Fixed Assets and Intangible Assets Financial and Managerial Accounting Chapter 9 Fixed Assets and Intangible Assets Financial and Managerial Accounting 8th Edition Warren Reeve Fess © Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc. PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University

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After studying this chapter, you should be able to: Objectives 1. Define fixed assets and describe the accounting for their cost. 2. Compute depreciation, using the following methods: straight-line method, units-of-production method, and declining-balance method. 3. Classify fixed asset costs as either capital expenditures or revenue expenditures. 4. Journalize entries for the disposal of fixed assets. 5. Define a lease and summarize the accounting rules related to the leasing of fixed assets. After studying this chapter, you should be able to:

Objectives 6. Describe internal controls over fixed assets. 7. Compute depletion and journalize the entry for depletion. 8. Describe the accounting for intangible assets, such as patents, copyrights, and goodwill. 9. Describe how depreciation expense is reported in an income statement, and prepare a balance sheet that includes fixed assets and intangible assets. 10. Compute and interpret the ratio of fixed assets to long-term debt.

Nature of Fixed Assets Fixed assets are long term or relatively permanent assets Fixed assets are tangible assets because they exist physically. They are owned and used by the business and are not held for sale as part of normal operations.

Classifying Costs Expense Fixed Assets Investment Is the purchased item long-lived? Yes No Expense Is the asset used in a productive purpose? Yes No Fixed Assets Investment

Cost of Fixed Assets

Land Purchase price Sales taxes Permits from government agencies Broker’s commissions Title fees Surveying fees

Land Purchase price Sales taxes Delinquent real estate taxes Permits from government agencies Broker’s commissions Title fees Surveying fees Delinquent real estate taxes Razing or removing unwanted buildings, less the salvage Grading and leveling Paving a public street bordering the land

Buildings Architects’ fees Engineers’ fees Insurance costs incurred during construction Interest on money borrowed to finance construction Walkways to and around the building

Buildings Sales taxes Repairs (purchase of existing building) Reconditioning (purchase of an existing building) Modifying for use Permits from governmental agencies

Land Improvements Trees and shrubs Fences Parking areas Outdoor lighting Concrete sewers and drainage Paved parking areas

Machinery and Equipment Sales taxes Freight Installation Repairs (purchase of used equipment) Reconditioning (purchase of used equipment)

Machinery and Equipment Insurance while in transit Assembly Modifying for use Testing for use Permits from governmental agencies

Cost of Acquiring Fixed Assets Excludes: Vandalism Mistakes in installation Uninsured theft Damage during unpacking and installing Fines for not obtaining proper permits from government agencies

Nature of Depreciation All fixed assets except land lose their capacity to provide services. This loss of productive capacity is recognized as Depreciation Expense. Physical depreciation occurs from wear and tear while in use and from the action of the weather. Functional depreciation occurs when a fixed asset is longer able to provide services at the level for which it was intended, e.g., personal computer.

Depreciation Expense Factors Initial Cost Residual Value - = Depreciable Cost Useful Life 1 Periodic Depreciation Expense 2 3 4 5

Use of Depreciation Methods Units-of-Production Other Declining- Balance 5% 8% 4% 83% Straight-Line Source: Accounting Trends & Techniques, 56th. ed., American Institute of Certified Public Accountants, New York, 2002.

Facts Original Cost.....………….. $24,000 Estimated Life in years….. 5 years Estimated Life in hours….. 10,000 Estimated Residual Value... $2,000

Cost – estimated residual value Straight-Line Method Cost – estimated residual value Estimated life = Annual depreciation

$24,000 – $2,000 Straight-Line Method 5 years = $4,400 annual depreciation

$24,000 – $2,000 Straight-Line Rate = $4,400 $4,400 = 18.3% $24,000 5 years $4,400 = 18.3% $24,000

Straight-Line Method The straight-line method is widely used by firms because it is simple and it provides a reasonable transfer of cost to periodic expenses if the asset is used about the same from period to period.

