1. 10 Fixed Assets and Intangible Assets Financial Accounting 14e
C H A P T E R
Fixed Assets and Intangible Assets
Financial Accounting
14e
Warren
Reeve
Duchac
human/iStock/360/Getty Images

2. Learning Objectives
LO1: Define, classify, and account for the cost of fixed assets.
LO2: Compute depreciation, using the following methods: straight-line method, units-of-output method, and double-declining-balance method.
LO3: Journalize entries for the disposal of fixed assets.
LO4: Compute depletion and journalize the entry for depletion.
LO5: Describe the accounting for intangible assets, such as patents, copyrights, and goodwill.
LO6: Describe how depreciation expense is reported in an income statement and prepare a balance sheet that includes fixed assets and intangible assets.
LO7: Describe and illustrate the fixed asset turnover ratio to assess the efficiency of a company’s use of its fixed assets.
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3. Fixed assets have the following characteristics:
Nature of Fixed Assets
Fixed assets are long-term or relatively permanent assets such as equipment, machinery, buildings, and land.
Other descriptive titles for plant assets or property, plant, and equipment.
Fixed assets have the following characteristics:
They exist physically and, thus, are tangible assets.
They are owned and used by the company in its normal operations.
They are not offered by sale as part of normal operations.
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4. Fixed Assets as a Percent of Total Assets—Selected Companies
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5. Classifying Costs (slide 1 of 2)
A cost that has been incurred may be classified as a fixed asset, an investment, or an expense.
Items that are classified and recorded as fixed assets include land, buildings, or equipment. Such assets normally last more than a year and are used in the normal operations.
Investments are long-lived assets that are not used in the normal operations and are held for future resale. Such assets are reported on the balance sheet in a section entitled Investments.
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6. Classifying Costs (slide 2 of 2)
Classifying a cost involves the following steps:
Step 1. Is the purchased item long-lived?
If yes, the item is recorded as an asset on the balance sheet, either as a fixed asset or an investment. Proceed to Step 2.
If no, the item is classified and recorded as an expense.
Step 2. Is the asset used in normal operations?
If yes, the asset is classified and recorded as a fixed asset.
If no, the asset is classified and recorded as an investment.
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7. Classifying Costs
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8. Costs of Acquiring Fixed Assets
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9. The Cost of Fixed Assets
Only costs necessary for preparing the fixed asset for use are included as a cost of the asset.
Unnecessary costs that do not increase the asset’s usefulness are recorded as an expense. These include the following:
Vandalism
Mistakes in installation
Uninsured theft
Damage during unpacking and installing
Fines for not obtaining proper permits from governmental agencies
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10. Capital and Revenue Expenditures
Costs that benefit only the current period, such as ordinary maintenance and repairs, are called revenue expenditures.
Costs that improve the asset or extend its useful life, such as improvements or extraordinary repairs, are called capital expenditures.
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11. Ordinary Maintenance and Repairs
Costs related to the ordinary maintenance and repairs of a fixed asset are revenue expenditures and are recorded as increases to Repairs and Maintenance Expense.
For example, $300 paid for a tune-up of a delivery truck is recorded as follows:
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12. Asset Improvements
Costs related to improvements are capital expenditures and are recorded as increases to the fixed asset account.
For example, the service value of a delivery truck is improved by adding a $5,500 hydraulic lift to allow for easier and quicker loading of heavy cargo. The expenditure is recorded as follows:
Because the cost of the delivery truck has increased, depreciation for the truck will also change over its remaining life.
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13. Extraordinary Repairs
Costs related to extraordinary repairs are capital expenditures and are recorded as a decrease in an accumulated depreciation account.
For example, the engine of a forklift that is near the end of its useful life may be overhauled at a cost of $4,500, extending its useful life by eight years. The expenditure is recorded as follows:
Because the forklift’s remaining useful life has changed, depreciation for the forklift will also change based on the new book value of the forklift.
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14. Revenue and Capital Expenditures
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15. Capital and Revenue Expenditures
On June 18, GTS Co. paid $1,200 to upgrade a hydraulic lift and $45 for an oil change for one of its delivery trucks. Journalize the entries for the hydraulic lift upgrade and oil change expenditures.
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16. Leasing Fixed Assets
A lease is a contract for the use of an asset for a period of time.
