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posal simply means that, given the information we now have, it appears that we didn t record
enough depreciation expense in previous years. As a result, the book value of the asset is higher
than the amount we can get on disposal. Similarly, a gain means that too much depreciation
expense was recognized in prior years, making the book value of the asset lower than its actual
disposal value.

Selling Property, Plant, and Equipment
A second way of disposing of property, plant, and equipment is to sell it. If the sales price of
the asset exceeds its book value (the original cost less accumulated depreciation), there is a gain
on the sale. Conversely, if the sales price is less than the book value, there is a loss.
To illustrate, we refer again to Wheeler s $15,000 computer. If the computer is sold for
$600 after five full years of service, assuming no disposal costs, the entry to record the sale is:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600
Accumulated Depreciation, Computer . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Computer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Gain on Sale of Computer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600
Sold $15,000 computer at a gain of $600.


Because the asset was fully depreciated, its book value was zero and the $600 cash received
represents a gain. If the computer had been sold for $600 after only four years of service, there
would have been a loss of $2,400 on the sale, and the entry to record the sale would have been:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600
Accumulated Depreciation, Computer . . . . . . . . . . . . . . . . . . . . . . . . . 12,000
Loss on Sale of Computer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400
Computer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Sold $15,000 computer at a loss of $2,400.


The $2,400 loss is the difference between the sales price of $600 and the book value of
$3,000 ($15,000 $12,000). The amount of a gain or loss is thus a function of two factors:
(1) the amount of cash received from the sale, and (2) the book value of the asset at the date of
sale. The book value can vary from the market price of the asset for two reasons: (1) the ac-
415
f416 Part 3 Investments In Property, Plant, And Equipment And In Intangible Assets
Investing and Financing Activities


counting for the asset is not intended to show market value in the financial statements, and (2)
it is difficult to estimate salvage value and useful life at the outset of an asset s life.

Exchanging Property, Plant, and Equipment
A third way of disposing of property, plant, and equipment is to exchange it for another asset.
Such exchanges occur regularly with cars, trucks, machines, and other types of large equipment.
When dissimilar assets are exchanged, such as a truck for a computer, the transaction is ac-
counted for exactly as outlined previously: the acquired asset is recorded in the books at its fair
market value, and a gain or loss may be recognized depending on the difference between this
market value and the book value of the asset that was disposed of. Accounting for exchanges of
similar assets can be more complicated and therefore is not discussed in this text. For a full treat-
ment of the accounting for the exchange of similar assets, see an intermediate accounting text.




to summarize
There are three ways of disposing of assets: (1) discarding (scrapping), (2) sell-
ing, and (3) exchanging. If a scrapped asset has not been fully depreciated, a
loss equal to the undepreciated cost or book value is recognized. When an as-
set is sold, there is a gain if the sales price exceeds the book value and a loss
if the sales price is less than the book value.




8 ACCOUNTING FOR INTANGIBLE ASSETS
Account for the acquisition
Intangible assets are rights and privileges that are long-lived, are not held for resale, have no
and amortization of
intangible assets and physical substance, and usually provide their owner with competitive advantages over other firms.
understand the special
Familiar examples are patents, franchises, licenses, and goodwill. Although intangible assets have
difficulties associated with
no physical substance, they are accounted for in the same way as other long-term operating as-
accounting for intangibles.
sets. That is, they are originally recorded at cost, and the cost is allocated over the useful or le-
gal life, whichever is shorter. The periodic allocation to expense of an intangible asset s cost is
called amortization. Conceptually, depreciation (with plant and equipment), depletion (with
amortization The process
of cost allocation that as- natural resources), and amortization (with intangible assets) are exactly the same thing. Straight-
signs the original cost of an line amortization is generally used for intangible assets.
intangible asset to the peri-
The traditional accounting model is designed for manufacturing and merchandising com-
ods benefited.
panies. Accordingly, accountants have developed intricate and sophisticated accounting methods
for use with buildings, equipment, inventory, and receivables. The accounting procedures for
gathering and reporting useful information about intangible assets are not as well developed. As
the business environment is increasingly dominated by information, service, and reputation, the
net work
accounting profession is facing the challenge of improving the accounting for intangible assets.
Fortune magazine posts its The importance of intangible assets can be illustrated by considering GENERAL ELEC-
Fortune 500 list on its Web
TRIC. As mentioned in Chapter 2, if the balance sheet were perfect, the amount of owners eq-
site, http://fortune.com.
uity would be equal to the market value of the company. On December 31, 1999, GE s re-
The information posted in-
cludes the reported equity ported equity was equal to $42.557 billion. The actual market value of GE on December 31,
and market values for the
1999, was $511 billion. The reason for the large difference between the recorded value and the
500 largest companies in
actual value is that a traditional balance sheet excludes many important intangible economic as-
the United States. What are
the differences between re- sets. Examples of GE s important intangible economic assets are its track record of successful
ported equity and the mar-
products and its entrenched market position in the many industries in which it operates. These
ket value of equity for THE
intangible factors are by far the most valuable assets owned by GE, but they fall outside the tra-
COCA-COLA COMPANY
and for GENERAL MOTORS ditional accounting process.
CORPORATION?
As with many accounting issues, accounting for intangibles involves a trade-off between rel-
evance and reliability. Information concerning intangible assets is relevant, but to meet the stan-
416 f417
Investments In Property, Plant, And Equipment And Inand Equipment and in Intangible Assets
Investments in Property, Plant, Intangible Assets Chapter 9


dard for recognition in the financial statements, the recorded amount for the intangible must
also be reliable. As a result, accounting for intangibles focuses on identifying the costs associated
with securing or developing the intangible assets.
Because intangible assets are characterized by a lack of physical qualities, it is difficult to
determine the value and life of any future benefits those assets might produce. As a result, it is
difficult to separate expenditures that are essentially operating expenses from those that give rise
to intangible assets. For example, advertising and promotion campaigns and training programs
provide future benefits to the firm. If this were not the case, firms would not spend the millions
of dollars on these programs that they do. From an accounting perspective, however, it is ex-
tremely difficult to measure the amount and life of the benefits generated by such programs.
Therefore, as discussed in Chapter 8, expenditures for these and similar items are typically writ-
ten off as an expenses in the period incurred.
The accounting for intangible assets is illustrated below with a discussion of the account-
ing for patents, franchises, and licenses.
patent An exclusive right
granted for 17 years by the
Patents
federal government to man-
ufacture and sell an inven-
A patent is an exclusive right to produce and sell a commodity that has one or more unique
tion.
features. In the United States, patents are issued to inventors by the federal government and
have a legal life of 17 years. Patents may be obtained on new products developed in a
fyi company s own research laboratories, or they may be purchased from others. If a patent
is purchased from others, its cost is simply the purchase price, and it is recorded as an as-
The U.S. rule for accounting for
set (patent). The cost of the patent is amortized over the useful life of the patent, which
research and development dif-
may or may not coincide with the patent s legal life.
fers from the international rule.
The cost of a patent for a product developed within a firm is difficult to determine.
According to international ac-
Should it include research and development costs as well as legal fees to obtain the patent?
counting rules, research and
Should other company expenses such as administrative costs be included? Because of the
development costs that are in-
high degree of uncertainty about their future benefits, U.S. accounting rules dictate that
curred after the technological
research and development costs must be expensed in the period in which they are incurred.
feasibility of a project has been
Therefore, all research and development costs of internally developed patents are expensed
demonstrated should be capi-
as they are incurred.
talized as an asset. To illustrate the accounting for patents, assume that Wheeler Resorts, Inc., acquires,
for $200,000, a patent granted seven years earlier to another firm. The entry to record
the purchase of the patent is:


Patent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
Purchased patent for $200,000.



