Chapter 7
Long-Term Assets
INSTRUCTOR’S MANUAL
Learning Objectives
LO7-1 Identify the major types of property, plant, and equipment.
LO7-2 Identify the major types of intangible assets.
LO7-3 Describe the accounting treatment of expenditures after acquisition.
LO7-4 Calculate depreciation of property, plant, and equipment.
LO7-5 Calculate amortization of intangible assets.
LO7-6 Account for the disposal of long-term assets.
Analysis
LO7-7 Describe the links among return on assets, profit margin, and asset turnover.
Appendix
LO7-8 Identify impairment situations and describe the two-step impairment process.
Teaching Suggestions
Chapter 7 is separated into three parts. Part A focuses on acquisitions and improvements. What amounts
should we include in the cost of long-term assets? Part B addresses depreciation and amortization. How
do we expense the cost of long-term assets over the period benefited? Part C describes the reporting of
asset dispositions. How do we record the sale or disposal of a long-term asset at the end of its useful life?
Many financial accounting textbooks first cover all the reporting issues for property, plant, and
equipment, and then repeat many of these issues again in a discussion of the reporting of intangible assets.
Since the basic principles in the reporting of long-term assets are similar, we combine the reporting of
property, plant, and equipment with the reporting of intangible assets to avoid unnecessary repetition.
Part A begins with reporting the cost of property, plant and equipment. Separate discussions are
provided for land, land improvements, buildings, equipment, and natural resources. Intangible assets
including patents, copyrights, trademarks, franchises, and goodwill are covered next. Part A finishes with
a discussion of the accounting treatment of expenditures after acquisition including repairs and
maintenance, additions, improvements, and litigation costs. Illustration 7-7 provides a helpful summary of
expenditures after acquisition.
Part B contrasts the dictionary definition of depreciation with the accounting definition. This is
important as many students mistakenly think of depreciation as a decrease in value. Straight-line
depreciation is explained in detail as this method is much more common in practice. Illustrations using
the same delivery truck example are also provided for declining-balance and activity-based methods,
providing instructors flexibility in choosing whether to just cover straight-line depreciation or
demonstrate multiple depreciation methods. The sum-of-the-years-digits depreciation method is not
included since it is rarely used in practice. Part B concludes by showing how amortization of intangible
assets is similar to depreciation of tangible assets.
Part C continues the delivery truck example to illustrate the recording of sale, retirement, and an
exchange of long-term assets. Note that a recent standard (FASB ASC 845: Nonmonetary transactions)
simplified the accounting for an exchange of long-term assets. Gains are no longer deferred on exchanges
of similar assets. The final section of the chapter uses actual financial statement data for Wal-Mart and
Target to analyze the profitability of a company’s assets. This is done by separating return on assets into
profit margin and asset turnover. We find that Target has a higher profit margin while Wal-Mart has a
higher asset turnover supporting our expectations regarding the different business strategies Wal-Mart and
Target are pursuing.
The appendix describes the two-step impairment process. Including this topic in an appendix provides
instructors the choice whether to cover asset impairments in the first accounting class. Illustration 7-32
provides a nice overview of the two-step impairment process. Students might also be interested in
learning about the management practice of taking a “big bath” discussed in the decision maker’s
perspective at the end of the appendix.
Assignment Charts
Assignment Charts
Questions
Learning
Objective(s) Topic
Time
(Min.)
