© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-1 CHAPTER 7 Plant Assets, Intangible Assets, and Related Expenses

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-2 TYPE OF ASSETS Plant assets (fixed assets) –Are long-lived assets that are tangible Land Buildings Equipment –Expensed through depreciation Land is not depreciated Long-lived assets used in the operation of a business are divided into categories:

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-3 Intangible assets –Are useful not because of their physical characteristics, but because of the special rights they convey –Include Patents Copyrights Trademarks TYPE OF ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-4 Asset Account on the Balance Sheet Related Expense Account on the Income Statement Plant Assets: Land Buildings, Machinery and Equipment, Furniture and Fixtures, and Land Improvements Natural Resources Intangibles Terminology Used in Accounting for Plant Assets and Intangible Assets None Depreciation Depletion Amortization

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-5 MEASURING THE COST OF A PLANT ASSET The cost principle directs a business to carry an asset on the balance sheet at the amount paid for the asset The cost of a plant asset includes –The purchase price –Applicable taxes –Purchase commissions –All other amounts paid to acquire the asset and ready it for its intended use

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-6 The cost of land includes –The purchase price –Brokerage commissions –Survey fees –Legal fees –Back property taxes that the purchaser pays –Land grading and clearing, and demolition of any unwanted buildings MEASURING THE COST OF A PLANT ASSET

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-7 Suppose a business signs a $300,000 note payable to purchase land for a new store site. It pays $10,000 in back property tax, $8,000 in transfer taxes, $5,000 for removal of an old building, a $1,000 survey fee, and $260,000 to pave the parking lot. The cost of the land is Purchase price of land$300,000 Add related costs: Back property tax$10,000 Transfer taxes 8,000 Building removal cost 5,000 Survey Fee 1,000 Total related costs 24,000 Total cost of land$324,000 Purchase price of land$300,000 Add related costs: Back property tax$10,000 Transfer taxes 8,000 Building removal cost 5,000 Survey Fee 1,000 Total related costs 24,000 Total cost of land$324,000

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-8 The cost of paving the parking lot, $260,000, is not included in the cost of the land, because the pavement is a land improvement. The entry to record purchase of the land is Land324,000 Note payable300,000 Cash 24,000 Land324,000 Note payable300,000 Cash 24,000

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-9 The cost of constructing a building includes –Architectural fees –Building permits –Contractors’ charges –Payments for material –Labor –Overhead MEASURING THE COST OF A PLANT ASSET

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-10 The cost of purchasing an existing building includes –The purchase price –Brokerage commissions –Sales and other taxes –Cash or credit expenditures for repairing and renovating the building for its intended purpose MEASURING THE COST OF A PLANT ASSET

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-11 The cost of machinery and equipment includes –The purchase price (less any discounts) –Transportation charges –Insurance while in transit –Sales and other taxes –Purchase commissions –Installation costs –Expenditures for testing the asset before placing it into service MEASURING THE COST OF A PLANT ASSET

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-12 Land improvements –Include the cost of Paving Driveways Signs Fences Sprinkler systems –Are recorded in a separate account titled Land Improvements, and depreciated MEASURING THE COST OF A PLANT ASSET

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-13 The cost of improvements to leased assets –Appears on the company’s balance sheet as Leasehold Improvements –Is depreciated (amortized) over the term of the lease MEASURING THE COST OF A PLANT ASSET

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-14 Construction in Progress is –An asset, such as a warehouse, that the company is constructing for its own use –A plant asset because the company will use the asset in its operations A capital lease is –A lease arrangement similar to an installment purchase of the leased asset –Reported as an asset MEASURING THE COST OF A PLANT ASSET

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-15 An operating lease is –An ordinary rental agreement –Recorded as Rent Expense Interest cost is capitalized –When it is a part of the cost of a self- constructed asset that takes a long time to build MEASURING THE COST OF A PLANT ASSET

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-16 Assets purchased in a group or “basket” for a lump-sum amount require the identification of cost for each asset –The total cost is divided among the assets according to their relative sales (or market) value –This allocation technique is called the relative-sales-value method MEASURING THE COST OF A PLANT ASSET

