Fixed assets are long-term or relatively permanent assets such as equipment, machinery, buildings, and land. Other descriptive titles for fixed assets are plant assets, property, plant, and equipment, or tangible assets. These assets are called tangible because they exist physically. Fixed assets are owned and used by the company in normal operations; they are not held for the main purpose of resale.
For many companies, fixed assets are a significant portion of the total assets of a company. Usually, companies who have a significant investment in fixed asset are manufacturing companies. Manufacturing companies require property, plant and equipment to manufacture their products.
A cost that has been incurred could be classified as a fixed asset, an investment, or an expense. If an asset purchased is determined to be long-lived, the item should be capitalized on the balance sheet as a fixed asset or an investment; if not, expense the item in the current period. If an item purchased has been determined to be long-lived, the next question to determine is if the asset will be used in normal operations. If the answer is yes, the asset is recorded as a fixed asset. If the answer is no, the asset is recorded as an investment. Costs that are classified as fixed assets include the purchase of property, plant, or equipment. Such assets normally last more than one year and are used in normal operations. Although fixed assets can ultimately be sold when they have reached the end of their useful life or are replaced by an improved asset, they should not be offered for sale as a normal part of operations. Investments are long-lived assets that are not used in normal operations. Investments are normally held for future resale. For example, underdeveloped land acquired for a future resale would be classified as an investment, not as the fixed asset of land.
The costs of acquiring fixed assets include all amounts spent to get the asset in place and ready for use. For example, in the purchase of land, in addition to the purchase price, the cost will include items such as sales taxes, title fees, or surveying fees. For the purchase of a building, the costs may include property taxes, repairs to existing building, or reconditioning costs in addition to the purchase price. If a company decides to construct a building, costs included would be items such as engineers’ fees, insurance cost incurred during construction, architects’ fees, etc. The costs incurred during construction would be capitalized in an asset account called “Construction in Process”. Once construction is complete, the total cost of the building is transferred to fixed assets.
When acquiring machinery and equipment, in addition to the purchase price, costs such as sales taxes, freight and installation should be included in the cost of the fixed asset. Land improvements are considered fixed assets separate from land as land improvements are usually depreciated.
Once assets are acquired and placed in service, additional expenditures may be incurred. These expenditures fall into one of the following categories: Revenue expenditures Capital expenditures
The first question to consider when determining whether an expenditure should be classified as a revenue expenditure or a capital expenditure is if the expenditure made will benefit only the current period or if the expenditure will benefit current and future periods. If the expenditure only benefits the current period, it will be classified as a revenue expenditure. Costs related to the ordinary maintenance and repairs of a fixed asset normally do not extend an asset’s life. They are considered revenue expenditures and recorded as expenses (Repairs and Maintenance account) in the current period. If an expenditure is made to improve an asset, the expenditure is considered a capital expenditure and would be recorded as an increase to the fixed asset account. This type of expenditure, since it affect the cost of the fixed asset, would require a change to the depreciation on the asset over the remaining useful life. After a fixed asset has been placed in service, costs may be incurred to extend the asset’s useful life. Such costs are classified as capital expenditures and are recorded by a decrease to the accumulated depreciation account related to the asset.
Fixed assets, with the exception of land, lose their ability to produce services. Sometimes this loss of ability is due to wear and tear from usage over time, sometimes the loss of ability is due to other factors such as obsolescence. Thus, the cost of fixed assets such as equipment and buildings should be spread out over time as an expense while the assets are useful in generating revenues. This periodic recording of the cost of fixed assets is called depreciation. The adjustment to record depreciation increases a Depreciation Expense account and a contra asset account titled Accumulated Depreciation. The use of a contra asset account allows the original cost of the asset to remain unchanged in the fixed asset account. Physical depreciation is considered depreciation of an asset’s value due to wear and tear from usage over time. Functional depreciation is considered depreciation of an asset’s value due to factors that cause the asset to no longer provide services to the company. This would include factors such as obsolescence. For example, equipment may become obsolete due to changing technology. Two common misunderstandings exist about depreciation. The first is that depreciation measures a decline in the market value of an asset. This is not true; depreciation is simply an allocation of the cost of a fixed asset to expense over the asset’s useful life. This matches the expense with the generation of revenue from use of the asset. Thus, the book value of an asset usually does not agree with an asset’s market value. The second misunderstanding is depreciation provides some sort of cash fund used to replace fixed assets as they wear out. This is also not true.
