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9-1 Notes
CHAPTER 9
LONG-LIVED TANGIBLE AND INTANGIBLE ASSETS:
I. Learning Objectives
1. Understand the concepts distinguishing expenditures on long-lived assets
that qualify for asset recognition from expenditures that firms treat as
expenses in the period incurred.
2. Understand the concepts underlying the measurement of acquisition cost.
3. Understand the distinction between finite-lived and indefinite-lived assets
and the implications for depreciation or amortization.
4. Develop the skills to compute depreciation based on initial estimates of
useful life and residual value and to adjust depreciation for changes in
those estimates over time.
5. Develop the skills to compute an impairment loss on long-lived assets.
6. Develop the skills to record the disposal of assets at various selling prices.
II. Organization of Class Sessions
The coverage of the various topics in this chapter depends on the total
amount of class time that we devote to this chapter. When we devote one hour
of class time, we emphasize the accounting for depreciable assets, including
measurement of acquisition cost, depreciation, and disposal. When we devote
two hours of class time, we consider the accounting for intangible assets. A
third hour of class time permits us to explore in greater depth issues in
capitalizing versus expensing expenditures on depreciable assets, revisions of
depreciable lives, and impairment losses. The application of these concepts to
depreciable and intangible assets, however, is more difficult than for
inventories.
Notes 9-2
III. Lecture Outline
1. Understand the concepts distinguishing expenditures on long-
lived assets that qualify for asset recognition from expenditures
that firms treat as expenses in the period incurred.
2. Understand the concepts underlying the measurement of
acquisition cost.
Begin by reviewing the definition of an asset: a resource that provides
a firm with future benefits. Then review the concept that accountants
measure these benefits using the acquisition cost of the assets. This
does not fully settle the accounting problem; we must address the
question as to which expenditures on an asset accountants should
include in acquisition cost. The general concept is that acquisition cost
should include all costs necessary to prepare an asset for its intended
use. Application of this concept to purchased depreciable assets is
straightforward, but we must remember to include freight charges and
installation costs. For self-constructed assets, the problem is more
difficult. Many costs are easily traceable to the self-constructed asset
and clearly are a component of acquisition cost. Many expenditures are
more indirect, such as the salaries of administrative personnel
overseeing the construction. Some expenditures are relatively small and
firms immediately expense them. Similar issues arise when
distinguishing repairs and maintenance expenditures (expensed when
incurred) and betterments (capitalized and amortized). We work
Exercise 9.15 to illustrate the difficulties accountants often encounter in
applying the broad concepts of acquisition cost accounting to depreciable
assets. Students need to see that accounting is not as clear-cut as they
probably think.
3. Understand the distinction between finite-lived and indefinite-
lived assets and the implications for depreciation or amortization.
We begin by explaining the students that finite life is when the asset
services over time are recognized as expense each period. When the
length of benefit for an asset cannot be estimated it is said to have
indefinite life. Important distinction between the two should be made.
We attempt to get students to see that inventories and depreciable
assets are similar in one important respect: they both provide future
benefits to a firm. An inventory item provides all of its future benefit in
a single accounting period (that is, when it is sold). A depreciable asset,
on the other hand, provides its future benefits over several accounting
periods. Accounting allocates the acquisition cost of an inventory item to
9-3 Notes
the period of sale as an expense. Accounting allocates the acquisition
cost of a depreciable asset to the periods of its use. Thus, the concepts
are similar. The difficulties arise in deciding how much of the
acquisition cost the accountant should allocate to each accounting
period. The analogy breaks down somewhat when accounting applies the
lower of cost or market method to inventories, because both valuation
and cost allocation enter the picture.
4. Develop the skills to compute depreciation based on initial
estimates of useful life and residual value and to adjust
depreciation for changes in those estimates over time
Depreciation accounting requires the following information:
(1) The acquisition cost of a depreciable asset,
(2) An estimate of the number of periods during which the firm expects to
receive benefits from the asset, and
(3) The pattern of benefits received. Issues in measuring acquisition cost
were discussed under the first and second learning objectives.