The two parties to a lease contract are as follows:
The lessor is the party who owns the asset.
The lessee is the party to whom the rights to use the asset are granted by the lessor.
Leasing an asset has the following advantages:
The lessee has access to an asset without having to spend funds or obtain financing to buy the asset.
Expenses such as repair and maintenance may be the responsibility of the lessor.
The risk of incurring additional cost because the asset may become obsolete before the end of its useful life can be mitigated.
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17. Because land has an unlimited life, it is not depreciated.
Depreciation
Over time, fixed assets, with the exception of land, lose their ability to provide services.
Thus, the costs of fixed assets such as equipment and buildings should be recorded as an expense over their useful lives.
This periodic recording of the cost of fixed assets as an expense is called depreciation.
Because land has an unlimited life, it is not depreciated.
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18. Accounting for Depreciation (slide 1 of 2)
The adjusting entry to record depreciation debits Depreciation Expense and credits a contra asset account entitled Accumulated Depreciation or Allowance for Depreciation.
The use of a contra asset account allows the original cost to remain unchanged in the fixed asset account.
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19. Accounting for Depreciation (slide 2 of 2)
Depreciation can be caused by physical or functional factors.
Physical depreciation factors include wear and tear during use or from exposure to weather.
Functional depreciation factors include obsolescence and changes in customer needs that cause the asset to no longer provide services for which it was intended.
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20. Factors in Computing Depreciation Expense (slide 1 of 3)
Three factors determine the depreciation expense for a fixed asset. These three factors are as follows:
The asset’s initial cost
The asset’s expected useful life
The asset’s estimated residual value
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21. Factors in Computing Depreciation Expense (slide 2 of 3)
The expected useful life of a fixed asset is estimated at the time the asset is placed into service.
Estimates of expected useful lives are available from industry trade associations.
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22. Factors in Computing Depreciation Expense (slide 3 of 3)
The residual value of a fixed asset at the end of its useful life is also estimated at the time the asset is placed into service. Residual value is sometimes referred to as scrap value, salvage value, or trade-in value.
The difference between a fixed asset’s initial cost and its residual value is called the asset’s depreciable cost.
The depreciable cost is the amount of the asset’s cost that is allocated over its useful life as depreciation expense.
If a fixed asset has no residual value, then its entire cost should be allocated to depreciation.
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23. Depreciation Expense Factors
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24. Use of Depreciation Methods
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25. Straight-Line Method (slide 1 of 4)
The straight-line method provides for the same amount of depreciation expense for each year of the asset’s useful life.
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26. Straight-Line Method (slide 2 of 4)
Assume that equipment was purchased on January 1 as follows:
The annual straight-line depreciation is computed as follows:
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27. Straight-Line Method (slide 3 of 4)
Assume the preceding equipment was purchased and placed into service on October 1. If an asset is used for only part of a year, the annual depreciation is prorated. Therefore, the depreciation for the year ending December 31 is computed as follows:
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28. Straight-Line Method (slide 4 of 4)
The computation of straight-line depreciation may be simplified by converting the annual depreciation to a percentage of depreciable cost.
The straight-line percentage is determined by dividing 100% by the number of years of expected useful life, computed as follows:
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29. Straight-Line Depreciation
Equipment acquired at the beginning of the year at a cost of $125,000 has an estimated residual value of $5,000 and an estimated useful life of 10 years. Determine (a) the depreciable cost, (b) the straight-line rate, and (c) the annual straight-line depreciation.
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30. Units-of-Output Method (slide 1 of 3)
The units-of-output method provides the same amount of depreciation expense for each unit of output of the asset. Depending on the asset, the units of output can be expressed in terms of hours, miles driven, or quantity produced.
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31. Units-of-Output Method (slide 2 of 3)
The units-of-output method is applied in the following two steps:
Step 1. Determine the depreciation per unit as follows:
Step 2. Compute the depreciation expense as follows:
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32. Units-of-Output Method (slide 3 of 3)
Assume that equipment costs $24,000. Its estimated residual value is $2,000, and it is expected to have a useful life of 10,000 operating hours. During the year, the asset was operated 2,100 hours. The units-of-output depreciation is computed as follows:
Step 1. Determine the depreciation per hour as follows:
Step 2. Compute the depreciation expense as follows:
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33. Units-of-Output Depreciation
Equipment acquired at the beginning of the year at a cost of $180,000 has an estimated residual value of $10,000, has an estimated useful life of 40,000 hours, and was operated 3,600 hours during the year. Determine (a) the depreciable cost, (b) the depreciation rate, and (c) the unit-of-output depreciation for the year.
