Chapter 8
________
Operating Assets: Property,
Plant, and Equipment, and
Intangibles
After studying this chapter, students should be able to:
◼ Understand balance sheet disclosures for operating assets (Module 1–LO1).
◼ Determine the acquisition cost of an operating asset (Module 1–LO2).
◼ Explain how to calculate the acquisition cost of assets purchased for a lump sum (Module 1–LO3).
◼ Describe the impact of capitalizing interest as part of the acquisition cost of an asset
(Module 1–LO4).
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Chapter Outline
MODULE 1 ACQUISITION OF OPERATING ASSETS
Module 1
LO 1
Acquisition of Operating Assets
Operating assets constitute the major productive assets of many companies.
◼ Operating assets are absolutely essential to a company’s long-term future because they are used to
produce the goods or services the company sells to customers.
◼ Not acquired for resale purposes.
Module 1
LO 2
Acquisition of Property, Plant, and Equipment
Property, plant, and equipment are initially recorded at acquisition cost.
◼ Acquisition cost (also called historical cost or original cost) is the amount that includes all of the
costs that are normal and necessary to acquire an asset and prepare it for its intended use, such as:
Module 1
LO 3
Group Purchase
Several assets can be purchased as a group and one price (lump sum) paid for all the assets.
◼ The purchase of land and a building situated on the land and paid for in a lump sum is a common
example.
CHAPTER 8 OPERATING ASSETS: PROPERTY, PLANT, AND EQUIPMENT, AND INTANGIBLES
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Module 1
LO 4
Capitalization of Interest
Interest is generally an expense of the period in which it is incurred, not a part of the cost of the related
asset.
◼ If a company buys an asset and borrows money to finance the purchase, interest on the borrowed
money is not part of the cost of the asset.
• Purchase of an asset is an investing activity and is separate from the decision concerning the
financing of an asset.
• Interest expense is treated as a period cost and appears on the income statement as interest
expense in the period incurred.
capitalized interest and this total cost will be depreciated over the life of the asset.
Land Improvements
◼ Land and land improvements are recorded separately.
• Land is not depreciated because it has an unlimited life.
• Land improvements are costs that are related to land but have a limited life and are
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MODULE 2 DEPRECIAION AND DISPOSAL OF OPERATING
ASSETS
Module 2
LO 5
Depreciation and Disposal of Operating Assets
The accrual accounting process requires matching of expenses and revenue to measure income accurately.
◼ Accountant must estimate the decline in usefulness of operating assets and allocate the acquisition
cost over the useful life of an asset, consistent with the decline in usefulness.
◼ This allocation is referred to as depreciation. It is the allocation of the original cost of an asset to
the periods benefited by its use.
◼ All property, plant, and equipment, except land, have a limited life and decline in usefulness over
time.
Straight-Line Method
◼ Allocates the cost of the asset evenly over time. (Example 8-2).
◼ The same dollar amount of depreciation is recorded in each year of asset use.
• Depreciation each year is computed as follows:
Acquisition Cost – Residual Value
Life
CHAPTER 8 OPERATING ASSETS: PROPERTY, PLANT, AND EQUIPMENT, AND INTANGIBLES
Units-of-Production Method
◼ The decline in an asset’s usefulness is directly related to the wear and tear as a result of the
number of units it produces. (Example 8-3).
• The annual depreciation for a given year can be calculated based on the number of
units produced during that year, as follows:
Annual Depreciation = Depreciation per Unit × Units Produced in Current Year.
Depreciate until all expected units have been produced.
NOTE: Under any depreciation method, do not depreciate an asset below its expected
residual value.
Accelerated Depreciation Methods
◼ Assumes assets produce more revenue in the earlier years of life, so more depreciation expense is
recorded in earlier years of life than in later ones.
• Under accelerated depreciation higher amount of depreciation is recorded in the early years
and a lower amount in the later years.
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Not widely used for financial statements.
NOTE: For this method, the residual value is not deducted from the cost before
multiplying by the depreciation rate.
NOTE: Once again, the asset cannot be depreciated below its residual value.
◼ Comparison of Depreciation Methods (Exhibit 8–1)
◼ All methods have the same total depreciation expense over the life of the asset; however, the
amount of depreciation per year depends on the method chosen.
• Depreciation is NOT a process of valuing the asset.
◼ Depreciation and Income Taxes
• Sometimes deprecation is referred to as a tax shield because it reduces the amount of income
tax expense.
• The company wants to minimize the present value of the tax burden over asset’s life.
◼ Choice of Depreciation Method (Exhibit 8-2)
• Choice of depreciation method can have a significant impact on the bottom line.
• Many factors determine the choice of depreciation method:
When depreciation is calculated for financial statement purposes, want to present highest
income possible.
Generally use straight-line for financial statements.
Module 2
LO 6
Change in Depreciation Estimate
CHAPTER 8 OPERATING ASSETS: PROPERTY, PLANT, AND EQUIPMENT, AND INTANGIBLES
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Sometimes an estimate of the useful life or residual value of an asset must be altered after the depreciation
process has begun due to changes in technology, better information, etc. (Example 8-5).
◼ This is called a change in estimate.
◼ A change in estimate should be recorded prospectively, that is, from the time of the change
forward, with no adjustments to previous periods.
