Financial Accounting
A Decision-Making Approach, 2nd Edition
King, Lembke, and Smith
*
Prepared by
Dr. Denise English,
Boise State University
John Wiley & Sons, Inc.
CHAPTER
TEN
OPERATING ASSETS AND
INTANGIBLES
After reading Chapter 10, you should be able to:
1. Describe long-lived nonfinancial assets and their importance for
decision making.
2. Describe the valuation methods used for long-lived nonfinancial assets
both at acquisition and after acquisition, and explain how these
methods facilitate decision making.
3. Explain how intangible assets differ from tangible assets; describe the
similarities and differences in accounting and reporting for tangible
and intangible assets, and describe how they might affect decision
making.
4. Define key ratios and indicators for financial analysis related to longlived nonfinancial assets, and use these ratios and indicators to
understand a company’s activities and financial position.
5. Describe the different means of financing asset acquisitions, and
indicate the important considerations for decision making relating to
financing asset acquisitions and reporting for them.
Understanding Operating Assets

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Operating assets are those used in a
company’s central activities and are often
labeled fixed assets or property, plant, and
equipment.
Operating assets are tangible in nature
because they have physical existence.
Operating assets are long-lived because they
are expected to last beyond a single period or
operating cycle.
Operating Asset Evaluation Measures
Operating assets are usually costly, and an evaluation of
them often focuses on whether they are being used
efficiently and profitably. A commonly used measure of
profitably is:
Return on Assets
Net Income
$1,500,000
= ---------------------------- = ---------------- = 15%
Average Total Assets $10,000,000
A high return on assets relative to other investment
alternatives signals a good use of investment capital.
Inventory Evaluation Measures
Some companies separate the return on assets
calculation into two components that contribute to
Return on Assets:
Net Income
Sales
Net Income
---------------- X --------------------------- = ----------------------------Sales
Average Total Assets
Average Total Assets
The first component is Margin on Sales indicating
the portion of sales remaining as profit after
expenses. The second component is Asset
Turnover, a measure of the effectiveness with
which assets are used.
Inventory Evaluation Measures
A similar measure to Asset Turnover is Fixed
Asset Turnover, calculated as follows:
Fixed Asset Turnover =
Sales
----------------------------Average Fixed Assets
The higher the turnover, the more efficient the
enterprise is in generating revenues using its
current investment in property, plant, and
equipment.
How
much?
Determining Operating Asset Cost

The cost of operating assets includes all costs
necessarily incurred to acquire those assets
such as:
– Shipping charges borne by the purchaser;
– Transfer costs such as legal fees;
– Costs of preparing operating assets for their
intended use;
– Interest costs incurred on borrowing when
operating assets are constructed over an
extended period of time.
Matching the Costs of
Operating Assets

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All operating assets with the exception of land have
lives that are limited by wear and tear, deterioration,
and obsolescence.
When operating assets are no longer useful to the
company, they are sold or scrapped; any proceeds
upon disposal are referred to as salvage value.
Operating assets’ net cost or depreciable base is
the difference between cost and salvage value.
Depreciation is the process used to match the
expired net cost of the operating asset against the
benefits it provides during its useful life.
Allocating the Cost of Operating Assets
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The allocation of the cost of a tangible operating asset
to the periods benefiting from its use is referred to as
depreciation.
In order to maintain the historical cost of operating
assets in the accounts, a separate account called
Accumulated Depreciation (a contra-asset account) is
used in which the amounts of the asset cost that have
expired are accumulated.
The book value of an asset is the amount at which the
asset is reported on the balance sheet and is equal to
the original cost of the asset minus the accumulated
depreciation to date.
We Deliver
Allocating the Cost of Operating Assets:
an Example
A delivery van costing $40,000 expected to last 5 years, after
which it will have a salvage value of $3,000, is anticipated to
provide equal benefits each year of its life.
Annual Adjusting Entry:
Depreciation expense
Accumulated Depreciation
Balance Sheet Presentation after 4 years:
Equipment
Less Accumulated Depreciation
Book value
$ 7,400
$ 7,400
$ 40,000
(29,600)
$ 10,400
======
We Deliver
Depreciation Methods
The depreciation methods used most commonly
for financial reporting are:
1) Straight-line
2) Declining-balance
3) Activity-based depreciation.
The first two methods are calculated based upon
the passage of time, while the third is based
upon the usage of the asset.
We Deliver
Straight-Line Depreciation