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-17 Suppose a combined purchase price of land and building is $2,800,000. The following table presents the market values for the land and building, along with the ratio of each asset’s market value to the total market value: Land Building Total $ 300,000 2,700,000 $3,000,000 10% 90% 100% $2,800,000 $ 280,000 2,520,000 $2,800,000 ====  xxxx ==== Asset Market (Sales) Value Total Market Value % of Total Market Value Total Cost Cost of Each Asset

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-18 The entry to record the purchase of the land and building is Land 280,000 Building2,520,000 Cash2,800,000 Land 280,000 Building2,520,000 Cash2,800,000 MEASURING THE COST OF A PLANT ASSET

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-19 CAPITAL EXPENDITURES VS. REVENUE EXPENDITURES Capital expenditures increase the asset’s capacity or efficiency or extend its useful life –Repair work that generates a capital expenditure is called an extraordinary repair –Extraordinary repairs are debited to an asset account

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-20 Revenue expenditures do not extend the asset’s capacity, but merely maintain it or restore it to working order –Ordinary repairs are revenue expenditures –Ordinary repairs are debited to an expense account CAPITAL EXPENDITURES VS. REVENUE EXPENDITURES

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-21 Debit an Asset Account for Capital Expenditures Debit Repair and Maintenance Expense for Revenue Expenditures Extraordinary repairs Major engine overhaul Modification of body for new use of truck Addition to storage capacity of truck Ordinary repairs Repair of transmission or other mechanism Oil change, lubrication, etc. Replacement tires, windshield Paint job Delivery Truck Expenditures: Capital Expenditure or Revenue Expenditure?

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-22 MEASURING THE DEPRECIATION OF PLANT ASSETS Depreciation is the allocation of a plant asset’s cost to expense over the period the asset is used The matching principle matches an asset’s expense against the revenue generated over the asset’s life

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-23 Estimated useful life, 20 years Annual revenue generated, $9 million minus Annual depreciation expense, $1.6 million* Depreciation and the Matching of Expense with Revenue *$32 million/20 yrs. = $1.6 million per year $32 million cost

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-24 Depreciation –Is not a process of valuation –Does not mean that the business sets aside cash to replace assets as they wear out Accumulated depreciation does not represent a growing amount of cash MEASURING THE DEPRECIATION OF PLANT ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-25 The causes of depreciation are –Physical wear and tear –Obsolescence An asset is obsolete when another asset can do the job better or more efficiently MEASURING THE DEPRECIATION OF PLANT ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-26 To measure depreciation for a plant asset one must know the –Cost –Estimated useful life The length of service the business expects to get from the asset--an estimate of how long an asset will be useful Useful life may be expressed in years, units of output, miles, or another measure MEASURING THE DEPRECIATION OF PLANT ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-27 –Estimated residual value (scrap value) The expected cash value of an asset at the end of its useful life Estimated residual value is not depreciated because the business expects to receive this amount from disposing of the asset MEASURING THE DEPRECIATION OF PLANT ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-28 A plant asset’s depreciable cost: MEASURING THE DEPRECIATION OF PLANT ASSETS Depreciable cost = Asset’s cost - Estimated residual value

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-29 The four methods for computing depreciation are –Straight line –Units of production –Declining-balance –Sum-of-years’-digits MEASURING THE DEPRECIATION OF PLANT ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-30 MEASURING THE DEPRECIATION OF PLANT ASSETS The following data will be used to illustrate depreciation computations of a Home Depot truck by the three most widely used methods. The sum-of-the-years’-digits method is omitted because so few companies use it. Cost of truck$41,000 Less: Estimated residual value (1,000) Depreciable cost$40,000 Estimated useful life: Years 5 years Years 5 years Units of production100,000 units (miles) Units of production100,000 units (miles) Cost of truck$41,000 Less: Estimated residual value (1,000) Depreciable cost$40,000 Estimated useful life: Years 5 years Years 5 years Units of production100,000 units (miles) Units of production100,000 units (miles)

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-31 MEASURING THE DEPRECIATION OF PLANT ASSETS Straight-line Method An equal amount of depreciation is assigned to each year of asset use Straight-line depreciation per year Cost - Residual value Useful life, in years $41,000 - $1,000 5 $8,000 = = =

