1. Chapter 7
Long-Lived Assets
and Depreciation

2. Learning Objectives
After studying this chapter, you should be able to:
Measure the acquisition cost of tangible assets such as land, buildings, and equipment.
Compute depreciation for buildings and equipment using various depreciation methods.
Differentiate financial statement depreciation from income tax depreciation.
Explain depreciation’s effects on cash flow.

3. Learning Objectives
After studying this chapter, you should be able to:
Distinguish expenses from expenditures that should be capitalized.
Compute gains and losses on disposal of fixed assets.
Interpret depletion of natural resources.
Account for various intangible assets.

4. Overview of Long-Lived Assets
Long-lived assets - resources that are held for an extended time, such as land, buildings, equipment, natural resources, and patents
These assets help produce revenues over many periods by facilitating the production and sale of goods or services to customers.

5. Overview of Long-Lived Assets
Tangible assets - physical items that can be seen and touched, such as land, natural resources, buildings, and equipment
Also known as fixed assets or plant assets
Intangible assets - rights or economic benefits, such as franchises, patents, trademarks, copyrights, and goodwill that are not physical in nature

6. Overview of Long-Lived Assets
Terms for allocation of costs over time:
Depreciation - allocation of the cost of tangible assets to the periods in which the assets are used
Depletion - allocation of the cost of natural resources to the periods in which the resources are used
Amortization - allocation of the cost of intangible assets to the periods that benefit from these assets
Land is not depreciated because it does not wear out or become obsolete.

7. Acquisition Cost of Tangible Assets
The acquisition cost of long-lived assets is the purchase price, including incidental costs required to complete the purchase, to transport the asset, and to prepare it for use.

8. Acquisition Cost of Tangible Assets
Land
The acquisition cost of land includes costs of land surveys, legal fees, title fees, realtor commissions, transfer taxes, and the demolition costs of old structures.
Under historical cost accounting, land is carried on the balance sheet at its original cost even if the market value of the land is many times that of the original cost.

9. Acquisition Cost of Tangible Assets
Buildings and Equipment
Costs should include all costs of acquisition and preparation for use, such as sales taxes, transportation costs, installation costs, and repairs to the asset prior to use.
Costs included in the cost of an asset are capitalized (added to the asset account), as distinguished from being expensed immediately.

10. Depreciation of Buildings and Equipment
Depreciation in the accounting sense is not a process of valuation.
Depreciation is a form of allocating the cost of an asset to periods when the asset is used.
Depreciation is one key factor that distinguishes accrual accounting from cash-basis accounting.
Under the accrual basis, the cost of the asset is allocated to the periods benefited.
Under the cash basis, the cost of the asset would be expensed immediately.

11. Depreciation of Buildings and Equipment
Depreciable value - the amount of acquisition cost to be allocated as depreciation over the total useful life of an asset
The depreciable value is the difference between the acquisition cost and the predicted residual value.
Residual value - the amount received from disposal of a long-lived asset at the end of its useful life

12. Depreciation of Buildings and Equipment
Useful life (economic life) - the time period over which an asset is depreciated
The useful life is the shorter of the physical life of the asset before it wears out or the economic life of the asset before it becomes obsolete.
The useful life can be measured in terms other than time. For example, the life of a truck can be measured in miles driven.

13. Straight-Line Depreciation
Straight-line depreciation - a method that spreads the depreciable value evenly over the useful life of an asset
Depreciation expense

14. Straight-Line Depreciation
A truck with a cost of $41,000 and a residual value of $1,000 has a useful life of 4 years. Depreciation expense is calculated as follows:
($41,000 - $1,000) / 4 = $10,000*
*Depreciation is the same each year for the life of the asset.

15. Depreciation Based on Units
Unit depreciation - a depreciation method based on units of service when physical wear and tear is the dominating influence on the useful life of the asset
A depreciation rate per unit is determined by dividing the depreciable value (cost less residual value) by the useful life in units.
To determine depreciation expense, the actual usage of the asset is multiplied by the depreciation rate.

16. Depreciation Based on Units
A truck with a cost of $41,000 and a residual value of $1,000 has a useful life of 200,000 miles. During the year, the truck is driven for 45,000 miles. Depreciation expense is calculated as follows:
($41,000 - $1,000) / 200,000 = $.20 per mile
45,000 x $.20 = $9,000*
*Depreciation over the life of the asset will fluctuate as the usage of the asset fluctuates.

17. Declining-Balance Depreciation
Accelerated depreciation - any depreciation method that writes off depreciable costs more quickly than the ordinary straight-line method based on expected useful life
Double-declining-balance (DDB) depreciation - the most popular form of accelerated depreciation
It is computed by doubling the straight-line rate and multiplying the resulting DDB rate by the beginning book value.

18. Declining-Balance Depreciation
Computing DDB depreciation:
Compute a rate by dividing 100% by the number of years of useful life.
Double the rate.
Ignore the residual value, and multiply the asset’s book value at the beginning of the year by the DDB rate.
Stop depreciation when the book value reaches the residual value.

