Financial & Managerial Accounting 2002e Belverd E. Needles, Jr. Marian Powers Susan Crosson ----------Multimedia Slides by: Harry Hooper Santa Fe Community College Copyright © by Houghton Mifflin Company. All rights reserved. 1 Chapter 10 Long-Term Assets LEARNING OBJECTIVES 1. Identify the types of long-term assets and explain the management issues related to accounting for them. 2. Distinguish between capital and revenue expenditures, and account for the cost of property, plant, and equipment. 3. Define depreciation, state the factors that affect its computation, and show how to record it. Copyright © by Houghton Mifflin Company. All rights reserved. 3 LEARNING OBJECTIVES (continued) 4. Compute periodic depreciation under the straight-line method, production method, and declining-balance method. 5. Account for the disposal of depreciable assets not involving exchanges. 6. Account for the disposal of depreciable assets involving exchanges. Copyright © by Houghton Mifflin Company. All rights reserved. 4 LEARNING OBJECTIVES (continued) 7. Identify the issues related to accounting for natural resources and compute depletion. 8. Apply the matching rule to intangible assets, including research and development costs and goodwill. Copyright © by Houghton Mifflin Company. All rights reserved. 5 SUPPLEMENTAL OBJECTIVES 9. Apply depreciation methods to problems of partial years, revised rates, groups of similar items, special types of capital expenditures, and cost recovery. Copyright © by Houghton Mifflin Company. All rights reserved. 6 Management Issues Related to Accounting for Long-Term Assets OBJECTIVE 1 Identify the types of long-term assets and explain the management issues related to accounting for them. Characteristics of Long-Term Assets Long-term assets are assets that: Have a useful life of more than one year. Are acquired for use in the operation of a business. Are not intended for resale to customers. Must be capable of repeated use for a period of at least one year. Support the operating cycle instead of being a part of it. Are reported at carrying (book) value. Carrying value is the unexpired part of the cost of an asset. Copyright © by Houghton Mifflin Company. All rights reserved. 8 Assets not used in the normal course of business, such as speculative investments, should be classified as long-term investments, not property, plant and equipment. Asset impairment occurs when the sum of the expected cash flows from the asset is less than the carrying value. The carrying value is reduced to fair value, and the reduction in carrying value is recorded as a loss. Copyright © by Houghton Mifflin Company. All rights reserved. 9 Long-Term Assets as a Percentage of Total Assets for Selected Industries Copyright © by Houghton Mifflin Company. All rights reserved. 10 Deciding to Acquire Long-Term Assets A capital budgeting decision. Decision is based on analyzing: The present value of the future positive and negative cash flows. The costs of training and maintenance. The possibility that the expected savings may not occur. Information on acquisitions of long-term assets is found under investing activities in the statement of cash flows. Copyright © by Houghton Mifflin Company. All rights reserved. 11 Classification of Long-Term Assets and Corresponding Expenses Copyright © by Houghton Mifflin Company. All rights reserved. 12 Carrying Value of Long-Term Assets on Balance Sheet Copyright © by Houghton Mifflin Company. All rights reserved. 13 Financing Long-Term Assets Financing alternatives: Use cash flows from operations. Take a long-term loan. Issue common stock. Issue long-term notes. Issue bonds. Copyright © by Houghton Mifflin Company. All rights reserved. 14 Applying the Matching Rule to Long-Term Assets Two important issues must be resolved. 1. How much of the total cost to allocate to expense in the current accounting period. 2. How much to retain on the balance sheet as an asset to benefit future periods. Copyright © by Houghton Mifflin Company. All rights reserved. 15 Questions about the Acquisition, Use, and Disposal of Each Long-Term Asset 1. How is the cost of the long-term asset determined? 2. How should the expired portion of the cost of the long-term asset be allocated against revenues over time? 3. How should subsequent expenditures, such as repairs and additions, be treated? 4. How should disposal of the long-term asset be recorded? Copyright © by Houghton Mifflin Company. All rights reserved. 16 Issues of Accounting for Long-Term Assets Copyright © by Houghton Mifflin Company. All rights reserved. 