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-32 The entry to record depreciation is Depreciation expense8,000 Accumulated depreciation 8,000 Depreciation expense8,000 Accumulated depreciation 8,000 MEASURING THE DEPRECIATION OF PLANT ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-33 Assume that the truck was purchased on January1, 20X1, and that Home Depot’s fiscal year ends on December 31 A straight-line depreciation schedule is presented on the next slide The final column shows the asset’s book value, the asset’s cost less accumulated depreciation MEASURING THE DEPRECIATION OF PLANT ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren X1 $41,000 $41, X1 $0.20 x $40,000 = $8,000 $ 8,000 33, X2.20 x 40,000 = 8,000 16,000 25, X3.20 x 40,000 = 8,000 24,000 17, X4.20 x 40,000 = 8,000 32,000 9, X5.20 x 40,000 = 8,000 40,000 1,000 Depreciation Rate Depreciable Cost Depreciation Expense Accumulated Depreciation Asset Book Value Depreciation for the Year Asset CostDate Straight-Line Depreciation Schedule for the Home Depot Truck

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-35 MEASURING THE DEPRECIATION OF PLANT ASSETS Units-of-Production Method Units-of-production depreciation per unit of output Cost - Residual value Useful life, in units of production $41,000 - $1, ,000 miles $0.40 per mile = = = The UOP depreciation equation for the Home Depot truck data in which the units are miles is

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-36 In the units-of-production (UOP) method –Depreciation is assigned to each unit of output –Depreciable cost is divided by useful life (in units of production) to determine the per- unit depreciation amount –The per-unit depreciation expense is multiplied by the number of units produced each period to compute depreciation MEASURING THE DEPRECIATION OF PLANT ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-37 The truck is expected to be driven 20,000 miles during the first year, 30,000 miles the second, 25,000 during the third, 15,000 during the fourth, and 10,000 during the fifth. The UOP depreciation schedule for this asset is shown below: X1 $41,000 $41, X1 $0.40 x $20,000 = $ 8,000 $ 8,000 33, X2.40 x 30,000 = 12,000 20,000 21, X3.40 x 25,000 = 10,000 30,000 11, X4.40 x 15,000 = 6,000 36,000 5, X5.40 x 10,000 = 4,000 40,000 1,000 Depreciation Per Unit Number of Units Depreciation Expense Accumulated Depreciation Asset Book Value Depreciation for the Year Asset CostDate

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-38 MEASURING THE DEPRECIATION OF PLANT ASSETS Double-Declining-Balance Method DDB depreciation rate per year 1 Useful life, in years 1 5 years 20% X 2 = 40% = = = X 2

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-39 Double-declining-balance (DDB) depreciation –Is an accelerated depreciation method A method that writes off a relatively larger amount of the asset’s cost nearer the start of its useful life than the straight-line method –Computes annual depreciation by multiplying the asset’s book value by a constant percentage, which is 2 times the straight-line depreciation rate MEASURING THE DEPRECIATION OF PLANT ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-40 In the DDB depreciation schedule, the fifth and final year’s depreciation is $4,314 (the $5,314 book value less $1,000 residual value): X1 $41,000 $41, X x $41,000 = $16,400 $16,400 24, X x 24,600 = 9,840 26,240 14, X x 14,760 = 5,904 32,144 8, X x 8,856 = 3,542 35,686 5, X5 4,314* 40,000 1,000 *Last-year depreciation is the amount needed to reduce asset book value to the residual value ($5,314 - $1,000 = $4,314). Depreciation Expense Accumulated Depreciation Asset Book Value DDB Rate Asset Book Value Asset Cost Depreciation for the Year Date

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-41 The DDB method differs from other methods in two ways: –The asset’s residual value is ignored initially; in the first year depreciation is computed on the asset’s full cost –Depreciation expense in the final year is whatever amount is needed to reduce the asset’s book value to its residual value MEASURING THE DEPRECIATION OF PLANT ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-42 Comparing the Depreciation Methods YearStraight-LineUnits-of-Production Accelerated Method Double-Declining-Balance 1 $ 8,000 $ 8,000 $16, ,000 12,000 9, ,000 10,000 5, ,000 6,000 3, ,000 4,000 4,314 Total $40,000 $40,000 $40,000

