Long-term assets are assets that help generate revenue. Long-term assets are classified into two major categories:Tangible assets: Assets in this category include land, land improvements, buildings, equipment, and natural resources. Intangible assets: Assets in this category include patents, trademarks, copyrights, franchises, and goodwill. We distinguish these assets from property, plant, and equipment by their lack of physical substance. The evidence of their existence often is based on a legal contract.
In this section, we will consider the first issue in accounting for long-term assets which is to identify them and measure their costs.
The property, plant, and equipment category consists of land, land improvements, buildings, equipment, and natural resources. We record a long-term asset at its cost plus all expenditures necessary to get the asset ready for use. Thus, the initial cost of a long-term asset might be more than just its purchase price; it also will include any additional amounts the firm paid to bring the asset to its desired condition and location for use. We use the term capitalize to describe recording an expenditure as an asset.
The Land account represents land a company is using in its operations. We capitalize to Land all expenditures necessary to get the land ready for its intended use. Land improvements refer to amounts spent to improve the land by adding a parking lot, sidewalks, driveways, landscaping, lighting systems, fences, sprinklers, and similar additions.Capitalized costs include the purchase price of the land plus closing costs such as fees for the attorney, real estate agent commissions, title, title search, and recording fees. If the property is subject to back taxes or other obligations, we include these amounts as well. Any additional expenditure such as clearing, filling, and leveling the land, or even removing old buildings to prepare the land for its intended use, become part of the land’s capitalized cost. If we receive any cash from selling salvaged materials from old buildings torn down, we reduce the cost of land by that amount.Depreciationis the allocation of the cost of a tangible asset over its service life. We will discuss depreciation in detail later in this chapter. When we do so, you will discover that land is an asset we do not depreciate because its life is indefinite. However, we do depreciate land improvements.
Buildings include administrative offices, retail stores, manufacturing facilities, and storage warehouses.The cost of acquiring a building usually includes realtor commissions and legal fees in addition to the purchase price. The new owner sometimes needs to remodel or otherwise modify the building to suit its needs. These additional costs are part of the building’s acquisition cost. Unique accounting issues arise when a firm constructs a building rather than purchasing it. Of course the cost of construction includes architect fees, material costs, and construction labor. New building construction likely also includes costs such as manager supervision, overhead (costs indirectly related to the construction),and interest costs incurred during construction.
Equipment is a broad term that includes machinery used in manufacturing, computers and other office equipment, vehicles, furniture, and fixtures. The cost of equipment is the actual purchase price plus all other costs necessary to prepare the asset for use. These can be any of a variety of other costs including sales tax, shipping, delivery insurance, assembly, installation, testing, and even legal fees incurred to establish title. Any recurring costs related to equipment, such as annual property insurance and annual property taxes on vehicles, are expensed as they are incurred, in order to properly match them with revenues generated during the same period.
Basket purchase is purchase of more than one asset at the same time for one purchase price. The accounting issue is to allocate the purchase price among individual assets. We allocate the total purchase price based on the estimated fair values of each of the individual assets. However, often the estimated fair values of the individual assets exceed the total purchase price.
Assume Olive Garden purchases land, building, and equipment together for $900,000. We need to record land, building, and equipment in separate accounts because these assets have different service lives for purposes of depreciation. We allocate the total purchase price of $900,000 based on the estimated fair values of each of the individual assets.In this case, the estimated fair values of land, building, and equipment are $200,000, $700,000, and $100,000, respectively, for a total estimated fair value of $1 million, which exceeds the total purchase price of $900,000. Therefore, Olive Garden’s total purchase of $900,000 will be allocated to the separate accounts for Land, Building, and Equipment based on their relative fair values as shown in here.
In addition to land, buildings, and equipment, many companies depend heavily on natural resources,such as oil, natural gas, timber, and even salt.We can distinguish natural resources from other property, plant, and equipment by the fact that we can physically use up, or deplete, natural resources.The allocation of the cost of a natural resource over its service life is called depletion. That process for natural resources is nearly identical to the activity-based method of recording depreciation.