1 LO7-1 Describe how WorldCom carried out the largest fraud in
U.S. history
5
2 LO7-1 Explain how the two major categories of long-term
assets differ
5
3 LO7-1 Explain how we initially record a long-term asset 5
4 LO7-1 Discuss how incorrectly recording an expense as an asset
affects the financial statements
5
5 LO7-1 Identify costs incurred to make land ready for use 5
6 LO7-1 Explain why we record land and land improvements
separately
5
7 LO7-1 Identify costs incurred to make equipment ready for use 5
8 LO7-1 Provide examples of natural resource assets 5
9 LO7-2 Explain how the accounting treatment differs between
purchased and internally developed intangible assets
5
10 LO7-2 Describe the differences among a patent, a copyright,
and a trademark
5
11 LO7-2 Explain what is goodwill and how we measure it 5
12 LO7-3 Explain how we decide whether to capitalize or expense
a particular cost
5
13 LO7-3 Explain the usual accounting treatment for repairs and
maintenance, additions, and improvements
5
14 LO7-3 Discuss the reporting of litigation costs to defend an
intangible asset
5
15 LO7-4 Describe how the dictionary definition differs from the
accounting definition of depreciation
5
16 LO7-4 Identify factors that must be estimated in allocating the
cost of a long-term asset over its service life
5
17 LO7-4 Explain how we determine service life under different
depreciation methods
5
18 LO7-4 Define residual value and explain how it is used in
calculating depreciation under the straight-line method
5
19 LO7-4 Contrast the effects of the straight-line,
declining-balance, and activity-based depreciation
methods
5
20 LO7-4 Explain the difficulty of comparing companies that use
different depreciation methods
5
21 LO7-4 Explain the difficulty of comparing companies that
estimate different service lives for similar assets
5
22 LO7-4 Identify the most common depreciation method for
financial reporting and tax reporting
5
23 LO7-5 Describe which intangible assets are subject to
amortization
5
24 LO7-6 Explain how we compute the gain or loss on the sale of
long-term assets
5
25 LO7-7 Describe return on assets, profit margin, and asset
turnover
5
26 LO7-7 Provide an example of a company with a high profit
margin and one with a high asset turnover
5
27 LO7-8 Describe the two-step process for recording impairments. 5
28 LO7-8 Explain the effect of a big bath on the current year’s and
future years’ net income
5
Brief Exercises
Learning
Objective(s) Topic
Time
(Min.)
BE7-1 LO7-1 Determine initial cost of land 5
BE7-2 LO7-1 Determine the initial cost of equipment 5
BE7-3 LO7-2 Calculate goodwill 5
BE7-4 LO7-2 Compute research and development expense 5
BE7-5 LO7-3 Account for expenditures after acquisition 5
BE7-6 LO7-4 Explain depreciation 5
BE7-7
BE7-8
LO7-4
LO7-4
Calculate partial year depreciation
Calculate depreciation
10
10
BE7-9 LO7-5 Calculate amortization expense 10
BE7-10 LO7-6 Account for the sale of long-term assets 5
BE7-11 LO7-6 Account for the exchange of long-term assets 5
BE7-12 LO7-6 Account for the exchange of long-term assets 5
BE7-13 LO7-7 Use the return on assets ratio 5
BE7-14 LO7-8 Determine the impairment loss 5
BE7-15 LO7-8 Determine the impairment loss 5
Exercises
Learning
Objective(s) Topic
Time
(Min.)
E7-1
E7-2
E7-3
LO7-1
LO7-1
LO7-1
Record purchase of land
Record the purchase of equipment
Allocate costs in a basket purchase
15
15
15
E7-4 LO7-1,7-4 Ethical Dilemma in a basket purchase 15
E7-5 LO7-2 Reporting intangible assets 15
E7-6 LO7-2 Calculate the amount of goodwill 15
E7-7 LO7-2 Record patent and research and development expense 15
E7-8 LO7-2,7-4 Match terms used in the chapter 10
E7-9 LO7-3 Record expenditures after acquisition 10
E7-10 LO7-4 Determine depreciation for the first year under three
methods
20
E7-11 LO7-4 Determine depreciation under three methods 35
E7-12 LO7-4 Determine straight-line depreciation for partial periods 15
E7-13 LO7-4 Determine straight-line depreciation for partial periods 15
E7-14 LO7-4 Determine depreciation expense for a change in
depreciation estimate
15
E7-15 LO7-4 Determine activity-method depreciation 10
E7-16 LO7-5 Record amortization expense 20
E7-17 LO7-6 Record the sale of equipment 15
E7-18 LO7-6 Record an exchange of land 10
E7-19 LO7-7 Calculate ratios 15
E7-20 LO7-8 Calculate impairment loss 15
Problems
Learning
Objective(s) Topic
Time
(Min.)
