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Zepplin provides the following additional relevant information:

• The company uses the percentage of receivables method in estimating bad debts; 2% of the
ending receivables balance is deemed to be uncollectible.
• Zepplin conducts an actual physical count of its inventory and office supplies at the end of
each month.
• Zepplin rents its warehouse, office facilities, and computer equipment. Rent on the com-
puter equipment is paid at the beginning of each month. Rent on the warehouse and of-
fice space is paid on the 15th of each month.
• Payroll is paid on the 5th and the 20th (pay periods end on the 15th and the last day of
the month).
• Taxes Payable represents payroll taxes that are due by the 5th of the following month.
• All sales and all inventory purchases are on account.
391
f392 Completing The Operating Cycle
Part 2 Comprehensive Problem 6-8


The following transactions occurred for Zepplin during January of 2003:
Jan. 1 Paid rent on the computer equipment, $1,800.
5 Recorded sales for the week, 125 units at $220 per unit. (The company uses a peri-
odic inventory system.)
5 Paid wages payable and taxes payable from the prior period.
5 Collected $15,000 from customers on account during the week.
8 Purchased office supplies for cash, $350.
10 Received 50 YO-660s from the manufacturer at a cost of $160 per unit.
11 Paid accounts payable, $17,500.
12 Collected $27,000 from customers on account during the week.
12 Recorded sales for the week, 140 units at $220 per unit.
15 Paid monthly rent for the office and warehouse, $3,000.
15 Received 140 YO-660s from the manufacturer at a cost of $162 per unit.
18 A customer returned a YO-660 and requested a refund. A check was immediately mailed
to the customer in the amount of $220.
19 Collected $38,000 from customers on account during the week.
19 Recorded sales for the week, 115 units at $220 per unit.
20 Paid the semimonthly payroll for the pay period ending on January 15. Salaries and
wages total $5,300 and payroll taxes were as follows: FICA taxes payable, employee,
$405; FICA taxes payable, employer, $405; state withholding taxes payable, $280; fed-
eral withholding taxes payable, $810; federal unemployment taxes payable, $50; state
unemployment taxes payable, $150.
22 Received notice that a customer owing Zepplin $440 had filed bankruptcy and would
be unable to pay.
23 Paid the taxes payable from the payroll on January 20.
24 Received 190 YO-660s from the manufacturer at a cost of $160 per unit.
25 Purchased office supplies for cash, $730.
25 Paid accounts payable, $39,000.
26 Collected $44,500 from customers on account during the week.
26 Recorded sales for the week, 135 units at $225 per unit.
29 Customers returned 5 YO-660s and requested refunds. Checks were immediately mailed
to each customer in the amount of $220 each.
30 Received 130 YO-660s from the manufacturer at a cost of $160 per unit.
31 Collected $21,800 from customers on account.
31 Recorded sales for the partial week, 65 units at $225 per unit.
31 Accrued the semimonthly payroll for the pay period ending on January 31. Salaries and
wages total $5,400 and payroll taxes were as follows: FICA taxes payable, employee,
$410; FICA taxes payable, employer, $410; state withholding taxes payable, $285; fed-
eral withholding taxes payable, $820; federal unemployment taxes payable, $55; state
unemployment taxes payable, $160.
Required: 1. Provide the required journal entries to record each of the above events.
2. Make the adjusting entries necessary to (1) record bad debt expense for the period and (2)
to adjust inventory and office supplies. A count of inventory and office supplies revealed
160 YO-660s on hand and supplies valued at $800.
3. Prepare a trial balance as of January 31, 2003.
4. Prepare an income statement and a balance sheet for Zepplin Enterprises.
5. Prepare a common-size income statement for Zepplin Enterprises.
6. Compute Zepplin™s number of days™ sales in inventory, number of days™ sales in accounts
receivable, and number of days™ sales in accounts payable ratios. What can you conclude
about the company™s liquidity position based on this analysis?
Investments in
Property, Plant,
and Equipment
and in Intangible
Assets

chapter



9
f9
learning objectives After studying this chapter, you should be able to:

purchase as well as through a decline in value and record efficiently a company is
1 Identify the two major a lease, by self-construction, the decline. using its property, plant, and
categories of long-term
and as part of the purchase equipment.
7 Record the discarding and
operating assets: property,
of several assets at once. selling of property, plant,
plant, and equipment and
4 Compute straight-line and and equipment.
intangible assets.
units-of-production
8 Account for the acquisition
2 Understand the factors depreciation expense for and amortization of
important in deciding
plant and equipment. intangible assets and
10 Compute declining-balance
whether to acquire a long-
5 Account for repairs and understand the special and sum-of-the-years -
term operating asset.
improvements of property, difficulties associated with digits depreciation expense
3 Record the acquisition of plant, and equipment. accounting for intangibles. for plant and equipment.
property, plant, and
6 Identify whether a long-term 9 Use the fixed asset turnover
11 Account for changes in
equipment through a simple operating asset has suffered ratio as a measure of how
depreciation estimates.
394 chapter f9
Investments In Property, Plant, And Equipment And In Intangible Assets


Thomas Edison received $300,000 in in- From the beginning, General Electric s
vestment funds in 1878 in order to start his strength has been research. In addition to
EDISON ELECTRIC LIGHT COMPANY. To- improving the design of the light bulb (in-
day, GENERAL ELECTRIC is the direct de- cluding the development in the early 1900s
scendant of Edison s company and, with a of gas-filled, tungsten-filament bulbs that
market value of $583 billion (as of October are the model for bulbs still used today),
2000), is the most valuable company in the GE was also instrumental in developing al-
world. General Electric has been a fixture most every familiar household appliance
in corporate America since the late 1800s the iron, washing machine, refrigerator,
and is the only one of the 12 companies in range, air conditioner, dishwasher, and
the original Dow Jones Industrial Average more. In addition, GE research scientists
that is still included among the 30 compa- helped create FM radio, aircraft jet en-
nies making up the Dow today.1 gines, and nuclear-power reactors.
The stated purpose of the creation of Today, General Electric operates in a
the Edison Electric Light Company was the diverse array of businesses, ranging from
development of an economically practical train locomotives to medical CT scanners
electric light bulb. After a year of experi- to consumer financing to the NBC televi-
mentation, Thomas Edison discovered that sion network. When Jack Welch became
carbonized bamboo would provide a long- CEO of GE in 1981, his goal was to make
lasting light filament that was also easy to GE number one or number two in each
produce. Edison quickly found that deliv- market segment in which it operates, or
ering electric light to people s homes re- else get out of that particular line of busi-
quired more than a light bulb, however. ness. This strategy has enabled GE s suc-
So, he developed an entire electricity gen- cess to continue its market value has
eration and distribution system, inventing grown by an average of 25% per year over
new pieces of equipment when he couldn t the past 19 years.
find what he needed. The first public elec- To support its broad array of busi-
tric light system was built in London, fol- nesses, General Electric maintains a vast
lowed soon after by the Pearl Street Sta- quantity of long-term assets that cost over
tion system in New York City in 1882. In $101 billion to acquire. In 1999 alone, GE
setting the stage
1892, Edison s company merged with the spent an additional $15.5 billion in acquir-
THOMSON-HOUSTON ELECTRIC COM- ing long-term operating assets and re-
PANY (developer of alternating-current ceived $6.3 billion for disposing of old as-
[AC] equipment that could transmit over sets. Its long-term assets include $3.3
longer distances than Edison s direct- billion in rail cars, $6.7 billion in buildings,
current [DC] system), and the General Elec- $20.8 billion in machinery, and $26.0 bil-
tric Company (GE) was born. lion in intangible assets.