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-43 The straight-line method best meets the matching principle for a plant asset that generates revenue evenly over time The units-of-production method best fits those assets that wear out because of physical use rather than obsolescence The accelerated method (DDB) applies best to those assets that generate greater revenue earlier in their useful lives MEASURING THE DEPRECIATION OF PLANT ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren $ of Annual Depreciation Time, in years Straight-LineUnits-of-Production Accelerated (DDB) Depreciation Patterns Through Time

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-45 *Most of these are probably declining-balance methods because depreciation for income tax purposes is based on the declining-balance concept. Some companies use the same depreciation method for financial statement purposes and for tax purposes. Use of the Depreciation Methods by 600 Companies

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-46 THE RELATIONSHIP BETWEEN DEPRECIATION AND TAXES Most companies use an accelerated depreciation method for tax purposes because –It provides the most depreciation expense as quickly as possible –It decreases the tax liability

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-47 THE RELATIONSHIP BETWEEN DEPRECIATION AND TAXES Suppose during the first depreciation year of the Home Depot truck example the store’s lumber department has –$40,000 in cash sales –$300,000 in cash operating expenses –An income tax rate of 30 percent The cash flow analysis on the next slide indicates that a higher depreciation expense yields lower income and a lower tax payment

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-48 Cash revenues$400,000$400,000 Cash operating expenses 300, ,000 Cash provided for operations before tax 100, ,000 Depreciation expense (a noncash expense) 8,000 16,400 Income before income tax 92,000 83,600 Income tax expense (30%) 27,600 25,080 Net income$ 64,400$ 58,520 Cash-flow analysis$100,000$100,000 Income tax expense 27,600 25,080 Cash provided by operations $ 72,400 $ 74,920 Extra cash available for investment if DDB is used ($74, ,400) $2,520 Assumed earnings rate on investment of extra cash x 0.10 Cash advantage of using DDB over SL $ 252 Income Tax Rate (30%) SLAccelerated Cash-Flow Advantage of Accelerated Depreciation over Straight-line for Income Tax Purposes

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-49 THE RELATIONSHIP BETWEEN DEPRECIATION AND TAXES Under the Modified Accelerated Cost Recovery System (MACRS), assets are grouped into one of eight classes identified by asset life: Class Identification by Asset Life (years) Representative Assets Depreciation Method

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-50 DEPRECIATION FOR PARTIAL YEARS Since companies purchase plant assets as needed, they must develop policies to compute depreciation for partial years Suppose a calendar-year business purchases a building on April 1 for $500,000 with an estimated life of 20 years and an estimated residual value of $80,000. Assuming the straight-line method, the year’s depreciation for the building is $15,750, computed as follows: Since companies purchase plant assets as needed, they must develop policies to compute depreciation for partial years Suppose a calendar-year business purchases a building on April 1 for $500,000 with an estimated life of 20 years and an estimated residual value of $80,000. Assuming the straight-line method, the year’s depreciation for the building is $15,750, computed as follows: Full-year depreciation: Partial year depreciation: $500,000 - $80, $21,000 $21,000 X 9/12$15,750= =

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-51 After an asset is put into use, the business may refine its estimate of the useful life on the basis of experience and new information CHANGING THE USEFUL LIFE OF A DEPRECIABLE ASSET

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-52 Assume an asset cost of $40,000, an eight-year useful life with no residual value, and the straight-line method The company would record $5,000 depreciation each year ($40,000/8 years) CHANGING THE USEFUL LIFE OF A DEPRECIABLE ASSET

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-53 After two years, accumulated depreciation reaches $10,000, leaving a remaining depreciable book value of $30,000 ($40,000 - $10,000) Management believes the asset will remain useful for an additional ten years. The company would spread the remaining book value over the asset’s remaining life as follows: CHANGING THE USEFUL LIFE OF A DEPRECIABLE ASSET

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-54 Asset’s remaining depreciable book value (New) Estimated useful life remaining (New) Annual depreciation $30,00010 years$3,000   = = The yearly depreciation entry based on the new estimated useful life is Depreciation Expense3,000 Accumulated Depreciation3,000 Depreciation Expense3,000 Accumulated Depreciation3,000

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-55 USING FULLY DEPRECIATED ASSETS A fully depreciated asset is –An asset that has reached the end of its estimated useful life –An asset on which no more depreciation is recorded The asset and its depreciation account remain in the ledger with no additional depreciation entries An asset can be used after it is fully depreciated

