By Rachelle Agatha, CPA, MBA

By Rachelle Agatha, CPA, MBA
Fixed Assets By Rachelle Agatha, CPA, MBA Slides by Rachelle Agatha, CPA, with excerpts from Warren, Reeve, Duchac

Objectives: Define, classify, and account for the cost of fixed assets. Compute depreciation, using the following methods: straight-line method, units-of-production method, and double-declining-balance method.

Objectives: Journalize entries for the disposal of fixed assets. Compute depletion and journalize the entry for depletion. Describe the accounting for intangible assets, such as patents, copyrights, and goodwill.

Objectives: Describe how depreciation expense is reported in an income statement, and prepare a balance sheet that includes fixed assets and intangible assets.

Define, classify, and account for the cost of fixed assets.
Objective 1 Define, classify, and account for the cost of fixed assets.

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

Fixed Assets as a Percent of Total Assets—Selected Companies

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

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

Insurance costs incurred during construction
Cost of Acquiring Fixed Assets BUILDING Architects’ fees Engineers’ fees Insurance costs incurred during construction Interest on money borrowed to finance construction Walkways to and around the building Sales taxes Repairs (purchase of existing building) Reconditioning (purchase of existing building) Modifying for use Permits from government agencies

MACHINERY AND EQUIPMENT
Cost of Acquiring Fixed Assets MACHINERY AND EQUIPMENT Modification for user Testing for use Permits from government agencies Sales taxes Freight Installation Repairs (purchase of used equipment) Reconditioning (purchase of used equipment) Insurance while in transit Assembly LAND IMPROVEMENT Trees and shrubs Fences Outdoor lighting Paved parking areas

Mistakes in installation Uninsured theft
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

Capital and Revenue Expenditures Expenditures that benefit only the current period are called revenue expenditures. Expenditures that improve the asset or extend its useful life are capital expenditures.

Normal and ordinary repairs and maintenance
REVENUE EXPENDITURES CAPITAL EXPENDITURES Additions Improvements Extraordinary repairs Normal and ordinary repairs and maintenance Operating Expenses

This is a revenue expenditure/operating exp
Ordinary Maintenance and Repairs On April 9, the firm paid $300 for a tune-up of a delivery truck. Apr. 9 Repairs and Maintenance Exp Cash This is a revenue expenditure/operating exp

This is a capital expenditure
Asset Improvements On May 4, a $5,500 hydraulic lift was installed on the delivery truck to allow for easier and quicker loading of heavy cargo. May 4 Delivery Truck Cash This is a capital expenditure

This is a capital expenditure
Extraordinary Repairs The engine of a forklift that is near the end of its useful life is overhauled at a cost of $4,500, which extends its useful life eight years. Work on the forklift was completed on Oct. 14. Oct. 14 Accum. Depreciation—Forklift Cash This is a capital expenditure

Capital or Revenue Expenditure

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. June 18 Delivery Truck 1,200 Cash 1,200 18 Repairs and Maintenance Exp. 45 Cash 45 19

Leasing Fixed Assets A capital lease is accounted for as if the lessee has, in fact, purchased the asset. The asset is then amortized over the life of the capital lease.

Leasing Fixed Assets A lease that is not classified as a capital lease for accounting purposes is classified as an operating lease (an operating leases is treated as an expense).

Objective 2 Compute depreciation using the following methods: straight-line method, units-of-production method, double-declining-balance method.

Accounting for Depreciation Over time, fixed assets such as equipment, buildings, and land improvements lose their ability to provide services. The periodic transfer of the cost of fixed assets to expense is called depreciation.

Physical and Functional Depreciation 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 no longer able to provide services at the level for which it was intended.

Factors in Computing Depreciation The three factors in determining the amount of depreciation expense to be recognized each period are: (a) the fixed asset’s initial cost, (b) its expected useful life, and (c) its estimated value at the end of the useful life.

Residual Value The fixed asset’s estimated value at the end of its useful life is called the residual value, scrap value, salvage value, or trade-in value. A fixed asset’s residual value and its expected useful life must be estimated at the time the asset is placed in service.

Exhibit 5: Use of Depreciation Methods
Exhibit 5: Use of Depreciation Methods Straight-line Units-of-production Double-declining-balance Other Source: Accounting Trends & Techniques, 59th ed., American Institute of Certified Public Accountants, New York, 2005.