Because 7 years of its 17-year legal life have already elapsed, the patent now has a legal life of
only 10 years, although it may have a shorter useful life. If its useful life is assumed to be eight
years, one-eighth of the $200,000 cost should be amortized each year for the next eight years.
The entry each year to record the patent amortization expense is:


Amortization Expense, Patent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Patent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
To amortize one-eighth of the cost of the patent.



Notice that in the above entry, the patent account was credited. Alternatively, a contra-asset ac-
count, such as Accumulated Amortization, could have been credited. In practice, however, cred-
iting the intangible asset account directly is more common. This is different from the normal
practice of crediting Accumulated Depreciation for buildings or equipment.
417
f418 Part 3 Investments In Property, Plant, And Equipment And In Intangible Assets
Investing and Financing Activities



Franchises and Licenses
Issued either by companies or by government agencies, franchises and licenses are exclusive
franchise An entity that has
been licensed to sell the rights to perform services in certain geographic areas. For example, MCDONALD S CORPO-
product of a manufacturer
RATION sells franchises to individuals to operate its fast-food outlets in specific locations. Sim-
or to offer a particular ser-
ilarly, local airports issue licenses to airlines allowing them to use a specified number of board-
vice in a given area.
ing gates for a specified length of time. As with patents, the cost of a franchise or license is
license The right to perform amortized over its useful or legal life, whichever is shorter.
certain activities, generally
granted by a governmental
Goodwill
agency.

When a business is purchased, the negotiated price often exceeds the total fair market
value of the individual assets purchased minus the outstanding liabilities assumed by the
caution
buyer. As mentioned earlier, this excess in purchase price that cannot be allocated to spe-
Goodwill is recorded only when
cific assets is called goodwill and is an intangible asset. The emergence of goodwill in such
it is purchased. A company s re-
a transaction is considered an indication that the purchased business is worth more than
ported goodwill balance does its net assets, due to such favorable characteristics as a good reputation, a strategic loca-
not reflect the company s own tion, product superiority, or management skill.
homegrown goodwill. So, MI- Goodwill is recorded only if its value can be objectively determined by a transaction.
Therefore, even though two businesses may enjoy the same favorable characteristics, good-
CROSOFT s goodwill is not rec-
will will be recognized only when it is purchased, that is, when one company buys an-
ognized in Microsoft s balance
other company. This disparity in accounting exists because the action of a buyer in pay-
sheet, but it would be recog-
ing a premium for a firm is objective evidence that goodwill exists and has a specific value.
nized in your balance sheet if
As you can imagine, estimating the useful life of goodwill is extremely difficult. To
you were to purchase Microsoft.
give companies some direction in estimating the useful life of goodwill, accounting
standard-setters have established some guidelines. In the United States, for example, his-
torically the accounting rule has been that the estimated life of goodwill must be 40 years
or less. According to international accounting standards, goodwill usually is assumed to
fyi
have a life of 5 years or less, although a life of up to 20 years is sometimes justifiable. Most
In 2001, the FASB was consid- U.S. companies simply assume that any goodwill they purchase has a life of 40 years.
ering whether to lower the To illustrate the accounting for goodwill, assume that, in order to cater to the med-
maximum allowable estimated icinal needs of its guests, Wheeler Resorts purchases Valley Drug Store for $400,000. At
the time of purchase, the recorded assets and liabilities of Valley Drug have the following
life for goodwill to 20 years.
fair market values:
Inventory $220,000
Long-term operating assets 110,000
Other assets (prepaid expenses, etc.) 10,000
Liabilities (20,000)
Total net assets $320,000


Note that Wheeler Resorts records these items at their fair market values on the date purchased,
just as it does when purchasing individual assets.
Because Wheeler was willing to pay $400,000 for Valley Drug, there must have been other
favorable, intangible factors worth approximately $80,000. These factors are called goodwill, and
the entry to record the purchase of the drug store is:

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220,000
Long-Term Operating Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110,000
Other Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000
Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000
Purchased Valley Drug Store for $400,000.
418 f419
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Investments in Property, Plant, Intangible Assets Chapter 9


If Wheeler decides to use 40 years as the useful life of the goodwill, the yearly amortization
entry is:

Amortization Expense, Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
To record annual straight-line amortization of goodwill
($80,000/40 years).


An extreme example of the amount of goodwill that can be involved in a transaction oc-
curred when DISNEY acquired ABC in 1996. At the time of the acquisition, ABC had identi-
fiable assets worth $4.0 billion and identifiable liabilities of $4.3 billion, indicating a fair mar-
ket value of net identifiable assets of $0.3 billion. In spite of this apparent negative net worth,
Disney paid $18.9 billion for ABC, a price that exceeded the fair market value of ABC s net
identifiable assets by more than $19 billion. Presumably, Disney knew what it was doing in pay-
ing this much for ABC, and the $19 billion, which was recorded as goodwill on Disney s books,
represents the fair market value of ABC s market position, reputation, network of radio and tele-
vision affiliates, and creative staff under contract.

Difficulties of Accounting for Intangible Assets:
The Case of Brand Names
Brand names offer a good illustration of the difficulty associated with accounting for intangible
assets. As shown in Exhibit 9-10, a brand name can be an extremely valuable asset. According
to INTERBRAND, a consulting firm specializing in valuing brand names, if you were to try to
buy the worldwide rights to the exclusive use of the name Coca-Cola, you would have to pay
in excess of $85 billion. A valuable brand name such as Coca-Cola or Disney arises as an in-
tegral part of improving products, advertising, strategic expansion, and so forth. Accordingly, it
is very difficult to identify which costs associated with brand name sales are normal business ex-
penses and which actually contribute to brand name value. Therefore, even though a brand name
might have significant economic value, it is unlikely that the value, or the costs associated with
developing the brand name, could be separately and reliably identified.


Ten Most Valuable Brands in the World for 1999
exhibit 9-10




Brand Value
(in millions)
Coca“Cola $85.6
Microsoft 57.8
IBM 44.7
General Electric 34.2

CO K E
Ford 33.9
Disney 32.9
Intel 30.9
McDonald˜s 26.8
AT&T 24.7
Marlboro 21.5

Source: Interbrand, as reported in “The Upwardly Mobile Nokia; Phone Makers Leap into
Top Names List,” The Mirror, June 23, 1999, p.19.
419
f420 Part 3 Investments In Property, Plant, And Equipment And In Intangible Assets
Investing and Financing Activities


As mentioned earlier in the chapter, a useful technique for valuing tangible long-term as-
sets is to estimate the present value of the future cash flows expected to be associated with the
asset. This technique is impractical for most intangible assets because the value of the intangi-
ble is inextricably connected with its use in conjunction with other assets. Thus, identifying the
future cash flows associated with the intangible asset itself is nearly impossible.
In summary, the accounting for intangibles is still in its infancy. As accountants strive to
meet the information demands of business decision makers, we will see a rapid development in
the standards of accounting for intangibles.




to summarize
Intangible assets are long-term rights and privileges that have no physical
substance but provide competitive advantages to owners. Common intan-
gible assets are patents, franchises, licenses, and goodwill. The cost of an
intangible asset is amortized over the economic life of the asset. Because
it is often difficult to trace the development of specific intangible assets to
specific costs, it is difficult to reliably recognize the assets in the financial
statements.




9 MEASURING PROPERTY, PLANT, AND
EQUIPMENT EFFICIENCY
Use the fixed asset
turnover ratio as a measure
of how efficiently a
In this section we discuss the fixed asset turnover ratio, which uses financial statement data to
company is using its
give a rough indication of how efficiently a company is utilizing its property, plant, and equip-
property, plant, and
equipment. ment to generate sales. We also illustrate that the fixed asset turnover ratio must be interpreted
carefully because, as with most other financial ratios, acceptable values for this ratio differ sig-
nificantly from one industry to the next.

