978-1133939283 Chapter 10 Lecture Note Part 2

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Summary

The cost of a long-term asset includes the purchase cost, freight charges, insurance while in

transit, installation, and other costs involved in the acquisition of the asset. Interest incurred

during the construction of a plant asset is included in the cost of the asset; interest incurred

for the purchase of a plant asset is expensed when incurred.

When land is purchased, the Land account is debited for the price paid for the land; real

estate commissions; lawyers’ fees; back taxes assumed; draining, clearing, and grading

costs; assessments for local improvements; the cost (less salvage value) of razing structures

situated on the property; and (usually) the cost of landscaping.

Land improvements, such as driveways, parking lots, and fences, are subject to depreciation

and require a separate Land Improvements account.

The cost of buildings and equipment includes all costs necessary to occupy the building or

ready the equipment for use.

Leasehold improvements are improvements made to leased property that revert to the

lessor at the end of the lease.

When a group of long-term assets is purchased for a lump sum (group purchase), the cost

should be allocated to the assets acquired in proportion to their appraised values.

Depreciation, as used in accounting, refers to the allocation of the cost (less the residual

value) of a tangible asset to the periods that bene(t from the services of that asset. It does

not refer to the physical deterioration or the decrease in market value of the asset; it is a

process of allocation, not of valuation.

A tangible asset should be depreciated over its estimated useful life in a systematic, rational

manner. Tangible assets have limited useful lives because of physical deterioration and

obsolescence.

Depreciation can be computed once the cost, residual value, depreciable cost, and

estimated useful life have been determined. Cost is the net purchase price plus all

expenditures to ready the asset for use. Residual value is the estimated value at the

disposal date; it is often referred to as salvage value or disposal value. Depreciable cost

equals the cost less the residual value. Estimated useful life is measured in time or in

units and requires careful consideration by the accountant.

The most common methods of depreciation are (1) the straight-line method, (2) the

production method, and (3) the declining-balance method.

Under the straight-line method, the depreciable cost is spread uniformly over the

estimated useful life of the asset. Depreciation for each year is computed as follows:

Cost – Residual Value

Estimated Useful Life (in

years)

Under the production method, depreciation is based not on time but on the use of the

asset in units. Depreciation for each year is computed as follows:

Cost – Residual Value

Estimated Units of Useful

Life

An accelerated method of depreciation results in larger amounts of depreciation in the

early years of an asset’s life and smaller amounts in later years. Under the

declining-balance method, depreciation is computed by multiplying the remaining

carrying value of the asset by a (xed percentage. The double-declining-balance method

is a form of the declining-balance method; it uses a (xed percentage that is twice the

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Chapter 10: Long-Term Assets Instructor’s Manual, p. 2

straight-line depreciation percentage. Under the double-declining-balance method, the

depreciation for each year is computed as follows:

Remaining Carrying Value ×

100%

× 2

Useful Life (in

years)

Although the declining-balance method does not use residual value in (guring the rate, the

depreciation in the last year is limited to the amount necessary to bring the carrying value

down to the estimated residual value.

The following journal entry for depreciation is introduced in this section:

Depreciation Expense—Asset Name XX (amount allocated)

Accumulated Depreciation—Asset Name XX (amount allocated)

To record depreciation for the period

When a company has several plant assets that are similar, it is likely to use a method known

as group depreciation rather than individual depreciation. Under group depreciation, the

original cost of all similar assets is recorded in one summary account. Then depreciation is

computed for these assets as a whole, using the straight-line or declining-balance method.

When an asset is purchased after the beginning of the year or is discarded before the end of

the year, depreciation is recorded for only part of the year. This is done by computing the

year’s depreciation and multiplying this (gure by the fraction of the year that the asset was

in use. Some companies compute depreciation to the nearest month, while others use the

half–year convention.

When the estimated useful life or residual value is found to be over– or understated after

some depreciation has been taken, the accountant must produce a revised (gure for the

remaining useful life or remaining depreciable cost. Future depreciation is then calculated by

spreading the remaining depreciable cost over the remaining useful life, leaving previous

depreciation unchanged.

