181
chapter
10
Fixed Assets and
Intangible Assets
______________________________________________
OPENING COMMENTS
Chapter 10 addresses fixed assets, intangible assets, natural resources, and the accounting issues related to
these assets.
After studying the chapter, your students should be able to:
1. Define, classify, and account for the cost of fixed assets.
2. Compute depreciation, using the following methods: straight-line method, units-of-production
method, and double-declining-balance method.
3. Journalize entries for the disposal of fixed assets.
4. Compute depletion and journalize the entry for depletion.
5. Describe the accounting for intangible assets, such as patents, copyrights, and goodwill.
6. Describe how depreciation expense is reported in an income statement and prepare a balance sheet
that includes fixed assets and intangible assets.
7. Describe and illustrate the fixed asset turnover ratio to assess the efficiency of a company’s use of its
fixed assets.
KEY TERMS
accelerated depreciation method
amortization
book value
boot
capital expenditures
182 Chapter 10 Fixed Assets and Intangible Assets
capital lease
copyright
depletion
depreciation
double-declining-balance method
fixed asset turnover ratio
fixed assets
goodwill
intangible assets
operating lease
patents
residual value
revenue expenditures
straight-line method
trade-in allowance
trademark
units-of-output method
STUDENT FAQS
• Why is three to six months a reasonable time to get an asset such as used delivery truck up and
running?
• When an extraordinary repair is made to an asset, why do you debit accumulated depreciation?
Wouldn’t it be easier to simply debit the asset account? After all, the value to the asset has just
increased due to the repair.
• When you have a gain on the exchange of similar assets, why don’t you show it?
• Which method of depreciation is always best to use?
• Why do accountants have to classify items as capital or revenue expenditures?
• Is it true that the higher the depreciation, the lower the net income? If that is the case, why would we
not want the lowest depreciation method so we can show the highest net income?
• Why do we have various methods of depreciation? Isn’t that encouraging misleading results?
• Do you have to use the depreciation method that best matches the use of the asset? For example,
would all trucks be required to be depreciated under the units of production method?
• Why is it important to use the gain and loss accounts when recording disposals of assets? Why can’t
we credit revenue or debit expense on sales of assets?
• Why do you update the depreciation before you remove the asset?
• Why does it matter if we identify the exchanged assets as similar or dissimilar?
• Does it really matter if you classify an item as capital or revenue expenditure? You still spent the
same amount of money to acquire or repair the asset.
• Isn’t not recording the gain on an exchange of similar assets misleading? Looks like you are
“playing” with the numbers to me.
Chapter 10 Fixed Assets and Intangible Assets 183
• How can you depreciate an asset that is going up in value? There is no cost to using it, since it can be
sold for more than cost when you are through with it.
• Why is interest during construction part of the cost of a building and not an expense?
• In order to buy a car, I must have insurance and buy license plates. Is this part of the cost of the car?
• Why does the double-declining-balance method use book value instead of depreciable cost?
• Why does the depreciation method required for taxes differ from the methods required for financial
reporting? Isn’t this like “keeping two sets of books”?
• What happens if we continue to use the asset after it is fully depreciated or when we reach the salvage
value?
• Why do you treat exchanges of similar and dissimilar assets differently? Aren’t they all exchanges?
• Who decides what the “useful” life of an asset is?
OBJECTIVE 1
Define, classify, and account for the cost of fixed assets.
SYNOPSIS
A fixed asset has the following characteristics: it is tangible, owned by the business, used in normal
operations, and not offered for sale in the normal course of business. A cost may be classified as a fixed
asset, an investment, or an expense. Exhibit 2 shows how to classify cost to determine how it should be
recorded. Assets recorded as fixed assets include land, buildings, and equipment. These assets last more
than one year. Investments are long-term assets that are not used in the normal course of business.