Cost – est residual value Estimated life
Straight-Line Method The straight-line method provides for the same amount of depreciation expense for each year of the asset’s useful life. Annual depreciation = Cost – est residual value Estimated life

A depreciable asset cost $24,000. Its estimated residual value is $2,000 and its estimated life is 5 years. Annual depreciation = Cost – est residual value Estimated life Annual depreciation = $24,000 – $2,000 5 years Annual depreciation = $4,400

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.

Equipment that was 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 the (a) depreciable cost, (b) straight-line rate, and (c) annual straight-line depreciation. $120,000 ($125,000 – $5,000) 10% = (1/10) $12,000 ($120,000 x 10%) or ($120,000 ÷ 10 years)

Cost – estimated residual value Estimated hours, units, etc.
Units-of-Production Method The units-of-production method provides for the same amount of depreciation expense for each unit produced or each unit of capacity used by the asset. Unit depreciation = Cost – estimated residual value Estimated hours, units, etc.

A depreciable asset cost $24,000. Its estimated residual value is $2,000 and its expected to have an estimated life of 10,000 operating hours. Hourly depreciation = Cost – estimated residual value Estimated hours Hourly depreciation = $24,000 – $2,000 10,000 estimated hours Hourly depreciation = $2.20 hourly depreciation

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.

Equipment acquired at a cost of $180,000 has an estimated residual value of $10,000, an estimated useful life of 40,000 hours, and was operated 3,600 hours during the year. Determine the (a) depreciable cost, (b) depreciation rate, and (c) the units-of-production depreciation for the year. $170,000 ($180,000 – $10,000) $4.25 per hour ($170,000/40,000 hours) $15,300 (3,600 hours x $4.25)

Double-Declining-Balance Method The double-declining-balance method provides for a declining periodic expense over the estimated useful life of the asset.

A double-declining balance rate is determined by doubling the straight-line rate. A shortcut to determining the straight-line rate is to divide one by the number of years (1/5 = .20). Hence, using the double-declining- balance method, a five-year life results in a 40 percent rate (.20 x 2).

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. Continuing with the example where the fixed asset cost $24,000 and has an expected residual value of $2,000, a table can be built.

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

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

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

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

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

DEPRECIATION STOPS WHEN BOOK VALUE EQUALS RESIDUAL VALUE!
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 STOP DEPRECIATION STOPS WHEN BOOK VALUE EQUALS RESIDUAL VALUE!

“Forced” annual depreciation Desired ending book value
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 – $2,000 1,110 22,000 2,000 “Forced” annual depreciation Desired ending book value

Equipment that was 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 the (a) depreciable cost, (b) double-declining-balance rate, and (c) double-declining balance depreciation for the first year. $120,000 ($125,000 – $5,000) 20% [(1/10) x2] $25,000 ($125,000 x 20%)

Comparing Depreciation Methods

Depreciation for Federal Income Tax The Internal Revenue Code specifies the Modified Accelerated Cost Recovery System (MACRS) for use by businesses in computing depreciation for tax purposes.

MACRS specifies eight classes of useful life and depreciation rates for each class. The two most common classes are the 5-year class (includes automobiles and light duty trucks) and the 7-year class (includes most machinery and equipment).

Annual Depreciation (S/L)
Revising Depreciation Estimates A machine purchased for $140,000 was originally estimated to have a useful life of five years and a residual value of $10,000. The asset has been depreciated for two years using the straight-line method. $140,000 – $10,000 5 years Annual Depreciation (S/L) = $26,000 per year Annual Depreciation (S/L) =

At the end of two years, the asset’s book value is $88,000, determined as follows: Asset cost $140,000 Less accumulated depreciation ($26,000 per year x 2 years) 52,000 Book value, end of second year $ 88,000

During the third year, the company estimates that the remaining useful life is eight years (instead of three) and that the residual value is $8,000 (instead of $10,000). Depreciation expense for each of the remaining eight year is determined as follows: Book value, end of second year $88,000 Less revised estimated residual value 8,000 Revised remaining depreciation cost $80,000 Revised annual depreciation expense ($80,000 ÷ 8 years) $10,000

A warehouse with a cost of $500,000 has an estimated residual value of $120,000, an estimated useful life of 40 years, and is depreciated by the straight-line method. (a) Determine the amount of annual depreciation. (b) Determine the book value at the end of the 20th year of use. (c) If at the start of the 21st year it is estimated that the remaining life is 25 years and that the residual value is $150,000, determine the depreciation expense for each of the remaining 25 years.

$9,500 [($500,000 – $120,000)/40] $310,000 [$500,000 – ($9,500 x 20)] $6,400 [310,000 – $150,000)/25]

Journalize entries for the disposal of fixed assets.
Objective 3 Journalize entries for the disposal of fixed assets.

