1. Chapter 07 Long-Term Assets This chapter is divided into 3 parts
Part A: Acquisition and Improvements
Part B: Cost Allocation
Part C: Asset Disposition
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc. 1

2. Participation Questions – Chapter 7
Nike was used as an example for the intangible asset of Trademarks.
True or False
What company committed fraud by capitalizing $11 billion of costs instead of properly expensing them?
Target, WorldCom, JC Penney, Albright Mobile Communications
Name a type of intangible asset.
Equipment, Building, Land, Goodwill
Tangible property is depreciated each year in order to comply with the matching principle.
The double declining balance method of calculating depreciation expense forces companies to pay higher income taxes in the earlier years of the assets life.

3. Announcements
Handouts PPT pgs. 25, 28, 32, 34, 39, 40, 42, 44, 51, 53 or in Webcourses Class Materials
Verizon Director of Accounting, Tuesday 10/27 at 10 AM in COBA Exchange
Assignments – Due 11/1/15
Chapter 7 Homework (Connect) – unlimited attempts
Participation questions for Chapter 7 (Webcourses) – 1 attempt
Learn Smart Extra Credit for Block 2 (All 4 100%)
Exam 2: 11/2 – 11/4
Study Sessions for Exam #2 - October 12:00 PM – 2:00 PM with Louis
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College of Business Accounting Tutoring Lab - BA 1 – Room 355
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4. Retired, Vice Chairman, US Public Sector Leader, State Sector Leader,
“My Career Story and What Students Can Learn From It”
Jessica Blume
Retired, Vice Chairman, US Public Sector Leader,
State Sector Leader,
Deloitte, LLP
Wednesday, November 4th, 2015
2 Sessions: 11 a.m. and 1 p.m.
BA1 Rm 148 (The Exchange)
Register: exchange-blume.eventbrite.com

5. Questions to be Answered
Overall - What is financial reporting’s role in today’s American society?
Chapter 7 – How does the purchase, using, or sale of long-term assets impact period earnings and the balance sheet?

6. Chapter 7 - LONG-TERM ASSETS

7. WorldCom
2002 – WorldCom did not record expenses for costs associated with lines and cabling; instead they ‘parked’ the cost on the balance sheet to be expensed at a later time.
Found through a routine internal audit.
If the amount = $11 Billion – what is the result to the financial statements?
Led to $100 Billion in losses to shareholders
Lease payments for lines – should have been expenses and were capitalized.

8. WorldCom – Capitalization of Lease Expenses – (not actual results, just for representation)

9. Chapter 7 – Long-term Assets (LTA)
What is it?
Calculate costs
Purchase
Cost allocation - Spread costs to the periods when revenue is earned
Sell or retire asset
Tangible Asset
Intangible Asset

10. Categories of Long-Term Assets
Tangible Assets- Property, Plant and Equipment
Intangible Assets
Land, land improvements, buildings, equipment, and natural resources
Patents, trademarks, copyrights, franchises, and goodwill
Physical substance
Lacks physical substance
We classify long-term assets into two major categories:
Property, plant, and equipment. Assets in this category include land, land improvements, buildings, equipment, and natural resources.
Intangible assets. Assets in this category include patents, trademarks, copyrights, franchises, and goodwill. We distinguish these assets from property, plant, and equipment by their lack of physical substance.
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11. Acquisition (Purchase)
Part A
Acquisition (Purchase)
First, lets look at the acquisition of tangible and intangible assets.
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12. Purchase of Long-term Assets - Measuring the Cost of a Plant Asset
Sum of all costs incurred to bring the asset to its
intended use
Record a long-term asset at
Cost +
All expenditures necessary to get the asset ready for use
Here is a basic working rule for determining the cost of an asset: The cost of any asset is the sum of all the costs incurred to bring the asset to its intended use. The cost of a plant asset includes purchase price, plus any taxes, commissions, and other amounts paid to make the asset ready for use.
Similar to “Inventory”
Copyright ©2010 Pearson Education Inc. Publishing as Prentice Hall.