Although fixed assets can be sold, they should not be offered for sale in the normal course of business. To
determine the cost of a fixed asset, the purchase is added to all the costs that are incurred to get the asset
in place and ready for use. Exhibit 3 shows common costs associated with acquiring assets. Once a fixed
asset is in place and ready to use, additional costs may be incurred. If these are ordinary maintenance and
repairs, they are classified as an expense. If cost is incurred to improve the asset, it is classified as a
capital expenditure and recorded as increase to the asset account. If the costs incurred extend the useful
life of the asset, it is also a capital expenditure but is recorded as a decrease to accumulated depreciation
and a credit to Cash. The depreciation schedule will also change based on the new book value of the asset.
Fixed assets may also be leased from another business. In this case, they are recorded as an expense.
Key Terms and Definitions
• Capital Expenditures – The costs of acquiring fixed assets, adding to a fixed asset, improving a
fixed asset, or extending a fixed asset’s useful life.
• Capital Lease – A lease that includes one or more provisions that result in treating the leased
assets as purchased assets in the accounts.
• Fixed Assets (or Plant Assets) – Long-term or relatively permanent tangible assets such as
equipment, machinery, and buildings that are used in the normal business operations and that
depreciate over time.
• Operating Lease – A lease that does not meet the criteria for capital leases and thus is accounted
for as an operating expense.
184 Chapter 10 Fixed Assets and Intangible Assets
• Revenue Expenditures – Costs that benefit only the current period or costs incurred for normal
maintenance and repairs of fixed assets.
Relevant Examples Exercises and Exhibits
• Example Exercise 10-1 Capital and Revenue Expenditures
• Exhibit 1 – Fixed Assets as a Percent of Total Assets—Selected Companies
• Exhibit 2 – Classifying Costs
• Exhibit 3 – Costs of Acquiring Fixed Assets
• Exhibit 4 – Revenue and Capital Expenditures
SUGGESTED APPROACH
Review the definition of fixed assets. Ask students to give examples of fixed assets, listing them on the
board as they are called out.
LECTURE AID—Defining Fixed Assets
Fixed assets are long-term (or relatively permanent) assets that can be used in a business. Emphasize that
the word “used” is essential in this definition. As long as the asset is capable of being used, it is
considered a fixed asset. Therefore, equipment held as back-up in case regular equipment breaks or there
is abnormally high volume is a fixed asset. If an asset is being held for sale or future use, but it is not
capable of being used in its current condition (such as undeveloped land), it should be classified as an
investment, not a fixed asset.
The costs of acquiring fixed assets can be summarized by the following general rule:
GENERAL RULE: The cost of acquiring a fixed asset includes all costs necessary to get the asset to its
place of use and ready for use.
Exhibit 3 in the text lists examples of costs to be included in the total cost capitalized when recording a
fixed asset. After referring your students to this exhibit, use Transparency Masters (TMs) 10-1 through
10-4 to review specific cost examples with your class.
TM 10-3 will provide an opportunity for you to introduce the concept of land improvements. Emphasize
that these expenditures are for improvements to land that are neither as permanent as the land nor directly
related to a building.
LECTURE AID—Nature of Depreciation
The nature of depreciation was explained in Chapter 3. However, a considerable amount of material has
been covered since that explanation. You will probably want to explain the nature of depreciation again to
ensure that the class is focused on the correct concept before beginning depreciation calculations. In this
review, emphasize once again that accounting is concerned only with allocating the cost of an asset to the
period in which it is used. Accountants do not attempt to track the market value of an asset.
Chapter 10 Fixed Assets and Intangible Assets 185
(As an aside, I once heard the following story concerning a history professor: During his first term as a
teacher, he spent two class periods in one of his courses discussing the contributions of Martin Luther. At
the end of the second class, a group of students asked him when they were going to cover the “I Have a
Dream” speech. It dawned on the professor that the whole time he was discussing Martin Luther, his
students were picturing the twentieth-century African American civil rights leader Martin Luther King, Jr.
You don’t want to allocate a class period to depreciation calculations only to find that your students think
they are learning how to determine the decrease in market value of an asset.)