Straight-Line Method Annual Depreciation Accum. Depr. Book Value Depr. Book Value at Beginning at Beginning Expense at End Year Cost of Year of Year for Year of Year 1 $24,000 $24,000 $4,400 $19,600 2 24,000 $ 4,400 19,600 4,400 15,200 3 24,000 8,800 15,200 4,400 10,800 4 24,000 13,200 10,800 4,400 6,400 5 24,000 17,600 6,400 4,400 2,000 Annual Depreciation Expense ($4,400) Cost ($24,000) – Residual Value ($2,000) = Estimated Useful Life (5 years)

Units-of-Production Method Cost – estimated residual value Estimated life in units, hours, etc. = Depreciation per unit, hour, etc.

Units-of-Production Method $24,000 – $2,000 10,000 hours = Depreciation per unit, hour, etc. = $2.20 per hour

Units-of-Production Method The units-of-production method is more appropriate than the straight-line method when the amount of use of a fixed asset varies from year to year.

Declining-Balance Method Step 1 Ignoring residual value, determine the straight-line rate $24,000 – $2,000 5 years = $4,800 $4,800 $24,000 = 20%

Declining-Balance Method There’s a shortcut. Simply divide one by the number of years (1 ÷ 5 = .20).

Declining-Balance Method Step 2 Double the straight-line rate. .20 x 2 = .40 For the first year, the cost of the asset is multiplied by 40 percent. After the first year, the declining book value of the asset is multiplied 40 percent.

Declining-Balance Method Step 3 Build a table.

Declining-Balance Method Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End 1 $24,000 40% $9,600 $24,000 x .40

Declining-Balance Method Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End 1 $24,000 40% $9,600 $9,600 $14,400

Declining-Balance Method Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End 1 $24,000 40% $9,600 $9,600 $14,400 2 14,400 40% 5,760 $14,400 x .40

Declining-Balance Method Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End 1 $24,000 40% $9,600 $9,600 $14,400 2 14,400 40% 5,760 15,360 8,640

Declining-Balance Method Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End 1 $24,000 40% $9,600 $9,600 $14,400 2 14,400 40% 5,760 15,360 8,640 3 8,640 40% 3,456 18,816 5,184

Declining-Balance Method Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End 1 $24,000 40% $9,600 $9,600 $14,400 2 14,400 40% 5,760 15,360 8,640 3 8,640 40% 3,456 18,816 5,184 4 5,184 40% 2,074 20,890 3,110

Declining-Balance Method Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End STOP! 1 $24,000 40% $9,600 $9,600 $14,400 2 14,400 40% 5,760 15,360 8,640 3 8,640 40% 3,456 18,816 5,184 4 5,184 40% 2,074 20,890 3,110 5 3,110 40% 1,244 22,134 1,866

Declining-Balance Method If we use this approach in Year 5, we will end the year with a book value of $1,866. Remember, the residual value at the end of Year 5 is expected to be $2,000, so we must modify our approach. Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End 1 $24,000 40% $9,600 $9,600 $14,400 2 14,400 40% 5,760 15,360 8,640 3 8,640 40% 3,456 18,816 5,184 4 5,184 40% 2,074 20,890 3,110 5 3,110 40% 1,244 22,134 1,866

Declining-Balance Method Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End 1 $24,000 40% $9,600 $9,600 $14,400 2 14,400 40% 5,760 15,360 8,640 3 8,640 40% 3,456 18,816 5,184 4 5,184 40% 2,074 20,890 3,110 5 3,110 --- 1,110 $3,110 – $2,000

Desired ending book value Declining-Balance Method Book Value Accum. Beginning Annual Deprec. Book Value Year of Year Rate Deprec. Year-End Year-End 1 $24,000 40% $9,600 $9,600 $14,400 2 14,400 40% 5,760 15,360 8,640 3 8,640 40% 3,456 18,816 5,184 4 5,184 40% 2,074 20,890 3,110 5 3,110 --- 1,110 22,000 2,000 Desired ending book value

Comparing Straight-Line With the Declining-Balance Method 5,000 4,000 3,000 2,000 1,000 Depreciation ($) 1 2 3 4 1 2 3 4 Life (years) Life (years)

Revising Depreciation Estimates

Revising Depreciation Estimates A machine purchased for $130,000 was originally estimated to have a useful life of 30 years and a residual value of $10,000. The asset has been depreciated for ten years using the straight- line method. Annual Depreciation $130,000 – $10,000 30 years $4,000 per year

Revising Depreciation Estimates Accumulated Depreciation Equipment 130,000 4,000 40,000 Book value = $90,000 Before revising

Revising Depreciation Estimates During the eleventh year, it is estimated that the remaining useful life is 25 years (rather than 20) and that the revised estimated residual value is $5,000. Book value – revised residual value Revised estimated remaining life $90,000 – $5,000 25 years $3,400 revised annual depreciation =

Capital and Revenue Expenditures Expenditures made to acquire new plant assets are known as capital expenditures.