13. grading and removing unwanted buildings Land Improvements
Asset
Costs included
Land
Purchase price, commissions, survey & legal fees, and back property taxes paid;
grading and removing unwanted buildings
Land Improvements
Fencing, paving, security systems & lighting
Building –
Constructed
Architectural fees, contractors’ charges, materials, labor, and overhead; interest on funds borrowed
Purchased
Purchase price, broker’s commission, taxes paid and all costs to repair and renovate building
Equipment
Purchase price, transportation, insurance in transit, sales tax, installation and testing
The cost of land does not include the cost of fencing, paving, security systems, and lighting. These are separate plant assets—called land improvements—and they are subject to depreciation.
The cost of equipment includes its purchase price (less any discounts), plus transportation from the seller, insurance while in transit, sales and other taxes, purchase commission, installation costs, and any expenditures to test the asset before it’s placed in service. The equipment cost will also include the cost of any special platforms. Then after the asset is up and running, insurance, taxes, and maintenance costs are recorded as expenses, not as part of the asset’s cost.

14. Cash Purchase of Land and Related costs
Add up all of the costs associated with ‘Land’ and debit these costs to the Land account.
Add up all of the costs associated with ‘Land’ and debit these costs to the Land account.

15. Lump-sum (Basket) Purchases
How do you allocate the purchase cost when you pay a lump sum for more than 1 asset?
Two different Situations that occur in Basket Purchases:
1.) Market Value and Cost match: Purchase Land and Building for $450,000 and signed a promissory note.
Appraisal shows the land value at $100,000
Appraisal shows the buildings value at $350,000
2.) Market Value and Cost do not match: Purchase Land and Building for $450,000 and signed a promissory note
Appraisal shows the buildings value at $400,000
Businesses often purchase several assets as a group, or a “basket,” for a single lump-sum amount. For example, a business may pay one price for land and a building. The company must identify the cost of each asset. The total cost is divided among the assets according to their relative sales (or market) values. This technique is called the relative-sales-value method.
In the above table, assume a company purchased land and building for a combined price of $450,000. The values of the individual assets are shown in the market value column. This column is totaled. Then the market value of each asset is divided by the total market to determine a percent. This percent is multiplied by the cost. The end result is that land is allocated $90,000 (20%) of the cost, and building is allocated $360,000 of the cost.

16. Lump-sum (Basket) Purchases (Cont.)
Step 1.) Calculate the % each asset account is of the total Fair Market Value of the asset bundle purchased (appraisal). Step 2.) Multiply each asset accounts % by the Total Cost of the asset bundle.
Step 1
Step 2
Asset
Market value
Total market value
% of total market value
Total cost
Cost of each asset
Land
$100,000
$500,000
20%
$450,000
$90,000
Building
$400,000
80%
$360,000
100% = =
Businesses often purchase several assets as a group, or a “basket,” for a single lump-sum amount. For example, a business may pay one price for land and a building. The company must identify the cost of each asset. The total cost is divided among the assets according to their relative sales (or market) values. This technique is called the relative-sales-value method.
In the above table, assume a company purchased land and building for a combined price of $450,000. The values of the individual assets are shown in the market value column. This column is totaled. Then the market value of each asset is divided by the total market to determine a percent. This percent is multiplied by the cost. The end result is that land is allocated $90,000 (20%) of the cost, and building is allocated $360,000 of the cost.
Step 1
Step 2

17. Basket Purchase Example
On 1/1/14, a used truck and fork lift are purchased for $50,000 cash. The Fair Market Value (FMV) on the truck is $30,000 and the FMV for the fork lift is $30,000. Journalize the purchases.