The Economic Stimulus Act of 2008 allows rapid write-o@s of plant assets, known as

accelerated cost recovery. Businesses are allowed to deduct the (rst $250,000 of equipment

purchases in any given year.

When an asset is still in use after it has been fully depreciated, no more depreciation should

be taken, but the asset should not be written o@ until its disposal. Disposal occurs when the

asset is discarded, sold, or traded in.

When a business disposes of an asset, depreciation is recorded for the period preceding

disposal. This brings the asset’s Accumulated Depreciation account up to the date of

disposal.

For example, when a machine is discarded, Accumulated Depreciation, Machinery is debited

and Machinery is credited for their present balances. If the machine has not been fully

depreciated, then Loss on Disposal of Machinery must be debited for the carrying value to

balance the entry.

When a machine is sold for cash, Accumulated Depreciation, Machinery is debited, Cash is

debited, and Machinery is credited. If the cash received is less than the carrying value of the

machine, then Loss on Sale of Machinery would also be debited. On the other hand, if the

cash received is greater than the carrying value, then Gain on Sale of Machinery would be

credited to balance the entry.

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Chapter 10: Long-Term Assets Instructor’s Manual, p. 3

When an asset is traded in (exchanged) for a similar one, the gain or loss should (rst be

computed by treating the trade-in value in a similar manner to cash. Trade-ins are subject to

special rules that are reserved to more advanced courses.

The following journal entries for the disposal of assets are introduced in this section:

Accumulated Depreciation—Machinery XX (existing balance)

Loss on Disposal of Machinery XX (carrying value)

Machinery XX (recorded cost)

Discarded machine no longer in use

Cash XX (proceeds on sale)

Accumulated Depreciation—Machinery XX (existing balance)

Machinery XX (recorded cost)

Sale of machine for carrying value, no

gain or loss

Cash XX (proceeds on sale)

Accumulated Depreciation—Machinery XX (existing balance)

Loss on Sale of Machinery XX (carrying value minus cash)

Machinery XX (recorded cost)

Sale of machine at less than carrying

value; loss recorded

Cash XX (proceeds on sale)

Accumulated Depreciation—Machinery XX (existing balance)

Gain on Sale of Machinery XX (cash minus carrying value)

Machinery XX (recorded cost)

Sale of machine at more than carrying

value; gain recorded

Natural resources are tangible assets containing valuable substances that may be extracted

and sold. They are sometimes referred to as wasting assets and include standing timber, oil

and gas (elds, and mineral deposits.

Depletion refers to the allocation of a natural resource’s cost to accounting periods based on

the amount extracted each period. Depletion for each year is computed as follows:

Cost – Residual Value × Actual Units Extracted During

Period

Estimated Units to Be

Extracted

Units extracted but not sold during the year are recorded as inventory, to be charged as an

expense in the year sold.

Plant assets that are acquired in conjunction with the natural resource and that have no

useful purpose after the natural resource is depleted should be depreciated on the same

basis as depletion.

There are two acceptable methods of accounting for exploration and development of oil and

gas reserves. Under successful e!orts accounting, the cost of successful explorations,

such as producing wells, is capitalized and depleted, whereas the cost of unsuccessful

explorations, such as dry wells, is expensed immediately. Under the full-costing method,

the cost of all wells is capitalized and depleted.

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Chapter 10: Long-Term Assets Instructor’s Manual, p. 4

The following journal entry for the depletion of natural resources is introduced in this

section:

Depletion Expense—Natural Resource Name XX (amount allocated)

Accumulated Depletion—Natural Resource Name XX (amount allocated)

To record depletion of natural resource

Intangible assets are long-term assets that have no physical substance; they represent

certain rights and advantages available to their owner. Examples of intangible assets are

patents, copyrights, trademarks, goodwill, leaseholds, leasehold improvements, franchises,

licenses, brand names, software, noncompete covenants, and customer lists. An intangible

asset, with the exception of goodwill, should be written o@ over its useful life (not to exceed

40 years) through a process called amortization. This is to be accomplished by a direct

reduction of the asset account and an increase in amortization expense.