Evaluating the Level of Property, Plant, and Equipment
Fixed asset turnover can be used to evaluate the appropriateness of the level of a company s
fixed asset turnover The
number of dollars in sales property, plant, and equipment. Fixed asset turnover is computed as sales divided by average
generated by each dollar of property, plant, and equipment (fixed assets) and is interpreted as the number of dollars in sales
fixed assets; computed as
generated by each dollar of fixed assets. This ratio is also often called PP&E turnover. The com-
sales divided by property,
putation of the fixed asset turnover for GENERAL ELECTRIC is given below. All financial
plant, and equipment.
statement numbers are in millions.

1999 1998

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $111,630 $100,469
Property, plant, and equipment: . . . . . . . . . . . . . . . .
Beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,730 $ 32,316
End of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41,022 35,730
Average fixed assets [(beginning . . . . . . . . . . . . . . .
balance ending balance) 2] . . . . . . . . . . . . . . $ 38,376 $ 34,023
Fixed asset turnover . . . . . . . . . . . . . . . . . . . . . . . . . 2.91 times 2.95 times


The fixed asset turnover calculations suggest that GE used its fixed assets to generate sales about
as efficiently in 1999 as in 1998. In 1999, each dollar of fixed assets generated $2.91 in sales,
down just slightly from $2.95 in 1998.
420 f421
Investments In Property, Plant, And Equipment and Equipment and in Intangible Assets
Investments in Property, Plant, And In Intangible Assets EM Chapter 9



Industry Differences in Fixed Asset Turnover
As with all ratios, the fixed asset turnover ratio must be used carefully to ensure that erroneous
conclusions are not made. For example, fixed asset turnover ratio values for two companies in
different industries cannot be meaningfully compared. This point can be illustrated using the
fact that General Electric is composed of two primary parts General Electric, the manufactur-
ing company, and GE Capital Services, the financial services firm. The fixed asset turnover ra-
tio computed earlier was for both these parts combined. Because GE Capital Services does not
use property, plant, and equipment for manufacturing but instead leases the assets to other com-
panies in order to earn financial revenue, one would expect its fixed asset turnover ratio to be
quite unlike that for a manufacturing firm. In fact, as shown below, the fixed asset turnover ra-
tio for the manufacturing segments of General Electric was 5.06 in 1999, nearly double the ra-
tio value for the company as a whole.


Fixed Asset Turnover Ratio
General Electric Manufacturing Segments Only

1999 1998
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,944 $56,026
Property, plant, and equipment:
Beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . $11,694 $11,118
End of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,381 11,694
Average fixed assets [(beginning
balance ending balance) 2] . . . . . . . . . . . . . . $12,038 $11,406
Fixed asset turnover. . . . . . . . . . . . . . . . . . . . . . . . . 5.06 times 4.91 times




to summarize
The fixed asset turnover ratio can be used as a general measure of how efficiently
a company is using its property, plant, and equipment. Fixed asset turnover is
computed as sales divided by average property, plant, and equipment and is in-
terpreted as the number of dollars in sales generated by each dollar of fixed as-
sets. Standard values for this ratio differ significantly from industry to industry.




Two topics related to operational assets that are traditionally covered in in-
troductory accounting classes were not covered in the main part of this chap-

ter. These two topics relate to depreciation accelerated depreciation meth-
ods and changes in depreciation estimates.


10 ACCELERATED DEPRECIATION METHODS
Compute declining-balance
Earlier in the chapter, straight-line and units-of-production depreciation methods were discussed.
and sum-of-the-years -digits
depreciation expense for Both of these methods allocate the cost of an asset evenly over its life. With straight-line deprecia-
plant and equipment.
tion, each time period during the asset s useful life is assigned an equal amount of depreciation. With
421
f422 Investing and Financing Activities Property, Plant, And Equipment And In Intangible Assets
Investments In
Part 3 EM


units-of-production depreciation, each mile driven, hour used, or other measurement of useful life
is assigned an equal amount of depreciation. Sometimes, a depreciation method that does not as-
sign costs equally over the life of the asset is preferred. For example, if most of an asset s benefits
will be realized in the earlier periods of the asset s life, the method used should assign more depre-
ciation to the earlier years and less to the later years. Examples of these accelerated depreciation
methods are the declining-balance and the sum-of-the-years -digits methods. These methods are
merely ways of assigning more of an asset s depreciation to earlier periods and less to later periods.
To illustrate these depreciation methods, we will again use the Wheeler Resorts example
from earlier in the chapter. Assume again that Wheeler Resorts purchased a van for transport-
ing hotel guests to and from the airport. The following facts apply:
Acquisition cost $24,000
Estimated salvage value $2,000
Estimated life:
In years 4 years
In miles driven 60,000 miles


Declining-Balance Method of Depreciation
The declining-balance depreciation method provides for higher depreciation charges in the
declining-balance deprecia-
tion method An accelerated earlier years of an asset s life than does the straight-line method. The declining-balance method
depreciation method in involves multiplying a fixed rate, or percentage, by a decreasing book value. This rate is a mul-
which an asset s book value
tiple of the straight-line rate. Typically, it is twice the straight-line rate, but it also can be 175,
is multiplied by a constant
150, or 125% of the straight-line rate. Our depreciation of Wheeler s hotel van will illustrate
depreciation rate (such as
the declining-balance method using a fixed rate equal to twice the straight-line rate. This method
double the straight-line
percentage, in the case of is often referred to as the double-declining-balance depreciation method.
double-declining-balance). Declining-balance depreciation differs from the other depreciation methods in two respects:
(1) the initial computation ignores the asset s salvage value, and (2) a constant depreciation rate
is multiplied by a decreasing book value. The salvage value is not ignored completely because
the depreciation taken during the asset s life cannot reduce the asset s book value below the es-
timated salvage value.
The double-declining-balance (DDB) rate is twice the straight-line rate, computed as follows:

1
2 DDB rate
Estimated life (years)


This rate is multiplied times the book value at the beginning of each year (cost accumulated
depreciation) to compute the annual depreciation expense for the year. If the 150% declining




business environment essay


Pay Me Now or Pay Me Later? Given One way that businesses can defer income taxes is
the choice of paying income taxes now through the selection of accounting methods. The LIFO
or later, an overwhelming majority of (last-in, first-out) method of inventory valuation, for ex-
U.S. taxpayers would choose to pay ample, is used primarily for the purpose of postpon-
later. Although it is illegal to evade in- ing tax payments. In some cases, companies use one
come taxes, the postponement or de- accounting method for their financial statements and
ferral of tax payments is not only legal another for their tax returns.
but is also a fundamental principle of Depreciation is the most common cause of differ-
good tax planning. ences between net income on the income statement
422 f423
Investments In Property, Plant, And Equipment and Equipment and in Intangible Assets
Investments in Property, Plant, And In Intangible Assets EM Chapter 9


balance were being used instead, the 2 in the rate formula would be replaced by 1.5 and so on
for any other percentages.
To illustrate, the depreciation calculation for the van using the 200% (or double) declining-
balance method is:
Straight-line rate 4 years ¦ 25%
Double the straight-line rate 25% 2 50%
Annual depreciation 50% undepreciated cost (book value)

Based on this information, the formula for double-declining-balance depreciation can be
caution expressed as (straight-line rate 2) (cost accumulated depreciation) current year s
depreciation expense. The double-declining-balance depreciation for the four years is
With declining-balance depre-
shown in Exhibit 9-11. As you review this exhibit, note that the book value of the van at
ciation, the asset is not depre-
the end of year 4 is $2,000, its salvage value.
ciated below its salvage value,
If Wheeler had applied the declining-balance method to depreciate the hotel van on
though this figure is ignored in
the basis of 150% of the straight-line rate, the fixed rate would have been 37.5%, com-
the initial computations.
puted as follows: 25% 1.50 37.5%. Using the 37.5% fixed rate, the annual depre-
ciation of the hotel van would have been as follows:
First year: $24,000 37.5% $9,000
Second year: $24,000 $9,000 $15,000 37.5% $5,625
Third year: $15,000 $5,625 $9,375 37.5% $3,516
Fourth year: $9,375 $3,516 $5,859 $2,000 salvage value $3,859