Use the following story (TM 10-5) to reinforce the concept of depreciation, which was introduced in
Chapter 3:
Assume you have just accepted a job that requires you to do a lot of driving. Because your current car is
on its “last leg,” you have decided to purchase an automobile. You estimate that you will drive 20,000
miles each year. Since you don’t like to deal with major car repairs, you will trade in the car when it
reaches 60,000 miles. You have found two cars that you are considering. One is a new car, and you can
purchase it for $18,000. The other is a late-model used car. The used car has 20,000 miles on it, but it is in
excellent condition. The price of this used car is $11,000.
Using the criteria outlined, what would be your depreciation cost per year for each car?
Answer: New Car: $18,000/3 = $6,000
Used Car: $11,000/2 = $5,500
Point out that when evaluating major purchases, we sometimes compare the cost of an item to the number
of years it will be used. In the previous example, we computed a cost per year to compare the two
automobiles.
186 Chapter 10 Fixed Assets and Intangible Assets
REMINDER: The adjusting entry to reduce supplies credits the supplies account, reducing it directly for
the amount of supplies that are physically gone. Since depreciation is only an estimate of the usefulness of
a long-term asset that has expired, the Asset account is not reduced directly. Rather, a contra-account
called Accumulated Depreciation is used to reduce the asset.
For example, the adjusting entry to record depreciation on a piece of machinery would be:
Depreciation Expense—Machinery…………… XXX
Accumulated Depreciation—Machinery XXX
As a final note, stress that depreciation does not provide cash for replacing assets as they wear out.
Depreciation only allocates a past cost to current and future periods. A business must separately budget
for the replacement of assets.
INTERNET ACTIVITY—Fixed Assets
Instruct your students to search the Web using “fixed assets” as their search criteria. This search will
bring up many Web sites promoting fixed asset software packages. Ask your students to pick a software
package and describe its capabilities. Sage Software has several fixed asset packages. Information can be
found at http://www.sagesoftware.com/.
LECTURE AID—Capital and Revenue Expenditures
Review the definitions of capital and revenue expenditures and their accounting treatment by using TMs
10-10 and 10-11. Next, give your students an opportunity to apply these definitions in practice through a
Group Learning Activity.
Capital expenditures are expenditures that benefit future operating periods, such as purchasing fixed
assets, adding to an existing fixed asset, improving a fixed asset, or extending the life of a fixed asset.
GROUP LEARNING ACTIVITY—Capital and Revenue Expenditures
TM 10-11 lists several expenditures related to fixed assets. Ask your students to classify each as a capital
or a revenue expenditure. Also instruct them to name the specific account that would be debited to record
each expenditure. TM 10-12 presents the solution.
Chapter 10 Fixed Assets and Intangible Assets 187
LECTURE AID—Capital Leases
Use the following scenario (TM 10-13) to introduce capital leases:
Company A: Purchases a $250,000 asset that has an estimated 15-year life, after which time it will have a
$10,000 salvage value. The asset is purchased on credit. Therefore, Company A records a $250,000 asset
and a $250,000 liability.
Company B: Leases the same $250,000 asset for 15 years. At the end of the 15 years, the company has
the right to purchase the asset for $100. Since Company B does not own the asset, it does not record the
asset on its accounting records. In addition, it does not recognize any liability related to the lease.
Is this a fair accounting treatment?
In 1976, the Financial Accounting Standards Board decided that it was unacceptable for Company B to
avoid recording a $250,000 debt on its balance sheet just because it used something legally called a
“lease” to obtain use of the asset.
The criteria to determine if a lease is a capital lease are not presented in the text; this is more an
intermediate accounting concern. However, in case your students ask, a lease is classified as a capital
lease if it meets one of these four criteria:
1. The lease transfers ownership of the asset to the lessee at the end of the lease term.
2. The lease contains an option for a bargain purchase of the asset by the lessee.
188 Chapter 10 Fixed Assets and Intangible Assets
OBJECTIVE 2
Compute depreciation, using the following methods: straight-line method, units-of-
production method, and double-declining-balance method.