18. Part B Cost Allocation 7-18
Now, lets focus on the allocation of cost of an asset over its useful life. We will have a look at cost allocation of both tangible assets known as depreciation; and cost allocation of intangible assets known as amortization.
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19. Plant Asset Terminology – Cost Allocation
Asset Account
(Balance Sheet)
Related Expense Account
(Income Statement)
Plant assets (aka fixed, capital)
Land
None
Buildings, Machinery & Equipment
Depreciation
Furniture & Fixtures
Land Improvements
Natural Resources
Depletion
Intangibles
Amortization
Businesses use several types of long-lived assets, as shown in this table. The table also shows the expense that applies to each asset. For example, buildings, airplanes, and equipment depreciate. Natural resources deplete, and intangible assets are amortized.
■ Plant assets, or fixed assets, are long-lived assets that are tangible, meaning they have physical substance —for instance, land, buildings, and equipment. The expense associated with plant assets is called depreciation. Of the plant assets, land is unique. Land is not expensed through depreciation over time because its usefulness does not decrease. Most companies report plant assets as Property, plant, and equipment on the balance sheet.
■ Intangible assets are useful because of the special rights they carry. They have no physical form. Patents, copyrights, and trademarks are intangible assets; so is goodwill. Accounting for intangibles is similar to accounting for plant assets.
Accounting for plant assets and intangibles has its own terminology. Different names apply to the individual plant assets and their corresponding expenses as shown above.

20. LO4 Calculate depreciation of property, plant, and equipment
Dictionary definition = Decrease in value.
Accounting definition = Allocation of an asset’s cost
$Cost
$Benefit
Time Periods
Depreciation = Allocation of a portion of the asset’s cost to an expense over all periods benefited.
Cost incurred to purchase
an asset (future benefit)
Depreciation in accounting is the process of allocating to an expense the cost of an asset over its service life.
Depreciation satisfies the matching principle since we expense the cost of the asset over the periods in which the asset creates revenues. As the figure reflects, an asset provides benefits (revenues) to a company in future periods. To properly match the cost (expense) with the revenues it helps to generate, we allocate a portion of the asset’s cost to an expense in each year that the asset provides a benefit. If the asset will provide benefits to the company for four years, then we allocate a portion of the asset’s cost to depreciation expense in each year for four years.
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21. Matching Expense to Revenue

22. Depreciation Terminology
Residual value (or salvage value) is the amount the company expects to receive from selling the asset at the end of its service life. (Residual value is never depreciated)
Depreciable cost – total purchase cost less residual value.
Service life (or useful life) is how long the company expects to receive benefits from the asset before disposing of it; can be measured in units of time or in units of activity.
Accumulated depreciation is a contra-asset account representing the total depreciation taken to date (cumulative).
Book value is equal to the original cost of the asset minus the current balance in accumulated depreciation.
Lets consider few of the terms normally used in the context of Depreciation accounting.
Accumulated depreciation, as we have just seen, is a contra-asset account representing the total depreciation taken to date.
Book value is equal to the original cost of the asset minus the current balance in accumulated depreciation.
Note that by increasing accumulated depreciation each period, we are reducing the book value of equipment.
The service life or useful life is how long the company expects to receive benefits from the asset before disposing of it. We can measure service life in units of time or in units of activity.
Residual value, also referred to as salvage value, is the amount the company expects to receive from selling the asset at the end of its service life.
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23. Southwest Airlines
2011 operating income would have been = 1408 without depreciation.

24. Depreciation Methods Depreciation Methods Straight-line
Declining-balance
Activity-based
The three most commonly used depreciation methods are:
Straight-line
Declining-balance
Activity-based
Lets have a look on each of these methods in detail.
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25. Straight-Line Depreciation
Allocates an equal amount of the depreciable cost based on time to each year (month) of the asset’s service life.
Asset cost - Estimated residual value
Straight-Line Depreciation =
Asset’s service life (Years or Months)
With the straight-line method, we allocate an equal amount of the allocation base to each year of the asset’s service life. The allocation base is the asset’s cost minus its estimated residual value. We simply divide the allocation base by the number of years in the asset’s life.
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26. Truck purchase for $41,000; residual value = $1,000; useful life = 5 years. What is Annual Depreciation Expense? Journalize.