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34. Double-Declining-Balance Method (slide 1 of 6)
The double-declining-balance method provides for a declining periodic expense over the expected useful life of the asset.
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35. Double-Declining-Balance Method (slide 2 of 6)
The double-declining-balance method is applied in the following three steps:
Step 1. Determine the straight-line percentage, using the expected useful life.
Step 2. Determine the double-declining-balance rate by multiplying the straight-line rate from Step 1 by 2.
Step 3. Compute the depreciation expense by multiplying the double-declining-balance rate from Step 2 times the book value of the asset. (For the first year, the book value of the asset is its initial cost.)
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36. Double-Declining-Balance Method (slide 3 of 6)
Assume that equipment was purchased as follows:
For the first year, the depreciation is computed as follows:
Step 1. Straight-line percentage = 20% (100% ÷ 5)
Step 2. Double-declining-balance rate = 40% (20% × 2)
Step 3. Depreciation expense = $9,600 ($24,000 × 40%)
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37. Double-Declining-Balance Method (slide 4 of 6)
The double-declining-balance depreciation for the full five-year life of the equipment is as follows:
The estimated residual value for the equipment is $2,000. However, when the double-declining-balance method is used, the asset should not be depreciated below its estimated residual value. Therefore, the depreciation for the fifth year is $1, ($3, – $2,000.00) instead of $1, (40% × $3,110.40).
After the first year, book value (cost minus accumulated depreciation) declines, and thus, the depreciation also declines.
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38. Double-Declining-Balance Method (slide 5 of 6)
Assume the preceding equipment was purchased and placed into service on October 1. Like straight-line depreciation, if an asset is used for only part of a year, the annual depreciation is prorated. Therefore, the depreciation for the year ending December 31 is computed as follows:
The depreciation for the second year would be computed as follows:
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39. Double-Declining-Balance Method (slide 6 of 6)
The double-declining-balance method provides a higher depreciation in the first year of the asset’s use, followed by declining depreciation amounts. Thus, it is called an accelerated depreciation method.
An asset’s revenues are often greater in the early years of its use than in later years. In such cases, the double-declining-balance method provides a good matching of depreciation expense with the asset’s revenues.
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40. Double-Declining-Balance Depreciation
Equipment acquired at the beginning of the year at a cost of $125,000 has an estimated residual value of $5,000 and an estimated useful life of 10 years. Determine (a) the double-declining-balance rate and (b) the double-declining-balance depreciation for the first year.
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41. Summary of Depreciation Methods
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42. Comparing Depreciation Methods
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43. Depreciation for Federal Income Tax
The Internal Revenue Code uses the Modified Accelerated Cost Recovery System (MACRS) to compute depreciation for tax purposes.
MACRS has eight classes of useful life and depreciation rates for each class. Two of the most common classes are the five-year class and the seven-year class.
The five-year class includes automobiles and light-duty trucks.
The seven-year class includes most machinery and equipment.
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44. MACRS Depreciation Rates for 5-Year-Class Assets
For the five-year-class assets, depreciation is spread over six years, as shown below.
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45. Revising Depreciation Estimates (slide 1 of 4)
Estimates of residual values and useful lives of fixed assets may change due to abnormal wear and tear or obsolescence.
When new estimates are determined, they are used to determine the depreciation expense in future periods. The depreciation expense recorded in earlier years is not affected.