Depreciation Schedule with Double-Declining-Balance Depreciation
exhibit 9-11


Annual
Depreciation Accumulated Book
Computation Expense Depreciation Value

Acquisition date $24,000
End of year 1 $24,000 0.50 $12,000 $12,000 12,000
End of year 2 12,000 0.50 6,000 18,000 6,000
End of year 3 6,000 0.50 3,000 21,000 3,000
End of year 4 * 1,000 22,000 2,000
$22,000

*In year 4, depreciation expense cannot exceed $1,000 because the book value cannot be reduced below
salvage value.




and taxable income on the tax return. Most companies of income taxes enables a business to earn additional
use straight-line depreciation for financial statements income by investing cash that is retained as a result
to maximize income reported to stockholders while us- of delaying tax payments to future years.
ing the accelerated methods permitted by the tax rules The amount of income taxes that companies can
to minimize taxable income in the early years of asset defer is by no means insignificant. For example, GEN-
life. This allows companies to save cash by reducing ERAL ELECTRIC was able to delay the payment of
the amount of taxes paid currently. Although the total $1.499 billion in taxes in 1999 because of differences
amount of asset cost to be deducted will ultimately be between financial accounting rules and income tax
the same for tax and financial reporting, the deferral regulations.
423
f424 Investing and Financing Activities Property, Plant, And Equipment And In Intangible Assets
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Part 3 EM


Since a total book value of $5,859 remains at the end of year 3, the remaining book value less
the estimated salvage value is expensed in year 4.

Net income reported on the financial
DEPRECIATION FOR INCOME TAX PURPOSES
statements prepared for stockholders, creditors, and other external users often differs from tax-
able income reported on income tax returns. The most common cause of differences between
financial reporting and tax returns is the computation of depreciation. Depreciation for income
tax purposes must be computed in accordance with federal income tax law, which specifies rules
to be applied in computing tax depreciation for various categories of assets. Income tax rules are
designed to achieve economic objectives, such as stimulating investment in productive assets.
The income tax depreciation system in the United States is called the Modified Accelerated
Cost Recovery System (MACRS). MACRS is based on declining-balance depreciation and is de-
signed to allow taxpayers to quickly deduct the cost of assets acquired. Allowing this accelerated
depreciation deduction for income tax purposes gives companies tax benefits for investing in
new productive assets. Presumably, this will spur investment, create jobs, and make voters more
likely to reelect their representatives.

Sum-of-the-Years -Digits Method of Depreciation
Like the declining-balance method, the sum-of-the-years -digits (SYD) depreciation method
sum-of-the-years -digits
(SYD) depreciation method provides for a proportionately higher depreciation expense in the early years of an asset s life. It
The accelerated deprecia- is therefore appropriate for assets that provide greater benefits in their earlier years (such as trucks,
tion method in which a
machinery, and equipment) as opposed to assets that benefit all years equally (as buildings do).
constant balance (cost mi-
The formula for calculating SYD is:
nus salvage value) is multi-
plied by a declining depre-
Number of years of
ciation rate.
life remaining at
beginning of year
(Cost Salvage value) Depreciation expense
Sum-of-the-years -digits

The numerator is the number of years of estimated life remaining at the beginning of the
current year. The van, with a four-year life, would have four years remaining at the beginning
of the first year, three at the beginning of the second, and so on. The denominator is the sum
of the years of the asset s life. The sum of the years digits for the van is 10 (4 3 2 1).
In other words, the numerator decreases by one year each year, whereas the denominator re-
mains the same for each year s calculation of depreciation. Also note that the asset s cost is re-
duced by the salvage value in computing the annual depreciation expense as is done for the
straight-line method but not for the declining-balance method.
The depreciation on the van for the first two years is:
First year: /10 ($24,000 $2,000) $8,800
4

Second year: 3/10 ($24,000 $2,000) $6,600

The depreciation schedule for four years is shown in Exhibit 9-12.


Depreciation Schedule with Sum-of-the-Years -Digits Depreciation
exhibit 9-12


Annual
Depreciation Accumulated
Expense Depreciation Book Value

Acquisition date $24,000
End of year 1 $ 8,800 $ 8,800 15,200
End of year 2 6,600 15,400 8,600
End of year 3 4,400 19,800 4,200
End of year 4 2,200 22,000 2,000
Total $22,000
424 f425
Investments In Property, Plant, And Equipment and Equipment and in Intangible Assets
Investments in Property, Plant, And In Intangible Assets EM Chapter 9


The entry to record the sum-of-the-years -digits depreciation for the first year is:

Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,800
Accumulated Depreciation, Hotel Van. . . . . . . . . . . . . . . . . . . . . . . . . 8,800
To record the first year s depreciation for the hotel van.


Subsequent years depreciation entries would show depreciation expense of $6,600, $4,400, and
$2,200.
When an asset has a long life, the computation of the denominator (the sum-of-the-years -
digits) can become quite involved. There is, however, a simple formula for determining the de-
nominator. It is:
n(n 1)
where n is the life (in years) of the asset
2

Given that the van has a useful life of four years, the formula works as follows:

4(5)
fyi 10
2
General Electric is one of the
few large companies that con- As you can see, the answer is the same as if you had added the years digits (4 3 2
1). If an asset has a 10-year life, the sum of the years digits is:
tinues to use the sum-of-the-
years -digits method of depre-
10(11)
ciation. 55
2

The depreciation fraction in year 1 would be 10/55, in year 2, 9/55, and so on.

A Comparison of Depreciation Methods
Now that you have been introduced to the four most common depreciation methods, we can
compare them both graphically and by using the Wheeler Resorts van example. Exhibit 9-13
compares the straight-line, sum-of-the-years -digits, and declining-balance depreciation methods
with regard to the relative amount of depreciation expense incurred in each year for an asset that
has a five-year life. The units-of-production method is not illustrated because there would not
be a standard pattern of cost allocation. Exhibit 9-14 shows the results for the Wheeler Resorts
van for all four depreciation methods.


Comparison of Depreciation Methods
exhibit 9-13
Depreciation expense each year




Straight-line method

Sum-of-the-years™-digits
method
Declining-balance
method
0 2 3 4 5
1
Years
425
f426 Investing and Financing Activities Property, Plant, And Equipment And In Intangible Assets
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Part 3 EM



Comparison of Depreciation Expense Using Different Depreciation Methods
exhibit 9-14


Units-of-
Straight-Line Production DDB SYD
Depreciation Depreciation Depreciation Depreciation

Year 1 $ 5,500 $ 4,400 $12,000 $ 8,800
Year 2 5,500 6,600 6,000 6,600
Year 3 5,500 7,700 3,000 4,400
Year 4 5,500 3,300 1,000 2,200
Totals $22,000 $22,000 $22,000 $22,000




to summarize
Two depreciation methods that allow for more depreciation expense in the
early years of an asset s life are the declining-balance and the sum-of-the-
years -digits methods. The declining-balance method involves multiplying the
asset s declining book value by a fixed rate that is a multiple of the straight-
line rate. Sum-of-the-years -digits depreciation is computed by multiplying
(cost salvage value) by a declining ratio based on the number of years in
the asset s estimated life.




