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Chapter 8 – Long-Lived Tangible
and Intangible Assets: The Source of
Operating Capacity
FINANCIAL ACCOUNTING
AN INTRODUCTION TO CONCEPTS,
METHODS, AND USES
10th Edition
Clyde P. Stickney and Roman L. Weil
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Learning Objectives
1. Understand the concepts distinguishing expenditures
capitalized as assets from expenditures expensed.
2. Understand the concepts of measurement of cost.
3. Understand depreciation and amortization as a process
of cost allocation, not one of valuation.
4. Develop the skills to compute depreciation or
amortization under various commonly used methods.
5. Develop the skills to re-compute depreciation or
amortization for changes in estimates.
6. Develop the skills to compute an impairment loss on
long-lived assets.
7. Develop the skills to record the retirement of assets.
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Chapter Outline
1. Capitalization versus expensing.
2. Acquisition costs.
3. Depreciation and amortization.
4. Depreciation methods.
5. Impact of new information.
6. Retirement of assets.
7. Intangible assets.
8. International perspective.
Chapter Summary
9. Appendix 8.1: Effects of Transactions Involving Plant and Intangible Assets on Cash Flows
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1. Capitalization versus Immediate Expensing
Should firms treat expenditures as:
1. Expenses in the period incurred, or
2. Assets (that is, capitalize the cost).
An expenditure is an asset if the firm:
1. has acquired rights to future use as the
result of a past transaction, and
2. can measure or quantify the future
benefits.
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1.a. Patterns of Expiration of Costs
Recognizing the expiration of the cost of an asset
need not be linear. There are many other patterns
each with some advantages and disadvantages. The
following summarized the possibilities:
A. accelerated depreciation
S. straight-line depreciation
D. decelerated depreciation
E. expense immediately
N. no depreciation
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2. Acquisition Costs
The acquisition value of an asset is either:
 The fair value of what was given up in exchange
for the asset (such as cash), or
 The fair value of what was received
 Which ever is more easily determined.
The acquisition value is all inclusive, that is, it
includes all costs of acquiring and putting the asset in
to use.
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3. Depreciation and Amortization
Depreciation
 Purpose of depreciation
 Allocation of cost
 Process of cost allocation
 Return of capital
 Conceptual discussion
 Depreciation is not a decline in value
The causes of the process requiring depreciation
Issues in depreciation accounting
1. Measuring the depreciable basis of the asset
2. Estimating its useful service life
3. Deciding on the pattern of expiration of asset cost
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3.a. Measuring the Depreciable
Basis of Plant Assets
Cost less salvage value
Measuring cost -- all inclusive basis
 Assets acquired in a swap for other assets may be
difficult to value,
 Asset value includes all costs necessary to acquire and
put the asset into use,
 Assets that are constructed by the firm may be difficult
to measure but do include certain financing charges.
Estimating salvage value -- estimate of a market price into
the distant future. Rarely, salvage values may be negative if
disposal costs are very high.
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3.b. Useful Service Life
Most difficult task in depreciation
Because obsolescence typically results from forces outside the
firm
Accountants reconsider assets’ estimated service lives every
few years
Tax reporting dictates useful lives for classes of assets for tax
filing purposes but not for financial reporting purposes
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4. Depreciation Methods
Depreciation methods systematically allocate the cost of the
asset (less its estimated salvage value) over the useful service
life of the asset. Not all patterns of expiration costs are used.
The expense immediately pattern is used in cases where the
future benefit is uncertain.
The no-depreciation option is used almost exclusively to value
land.
Most firms are currently using straight-line for financial
reporting purposes.
The U.S. income tax code requires a version of accelerated
expiration called modified accelerated cost recovers system
(MACRS).
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4. Depreciation Methods (Cont.)
Common methods used in financial reporting are:
1. Straight-line (time) method, pattern S.
2. Units-of-production method, straight line against
production rather than time, pattern S.
3. Accelerated methods, pattern A.
a. Declining-balance methods (typically double declining
balance)
b. Sum-of-the-years’-digits methods
c. Modified accelerated cost recovery system (income tax
reporting).