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46. Revising Depreciation Estimates (slide 2 of 4)
Assume the following data for a machine that was purchased on January 1, 2015:
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47. Revising Depreciation Estimates (slide 3 of 4)
At the end of 2016, the machine’s book value is $88,000, computed as follows:
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48. Revising Depreciation Estimates (slide 4 of 4)
At the beginning of 2017, the company estimates that the machine’s remaining useful life is eight years (instead of three) and that its residual value is $8,000 (instead of $10,000). The depreciation expense for each of the remaining eight years is computed as follows:
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49. Book Value of Asset with Change in Estimate
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50. Revision of Depreciation
A warehouse with a cost of $500,000 has an estimated residual value of $120,000, has an estimated useful life of 40 years, and is depreciated by the straight-line method. (a) Determine the amount of the annual depreciation. (b) Determine the book value at the end of the twentieth year of use. (c) Assuming that at the start of the twenty-first year the remaining life is estimated to be 25 years and the residual value is estimated to be $150,000, determine the depreciation expense for each of the remaining 25 years.
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51. Discarding Fixed Assets (slide 1 of 5)
If a fixed asset is no longer used and has no residual value, it is discarded.
The entry to record the disposal of a fixed asset removes the cost of the asset and its accumulated depreciation from the accounts.
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52. Discarding Fixed Assets (slide 2 of 5)
Assume that equipment acquired at a cost of $25,000 is fully depreciated at December 31, On February 14, 2016, the equipment is discarded. The entry to record the discard is as follows:
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53. Discarding Fixed Assets (slide 3 of 5)
If an asset has not been fully depreciated, depreciation should be recorded before removing the asset from the accounting records.
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54. Discarding Fixed Assets (slide 4 of 5)
Assume that equipment costing $6,000 with no estimated residual value is depreciated at a straight-line rate of 10%. On December 31, 2015, the accumulated depreciation balance, after adjusting entries, is $4,650. On March 24, 2016, the asset is removed from service and discarded. The entry to record the depreciation for the three months of 2016 before the asset is discarded is as follows:
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55. Discarding Fixed Assets (slide 5 of 5)
The discarding of the equipment is then recorded as follows:
The loss of $1,200 is recorded because the balance of the accumulated depreciation account ($4,800) is less than the balance in the equipment account ($6,000).
Losses on the discarding of fixed assets are reported on the income statement.
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56. Selling Fixed Assets (slide 1 of 3)
The entry to record the sale of a fixed asset is similar to the entry for discarding an asset. The only difference is that the receipt of cash is also recorded.
If the selling price is more than the book value of the asset, a gain is recorded.
If the selling price is less than the book value, a loss is recorded.
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57. Selling Fixed Assets (slide 2 of 3)
Assume that equipment is purchased at a cost of $10,000 with no estimated residual value and is depreciated at a straight-line rate of 10%. The equipment is sold for cash on October 12 of the eighth year of its use. The balance of the accumulated depreciation account as of the preceding December 31 is $7,000. The entry to update the depreciation for the nine months of the current year is as follows:
After the current depreciation is recorded, the book value of the asset is $2,250 ($10,000 – $7,750).
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58. Selling Fixed Assets (slide 3 of 3)
The entry to record the sale of the asset at book value is as follows:
The entry to record at a loss is as follows:
The entry to record at a gain is as follows:
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59. Sale of Equipment (slide 1 of 2)
Equipment was acquired at the beginning of the year at a cost of $91,000. The equipment was depreciated using the straight-line method based on an estimated useful life of nine years and an estimated residual value of $10,000.
What was the depreciation for the first year?
Assuming the equipment was sold at the end of the second year for $78,000, determine the gain or loss on the sale of the equipment.
Journalize the entry to record the sale.
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60. Sale of Equipment (slide 2 of 2)
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61. Natural Resources (slide 1 of 4)
The fixed assets of some companies include timber, metal ores, minerals, or other natural resources.
As these resources are harvested or mined and then sold, a portion of their cost is debited to an expense account.
This process of transferring the cost of natural resources to an expense account is called depletion.
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62. Natural Resources (slide 2 of 4)
Depletion is determined as follows:
Step 1. Determine the depletion rate as follows:
Step 2. Multiply the depletion rate by the quantity extracted from the resource during the period.
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63. Natural Resources (slide 3 of 4)
Assume that Karst Company purchased mining rights as follows:
The depletion expense for the year is computed as follows:
Step 1. Determine the depletion rate as follows:
Step 2. Multiply the depletion rate by the quantity extracted from the resource during the period.
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64. Natural Resources (slide 4 of 4)
The adjusting entry to record the depletion is:
Like the accumulated depreciation account, Accumulated Depletion is a contra asset account. It is reported on the balance sheet as a deduction from the cost of the mineral deposit.