27. Straight-line Depreciation – Balance Sheet
Partial balance sheet
Partial Income Statement
Partial balance sheet

28. Activity-Based Depreciation
Allocate an asset’s cost based on use rather than time
Step 1
Compute the average depreciation rate per unit
Depreciable Cost (Cost – Salvage Value)
Total units expected to be produced/used
Step 2
Multiply the average depreciation rate per unit by the number of units consumed each period
Step 3
Journal entry recording a debit to depreciation expense and a credit to accumulated depreciation.
Straight-line and declining-balance methods measure depreciation based on time. In an activity-based method we allocate an asset’s cost based on its use. For example, we could measure the service life of a machine in terms of its output (units, pounds, barrels).
Under this method, we first compute the average depreciation rate per unit by dividing the allocation base (cost minus residual value) by the number of units expected to be produced. We then multiply this per unit rate by the number of units of activity each period.
We allocate natural resources to expense through a process known as depletion. The process of recording depletion expense for natural resources is nearly identical to the activity-based method of recording depreciation.
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29. Activity Based Depreciation – Example Truck purchase $41,000, 5 year useful life, $1,000 residual value, 100,000 miles expected use.
Use Miles
Year ,000
Year ,000
Year ,000
Year ,000
Year ,000
100,000

30. Activity Based Depreciation – Example Truck purchase $41,000, 5 year useful life, $1,000 residual value, 100,000 expected use.

31. Declining-Balance Depreciation
An accelerated depreciation method
Depreciates a larger portion of the asset in the first years of the useful life.
Will be higher than straight-line depreciation in earlier years, but lower in later years
Double-declining-balance (DDB) depreciation computes annual depreciation by multiplying the asset’s declining book value by a constant percentage, which is two times the straight-line depreciation rate (hence – double).
Does not consider residual value until last year.
The declining-balance method is an accelerated depreciation method. Declining-balance depreciation will be higher than straight-line depreciation in earlier years, but lower in later years. However, both declining-balance and straight-line will result in the same total depreciation over the asset’s service life.
The depreciation rate we use under the declining-balance method is a multiple of the straight-line rate, such as 125%, 150%, or 200% of the straight-line rate. The most common declining-balance rate is 200%, which we refer to as the double-declining-balance method since the rate is double the straight-line rate.
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32. Double Declining Balance (DDB) - STEPS
Straight line Depreciation as a % - Compute straight-line deprec. in the form of a percentage.
For example, 4 year useful life = 25% of the value each year (1 / useful life)
DDB Percentage Rate - Multiply the straight-line percentage rate by 2 (hence, the title of ‘double’ declining balance) to compute the DDB percentage rate.
First Year Depreciation Expense - Multiply the DDB % rate by the period’s beginning asset book value
***Under the DDB method, ignore the residual value of the asset in computing depreciation, except during the last year. ***
Record Depreciation Expense - Record and post the calculated depreciation expense (debit depreciation expense and credit accumulated depreciation)
Next Years Depreciation Expense - Multiply the DDB % rate by the period’s beginning asset book value (cost less accumulated depreciation).
Determine the final year’s depreciation amount—that is, the amount needed to reduce asset book value to its residual value.
The residual value should not be depreciated but should remain on the books until the asset is disposed.

33. Double Declining Balance (DDB) - Example
Step 1
Step 2
DDB Percentage Rate
Step 1

34. DDB – Example – Using Depreciation Schedule

35. DDB Example and Differences
First-year depreciation is based on asset’s full cost (NOT the depreciable cost)
Final year depreciation is a “plug” amount needed to reduce book value to residual value
The DDB method differs from the other methods in two ways:
1. Residual value is ignored initially; first-year depreciation is computed on the asset’s full cost.
2. Depreciation expense in the final year is the “plug” amount needed to reduce the asset’s book value to the residual amount.