Capital and Revenue Expenditures Expenditures to repair or maintain plant assets that do not extend the life or enhance the value are known as revenue expenditures.

Increases useful life (extraordinary repairs)? Capital and Revenue Expenditures EXPENDITURE Increases useful life (extraordinary repairs)? No Revenue Expenditure (Debit expense account for ordinary maintenance and repairs) No Increases operating efficiency or adds to capacity? Capital Expenditure (Debit fixed asset account) Yes Capital Expenditure (Debit accumulated depreciation account) Yes

Capital and Revenue Expenditures LIABILITIES CAPITAL EXPENDITURES ASSETS OWNER’S EQUITY 1. Initial cost 2. Additions 3. Betterments 4. Extraordinary repairs net income EXPENSES REVENUES

Normal and ordinary repairs and maintenance Capital and Revenue Expenditures LIABILITIES ASSETS OWNER’S EQUITY net income REVENUE EXPENDITURES EXPENSES REVENUES Normal and ordinary repairs and maintenance

Accounting for Fixed Asset Disposals When fixed assets lose their usefulness they may be disposed of in one of the following ways: 1. discarded, 2. sold, or 3. traded (exchanged) for similar assets. Required entries will vary with type of disposition and circumstances, but the following entries will always be necessary: An asset account must be credited to remove the asset from the ledger, and the related Accumulated Depreciation account must be debited to remove it’s balance from the ledger.

Discarding Fixed Assets A piece of equipment acquired at a cost of $25,000 is fully depreciated. On February 14, the equipment is discarded.

Discarding Fixed Assets Feb. 14 Accumulated Depr.—Equipment 25 000 00 Equipment 25 000 00 To write off fully depreciated equipment.

Discarding Fixed Assets Equipment costing $6,000 is depreciated at an annual straight-line rate of 10%. After the adjusting entry, Accumulated Depreciation—Equipment had a $4,750 balance. The equipment was discarded on March 24. Mar. 24 Depreciation Expense.—Equipment 150 00 $600 x 3/12 Accum. Depreciation—Equipment 150 00 To record current depreciation on equipment discarded.

Discarding Fixed Assets Equipment costing $6,000 is depreciated at an annual straight-line rate of 10%. After the adjusting entry, Accumulated Depreciation—Equipment had a $4,750 balance. The equipment was discarded on March 24. Mar. 24 Accumulated Depr.—Equipment 4 900 00 Loss on Disposal of Fixed Asset 1 100 00 Equipment 6 000 00 To write off equipment discarded.

Sale of Fixed Assets When fixed assets are sold, the owner may break even, sustain a loss, or realize a gain. 1. If the sale price is equal to book value, there will be no gain or loss. 2. If the sale price is less than book value, there will be a loss equal to the difference. 3. If the sale price is more than book value, there will be a gain equal to the difference. Gain or loss will be reported in the income statement as Other Income or Other Loss.

Sale of Fixed Assets Equipment costing $10,000 is depreciated at an annual straight-line rate of 10%. The equipment is sold for cash on October 12. Accumulated Depreciation (last adjusted December 31) has a balance of $7,000. Oct. 12 Depreciation Expense—Equipment 750 00 Accumulated Depr.—Equipment 750 00 $10,000 x ¾ x10% To record current depreciation on equipment sold.

Sale of Fixed Assets Assumption 1: The equipment is sold for $2,250, so there is no gain or loss. Oct. 12 Cash 2 250 00 Accumulated Depr.—Equipment 7 750 00 Equipment 10 000 00 Sold equipment.

Sale of Fixed Assets Assumption 2: The equipment is sold for $1,000, so there is a loss of $1,250. Oct. 12 Cash 1 000 00 Accumulated Depr.—Equipment 7 750 00 Loss on Disposal of Fixed Assets 1 250 00 Equipment 10 000 00 Sold equipment.

