978-0136115274 Chapter 6 Lecture Notes

CHAPTER 6

ACQUISITION AND USE OF LONG-TERM ASSETS

CHAPTER OVERVIEW

The chapter begins with an introduction of long-term assets (fixed assets). An overview of the

acquisition of long-term assets is presented, including a discussion of tangible and intangible

assets. This section also discusses acquisition costs and basket purchase allocation.

The next part of the chapter discusses depreciation methods in detail. First, straight-line

depreciation is introduced, along with the terminology of cost, estimated useful life, residual

value, book value, and depreciable base. Next, the activity (units of production) method is

discussed, and finally, the declining balance method is covered. At the end of this section, a

summary of all of the depreciation methods and formulas is presented, along with comparisons

of the financial statement effects of the various methods.

Next, there is a discussion of depletion and amortization and when these methods would be used

for natural resources and intangible assets. The following part of the chapter discusses capital

expenditures and revenue expenditures. Then, there is a discussion of the proper treatment for

revisions of estimates of useful life and residual value. This is followed by a discussion of

selling long-term assets, including the calculation of gains and losses on disposal.

The next part of the chapter discusses where to find information about long-term assets in the

financial statements, how to use ratio analysis to understand how a company is using its

long-term assets, and what business risks are associated with owning long-term assets.

The chapter ends with a summary problem that continues the Team Shirts example from earlier

chapters and presents the student with transactions for the month of June. The student is then

required to make adjusting entries and prepare the four financial statements for the business.

LEARNING OBJECTIVES

After completing Chapter 6, your students should be able to answer these questions:

1. Explain how long-term assets are classified and how their cost is computed.

2. Explain and compute how tangible assets are written off over their useful lives and

reported on the financial statements.

3. Explain and compute how intangible assets are written off over their useful lives

and reported on the financial statements.

4. Explain how decreases in value, repairs, changes in productive capacity, and

changes in estimates of useful life and salvage value of assets are reported on the

financial statements.

5. Explain how the disposal of an asset is reflected in the financial statements.

6. Recognize and explain how long-term assets are reported on the financial statements,

and prepare financial statements that include long-term assets.

7. Use return on assets (ROA) and the asset turnover ratio to help evaluate a firm’s

performance.

8. Identify and describe the business risks associated with long-term assets and the

controls that can minimize those risks.

CHAPTER OUTLINE

Acquiring Plant Assets (LO 1)

I. Long-term assets (fixed assets) are assets that will be used for more than one accounting

period.

a. Tangible assets are assets with physical substance. They can be seen or touched.

i. Land

ii. Factory buildings

iii. Machines

iv. Natural resources (minerals or timber)

b. Intangible assets are rights, privileges, or benefits that result from owning long-lived

assets that do not have physical substance.

i. Copyrights

ii. Patents

iii. Trademarks

iv. Franchises

Acquisition Costs (LO 1)

I. Historical cost principle (Chapter 2) is used to record an asset at the amount paid for it.

II. Land purchase includes:

a. Purchase cost of land

b. Real estate commissions

c. Attorney’s fees

d. Costs of preparing the land for use (clearing or draining)

e. Costs of tearing down existing structures

III. Plant purchase includes:

a. Purchase cost of building or factories

b. Costs to update or remodel the facilities

c. Other costs to get the plant operational

IV. Equipment purchase includes:

a. Purchase cost

b. Freight-in (cost to have the equipment delivered)

c. Insurance while in transit

d. Installation costs, including test runs

e. Costs of training employees to use the new equipment

V. Building construction/acquisition includes:

a. Architect’s or contractor’s fees

b. Construction costs

c. Costs of renovating or repairing the building

Teaching Tip

The cost of removing an old building in order to construct a new building is included as a part of

the cost of the land, not as a part of the cost of the new building.

Basket Purchase Allocation (LO 1)

I. When two or more assets are acquired for a single price, the firm must calculate a

separate cost for each asset.

II. The relative fair market value method is a way to allocate the total cost for several

assets together to each of the individual assets. The method is based on the assets’

individual market values.

a. Determine a market value for each asset separately.

b. Add the separate market values to form the denominator.

c. Divide the market value of each asset by the denominator to provide a simple ratio to

allocate the total purchase price.

Teaching Tip

Use the example on page 270 in the text to illustrate the relative fair market value method of

allocating a basket purchase.