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65. Determine the depletion rate.
Depletion (slide 1 of 2)
Earth’s Treasures Mining Co. acquired mineral rights for $45,000,000. The mineral deposit is estimated at 50,000,000 tons. During the current year, 12,600,000 tons were mined and sold.
Determine the depletion rate.
Determine the amount of depletion expense for the current year.
Journalize the adjusting entry on December 31 to recognize the depletion expense.
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66. Depletion (slide 2 of 2)
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67. Intangible Assets
Patents, copyrights, trademarks, and goodwill are long-lived assets that are used in the operations of a business and are not held for sale. These assets are called intangible assets because they do not exist physically.
The accounting for intangible assets is similar to that for fixed assets. The major issues are:
Determining the initial cost.
Determining the amortization, which is the amount of cost to transfer to expense.
Amortization results from the passage of time or a decline in the usefulness of the intangible asset.
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68. These rights continue in effect for 20 years.
Patents (slide 1 of 4)
Manufacturers may acquire exclusive rights to produce and sell goods with one or more unique features.
Such rights are granted by patents, which the federal government issues to inventors.
These rights continue in effect for 20 years.
A business may purchase patent rights from others, or it may obtain patents developed by its own research and development.
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69. Patents (slide 2 of 4)
The initial cost of a purchased patent, including any legal fees, is debited to an asset account. This cost is written off, or amortized over the years of the patent’s expected useful life.
Patent amortization is normally computed using the straight-line method.
The amortization is recorded by debiting an amortization expense account and crediting the patents account. A separate contra asset account is usually not used for intangible assets.
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70. Patents (slide 3 of 4)
Assume that at the beginning of its fiscal year, a company acquires patent rights for $100,000. Although the patent will not expire for 14 years, its remaining useful life is estimated as five years. The adjusting entry to amortize the patent at the end of the year is as follows:
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71. Patents (slide 4 of 4)
For companies that develop their own patents through research and development, any research and development costs are usually recorded as current operating expenses in the period in which they are incurred.
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72. Copyrights and Trademarks (slide 1 of 4)
The exclusive right to publish and sell a literary, artistic, or musical composition is granted by a copyright.
Copyrights are issued by the federal government and extend for 70 years beyond the author’s death.
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73. Copyrights and Trademarks (slide 2 of 4)
The costs of a copyright include all costs of creating the work plus any other costs of obtaining the copyright.
A copyright that is purchased is recorded at the price paid for it.
Copyrights are amortized over their estimated useful lives.
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74. Copyrights and Trademarks (slide 3 of 4)
A trademark is a name, term, or symbol used to identify a business and its products.
Most businesses identify their trademarks with ® in their advertisements and on their products.
Trademarks can be registered for 10 years and renewed for 10-year periods thereafter.
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75. Copyrights and Trademarks (slide 4 of 4)
Like a copyright, the legal costs of registering a trademark are recorded as an asset.
If a trademark is purchased from another business, its cost is recorded as an asset.
In such cases, the cost of the trademark is considered to have an indefinite useful life. Thus, trademarks are not amortized but rather reviewed periodically for impaired value.
When a trademark is impaired, the trademark should be written down and a loss recognized.
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76. Goodwill (slide 1 of 3)
Goodwill refers to an intangible asset of a business that is created from such favorable factors as location, product quality, reputation, and managerial skill.
Generally accepted accounting principles (GAAP) allow goodwill to be recorded only if it is objectively determined by a transaction. (An example of such a transaction is the purchase of a business at a price in excess of the fair value of its net assets (assets – liabilities).) The excess is recorded as goodwill and reported as an intangible asset.
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77. Unlike patents and copyrights, goodwill is not amortized.
Goodwill (slide 2 of 3)
Unlike patents and copyrights, goodwill is not amortized.
However, a loss should be recorded if the future prospects of the purchased firm become impaired. This loss would normally be disclosed in the Other Expense section of the income statement.
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78. Goodwill (slide 3 of 3)
Assume that on December 31, FaceCard Company has determined that $250,000 of the goodwill created from the purchase of Electronic Systems is impaired. The entry to record the impairment is as follows:
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79. Frequency of Intangible Asset Disclosures for 500 Firms
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80. Comparison of Intangible Assets
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81. Impaired Goodwill and Amortization of Patent (slide 1 of 2)
On December 31, it was estimated that goodwill of $40,000 was impaired. In addition, a patent with an estimated useful economic life of 12 years was acquired for $84,000 on July 1.