SYNOPSIS
Depreciation can be caused by physical or functional factors. Depreciation is an allocation of a fixed
asset’s cost to expense over the asset’s useful life. Depreciation does not provide cash to replace the asset.
The three factors that determine depreciation expense are the asset’s initial cost, the expected useful life,
and the estimated residual value. Straight-line, units-of-output, and double-declining-balance methods
will be discussed in this objective. Some companies may use all three methods for different assets.
The straight-line method is the easiest to apply since it provides the same depreciation expense each year.
It is computed as: annual depreciation = (cost – residual value)/useful life. If the asset is purchased
midway through the year, prorate the year’s depreciation by the number of months it is in use. The units–
of-output method can be expressed in miles, hours, or units of production. It is calculated in two steps.
First, determine the depreciation per unit by the following formula: depreciation per unit = (cost –
residual value)/total units of output. Once depreciation per unit is determined, simply multiply by the total
number of units produced in the period or: depreciation expense = depreciation per unit × total units of
output used. The double-declining-balance method provides more depreciation expense in the initial years
of the asset’s use. It is determined in three steps: (1) determine the straight-line rate as a percentage, (2)
multiply that percentage by 2, and (3) determine the year’s depreciation by multiplying the percentage
calculated in Step 2 by the book value of the asset. A depreciation schedule for a five-year asset is shown
in the chart on page 469. If the asset is only used for part of the year, simply prorate the year’s
depreciation by multiplying it by the number of months it is used and dividing by 12. Exhibits 7 and 8
summarize and compare the results of the three methods of depreciation.
Any of the three methods of depreciation discussed above may be used for financial purposes. However,
when filing taxes, the IRS mandates a method of depreciation called MACRS. This method classifies
each asset in a class, commonly a five- or seven-year class. When determining the depreciation expense,
the residual value is ignored and the cost of the asset is multiplied by a different predetermined
percentage each year resulting in the expense for that year. Exhibit 9 shows the informational chart used
to determine the depreciation for a five-year asset. If during the life of an asset, it is determined that the
useful life has changed, only future depreciation expense is changed. Depreciation expense recorded in
past years is not affected.
Key Terms and Definitions
• Accelerated Depreciation Method – A depreciation method that provides for a higher
depreciation amount in the first year of the asset’s use, followed by a gradually declining amount
of depreciation.
• Book Value – The cost of a fixed asset minus accumulated depreciation on the asset.
• Depreciation – The systematic periodic transfer of the cost of a fixed asset to an expense account
during its expected useful life.
• Double-Declining-Balance Method – A method of depreciation that provides periodic
depreciation expense based on the declining book value of a fixed asset over its estimated life.
• Residual Value – The estimated value of a fixed asset at the end of its useful life.
Chapter 10 Fixed Assets and Intangible Assets 189
• Straight-Line Method – A method of depreciation that provides for equal periodic depreciation
expense over the estimated life of a fixed asset.
• Units-of-Output Method – A method of depreciation that provides for depreciation expense
based on the expected productive capacity of a fixed asset.
Relevant Example Exercises and Exhibits
• Example Exercise 10-2 Straight-Line Depreciation
• Example Exercise 10-3 Units-of-Output Depreciation
• Example Exercise 10-4 Double-Declining-Balance Depreciation
• Example Exercise 10-5 Revision of Depreciation
• Exhibit 5 – Depreciation Expense Factors
• Exhibit 6 – Use of Depreciation Methods
• Exhibit 7 – Summary of Depreciation Methods
• Exhibit 8 – Comparing Depreciation Methods
• Exhibit 9 – MACRS Depreciation Rates for 5-Year-Class Assets
• Exhibit 10 – Book Value of Asset with Change in Estimate
SUGGESTED APPROACH
The three factors used in determining depreciation are a fixed asset’s (1) initial cost, (2) useful life, and
(3) residual value. Review the formulas for each depreciation method, and give your students an
opportunity to apply these formulas using a Group Learning Activity.