11 CHANGES IN DEPRECIATION ESTIMATES
Account for changes in
As mentioned earlier in the chapter, useful lives and salvage values are only estimates. Wheeler
depreciation estimates.
Resorts van, for example, was assumed to have a useful life of four years and a salvage value of
$2,000. In reality, the van s life and salvage value may be different from the original estimates.
If, after three years, Wheeler realizes that the van will last another three years and that the sal-
vage value will be $3,000 instead of $2,000, the accountant would need to calculate a new de-
preciation expense for the remaining three years. Using straight-line depreciation, the calcula-
tions would be as follows:


Total
Formula Calculation Depreciation

Annual depreciation for the Depreciation
Cost Salvage value $24,000 $2,000
$5,500 $16,500
first three years expense
Estimated useful life 4 years

Cost Accumulated
Book value after three years Book value $24,000 $16,500 $7,500
depreciation to date

Annual depreciation for last
three years (based on new Depreciation
Book value Salvage value $7,500 $3,000
$1,500 4,500
total life of six years and new expense
Remaining useful life 3 years
salvage value of $3,000)

Total depreciation $21,000
426 f427
Investments In Property, Plant,in Property, Plant, and Equipment and in Intangible Assets
Investments And Equipment And In Intangible Assets EOC Chapter 9



Depreciation Schedule When There Is a Change in Estimate
exhibit 9-15


Annual
Depreciation Accumulated
Expense Depreciation Book Value

Acquisition date $24,000
Year 1 $ 5,500 $ 5,500 18,500
Year 2 5,500 11,000 13,000
Year 3 5,500 16,500 7,500
Change
Year 4 1,500 18,000 6,000
Year 5 1,500 19,500 4,500
Year 6 1,500 21,000 3,000
Total $21,000




The example shows that a change in the estimate of useful life or salvage value does
fyi
not require a modification of the depreciation expense already taken. New information
To illustrate the uncertainty affects depreciation only in future years. Exhibit 9-15 shows the revised depreciation ex-
about depreciation life esti- pense. Similar calculations, although more complex, would apply if either the sum-of-the-
mates, consider that BOEING years -digits or the declining-balance depreciation method had been used.
727 airplanes are lasting a lot
longer than initially expected.
The first Boeing 727 was deliv-
to summarize
ered in 1963; the last was built
in 1984. As of December 1998, Because depreciation is only an estimate, changes in estimates of useful
almost 1,500 of the 1,831 727s life or salvage value may be required as new information becomes avail-
delivered were still in service. able. When there is a change in estimate, past periods depreciation
amounts remain the same. The only change is in future years deprecia-
tion where the remaining book value is allocated over the new life (in the case
of a change in useful life), or the difference between the book value and the
new salvage value is allocated over the remaining life (in the case of a change
in salvage value).




review of learning objectives

Identify the two major categories of long-term oper- Understand the factors important in deciding
1 2
ating assets: property, plant, and equipment and in- whether to acquire a long-term operating asset. The
tangible assets. There are two major types of operating assets. value of long-term operating assets stems from the fact that
Property, plant, and equipment are long-lived, tangible assets they help companies generate future cash flows. Capital bud-
acquired for use in a business. This category includes land, geting is the name given to the process whereby decisions are
buildings, machinery, equipment, and furniture. Intangible as- made about acquiring long-term operating assets. Capital bud-
sets are long-lived assets used in a business, but they have no geting involves comparing the cost of the asset to the value of
physical substance. Common intangible assets are patents, li- the expected cash inflows, after adjusting for the time value of
censes, franchises, and goodwill. money. The value of a long-term operating asset can disappear
427
f428 Investing andInvestments In Property, Plant, And Equipment And In Intangible Assets
Part 3 EOC Financing Activities


instantly if events lower the expectations about the future cash Account for repairs and improvements of property,
5
flows generated by the asset. plant, and equipment. Expenditures incurred for prop-
erty, plant, and equipment after acquisition may be classified as
either ordinary expenditures or capital expenditures. Since ordi-
Record the acquisition of property, plant, and
3 nary expenditures merely maintain an asset s productive capac-
equipment through a simple purchase as well as
ity at the level originally projected, they are reported as repairs
through a lease, by self-construction, and as part of the
and maintenance expense and do not affect the asset s reported
purchase of several assets at once. Property, plant, and
cost. For an expenditure to be classified as a capital expenditure,
equipment may be acquired by purchase, lease, or self-
it must (1) increase the productive life or annual capacity of the
construction. When purchased, the assets are recorded at
asset, (2) be significant in amount, and (3) benefit the company
cost, which includes all expenditures associated with acquir-
over several periods. Because capital expenditures are added to
ing them and getting them ready for their intended use.
the cost of an asset, they affect future depreciation, whereas or-
When these types of assets are leased, the lease agreement
dinary expenditures are expenses of the current period.
may be classified as an operating lease or as a capital lease.
An operating lease results in a short-term use of the asset
Identify whether a long-term operating asset has suf-
without recording the asset on the books of the user, the
6 fered a decline in value and record the decline. Im-
lessee. Instead, the lessee records only the rental expense paid
pairment is the decline in a long-term operating asset s value
each period. If the lease is for a longer term and meets the
after it is purchased. In recording an impairment loss, the
conditions of a capital lease, the lessee records the leased
recorded book value of the asset is first compared with the sum
property as an asset and the related liability as if the prop-
of future cash flows to be generated by the asset. Next, if the
erty had been purchased and financed with long-term debt.
book value is lower, a loss is recognized. The amount of the
The asset is recorded at the present value of the lease rental
loss is the difference between the book value of the asset and
payments, which usually is equivalent to the current market
its fair value. According to U.S. accounting rules, increases in
value or the cash equivalent price. When a company con-
the value of property, plant, and equipment are not recog-
structs an asset for its own use, the recorded cost includes
nized.
building materials, labor, a reasonable allocation of general
administrative costs, and capitalized interest equal to the
amount of interest that could have been avoided if the con- Record the discarding and selling of property, plant,
7
struction expenditures had been used to repay loans. and equipment. Property, plant, and equipment may be
If two or more assets are acquired in a basket purchase, disposed of by discarding, selling, or exchanging. When an as-
the relative fair market value method is used to assign costs to set is sold, a gain is reported if the sales price exceeds the book
individual assets. If one company buys all the assets of another value, or a loss is reported if the book value exceeds the sales
company, the excess of the purchase price over the aggregate price.
fair value of the acquired net assets is recorded as goodwill, an
intangible asset. Account for the acquisition and amortization of in-
8 tangible assets and understand the special difficulties
Compute straight-line and units-of-production de- associated with accounting for intangibles. Intangible assets
4 preciation expense for plant and equipment. Depre- are rights and privileges that are long-lived, are not held for
ciation is the process of allocating the cost of plant and equip- resale, have no physical substance, and usually provide com-
ment to expense in the periods that are benefited from the use petitive advantages for the owner. Common examples are
of the asset. The two most common and simple methods of patents, franchises, licenses, and goodwill. Patents acquired by
depreciation are straight-line and units-of-production. purchase are recorded at cost and amortized over the shorter
The straight-line method is the only method that results of their economic life or their 17-year legal life. Research and
in the same amount of depreciation for each full year. The development costs incurred internally in a firm are expensed
units-of-production method allocates cost over the useful life as incurred even if they may result in the development of a le-
measured in units of output or usage. Both methods require gal patent. Franchises and licenses are exclusive rights to per-
salvage value to be subtracted from the original cost in com- form services or sell a product in certain geographic areas. The
puting depreciation expense. cost of acquiring a franchise or license is recorded as an asset,
The units-of-production method is also used with natural which is then amortized over its useful or legal life, whichever
resources such as coal, gravel, and timber. Depletion expense is shorter. Goodwill occurs when a business is purchased and
for a year is computed by first computing a depletion rate by the purchase price exceeds the total value of the identifiable
dividing the cost assigned to the natural resource by the esti- assets less outstanding liabilities assumed. The excess purchase
mated number of remaining units to be extracted. This de- price that cannot be allocated to specific assets is called good-
pletion rate is multiplied by the number of units extracted for will and is recorded as an intangible asset. Goodwill is amor-
the year to arrive at the dollar amount of depletion for the tized as an expense over its expected life, not to exceed 40
year. years. Because it is often difficult to trace the development of
428 f429
Investments In Property, Plant,in Property, Plant, and Equipment and in Intangible Assets
Investments And Equipment And In Intangible Assets EOC Chapter 9


