appraisal value.
2. Depreciation does not represent a fund of cash set aside to replace worn or obsolete assets.
3. Accumulated Depreciation, a contra-asset account, equals the portion of the asset’s cost that has already been depreciated (or expensed).
4. The causes of depreciation include physical wear and tear and obsolescence.
5. The asset’s cost (covered previously), estimated useful life, and estimated residual value must all be known in order to measure depreciation.
a. The useful life is an estimate of how many years the asset will be useful to the business, not an estimate of its actual physical life. Useful life may be limited by wear and tear or by obsolescence.
b. Residual value (salvage or scrap value) is the estimated expected cash value at the end of the asset’s useful life.
c. Cost minus residual value = depreciable cost.
Objective 2: Account for depreciation
A. Three basic methods are used for computing depreciation—straight-line, units-of-production, and declining-balance.
B. Using any of the three methods, the entry to record depreciation each period is:
Depreciation Expense XX
Accumulated Depreciation XX
C. The three methods are illustrated based on the data in Exhibit 10-5.
1. The straight-line (SL) depreciation formula is:
Cost - Residual value = Annual depreciation expense
Useful life in years
a. The SL method allocates an equal amount of depreciation expense to each year of the asset’s life.
b. Book value (carrying value) equals cost minus accumulated depreciation. (Exhibit 10-6 illustrates straight-line depreciation.)
2. The units-of-production (UOP) depreciation formula is:
Cost - Residual value = Depreciation expense/unit
Useful life in units
and, Depr./unit x Units of output = Annual depreciation expense
(current year) (current year)
a. The UOP method assigns a fixed amount of depreciation to each unit of output or production; however, depreciation per year will vary with the output.
b. Depreciation each period is based on actual usage or output. (Exhibit 10-7 illustrates UOP depreciation.)
3. The double-declining balance (DDB) depreciation formula is:
Twice the straight-line rate x Book value = Annual depreciation expense
(DDB rate) at beg. of year
a. DDB is an accelerated method of recording depreciation; higher amounts of the asset’s cost are written off to expense early in the life of the asset. (Exhibit 10-8 presents DDB depreciation calculations.)
b. Book value (cost minus accumulated depreciation) declines each year.
c. Residual value is not considered until near the last year of useful life.
(1) When book value approaches residual value, depreciation expense for that year is the amount required to bring remaining book value to residual value.
(2) This adjustment usually occurs in the last year of the asset’s useful life, but may occur before then.
D. Regardless of the method used, the same total amount of depreciation will be recorded over the useful life of the asset.
1. The three methods merely cause timing differences in recording annual depreciation expense. All are acceptable under GAAP. Exhibit 10-9 graphs depreciation patterns through time for the three methods.
2. Choosing a depreciation method may depend on the nature of the asset. A business should match an asset’s expense against the revenue the asset produces.
a. For an asset that generates revenue evenly over time, straight-line is best.
b. UOP is best suited for assets that wear out because of physical use.
c. The accelerated methods, such as DDB, are best suited for assets that generate greater revenue earlier in their useful life.
d. A survey of 600 companies (presented in Exhibit 10-10) reveals that the SL method is most popular for financial reporting.
Objective 3: Select the best depreciation method for tax purposes
A. Depreciation methods for financial statement presentation and income tax reporting may vary.
1. The straight-line method is most often used for financial statement purposes.
2. An accelerated method is most often used for tax purposes.
a. The higher the depreciation expense, the lower the income. Lower income results in lower income tax expense and lower tax payments. Lower tax payments mean greater (increased) cash flow. These tax savings can be invested.
b. The cash-flow advantage of using DDB depreciation over SL depreciation (for tax purposes) is illustrated in Exhibit 10-11.
c. The Modified Accelerated Cost Recovery System (MACRS) is a special depreciation method created by the 1986 Tax Reform Act solely for income tax purposes. It requires strict adherence to many guidelines.
d. Exhibit 10-12 presents the various assets, classes, and lives for the depreciation methods prescribed by MACRS.
B. Partial-year depreciation calculations are required for assets that are purchased and/or disposed of on a date other than the start of the fiscal year. (Refer to Exhibit 10-13 for an illustration of DDB depreciation for partial years.)
1. In the first and last years of the asset’s life, it may be necessary to calculate partial-year depreciation expense.
2. Compute the entire year’s depreciation expense first, then calculate the partial-year amount based on the number of months the item was actually held that year.
C. Changing the estimated useful life or estimated residual value requires a revised depreciation schedule.
1. The formula for revised depreciation (SL) is:
Cost - Accumulated depreciation - New residual value = New annual depreciation expense
New estimated useful life remaining
2. This type of change, a change in accounting estimate, is often footnoted.
D. The business may continue to use a fully depreciated asset, but may not record additional depreciation expense.
Objective 4: Account for the disposal of a plant asset
A. A business disposes of plant assets when they wear out, become obsolete, or are no longer useful to the business.
B. Always update depreciation by recording a partial-year depreciation expense; next, calculate the asset’s remaining book value.
C. If an asset is junked before it is fully depreciated, record a loss equal to the remaining book value.
D. The rules for the sale of a plant asset are:
1. Record gain on the sale if the cash received (sales proceeds) is greater than the remaining book value.
2. Record loss on the sale if the remaining book value is greater than the cash received (sales proceeds).
3. The journal entry is:
Cash XX
Accumulated Depreciation XX
Loss on Sale of Asset XX
Asset XX
Or, Cash XX
Accumulated Depreciation XX
Gain on Sale of Asset XX
Asset XX
E. The rules for the exchange (trade-in) of a plant asset are:
1. Remove balances of old asset and accumulated depreciation.
2. The entry to record the trade-in is:
Equipment (new) XX
Accumulated Depreciation (old) XX
Equipment (old) XX
Cash XX
Objective 5: Account for natural resources
A. The process of allocating the cost of a natural resource to expense over its useful life is called depletion. Natural resources include timber, iron ore, and petroleum.
1. Depletion expense represents the portion of the cost of natural resources (iron ore, gas, oil, coal, timber) that is used up in a period.
2. Depletion is calculated by the units-of-production formula:
Cost - Residual value = Depletion expense/unit
Estimated units of resource
and, Depl/unit x Number of units removed = Annual depletion expense
(current year) (current year)
B. Natural resources are reported at book value on the balance sheet. Accumulated Depletion is a contra-asset account similar to Accumulated Depreciation.
Objective 6: Account for intangible assets
A. The process of allocating the cost of an intangible asset to expense over its useful life is called amortization.
1. The calculation of amortization is based on the straight-line method and uses the estimated useful life of the intangible asset or its legal life, whichever is shorter.
2. Intangible assets represent rights to current and anticipated benefits. They have no physical characteristics.
a. The useful life of intangible assets varies; some have limited lives and some have unlimited lives.
b. Included in the intangible asset category are patents, copyrights, trademarks, franchises, and goodwill.
3. Patents grant the holder the exclusive right to produce and sell an invention for 20 years.
4. Copyrights grant exclusive rights to reproduce and sell a written or created work; copyrights extend for 75 years beyond the author’s life.
5. Trademarks, brand names represent distinctive products or services.
6. Franchises, licenses are privileges granted to sell a product or service under specified conditions.