Using Long-Term Tangible Assets: Depreciation and Depletion (LO 2)

I. To capitalize is to record a cost sheet as an asset rather than as an expense.

II. The cost is later recognized as an expense in the periods in which the asset is used.

a. Depreciation is a systematic, rational allocation process to recognize the expense of

long-term assets over the periods in which they are used.

b. Depreciation expense is recorded as part of the adjusting process, before the financial

statements are prepared.

c. The adjustment decreases the amount of the asset in the accounting records via

accumulated depreciation (a contra-asset) and decreases shareholders’ equity via

depreciation expense.

d. Also referred to as “writing off” or “expensing” the cost of the asset

e. Amortization refers to writing off an intangible asset (patent).

f. Depletion refers to writing off a natural resource (timber).

Depreciation (LO 2)

I. Depreciation is the systematic, rational allocation of the cost (minus its residual value) of

a fixed asset to the periods benefited by the asset.

a. Does not refer to physical deterioration

b. Does not refer to decrease in market value

c. It is a process of cost allocation to accounting periods.

II. Terminology for depreciation

a. Cost or acquisition cost

i. Amount paid for the asset

ii. Includes all amounts necessary to get the asset up and running

b. Estimated useful life

i. How long the company plans to use the asset

ii. Not necessarily the same as the physical life of the asset; may be measured in

units that the asset will produce

c. Residual value or salvage value

i. Estimated value of the asset at the end of its useful life

ii. Market value on disposal date

d. Depreciable base = cost – salvage value

e. Book value or carrying value = cost – total depreciation taken to date

Teaching Tip

Make sure students are aware that book value is a subtotal (cost – accumulated depreciation) and

is not an account.

III. Depreciation for financial statements must follow GAAP and depreciation for the tax

return must follow the applicable tax law.

IV. There are three methods of depreciation for financial statements.

a. Straight-line depreciation

b. Activity (units of production) depreciation

c. Declining balance depreciation

V. Straight-line depreciation is a depreciation method in which the depreciation is the

same each period.

a. Simplest method of calculating depreciation

b. Cost – salvage value = depreciable base

c. Depreciable base / useful life = annual depreciation expense

d. Book value (carrying value) = cost – accumulated depreciation

Teaching Tip

Use the example on page 272 to illustrate the straight-line method.

VI. Activity (units of production) is the method of depreciation in which useful life is

expressed in terms of the total units of activity or production expected from the asset, and

the asset is written off in proportion to its activity during the accounting period.

a. How many units will the asset produce or how much work will the asset do during its

life?

i. Miles driven

ii. Units produced

b. Cost – residual value = depreciable base

c. Depreciable base / estimated number of units = depreciation rate

d. Depreciation rate times number of units during the period = depreciation expense for

the period

Teaching Tip

Use the example on pages 274-5 to illustrate the activity method.

VII. Declining balance depreciation is an accelerated depreciation method in which

depreciation expense is based on the declining book value of the asset.

a. Accelerated depreciation is depreciation in which more expense is taken in the early

years of the asset’s life and less in the later years.

b. Yearly expense is computed by multiplying book value by 2 by the straight-line rate.

c. Residual value is not used in the declining balance calculation each year.

Teaching Tip

Use the example on pages 276-7 to illustrate the declining balance method. Remind students that

residual value is not considered in the declining balance method. Also, remind the students that

the percentage is applied to the book value of the asset and that the asset cannot be depreciated

below its salvage value.

Teaching Tip

A summary of all of the depreciation methods and formulas, with examples, is presented on page

278.

Depletion (LO 2)

I. Depletion

a. Natural resources are written off in a process called depletion.

b. Divide total cost of the natural resource (less any residual value) by estimated units of

activity or output (this is the depletion cost per unit).

c. The depletion cost per unit is then multiplied by the output to determine total

depletion for the period.

Amortization (LO 3)

I. Amortization

a. Intangible assets are written off in a process called amortization.

b. Intangible assets are recorded at cost.

c. Amortized over its useful life or legal life, whichever is shorter

d. If its useful life is indefinite, the asset is not amortized.

i. Periodically evaluate the asset for any permanent decline in value.

ii. Write it down if this occurs.

e. A copyright is a form of legal protection for authors of “original works of

authorship,” provided by U.S. law.

i. Costs to obtain and defend copyrights are part of the cost of the asset.

ii. Copyrights are amortized using straight-line amortization over their legal lives

or useful lives, whichever is shorter.

f. A patent is a property right that the U.S. government grants to an inventor “to

exclude others from making, using, offering for sale, or selling the invention

throughout the United States or importing the invention into the United States” for a

specific period of time.

i. Costs to obtain and defend patents are part of the cost of the asset.

ii. Most patents have a legal life of 20 years.

iii. Patents are amortized using straight-line amortization over their legal lives or

useful lives, whichever is shorter.