4. Decelerated methods are very rare.
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4.a. Straight-Line (Time) Depreciation
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Probably the most common method for financial reporting.
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Intuitive and long history of use
Ease of computation
Reduces expense to a minimum (assuming decelerated methods
are not allowed) thus increasing reported income
Not consistent with a discounted cash flow (or present value)
assumption
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4.b. Straight Line Depreciation:
An Example
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Problem for self study 8.2
Markam Corp acquires a new machine costing $20,000 of
year 3. The firm expects to use the machine for 5 years and
that the salvage value will be $2,000.
1. The straight line rate would be 1/( 5 years) or 20%
2. The basis to be depreciated is cost minus salvage or $18,000
year
1
2
3
4
5
beginning
net book
balance
$20,000
16,400
12,800
9,200
5,600
basis
$18,000
18,000
18,000
18,000
18,000
depreciation
ending
charge
accum.depr. net book
20% of basis after charge balance
$3,600
$3,600 $16,400
3,600
7,200
12,800
3,600
10,800
9,200
3,600
14,400
5,600
3,600
18,000
2,000
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4.c. Units of Production Depreciation
The exhaustion of some assets can be measured by units of
output or production. This may serve as a better measure than
time.
For example, a delivery truck may be good for 200,000 miles
before wear and tear make it uneconomically useful. It may
matter little whether the miles are driven in a few years or
many.
In these cases, depreciation based on units may be useful.
annual
cost - salvage value
units used
=
* in year
depreciation
service life (in units)
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4.d. Units of Production Depreciation:
An Example
Markam Corp acquires a new machine costing $20,000. Engineers
say the machine should run for 24,000 hours and that the salvage
value will be $2,000. The firm expects to run the machine for 5,000
hours for the first 4 years and for 4,000 hours during the last.
1. The basis to be depreciated is cost minus salvage or $18,000
2. The per hour unit rate would be $18,000/( 24,000 hours) or
$0.75 per hour
year
1
2
3
4
5
beginning
net book
balance
$20,000
16,250
12,500
8,750
5,000
hours
5,000
5,000
5,000
5,000
4,000
depreciation
ending
charge
accum.depr. net book
$0.75*hours after charge balance
$3,750
$3,750 $16,250
3,750
7,500
12,500
3,750
11,250
8,750
3,750
15,000
5,000
3,000
18,000
2,000
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4.e. Accelerated Methods
The earning power of some assets declines as they age.
In these cases, accelerated depreciation methods may be useful.
Some of the accelerated methods such as a present value
computation are computationally intense; that is, they require a
lot of calculations.
For this reason as well as some historical reasons, three
methods are generally used which produce accelerated
depreciation but are relatively easy to compute:
a. Declining-balance methods (typically double declining
balance)
b. Sum-of-the-years’-digits methods
c. Modified accelerated cost recovery system (income tax
reporting)
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4.f. Declining-Balance Methods
Depreciation charge is calculated as a fixed rate times the net
book value of the asset
 Net book value is cost reduced by accumulated depreciation
but not reduced by salvage value
 This is one of the very rare methods that does not subtract
salvage value
 The reason is that the method produces declining
depreciation charges and when the net book value is equal
to salvage, no further depreciation is taken.
 So this method does reduce the net book value to salvage
The fixed rate must be greater than the straight line rate for
the depreciation to be accelerated
Depreciation charges are greater in early years
4.g. Declining Balance Method:
An Example
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Markam Corp acquires a new machine costing $20,000. The firm
expects to use the machine for 5 years and that the salvage value
will be $2,000.
1. The straight line rate would be 1/( 5 years) or 20%
2. Double declining balance uses a fixed rate of twice the straight
line rate, or 40%
year
1
2
3
4
5
beginning
ending
net book
depreciation
accum.depr. net book
balance
charge
after charge balance
$20,000
$8,000 *
$8,000 $12,000
12,000
4,800 *
12,800
7,200
7,200
2,880 *
15,680
4,320
4,320
1,160 **
16,840
3,160
3,160
1,160 **
18,000
2,000
* 40% of net book value
** switch to straight line, one half of $4,320 per year
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4.h. Sum of Years’ Digits Methods
 Depreciation
charge is calculated as a variable rate
times the basis of the asset
 The basis of the asset is cost less salvage value and
it is constant
 The variable rate is equal to the number of years
remaining (including the current year) divided by
the sum of the years’ digits
 The sum of the years’ digits is the sum of the
numbers 1, 2, 3, …, up to and including the last
year of useful life
 For a 5 year useful life, the sum is 1+2+3+4+5 = 15
4.i. Sum of Years’ Digits Methods:
An Example
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Markam Corp acquires a new machine costing $20,000. The firm
expects to use the machine for 5 years and that the salvage value
will be $2,000.