Goodwill is the excess of the amount paid for the purchase of a business over the fair

market value of the net assets. A trademark and a brand name are the exclusive right of

an owner to use a registered symbol or name to identify a product or service. A copyright is

an exclusive legal right to reproduce and sell literary, musical, and other artistic materials

and computer programs for a period of the author’s life plus 70 years. A patent is an

exclusive legal right to make a product or use a process for a period of 20 years; a design

may be granted a patent for 14 years. A license is the exclusive right to use a formula,

technique, process, or design. A franchise is the exclusive right to operate a business or to

use another’s formula, technique, process, or design in a given territory or market. A

leasehold is the purchased right to rent property for a long period. Software is the

capitalized costs associated with computer programs developed for sale, lease, or internal

use. A noncompete covenant is a contract limiting the rights of others to compete in a

speci(c industry or line of business for a speci(ed period. A customer list is a list of

customers or subscribers.

Research and development encompass the development of new products, the testing of

existing and proposed products, and pure research. According to GAAP, research and

development costs normally should be expensed in the period in which they are incurred.

The costs of developing computer software should be treated as research and development

until the product is deemed technologically feasible. From that point on, software production

costs should be capitalized and amortized over the products’ useful lives using the

straight-line method.

Goodwill, as the term is used in accounting, refers to a company’s ability to earn more than

is normal for its particular industry or for the amount of its capitalization (net assets).

Goodwill is recorded only when a company is purchased and equals the excess of the

purchase cost over the fair market value of the net assets. The FASB, in Statement 142, has

determined that purchased goodwill is an asset to be reported as a separate line item on the

balance sheet and is subject to an annual impairment review. If the fair value of goodwill is

less than its carrying value on the balance sheet, goodwill is considered impaired.

As illustrated by Exhibit 10, the purchase, use, and disposal of long-term assets a@ects all of

the (nancial statements.

Relevant Examples and Exhibits

Exhibit 4 Depreciation Schedule, Straight-Line Method

Exhibit 5 Depreciation Schedule, Production Method

Exhibit 6 Depreciation Schedule, Double-Declining-Balance Method

Exhibit 7 Graphic Comparison of Three Methods of Determining Depreciation

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Chapter 10: Long-Term Assets Instructor’s Manual, p. 5

Exhibit 8 Accounting for Intangible Assets

Exhibit 9 Assets Reported by Large Companies

Exhibit 10 Relationship of Long-Term Assets to the Financial Statements

Teaching Strategy

In the preceding section, the need to recognize the “cost” of long-term assets was

introduced. Students may have assumed that the cost was the purchase price and may not

have considered the matter any further. Be prepared to enumerate items that may be part

of the total cost of a given long-term asset. Explain why it is important to include those

items, applying the matching rule.

Pick examples of acquisitions of land, buildings, and equipment. Point out that

improvements to land are in a category of their own, not part of the cost of the land.

Group purchases (the most typical of which is a purchase of a building and land) are

illustrated in the text. It is helpful to draw attention to the calculations involved.

Short Exercises 1 and 2, Exercises 2A through 4A, and Case 3 may be used for class

discussion on the estimates underlying depreciation.

The introduction of depreciation is facilitated by references to deterioration, obsolescence,

and the allocation of costs under the matching rule. These concepts are simple at (rst but

become more complex as students are required to apply the underlying principles. Stress

the importance of understanding the relationship between cost and expense categories.

Stress that depreciation and valuation are not the same. Draw students’ attention to the

situation in which an asset may, in actuality, be appreciating, although depreciation is being

recorded periodically.