Estimating the service life of a depreciable asset requires information
on the manner in which a firm intends to use the asset. A machine used
24 hours each day will have a shorter life than one used 8 hours a day. A
machine that undergoes regular maintenance will last longer than one
that the firm services only when a problem arises. Service life estimates
also require predictions about new technologies that might hasten the
obsolescence of the asset. We conclude discussion of service life by asking
whether a firm has an incentive to choose a shorter or longer life than the
expected economic life. The response to this question depends on
whether it relates to financial or tax reporting. A firm can delay the
recognition of depreciation by choosing a longer life and thereby
maximize cumulative reported earnings to shareholders. Choosing a
shorter depreciable life for tax purposes maximizes the present value of
tax savings from depreciation deductions. Firms are not required to use
the same depreciable life for financial and tax reporting.
Determining the pattern of depreciation involves answering the
question: How much of the benefit does a firm expect to receive from
using the assets and how much does it expect to receive from disposal of
the asset? The portion of the acquisition cost that the firm expects to
receive from disposal of the asset (that is, the salvage value) gets
allocated to the period of disposal (that is, the salvage value is in effect a
revenue and the allocated portion of the acquisition cost of the asset is in
effect an expense, so no gain or loss arises if the actual salvage value
Notes 9-4
coincides with expectations). The remaining acquisition cost gets
allocated to the periods when the firm uses the asset. We try to get
students to see that a firm cannot observe the pattern by which it uses up
a depreciable asset's benefits, so any pattern is probably as "accurate" as
any other. After illustrating the calculation of depreciation using various
depreciation methods, we discuss how a firm should choose a depreciation
method for financial reporting. (Exercises 9.19 and 9.20)
5. Develop the skills to compute an impairment loss on long-lived
assets.
The accounting for impairment losses on tangible assets with finite lives
requires a distinction between
(1) Recognition and
(2) Measurement of the loss.
Recognition of Impairment Loss—if Book Value of Assets Exceeds the
Sum of Expected Undiscounted Cash Flows from the Asset.
Measurement of Impairment Loss—equals Book Value of Assets minus
Present Value of Expected Cash Flows from the Asset.
We raise the question: Which of these two approaches best captures
the economic loss that a firm incurs from asset impairment? It is clear
that the second approach, which compares the book value of the assets
to the present value of expected cash flows, best measures the economic
loss. Then ask: Is it possible that a firm would incur an economic loss
but would not recognize the loss under GAAP? The answer is clearly
yes. For this to occur, the undiscounted expected cash flows would
exceed the book value of the asset, but the discounted expected cash
flows would be less than the book value. Finally, ask: Why might the
FASB have imposed a recognition test that uses undiscounted cash
flows? We confess that we see no economic rationale for such a test.
However, in accounting, income is cash in minus cash out, other than
transactions with owners. Thus, if the undiscounted cash flows from an
asset exceed its book value, that asset will not generate an accounting
loss. It can easily generate an economic loss (think invest $1 today to
get back $1.10 in five years, which generates an accounting profit of $5,
even though no sensible person would undertake such a project as it
does not make economic sense). The FASB uses the concept of
recoverability to justify this test. Recoverability means that a firm will
receive cash flows in the future whose sum equals or exceeds the current
book value of the asset, so there is no accounting loss. We use Problem
8.41 to illustrate the recognition and measurement of impairment losses
9-5 Notes
on tangible assets. We tend not to spend much class time on
impairment losses for intangible assets. (Exercises 9.09, 9.10, 9.11, 9.21,
9.24, and 9.25)
6. Develop the skills to record the disposal of assets at various
selling prices.
Chapter 5 discussed the accounting for asset disposals, so the
instructor may not wish to spend class time on this topic at this point.
The one concept we attempt to get across is that gains and losses on
disposal would not occur if the firm predicted correctly the amount of the
salvage value. If the actual salvage is less than the estimated amount,
the firm recognized too little depreciation during the asset's useful life.
The loss on disposal represents additional "depreciation" recognized in
the period of disposal. Had the firm perfect foresight, it would have
charged more for depreciation and income would have been smaller. The
loss is catch-up depreciation—catch-up relative to perfect foresight. If
the actual salvage value exceeds the estimated amount, then the firm
recognized too much depreciation during the asset's useful life. The gain
on disposal represents a recapture for that excess depreciation which the
firm recognizes in the period of disposal. The gain is a recovery of
expenses recognized earlier that the firm would not have recognized had
it been omniscient. The other concept to note is that accounting reports
the gain or loss as a net amount (instead of showing the sale proceeds as
a revenue and the unamortized cost of the asset as an expense) because
the sale of depreciable assets is a peripheral activity to the primary
operating activities of most firms.
Notes 9-6
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