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An equal amount of cost is allocated to each period
benefited and is reported as Depreciation Expense in
the income statement (as in the earlier example for the
delivery van).
This method is appropriate when the asset provides
approximately equal benefits each period.
The depreciation expense each period is equal to the
depreciable base (cost minus salvage value) divided by
its expected useful life.
We Deliver
Declining-Balance Depreciation
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Many assets are expected to provide greater benefits,
be more efficient and effective, and cost less for repairs
and maintenance in their earlier years.
Declining-balance depreciation is an accelerated
depreciation because it allocates more cost to early
years and less to later years.
Using declining-balance depreciation, a constant
percentage is applied each year to the decreasing book
value (cost minus accumulated depreciation) of the
asset. Thus, the amount of depreciation each year is
less as the book value decreases.
We Deliver
Declining-Balance Depreciation

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The percentage of depreciation taken each year depends on
how fast the asset is to be depreciated. Two common rates are
200% and 150% because these are also acceptable for tax
reporting.
If a delivery van costing $40,000 is to be depreciated over a 5year life at a 200% rate, and is assumed to have a $3,000
salvage value, the calculations would be as follows:
Year 1 (2.00 x 1/5) x ($40,000)
= $16,000
Year 2 (2.00 x 1/5) x ($40,000 - $16,000)
= $ 9,600
Year 3 (2.00 x 1/5) x ($40,000 - $25,400)
= $ 5,760
Year 4 (2.00 x 1/5) x ($40,000 - $31,360)
= $ 3,456
Year 5 Depreciate down to salvage ($3,000)
= $ 2,184
We Deliver
Activity-Based Depreciation


Depreciation can be based on usage rather than
the passage of time. The service-hours
depreciation method bases the computation on
the ratio of number of hours the asset was used
during the year to the total number of hours
expected in its service life.
The units-of-production method is similar but is
based on the number of units produced during the
current period as a percent of the total expected
production from the asset over its useful life.
We Deliver
Activity-Based Depreciation
If the same $40,000 van, estimated to last for 100,000
miles, was driven 25,000, 18,000, 20,000, 15,000 and
12,000 miles respectively during the first 5 years, the
depreciation calculations would be:
Year 1 (25,000/100,000) x ($40,000 - $3,000) = $9,250
Year 2 (18,000/100,000) x ($40,000 - $3,000) = $6,660
Year 3 (20,000/100,000) x ($40,000 - $3,000) = $7,400
Year 4 (15,000/100,000) x ($40,000 - $3,000) = $5,550
Year 5 (12,000/100,000) x ($40,000 - $3,000) = $4,440
We Deliver
Comparison of Depreciation Methods
Depreciation
Method
Description
Van Example
Year 1
Depreciation
Expense
Premise
Straight-line
Equal depreciation
expense each year
$7,400
Constant passage
of time
Decliningbalance
Constant depreciation
rate applied to
declining book value
$16,000
Accelerated
passage of time
Activity-based
Percentage of actual
to expected usage
applied to depreciable
base
$9,250
Varied based
upon actual usage
Depreciation and Income Taxes

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Depreciation reduces taxable income, but does
not require a cash outflow for the expense.
Thus, depreciation reduces the cash outlay for
income taxes paid, thereby providing a “tax
shield”.
Accelerated depreciation methods are preferred
because the tax savings are experienced sooner,
rather than later (and the time value of money is
important!).
Depreciation and Income Taxes

With few exceptions, a Modified Accelerated Cost
Recovery System (MACRS) is used for federal tax
reporting. It requires:
– Shorter depreciation periods for various categories of
assets;
– Salvage value be ignored in the computation;
– Either double-declining or 150-percent-declining
balance depreciation be used, depending upon asset
type, with a switch to straight-line in the year when it
becomes greater.
– Straight-line depreciation for longest-life asset
categories.
Depreciation of
Manufacturing Assets

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All costs of producing inventory must become part
of the cost of goods produced; thus, the cost of
depreciable assets such as factory buildings and
equipment used in the production of inventory
must be assigned to units of inventory.
The costs become part of Cost of Goods Sold
when the inventory is sold.
No depreciation expense related to manufacturing assets is reported directly in the
Income Statement because of its inclusion in Cost
of Goods Sold.
Depletion: Matching the
Costs of Natural Resources