The other major category of long-term assets, intangible assets, have no physical substance. Assets in this category include patents, trademarks, copyrights, franchises, and goodwill.Intangible assets can be very valuable. For many companies, trademark or brand are one of the most valuable intangible assets.Companies acquire intangible assets in two ways: They purchase intangible assetsThey create intangible assetsPurchased intangibleassets are recorded at their original cost plus all other costs, such as legal and filing fees, necessary to get the asset ready for use. For internally developed, most of the costs are expensed to the income statement as they are incurred.
A patent is an exclusive right to manufacture a product or to use a process. The U.S. Patent and Trademark Office grants this right for a period of 20 years.When a firm purchases a patent, it records the patent at its purchase price plus other costs such as legal and filing fees to secure the patent.When a firm develops a patent internally, it expenses the research and development costs as it incurs them. Any legal and filing fees incurred to secure the patent are capitalized.
A copyright is an exclusive right of protection given by the U.S. Copyright Office to the creator of a published work such as a song, film, painting, photograph, book, or computer software. Copyrights are protected by law and give the creator (and his or her heirs) the exclusive right to reproduce and sell the artistic or published work for the life of the creator plus 70 years. A copyright also allows the copyright holder to pursue legal action against anyone who attempts to infringe the copyright. Accounting for the costs of copyrights is virtually identical to that of patents.
A trademark is a word, slogan, or symbol that distinctively identifies a company, product, or service. The firm can register its trademark with the U.S. Patent and Trademark Office to protect it from use by others for a period of 10 years. The registration can be renewed for an indefinite number of 10-year periods, so a trademark is an example of an intangible asset whose useful life can be indefinite.Firms often acquire trademarks through acquisition. As an example, Hewlett-Packard (HP) acquired all the outstanding stock of Compaq Computer Corporation for $24 billion, of which $1.4 billion was assigned to the Compaq trademark.The estimated value of the trademark is not recorded on the balance sheet; instead, only the legal, registration, and design fees are recorded. The advertising costs that create value for the trademark are recorded as advertising expense.
Franchises are local outlets that pay for the exclusive right to use the franchisor company’s name and to sell its products within a specified geographical area. Many popular retail businesses such as restaurants, auto dealerships, and hotels are set up as franchises. Many franchisors provide other benefits to the franchisee, such as participating in the construction of the retail outlet, training employees, and purchasing national advertising. To record the cost of a franchise, the franchisee records the initial fee as an intangible asset. Additional periodic payments to the franchisor usually are for services the franchisor provides on a continuing basis, and the franchisee will expense them as incurred.
Goodwill represents the value of a company as a whole, over and above the value of its identifiable net assets. It often is the largest, yet the most confusing, intangible asset recorded in the balance sheet. While most long-term assets, even intangible ones, can be separated from the company and sold individually, goodwill cannot. That value can emerge from a company’s reputation, its trained employees and management team, its favorable business location, and any other unique features of the company that we are unable to associate with a specific asset. We record goodwill as an intangible asset in the balance sheet onlywhen we purchase it as part of the acquisition of another company. In such a case, the acquiring company records goodwill equal to the purchase price less the fair value of the net assets acquired. The fair value of the net assets is equal to the value of all identifiable assets acquired, minus the value of all liabilities assumed.Most companies also create goodwill to some extent through advertising, training, and other efforts. However, as it does for other internally generated intangibles, a company must expense any costs it incurs in the internal generation of goodwill. Imagine how difficult it would be to estimate the amount and future benefits of internally generated goodwill. Due to this difficulty, we record goodwill only when it is part of the acquisition of another business.
This illustration shows how to calculate the amount Allied Foods would report as goodwill, which is $10 million.
Over the life of a long-term asset, the owners often incur additional expenditures for repairs and maintenance, additions, improvements, or litigation costs. We capitalize such expenses if they increase future benefits. We expense an expenditure if it benefits only the current period.