17 It is helpful to think of a long-term asset as a long-term prepaid expense. Spread the cost of the services provided by the asset over its useful life. As the services benefit the company, the cost of the asset becomes an expense. Copyright © by Houghton Mifflin Company. All rights reserved. 18 Discussion Q. What are the characteristics of long-term assets? A. Long-term assets have a useful life of more than one year, are acquired for use in the operation of a business, and are not intended for resale to customers. Copyright © by Houghton Mifflin Company. All rights reserved. 19 Acquisition Cost of Property, Plant, and Equipment OBJECTIVE 2 Distinguish between capital and revenue expenditures, and account for the cost of property, plant, and equipment. Expenditures An expenditure is a payment or an obligation to make future payment for an asset or a service. A capital expenditure is an expenditure for the purchase or expansion of a long-term asset. A revenue expenditure is an expenditure to the repair, maintenance, and operation of a long-term asset. Careful distinction between expenditures is important to the proper application of the matching rule. Understatements and overstatements of income can occur. Determining when a payment is an expense and when it is an asset is a matter of management judgment. Copyright © by Houghton Mifflin Company. All rights reserved. 21 Costs of Land Purchase price. Commissions to real estate agents. Lawyers’ fees. Accrued taxes paid by the purchaser. Draining. Tearing down old building(s). Clearing and grading. Assessments for improvements. Landscaping. Land is not subject to depreciation. Not part of the list of “costs” Copyright © by Houghton Mifflin Company. All rights reserved. 22 Costs of Land Improvements Include driveways, parking lots, and fences. Have limited lives and are depreciated. Are recorded in the Land Improvements account rather than the Land account. Copyright © by Houghton Mifflin Company. All rights reserved. 23 Costs of Buildings Purchase price. Repairs and other expenditures required to put it in usable condition. Buildings are subject to depreciation because they have a limited useful life. Copyright © by Houghton Mifflin Company. All rights reserved. 24 Costs of Building Construction (included in total building costs) Materials Labor Overhead and other indirect costs Architects’ fees Insurance during construction Interest on construction loans Lawyers’ fees Building permits Outside contractors Copyright © by Houghton Mifflin Company. All rights reserved. 25 Costs of Equipment Purchase price. Other expenditures including: Freight Insurance in transit Excise taxes and tariffs Buying expenses Installation costs Cost of test runs Equipment is subject to depreciation. Copyright © by Houghton Mifflin Company. All rights reserved. 26 Costs of Group Purchases A lump sum purchase of land and other assets. Requires apportionment of the purchase price to Land and other asset accounts. Land must have a separate ledger account because it is nondepreciable. Land Building Totals Appraisal $ 10,000 90,000 $100,000 Percentage 10 90 100 Apportionment $ 8,500 76,500 $85,000 Thus, purchase price is $85,000. Copyright © by Houghton Mifflin Company. All rights reserved. 27 Discussion Q. Dyeing a carpet may make it look almost new. Why isn’t it a capital expenditure? A. Although the carpet looks better, its fibers are not stronger, and it probably will not last significantly longer than it would have before the color was changed. Copyright © by Houghton Mifflin Company. All rights reserved. 28 Accounting for Depreciation OBJECTIVE 3 Define depreciation, state the factors that affect its computation, and show how to record it. Definition of Depreciation Depreciation accounting is described by the AICPA as: . . . a system of accounting which aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit . . . in a systematic and rational manner. It is a process of allocation, not of valuation. Copyright © by Houghton Mifflin Company. All rights reserved. 30 Features of Depreciation All tangible assets except land have a limited useful life, because of physical deterioration and obsolescence. Depreciation means the allocation of the cost of a plant asset to the periods that benefit from the service of that asset. Depreciation is not a process of valuation. Even if the market value of the asset increases, depreciation must continue. Copyright © by Houghton Mifflin Company. All rights reserved. 31 Four Factors That Affect the Computation of Depreciation 1. Cost. Net purchase price. All reasonable and necessary expenditures to get the asset in place and ready for use. 2. Residual value (salvage or disposal value). An asset’s estimated net scrap, salvage, or trade-in value as of the estimated date of disposal. Copyright © by Houghton Mifflin Company. All rights reserved. 