Discarding Fixed Assets A piece of equipment acquired at a cost of $25,000 is fully depreciation. On February 14, the equipment is discarded. Feb. 14 Accumulated Depr.—Equipment Equipment To write off equipment discarded.

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 Accum. Depr.—Equipment $600 x 3/12 To record current depreciation on equipment discarded.

The discarding of the equipment is then recorded by the following entry: Mar. 24 Accum. Depreciation—Equipment Loss on Disposal of Fixed Assets Equipment To write off equipment discarded.

Selling 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 and needs to be updated. Oct. 12 Depreciation Expense—Equipment Accum. Depr.—Equipment $10,000 x ¾ x10% To record current depreciation on equipment sold.

The equipment is sold on October 12 for $2,250. No gain or loss.
Assumption 1 The equipment is sold on October 12 for $2,250. No gain or loss. Oct. 12 Cash Accum. Depreciation—Equipment Equipment Sold equipment at book value.

The equipment is sold on October 12 for $1,000; a loss of $1,250.
Assumption 2 The equipment is sold on October 12 for $1,000; a loss of $1,250. Oct. 12 Cash Accum. Depreciation—Equipment Loss on Disposal of Fixed Assets Equipment Sold equipment at a loss.

The equipment is sold on October 12 for $2,800; a gain of $550.
Assumption 3 The equipment is sold on October 12 for $2,800; a gain of $550. Oct. 12 Cash Accum. Depreciation—Equipment Equipment Gain on Disp. of Fixed Assets Sold equipment at a gain.

Equipment was acquired at the beginning of year at a cost of $91,000. The equipment was depreciated using the straight-line method based upon an estimated useful life of 9 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 sale of the equipment. Journalize the entry to record the sale.

$9,000 [($91,000 – $10,000)/9] $5,000 gain; $78,000 – [$91,000 – ($9,000 x 2)] Cash ,000 Accum. Depreciation—Equipment 18,000 Equipment ,000 Gain on Disposal of Fixed Assets ,000

Exchanging Fixed Assets When old equipment is traded for new equipment, the seller often allows the buyer a trade-in allowance for the old equipment traded. The remainder, the boot, is either paid in cash or recorded as a liability.

IMPORTANT! Gains on exchanges of similar fixed assets are not recognized for financial reporting purposes.

On June 19, assume that new equipment being purchased has a list price of $5,000. The dealer allows a trade-in allowance of $1,100 on the old, similar equipment. The old equipment cost $4,000 and has a book value of $800.

List price of new equipment $5,000 Trade-in allowance $1,100
Two Methods of Determining Cost Method One List price of new equipment $5,000 Trade-in allowance $1,100 Book value of old equipment Unrecognized gain on exchange (300) Cost of new equipment $4,700

Book value of old equipment $ 800 Cash paid at date of exchange 3,900
Method Two Book value of old equipment $ 800 Cash paid at date of exchange 3,900 Cost of new equipment $4,700 Note that either method provides the same cost for the new equipment.

On June 19, equipment was exchanged at a gain of $300.
On June 19, equipment was exchanged at a gain of $300. June 19 Accum. Depreciation—Equipment Equipment (new equipment) Equipment (old equipment) Cash To record exchange of equipment.

Losses on Exchanges For financial reporting purposes, losses are recognized on exchange of similar fixed assets if the trade-in allowance is less than the book value of the old equipment. On September 7, new equipment was acquired by trading in old equipment with a cost of $7,000 and a book value of $2,400, and giving a cash payment of $8,000.

Cost of old equipment $7,000 Accumulated depreciation at date of exchange 4,600 Book value at September 7, date of exchange $2,400 Trade-in allowance on old equipment 2,000 Loss on exchange $ 400 Sept 7 Accum. Depreciation—Equipment Equipment Loss on Disposal of Fixed Assets Equipment Cash To record exchange of equipment with loss.

On the first day of the fiscal year, a delivery truck with a list price of $75,000 was acquired in exchange for an old delivery truck and $63,000 cash. The old truck had a cost of $50,000 and accumulated depreciation of $39,500. Determine the cost of the new truck for financial reporting purposes. Journalize the entry to record the exchange.