In Chapters 6 through 8, operating activities of a business and the assets and liabilities arising from
those operations were discussed. In this and the next three chapters, investing and financing activities
are covered. In this chapter, investments in long-term assets that are used in the business, such as
buildings, property, land, and equipment, are discussed. In Chapter 10, long-term debt financing is
covered. In Chapter 11, equity financing is discussed. Once you understand debt and equity securi-
ties, as discussed in Chapters 10 and 11, you will understand how these same securities can be pur-
chased as investments. Therefore, in Chapter 12, investments in stocks and bonds (securities) of other
companies are discussed. Exhibit 9-1 shows the balance sheet and income statement accounts as well
as the cash flow items that will be covered in this chapter.
The two primary categories of long-term assets discussed in this chapter are (1) property, plant,
and equipment and (2) intangible assets. Because property, plant, and equipment and intangible
assets are essential to a business in carrying out its operating activities, they are sometimes called


1 This description is based on General Electric Company History at http://ge.com/ibhis0.htm; General Electric
Company, International Directory of Company Histories, vol. 12 (Detroit: St. James Press, 1996), pp. 193 197;
1999 Annual Report of the General Electric Company.
395
f396 Part 3 Investments In Property, Plant, And Equipment And In Intangible Assets
Investing and Financing Activities



long-term operating assets. Unlike inventories, these long-term operating assets are not acquired
long-term operating assets
Assets expected to be held for resale to customers but are held and used by a business to generate revenues. As illustrated by the
and used over the course
numbers given for GENERAL ELECTRIC at the beginning of the chapter, long-term operating
of several years to facilitate
assets often comprise a significant portion of the total assets of a company.
operating activities.



1 NATURE OF LONG-TERM OPERATING ASSETS
Identify the two major
Businesses make money by selling products and services. A company needs an infrastructure of
categories of long-term
operating assets: property, long-term operating assets in order to profitably produce and distribute these products and ser-
plant, and equipment and
vices. For example, GENERAL ELECTRIC needs factories in which to manufacture the loco-
intangible assets.
motives and light bulbs that it sells. GE also needs patents on its unique technology to protect
its competitive edge in the marketplace. A factory is an example of a long-term operating asset
that is classified as property, plant, and equipment. A patent is an example of an intangible as-
set. Property, plant, and equipment refers to tangible, long-lived assets acquired for use in busi-
property, plant, and equip-
ment Tangible, long-lived ness operations. This category includes land, buildings, machinery, equipment, and furniture. In-
assets acquired for use in
tangible assets are long-lived assets that are used in the operation of a business but do not have
business operations; in-
physical substance. In most cases, they provide their owners with competitive advantages over
clude land, buildings, ma-
other firms. Typical intangible assets are patents, licenses, franchises, and goodwill. The time line
chinery, equipment, and
in Exhibit 9-2 illustrates the important business issues associated with long-term operating assets.
furniture.
The following section outlines the process used in deciding whether to acquire a long-term
intangible assets Long-lived
operating asset. The subsequent sections discuss the accounting issues that arise when a long-
assets without physical
term operating asset is acquired: accounting for the acquisition of the asset, recording periodic
substance that are used in
depreciation, accounting for new costs and changes in asset value, and properly removing the
business, such as licenses,
patents, franchises, and asset from the books upon disposition.
goodwill.




Financial Statement Items Covered in This Chapter
exhibit 9-1



Statement of
Balance Sheet Cash Flows
Investing activities
Property, plant, and equipment
Purchase of
Intangible assets
property, plant,
and equipment
Proceeds from
sale of property,
plant, and equip-
ment




Income
Statement
Expenses
Depreciation
expense
Amortization
expense
396 f397
Investments In Property, Plant, And Equipment And Inand Equipment and in Intangible Assets
Investments in Property, Plant, Intangible Assets Chapter 9



Time Line of Business Issues Involved with Long-Term Operating Assets
exhibit 9-2




FOR SALE




ESTIMATE DISPOSE
ACQUIRE MONITOR
EVALUATE
and RECOGNIZE of assets
long-term asset value
possible acquisition
operating assets for possible
of long-term periodic
declines
operating assets depreciation
and amortization




to summarize
Long-term operating assets provide an infrastructure in which to conduct op-
erating activities. The category of property, plant, and equipment refers to tan-
gible, long-lived assets such as land and equipment. Examples of intangible
assets are patents and licenses.




2 DECIDING WHETHER TO ACQUIRE
A LONG-TERM OPERATING ASSET
Understand the factors
important in deciding
whether to acquire a long-
As mentioned in the previous section, long-term operating assets are acquired to be used over
term operating asset.
the course of several years. The decision to acquire a long-term asset depends on whether the
future cash flows generated by the asset are expected to be large enough to justify the asset cost.
The process of evaluating a long-term project is called capital budgeting. This process is briefly
capital budgeting System-
atic planning for long-term introduced here and is covered in more detail in Chapter 9 in the management accounting sec-
investments in operating
tion of this book.
assets.
Assume that Yosef Manufacturing makes joysticks and other computer game accessories.
Yosef is considering expanding its operations by buying an additional production facility. The
cost of the new factory is $100 million. Yosef expects to be able to sell the joysticks and other
items made in the factory for $80 million per year. At that level of production, the annual cost
of operating the factory (wages, insurance, materials, maintenance, etc.) is expected to total $65
million. The factory is expected to remain in operation for 20 years. Should Yosef buy the new
factory for $100 million?
To summarize the information in the preceding paragraph, Yosef must decide whether to
pay $100 million for a factory that will generate a net profit of $15 million ($80 million $65
million) per year for 20 years. At first glance, you might think that the decision is obvious be-
cause the factory costs only $100 million but will generate $300 million in profit ($15 million
20 years) during its 20-year life. But this analysis ignores the important fact that dollars re-
ceived far in the future are not worth as much as dollars received right now. For example, if you
time value of money The can invest your money and earn 10%, receiving $1 today is the same as receiving $6.73 20 years
concept that a dollar re-
from now because the $1 received today could be invested and would grow to $6.73 in 20 years.
ceived now is worth more
This important concept is called the time value of money and is essential to properly evaluat-
than a dollar received far in
ing whether to acquire any long-term asset.
the future.
397
f398 Part 3 Investments In Property, Plant, And Equipment And In Intangible Assets
Investing and Financing Activities


Using the time value of money calculations that will be explained in detail in Chapter 10, it
can be shown that receiving the future cash flows from the factory of $15 million per year for 20
years is the same as receiving $128 million in one lump sum right now, if the prevailing interest
rate is 10%. Thus, the decision to acquire the factory boils down to the following comparison:
Should we pay $100 million to buy a factory now if the factory will generate future cash flows
that are worth the equivalent of $128 million now? The decision is yes, because the $128 million
value of the expected cash inflows is greater than the $100 million cost of the factory. On the other
hand, if the factory were expected to generate only $10 million per year, then, using the compu-
tations that will be explained in Chapter 10, it can be calculated that the value of the cash flows
would be only $85 million, and the factory should not be purchased for $100 million.
The important concept to remember here is that long-term operating assets have value be-
cause they are expected to help a company generate cash flows in the future. If events occur that
change the expectation concerning those future cash flows, then the value of the asset changes.
For example, if consumer demand for computer joysticks dries up, the value of a factory built
to produce joysticks can plunge overnight even though the factory itself is still as productive as
it ever was. Accounting for this type of decline in the value of a long-term operating asset is dis-
cussed later in the chapter.



to summarize
Long-term operating assets have value because they help companies generate
future cash flows. The decision to acquire a long-term operating asset involves
comparing the cost of the asset to the value of the expected cash inflows, af-
ter adjusting for the time value of money. An asset s value can decline or dis-
appear if events cause a decrease in the expected future cash flows generated
by the asset.