36. Comparing Depreciation Methods
Straight line
Best for assets that generate revenue evenly - TIME
Units of production
Best for assets that wear out based on USAGE
Double declining balance
Best for assets that generate most revenues early in their life
Tax Advantage in the early years
Matching best achieved considering these scenarios

37. Depreciation for Tax Purposes
Tax savings increase cashflow and cash can be reinvested in business
Tax deductions decrease tax payments
Accelerated deprecation provides fastest tax deductions
Most companies use straight-line depreciation for reporting to stockholders and creditors on their financial statements. But for their income taxes they also keep a separate set of depreciation records. For tax purposes, many companies use an accelerated depreciation method. This is legal, ethical, and honest. U.S. law permits it. Suppose you are a business manager, and the IRS allows an accelerated depreciation method. Why do managers prefer accelerated over straight-line depreciation for income-tax purposes? Accelerated depreciation provides the fastest tax deductions, thus decreasing immediate tax payments. The company can reinvest the tax savings back in the business.

38. Comparison of Dep. Methods

39. Exercise

40. Straight-line Depreciation – Bought van on year useful life (36,000) miles Residual value = $2,800
What is book value at the end of year 2?

41. Straight Line – Journal Entry
Date
Account
Debit
Credit
12/31/2013
Depreciation Expense
4,050
Accumulated Depreciation
(Annual depreciation expense)
12/31/2014
12/31/2015
12/31/2016

42. Activity Based Depreciation Bought van on ; 4 year useful life (36,000) miles; Residual value = $2,800 Actual usage – Year 1 – 11,000 miles; Year 2 – 13,000 miles; Year 3 – 5,000 miles; Year 4 – 7,000 miles
What is book value at the end of year 2?

43. Activity Based – Journal Entries
Date
Account
Debit
Credit
12/31/2013
Depreciation Expense
4,950
Accumulated Depreciation
(Annual depreciation expense)
12/31/2014
5,850
12/31/2015
2,250
12/31/2016
3,150

44. Double-declining-balance
Bought van on year useful life (36,000) miles Residual value = $2,800
Step 1
Step 2
Double-declining-balance does not use the depreciable cost in its computations. First, the DDB rate is determined by dividing two by the life of the van. This results in a DDB rate of 50%. For the first year, the book value is the same as the cost of the van. It is multiplied by 50% to determine depreciation. The ending book value of year one becomes the beginning book value of year 2. The pattern continues. What is unique about this exercise is that in the third year, the book value is less than residual. We must “back up” and re-compute year three so this doesn’t happen. We have year 3 ending book value equal residual and then “back into” depreciation expense. So even though the van was assigned a four-year life, it became fully-depreciated in year 3.

45. Exercise DDB rate 50% Double-declining-balance 1/Life in years * 2
1/4 *2
50%
Depreciation
Accumulated
Ending
Date
Asset Cost
DDB Rate
Book Value
Expense
1/1/2011
19,000
12/31/2011
0.50
9,500
12/31/2012
4,750
14,250
12/31/2013
1,950
16,200
2,800
***
12/31/2014 -
Double-declining-balance does not use the depreciable cost in its computations. First, the DDB rate is determined by dividing two by the life of the van. This results in a DDB rate of 50%. For the first year, the book value is the same as the cost of the van. It is multiplied by 50% to determine depreciation. The ending book value of year one becomes the beginning book value of year 2. The pattern continues. What is unique about this exercise is that in the third year, the book value is less than residual. We must “back up” and re-compute year three so this doesn’t happen. We have year 3 ending book value equal residual and then “back into” depreciation expense. So even though the van was assigned a four-year life, it became fully-depreciated in year 3.