De(ne: Residual value, salvage value, disposal value

Depreciable cost as it di@ers from “cost”

Estimated useful life as it di@ers from physical life

If the preceding de(nitions are properly understood, the calculations presented in this

section can be readily mastered. The depreciation methods vary in diNculty and are

presented in the text in the order of simple to diNcult. Case 5 is relevant. Refer to the

example of the straight-line method in the text. Prepare other examples, taking care to

explain residual value. Short Exercise 3 and Exercise 5A include straight-line depreciation.

Explain that the production method is based on an activity level speci(c to the depreciable

asset. Point out that this formula is basically the same as the one used in the straight-line

method. Stress that this depreciation method is not time-based. Once that concept is clear,

refer to the illustration in the text. Short Exercise 4 and Exercise 5A include the production

method.

Accelerated methods of depreciation are challenging and will take more time to present than

either of the (rst two methods. There are additional steps in this method, and students often

(nd them confusing. Refer to the illustration in the text. Explain the calculations. Use Short

Exercise 5 and Exercise 6A to illustrate the accelerated method.

Compare all the methods of depreciation that have been introduced. The text uses the same

cost information for all illustrations, so it can be used for this comparison. Point out the

signi(cance of using accelerated or nonaccelerated methods. Point out that under all

methods, accumulated depreciation increases and carrying value decreases over time. The

rate at which they increase and decrease varies with the method used. Also point out

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Chapter 10: Long-Term Assets Instructor’s Manual, p. 6

another similarity among the three methods: An asset is never depreciated below its

residual value.

Refer to Exhibit 7 for a graphic presentation of the three methods.

Exercise 5A may be used to compare methods.

Depreciation for partial years poses signi(cant problems for students. The straight-line and

units of production methods should be used as examples (rst. DDB is next, in terms of

diNculty.

Revision of depreciation estimates is easily understood. Little time need be spent on this

topic, although a discussion is helpful.

The eNciency of group depreciation should be discussed.

Exercise 7A applies the concept of revised depreciation rates. It is advisable to assign as

many exercises and problems from this chapter as is reasonable. The concepts in this

chapter are pervasive in many areas of business.

Describe the circumstances that may occur in the disposal of equipment:

00. Discarded

00. Sold for cash

00. Exchanged for another asset

Begin a demonstration in which the same asset, with corresponding accumulated

depreciation, is disposed of by each of the possible disposal methods. The text illustrates the

topic in this manner. Refer to this sequence of calculations and journal entries.

Remind students that depreciation has accumulated from the beginning of the accounting

period to the date of disposal and needs to be recorded before the actual disposal is

recorded. Explain why.

Review the explanation of loss/gain recognition with the exchange of assets in the text.

Students may need to commit the rules to memory. Illustrate each possibility through

demonstration.

Short Exercise 6 and Exercises 8A and 9Aserve well for classroom discussion.

Point out that the computation of depletion is based on the same principles as that of

depreciation and amortization. Because students generally are unfamiliar with businesses

that consume natural resources, they tend to be intimidated by the di@erence in vocabulary.

To help reduce this confusion, refer to the journal entry illustrated in this section of the text.

Additionally, draw attention to the text section “Depreciation of Plant Assets Related to

Natural Resources,” which discusses depreciation of assets used in the conversion of natural

resources.

Short Exercise 7 and Exercise 10A relate to the topic of depletion and depreciation of related

assets.

Going over the list of intangible assets presented in the text helps con(rm the concepts on

which this section is based. Draw students’ attention to the similarities between the

accounting treatments of other assets and of intangible assets. Refer to Exhibit 8 for a

complete and succinct description of various intangible assets and their attributes. For each

asset described, discuss the accounting problems that arise.

Goodwill is particularly troublesome as an accounting subject. Students can de(ne it, and

they know that it exists for some companies and not for others, but they need some

discussion of how it is assigned a dollar value. Examples of local small businesses are helpful

for “bringing the de(nition home” and for assigning a value.

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Chapter 10: Long-Term Assets Instructor’s Manual, p. 7

Short Exercise 8 and Exercises 11A and 12A apply to this topic.