ACCOUNTING FOR ACQUISITION OF PROPERTY,
3
PLANT, AND EQUIPMENT
Record the acquisition of
property, plant, and
equipment through a
Like all other assets, property, plant, and equipment are initially recorded at cost. The cost of
simple purchase as well as
an asset includes not only the purchase price but also any other costs incurred in acquiring the
through a lease, by self-
construction, and as part of asset and getting it ready for its intended use. Examples of these other costs include shipping,
the purchase of several
installation, and sales taxes. The items that should be included in the acquisition cost of vari-
assets at once.
ous types of property, plant, and equipment are outlined in Exhibit 9-3.


Items Included in the Acquisition Cost of Property, Plant, and Equipment
exhibit 9-3


Land Purchase price, commissions, legal fees,
escrow fees, surveying fees, clearing and grading
costs.
Land improvements Cost of improvements, including expenditures for
(e.g., landscaping, paving, fencing) materials, labor, and overhead.
Buildings Purchase price, commissions, reconditioning costs.
Equipment Purchase price, taxes, freight, insurance,
installation, and any expenditures incurred in
preparing the asset for its intended use, e.g.,
reconditioning and testing costs.
398 f399
Investments In Property, Plant, And Equipment And Inand Equipment and in Intangible Assets
Investments in Property, Plant, Intangible Assets Chapter 9


Property, plant, and equipment are usually acquired by purchase. In some cases, assets are
acquired by leasing but are accounted for as assets in much the same way as purchased assets.
Plant and equipment can also be constructed by a business for its own use. Also, a company can
in one transaction purchase several different assets or even another entire company. The ac-
counting for each of these types of acquisition is explained below.

Assets Acquired by Purchase
A company can purchase an asset by paying cash, incurring a liability, exchanging another as-
set, or by a combination of these methods. If a single asset is purchased for cash, the account-
ing is relatively simple. To illustrate, we assume that Wheeler Resorts, Inc., purchases a new de-
livery truck for $15,096 (purchase price, $15,000, less 2% discount for paying cash, plus sales
tax of $396). The entry to record this purchase is:

Delivery Truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,096
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,096
Purchased a delivery truck for $15,096
($15,000 $300 cash discount $396 sales tax).


In this instance, cash was paid for a single asset, the truck. An alternative would be to bor-
row part of the purchase price. If the company had borrowed $12,000 of the $15,096 from a
bank, the entry would have been:


Delivery Truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,096
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,096
Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000
Purchased a delivery truck for $15,096; paid $3,096 cash
and issued a note for $12,000 to Chemical Bank.


The $12,000 represents the principal of the note; it does not include any interest charged by
the lending institution. (The interest is recognized later as interest expense.)
When one long-term operating asset is acquired in exchange for another, the cost of the
new asset is usually set equal to the market value of the asset given up in exchange.

Assets Acquired by Leasing
Leases are often short-term rental agreements in which one party, the lessee, is granted the right
lease A contract that speci-
fies the terms under which to use property owned by another party, the lessor. For example, as a student, you may decide
the owner of an asset (the
to lease (rent) an apartment to live in while you are attending college. The owner of the apart-
lessor) agrees to transfer
ment (lessor) will probably require you to sign a lease specifying the terms of the arrangement.
the right to use the asset to
The lease states the period of time in which you will live in the apartment, the amount of rent
another party (the lessee).
you will pay, and when each rent payment is due. When the lease expires, you will either sign
lessee The party that is
a new lease or move out of the apartment, which would then be rented to someone else.
granted the right to use
Companies enter into similar types of lease arrangements. For example, Wheeler Resorts
property under the terms of
might decide to lease a building because it needs additional office space. Assume Wheeler signs
a lease.
a two-year lease requiring monthly rental payments of $1,000. When the lease expires, Wheeler
lessor The owner of prop-
will either move out of the building or negotiate a new lease with the owner. Accounting for
erty that is leased (rented)
this type of rental agreement, called an operating lease, is straightforward. When rent is paid
to another party.
each month, Wheeler records the following journal entry:
operating lease A simple
rental agreement.
Rent (or Lease) Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
To record monthly rent of office building.
399
f400 Part 3 Investments In Property, Plant, And Equipment And In Intangible Assets
Investing and Financing Activities


A college student (lessee)
often rents an apartment
while attending college.
The apartment owner
(lessor) will require the
student to sign a lease
stating the terms of the
arrangement.




Some lease agreements, however, are not so simple. Suppose Wheeler has decided to ex-
pand its operations and wants to acquire a hotel in the Phoenix, Arizona area. Wheeler s al-
ternatives are to buy land and build a new hotel, purchase an existing hotel, or lease a ho-
tel. Assume Wheeler locates a desirable piece of land, and the owner of the land agrees to
build a hotel and lease the property to Wheeler. The lease agreement is noncancelable and
requires Wheeler to make annual lease payments of $100,000 for 20 years. At the end of 20
years, Wheeler will become the owner of the property. Clearly, this is not a simple rental
agreement, even though the transaction is called a lease by the parties involved. In reality,
this transaction is a purchase of the property with the payments being spread over 20 years.
The result is the same as if Wheeler had borrowed money on a 20-year mortgage and pur-
chased the property.
Generally accepted accounting principles require that the recording of a transaction reflect
its true economic nature, not its form. Instead of recognizing the individual lease payments as
an expense as was done with the operating lease, Wheeler records the property as an asset and
also records a liability reflecting the obligation to the lessor. The amount to be recorded is the
cash amount that Wheeler would have to pay right now in order to completely pay off the oblig-
ation to make the future lease payments. This amount is called the present value of the lease
payments (in the Wheeler example, the present value of 20 annual payments of $100,000) and
takes into account the time value of money. As mentioned earlier, the time value concept will
be explained in more detail in Chapter 10.
Continuing the example, assume that, at the beginning of the lease term, the present value of
the future lease payments is $851,360. Wheeler makes the following journal entry to record the lease:


Leased Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 851,360
Lease Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 851,360
To record hotel acquired under a 20-year noncancelable lease.


This type of lease is called a capital lease because the lessee records (capitalizes) the leased
capital lease A leasing
transaction that is recorded asset the same as if the asset had been acquired in an outright purchase. The asset is reported
as a purchase by the with Property, Plant, and Equipment on the lessee s balance sheet. The lessee (Wheeler Resorts)
lessee.
also shows the lease liability on the balance sheet as a long-term liability.
400 f401
Investments In Property, Plant, And Equipment And Inand Equipment and in Intangible Assets
Investments in Property, Plant, Intangible Assets Chapter 9


When annual lease payments are made, Wheeler will not record the payment as rent ex-
pense. Instead, the payment will be recorded as a reduction in the lease liability, with part
of each payment being interest on the outstanding obligation. The difference between the
total lease payments (20 years $100,000, or $2 million) and the cost or present value
of the property is the amount of interest that will be paid over the term of the lease. To il-
lustrate, assume that the first payment is made one year after the lease term begins and in-
cludes interest of $85,136 and a $14,864 reduction in the liability. The payment is recorded
as follows:


Lease Liability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,864
Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,136
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
To record annual lease payment under capital lease.


Accounting for payments on capital leases is discussed in more detail in Chapter 10.

As illustrated, an operating lease is accounted for as a simple rental,
CLASSIFYING LEASES
whereas a capital lease is accounted for as a purchase of the leased asset. Because the accounting
treatment of a lease can have a major impact on the financial statements, the accounting pro-
fession has established criteria for determining whether a lease should be classified as an operat-
ing or a capital lease. If a lease is noncancelable and meets any one of the following four crite-
ria, it is recorded as a capital lease:

1. The lease transfers ownership of the leased asset to the lessee by the end of the lease term
(as in the Wheeler Resorts example).
2. The lease contains an option allowing the lessee to purchase the asset at the end of the lease
term at a bargain price, essentially guaranteeing that ownership will eventually transfer to
the lessee.
3. The lease term is equal to 75% or more of the estimated economic life of the asset, mean-
ing that the lessee will use the asset for most of its economic life.
4. The present value of the lease payments at the beginning of the lease is 90% or more of
the fair market value of the leased asset. Meeting this criterion means that, in agreeing to
make the lease payments, the lessee is agreeing to pay almost as much as the cash price to
purchase the asset outright.