46. Double Declining Balance – JE’s
Date
Account
Debit
Credit
12/31/2011
Depreciation Expense
9,500
Accumulated Depreciation
(Annual depreciation expense)
12/31/2012
4,750
12/31/2013
1,950
12/31/2014 -

47. Partial Year Depreciation
Months from date of purchase to end of year
Annual depreciation 12
Companies purchase plant assets whenever they need them, not just at the beginning of the year. Therefore, companies must compute depreciation for partial years. First, compute depreciation for a full year. Second, multiply full-year depreciation by the fraction of the year that the company held the asset.

48. Partial Year Depreciation Example Cost = $500,000; Residual Value = $80,000; Useful Life = 20 years – bought April 1st.
Step 1 – Calculate Annual Amount
Step 2 – Multiply by Time
Step 1

49. Part C Asset Disposition THE FOOD STORE 7-49
Now, lets consider the ways in which assets can be disposed.
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50. LO6 Disposal of Long-Term Assets
Sale
Retirement
Can result in either a gain or a loss
Occurs when a long-term asset is no longer useful but cannot be sold
Long-term assets can be sold, retired, or exchanged for other assets.
A sale is the most likely. Selling a long-term asset can result in either a gain or a loss.
When a long-term asset is no longer useful but cannot be sold, we have a retirement. For example, Little King Sandwiches might physically remove a baking oven that no longer works and also remove it from the accounting records through a retirement entry.
An exchange occurs when two companies trade assets. In a trade, we often use cash to make up for any difference in fair value between the assets.
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51. Disposal of Long-Term Assets - STEPS
Calculate Gain or Loss on Sale/Retirement
Bring accumulated depreciation up-to-date to:
Record depreciation expense up to date of disposal
Calculate sale amount based on one of 2 scenarios
Sale Price - Equals cash received (sale)
Retirement, $0.00 is received.
Subtract current book value (Updated after Step 1).
If result is positive, record gain (credit); if negative, record loss (debit).
Journal Entry – close out asset and accumulated depreciation
1. Debit Cash if sale (if retirement, no cash is received)
2. Debit accumulated depreciation (to close out account)
3. Credit tangible asset account (to close out account)
4. Record gain (credit) or loss (debit) on disposal (New accounts – Gain with a normal Credit Balance and Loss with a normal Debit Balance)

52. Selling a Plant Asset GAIN LOSS
If cash received is greater than book value
GAIN
(Credit)
If cash received is less than book value
LOSS
(Debit)
When plant assets are sold for cash, a gain or loss can be incurred. If the cash received is greater than the book value of the asset at the time of the sale, a gain is recorded. If the cash received is less than the book value, a loss is recorded.