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Resource-bearing land is acquired at a cost that includes the
value of anticipated recoverable resources contained within.
The land is generally less valuable after the resources are
removed (salvage value), and the net cost (cost – salvage)
should be matched with the benefits provided.
Depletion is the process of allocating the net cost of the land
to the units of the natural resources as part of the cost of the
natural resource. Depletion costs will not be seen as a
separate line item on the income statement, but are a part of
the cost of the resources sold.
Depletion costs are allocated on a units-of-production basis
by dividing the total cost to be allocated by the number of units
of resources expected to be extracted.
Depletion: an example
Texas Gold, Inc. acquired an oil well for $34,000,000 containing an
estimated 7 million barrels of crude oil and spent an additional
$1,400,000 preparing it for production. The salvage value is estimated to
be $1,000,000. During the first year, 1,200,000 barrels of oil were
produced and sold. Depletion would be calculated as follows:
Cost ($34,000,000 + $1,400,000) – Salvage ($400,000)
---------------------------------------------------------------------------- =
Estimated resources of 7,000,000 barrels
$5.00 per barrel depletion as part of the Cost of Resources Sold.
If other production costs per barrel are $2.50, then total costs of production are ($5.00 + $2.50) = $7.50 per barrel. For the first year, $7.50
x 1,200,000 barrels = $9,000,000 Cost of Resources (Goods) Sold
would be expensed.
For Sale
Disposals and Impairments
of Operating Assets
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Once specific operating assets are no longer
needed, they are usually sold or scrapped.
The difference between the proceeds received
(if any) and the book value (cost minus
accumulated depreciation or depletion)
requires a gain (or loss) be recognized.
Such gains and losses are not typically
recurring income and thus their importance in
the net income presentation is less significant.
For Sale
Disposals and Impairments
of Operating Assets


Assets Held for Disposal—when no longer used
these assets must be written down to net realizable
value (expected sales proceeds minus costs of
disposal) if less than book value. They are no longer
depreciated if not in use, and must be revalued to net
realizable value each year if still held.
Asset impairments—an asset currently in use may
become impaired, meaning that the expected future
cash flow from using and ultimately selling it are less
than its current book value. The asset must be
immediately written down to its fair value and a loss
recognized in the income statement.
Rights
Intangible Assets

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
Generally, accounting for intangibles that confer rights
requires the same accounting treatment as other longlived operating assets—they are recorded initially at
cost, and that cost is matched with the benefits provided
through a process of amortization.
Amortization is similar to depreciation, but GAAP limits
the useful life of an intangible to 40 years. Typically a
straight-line method is used and amortization is
deducted directly from the intangible account.
The value of intangibles is subject to scrutiny because
of the tentative nature of the economic benefits they
provide.
Research and
Development Costs

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
Research and development costs incurred to
discover new knowledge and develop new
products (or improve existing ones) are expected
to provide future benefits.
Because of the uncertainty of realizing the future
benefits, however, the FASB requires all such
costs to be expensed as incurred.
For some companies these costs are significant,
but necessary if the company hopes to survive in
the long run. Net income will be impaired in the
short-run for (hopefully) long run improvement.
ABC
Company
Goodwill



buys
123
Company
ABC123 Company
An intangible asset of particularly tenuous nature is
Goodwill. It is the combination of all those factors (location,
reputation, management) that make the value of an ongoing
business higher than the total value of the individual assets.
Goodwill is only recorded when one company purchases
another in a business combination, and is measured as the
difference between the total price paid for the business and
the fair value of the individual identifiable assets less the
liabilities acquired.
Goodwill must be amortized over the period of time
benefiting from the excess earning power acquired, not to
exceed 40 years.
Nonfinancial Asset Disclosures
In addition to the financial statement numbers,
several other disclosures pertaining to nonfinancial assets are required:
–
–
–
the valuation basis for each type of nonfinancial asset;
the amortization methods for limited-life assets and the
amortization periods;
creditor’s claims on assets, including details of asset
financing arrangements and required future cash
payments.
Financing Asset Acquisitions


Because operating assets are very costly, how
asset acquisitions are financed may determine
whether certain assets are acquired, and the
profitability of the acquisition itself.
Two areas of interest affected by financing
arrangements are tax benefits and loan security.
Tax benefits can be acquired through buying and
depreciating or “renting” through an operating
lease arrangement. Security of the loan for the
lender can be enhanced by establishing the
asset as collateral for the loan.
Leasing Assets
There are two types of lease arrangements:
1) An operating lease exists when the lease arrangement
resembles a rental agreement. A more flexible commitment
exists and rent expense (lessee) and rental income (lessor) is
recognized to be more indicative of the nature of the lease
agreement.
2) A capital lease exists when most of the risks and rewards of
ownership transfer from the lessor to the lessee. It is a longterm arrangement and resembles the lessee borrowing to buy
the asset. The accounting for such a lease is similar to an
installment purchase of an asset whereby the asset and a
related liability are recorded at the present value of the future
lease payments.
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