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-56 DISPOSAL OF PLANT ASSETS Before accounting for the disposal of the asset, the business should bring depreciation up to date to measure the asset’s final book value To account for disposal, credit the asset account and debit its related accumulated depreciation account

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-57 DISPOSAL OF PLANT ASSETS Suppose Wal-Mart store fixtures that cost $4,000 are disposed of in this manner. Accumulated depreciation is $3,000, and book value is therefore $1,000. Disposal of these store fixtures records a loss as follows: Accumulated Depreciation - Store Fixtures 3,000 Loss on Disposal of Store Fixtures 1,000 Store Fixtures 4,000 To dispose of store fixtures Accumulated Depreciation - Store Fixtures 3,000 Loss on Disposal of Store Fixtures 1,000 Store Fixtures 4,000 To dispose of store fixtures Junking a Plant Asset

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-58 DISPOSAL OF PLANT ASSETS Selling a Plant Asset Suppose a Home Depot store sells fixtures on September 30, 20X4, for $5,000 cash. The fixtures cost $10,000 when purchased on January 1, 20X1, and have been depreciated on a straight-line basis. Assuming a ten-year useful life, no residual value, and a calendar-year company, partial-year depreciation must be recorded for the asset’s expense from January 1, 20X4, to the sale date. The straight-line depreciation entry at September 30, 20X4, is Sep. 30 Depreciation Expense ($10,000/10 years X 9/12)750 Accumulated Depreciation - Fixtures750 To update depreciation Sep. 30 Depreciation Expense ($10,000/10 years X 9/12)750 Accumulated Depreciation - Fixtures750 To update depreciation

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-59 DISPOSAL OF PLANT ASSETS After this entry is posted, the Fixtures account and the Accumulated Depreciation - Fixtures account appear as follows. The fixture’s book value is $6,250 ($10,000 - $3,750): Accumulated Depreciation - Fixtures Dec. 31, 20X1 1,000 Dec. 31, 20X2 1,000 Dec. 31, 20X3 1,000 Sep. 30, 20X4 750 Balance 3,750 Fixtures Jan. 1, 20X1 10,000

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-60 DISPOSAL OF PLANT ASSETS If the business sells the fixtures for $5,000 cash, the loss on the sale is $1,250, determined as follows: Cash received from sale of the asset $5,000 Book value of asset sold: Cost$10,000 Less accumulated depreciation up to date of sale ( 3,750) 6,250 Gain (loss) on sale of the asset ($1,250) Cash received from sale of the asset $5,000 Book value of asset sold: Cost$10,000 Less accumulated depreciation up to date of sale ( 3,750) 6,250 Gain (loss) on sale of the asset ($1,250)

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-61 DISPOSAL OF PLANT ASSETS The entry to record sale of the fixtures for $5,000 cash is Sep. 30 Cash5,000 Accumulated Depreciation - Fixtures3,750 Loss on Sale of Fixtures1,250 Fixtures10,000 To sell fixtures Sep. 30 Cash5,000 Accumulated Depreciation - Fixtures3,750 Loss on Sale of Fixtures1,250 Fixtures10,000 To sell fixtures

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-62 DISPOSAL OF PLANT ASSETS If the sale price had been $7,000, the business would have had a gain of $750 (Cash, $7,000 - asset book value, $6,250): Sep. 30 Cash7,000 Accumulated Depreciation - Fixtures3,750 Fixtures 10,000 Gain on Sale of Fixtures 750 To sell fixtures Sep. 30 Cash7,000 Accumulated Depreciation - Fixtures3,750 Fixtures 10,000 Gain on Sale of Fixtures 750 To sell fixtures

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-63 A gain is recorded when an asset is sold for a price greater than the asset’s book value A loss is recorded when the sale price is less than book value Gains increase net income Losses decrease net income DISPOSAL OF PLANT ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-64 Businesses often trade in their old plant assets for similar assets that are newer and more efficient In many cases, the business simply transfers the book value of the old asset plus any cash payment into the new asset account DISPOSAL OF PLANT ASSETS Trading Plant Assets