Teaching Tip

A company acquired a patent at a cost of $10,000 in 20X2. The asset is expected to have an

economic life of 10 years. Over how many years should the patent be amortized? Ten years – its

economic life.

Over how many years should the patent be amortized if its useful life is indefinite? Twenty years

– its legal life.

g. A trademark is a symbol, word, phrase, or logo that legally distinguishes one

company’s product from any others.

i. Many trademarks are not amortized because their useful lives are indefinite.

ii. Trademarks have a 10-year life but are renewable as long as the trademark is

in use.

h. A franchise is an agreement that authorizes someone to sell or distribute a company’s

goods or services in a certain area.

i. Amortized over life of franchise if life is definite

i. Goodwill is the excess of cost over market value of the net assets when one company

purchases another company.

i. Goodwill is not amortized because it is assumed to have an indefinite life.

ii. Companies must evaluate it yearly to make sure it is not overvalued.

iii. If so, it must be written down. This means goodwill is decreased and a loss is

increased.

Teaching Tip

Explain that goodwill will appear on the balance sheet only when the company has paid more

than the fair value for the assets of another business. Note, also, that goodwill is not amortized,

but must be written off as the value becomes impaired.

j. Research and development (R&D) costs are expensed when incurred and are not

capitalized.

Changes after the Purchase of the Asset (LO 4)

I. Asset impairment

a. Impairment is a permanent decline in the market value of an asset such that its book

value exceeds its market value.

b. Changes that cause asset impairment include:

i. A downturn in the economy that causes a significant decrease in the market

value of a long-lived asset

ii. A change in how the company uses an asset

iii. A change in the business climate that could affect the asset’s value

Teaching Tip

Use Exhibit 6.9 to illustrate a disclosure about asset impairment.

Expenditures to Improve an Asset or Extend Its Useful life (LO 4)

I. A capital expenditure is a cost that is recorded as an asset, not an expense, at the time it

is incurred.

a. Expenditure that will benefit current and future accounting periods

b. Depreciated over the accounting periods in which it is used

c. Referred to as “capitalizing the cost” of the asset

II. A revenue expenditure is any expenditure that will benefit only the current accounting

period.

a. Recorded as an expense in the accounting period in which it occurs

b. Rules concerning capital and revenue expenditures

c. Capital expenditures either increase the useful life of the asset or increase the

efficiency or productivity of the asset.

d. Revenue expenditures are routine and do not increase the useful life or efficiency of

an asset.

e. Companies establish policies that categorize purchases as capital expenditures or

revenue expenditures based on type of expenditure or dollar amount (materiality).

Revising Estimates of Useful Life and Salvage Value (LO 4)

I. Useful life and residual value information used in depreciation calculations is estimated

and may need to be revised.

a. Not treated as an error

b. Previous records and financial statements are not changed.

c. Instead, the undepreciated balance, less the revised estimated residual value, is spread

over the new estimated (remaining) useful life.

Teaching Tip

Use the example on pages 282-3 to illustrate the revision of useful life and residual value.

Selling Long-Term Assets (LO 5)

I. Gain or loss on disposal is calculated by comparing the cash received for the asset

(proceeds) with the asset’s book value at the time of disposal.

a. Cash proceeds are greater than book value = gain

b. Cash proceeds are less than book value = loss

c. Cash proceeds are equal to book value = no gain or loss

II. Gains and losses

a. Gain is an addition to income earned outside the normal course of business.

b. Loss is a reduction to income incurred outside the normal course of business.

Presentation of Long-Term Assets on the Financial Statements (LO 6)

I. Information on the balance sheet

a. Original cost of land and buildings, fixtures and equipment, and other tangible and

intangible assets

b. Accumulated depreciation on all fixed assets

II. Information on the income statement

a. Depreciation expense for the period

b. Amortization expense for the period

III. Information on the statement of cash flows

a. Cash expenditure for long-term assets

b. Cash received from sales of long-term assets

IV. Information in the footnotes

a. Depreciation method used

b. Information about the useful life of the assets

Preparing Statements for Team Shirts (LO 6)

I. The summary problem uses the Team Shirts example developed in earlier chapters.

II. Transactions for the month of June are introduced.

III. The students are shown how to make the necessary adjustments and prepare financial

statements for the month of June.