53. Recording Long-Term Asset Disposals
Little King Sandwiches purchased a new delivery truck.
Here are the specific details:
Cost of the new truck
$40,000
Estimated residual value
$5,000
Estimated service life
5 years
Assume a sale at the end of 3 years for 22,000 & SL Depreciation
To illustrate the recording of disposals, let’s return to our delivery truck example for Little King Sandwiches. Assume Little King uses straight-line depreciation in all cases (sale, retirement and exchange).
Little King Sandwiches, a local submarine sandwich restaurant, purchased a new delivery truck. Here are the specific details:
Cost of the new truck $40,000
Estimated residual value $5,000
Estimated service life 5 years
Now consider how the treatment differs under a sale, a retirement and an exchange.
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54. Sale
If we assume that Little King sells the delivery truck at the end of year 3 for $22,000, we can calculate the gain as $3,000. Note that both the delivery truck and the related accumulated depreciation account are removed.
STEP 2
Sale amount
$22,000
Less:
Cost of the new truck
$40,000
Less: Accumulated depreciation (3 years x $7,000/year)
(21,000)
Book value at the end of year 3
19,000
Gain on sale
$3,000
STEP 3
STEP 4
The entry to record the gain on sale is:
Cash
22,000
Accumulated Depreciation
21,000
Delivery Truck
40,000
Gain on sale
3,000
(Record gain on sale)
If we assume that Little King sells the delivery truck at the end of year 3 for $22,000, we can calculate the gain as $3,000. Note that both the delivery truck and the related accumulated depreciation are removed.
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55. Retirement
If we assume that the delivery truck is totaled in an accident at the end of year 3, we have a $19,000 loss on retirement.
If we assume that the delivery truck is totaled in an accident at the end of year 3, we have a $19,000 loss on retirement. The above entry assumes Little King did not have collision insurance coverage.
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56. Retirement STEP 2 STEP 3 STEP 4
If we assume that the delivery truck is totaled in an accident at the end of year 3, we have a $19,000 loss on retirement.
STEP 2
Sale amount $0
Less:
Cost of the new truck
$40,000
Less: Accumulated depreciation (3 years x $7,000/year)
(21,000)
Book value at the end of year 3
19,000
Loss on retirement
($19,000)
The entry to record the loss on retirement is:
Accumulated Depreciation
21,000
Loss on Retirement
Delivery Truck
40,000
(Record loss on retirement)
STEP 3
STEP 4
If we assume that the delivery truck is totaled in an accident at the end of year 3, we have a $19,000 loss on retirement. The above entry assumes Little King did not have collision insurance coverage.
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57. INTANGIBLE ASSETS – Purchase or Create
Purchase intangible assets like patents, copyrights, trademarks, or franchise rights from other entities.
Record purchased intangible assets at their original cost plus all other costs, such as legal and filing fees, necessary to get the asset ready for use.
Create intangible assets internally through research and development or advertising.
Most of the costs for internally developed intangible assets are expensed to the income statement as they are incurred.
Despite their lack of physical substance, intangible assets can be very valuable indeed.
Companies can either (1) purchase intangible assets like patents, copyrights, trademarks, or franchise rights from other entities or (2) create intangible assets internally by developing a new product or process and obtaining a protective patent. Reporting purchased intangibles is similar to reporting purchased property, plant, and equipment. We record purchased intangible assets at their original cost plus all other costs, such as legal and filing fees, necessary to get the asset ready for use.
Reporting intangible assets developed internally is quite different. Rather than recording these as an intangible asset on the balance sheet, we expense most of the costs for internally developed intangible assets to the income statement as we incur them. For example, the research and development costs incurred in developing a patent internally are not recorded as an intangible asset in the balance sheet, but rather are expensed directly in the income statement.
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59. Research & Development Costs
R&D costs are generally not capitalized.
Generally, all R&D costs are expensed when incurred
What makes sense is not always GAAP
Research & development may lead to revenue producing intangible assets
Drug formula, special recipes, processes
Copyright ©2010 Pearson Education Inc. Publishing as Prentice Hall. 59 59

60. LO5 Amortization of Intangible Assets
Definition: Allocation of the cost of intangible assets to the periods it helped earn the revenue
Intangible assets subject to amortization for useful life only
Intangible assets not subject to amortization
Assets having a FINITE useful life that we can estimate
Assets having INDEFINITE useful lives
Patents, Copyrights, Franchises
Goodwill, Trademarks
Allocating the cost of property, plant, and equipment to expense is called depreciation. Allocating the cost of natural resources to expense is called depletion. Similarly, allocating the cost of intangible assets to expense is called amortization.
Most intangible assets have a finite useful life that we can estimate. For example: Patents, copyrights, and franchises. We amortize such assets.
We do not amortize intangible assets with indefinite useful lives. For example: Goodwill, and most trademarks.
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61. Amortization of Intangible Assets (Cont.)
Allocates an equal amount of the amortization cost to each year of the asset’s useful life.
Asset cost
Straight-Line Amortization =
Lessor of Useful Life or Legal Life
With the straight-line method, we allocate an equal amount of the allocation base to each year of the asset’s service life. The allocation base is the asset’s cost minus its estimated residual value. We simply divide the allocation base by the number of years in the asset’s life.
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62. Patents (example, patent with a useful life of 5 years is purchased for $100,000 cash).
Granted by federal government
Give holder exclusive right to produce & sell an invention
Granted for 20 years
Useful life may be less
Patents are federal government grants that give the holder the exclusive right for 20 years to produce and sell an invention. The invention may be a product or a process—for example, Sony compact disc players and the Dolby noise-reduction process. Like any other asset, a patent may be purchased.