If just one of the above criteria is met, then the lease agreement is classified as a capital
lease and is accounted for by the lessee as a debt-financed purchase. A lease that does not
fyi meet any of the capital lease criteria is considered an operating lease. Keep in mind that
these two types of leases are not alternatives for the same transaction. If the terms of the
One of the most interesting ac-
lease agreement meet any one of the capital lease criteria, the lease must be accounted
counting manipulations involv-
for as a capital lease.
ing the four lease criteria re-
The accounting for leases has been a thorn in the side of accounting standard-setters
lates to the 90% threshold for
for at least 50 years. From the beginning, the crucial issue has been how to require com-
the present value of the mini-
panies to report leased assets and lease liabilities in the balance sheet when a lease consti-
mum lease payments. By hiring
tutes an effective transfer of ownership. The four lease criteria outlined above were issued
an insurance company to guar-
by the FASB in 1976, with the thought that the rigidity and strictness of the criteria would
antee a portion of the lease
result in most leases being reported on lessee companies balance sheets as capital leases.
payments, a lessee is able to In practice, U.S. companies have taken these four criteria as a challenge and have care-
exclude these payments from fully crafted their lease agreements so that none of the criteria is satisfied, allowing the
leases to continue to be accounted for as operating leases.
the present value computa-
One of the largest leasing companies in the United States is a subsidiary of GEN-
tions, lowering the present
ERAL ELECTRIC called GE CAPITAL SERVICES. GE Capital Services leases indus-
value below the 90% threshold.
trial equipment, factory buildings, rail cars, shipping containers, computers, medical equip-
401
f402 Part 3 Investments In Property, Plant, And Equipment And In Intangible Assets
Investing and Financing Activities



business environment essay


Lease or Buy? Leasing is an integral part WEST, and UNITED often lease many of their air-
of American business. From its begin- planes. Retail chains such as WAL-MART and SAFE-
ning, a major aspect of IBM s business WAY often lease their stores.
has been the leasing, rather than the Virtually any type of operating asset can be acquired
outright sale, of its equipment. Over the by leasing. Companies often lease such assets as rail
years, Ray Kroc s MCDONALD S empire cars, automobiles and trucks, airplanes, and various
has made more money leasing land and other types of equipment, as well as real estate. There
buildings to franchisees than it has are several reasons why a company might choose to
made selling hamburgers. In short, leas- lease rather than purchase an asset. A purchase trans-
ing has long been a popular method of action often requires a significant cash outlay in the
acquiring and financing operating assets. For exam- form of a down payment at the date of purchase; leas-
ple, airlines such as AMERICAN, DELTA, SOUTH- ing, therefore, can be used to minimize the amount of




ment, and more. In 1999, the total original cost of assets leased by GE Capital Services to other
companies was $31.0 billion.

Assets Acquired by Self-Construction
Sometimes buildings or equipment are constructed by a company for its own use. This may be
done to save on construction costs, to utilize idle facilities or idle workers, or to meet a special
set of technical specifications. Self-constructed assets, like purchased assets, are recorded at cost,
including all expenditures incurred to build the asset and make it ready for its intended use.
These costs include the materials used to build the asset, the construction labor, and some rea-
sonable share of the general company overhead (electricity, insurance, supervisors salaries, etc.)
during the time of construction.
Another cost that is included in the cost of a self-constructed asset is the interest cost asso-
ciated with money borrowed to finance the construction project. Just as the cost to rent a crane
to be used to construct a building would be included in the cost of the building, the cost to
rent money to finance the construction project should also be included in the building cost.
Interest that is recorded as part of the cost of a self-constructed asset is called capitalized in-
capitalized interest Interest
that is recorded as part terest. The amount of interest that should be capitalized is that amount that could have been
of the cost of a self-
saved if the money used on the construction project had instead been used to repay loans.
constructed asset.
The following illustration demonstrates the computation of the cost of a self-constructed
asset. Wheeler Resorts decided to construct a new hotel using its own workers. The construc-
tion project lasted from January 1 to December 31, 2000. Building materials costs for the pro-
ject were $4,500,000. Total labor costs attributable to the project were $2,500,000. Total com-
pany overhead (costs other than materials and labor) for the year was $10,000,000; of this
amount, it is determined that 15% can be reasonably assigned as part of the cost of the con-
struction project. A construction loan was negotiated with Wheeler s bank; during the year,
Wheeler was able to borrow from the bank to pay for materials, labor, etc. The total amount of
interest paid on this construction loan during the year was $500,000. The total cost of the self-
constructed hotel is computed as follows:
Materials $4,500,000
Labor 2,500,000
Overhead allocation ($10,000,000 0.15) 1,500,000
Capitalized interest 500,000
Total hotel cost $9,000,000
402 f403
Investments In Property, Plant, And Equipment And Inand Equipment and in Intangible Assets
Investments in Property, Plant, Intangible Assets Chapter 9




cash paid initially to acquire the asset. For some types primary purpose of a leasing arrangement was to ac-
of assets, such as computers, leasing enables the quire an asset without reporting any related liability.
lessee to avoid risks of obsolescence if the appropriate Some companies are still using leasing for this pur-
terms are written into the lease agreement. pose. They do so by writing the terms of a lease agree-
Another potential advantage of leasing is that if the ment in a manner that circumvents the generally ac-
agreement can be recorded as an operating lease, the cepted accounting capitalization criteria. The result is
lessee does not have to report any related liability. that some leasing transactions are reported as simple
This is an important consideration if a company is con- rental agreements (operating leases) when in fact they
cerned about the effect of reporting additional debt have many characteristics of a purchase transaction.
on the balance sheet. Before criteria were established Leasing and other forms of off-balance-sheet fi-
for classifying leases as operating or capital, almost nancing are of major concern to the accounting pro-
all leases were treated as operating leases. Often the fession and financial statement users.




The new hotel would be reported in Wheeler s balance sheet at a total cost of $9,000,000.
As with other long-term operating assets, self-constructed assets are reported at the total cost
necessary to get them ready for their intended use.
The amount of capitalized interest reported by several large U.S. compa-
What is the difference
nies, relative to their total interest expense, is displayed in Exhibit 9-4. As you
between capitalized interest and regular
can see, General Electric capitalized only an insignificant amount of its $10.013
interest?
billion in interest during 1999. On the other hand, EXXONMOBIL capital-
ized more than one-third of its interest during 1999.

Acquisition of Several Assets at Once
A basket purchase occurs when two or more assets are acquired together at a single price. A
basket purchase The pur-
chase of two or more as- typical basket purchase is the purchase of a building along with the land on which the building
sets acquired together at a sits. Because there are differences in the accounting for land and buildings, the purchase price
single price.



Magnitude of Capitalized Interest for Several Large U.S. Companies
exhibit 9-4




Capitalized,
as a Percentage
Capitalized Interest
of Total Interest
Interest Expense
Company

General Electric* $ 0 $10,013 0.0%
General Motors 95 7,750 1.2
ExxonMobil 423 695 37.8
McDonald™s 14 396 3.4
Disney 109 717 13.2

Note: Numbers are for 1999 and are in millions of dollars.