LECTURE AID—Straight-Line and Units-of–Production Methods
The straight-line depreciation method allocates the cost of an asset evenly over the number of years it is
used. The formula to calculate the depreciation expense recorded each year is as follows:
(Cost – Residual Value)/Number of Years of Useful Life
Remind students that under the straight-line method, the depreciation expense recognized is the same
each year. Point out that assets purchased mid-year receive a partial year’s depreciation. Calculate the
depreciation for the entire year and then multiply the entire year’s depreciation by the percent of the year
the asset is used. For example, an asset purchased on April 1 would be used for 9 months. Prorate its
depreciation by multiplying by 9/12.
The units-of-production depreciation method allocates depreciation based on an asset’s usage. The life of
some assets is more easily measured in units, such as miles driven or hours used, than in years. The units–
of-production depreciation method calculates depreciation per unit of usage. The formula is:
(Cost – Residual Value)/Estimated Life in Units of Usage
Once a depreciation rate per unit is established, the yearly depreciation expense is calculated by
multiplying this rate by the number of units consumed in a year. For example, assume that a machine had
a units-of-production depreciation rate of $2 per operating hour. That machine was used 20,000 hours the
190 Chapter 10 Fixed Assets and Intangible Assets
first year. Depreciation for that year would be $40,000 ($2/hour 20,000 hours). The depreciation
expense recorded each year will change, based on the asset’s actual usage for each year. The units–of-
production method is the only method that considers the amount of usage in determining depreciation.
Make sure to clarify that the asset’s total depreciation can never exceed the amount where book value will
equal residual value.
GROUP LEARNING ACTIVITY—Straight-Line and Units-of–Production
Depreciation
TM 10-6 presents a depreciation exercise for small groups. The solution is provided on TM 10-7.
LECTURE AID—Double-Declining-Balance Method
The formula for double-declining-balance depreciation is as follows:
(Cost – Accumulated Depreciation) Declining-Balance Rate
OR
Book Value Declining-Balance Rate
The declining-balance rate is twice (or double) the depreciation rate that would be used under the straight-
line method. Therefore, to solve a double-declining-balance depreciation problem, use the following
steps:
1. Calculate the rate that would be used under straight-line depreciation.
Example: A $10,000 machine will be used for five years. At that time, the machine’s salvage value
will be $2,000.
Straight-line rate = 1/5 or 20 percent
Spreading the cost of the asset evenly over five years requires 1/5 of the asset to be depreciated each
year.
Chapter 10 Fixed Assets and Intangible Assets 191
GROUP LEARNING ACTIVITY—Declining-Balance Depreciation
Using TM 10-8, ask your students to calculate depreciation under the declining-balance method.
TM 10-9 contains the solution to this problem. When reviewing the solution, be sure to point out the
LECTURE AID—Comparing Depreciation Methods
Point out that the declining-balance method is called an accelerated depreciation method since the
depreciation expense is highest in the first year of the asset’s life and gradually declines.
The benefits of accelerated depreciation are:
1. Decreasing depreciation charges are matched against increasing repair and maintenance charges.
LECTURE AID—Tax Depreciation
Stress that assets are depreciated for tax purposes using methods prescribed by the Internal Revenue
Service (IRS). Therefore, a company may be recording different depreciation for tax and financial
accounting purposes. Assets acquired after 1986 are depreciated using the Modified Accelerated Cost
Recovery System (MACRS). MACRS depreciates assets using the declining-balance method at twice the
LECTURE AID—Miscellaneous
In addition to the information above, you may want to stress the following points.
1. Revision of Depreciation—If estimates of a fixed asset’s residual value or useful life change, this
affects the depreciation calculation. However, depreciation charges are revised only for future
periods. No attempt is made to “correct” past depreciation amounts.