19. Declining-Balance Depreciation
A truck with a cost of $41,000 and a residual value of $1,000 has a useful life of 4 years. Double-declining-balance depreciation expense is calculated as follows:
100% / 4 = 25% x 2 = 50% per year
Year 1: $41,000 x 50% = $20,500*
Year 2: ($41,000 - $20,500) x 50% = $10,250*
*Depreciation over the life of the asset declines each year.

20. Comparing and Choosing Depreciation Methods
Straight-line gives the same depreciation expense each year of the useful life of the asset.
DDB gives accelerated depreciation expense (more than regular straight-line) in the first years of the useful life of the asset.
Companies will often switch from DDB to straight-line part way through the life of the asset to compensate for the fact the DDB may not fully depreciate the asset.

21. Comparing and Choosing Depreciation Methods
Companies do not always use the same depreciation methods for all types of depreciable assets.
The choice of depreciation alternatives comes from several places:
Tradition or use by other companies in the industry
Better matching of expenses with revenues
The nature of the industry and the equipment and the goals of management

22. Contrasting Income Tax and Shareholder Reporting
Reports to stockholders must follow GAAP, but reports to income tax authorities must follow the income tax rules and regulations.
These rules are usually alike, but sometimes they differ.
These difference cause business to keep two sets of books – one for financial statements and one for taxes.
Financial
Statements
Taxes

23. Depreciation on Tax Reports
Tax laws require the use of the Modified Accelerated Cost Recovery System (MACRS) for computing accelerated depreciation.
MACRS uses tax lives that are much shorter than the real economic life of most assets.
These short lives produce very accelerated depreciation in the early years of the life of the asset, which lowers taxable income in those years.

24. Shareholder Reporting
Shareholder reporting is driven by efforts to match the cost of assets to the periods in which the assets generate revenues.
Most companies use straight-line depreciation to accomplish this.
Companies also want higher earnings in their financial statements.
Straight-line produces lower depreciation in the early years than accelerated depreciation.

25. Depreciation and Cash Flow
Depreciation does not generate cash.
Depreciation allocates the original cost of an asset to the periods when the asset is used.
Accumulated depreciation is merely the total amount that an asset has been depreciated throughout its life.
2002

26. Effects of Depreciation on Cash
Depreciation has no effect on ending cash balances because it is a noncash expense.
Before taxes, changes in the depreciation method affect only the Accumulated Depreciation and Retained Earnings accounts.

27. Effects of Depreciation on Income Taxes
Depreciation is a deductible noncash expense for income tax purposes.
If depreciation expense is higher, taxes are lower, and more cash can be kept for use in the business.
Accelerated depreciation generally has higher depreciation expense.
Depreciation does not generate cash, but it does have a cash benefit if it results in lower taxes.

28. Contrasting Long-Lived Asset Expenditures With Expenses
Expenditures - purchases of goods or services, whether for cash or on credit
Asset-related expenditures that will benefit more than one year are capitalized.
Capital expenditures add new fixed assets or increase the capacity, efficiency, or useful life of an existing fixed asset.
Expenditures that provide a benefit lasting one year or less are expensed in the current year.

29. The Decision to Capitalize
No rules about when to expense or capitalize an expenditure are definitive.
An accountant might want to expense something that a tax auditor might want to capitalize.
The tendency in practice is to charge an expense for repairs, parts, and similar items.
Most of these expenditures are minor, so the cost-benefit and materiality concepts justify this choice.

30. Repairs and Maintenance Versus Capital Improvements
Repairs and maintenance are required to keep an asset in good working order.
Repairs include costs of fixing an asset after a breakdown or accident.
Maintenance includes routine costs of keeping the asset in good condition, such as oiling, painting, and adjusting.
Both repairs and maintenance are period costs and are treated as expenses.

31. Repairs and Maintenance Versus Capital Improvements
Improvement (betterment) - an expenditure that is intended to add to the future benefits from an existing fixed asset
Improvements are generally capitalized.
Examples are renovating an apartment building so the rent can be increased or rebuilding a packaging machine so the capacity is increased or its useful life extended.

32. Repairs and Maintenance Versus Capital Improvements
Improvements require adjustments to existing accounting records of the asset.
The book value of the asset must be increased by the amount of the expenditure.
The depreciation schedule must be revised to account for the increased book value and the increased useful life of the asset.

33. Gains and Losses on Sales of Tangible Assets
Assets are often sold before the end of their useful lives.
When an asset is sold, a gain or loss usually occurs.
The gain or loss is the difference between cash received and the net book value of the asset given up.

34. Recording Gains and Losses
Remember that when depreciation is recorded, two accounts are affected, Depreciation Expense and Accumulated Depreciation.
Accumulated depreciation reduces the book value of the fixed asset.
The disposal of a fixed asset requires the removal of its book value (carrying amount), which appears in two accounts, the asset account and Accumulated Depreciation.