a. Adjustment 1 – Insurance expense

i. This is a cash exchange that took place in May.

ii. The expense was deferred until incurred (insurance coverage was provided).

iii. The adjustment involves recognizing insurance expense and reducing prepaid

insurance.

b. Adjustment 2 – Rent expense

i. This is a cash exchange that took place on June 15.

ii. The expense was deferred until incurred.

iii. The adjustment involves recognizing rent expense and reducing prepaid rent.

c. Adjustment 3 – Depreciation expense

i. The expense was deferred until incurred (computer was used).

ii. The adjustment involves recognizing depreciation expense and accumulated

depreciation (a contra-asset).

d. Adjustment 4 – Depreciation expense

i. The expense was deferred until incurred (van was driven).

ii. The adjustment involves recognizing depreciation expense and accumulated

depreciation (a contra-asset).

e. Adjustment 5 – Interest expense

i. This is a cash exchange that will take place in the future (when the loan is

repaid).

ii. The expense needs to be accrued because it has been incurred (someone else’s

money was used).

iii. The adjustment involves recognizing interest expense and interest payable (a

liability).

f. Adjustment 6 – Interest expense

i. This is a cash exchange that will take place in the future (when the loan is

repaid).

ii. The expense needs to be accrued because it has been incurred (someone else’s

money was used).

iii. The adjustment involves recognizing interest expense and interest payable (a

liability).

Applying Your Knowledge – Ratio Analysis (LO 7)

I. Return on assets (ROA)

a. ROA measures how well a company is using its assets to generate revenue.

b. Calculated as net income (with interest added back) divided by average total assets

II. Asset turnover ratio

a. Measures how efficiently a company is using its assets

b. Calculated as net sales divided by average total assets

III. All ratios mean more when compared to other ratios.

a. Compared to ratios from other years for the same company

b. Compared to ratios of other companies for the same years

Business Risk, Control, and Ethics (LO 8)

I. Most significant risk related to long-term assets is theft.

a. Not a problem with large, stationary assets

b. Serious problem with small, mobile assets

c. Controls are used to protect assets from theft and damage.

II. Controls over long-term assets

a. Physical controls

i. Locks

ii. Security guards

iii. Limited access

b. Complete and reliable record keeping

c. Monitoring

CHAPTER 6 NAME ___________________________________

TEN-MINUTE QUIZ Section _____________ Date____________

_____________________________________________________________________________

_

_____ 1. Long-term assets are assets that will be:

a. Used up in one accounting period

b. Used for more than one accounting period

c. Converted into cash within one year

d. Sold in the near future

_____ 2. Assets that you can see and touch are:

a. Long-term assets

b. Intangible assets

c. Tangible assets

d. Current assets

_____ 3. Intangible assets include:

a. Copyrights

b. Trademarks

c. Goodwill

d. All of the above

_____ 4. Depreciation is defined as:

a. A decline in market value of a long-term asset

b. A systematic, rational process to allocate the cost of a long-term asset

c. Deterioration of a long-term asset

d. Accruing an expense

_____ 5. Amortization is used to describe the writing off of:

a. Equipment

b. Tangible assets

c. Natural resources

d. Intangible assets

_____ 6. Natural resources are written off through a process known as:

a. Depletion

b. Depreciation

c. Amortization

d. Capitalization

_____ 7. Equipment costing $18,000 was purchased on January 1, 20X2. It has an

estimated useful life of 5 years and a residual value of $3,000. What is depreciation expense

under straight-line for 20X5?

a. $3,000

b. $6,000

c. $9,000

d. $15,000

_____ 8. Straight-line depreciation expense is calculated as:

a. (Cost – book value) / Useful life

b. Depreciable base / Useful life

c. (Cost – salvage value) / Depreciable base

d. Book value / Useful life

_____ 9. Land and building were purchased together for $180,000. Independent separate

appraisals were obtained that valued the land at $50,000 and the building at $150,000. How

much will the land account be valued at?

a. $50,000

b. $90,000

c. $45,000

d. Land cannot be recorded separately for this purchase.

_____ 10. If the cash proceeds exceed the book value of a long-term asset at the date of

disposal:

a. A loss will be recognized

b. A gain will be recognized

c. Neither a gain nor loss will be recognized

d. The residual value must be revised

ANSWER KEY – CHAPTER 6 – TEN-MINUTE QUIZ

B

C

D

B

D

A

B

C

B