1. Basis is $20,000 - $2,000 = $18,000
2. The sum of the years’ digits is 1+2+3+4+5 = 15
3. The rate is the remaining years / the sum of the years’ digits
year
1
2
3
4
5
remaining
years
5
4
3
2
1
rate
5/15
4/15
3/15
2/15
1/15
basis
$18,000
18,000
18,000
18,000
18,000
accum.depr. ending
after charge net book
(rate * basis) balance
$6,000 $14,000
4,800
9,200
3,600
5,600
2,400
3,200
1,200
2,000
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4.j. Modified Asset Cost Recovery Method
This method is used for U.S. income tax reporting and not for
financial reporting.
The rates for each year are given by statue for each class of
assets.
The method is based on accelerated declining balance methods
with only partial depreciation recognized in the first year.
Basically, the IRS specifies the depreciation schedule and the
tax payer has little control over the method, the rate or the
useful life.
MACRS ignores salvage values. When the asset is disposed,
any proceeds are taxed as a gain.
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4.j. Modified Asset Cost Recovery Method:
An Example
Markam Corp acquires a new machine costing $20,000. The IRS
classified the machine as a 5-year asset.
1. Basis is $20,000
2. The rates are given in IRS publications
3. Notice that the first year of depreciation only gets a part of the
year of a charge and that the missing half is made up in the
sixth calendar year
year
1
2
3
4
5
6
rate from
depreciation accum.depr. ending
IRS
charge
after charge net book
schedule
basis
rate*basis (rate * basis) balance
20.0% $20,000
$4,000
$4,000 $16,000
32.0% 20,000
$6,400
10,400
9,600
19.2% 20,000
$3,840
14,240
5,760
11.5% 20,000
$2,300
16,540
3,460
11.5% 20,000
$2,300
18,840
1,160
5.8% 20,000
$1,160
20,000
0
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5. Impact of New Information
Depreciation and amortization are based on
knowledge at the time of the initial acquisition,
however, these methods should be updated
when new information becomes available.
 Changes in expected service lives or salvage
values.
 Additional expenditures to maintain or
improve the assets.
 Changes in the market value of assets.
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6. Retirement of Assets
When the asset is removed from service, either sold or disposed, the
accounts need to reflect this change. There are three adjustments:
The asset account must be closed (removed)
 The accumulated depreciation account for that asset must also
be closed (removed)
 And any gain or loss on retirement needs to be recognized.
If the depreciation schedule was perfect, the asset value less the
accumulated depreciation would equal exactly the salvage value.
Differences give rise to a gain (if a credit) or a loss (if a debit).
cash (received or asset)*
accum.depr (to remove the account)
loss on retirement (plug)
equipment (to remove the asset)
$1,500
3,000
300
5,000
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7. Intangible Assets and Amortization
Assets may provide future benefits without having physical
form; for example, a patent or copyright.
Such assets are called intangible assets.
Intangible assets may have a limited life. Patents expire after
20 years in the U.S.
Intangible assets are reduced in value in recognition of this
limited life. The revaluation is similar to depreciation but is
called amortization.
Specific examples of intangibles are
a. Research and development
b. Patents
c. Advertising
d. Goodwill
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7. Intangible Assets (Cont.)
Accountants face two key issues with regards to intangible
assets:
 Have the expenditures made to acquire or develop the
intangible asset generated sufficient future benefits that the
expenditures should be capitalized?
 Have the expenditures produced no future benefit for the
firm or benefits so hard to quantify or measure that the the
expenditures should be expensed.