35. Recording Gains and Losses
A piece of equipment with an original cost of $50,000 that has $20,000 of accumulated depreciation is sold for $35,000 cash. The journal entry to record this transaction is as follows:
Cash ,000
Accumulated depreciation 20,000
Equipment ,000
Gain on sale of equipment* 5,000
*[35,000 - (50, ,000) = 5,000]

36. Recording Gains and Losses
A piece of equipment with an original cost of $50,000 that has $20,000 of accumulated depreciation is sold for $23,000 cash. The journal entry to record this transaction is as follows:
Cash ,000
Accumulated depreciation 20,000
Loss on sale of equipment* 7,000
Equipment ,000
*[23,000 - (50, ,000) = -7,000]

37. Income Statement Presentation
Gains and losses on sales of assets are usually insignificant, so they are included as “other income” on the income statement.

38. Depletion of Natural Resources
Depletion - the accounting measure used to allocate the acquisition cost of natural resources, such as minerals, oil, and timber
Depletion focuses on the physical use and exhaustion of the natural resource.
Depletion is measured on a units-of-production basis.
Depletion can be accounted for as a direct reduction of the asset or in an Accumulated Depletion account.

39. Depletion of Natural Resources
Dewey Company purchased a coal mine for $30,000,000. The company estimates that the mine contains 5,000,000 tons of coal. In the first year, Dewey Company mines 250,000 tons of coal, and in the second year the company mines 300,000 tons of coal. Depletion expense is calculated as follows:
$30,000,000 / 5,000,000 = $6 per ton depletion rate
Year 1: 250,000 tons x $6 per ton = $1,500,000 depletion expense
Year 2: 300,000 tons x $6 per ton = $1,800,000 depletion expense

40. Amortization of Intangible Assets
Intangible assets are rights or claims to expected benefits that tend to be contractual in nature rather than physical in nature.
Examples are patents, copyrights, and franchises.
The accounting for intangibles is much like that of tangible assets.
Acquisition costs are capitalized and are then gradually expensed (amortized) over the life of the asset.

41. Amortization of Intangible Assets
Intangible assets are shown on the balance sheet only if rights to some benefit are purchased.
Assets created by the company are not treated as assets on the balance sheet.
Internal development is treated as research and development costs and is expensed during the period when incurred.
Intangibles are amortized using the straight-line method.

42. Examples of Intangible Assets
Patent - a grant by the federal government to an inventor, bestowing the exclusive right to produce and sell a given invention for 17 years
The economic life of a patent is often much less than 17 years.

43. Examples of Intangible Assets
Copyright - exclusive rights to reproduce and sell a book, musical composition, film, or similar creative items
Copyrights last for 75 years, but the economic life is often no longer than 2 or 3 years.

44. Examples of Intangible Assets
Trademarks - distinctive identifications of a manufactured product or of a service taking the form of a name, a sign, a slogan, a logo, or an emblem
Examples are trade names, trade brands, secret formulas, or similar items.
Economic lives depend on the length of use.

45. Examples of Intangible Assets
Franchises or licenses - privileges granted by a government, manufacturer, or distributor to sell a product or service in accordance with specified conditions
An example is a local McDonald’s franchise. The franchisee pays for the right to use the name and acquire branded products, such as cups and bags, and to share in advertising and special promotions. In return, the franchisee must meet the standards set forth by McDonald’s.

46. Amortization of Leaseholds and Leasehold Improvements
Leasehold - the right to use a fixed asset for a specified period of time, typically beyond one year
Leaseholds are frequently referred to as plant assets, but they are only the right to use that plant asset; they are not ownership rights.

47. Amortization of Leaseholds and Leasehold Improvements
Leasehold improvements - investments by a lessee in items that are not permitted to be removed from the premises when a lease expires, such as installation of new fixtures, panels, walls, and air conditioning equipment.
These items become part of the leased property and are no longer owned by the lessee.
Leases and improvements are amortized over the life of the lease, even if the physical life is longer.

48. Amortization of Deferred Charges
Deferred charges - items similar to prepaid expenses, but that have longer-term benefits
For example, costs of rearranging an assembly line must be paid before any benefit from this action is realized.
Costs are carried forward and written off over a 3- to 5-year period.

49. Basket Purchases
Basket purchase - the acquisition of two or more types of assets for a lump-sum cost at the same time
The acquisition cost must be split among the assets according to some estimate of relative sales value for the assets.

50. Basket Purchases
Rogers Corporation purchases a building and some land for $2,000,000. An appraiser estimates that the building is worth $1,500,000 and the land is worth $1,000,000. How much of the acquisition price is allocated to each asset?
Building: ($1,500,000/$2,500,000) x $2,000,000 = $1,200,000
Land: ($1,000,000/$2,500,000) x $2,000,000 = ,000
$2,000,000
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51. Basket Purchases
The allocation of the acquisition price can have a significant effect on future income.
If more cost is allocated to depreciable assets, depreciation expense will be greater in the future, which will decrease future earnings and lower income taxes.

52. Introduction to Financial Accounting 8th Edition PowerPoint Presentation
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Eddie Metrejean, MTAX, CPA
University of Mississippi
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