specific intangible assets to specific costs, it is difficult to reli- asset cannot be less than the salvage value at the end of any
ably recognize the assets in the financial statements. reporting year. With declining-balance, the depreciation rate
is calculated by multiplying a desired factor (such as 1.5 or
Use the fixed asset turnover ratio as a measure of how 2.0) by the straight-line depreciation rate. This rate is then
9 efficiently a company is using its property, plant, and multiplied times the book value to determine annual depreci-
equipment. Fixed asset turnover is computed as sales divided ation expense. The declining-balance method is the basis for
by average property, plant, and equipment (fixed assets) and is the MACRS income tax depreciation calculations in the
interpreted as the number of dollars in sales generated by each United States. With sum-of-the-years -digits depreciation, a ra-
dollar of fixed assets. Fixed asset turnover ratios can be mean- tio, computed by dividing the number of years of estimated
ingfully compared only between firms in similar industries. life remaining at the beginning of the year by the sum of the
years of the asset s life, is multiplied by the book value (cost
salvage value) of the asset to determine annual depreciation
expense.
Compute declining-balance and sum-of-the-
10 years -digits depreciation expense for plant and Account for changes in depreciation estimates.
11
equipment. The two most common accelerated depreciation Useful lives and salvage values of plant and equip-
methods are declining-balance and sum-of-the-years -digits. ment are only estimates and may need adjustment during an
The declining- balance method is different from straight-line, asset s life. Changes in estimates of useful life or salvage value
units-of-production, and sum-of-the-years -digits deprecia- do not require modification of depreciation expense already
tion. The salvage value is ignored in the declining-balance taken. Rather, only future depreciation amounts are affected
method in the annual computation, but the book value of the by changes in estimates.




key terms and concepts

amortization 416 impairment 412 salvage value 405
basket purchase 403 intangible assets 396 straight-line depreciation method
405
book value 405 lease 399
time value of money 397
capital budgeting 397 lessee 399
units-of-production method 405
capital lease 400 lessor 399
capitalized interest 402 license 418
depletion 409 long-term operating assets 396
depreciation 405 natural resources 409
declining-balance depreciation
fixed asset turnover 420 operating lease 399 method 422
franchise 418 patent 417 sum-of-the-years -digits (SYD)
goodwill 404 property, plant, and equipment 396 depreciation method 424




review problems

Swift Motor Lines is a trucking company that hauls crude oil in the Rocky Mountain states. It
Property, Plant, and
currently has 20 trucks. The following information relates to a single truck:
Equipment
a. Date truck was purchased, July 1, 2000.
b. Cost of truck:
Truck . . . . . . . . . . . . . . . $125,000
Paint job . . . . . . . . . . . . 3,000
Sales tax . . . . . . . . . . . . 7,000
429
f430 Investing andInvestments In Property, Plant, And Equipment And In Intangible Assets
Part 3 EOC Financing Activities


c. Estimated useful life of truck, 120,000 miles.
d. Estimated salvage value of truck, $27,000.
e. 2002 expenditures on truck:
(1) $6,000 on new tires and regular maintenance.
(2) On January 1, spent $44,000 to completely rework the truck s engine; increased the
total life to 200,000 miles but left expected salvage value unchanged.
f. Miles driven:
2000. . . . . . . . . . . . . . . . . . . . . . . 11,000
2001. . . . . . . . . . . . . . . . . . . . . . . 24,000
2002 (after reworking of engine) . 20,000
2003. . . . . . . . . . . . . . . . . . . . . . . 14,000

Record journal entries to account for the following. (Use the units-of-production depreciation
Required:
method.)
1. The purchase of the truck.
2. The expenditures on the truck during 2002.
3. Depreciation expense for:
a. 2000
b. 2001
c. 2002
d. 2003

1. Truck Purchase
Solution
The cost of the truck includes both the amount paid for it and all costs incurred to get it in
working condition. In this case, the cost includes both the paint job and the sales tax. Thus, the
entry to record the purchase is:
Truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135,000
Purchased truck for cash.

2. Expenditures
The expenditure of $6,000 is an ordinary expenditure and is expensed in the current year. The
engine overhaul is capitalized. The entries are:
Repairs and Maintenance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Recorded purchase of new tires and regular maintenance
on truck.
Truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,000
Recorded major overhaul to truck s engine.

3. Depreciation Expense
The formula for units-of-production depreciation on the truck is:

Number of miles
Cost Salvage value
Depreciation expense
driven in any year
Total miles expected to be driven


Journal entries and calculations are as follows:
a. 2000:
Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,900
Accumulated Depreciation, Truck. . . . . . . . . . . . . . . . . . . . . . . . . . . 9,900
Recorded depreciation expense for 2000.

$135,000 $27,000
11,000 miles $9,900 or $0.90 per mile 11,000 miles
120,000 miles
430 f431
Investments In Property, Plant,in Property, Plant, and Equipment and in Intangible Assets
Investments And Equipment And In Intangible Assets EOC Chapter 9


b. 2001:
Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,600
Accumulated Depreciation, Truck . . . . . . . . . . . . . . . . . . . . . . . . . 21,600
Recorded depreciation expense for 2001.

$0.90 24,000 miles $21,600


c. 2002:
Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,600
Accumulated Depreciation, Truck . . . . . . . . . . . . . . . . . . . . . . . . . 14,600
Recorded depreciation expense for 2002.

$135,000 $9,900 $21,600
$44,000 $27,000
20,000 miles $14,600 or $0.73* per mile 20,000 miles
165,000 miles
(200,000 11,000 24,000)

*Rounded to the nearest cent.


d. 2003:
Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,220
Accumulated Depreciation, Truck . . . . . . . . . . . . . . . . . . . . . . . . . 10,220
Recorded depreciation expense for 2003.

$0.73 14,000 miles $10,220




Swift Motor Lines is a trucking company that hauls crude oil in the Rocky Mountain states. It
Property, Plant, and
currently has 20 trucks. The following information relates to a single truck:
Equipment
a. Date truck was purchased, July 1, 2000.
b. Cost of truck:
Truck . . . . . . . . . . . . . . . . $125,000
Paint job . . . . . . . . . . . . . 3,000
Sales tax . . . . . . . . . . . . . 7,000

c. Estimated useful life of truck, eight years.
d. Estimated salvage value of truck, $27,000
e. 2002 expenditures on truck:
(1) $6,000 on new tires and regular maintenance.
(2) On January 1, spent $44,000 to completely rework the truck s engine. As a result of
the engine work, the remaining life of the truck is increased to nine years, but the ex-
pected salvage value remains the same.

Record journal entries to account for the following. (Use the sum-of-the-years -digits deprecia-
Required:
tion method.)
1. The purchase of the truck.
2. Depreciation expense for:
a. 2000
b. 2001
c. 2002
3. The expenditures on the truck during 2002.
431
f432 Investing andInvestments In Property, Plant, And Equipment And In Intangible Assets
Part 3 EOC Financing Activities


1. Truck Purchase
Solution
The cost of the truck includes both the amount paid for it and all costs incurred to get it in
working condition. In this case, the cost includes both the paint job and the sales tax. Thus, the
entry to record the purchase is:
Truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135,000
Purchased truck for cash.