This illustration summarizes the Repairs and maintenance: We expense repairs and maintenance expenditures, such as the cost of an engine tune-up or the repair of an engine part for a delivery truck, because they maintain a given level of benefits in the period incurred. If the repairs are extensive and increase the future benefits from the asset, the cost of the addition must be capitalized.Additions:Theyoccur when we add a new major component to an existing asset. We should capitalize the cost of additions if they increase, rather than maintain, the future benefits from the expenditure. Improvements: They are the costs of replacing major components of an asset. The replacements can be new components with the same characteristics as the old components, or new components with enhanced operating capabilities. In either case, the cost of the improvements usually increases future benefits, and we should capitalize it to the asset account.Legal defense of intangible assets: Intangible assets also can require expenditures after their acquisition, the most frequent being the cost of legally defending the right that gives the asset its value. If a firm successfully defends an intangible right, it should capitalize the litigation costs. If the defense of an intangible right is unsuccessful, then the firm should expense the litigation costs as incurred because they provide no future benefit.
Materiality relates to the size of an item that is likely to influence a decision. An item is said to be material if it is large enough to influence a decision. Materiality is an important consideration in the “capitalize versus expense” decision. There often are practical problems in capitalizing small expenditures. For example, a stapler may have a 20-year service life, but it would not be practical to capitalize and then allocate that small of a cost to expense over 20 years. Companies generally expense all costs under a certain dollar amount, say $1,000, regardless of whether future benefits are increased. It’s important for a company to establish a policy for treating these expenditures and apply the policy consistently.
In this section, we will see how cost of an asset is allocated over time.
Depreciation in accounting is the process of allocating to an expense the cost of an asset over its service life. An asset provides benefits (revenues) to a company in future periods. To properly match the cost (expense) with the revenues it helps to generate, we allocate a portion of the asset’s cost to depreciation expense in each year the asset provides a benefit. If the asset will provide benefits to the company for four years, for example, then we allocate a portion of the asset’s cost to depreciation expense in each year for four years.
Assume the local Starbucks pays $1,200 for equipment. The machine is expected to have a useful life of four years. The entry to record the adjustment is shown here. Notice that rather than credit the equipment account directly, we instead credit its contra account, Accumulated Depreciation, which is then offset against the equipment account in the balance sheet. You can also see what the balances will be after one year.
Here are some of the common terms related to depreciation:Accumulated Depreciation is a contra asset account, meaning that it reduces an asset account. This account accumulates the depreciation we record each period.Book value equals the original cost of the asset minus the current balance in Accumulated Depreciation. Increasing accumulated depreciation each period will reduce the book value.The service life, or useful life, is how long the company expects to receive benefits from the asset before disposing of it. This can be measured in units of time (years) or in units of activity (units produced). The residual value, or salvage value, is the amount the company expects to receive from selling the asset at the end of its service life.
Straight-line: This method simply takes an equal amount of depreciation each year. It is by far the most common depreciation method used in financial accounting. Declining-balance: This method is an accelerated method, meaning that more depreciation expense is taken in the early years than in the later years of an asset’s life. The concepts behind declining-balance are also used in calculating depreciation for tax purposes. Activity-based: This method calculates depreciation based on the use of the asset. It is commonly used by companies that depend heavily on natural resources.
The straight-line method is the most easily understood and widely used. This method allocates an equal amount of the depreciable cost to each year of the asset’s service life. As you can see, the depreciable cost is the asset’s cost minus its estimated residual value and represents the total depreciation to be taken over the asset’s useful life.This illustration shows how depreciation is calculated under the straight-line method.Partial-year depreciation—when an asset is bought during the year, the asset is depreciated for only the portion of the first year that it was owned.Change in depreciation estimate—if a change in estimate is required, the company changes depreciation in current and future years, but not in prior periods.
This illustration shows how depreciation is calculated under the double-declining method. The declining-balance method is an accelerated depreciation method. Declining-balance depreciation will be higher than straight-line depreciation in earlier years, but lower in later years.The double-declining-balance method uses double the straight-line rate. This rate is then multiplied by book value (cost minus accumulated depreciation), rather than by the depreciable cost (cost minus residual value).Note that both declining-balance and straight-line will result in the same total depreciation over the asset’s service life.