Three factors determine the depreciation expense for a fixed asset. They are: The asset’s initial cost The asset’s expected useful life The asset’s estimated residual value In addition to the asset’s initial cost, the useful life is a factor in computing depreciation. The expected useful life is the estimated time the asset is expected to provide service. The Internal Revenue Service publishes guidelines for assigning useful lives, but it is also common for an organization to use different estimates of useful lives. Sometimes useful lives can be stated as a number of years; sometimes useful lives can be states in terms of units of production for items such as machines or equipment. The third factor in computing the depreciation expense is an estimate of residual value. Residual value may also be referred to as scrap value, salvage value, or trade-in value. It is the estimate of the value of the asset at the end of its useful life. The difference between the asset’s original cost and its residual value is referred to as the asset’s depreciable cost.
Straight-Line Same amount of depreciation each year Double-Declining-Balance Accelerated method that provides more depreciation in earlier years
The straight-line method provides for the same amount of depreciation expense for each year of the asset’s useful life. This method is the most widely used depreciation method. If an asset is used for only part of a year, the annual depreciation is prorated. Using this example, if the equipment was purchased and placed into service on October 1, the depreciation for the first year ending December 31 would be: First Year Partial Depreciation = $4,400 * 3/12 = $1,100 The straight-line computation may be simplified by converting the annual depreciation to a percentage of depreciable cost. For example, if an asset has a 5 year useful life, each period 1/5 or 20% of the asset’s depreciable cost will be recorded as depreciation.
Straight-Line Same amount of depreciation each year Double-Declining-Balance Accelerated method that provides more depreciation in earlier years
The double-declining-balance method provides for a declining depreciation expense each period of the asset’s useful life. This method assumes the asset has the capacity to provide higher revenues during the early years of the asset’s life. In such cases, the double-declining-balance method provides a good matching of depreciation expense with the asset’s revenues. The first step in computing depreciation expense under the double-declining-balance method is to calculate the straight-line percentage rate. Then, multiply the straight-line rate by 2 to arrive at the double-declining-balance rate. Multiply the double-declining-balance rate against the book value of the asset to calculate the depreciation expense for the period. When the double-declining-balance method is used, the estimated residual value is not considered in the computation of the depreciation expense for a period. However, the asset should not be depreciated below its estimated residual value. Like straight-line depreciation, if an asset is used for only part of a year, the annual depreciation is prorated. Calculating the depreciation for future years will be a bit more complicated under the double-declining-balance method because in all the future periods after a first year of pro-rated depreciation, the depreciation expense will have to be prorated between two different depreciation years in the useful life of the asset.
Both depreciation methods allocate a portion of the total cost of an asset to an accounting period and both methods do not depreciate an asset below its estimated residual value. The straight-line method allocates the same amount each period over the life of the asset. The double-declining-balance method provides for higher depreciation expenses earlier in the useful life of the asset.
The IRS has rules that govern the calculation of depreciation for purposes of a tax deduction on a company’s federal income tax filing. These rules are outlined under the Modified Cost Recovery System (MACRS). MACRS classifies different types of assets into different categories, and each category has its own depreciation rate schedule. Like the double-declining-balance method, residual value is ignored in MACRS and more depreciation is recorded in the early years of the useful life of the asset.
Fixed assets that are not longer useful can be discarded or sold. When an asset is discarded or sold, it must be removed from the accounting records. However, a fully depreciated asset is not automatically removed from the accounting records simply because it is fully depreciated; the asset must be sold or discarded. If an asset is still being used, it should remain on the records of the company even if it is fully depreciated. This provides an internal control over the safeguarding of the assets of a company. Records of assets owned are also needed for many tax forms.
If a fixed asset has no residual value and is no longer used, it may be discarded by the business. If the asset is fully depreciated, the equipment account is reduced for the cost of the asset and the corresponding accumulated depreciation is eliminated.
If an asset has not been fully depreciated, depreciation should be recorded up to the disposal date before removing the asset from the company records. In this example, 3 months of depreciation expense in the amount of $150 is recorded before the asset is removed from the books. After bringing depreciation expense up to the date of the sale, the accumulated depreciation balance on this asset is $4,900. The impact on the financial statements of discarding this asset is a $1,100 loss to be reported on the Income Statement. This is because an asset with a book value of $1,100 (cost of $6,000 less accumulated depreciation of $4,900) is being discarded for no value. Losses on the discarding of fixed assets are considered non-operating items and reported on the Income Statement in the section for Other Expenses.
Under the sale of an asset, cash is received as part of the transaction. If the selling price is greater than the book value, a gain will result. If the cash received is less than the book value, the sale of the asset will result in a loss.
Depreciation on the fixed asset that is about to be sold must be brought up to date before recording the sale in the accounting records. Depreciation for nine months of a year amounts to $750. After the adjusting entry, the balance in accumulated depreciation related to this fixed asset amounts to $7,750, bringing the book value to $2,250 (Cost of $10,000 less accumulated depreciation of $7,750).
In this transaction, the asset is sold for an amount equal to the book value of the asset ($2,250). No gain or loss is recorded.