*General Electric reports that it capitalized an “insignificant” amount of interest in 1999.
403
f404 Part 3 Investments In Property, Plant, And Equipment And In Intangible Assets
Investing and Financing Activities


must be allocated between the two assets on some reasonable basis. The relative fair market val-
ues of the assets are usually used to determine the respective costs to be assigned to the land and
the building.
To illustrate, we will assume that Wheeler Resorts purchases a 40,000-square-foot building
on 2.6 acres of land for $3,600,000. How much of the total cost should be assigned to the land
and how much to the building? If an appraisal indicates that the fair market values of the land
and the building are $1,000,000 and $3,000,000, respectively, the resulting allocated costs would
be $900,000 and $2,700,000, calculated as follows:


Fair Market Percentage of Apportionment of
Asset Value Total Value Lump-Sum Cost

Land $1,000,000 25% 0.25 $3,600,000 $ 900,000
Building 3,000,000 75 0.75 $3,600,000 2,700,000
Total $4,000,000 100% $3,600,000



In this case, the fair market value of the land is $1,000,000, or 25% of the total market
value of the land and building. Therefore, 25% of the actual cost, or $900,000, is allocated to
the land, and 75% of the actual cost, or $2,700,000, is allocated to the building. The journal
entry to record this basket purchase is:

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000
Building. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,700,000
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600,000
Purchased 2.6 acres of land and a 40,000-square-foot building.


If part of the purchase price is financed by a bank, an additional credit to Notes Payable or
Mortgage Payable would be included in the entry.
Sometimes one company will buy all the assets of another company. For example, in its
1999 annual report, General Electric discloses that its financing subsidiary, GE Capital Services,
acquired JAPAN LEASING, which leases fleets of automobiles to Japanese corporations. Simi-
larly, in its 1999 annual report (included in Appendix A), MICROSOFT discloses that, in No-
vember 1998, it purchased LINKEXCHANGE for $265 million. The purchase of an entire
company raises a number of accounting issues. The first, already discussed above, is how to al-
locate the purchase price to the various assets acquired. In general, all acquired assets are recorded
on the books of the acquiring company at their fair values as of the acquisition date.
The second major accounting issue associated with the purchase of an entire company is
the recording of goodwill. Goodwill represents all the special competitive advantages enjoyed
goodwill An intangible as-
set that exists when a busi- by a company, such as a trained staff, good credit rating, reputation for superior products and
ness is valued at more than services, and an established network of suppliers and customers. These factors allow an estab-
the fair market value of its
lished business to earn more profits than would a new business, even though the new business
net assets, usually due to
might have the same type of building, the same equipment, and the same type of production
strategic location, reputa-
processes.
tion, good customer rela-
tions, or similar factors; When one company purchases another established business, the excess of the purchase price
equal to the excess of the over the value of the identifiable net assets is assumed to represent the purchase of goodwill.
purchase price over the fair
The accounting for goodwill is illustrated later in the chapter.
market value of the net as-
sets purchased.



to summarize
When property, plant, and equipment assets are purchased, they are recorded
at cost, which includes all expenditures associated with acquiring and getting
them ready for their intended use, such as sales tax, shipping, and installation.
404 f405
Investments In Property, Plant, And Equipment And Inand Equipment and in Intangible Assets
Investments in Property, Plant, Intangible Assets Chapter 9



Sometimes assets are acquired by lease rather than purchase. A lease may be
a simple short-term rental agreement, called an operating lease, or it may be
substantially the same as a purchase transaction. In the latter case, called a
capital lease, the party acquiring the asset (the lessee) records the asset and
related liability as if the property had been purchased and financed with long-
term debt. When a company constructs an asset for its own use, the recorded
cost includes materials, labor, a reasonable allocation of overhead, and the cost
of interest used to finance the construction. When two or more assets are ac-
quired for a single price in a basket purchase, the relative fair market values
are used to determine the respective costs.




4 CALCULATING AND RECORDING DEPRECIATION
EXPENSE
Compute straight-line and
units-of-production
depreciation expense for
The second element in accounting for plant and equipment is the allocation of an asset s cost
plant and equipment.
over its useful life. The matching principle requires that this cost be assigned to expense in the
periods benefited from the use of the asset. The allocation procedure is called depreciation, and
depreciation The process of
cost allocation that assigns the allocated amount, recorded in a period-ending adjusting entry, is an expense that is deducted
the original cost of plant
from revenues in order to determine income. It should be noted that the asset plant normally
and equipment to the peri-
refers to buildings only; land is recorded as a separate asset and is not depreciated because it is
ods benefited.
usually assumed to have an unlimited useful life.
Accounting for depreciation is often confusing because students tend to think that depre-
ciation expense reflects the decline in an asset s value. The concept of depreciation is nothing
more than a systematic write-off of the original cost of an asset. The undepreciated cost is re-
ferred to as book value, which represents that portion of the original cost not yet assigned to
book value For a long-term
operating asset, the asset s the income statement as an expense. A company never claims that an asset s recorded book value
original cost less any accu- is equal to its market value. In fact, market values of assets could increase at the same time that
mulated depreciation.
depreciation expense is being recorded.
To calculate depreciation expense for an asset, you need to know (1) its original cost, (2)
its estimated useful life, and (3) its estimated salvage, or residual, value. Salvage value is the
salvage value The amount
expected to be received amount expected to be received when the asset is sold at the end of its useful life. When an as-
when an asset is sold at the set is purchased, its actual life and salvage value are obviously unknown. They must be estimated
end of its useful life.
as realistically as is feasible, usually on the basis of experience with similar assets. In some cases,
an asset will have little or no salvage value. If the salvage value is not significant, it is usually ig-
nored in computing depreciation.
Several methods can be used for depreciating the costs of assets for financial reporting. In
the main part of this chapter, we describe two: straight-line and units-of-production. In the ex-
panded material section of this chapter, we describe two more depreciation methods: sum-of-
the-years -digits and declining-balance.
The straight-line depreciation method assumes that an asset will benefit all periods
straight-line depreciation
method The depreciation equally and that the cost of the asset should be assigned on a uniform basis for all account-
method in which the cost ing periods. If an asset s benefits are thought to be related to its productive output (miles
of an asset is allocated
driven in an automobile, for example), the units-of-production method is usually appro-
equally over the periods of
priate.
an asset s estimated useful
To illustrate straight-line and units-of-production depreciation methods, we assume that
life.
Wheeler Resorts purchased a van on January 1 for transporting hotel guests to and from the air-
units-of-production method
port. The following facts apply:
The depreciation method in
which the cost of an asset Acquisition cost $24,000
is allocated to each period
Estimated salvage value $2,000
on the basis of the produc-
Estimated life:
tive output or use of the as-
In years 4 years
set during the period.
In miles driven 60,000 miles
405
f406 Part 3 Investments In Property, Plant, And Equipment And In Intangible Assets
Investing and Financing Activities



Straight-Line Method of Depreciation
The straight-line depreciation method is the simplest depreciation method. It assumes that an
asset s cost should be assigned equally to all periods benefited. The formula for calculating an-
nual straight-line depreciation is:

Cost Salvage value
Annual depreciation expense
Estimated useful life (years)


With this formula, the annual depreciation expense for the van is calculated as:

$24,000 $2,000
$5,500 depreciation expense per year
4 years


When the depreciation expense for an asset has been calculated, a schedule showing the an-
nual depreciation expense, the total accumulated depreciation, and the asset s book value (un-
depreciated cost) for each year can be prepared. The depreciation schedule for the van (using
straight-line depreciation) is shown in Exhibit 9-5.