32 Four Factors That Affect the Computation of Depreciation (continued) 3. Depreciable cost. Cost less residual value. Depreciable cost is allocated over the useful life of an asset. 4. Estimated useful life. Total number of service units expected from a long-term asset. May be measured in years, miles, units, or similar measures. Copyright © by Houghton Mifflin Company. All rights reserved. 33 Accounting for Depreciation Depreciation is recorded at the end of the accounting period by an adjusting entry in the following form: Depreciation Expense, Asset Name xxx Accumulated Depreciation, Asset Name xxx To record depreciation for the period Copyright © by Houghton Mifflin Company. All rights reserved. 34 Discussion Q. A company purchased a building five years ago. The market value of the building is now greater than it was when the building was purchased. Explain why the company should continue depreciating the building. A. The company should continue depreciating the building because depreciation is an allocation of cost and not a valuation process. Copyright © by Houghton Mifflin Company. All rights reserved. 35 Methods of Computing Depreciation OBJECTIVE 4 Compute periodic depreciation under the straight-line method, or production method and the declining-balance method. Straight-Line Method This method spreads the depreciable costs evenly over the asset’s estimated useful life. Annual depreciation is computed as follows: Cost - Residual Value $10,000 - $1,000 Estimated Useful Life = 5 years Copyright © by Houghton Mifflin Company. All rights reserved. = $1,800 per year 37 Depreciation Schedule, Straight-Line Method Date of Purchase End of year 1 End of year 2 End of year 3 End of year 4 End of year 5 Stop at residual value Cost $10,000 10,000 10,000 10,000 10,000 10,000 Yearly Deprec. 0 $1,800 1,800 1,800 1,800 1,800 Same each year. Copyright © by Houghton Mifflin Company. All rights reserved. Accum. Deprec. 0 $1,800 3,600 5,400 7,200 9,000 Carrying Value $10,000 8,200 6,400 4,600 2,800 1,000 Increases Decreases uniformly. uniformly. 38 Production Method This method is based on the assumption that depreciation is solely the result of use and that the passage of time plays no role in the depreciation process. Annual depreciation is computed as follows: Cost - Residual Value $10,000 - $1,000 = $.10/mile = Estimated Units of Useful Life 90,000 miles Copyright © by Houghton Mifflin Company. All rights reserved. 39 Depreciation Schedule, Production Method DOP EOY 1 EOY 2 EOY 3 EOY 4 EOY 5 Cost $10,000 10,000 10,000 10,000 10,000 10,000 Miles 0 20,000 30,000 10,000 20,000 10,000 Yearly Deprec. 0 $2,000 3,000 1,000 2,000 1,000 Accum. Deprec. 0 $2,000 5,000 6,000 8,000 9,000 Relates to miles. Increases Decreases related related to miles. to miles. Copyright © by Houghton Mifflin Company. All rights reserved. Carrying Value $10,000 8,000 5,000 4,000 2,000 1,000 40 Declining-Balance Method An accelerated method. Results in relatively large amounts of depreciation in the early years of an asset’s life and smaller amounts in later years. Assumes that plant assets are most efficient when new. Is consistent with the matching rule. Copyright © by Houghton Mifflin Company. All rights reserved. 41 Accelerated Depreciation Recognizes that changing technologies result in earlier obsolescence. Maintains more constant total expenses for equipment, assuming repair expense is greater in later years. Most common rate of depreciation, applied to the carrying value of a longterm asset, is twice the straight-line percentage, known as double-decliningbalance method. Copyright © by Houghton Mifflin Company. All rights reserved. 42 Computation of Double-Declining-Balance Method Annual depreciation is computed as follows: Number of years = Depreciation Rate (DR) 5 year asset = 20% per year x 2 = 40% Depreciation Expense = DR x Carrying Value (CV) CV = Cost - Accumulated Depreciation Copyright © by Houghton Mifflin Company. All rights reserved. 43 Depreciation Schedule, Double-Declining-Balance Method Cost $10,000 10,000 10,000 10,000 10,000 10,000 DOP EOY 1 EOY 2 EOY 3 EOY 4 EOY 5 YDR = 40% 5 yrs. = 20% 20% x 2 Yearly Deprec. 0 $4,000 2,400 1,440 864 296 Accum. Deprec. 0 $4,000 6,400 7,840 8,704 9,000 Carrying Value $10,000 6,000 3,600 2,160 1,296 1,000 (can’t go below residual) Increases Decreases quickly. quickly. Copyright © by Houghton Mifflin Company. All rights reserved. 44 Graphical Comparison of Three Methods of Determining Depreciation Copyright © by Houghton Mifflin Company. All rights reserved. 