In this transaction, the fixed asset is sold for a selling price that is below the book value of the asset. The impact on the Income Statement will be a loss on the disposal of equipment in the amount of $1,250. This is calculated by comparing the selling price of $1,000 to the book value of the asset of $2,250: Selling Price $1,000 – Book Value $2,250 = Loss of $1,1000
In this transaction, the fixed asset is sold for a selling price that is above the book value of the asset. The impact on the Income Statement will be a gain on the disposal of equipment in the amount of $550. This is calculated by comparing the selling price of $2,800 to the book value of the asset of $2,250: Selling Price $2,800 – Book Value $2,250 = Gain of $550
The fixed assets of some companies include natural resources such as oil deposits, timber, or minerals. As these resources are harvested and sold, a portion of their cost is assigned to an expense account to be matched against the revenue generated. This process of transferring the cost of natural resources to an expense account is called depletion.
In order to determine depletion for a period, the cost of the natural resource is divided by the estimated total units expected to be harvested or extracted from the natural resource in order to arrive at the depletion rate. The depletion rate is then multiplied by the quantity extracted during the period to arrive at depletion expense.
The first step of calculating the depletion expense in this example is to calculate the depletion rate. That is determined by dividing the total $400,000 cost of the mining rights by the 1,000,000 tons of ore expected to be extracted. The resulting depletion rate is $.40 per ton. Since 90,000 tons are extracted, the depletion for the year is $36,000 or 90,000 tons times $.40 per ton. Like accumulated depreciation, accumulated depletion is a contra asset account reported as a deduction from the original cost of the mineral deposit.
Patents, copyrights, and trademarks are examples of long-lived assets used in the operations of a business and are not specifically held for resale. However, unlike property, plant and equipment, they do not have any tangible characteristics. Accounting for intangible assets is similar to accounting for fixed assets. The major issues are determining the initial cost and determining the amortization.
This exhibit illustrates the frequency of intangible asset distribution for 600 firms. A Patent is an e xclusive right to produce and sell goods with one or more unique features granted to manufacturers by the government. These rights continue in effect for 20 years. A Copyright is an e xclusive right to publish and sell a literary, artistic, or musical composition. Copyrights extend 70 years beyond the death of the author. A Trademark is a name, term, or symbol used to identify a business and its products. Trademarks are protected under federal law for 10 years, with renewals over additional 10 year periods. Goodwill refers to an intangible business asset that is created from favorable factors such as location, quality, reputation, etc.
Amortization results from the passage of the legally determined useful life or a decline in usefulness of the intangible asset. For example, patent rights extend for 20 years. Amortization of a patent can be, at the most, 1/20 of the patent cost per year or a lesser amount calculated from what the useful life of the patent may be.
Amortization is normally computed using a straight-line methodology. In this case, an expense of $20,000 is recorded each period ($100,000 cost / 5 years of remaining useful life). A separate contra asset account is not used for intangible assets; the asset account itself is directly decreased.
Goodwill is an intangible created from favorable business factors such as location, product quality, reputation, and managerial skill. It is only recorded if objectively determined by a transaction (e.g., purchase of a business for more than the fair value of identifiable net assets). Goodwill is not amortized; if Goodwill values are impaired the impaired values are adjusted. Goodwill is the most frequently reported intangible asset.
This schedule compares the significant characteristics of intangible assets.
Depreciation expense and amortization expense are reported separately in the income statement or disclosed in a note. A general description of the methods used should be disclosed. On the balance sheet, the amount of each major class of fixed asset should be disclosed or they should be disclosed in the notes. The balance sheet may present a single amount for fixed assets with separate, more detailed disclosures in the notes. The fixed assets may be shown at their book value (cost less accumulated depreciation) , which can also be described as their net value.
On the balance sheet, the property, plant, and equipment come first in the long-term asset section. Land is usually the first line of property, plant and equipment because it will not be depreciated. After property, plant and equipment information, natural resources and their related depletion is reported. Finally, Intangibles are reported last.