Depreciation Schedule with Straight-Line Depreciation
exhibit 9-5


Annual
Depreciation Accumulated
Expense Depreciation Book Value

Acquisition date $24,000
End of year 1 $ 5,500 $ 5,500 18,500
End of year 2 5,500 11,000 13,000
End of year 3 5,500 16,500 7,500
End of year 4 5,500 22,000 2,000
$22,000




The entry to record straight-line depreciation each year is:


Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,500
Accumulated Depreciation, Hotel Van . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,500
To record annual depreciation for the hotel van.



Depreciation Expense is reported on the income statement. Accumulated Depreci-
fyi
ation is a contra-asset account that is offset against the cost of the asset on the balance
A comparison of the amounts
sheet. Book value is equal to the asset account balance, which retains the original cost
of cost and accumulated de- of the asset as a debit balance, minus the credit balance in the accumulated deprecia-
preciation reveals how old the tion account.
At the end of the first year, the acquisition cost, accumulated depreciation, and book
plant and equipment is relative
value of the van are presented on the balance sheet as follows:
to its total expected life.

Property, Plant, and Equipment:
Hotel van $24,000
Less: Accumulated depreciation 5,500
Book value $18,500
406 f407
Investments In Property, Plant, And Equipment And Inand Equipment and in Intangible Assets
Investments in Property, Plant, Intangible Assets Chapter 9


Similar information is provided in the annual reports of all companies with property, plant,
and equipment. For example, GENERAL ELECTRIC reported the following in the notes to
its 1999 financial statements:



Original Cost (in millions)

1999 1998

GE
Land and improvements $ 526 $ 483
Buildings, structures, and related equipment 6,674 6,579
Machinery and equipment 20,849 19,491
Leasehold costs and manufacturing plant
under construction 2,150 1,757
$30,199 $28,310
GE Capital Services
Buildings and equipment $ 7,163 $ 4,828
Equipment leased to others
Vehicles 10,942 9,825
Aircraft 10,591 9,321
Railroad rolling stock 3,323 2,804
Marine shipping containers 2,309 2,565
Other 3,832 3,447
$38,160 $32,790
$68,359 $61,100

Accumulated Depreciation and Amortization

GE $17,818 $16,616
GE Capital Services
Buildings and equipment 2,127 1,733
Equipment leased to others 7,392 7,021
$27,337 $25,370



Using this information, one can calculate that the property, plant, and equipment used by Gen-
eral Electric had been used for 59% ($17,818/$30,199) of its useful life as of the end of 1999.
Similarly, the buildings and equipment used by GE CAPITAL SERVICES had been used for
30% ($2,127/$7,163) of its life, and the equipment leased by GE Capital Services to others had
been used for 24% ($7,392/$30,997) of its useful life.

Units-of-Production Method of Depreciation
The units-of-production depreciation method allocates an asset s cost on the basis of use rather
than time. This method is used primarily when a company expects that asset usage will vary sig-
nificantly from year to year. If the asset s usage pattern is uniform from year to year, the units-
of-production method will produce the same depreciation pattern as the straight-line method.
Assets with varying usage patterns for which this method of depreciation may be appropriate in-
clude automobiles and other vehicles whose life is estimated in terms of number of miles dri-
ven. It is also used for certain machines whose life is estimated in terms of number of units pro-
duced or number of hours of operating life. The formula for calculating the units-of-production
depreciation for the year is:

Cost Salvage value Number of units produced,
Current year s depreciation expense
hours used, or miles driven
Total estimated life in
during the year
units, hours, or miles
407
f408 Part 3 Investments In Property, Plant, And Equipment And In Intangible Assets
Investing and Financing Activities


To illustrate, we again consider Wheeler Resorts van, which has an expected life of 60,000
miles. With the units-of-production method, if the van is driven 12,000 miles during the first
year, the depreciation expense for that year is calculated as follows:

$24,000 $2,000
12,000 miles $4,400 depreciation expense
60,000 miles

The entry to record units-of-production depreciation at the end of the first year of the van s
life is:

Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,400
Accumulated Depreciation, Hotel Van . . . . . . . . . . . . . . . . . . . . . . . . . 4,400
To record depreciation for the first year of the hotel van s life.


The depreciation schedule for the four years is shown in Exhibit 9-6. This exhibit assumes
that 18,000 miles were driven the second year, 21,000 the third year, and 9,000 the fourth year.


Depreciation Schedule with Units-of-Production Depreciation
exhibit 9-6


Depreciation Accumulated
Miles Driven Expense Depreciation Book Value

Acquisition date $24,000
End of year 1 12,000 $ 4,400 $ 4,400 19,600
End of year 2 18,000 6,600 11,000 13,000
End of year 3 21,000 7,700 18,700 5,300
End of year 4 9,000 3,300 22,000 2,000
$22,000




Note that part of the formulas for straight-line and units-of-production depreciation is the
same. In both cases, cost salvage value is divided by the asset s useful life. With straight-line,
life is measured in years; with units-of-production, life is in miles or hours. With units-of-
production, the depreciation per mile or hour must then be multiplied by the usage for the year
to determine depreciation expense.
What if the van lasts longer than four years or is driven for more than 60,000 miles? Once
the $22,000 difference between cost and salvage value has been recorded as depreciation expense,
there is no further expense to record. Thus, any additional years or miles are free in the sense
that no depreciation expense will be recognized in connection with them. However, as other
vans are purchased in the future, the initial estimates of their useful lives will be adjusted to re-
flect the experience with previous vans.
What if the van lasts less than four years or is driven fewer than 60,000 miles? This topic
is covered later in the chapter in connection with the accounting for the disposal of property,
plant, and equipment.

A Comparison of Depreciation Methods
The amount of depreciation expense will vary according to the depreciation method used by a
company. Exhibit 9-7 compares the annual depreciation expense for Wheeler Resorts van un-
der the straight-line and units-of-production depreciation methods. As this schedule makes clear,
the total amount of depreciation is the same regardless of which method is used.
Straight-line is by far the most commonly used depreciation method because it is the sim-
plest to apply and makes intuitive sense. For example, in the notes to its 1999 financial state-
ments (see Appendix A), MICROSOFT discloses that it depreciates its property, plant, and
equipment using the straight-line method over useful lives ranging from 1 to 15 years.
408 f409
Investments In Property, Plant, And Equipment And Inand Equipment and in Intangible Assets
Investments in Property, Plant, Intangible Assets Chapter 9



Comparison of Depreciation Expense Using Different Depreciation Methods
exhibit 9-7


Straight-Line Units-of-Production
Depreciation Depreciation

End of year 1 $ 5,500 $ 4,400
End of year 2 5,500 6,600
End of year 3 5,500 7,700
End of year 4 5,500 3,300
Totals $22,000 $22,000



Partial-Year Depreciation Calculations
Thus far, depreciation expense has been calculated on the basis of a full year. Businesses pur-
chase assets at all times during the year, however, so partial-year depreciation calculations are of-
ten required. To compute depreciation expense for less than a full year, first calculate the de-
preciation expense for the year and then distribute it evenly over the number of months the asset
is held during the year.
To illustrate, assume that Wheeler Resorts purchased its $24,000 van on July 1 instead of
January 1. The depreciation calculations for the first one and one-half years, using straight-line
depreciation, are shown in Exhibit 9-8. The units-of-production method has been omitted from
the exhibit; midyear purchases do not complicate the calculations with this method because it
involves number of miles driven, hours flown, and so on, rather than time periods.


Partial-Year Depreciation
exhibit 9-8


Full-Year Depreciation Depreciation
Method Depreciation 1st Year (6 months) 2nd Year (12 months)

Straight-line $5,500 $2,750 ($5,500 °) $5,500



In practice, many companies simplify their depreciation computations by taking a full year
of depreciation in the year an asset is purchased and none in the year the asset is sold, or vice
versa. This is allowed because depreciation is based on estimates, and in the long run, the dif-
ference in the amounts is usually immaterial.