Intangibles are generally amortized on a straight line basis
based on time.
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7.a. Research and Development (R&D)
Research and development are expenditures for knowledge that
may increase the competitiveness of the firm in the future.
Examples include the development of new pharmaceuticals,
new technologies, new manufacturing methods, and general
scientific endeavors.
GAAP is very conservative on the question of R&D. Such
expenditures are considered so difficult to measure and future
benefits are generally so uncertain that U.S. GAAP requires
expensing of the expenditure in the year of the expenditure.
This requirement is quite controversial and some managers
argue that forcing them to expense R&D discourages them
from investing in R&D.
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7.b. Patents
A patent  is a right granted by a government for exclusive use
and benefits for and invention for a limited time.
The U.S. has been extending the definition of what qualifies as
an invention to include what are called intellectual property
rights. U.S. Patents may now cover ideas, mathematical
formulas and (in one case at least) a very large prime number.
Copyrights  are similar but are not inventions, rather they are
rights given for exclusive use of an artistic design or words.
Music, photographs, and famous people are sometimes
copyrighted.
Trademarks, TM, are similar but are specific identifiers for
firms.
Patents in the U.S. are generally amortized over 20 years using
a straight line method.
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7.c. Advertising
Advertising is expenditures to inform potential customers
about the product or services of the firm.
It is hoped that an informed potential customer will be more
likely to purchase from the firm.
The benefits of successful advertising may extend for many
periods into the future, however, any such benefits are very
difficult to measure.
GAAP requires immediate expensing of most advertising costs
because:
 This is more conservative than capitalization
 Any future benefits are difficult to measure
 For many firms, advertising costs are fairly stable
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8. An International Perspective
Accounting for plant assets around the world is similar to U.S.
accounting. Some countries allow for inflation adjustments to
the value of the asset. Rarely the adjustment may be to a
market value.
Depreciation accounting is similar for most countries. Where
financial reporting is more closely linked to tax accounting,
accelerated depreciation is common.
The IASC allows capitalization of development costs under
some conditions.
Specific laws relating to length of time for patents, trademarks,
copyrights may vary as to what is recognized and how long any
benefits last.
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Chapter Summary
Long lived assets include plant assets, natural resources (or
wasting assets) and intangibles.
Each class presents similar accounting problems:
 How to determine the amount to be capitalized including
whether to capitalize or expense,
 How to estimate any future benefit,
 How to amortize the capitalized amount over the expected
time of benefits.
Intangible assets have value even though they may lack a
physical presence. This value and the length of time of any
future benefits may be very difficult to measure.
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Appendix 8.1: Effects of Transactions Involving Plant and Intangible Assets on Cash Flows
Retirement entries -- retirement may result in cash inflows or
even cash outflows if the assets have a high disposal cost. These
cash flows along with removing the asset account show up in
the investing section of the cash flow statement; removing the
accumulated depreciation account along with any gain or loss
appear in the operating cash flow section. Net cash flows is
unchanged but amounts may be moved from one section of the
cash flow statement to another.
Depreciation and amortization charges -- because both are
noncash expenses, they are added back and appear in the
operating section of the cash flow statement.
Noncash acquisition of assets -- barter trade would not show in
the cash flow statement because the amount given would cancel
the amount received.
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1. Plant Assets
Plant assets and fixed assets are sometimes used
interchangeably.
Both are long-lived assets and include land, buildings,
machinery and equipment.
Plant assets includes more than just the manufacturing
building.
Fixed assets includes more than just immobile assets. Also,
fixed in this usage does not mean non-variable.
Two main issues with plant assets are
1. How to measure the acquisition value of the asset
2. How to measure the assets utilization over time
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5. Repairs and Improvements
Repairs and improvements both require expenditures.
Repairs generally restore usefulness. As such, repairs are
expensed in the period they occur.
Improvements generally increase usefulness. As such,
improvements can either
 Increase the useful life of the asset in which case the offset
to the expenditure (a credit) would be a debit to
accumulated depreciation (a debit) which allows the asset
to be depreciated for a longer time.
 Increase the output of the asset in which case the offset
could be to the cost of the asset and a new depreciation
schedule would have to be determined.