Module 2
LO 7
Capital versus Revenue Expenditures
◼ Accountants often must decide whether certain expenditures related to operating assets should be
added to the cost of the asset or shown as an expense.
• Should repairs constitute capital expenditures or revenue expenditures?
◼ Capital expenditure is a cost that improves the asset and is added to the asset account (alternate
term – item treated as an asset). It is then depreciated.
◼ Revenue expenditure is a cost that keeps an asset in its normal operating condition and is treated
as an expense on the income statement and is not added to the cost of the asset (alternate term –
item treated as an expense of the period).
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◼ Items treated as capital expenditures affect the amount of depreciation that should be recorded
over the asset’s remaining life.
Environmental Aspects of Operating Assets
◼ Requires a thorough investigation to determine the implications of environmental regulations that
may affect the value of the assets.
Module 2
LO 8
Disposal of Property, Plant, and Equipment
Disposal of an asset occurs when the asset is sold, traded, or discarded.
◼ Sale of an asset involves two important considerations:
• Record depreciation to date of sale.
◼ Gain on sale of assets (Example 8–7):
• Record depreciation expense to the date of the sale.
• Debit cash or other consideration/assets received.
• Remove all accounts relating to asset.
Debit accumulated depreciation.
Credit asset.
◼ Loss on sale of assets (Example 8–8):
• Record depreciation expense to the date of the sale.
• Debit cash or other consideration/assets received.
CHAPTER 8 OPERATING ASSETS: PROPERTY, PLANT, AND EQUIPMENT, AND INTANGIBLES
• Remove all accounts relating to asset.
Debit accumulated depreciation.
Credit asset.
IFRS and Property, Plant and Equipment
◼ Important differences:
• IFRS requires that estimates of residual value and estimated life be reviewed at least annually
and revised if necessary. Treated as a change in estimate.
MODULE 3 INTANGIBLE ASSETS
Module 3
LO 9
Intangible Assets
Intangible assets are long-term assets that have no physical properties, but provide rights or privileges.
◼ Patent, copyright, brand name, logo are examples of intangible assets.
◼ For many companies (pharmaceutical companies), intangibles (drug patents) are their most
important assets.
Balance Sheet Presentation
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◼ Intangibles are long-term assets and should be shown separately from property, plant and
equipment.
◼ Exhibit 8-3 shows most common intangibles.
Acquisition Cost of Intangible Assets
◼ Acquisition cost of an intangible asset, like any asset, includes the costs necessary to acquire and
prepare it for use.
• Includes legal costs incurred at the time of acquisition.
• Also includes any costs incurred after acquisition that are necessary to the existence of the
asset, such as legal cost to protect patents.
Module 3
LO 10
Amortization of Intangibles
Amortization is the allocation of the acquisition cost of an intangible asset to the periods benefited by the
use of the asset.
◼ Straight-line amortization is most often used.
CHAPTER 8 OPERATING ASSETS: PROPERTY, PLANT, AND EQUIPMENT, AND INTANGIBLES
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• Amortize these assets over the legal life or the useful life of the asset, whichever is shorter.
(Example 8–9)
Debit Amortization Expense and credit Accumulated Amortization.
◼ Intangibles with Indefinite Life
• Some assets, such as trademarks, broadcast rights, etc., have an indefinite life.
• Amortization of these assets is NOT recognized.
◼ Goodwill and impairments
• Goodwill has an indefinite life and should not be amortized.
IFRS and Intangible Assets
• IFRS more flexible in allowing the use of fair market values for intangibles.
Such values can only be used for those assets where an “active market” exists and it is
possible to determine fair value.
MODULE 4 CASH FLOW AND ANALYSIS ISSUES
Module 4
LO 11
Cash Flow and Analysis Issues
The acquisition, depreciation, and sale of long-term assets influence the statement of cash flows
(Exhibit 8-5).
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• Since it is an expense and is deducted to arrive at net income, but required no cash, it is added
back to net income to calculate cash provided by operations (indirect method).
◼ Sale or disposition of long-term assets is an investing activity.
Module 4
LO 12
Analyzing Long-Term Assets for Average Life and Asset Turnover
Ratios used for analyzing long-term assets:
◼ Average life, if straight-line depreciation is used:
Average Life = Property, Plant, and Equipment
Depreciation Expense
• This ratio is a measure of how many dollars of sales are generated for every dollar of assets; it
is intended to measure the productivity of assets.
◼ Investors and lenders who read financial statements must determine the age, composition, and
productivity of operating assets.
• Ratio Analysis Model:
1. Formulate the Question. What is the average life of the assets? What is the average age of the
assets? How productive are the assets in producing revenue for the company?
CHAPTER 8 OPERATING ASSETS: PROPERTY, PLANT, AND EQUIPMENT, AND INTANGIBLES
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Depreciation Expense
• Using the Business Decision Model:
1. Formulate the Question. Would you be willing to lend money to Nike and use the operating
assets as collateral?
2. Gather Information from the Financial Statements and Other Sources. Information will come
from a variety of sources, including, but not limited to:
The balance sheet (age and composition of assets), income statement (profitability and
depreciation), and the statement of cash flows.
3. Analyze the Information Gathered.
Compare Nike’s ratios with Foot Locker’s as well as industry averages.
Look at trends over time in the age, composition and productivity of assets.
Review projections for the economy and the industry.