P7-1A LO7-1 Determine the acquisition cost of land and building 30
P7-2A LO7-1 Determine the acquisition cost of equipment 20
P7-3A LO7-2 Calculate and record goodwill 25
P7-4A LO7-3 Record expenditures after acquisition 20
P7-5A LO7-4 Determine depreciation under three methods 45
P7-6A LO7-5 Record amortization and prepare the intangible assets
section
30
P7-7A LO7-4,7-5 Compute depreciation, amortization, and book value of
long-term assets
30
P7-8A LO7-6 Record disposal of equipment 25
P7-9A LO7-7 Calculate and interpret ratios 35
P7-10A LO7-7 Calculate and interpret ratios 35
P7-1B LO7-1 Determine the acquisition cost of land and building 30
P7-2B LO7-1 Determine the acquisition cost of equipment 20
P7-3B LO7-2 Calculate and record goodwill 25
P7-4B LO7-3 Record expenditures after acquisition 20
P7-5B LO7-4 Determine depreciation under three methods 45
P7-6B LO7-5 Record amortization and prepare the intangible assets
section
30
P7-7B LO7-4,7-5 Compute depreciation, amortization, and book value of
long-term assets
30
P7-8B LO7-6 Record disposal of equipment 25
P7-9B LO7-7 Calculate and interpret ratios 35
P7-10B LO7-7 Calculate and interpret ratios 35
Additional
Perspectives Topic
Time
(Min.)
AP7-1 Continuing Problem: Great Adventures 40
AP7-2 Financial Analysis: American Eagle Outfitters, Inc. 20
AP7-3 Financial Analysis: The Buckle, Inc. 20
AP7-4 Comparative Analysis: American Eagle Outfitters, Inc., vs. The Buckle,
Inc.
35
AP7-5 Ethics 20
AP7-6 Internet Research 20
AP7-7 Written Communication 20
AP7-8 Earnings Management 35
Chapter Quiz Questions
The following multiple-choice questions are 10 unique quiz questions that correspond to the 10 questions
at the end of each chapter. Each question covers the same learning objective but with a little different
twist. The correct answer is highlighted in bold for each item.
LO7-1
1. We initially record long-term assets at the:
a. Cost of the asset.
b. Fair value.
c. Cost of the asset plus all costs necessary to get the asset ready for use.
d. Cost of the asset, but subsequently adjusted up or down to fair value.
LO7-1
2. Tasty Inn and Out incurred the following costs related to its purchase of equipment.
Cost of the equipment $10,000
Sales tax (7%) 700
Annual property insurance 500
Shipping 200
Installation 1,000
Total costs $12,400
What is the recorded cost of the equipment?
a. $10,000.
b. $10,700.
c. $11,900.
d. $12,400.
LO7-2
3. An exclusive 20-year right to manufacture a product or to use a process is a:
a. Patent.
b. Copyright.
c. Trademark.
d. Franchise.
LO7-3
4. Which of the following expenditures should be recorded as an expense?
a. An addition.
b. An improvement.
c. Ordinary repairs and maintenance.
d. Successful legal defense of an intangible asset.
LO7-4
5. Which of the following will result in higher depreciation expense in the first year of the asset’s life?
a. Short service life, high residual value, and straight-line depreciation.
b. Short service life, low residual value, and double-declining balance depreciation.
c. Long service life, low residual value, and straight-line depreciation.
d. Long service life, high residual value, and double-declining balance depreciation.
LO7-4
6. The asset’s cost less accumulated depreciation is called:
a. Replacement cost.
b. Book value.
c. Net fair value.
d. Residual value.
LO7-4
7. Depreciation in accounting is the:
a. Decrease in fair value of an asset.
b. Decrease in selling price of an asset.
c. Allocation of an asset’s cost to an expense over time.
d. Change in fair value of an asset.
LO7-5
8. Which of the following statements is false regarding the amortization of intangible assets?
a. Intangible assets with a limited useful life are amortized.
b. The service life of an intangible asset is always equal to its legal life.
c. The expected residual value of most intangible assets is zero.
d. Goodwill is the most common intangible asset with an indefinite useful life.
LO7-6
9. Equipment originally costing $65,000 has accumulated depreciation of $25,000. If the equipment is
sold for $50,000, the company should record:
a. No gain or loss.
b. A gain of $10,000.
c. A loss of $10,000.
d. A loss of $15,000.
LO7-7
10. The return on assets is equal to:
a. Net income divided by long-term assets.
b. Net income divided by average long-term assets.
c. Average total assets divided by net income.
d. Net income divided by average total assets.
Alternate Let’s Review
Chicago Style Pizza purchases a delivery van at a cost of $30,000. On the date of purchase, the company
estimates the van will have a residual value of $5,000. The company expects to use the van for five years
or about 100,000 miles.