Units-of-Production Method with Natural Resources
Another common use for the units-of-production method is with natural resources. Natural re-
natural resources Assets
that are physically con- sources include such assets as oil wells, timber tracts, coal mines, and gravel deposits. Like all
sumed or waste away, such
other assets, newly purchased or developed natural resources are recorded at cost. This cost must
as oil, minerals, gravel, and
be written off as the assets are extracted or otherwise depleted. This process of writing off the
timber.
cost of natural resources is called depletion and involves the calculation of a depletion rate for
depletion The process of each unit of the natural resource. Conceptually, depletion is exactly the same as depreciation;
cost allocation that assigns
with plant and equipment, the accounting process is called depreciation, whereas with natural
the original cost of a nat-
resources it is called depletion.
ural resource to the periods
To illustrate, assume that Power-T Company purchases a coal mine for $1,200,000 cash.
benefited.
The entry to record the purchase is:

Coal Mine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200,000
Purchased a coal mine for $1,200,000.
409
f410 Part 3 Investments In Property, Plant, And Equipment And In Intangible Assets
Investing and Financing Activities


If the mine contains an estimated 200,000 tons of coal deposits (based on a geologist s es-
timate), the depletion expense for each ton of coal extracted and sold will be $6
($1,200,000/200,000 tons). Here, the unit of production is the extraction of one ton of coal.
If 12,000 tons of coal are mined and sold in the current year, the depletion entry is:

Depletion Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,000
Accumulated Depletion, Coal Mine . . . . . . . . . . . . . . . . . . . . . . . . . 72,000
To record depletion for the year: 12,000 tons at $6 per ton.


After the first year s depletion expense has been recorded, the coal mine is shown on the
balance sheet as follows:
Coal mine $1,200,000
Less: Accumulated depletion 72,000
Book value $1,128,000


But how do you determine the number of tons of coal in a mine? Because most natural re-
sources cannot be counted, the amount of the resource owned is an estimate. The depletion cal-
culation is therefore likely to be revised as new information becomes available. When an esti-
mate is changed, a new depletion rate per unit is calculated and used to compute depletion
during the remaining life of the natural resource or until another new estimate is made. Cover-
age of accounting for changes in estimates is included in the expanded material section of this
chapter.



to summarize
Depreciation is the process whereby the cost of an asset is allocated over its
useful life. Two common and simple methods of depreciation are straight-line
and units-of-production. The straight-line and units-of-production methods al-
locate cost proportionately over an asset s life on the bases of time and use,
respectively. Regardless of which method is used, depreciation is only an al-
location of an asset s cost over the periods benefited and is not a method of
valuation. Natural resources are assets, such as gravel deposits or coal mines,
that are consumed or that waste away. The accounting process of deprecia-
tion for natural resources is called depletion.




5 REPAIRING AND IMPROVING PROPERTY,
PLANT, AND EQUIPMENT
Account for repairs and
improvements of property,
plant, and equipment.
Sometime during its useful life, an asset will probably need to be repaired or improved. The ac-
counting issue associated with these postacquisition expenditures is whether they should be im-
mediately recognized as an expense or be added to the cost of the asset (capitalized). Remem-
ber from the discussion in Chapter 8 that an expenditure should be capitalized if it is expected
to have an identifiable benefit in future periods.
Two types of expenditures can be made on existing assets. The first is ordinary expendi-
tures for repairs, maintenance, and minor improvements. For example, a truck requires oil
changes and periodic maintenance. Because these types of expenditures typically benefit only the
period in which they are made, they are expenses of the current period.
The second type is an expenditure that lengthens an asset s useful life, increases its capac-
ity, or changes its use. These expenditures are capitalized; that is, they are added to the asset s
410 f411
Investments In Property, Plant, And Equipment And Inand Equipment and in Intangible Assets
Investments in Property, Plant, Intangible Assets Chapter 9


cost instead of being expensed in the current period. For example, overhauling the engine of a
delivery truck involves a major expenditure to extend the useful life of the truck. To qualify for
capitalization, an expenditure should meet three criteria: (1) it must be significant in amount;
(2) it should benefit the company over several periods, not just during the current one; and (3)
it should increase the productive life or capacity of the asset.
To illustrate the differences in accounting for capital and ordinary expenditures, assume
that Wheeler Resorts also purchases a delivery truck for $42,000. This truck has an estimated
useful life of eight years and a salvage value of $2,000. The straight-line depreciation is $5,000
per year [($42,000 $2,000)/8 years]. If the company spends $1,500 each year for normal
maintenance, its annual recording of these expenditures is:

Repairs and Maintenance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Spent $1,500 for maintenance of delivery truck.


This entry has no effect on either the recorded cost or the depreciation expense of the truck.
Now suppose that at the end of the sixth year of the truck s useful life, Wheeler spends $8,000
to overhaul the engine. This expenditure will increase the truck s remaining life from two to
four years, but will not change its estimated salvage value. The depreciation for the last four
years will be $4,500 per year, calculated as shown below.


Depreciation Depreciation
before Overhaul after Overhaul

Original cost $42,000 Original cost $42,000
Less salvage value 2,000 Accumulated depreciation
Cost to be allocated (depreciable amount) $40,000 (prior to overhaul) 30,000
Original life of asset 8 years Remaining book value $12,000
Original depreciation per year ($40,000/8) $5,000 Capital expenditure (overhaul) 8,000
Usage before overhaul 6 years New book value $20,000
Accumulated depreciation prior to overhaul $30,000 Less salvage value 2,000
New depreciable amount $18,000
Remaining life 4 years
New annual depreciation ($18,000/4) $4,500



The journal entry to record the $8,000 capitalized expenditure is:


Delivery Truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
Spent $8,000 to overhaul the engine of the $42,000 truck.


Another example of a capital expenditure is the cost of land improvements. Certain im-
provements are considered permanent, such as moving earth to change the land contour. Such
an expenditure would be capitalized as part of the land account. Other expenditures may have
a limited life, such as those incurred in building a road, a sidewalk, or a fence. These expendi-
tures would be capitalized in a separate land improvements account and be depreciated over
their useful lives.
It is often difficult to determine whether a given expenditure should be capitalized or ex-
pensed. The two procedures produce a different net income, however, so it is extremely impor-
tant that such expenditures be properly classified. When in doubt, accepted practice is to record
an expenditure as an expense to ensure that the asset is not reported at an amount that exceeds
its future benefit.
411
f412 Part 3 Investments In Property, Plant, And Equipment And In Intangible Assets
Investing and Financing Activities




to summarize
There are two types of expenditures for existing long-term operating assets:
capital and ordinary. In general, for an expenditure to be capitalized, it must (1)
be significant in amount, (2) provide benefits for more than one period, and (3)
increase the productive life or capacity of an asset. Ordinary expenditures merely
maintain an asset s productive capacity at the level originally projected. Capi-
tal expenditures are added to the cost of an asset and thus affect future depre-
ciation, whereas ordinary expenditures are expenses of the current period.




6 RECORDING IMPAIRMENTS OF ASSET VALUE
Identify whether a long-
As mentioned earlier, the value of a long-term asset depends on the future cash flows expected
term operating asset has
suffered a decline in value to be generated by that asset. Occasionally, events occur after the purchase of an asset that sig-
and record the decline.
nificantly reduce its value. For example, a decline in the consumer demand for high-priced ath-
letic shoes can cause the value of a shoe-manufacturing plant to plummet. Accountants call this
impairment. When an asset is impaired, the event should be recognized in the financial state-
impairment A decline in the
ments, both as a reduction in the reported value of the asset in the balance sheet and as a loss
value of a long-term operat-
ing asset. in the income statement. Of course, the value of long-term assets can also increase after the pur-
chase date. In the United States, these increases are not recorded, as explained more fully later
in this section.