2. Depreciation Expense
The formula for sum-of-the-years -digits depreciation on the truck is:

Number of years of life
remaining at beginning of year
(Cost Salvage value) Depreciation expense
Sum-of-the-years -digits

Depreciation for the three years is calculated as follows:

8
2000: ($135,000 $27,000) $24,000; $24,000 ° year $12,000
36

7.5
2001: ($135,000 $27,000) $22,500
36

9
2002: [($135,000 $44,000) ($12,000 $22,500) $27,000] $23,500
45


The depreciation entries are:
a. 2000:
Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000
Accumulated Depreciation, Truck. . . . . . . . . . . . . . . . . . . . . . . . . . 12,000
Recorded depreciation expense for 2000.
b. 2001:
Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,500
Accumulated Depreciation, Truck. . . . . . . . . . . . . . . . . . . . . . . . . . 22,500
Recorded depreciation expense for 2001.
c. 2002:
Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,500
Accumulated Depreciation, Truck. . . . . . . . . . . . . . . . . . . . . . . . . . 23,500
Recorded depreciation expense for 2002.

3. Expenditures
The first expenditure of $6,000 is an ordinary expenditure and is expensed in the current year.
The $44,000 expenditure is capitalized because it lengthens the truck s life. The entries are:
Repairs and Maintenance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Recorded purchase of new tires and regular maintenance
on truck.
Truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,000
Recorded major overhaul of truck engine.
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discussion questions

1. What are the major characteristics of property, plant, increase. Why are U.S. accountants reluctant to increase
and equipment? the recorded value of property, plant, and equipment
2. When buying a long-term asset such as a building or when their value increases?
piece of equipment, the time value of money must be 12. Why is it common to have a gain or loss on the dis-
considered. With respect to time value, it is often said posal of a long-term operating asset? Is it true that if
that the last payment (say, 20 years in the future) doesn t the useful life and salvage value of an asset could be
cost as much as the next payment today. Explain. known with certainty and were realized, there would
3. Why are expenditures other than the net purchase price never be such a gain or loss?
included in the cost of an asset? 13. When recording the disposal of a long-term operating
4. Why would a company include leased assets in the asset, why is it necessary to debit the accumulated de-
property, plant, and equipment section of its balance preciation of the old asset?
sheet when the assets are owned by another entity? 14. Why are intangible assets considered assets although
5. A company that borrows money to construct its own they have no physical substance?
building generally should include the interest paid on 15. Goodwill can be recorded only when a business is pur-
the loan during the construction period in the cost of chased. Does this result in similar businesses having in-
the building. Why? comparable financial statements?
6. Why are fair market values used to determine the cost 16. How is fixed asset turnover calculated, and what does
of operating assets acquired in a basket purchase? the resulting ratio value mean?
7. Companies usually depreciate assets such as buildings
even though those assets may be increasing in value.
Why?
8. How does the company accountant decide whether an
expenditure should be capitalized or expensed? 17. Which of the depreciation methods discussed in this
9. If a firm is uncertain whether an expenditure will bene- chapter will usually result in the highest net income in
fit one or more than one accounting period, or whether the early years of an asset s life?
it will increase the capacity or useful life of an opera- 18. How does the declining-balance method of depreciation
tional asset, most firms will expense rather than capital- differ from other methods of depreciation?
ize the expenditure. Why? 19. Modified accelerated cost recovery system (MACRS)
10. Sometimes long-term assets experience sudden dramatic depreciation is allowed by the IRS but usually is not
decreases in value. For example, a waste dump might used in financial reporting. Why do you think this is
suddenly be constructed next to an office building. the case?
When such impairment of value occurs, should the de- 20. When changing the estimate of the useful life of an as-
crease in value be recognized immediately, or should set, should depreciation expense for all the previous
the same amount of depreciation expense be recognized years be recalculated? If not, how do you account for a
as in past years? change in this estimate?
11. Accountants in other countries sometimes write up the 21. Why is it often necessary to recalculate the depletion
recorded amounts of long-term assets when their values rate for natural resources?




discussion cases


CASE 9-1 INTANGIBLE ASSETS
Renford Company owns two restaurants. One, located in Tacoma, was purchased from a pre-
vious owner and the other, located in Seattle, was built by Renford Company after purchasing
the franchise. The restaurant in Seattle has a $20,000 unamortized franchise on the books. (The
franchise originally cost $200,000 and is being amortized over 10 years.) The restaurant was
built nine years ago. The Tacoma restaurant was purchased last year and has goodwill of $550,000
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on the books. As it turns out, the Seattle restaurant does twice as much business as the Tacoma
restaurant and is much more profitable. The Seattle restaurant is in a prime location, and busi-
ness keeps increasing each year. The Tacoma restaurant does about the same amount of busi-
ness each year, and it doesn t look as if it will ever do any better. Does it make sense to you to
have goodwill on the books of the less profitable restaurant? Should Renford record goodwill on
the books of the Seattle restaurant, or should it write off the goodwill on the Tacoma restau-
rant s books (which is being amortized over a 20-year period)?




CASE 9-2 STRAIGHT-LINE VERSUS ACCELERATED DEPRECIATION
Dennis Company currently depreciates its assets using the straight-line method for both tax and
financial accounting. Total depreciation expense for this year will be $250,000 using straight-
line depreciation. A consultant has just advised the company that it should use accelerated de-
preciation methods for both tax and financial accounting because paying lower taxes is better
than recognizing higher income. Using accelerated depreciation methods, total depreciation ex-
pense this year would be $400,000. The company has an effective tax rate of 40%. Do you agree
with the consultant? Why or why not?




exercises


EXERCISE 9-1 ACQUISITION DECISION
Johnson Company is considering acquiring a new airplane. It has looked at two financing op-
tions. The first is to lease the airplane for 10 years with lease payments of $70,000 each year.
The second is to purchase the airplane, making a down payment of $250,000 and annual pay-
ments of $40,000 for 10 years. If the present value of the two financing options is the same,
what other factors must be considered in deciding whether to purchase or to lease?

EXERCISE 9-2 ACCOUNTING FOR THE ACQUISITION OF A LONG-TERM
ASSET
Chong Lai Company acquired a new machine in order to expand its productive capacity. The
costs associated with the machine purchase were as follows:
Purchase price . . . . . . . . . . . . $10,000
Installation costs . . . . . . . . . . 500
Cost of initial testing . . . . . . . 600
Sales tax . . . . . . . . . . . . . . . . 750

1. Make the journal entry to record the acquisition of the machine. Assume that all costs
were paid in cash.
2. Make the journal entry to record the acquisition of the machine. Assume that Chong Lai
Company signed a note payable for the $10,000 purchase price and paid the remaining
costs in cash.

EXERCISE 9-3 COMPUTING ASSET COST AND DEPRECIATION EXPENSE
Antique Furniture Company decided to purchase a new furniture-polishing machine for its
store in New York City. After a long search, it found the appropriate polisher in Chicago. The
machine costs $75,000 and has an estimated 10-year life and no salvage value. Antique Furni-
ture Company made the following additional expenditures with respect to this purchase:
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Sales tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000
Delivery costs (FOB shipping point) . . . . . . . . . 1,500
Installation costs . . . . . . . . . . . . . . . . . . . . . . . 2,200
Painting of machine to match the decor. . . . . . 300

1. What is the cost of the machine to Antique Furniture Company?
2. What is the amount of the first full year s depreciation if Antique uses the straight-line
method?

EXERCISE 9-4 ACQUISITION AND DEPRECIATION OF ASSETS
Western Oil Company, which prepares financial statements on a calendar-year basis, pur-
chased new drilling equipment on July 1, 2003, using check numbers 1015 and 1016. The
check totals are shown here, along with a breakdown of the charges.
1015 (Payee Oil Equipment, Inc.):
Cost of drilling equipment. . . . . . . . . . . . . . . $ 75,000
Cost of cement platform . . . . . . . . . . . . . . . . 25,000
Installation charges . . . . . . . . . . . . . . . . . . . . 13,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $113,000
1016 (Payee Red Ball Freight):
Freight costs for drilling equipment. . . . . . . . $ 2,000

Assume that the estimated life of the drilling equipment is 10 years and its salvage value is
$5,000.
1. Record the disbursements on July 1, 2003, assuming that no entry had been recorded for
the drilling equipment.
2. Disregarding the information given about the two checks, assume that the drilling equip-
ment was recorded at a total cost of $95,000. Calculate the depreciation expense for
2003 using the straight-line method.