Section 3: Business Applications

Business Applications

Acquiring and Financing Long-Term Assets

Free Cash Flow

Ethics

Lecture Outline

I0. A standard measure of a company’s capacity to (nance long-term assets is free cash

Pow (Net cash Pows from operating activities less dividends and purchases of plant

assets plus sales of plant assets).

II0. Before investing in plant assets, cash inPows and outPows should be analyzed.

0. Accounting for long-term assets requires proper application of the matching rule by

resolving two issues:

0. How much of the total cost to allocate to expense in the current accounting period

0. How much to retain on the balance sheet as an asset to bene(t future periods

Summary

The decision to acquire a long-term asset involves an analysis of the cash inPows and

outPows over the asset’s useful life. The acquisition of long-term assets is often (nanced by

issuing stock, notes, or bonds or through operations. Information about investing and

(nancing of long-term assets is found in the statement of cash Pows.

A useful measure of a company’s ability to (nance long-term assets is free cash *ow,

which is the amount of cash that remains after all deductions for costs to continue

operations at plan level.

To account for long-term assets, one must determine (1) the cost of the asset, (2) the

method of matching the cost with revenues, (3) the treatment of subsequent expenditures

(repairs, maintenance, and additions), and (4) the treatment of asset disposal.

Relevant Examples and Exhibits

Exhibit 11 Issues in Accounting for Long-Term Assets

Teaching Strategy

It is important that the student have a working knowledge of free cash Pow. It is often

helpful if students view free cash Pow as the cash that remains after all the corporate

commitments have been satis(ed. After identifying company commitments related to the

calculation of free cash Pow, it is sometimes useful to discuss the bene(ts of positive free

cash Pow and the corporate strategies related to negative free cash Pow. Short Exercises 9

and 10 and Exercises 13A and 14A pertain to this section.

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Chapter 10: Long-Term Assets Instructor’s Manual, p. 8

Student Engagement Tactics

00. Assign Case 7 as advance reading for class. Let students form their own groups of four

or (ve.

00. Ask half the groups to prepare the role of the CFO and the other half, the role of the

controller. You may choose to provide the additional information about the CFO but not

controller information to CFO groups and vice versa. Each group will need to anticipate

the opposing views in preparation for role-play.

Chief Financial O,cer (CFO)

The CFO wants to have the best earnings result. In addition, the CFO knows (but the

controller does not) that the president has concerns about analysts’ earnings forecasts

and wants to report higher earnings.

If the CFO encounters resistance, he or she will argue that the current condition of the

warehouse warrants a valuation of only $12 million, since improvements will be

necessary to update the warehouse for Hamlin’s use.

He or she believes that land is notoriously undervalued in the long run on a historical

cost basis.

Controller

The controller believes that cash Pows (lower taxes) should be the dominant criterion

for determining allocation because he or she believes that this choice will help

ease an expected cash Pow crunch partially caused by the $18 million

expenditure from internal sources. The controller understands earnings issues,

but the controller is prepared to argue the following:

a0. Conservatism supports allocating $3.6 million to land. The company won’t risk

overstating its income.

b0. Over the 20 years, the company will save $648,000 in tax payments ($32,400

annually), which will greatly help cash Pow.

c0. The CFO’s split of the purchase price requires borrowing to pay the higher taxes.

Assuming an interest rate of 7 percent, interest expense on these incremental

taxes is $2,268 ($32,400 × .07). This means greater cash outPows annually and

over 20 years for an already tight cash situation. Borrowing will reduce after-tax

earnings in the (rst year by $1,588 ($2,268 × [1 – .30]).

00. In class, have representatives of each viewpoint role-play the situation. Observers of

role-play enactment must listen carefully to the points made. All students will be

evaluated with a questionnaire at the end of the role-play. If key points are not covered

in the (rst role-play demonstration, perform it a second time to cover the additional

issues.

00. Follow up with assessment and debrie(ng.

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