Recording Decreases in the Value of Property,
Plant, and Equipment
According to U.S. accounting rules, the value of an asset is impaired when the sum of estimated
future cash flows from that asset is less than the book value of the asset. This computation ig-
nores the time value of money. As illustrated in the example below, this is a strange impairment
threshold a more reasonable test would be to compare the book value to the fair value of the
asset.
Once it has been determined that an asset is impaired, the amount of the impairment is
measured as the difference between the book value of the asset and the fair value. To summa-
rize, the existence of an impairment loss is determined using the sum of the estimated future
cash flows from the asset, ignoring the time value of money. The amount of the impairment
loss is measured using the fair value of the asset, which does incorporate the time value of money.
The practical result of this two-step process is that an impairment loss is not recorded unless it
is quite certain that the asset has suffered a permanent decline in value.
To illustrate, assume that Wheeler Resorts purchased a fitness center building five years ago
for $600,000. The building has been depreciated using the straight-line method with a 20-year
useful life and no residual value. Wheeler estimates that the building has a remaining useful life
of 15 years, that net cash inflow from the building will be $25,000 per year, and that the fair
value of the building is $230,000.
Annual depreciation for the building has been $30,000 ($600,000 20 years). The cur-
rent book value of the building is computed as follows:

Original cost $600,000
Accumulated depreciation ($30,000 5 years) 150,000
Book value $450,000


The book value of $450,000 is compared with the $375,000 ($25,000 15 years) sum of
future cash flows (ignoring the time value of money) to determine whether the building is im-
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Investments In Property, Plant, And Equipment And Inand Equipment and in Intangible Assets
Investments in Property, Plant, Intangible Assets Chapter 9


paired. The sum of future cash flows is only $375,000, which is less than the $450,000 book
value, so an impairment loss should be recognized. The loss is equal to the $220,000 ($450,000
$230,000) difference between the book value of the building and its fair value. The impair-
ment loss would be recorded as follows:


Accumulated Depreciation, Building . . . . . . . . . . . . . . . . . . . . . . . . 150,000
Loss on Impairment of Building . . . . . . . . . . . . . . . . . . . . . . . . . . . 220,000
Building ($600,000 $230,000) . . . . . . . . . . . . . . . . . . . . . . . . . . 370,000
Recognized $220,000 impairment loss on building.



This journal entry basically records the asset as if it were being acquired brand new at its
fair value of $230,000. The existing accumulated depreciation balance is wiped clean, and the
new recorded value of the asset is its fair value of $230,000 ($600,000 $370,000). After an
impairment loss is recognized, no restoration of the loss is allowed even if the fair value of the
asset later recovers.
The odd nature of the impairment test can be seen if the facts in the Wheeler example are
changed slightly. Assume that net cash inflow from the building will be $35,000 per year and
that the fair value of the building is $330,000. With these numbers, no im-
Do you think businesses pairment loss is recognized, even though the fair value of $330,000 is less than
the book value of $450,000, because the sum of future cash flows of $525,000
would prefer an impairment test involving
($35,000 15 years) exceeds the book value. Thus, in this case the asset would
only the comparison of the book value of
still be recorded at its book value of $450,000, even though its fair value is ac-
an asset to its fair value? Explain.
tually less. As mentioned above, the practical impact of the two-step impair-
ment test is that no impairment losses are recorded unless the future cash flow calculations of-
fer very strong evidence of a permanent decline in asset value. The impairment test is summarized
in Exhibit 9-9.
RITE AID, one of the largest retail drugstore chains in the United States, provides an ex-
ample of the reporting of an impairment loss. As of February 27, 1999, Rite Aid operated 3,821
drugstores. During 1998 and 1999, Rite Aid experienced significant financial difficulties and
initiated a plan to vacate some markets and to close or consolidate some stores in other mar-
kets. In connection with this plan, Rite Aid recorded a $94 million loss for impairment losses
associated with land, buildings, fixtures, leasehold improvements, prescription files, lease acqui-
sition costs and goodwill.




Impairment Test
exhibit 9-9


Sum of Future Cash Flows Book Value
from Asset of Asset



IMPAIRMENT.
Sum of Future Cash Flows Record Asset
YES
Less than Book Value? at Its
Fair Value.

NO


NO IMPAIRMENT.
Asset Continues
to Be Reported at
Book Value.
413
f414 Part 3 Investments In Property, Plant, And Equipment And In Intangible Assets
Investing and Financing Activities



Recording Increases in the Value of Property,
Plant, and Equipment
Under U.S. accounting standards, increases in the value of property, plant, and equipment are
not recognized. Gains from increases in asset value are recorded only if and when the asset is
sold. Thus, in the Wheeler example discussed above, if the fair value of the building rises to
$800,000, the building would still be reported in the financial statements at its depreciated book
value of $450,000. This is an example of the conservative bias that often exists in the account-
ing rules: losses are recognized when they occur, but the recognition of gains is deferred until
the asset is sold.
Although increases in the value of property, plant, and equipment are not recognized in the
United States, accounting rules in other countries do allow for their recognition. For example,
companies in Great Britain often report their long-term operating assets at their fair values. Be-
cause this upward revaluation of property, plant, and equipment is allowable under international
accounting standards, it will be interesting to watch over the next decade or so to see whether
sentiment grows to allow this practice in the United States as well.



to summarize
When an asset s value declines after it is purchased, it is said to be impaired.
Recording an impairment loss is a two-step process. First, the recorded book
value of the asset is compared with the sum of future cash flows expected to
be generated by the asset. Second, if the book value is lower, then a loss is
recognized in an amount equal to the difference between the book value of the
asset and its fair value. According to U.S. accounting rules, increases in the
value of property, plant, and equipment are not recognized.




7 DISPOSAL OF PROPERTY, PLANT,
AND EQUIPMENT
Record the discarding and
selling of property, plant,
and equipment.
Plant and equipment eventually become worthless or are sold. When a company removes one
of these assets from service, it has to eliminate the asset s cost and accumulated depreciation
from the accounting records. There are basically three ways to dispose of an asset: (1) discard
or scrap it, (2) sell it, or (3) exchange it for another asset.

Discarding Property, Plant, and Equipment
When an asset becomes worthless and must be scrapped, its cost and its accumulated deprecia-
tion balance should be removed from the accounting records. If the asset s total cost has been
depreciated, there is no loss on the disposal. If, on the other hand, the cost is not completely
depreciated, the undepreciated cost represents a loss on disposal.
To illustrate, we assume that Wheeler Resorts, Inc., purchases a computer for $15,000. The
computer has a five-year life and no estimated salvage value and is depreciated on a straight-line
basis. If the computer is scrapped after five full years, the entry to record the disposal is as follows:

Accumulated Depreciation, Computer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Computer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Scrapped $15,000 computer.


If Wheeler must pay $300 to have the computer dismantled and removed, the entry to
record the disposal is:
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Investments In Property, Plant, And Equipment And Inand Equipment and in Intangible Assets
Investments in Property, Plant, Intangible Assets Chapter 9



Accumulated Depreciation, Computer . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Loss on Disposal of Computer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
Computer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
Scrapped $15,000 computer and paid disposal costs of $300.


If the computer had been scrapped after only four years of service (and after $12,000 of the
original cost has been depreciated), there would have been a loss on disposal of $3,300 (in-
cluding the disposal cost), and the entry would have been:


Accumulated Depreciation, Computer . . . . . . . . . . . . . . . . . . . . . . . . . 12,000
Loss on Disposal of Computer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,300
Computer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
Scrapped $15,000 computer and recognized loss of $3,300
(including $300 disposal costs).


Don t think of the losses recognized above as bad or the gains as good. A loss on dis-

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