List price of new truck $75,000 Trade-in allowance on old truck
$73,500 List price of new truck $75,000 Trade-in allowance on old truck ($75,000 – $63,000) $12,000 Book value of old truck ($50,000 – $39,500) ,500 Unrecognized gain on exchange ,500) Cost of new truck $73,500 (Continued) or

Plus cash paid at date of exchange 63,000 Cost of new truck $73,500
Book value of old truck ($50,000 – $39,5000) $10,500 Plus cash paid at date of exchange 63,000 Cost of new truck $73,500 Truck (new) 73,500 Accum Dep Truck (old) 39,500 Truck (old) 50,000 Cash 63,000

Compute depletion and journalize the entry for depletion.
Objective 4 Compute depletion and journalize the entry for depletion.

Natural Resources The process of transferring the cost of natural resources to an expense account is called depletion.

Recording 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).

If 90,000 tons are mined during the year, an adjusting entry is required at the end of the accounting period. Adjusting Entry Dec. 31 Depletion Expense Accumulated Depletion Depletion of mineral deposit.

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.

Depletion of mineral deposit.
$0.90 per ton = $45,000,000/50,000,000 tons $11,340,000 – (12,600,000 tons x $0.90 per ton) Dec. 31 Depletion Expense 11,340,000 Accumulated Depletion 11,340,000 Depletion of mineral deposit.

Objective 5 Describe the accounting for intangible assets, such patents, copyrights, and goodwill.

Intangible Assets Patents, copyrights, trademarks, and goodwill are long-lived assets that are useful in the operations of a business and not held for sale. These assets are called intangible assets because they do not exist physically.

The exclusive right granted by the federal government to manufacturers to produce and sell goods with one or more unique features is a patent. These rights continue in effect for 20 years.

Journalizing Amortization of a Patent At the beginning of its fiscal year, a business acquires a patent right for $100,000. Its remaining useful life is estimated at 5 years. Adjusting Entry Dec. 31 Amortization Expense—Patents Patents Patent amortization ($100,000/5).

Dec. 31 Amortization Expense—Patents Patents Patent amortization ($100,000/5). Adjusting Entry Because a patent (and other intangible assets) does not exist physically, it is acceptable to credit the asset. This approach is different from physical fixed assets that require the use of a contra asset account.

Copyright The exclusive right granted by the federal government to publish and sell a literary, artistic, or musical composition is a copyright. A copyright extends for 70 years beyond the author’s death.

Trademark A trademark is a unique 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 can be renewed every 10 year period thereafter.

Goodwill 10-5 In business, 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 permit goodwill to be recorded in the accounts only if it is objectively determined by a transaction.

Impaired Goodwill A loss should be recorded if the business prospects of the acquired firm (and the acquired goodwill) become significantly impaired. Mar Loss from Impaired Goodwill Goodwill Impaired goodwill.

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 $484,000 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.

Dec. 31 Loss from Impaired Goodwill 40,000 Goodwill 40,000 Impaired goodwill. Dec. 31 Amortization Expense—Patents 3,500 Patents 3,500 Amortized patent rights [($84,000/12) x (6/12)].

Objective 6 Describe how depreciation expense is reported in an income statement, and prepare a balance sheet that includes fixed assets and intangible assets.

The fixed assets may be shown at their net amount.
The amount of each major class of fixed assets should be disclosed in the balance sheet or in notes. The fixed assets may be shown at their net amount. Office equipment $125,750 Less accumulated depreciation ,300 Net book value $ 39,450

The cost of mineral rights or ore deposits is normally shown as part of the fixed asset section of the balance sheet. The related accumulated depletion should also be disclosed. Intangible assets are usually reported (net of amortization) in the balance sheet in a separate section immediately following fixed assets.

Fixed Assets and Intangible Assets in the Balance Sheet

Fixed Asset Turnover Ratio One measure of the revenue-generating efficiency of fixed assets is the fixed asset turnover ratio. It measures the number of dollars of revenue earned per dollar of fixed assets and is computed as follows: Fixed Asset Turnover Ratio Revenue Average Book Value of Fixed Assets =

Fixed Asset Turnover Ratio Revenue Average Book Value of Fixed Assets
Financial Analysis and Interpretation For Marriott International, Inc. (in millions) Fixed Asset Turnover Ratio Revenue Average Book Value of Fixed Assets = Fixed Asset Turnover Ratio $11,550 ($2, ,389)/2 = Fixed Asset Turnover Ratio = 4.88 Conclusion: For every dollar of fixed assets, Marriott earns $4.88 of revenue.

Summary Classification of Fixed Assets Depreciation Methods
Journalize related entries Depletion Intangibles Financial Statement presentation

By Rachelle Agatha, CPA, MBA

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