This illustration shows how depreciation is calculated under the activity-based method. We first compute the average depreciation rate per unit by dividing the depreciable cost (cost minus residual value) by the number of units expected to be produced. We then multiply the per-unit rate by the number of units of activity each period.
This illustration compares annual depreciation under the three alternatives we discussed.
Companies generally want to report a higher net income, but they also want to reduce taxes by reducing taxable income. Using an accelerated method serves this objective by reducing taxable income more in the earlier years of an asset’s life than does straight-line. Most companies use the straight-line method for financial reporting and the Internal Revenue Service’s prescribed accelerated method (called MACRS) for income tax purposes.
Allocating the cost of property, plant, and equipment to expense is called depreciation. Similar to it, allocating the cost of intangible assets to expense is called amortization.
In early January, Little King Sandwiches acquires franchise rights from University Hero for $800,000. The franchise agreement is for a period of 20 years. In addition, Little King purchases a patent for a meat-slicing process for $72,000. The original legal life of the patent was 20 years, and there are 12 years remaining. However, due to expected technological obsolescence, the company estimates that the useful life of the patent is only 8 more years.Little King records the amortization expense for the franchise and the patent as shown here.
We do not amortize intangible assets with indefinite useful lives. This table provides the list of intangible assets that are amortized and those that are not amortized. These and all other long-term assets must be reviewed for a potential write-down when events or changes in circumstances indicate the amount recorded for an asset in the accounting records might not be recoverable. All long-term assets are subject to these “impairment” rules, which we will discuss later.
In this section we discuss what to do when we no longer use a long-term asset.
Long-term assets can be sold, retired, or exchanged for other assets.A sale is the most likely. Selling a long-term asset can result in either a gain or a loss. A retirement is when a long-term asset is no longer useful but cannot be sold. An exchange occurs when two companies trade assets. In a trade, we often use cash to make up for any difference in fair value between the assets.
Assume Little King uses straight-line depreciation and records the delivery truck in the Equipment account. The specific details are summarized here.If we assume that Little King sells the delivery truck at the end of year 3 for $22,000, we can calculate the gain as $3,000. The entry to record the transaction is also shown here.
Assume that Little King sells the delivery truck at the end of year 3 for only $17,000 instead of $22,000, we have a $2,000 loss as calculated here.We also have the entry to record this transaction.
Now assume that Little King retires the delivery truck instead of selling it. If, for example, the truck is totaled in an accident at the end of year 3, we have a $19,000 loss on retirement as calculated here. The above entry assumes Little King did not have collision insurance coverage. If Little King had insured the truck and collected $17,000 in insurance money for the totaled vehicle, the entry would be identical to the sale for $17,000 in previous slide.
Now assume that Little King exchanges the delivery truck at the end of year 3 for a new truck valued at $45,000. The dealership gives Little King a trade-in allowance of $23,000 on the exchange, with the remaining $22,000 paid in cash. We have a $4,000 gain, as calculated here.
It is not easy to compare net income of different companies. To make a more meaningful comparison, we calculate the return onassets. Return on assets is calculated as net income divided by average total assets. The average is calculated as the beginning amount plus the ending amount, divided by 2.Return on assets can be further separated into components: profit margin and asset turnover.Profit margin is calculated as net income divided by net sales and indicates the earnings per dollar of sales.Asset turnover is calculated as net sales divided by average total assets and measures the sales per dollar of assets invested.
Management must review long-term assets for impairment when events or changes in circumstances indicate that book value might not be recoverable.Impairment occurs when the future cash flows (future benefits) generated for a long-term asset fall below its book value (cost minus accumulated depreciation). The relationship among future cash flows, fair value, and book value can be confusing.
Impairment is a two-step process: Step 1: Test for impairment: The long-term asset is impaired if future cash flows are less than book value. Step 2: If impaired, record impairment loss: The impairment loss is the amount by which book value exceeds fair value.