EXERCISE 9-5 ACCOUNTING FOR LEASED ASSETS
On January 1, 2003, Hartmeyer Company leased a fax machine with a laser printer from
Teleproducts, Inc. The five-year lease is noncancelable and requires monthly payments of
$150 at the end of each month, with the first payment due on January 31, 2003. At the end
of five years, Hartmeyer will own the equipment. The present value of the lease payments at
the beginning of the lease is determined to be $6,740.
1. Prepare journal entries to record:
a. The lease agreement on January 1, 2003.
b. The first lease payment on January 31, 2003, assuming that $68 of the $150 pay-
ment is interest.
2. Now assume that the lease expires after one year at which time a new lease can be ne-
gotiated or Hartmeyer can return the equipment to Teleproducts. Prepare any journal
entries relating to the lease that would be required on January 1 and January 31,
2003.

EXERCISE 9-6 INTEREST CAPITALIZATION
Litton Company is constructing a new office building. Costs of the building are as follows:
Wages paid to construction workers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $185,000
Building materials purchased. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 456,000
Interest expense on construction loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,800
Interest expense on mortgage loan during the
first year subsequent to the building s completion . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000

Given the above costs, at what amount should the building be recorded in the accounting
records?
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EXERCISE 9-7 ACCOUNTING FOR THE ACQUISITION OF ASSETS BASKET
PURCHASE
Sealise Corporation purchased land, a building, and equipment for a total cost of $450,000.
After the purchase, the property was appraised. Fair market values were determined to be
$120,000 for the land, $280,000 for the building, and $80,000 for the equipment. Given
these appraisals, record the purchase of the property by Sealise Corporation.

EXERCISE 9-8 DEPRECIATION CALCULATIONS
Luric Company purchased a new car on July 1, 2002, for $15,000. The estimated life of the
car was four years or 104,000 miles, and its salvage value was estimated to be $2,000. The car
was driven 9,000 miles in 2002 and 27,000 miles in 2003.
1. Compute the amount of depreciation expense for 2002 and 2003 using the following
methods:
a. Straight-line.
b. Units-of-production.
2. Which depreciation method more closely reflects the used-up service potential of the car?
Explain.

EXERCISE 9-9 DEPRECIATION CALCULATIONS
Denver Hardware Company has a giant paint mixer that cost $31,500 plus $400 to install.
The estimated salvage value of the paint mixer at the end of its useful life in 15 years is esti-
mated to be $1,900. Denver estimates that the machine can mix 850,000 cans of paint dur-
ing its lifetime. Compute the second full year s depreciation expense, using the following
methods:
1. Straight-line.
2. Units-of-production, assuming that the machine mixes 51,000 cans of paint during the
second year.

EXERCISE 9-10 ACQUISITION AND IMPROVEMENT OF ASSETS
Prepare entries in the books of Sanmara, Inc., to reflect the following. (Assume cash transactions.)
1. Purchased a lathing machine to be used by the firm in its production process.
Invoice price . . . . . . . . . . . . . $45,000
Cash discount taken . . . . . . . 900
Installation costs . . . . . . . . . . 1,200
Sales tax on machine . . . . . . 1,800

2. Performed normal periodic maintenance on the lathing machine at a cost of $200.
3. Added to the lathing machine a governor costing $400, which is expected to increase the
machine s useful life.

EXERCISE 9-11 ASSET IMPAIRMENT
Consider the following three independent scenarios:

1 2 3

Original cost of asset . . . . . . . . . . . . . . . $1,400 $1,400 $1,400
Accumulated depreciation . . . . . . . . . . . . 400 400 400
Sum of future cash flows . . . . . . . . . . . . 1,500 1,500 900
Fair value of the asset . . . . . . . . . . . . . . . 1,100 800 800


1. For each of the three scenarios, answer the following questions:
a. Is the asset impaired?
b. At what amount (net of accumulated depreciation) should the asset be reported?
2. Make the journal entry required in Scenario 3.
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EXERCISE 9-12 ASSET IMPAIRMENT
In 1998, Rhode Company purchased land and a building at a cost of $800,000, of which
$200,000 was allocated to the land and $600,000 was allocated to the building. As of De-
cember 31, 2002, the accounting records related to these assets were as follows:
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $200,000
Building . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000
Accumulated Depreciation, Building . . . . . 100,000

On January 1, 2003, it is determined that there is toxic waste under the building and the fu-
ture cash flows associated with the land and building are less than the recorded total book
value for those two assets. The fair value of the land and building together is now only
$100,000, of which $40,000 is land and $60,000 is the building. How should this impair-
ment in value be recognized? Make the entry on January 1, 2003, to record the impairment
of the land and building.

EXERCISE 9-13 ACCOUNTING FOR THE DISPOSAL OF ASSETS
Zimer Concrete Company has a truck that it wants to sell. The truck had an original cost of
$60,000, was purchased three years ago, and was expected to have a useful life of five years
with no salvage value.
Using straight-line depreciation, and assuming that depreciation expense for three full
years has been recorded, prepare journal entries to record the disposal of the truck under each
of the following independent conditions:
1. Zimer Concrete Company sells the truck for $25,000 cash.
2. Zimer Concrete Company sells the truck for $20,000 cash.
3. The old truck is wrecked and Zimer Concrete Company hauls it to the junkyard.

EXERCISE 9-14 DISPOSAL OF AN ASSET
Honey Bee Company purchased a machine for $91,000. The machine has an estimated useful
life of seven years and a salvage value of $7,000. Journalize the disposal of the machine under
each of the following conditions. (Assume straight-line depreciation.)
1. Sold the machine for $72,000 cash after two years.
2. Sold the machine for $28,000 cash after five years.

EXERCISE 9-15 ACCOUNTING FOR INTANGIBLE ASSETS
Gaylord Research, Inc., has the following intangible assets:

Expected Useful
Asset Cost Date Purchased or Legal Life

Goodwill . . . . . . . . . . . . . . . . . . . . . . . $ 16,000 January 1, 1994 20 years
Patent . . . . . . . . . . . . . . . . . . . . . . . . . 136,000 January 1, 1996 17 years
Franchise . . . . . . . . . . . . . . . . . . . . . . 180,000 January 1, 1997 10 years


1. Record the amortization expense for each of these intangible assets for 2003.
2. Prepare the intangible assets section of the balance sheet for Gaylord Research, Inc., as of
December 31, 2003.

EXERCISE 9-16 INTANGIBLE ASSETS
On January 1, 2002, Landon Company purchased a franchise to operate a regionally owned
fast-food restaurant for a cost of $250,000. On July 1, 2002, Landon Company purchased
another existing business in a nearby city for a total cost of $750,000. The market value of
the land, building, and equipment, and other tangible assets was $550,000. The excess
$200,000 was recorded as goodwill, to be amortized over a 20-year period.
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Assuming Landon Company amortizes franchises over a 10-year period, record the fol-
lowing:
1. The purchase of the franchise on January 1, 2002.
2. The amortization of the franchise and goodwill at December 31, 2002.
3. The amortization of the franchise and goodwill at December 31, 2003.

EXERCISE 9-17 COMPUTING GOODWILL
Stringtown Company purchased Stansbury Island Manufacturing for $1,800,000 cash. The
book value and fair value of the assets of Stansbury Island as of the date of the acquisition are
listed below:

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