Sale of Fixed Assets Assumption 2: The equipment is sold for $2,800, so there is a gain of $550. Oct. 12 Cash 2 800 00 Accumulated Depr.—Equipment 7 750 00 Equipment 10 000 00 Gain on Disposal of Fixed Assets 550 00 Sold equipment.

Exchanges of Similar Fixed Assets Trade-in Allowance (TIA) – amount allowed for old equipment toward the purchase price of similar new assets. Boot – balance owed on new equipment after trade-in allowance has been deducted. TIA > Book Value = Gain on Trade TIA < Book Value = Loss on Trade Gains are never recognized (not recorded). Losses must be recognized (recorded).

Exchanges of Similar Fixed Assets List price of new equipment acquired $5,000 Cost of old equipment traded in $4,000 Accum. depreciation at date of exchange 3,200 Book value at date of exchange $ 800 CASE ONE (GAIN): Trade-in allowance, $1,100 Cash paid, $3,900 ($5,000 – $1,100) TIA > Book Value = Gain $1,100 – $800 = $300 Boot + Book = Cost of New Equipment $3,900 + $800 = $4,700 Gains are not recognized for financial reporting.

Exchanges of Similar Fixed Assets On June 19, equipment exchanged at a gain of $300. June 19 Accumulated Depr.—Equipment 3 200 00 Equipment (new equipment) 4 700 00 Equipment (old equipment) 4 000 00 Cash 3 900 00

Exchanges of Similar Fixed Assets List price of new equipment acquired $10,000 Cost of old equipment traded in $7,000 Accum. depreciation at date of exchange 4,600 Book value at date of exchange $2,400 CASE TWO (LOSS): Trade-in allowance, $2,000 Cash paid, $8,000 ($10,000 – $2,000) TIA<Book Value = Loss $2,000 – $2,400 = $400 Losses are recognized for financial reporting.

Exchanges of Similar Fixed Assets On September 7, equipment exchanged at a loss of $400. Sept. 7 Accumulated Depr.—Equipment 4 600 00 Equipment (new equipment) 10 000 00 Loss on Disposal of Fixed Assets 400 00 Equipment (old equipment) 7 000 00 Cash 8 000 00

Natural Resources and Depletion Depletion is the process of transferring the cost of natural resources to an expense account.

Natural Resources and Depletion A business paid $400,000 for the mining rights to a mineral deposit estimated at 1,000,000 tons of ore. The depletion rate is $0.40 per ton ($400,000 ÷ 1,000,000 tons).

Natural Resources and Depletion During the current year, 90,000 tons are mined. The periodic depletion is $36,000 (90,000 tons x $0.40). Adjusting Entry Dec. 31 Depletion Expense 36 000 00 Accumulated Depletion 36 000 00

Intangible Assets and Amortization Amortization is the periodic cost expiration of intangible assets which do not have physical attributes and are not held for sale (patents, copyrights, and goodwill). Date Description Debit Credit Dec. 31 Amortization Expense 20,000 Patents 20,000 Paid $100,000 for patent rights. The patent life is 11 years and was issued 6 years prior to purchase. 11 years – 6 years = 5-year life ($100,000 / 5 years) = $20,000 per year

Discovery Mining Co. Partial Balance Sheet December 31, 2006 74 Discovery Mining Co. Partial Balance Sheet December 31, 2006 Accum. Book Property, plant, and equipment: Cost Depr. Value Land $ 30,000 $ 30,000 Buildings 110,000 $ 26,000 84,000 Factory equipment 650,000 192,000 458,000 Office equipment 120,000 13,000 107,000 $910,000 $231,000 $ 679,000 Accum. Book Mineral deposits: Cost Depr. Value Alaska deposit $1,200,000 $ 800,000 $400,000 Wyoming deposit 750,000 200,000 550,000 $1,950,000 $1,000,000 950,000 Total property, plant, and equipment $1,629,000 Intangible assets: Patents $ 75,000 Goodwill 50,000 Total intangible assets $ 125,000

Ratio of Fixed Assets to Long-Term Liabilities (in millions) 2002 2001 Procter & Gamble Fixed assets (net) $13,349 $13,095 Long-term debt $11,201 $9,792 Ratio of fixed assets to long-term liabilities 1.2 1.3 Use: To indicate the margin of safety to long-term creditors

Chapter 9 The End