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-65 DISPOSAL OF PLANT ASSETS Assume Mazzio’s Pizzeria’s old delivery car cost $9,000 and has accumulated depreciation of $8,000. If Mazzio’s trades in the old automobile and pays cash of $10,000, the cost of the new delivery car is $11,000 (book value of the old asset, $1,000, plus cash given, $10,000). The pizzeria records the exchange transaction as follows: Delivery Auto (new)11,000 Accumulated Depreciation (old) 8,000 Delivery Auto (old) 9,000 Cash10,000 Traded in old delivery car for new auto Delivery Auto (new)11,000 Accumulated Depreciation (old) 8,000 Delivery Auto (old) 9,000 Cash10,000 Traded in old delivery car for new auto

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-66 ACCOUNTING FOR NATURAL RESOURCES AND DEPLETION Natural resources are assets in the ground (oil) or on top of the ground (timber) Depletion expense is –That portion of the cost of natural resources that is used up in a particular period –Computed in the same way as units-of- production depreciation

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-67 ACCOUNTING FOR NATURAL RESOURCES AND DEPLETION Assume an oil lease cost $100,000 and contains an estimated 10,000 barrels of oil. The depletion rate would be $10 per barrel ($100,000/10,000 barrels). If 3,000 barrels are extracted during the year, depletion expense is $30,000 (3,000 barrels x $10 per barrel). The depletion entry for the year is Depletion Expense (3,000 barrels x $10)30,000 Accumulated Depletion - Oil 30,000 Depletion Expense (3,000 barrels x $10)30,000 Accumulated Depletion - Oil 30,000 Accumulated Depletion is a contra account similar to Accumulated Depreciation

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-68 Property, Plant, and Equipment: Land$120,000 Buildings$800,000 Equipment 160, ,000 Less: Accumulated depreciation (410,000) 550,000 Oil$340,000 Less Accumulated depletion (75,000) 265,000 Total property, plant, and equipment$935,000 Property, Plant, and Equipment: Land$120,000 Buildings$800,000 Equipment 160, ,000 Less: Accumulated depreciation (410,000) 550,000 Oil$340,000 Less Accumulated depletion (75,000) 265,000 Total property, plant, and equipment$935,000 THE PLANT ASSET SECTION OF THE BALANCE SHEET

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-69 ACCOUNTING FOR INTANGIBLE ASSETS Intangible assets are –Long-lived assets that are not physical in nature –Are recorded at acquisition cost and then systematically written off Amortization is –The systematic allocation of an intangible’s cost to expense over its useful life –Generally computed on a straight-line basis over a maximum period of 40 years