Journalize the adjusting entry on December 31 for the impaired goodwill.
Journalize the adjusting entry on December 31 for the amortization of the patent rights.
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82. Impaired Goodwill and Amortization of Patent (slide 2 of 2)
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83. Financial Reporting for Fixed Assets and Intangible Assets (slide 1 of 4)
In the income statement, depreciation and amortization expense should be reported separately or disclosed in a note.
A description of the methods used in computing depreciation should also be reported.
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84. Financial Reporting for Fixed Assets and Intangible Assets (slide 2 of 4)
In the balance sheet, each class of fixed assets should be disclosed on the face of the statement or in the notes.
The related accumulated depreciation should also be disclosed, either by class or in total.
The fixed assets may be shown at their book value (cost less accumulated depreciation).
If there are many classes of fixed assets, a single amount may be presented in the balance sheet, supported by a note with a separate listing.
Fixed assets may be reported under the more descriptive caption of property, plant, and equipment.
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85. Financial Reporting for Fixed Assets and Intangible Assets (slide 3 of 4)
Intangible assets are usually reported in the balance in a separate section following fixed assets.
The balance of each class of intangible assets should be disclosed net of any amortization.
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86. Financial Reporting for Fixed Assets and Intangible Assets (slide 4 of 4)
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87. Average Book Value of Fixed Assets
Financial Analysis and Interpretation: Fixed Asset Turnover Ratio (slide 1 of 2)
A measure of a company’s efficiency in using its fixed assets to generate revenue is the fixed asset turnover ratio. The fixed asset turnover ratio measures the number of dollars of sales earned per dollar of fixed assets.
The fixed asset turnover ratio is computed as follows:
The higher the fixed asset turnover, the more efficiently a company is using its fixed assets in generating sales.
Fixed Asset Turnover Ratio =
Sales
Average Book Value of Fixed Assets
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88. Financial Analysis and Interpretation: Fixed Asset Turnover Ratio (slide 2 of 2)
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89. Fixed Asset Turnover Ratio Examples
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90. Fixed Asset Turnover Ratio (slide 1 of 2)
Financial statement data for years ending December 31 for Broadwater Company follows:
Determine the fixed asset turnover ratio for 2016 and 2015.
Does the change in the fixed asset turnover ratio from 2015 to 2016 indicate a favorable or an unfavorable trend?
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91. Fixed Asset Turnover Ratio (slide 2 of 2)
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92. Appendix: Exchanging Similar Fixed Assets (slide 1 of 2)
Old equipment is often traded for new equipment having a similar use. In such cases, the seller allows the buyer an amount for the old equipment traded in. This amount, called the trade-in allowance, may be greater than or less than the book value of the old equipment.
The remaining balance—the amount owed—is either paid in cash or recorded as a liability. It is normally called boot, which is its tax name.
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93. Appendix: Exchanging Similar Fixed Assets (slide 2 of 2)
Accounting for the exchange of similar assets depends on whether the transaction has commercial substance.
An exchange has commercial substance if future cash flows change as a result of the exchange.
If an exchange of similar assets has commercial substance, a gain or loss is recognized.
In such cases, the exchange is accounted for similar to that of a sale of a fixed asset.
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94. Appendix: Gain on Exchange (slide 1 of 2)
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95. Appendix: Gain on Exchange (slide 2 of 2)
The gain on the exchange is the difference between the fair market value (trade-in allowance) of the asset given up (exchanged) and its book value, computed as follows:
The gain on the exchange can also be determined as the difference between the fair market value of the new asset and the book value of the old asset plus the cash paid, computed as follows:
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96. Appendix: Loss on Exchange (slide 1 of 2)
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97. Appendix: Loss on Exchange (slide 2 of 2)
The loss on the exchange is the difference between the fair market value (trade-in allowance) of the asset given up (exchanged) and its book value, computed as follows:
The loss on the exchange can also be determined as the difference between the fair market value of the new asset and the book value of the old asset trade in plus the cash paid, computed as follows:
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