Required:
Prepare a depreciation schedule using each of the following methods:
1. Straight-line.
2. Double-declining-balance.
3. Activity-based. Actual use per year was as follows:
Year Miles Used
1 22,000
2 24,000
3 18,000
4 21,000
5 20,000
Total 105,000
Solution
1. Straight-line.
Chicago Style Pizza
Calculation End of Year Amounts
Year
Depreciable
Cost XDepreciation
Rate* =Depreciation
Expense
Accumulated
Depreciation
Book
Value**
1 25,000 0.20 5,000 5,000 25,000
2 25,000 0.20 5,000 10,000 20,000
3 25,000 0.20 5,000 15,000 15,000
4 25,000 0.20 5,000 20,000 10,000
5 25,000 0.20 5,000 25,000 5,000
Total 25,000
* 1 / 5 years = 0.20 per year
** $30,000 cost minus accumulated depreciation
2.
Double-declining-balance.
3. Activity-based.
Chicago Style Pizza
Calculation End of Year Amounts
Year
Miles
Used XDepreciation
Rate* =Depreciation
Expense
Accumulated
Depreciation
Book
Value**
1 22,000 $0.25 5,500 5,500 24,500
2 24,000 $0.25 6,000 11,500 18,500
3 18,000 $0.25 4,500 16,000 14,000
4 21,000 $0.25 5,250 21,250 8,750
5 20,000 $0.25 3,750*** 25,000 5,000
Total 105,000 25,000
* $25,000 / 100,000 miles = $0.25/mile
** $30,000 cost minus accumulated depreciation
*** Amount needed to reduce book value to residual value.
Key Points By Learning Objective
LO7-1 Identify the major types of property, plant, and equipment.
Chicago Style Pizza
Calculation End of Year Amounts
Year
Beginning
Book Value XDepreciation
Rate* =Depreciation
Expense
Accumulated
Depreciation
Book
Value**
1 30,000 0.40 12,000 12,000 18,000
2 18,000 0.40 7,200 19,200 10,800
3 10,800 0.40 4,320 23,520 6,480
4 6,480 0.40 1,480*** 25,000 5,000
5 0.40 0
Total 25,000
* 2 / 5 years = 0.40 per year
** $30,000 cost minus accumulated depreciation
*** Amount needed to reduce book value to residual value.
Tangible assets include land, land improvements, buildings, equipment, and natural resources.
LO7-2 Identify the major types of intangible assets.
We record (capitalize) purchased intangible assets at their purchase price plus all costs necessary to get
the asset ready for use. We expense internally generated intangible assets, such as R&D and advertising
costs, as we incur those costs.
Intangible assets include patents, copyrights, trademarks, franchises, and goodwill.
LO7-3 Describe the accounting treatment of expenditures after acquisition.
Capital items (recorded as assets) benefit future periods. Expenses typically benefit only the current
period.
LO7-4 Calculate depreciation of property, plant, and equipment.
Depreciation refers to the allocation of an asset’s original cost to an expense during the periods benefited.
Depreciation does not refer to the change in value or selling price.
Straight-line, declining-balance, and activity-based depreciation all are acceptable depreciation methods
for financial reporting. Most companies use straight-line depreciation for financial reporting and an
accelerated method called MACRS for tax reporting.
LO7-5 Calculate amortization of intangible assets.
Amortization is a process, similar to depreciation, in which we allocate the cost of intangible assets over
their estimated service life. Intangible assets with an indefinite useful life (goodwill and most trademarks)
are not amortized.
LO7-6 Account for the disposal of long-term assets.
If we dispose of an asset for more than book value, we record a gain. If we dispose of an asset for less
than book value, we record a loss.
Analysis
LO7-7 Describe the links among return on assets, profit margin, and asset turnover.
Return on assets indicates the amount of net income generated for each dollar invested in assets. Return
on assets can be separated to examine two important business strategies: profit margin and asset turnover.
Appendix
LO7-8 Identify impairment situations and describe the two-step impairment process.
Impairment is a two-step process. Step 1: Test for impairment: The long-term asset is impaired if future
cash flows are less than book value. Step 2: If impaired, record loss: The impairment loss is the amount
book value exceeds fair value.
Common Mistakes
Common Mistake
Many students incorrectly add or ignore the cash received from sale of salvaged materials. Cash received
from sale of salvaged materials reduces the total cost of land.