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-70 Obsolescence often cuts an intangible’s useful life shorter than its legal life Amortization expense for an intangible asset can be written off directly against the asset account rather than held in an accumulated amortization account ACCOUNTING FOR INTANGIBLE ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-71 Patents are federal grants giving the holder the exclusive right for 20 years to produce and sell an invention ACCOUNTING FOR INTANGIBLE ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-72 Suppose a company pays $170,000 to acquire a patent on January 1, and the business believes the expected useful life of the patent is only five years. Amortization expense is $34,000 per year ($170,000/5years). The company’s acquisition and amortization entries for this patent are: Jan. 1Patents170,000 Cash 170,000 To acquire a patent Jan. 1Patents170,000 Cash 170,000 To acquire a patent Dec 31Amortization Expense Patents (170,000/5) 34,000 Patents 34,000 To amortize the cost of a patent Dec 31Amortization Expense Patents (170,000/5) 34,000 Patents 34,000 To amortize the cost of a patent ACCOUNTING FOR INTANGIBLE ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-73 Copyrights are exclusive rights to reproduce and sell a book, musical composition, film, or other work of art –Copyrights extend 50 years beyond the author’s life Trademarks and trade names (brand names) are distinctive identifications of products or services –The cost of a trademark is amortized over its useful life, not to exceed 40 years ACCOUNTING FOR INTANGIBLE ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-74 Franchises and licenses are privileges granted by a private business or a government to sell a product or service in accordance with specified conditions –The costs of franchises and licenses are amortized over their useful lives rather than over legal lives, not to exceed 40 years ACCOUNTING FOR INTANGIBLE ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-75 A leasehold is a prepayment of rent that a lessee (renter) makes to secure the use of an asset from a lessor (landlord) Goodwill is the excess of the cost of an acquired company over the sum of the market values of its net assets (assets minus liabilities) ACCOUNTING FOR INTANGIBLE ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-76 Goodwill is –Recorded only when it is purchased in the acquisition of another company –Is amortized over a period not to exceed 40 years ACCOUNTING FOR INTANGIBLE ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-77 Suppose Wal-Mart acquires Mexana Company at a cost of $10 million. The sum of the market values of Mexana’s assets is $9 million, and its liabilities total $1 million. Wal-Mart paid $2 million for goodwill, computed as follows: Purchase price paid for Mexana Company $10 million Sum of the market values of Mexana Company’s assets 9 million Less: Mexana Company’s liabilities ( 1 million) Market value of Mexana Company’s net assets 8 million Excess is called goodwill$2 million Purchase price paid for Mexana Company $10 million Sum of the market values of Mexana Company’s assets 9 million Less: Mexana Company’s liabilities ( 1 million) Market value of Mexana Company’s net assets 8 million Excess is called goodwill$2 million ACCOUNTING FOR INTANGIBLE ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-78 Wal-Mart’s entry to record the acquisition of Mexana Company would be Assets (Cash, Receivables, Inventories, Plant assets, all at market value)9,000,000 Goodwill2,000,000 Liabilities 1,000,000 Cash10,000,000 Assets (Cash, Receivables, Inventories, Plant assets, all at market value)9,000,000 Goodwill2,000,000 Liabilities 1,000,000 Cash10,000,000 ACCOUNTING FOR INTANGIBLE ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-79 ACCOUNTING FOR INTANGIBLE ASSETS The cost of research and development –Is one of a company’s most valuable intangible assets –Is expensed as it is incurred International accounting –Many international companies record goodwill as a decrease in owners’ equity –Since goodwill is not amortized, their net income is higher than a U.S. company’s would be in a similar situation

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-80 ETHICAL ISSUES The main ethical issue in accounting for plant assets and intangibles is whether to capitalize or expense a particular cost –Companies that want to save on taxes are motivated to expense all the costs they can to decrease taxable income –Companies also want financial statements with high net income and high reported amounts for assets

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-81 The ethical path is to follow the general guidelines for capitalizing a cost –Capitalize all costs that provide a future benefit for the business and expense all other costs ETHICAL ISSUES

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-82 Plant Assets and Related Expenses Decision Guidelines Capitalize or expense a cost? Capitalize or expense: Cost associated with a new asset? Cost associated with an existing asset? Interest cost incurred to finance? Which depreciation method to use: For financial reporting? For income tax? Capitalize or expense a cost? Capitalize or expense: Cost associated with a new asset? Cost associated with an existing asset? Interest cost incurred to finance? Which depreciation method to use: For financial reporting? For income tax? General rule: Capitalize all costs that provide future benefits for the business. Expense all costs that provide no future benefit. Capitalize all costs that bring the asset to its intended use. Capitalize only those costs that add to the asset’s usefulness or its useful life. Expense all other costs as maintenance or repairs. Capitalize interest cost only on assets constructed by the business for its own use. Expense all other interest cost. Use the method that best matches depreciation expense against the revenues produced by the asset. Use the method that produces the fastest tax deductions (MACRS). A company can use different depreciation methods for financial reporting and for income tax purposes. General rule: Capitalize all costs that provide future benefits for the business. Expense all costs that provide no future benefit. Capitalize all costs that bring the asset to its intended use. Capitalize only those costs that add to the asset’s usefulness or its useful life. Expense all other costs as maintenance or repairs. Capitalize interest cost only on assets constructed by the business for its own use. Expense all other interest cost. Use the method that best matches depreciation expense against the revenues produced by the asset. Use the method that produces the fastest tax deductions (MACRS). A company can use different depreciation methods for financial reporting and for income tax purposes.

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-83 REPORTING ON THE STATEMENT OF CASH FLOWS The plant asset transactions that appear on the statement of cash flows are –Acquisitions (an investing activity) –Sales –Depreciation (including amortization and depletion) Is reported in the operating section Decreases net income, but has no effect on cash Is added back to net income in determining cash flow from operations

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-84 REPORTING ON THE STATEMENT OF CASH FLOWS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 7-85 END OF CHAPTER 7