63. © Copyrights Granted by the federal government
Give holder exclusive rights to reproduce & sell a book, musical composition, film or other work of art
Extend 70 years after creator’s life
Useful life is usually very short
Copyrights are exclusive rights to reproduce and sell a book, musical composition, film, or other work of art. Copyrights also protect computer software programs. Issued by the federal government, copyrights extend 70 years beyond the author’s (composer’s, artist’s, or programmer’s) life. The cost of obtaining a copyright from the government is low, but a company may pay a large sum to purchase an existing copyright from the owner. For example, a publisher may pay the author of a popular novel $1 million or more for the book copyright. Because the useful life of a copyright is usually no longer than two or three years, each period’s amortization amount is a high proportion of the copyright cost. Owners of a copyright must use judgment in determining a reasonable life over which to amortize the asset.

64. Trademarks & Trade Names TM ®
Distinctive identification of a product or service
Also include
Advertising slogans
Coloring/uniforms
Signage, mastheads, etc.
Useful life may be set by contract
Or indefinite life
Trademarks and trade names (or brand names) are distinctive identification of a product or service. The “eye” symbol that flashes across our television screens is the trademark that identifies the CBS television network. You are probably also familiar with NBC’s peacock. Advertising slogans that are legally protected include United Airlines’ “Fly the friendly skies®” and Avis Rental Car’s “We try harder®.” These are distinctive identifications of products or services, marked with the symbol ™ or ®. Some trademarks may have a definite useful life set by contract. We should amortize this trademark’s cost over its useful life. But a trademark or a trade name may have an indefinite life and not be amortized.

65. Franchises & Licenses Granted by private business or government
Give purchaser right to sell a product or service with specified conditions
Include restaurant chains & sports organizations
May have indefinite life
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 Chicago Cubs baseball organization is a franchise granted to its owner by the National League. McDonald’s restaurants and Holiday Inns are popular franchises. Businesses purchase the rights to sell particular goods or services and in turn agree to operate under the standards and limitations imposed by the franchising corporation. The useful lives of many franchises and licenses are indefinite and, therefore, are not amortized.

66. Intangible with Finite life – Purchased Patent for $170,000 Legally Enforceable for 20 years Estimated Useful life – 5 years

67. Intangible with Finite life – Purchased Patent for $170,000 Legally Enforceable for 20 years Estimated Useful life – 5 years

68. Goodwill
Only recorded when assets are acquired in a business combination
Assets not individually identified
Reputation, corporate culture, market share
Defined as the excess of the purchase price of the company over the market value of its net assets
Represents future economic benefits (earning power of assets acquired in a business combination)
Not amortized – evaluate at least annually for impairment

69. Questions to be Answered
How does the purchase or sale of long-term assets impact period earnings?

70. Participation Questions – Chapter 7
Nike was used as an example for the intangible asset of Trademarks.
True or False
What company committed fraud by capitalizing $11 billion of costs instead of properly expensing them?
Target, WorldCom, JC Penney, Albright Mobile Communications
Name a type of intangible asset.
Equipment, Building, Land, Goodwill
Tangible property is depreciated each year in order to comply with the matching principle.
The double declining balance method of calculating depreciation expense forces companies to pay higher income taxes in the earlier years of the assets life.