Survey 5e ch7_lecture
Chapter 7 Fixed Assets and Intangible Assets
Learning ObjectivesAfter studying this chapter, you should be able to… Define, classify, and account for the cost of fixed assets. Compute depreciation using the straight-line and double-declining- balance methods. Describe the accounting for the disposal of fixed assets. Describe the accounting for the depletion of natural resources. Describe the accounting
Learning Objective 1 Define, classify, and account for the cost of fixed assets
Characteristics of Fixed Assets• They exist physically and thus are tangible assets• The are owned and used by the company in its normal operations• They are not offered for sale as part of normal operations
Revenue and Capital ExpendituresCapital Expenditures Revenue Expenditures• Are asset • Ordinary repairs and improvements maintenance• Benefit current and • Benefit only the current future periods period• Increase fixed assets • Increase repairs and maintenance expense
Learning Objective 2 Compute depreciation using the straight-line and double-declining- balance methods
Accounting for Depreciation• Over time, fixed assets other than land lose their ability to provide services• The cost of these fixed assets should be expensed in a systematic manner during their useful lives• This is called depreciation Physical Functional Depreciation Depreciation • Factors include • Factors include wear and tear obsolescence
Two Common Depreciation Methods • Straight-Line – Same amount of depreciation each year Equal amounts of depreciation each period Asset Residual acquired value
Straight-Line Cost – Estimated Residual Value Estimated Useful Life Example: Assume a $24,000 depreciable asset with an estimated 5-year useful life and estimated $2,000 residual value. Annual depreciation expense: ($24,000 - $2,000) / 5 = $4,400 20% per year Rate is 1/5 $2,000 $2,000 $24,000 $24,000Residual value = Asset cost = OR Depreciation = $4,400 per year
Two Common Depreciation Methods • Straight-Line • Double-Declining-Balance – Accelerated method that provides more depreciation in earlier years Depreciation expense larger in earlier periods Asset acquired Residual value
Double-Declining-Balance Double the Straight-Line Rate* Book ValueExample: Assume a $24,000 depreciable asset with an estimated 5-yearuseful life and estimated $2,000 residual value. Double Residual Straight Line Value Rate
Depreciation for Federal Income Tax• Modified Accelerated Cost Recovery System (MACRS) – Specifies eight classes of useful life and depreciation rates for each class. – Residual value is ignored. – Fixed assets are assumed to be put in and taken out of service in the middle of the year. Five year class: light trucks and automobiles Seven year class: machines and equipment
Learning Objective 3 Describe the accounting for the disposal of fixed assets
Disposal of Fixed Assets• Asset can be – Discarded – Sold – Traded• Book value must be removed from the accounts• Depreciation must be up to date
Discarding Fixed Assets• Happens when fixed assets are no longer useful to the business and have no market value.• Assume a $25,000 fixed asset that is fully depreciated is discarded:
Discarding Fixed Assets• Assume a $6,000 fixed asset with $4,750 of accumulated depreciation on December 31 is discarded in March:
Selling Fixed Assets• Similar to discarding fixed assets, except that the cash or other asset received must also be recorded• Could result in gain or loss
Selling Fixed Assets• Example: Assume that equipment costing $10,000 is depreciated at an annual straight-line rate of 10%. The equipment is sold for cash at book value on October 12 of the eighth year of use. Accumulated depreciation at the previous December 31 is $7,000.Accumulated Depreciationafter adjustment = $7,750Book value is now = $2,250
Selling Fixed Assets #1• The asset is sold for $2,250
Selling Fixed Assets #2• The asset is sold for $1,000
Selling Fixed Assets #3• The asset is sold for $2,800
Learning Objective 4 Describe the accounting for depletion of natural resources
Natural Resources• Natural resources include timber, metal ores, and minerals• As resources are harvested/mined and sold, a portion of the cost of acquiring them must be expensed• This is called depletion
Calculating Depletion Depletion Rate = Cost of the Natural Resource Estimated Size of the Resource Depletion = Quantity Extracted × Depletion Rate
Depletion Example• Assume that a business paid $400,000 for the mining rights to a mineral deposit estimated at 1,000,000 tons of ore.• Depletion rate = $400,000/1,000,000 = $0.40 per ton• If 90,000 tons are mined during the year, annual depletion is $36,000
Learning Objective 5 Describe the accounting for intangible assets
Intangible Assets• Long-lived assets lacking physical properties that are useful in the operations of a business and not held for sale; examples include patents, copyrights, trademarks, and goodwill.• Accounted for similar to fixed assets.• Cost is transferred to expense through amortization.
Amortization• Matching the cost of an intangible asset with its revenue over its useful (legal) life.• Amortization expense calculation is similar to straight-line depreciation: Amortization = Cost – Estimated Residual Value Estimated Useful Life
Patent Amortization• Assume a company acquires patent rights for $100,000. The remaining legal life of the patent rights is 14 years, however the company feels the remaining useful life is five years.
Goodwill• Created from favorable business factors• Only recorded if objectively determined by a transaction• Not amortized – impaired values are adjusted.• Goodwill is the most frequently reported intangible asset.
Learning Objective 6 Describe how depreciation expense is reported in an income statement,and prepare a balance sheet that includes fixed assets and intangible assets
Financial Reporting • Depreciation and amortization Income should be reported separately Statement • Description of computations should be disclosed • Each class of fixed asset should be disclosed Balance • Related accumulated depreciation Sheet should also be reported