Common Mistake
Students sometimes mistake accounting depreciation as recording the decrease in value of an asset.
Depreciation in accounting is not a valuation process. Rather, depreciation in accounting is an allocation
of the asset’s cost to expense over time.
Common Mistake
A common mistake is to depreciate land. Land is not depreciated because its service life never ends.
Common Mistake
Many students think March 1 to the end of the year is nine months since December is the twelfth month
and March is the third month. March 1 to the end of the year is actually ten months; it is every month
except January and February.
Common Mistake
When using the declining balance method, mistakes are commonly made in the first and last year of the
calculation. In the first year, students sometimes calculate depreciation incorrectly as cost minus residual
value times the depreciation rate. The correct way in the first year is to simply multiply cost times the
depreciation rate. In the final year, some students incorrectly calculate depreciation expense in the same
manner as in earlier years, multiplying book value by the depreciation rate. However, under the
declining-balance method, depreciation expense in the final year is the amount necessary to reduce book
value down to residual value.
Common Mistake
Some students forget to update depreciation prior to recording the disposal of the asset. Depreciation must
be recorded up to the date of the sale, retirement, or exchange. Otherwise, the book value will be
overstated, and the resulting gain or loss on disposal will be in error as well.
Common Mistake
Be careful not to combine the delivery truck ($40,000) and accumulated depreciation ($21,000) and credit
the $19,000 difference to the delivery truck account. Instead, remove the delivery truck and accumulated
depreciation from the accounting records separately, otherwise, the delivery truck and the accumulated
depreciation accounts will incorrectly have a remaining balance after the asset has been sold.
Common Mistake
Students sometimes divide by ending total assets rather than by average total assets. We measure net
income over time, whereas we measure total assets at a point in time. Therefore, whenever we divide a
number in the income statement by a number in the balance sheet, it’s more meaningful to use an average
balance sheet number.
Common Mistake
Some students forget step 1 when considering impairment. Record an impairment loss only when book
value exceeds both future cash flows and fair value.
Decision Points
Question Accounting Information Analysis & Decision
How different is the
company’s
recorded book
value from its
actual fair value?
Gain or loss on sale A gain on sale indicates the actual
fair value is more than the
recorded book value. A loss on
sale indicates the opposite.
Question Accounting Information Analysis & Decision
How effectively is
the company using
its assets?
Return on assets ratio A higher return on assets
generally indicates a more
effective use of assets.
Question Accounting Information Analysis & Decision
How much profit is
being generated
from sales?
Profit margin A higher profit margin indicates a
company generates a higher net
income per dollar of sales.
Question Accounting Information Analysis & Decision
Is the company
effectively
generating sales
from its assets?
Asset turnover ratio A higher asset turnover indicates
a company generates a higher
sales volume per dollar of assets
invested.
Career Corner
Career Corner
The legal defense of intangible asset rights often requires the services of a lawyer. Accounting and law
actually have a lot in common. Some business professionals (such as those specializing in tax laws) have
both a CPA license and a law degree. If you are considering a career in law, don’t shy away from
accounting and other business courses. The skills developed in accounting and related business courses
can be quite valuable in analyzing many of the challenging research questions addressed in law school.
While the most traditional career path to law is through a liberal arts degree such as political science,
many law students begin with undergraduate degrees in business.
Ethical Dilemma
Ethical Dilemma
James Wright is the Chief Financial Officer (CFO) for The Butcher Block, a major steakhouse restaurant
chain. As CFO, James has the final responsibility for all aspects of financial reporting. James tells
investors that The Butcher Block should post earnings per share (net income divided by the number of
shares of common stock) of at least $1 million.
In examining the preliminary year-end numbers, he notices that earnings are coming in at $950,000.
He also is aware that Butcher Block has been depreciating most of its restaurant equipment conservatively
over a five-year useful life. In some cases, the company uses the equipment for 10 years or more. He
proposes to change the estimated useful life for a subset of the equipment to a more reasonable useful life
of seven years, rather than five. By depreciating over a longer useful life, depreciation expense will be
lower in the current year, increasing earnings to just over $1 million. It looks like The Butcher Block is
going to exceed earnings of $1 million after all.
Do you think James Wright’s proposal to more accurately reflect the true depreciable life of assets is
ethical? What concerns might you have?