45 Depreciation Methods Used by 600 Large Companies Copyright © by Houghton Mifflin Company. All rights reserved. 46 Discussion Q. Contrast the assumptions underlying the straight-line depreciation method with the assumptions underlying the production depreciation method. A. The straight-line method assumes that depreciation is associated with the passage of time, whereas the production method assumes that depreciation is associated with use. Copyright © by Houghton Mifflin Company. All rights reserved. 47 Disposal of Depreciable Assets OBJECTIVE 5 Account for the disposal of depreciable assets not involving exchanges. Disposal of Depreciable Assets 3 ways of disposal: 1. Discarded 2. Sold for cash 3. Exchanged for another asset Assume: Machinery 6,500 Accumulated Depreciation, Machinery 4,200 Purchased: 1/1/x0 Carrying Value: (1/1/x7): $2,300 = $6,500 - $4,200 Estimated Useful Life: 10 Yrs; Residual Value: $500 Copyright © by Houghton Mifflin Company. All rights reserved. 49 Depreciation for Partial Year Disposal takes place 9/30/x7 It is necessary to record depreciation expense for the partial year up to the date of disposal. Sept. 30 Depreciation Expense, Machinery 450 Accumulated Depreciation, Machinery 450 To record depreciation up to date of disposal [($6,500 - $500) ÷ 10] x 9/12 = $450 Copyright © by Houghton Mifflin Company. All rights reserved. 50 Discarded Plant Assets Sept. 30 Accumulated Depreciation, Machinery 4,650 Loss on Disposal of Machinery 1,850 Machinery 6,500 Discarded machine no longer used in the business Copyright © by Houghton Mifflin Company. All rights reserved. 51 Plant Assets Sold for Cash: Receipts equal Carrying Value Sept 30 Cash 1,850 Accumulated Depreciation, Machinery 4,650 Machinery 6,500 Sale of machine for carrying value; no gain or loss Copyright © by Houghton Mifflin Company. All rights reserved. 52 Plant Assets Sold for Cash: Loss Recorded Sept. 30 Cash 1,000 Accumulated Depreciation, Machinery 4,650 Loss on Sale of Machinery 850 Machinery 6,500 Sale of machine at less than carrying value; loss of $850 = ($1,850 - $1,000) recorded Copyright © by Houghton Mifflin Company. All rights reserved. 53 Plant Assets Sold for Cash: Gain Recorded Sept. 30 Cash 2,000 Accumulated Depreciation, Machinery 4,650 Gain on Sale of Machinery 150 Machinery 6,500 Sale of machine at more than carrying value; gain of $150 = ($2,000 - $1,850) recorded Copyright © by Houghton Mifflin Company. All rights reserved. 54 Discussion Q. If a plant asset is discarded before the end of its useful life, how is the amount of loss measured? A. If a plant asset is discarded before the end of its useful life, the amount of loss is equal to its carrying value (cost less accumulated depreciation). Copyright © by Houghton Mifflin Company. All rights reserved. 55 Exchanges of Plant Assets OBJECTIVE 6 Account for the disposal of depreciable assets involving exchanges. Recognizing Gains and Losses on Exchanges Exchange Losses Gains Recognized Recognized For financial accounting purposes Of dissimilar assets Of similar assets For income tax purposes Of dissimilar assets Of similar assets Yes Yes Yes No Yes No Yes No Copyright © by Houghton Mifflin Company. All rights reserved. 57 Loss Recognized on the Exchange List price of new machine Trade-in allowance for old machine Cash payment requires Sept 30 Machinery (new) Accumulated Depreciation, Machinery $12,000 (1,000) $11,000 12,000 4,650 Loss on Exchange of Machinery Machinery (old) Cash 850 6500 11,000 Exchange of Machines Copyright © by Houghton Mifflin Company. All rights reserved. 58 Loss Not Recognized on the Exchange (similar assets, tax purposes only) Sept. 30 Carrying value of old machine Cash paid Cost basis of new machine $1,850 11,000 $12,850 Machinery (new) 12,850 Accumulated Depreciation, Machinery 4,650 Machinery (old) Cash Exchange of machines Copyright © by Houghton Mifflin Company. All rights reserved. 6,500 11,000 59 Gain Recognized on the Exchange List price of new machine Trade-in allowance for old machine Cash payment required Sept 30 $12,000 (3,000) $9,000 Machinery (new) 12,000 Accumulated Depreciation, machinery 4,650 Gain on exchange of machinery 1,150 Machinery (old) 6,500 Cash 9,000 Exchange of Machines Copyright © by Houghton Mifflin Company. All rights reserved. 60 Gain Not Recognized on the Exchange Carrying value of old machine Cash paid Cost basis of new machine Sept. 30 $1,850 9,000 $10,850 Machinery (new) 10,850 Accumulated Depreciation, Machinery 4,650 Machinery (old) 6,500 Cash 9,000 Exchange of machines Copyright © by Houghton Mifflin Company. All rights reserved. 61 Discussion Q. Are gains on similar assets completely unrecognized? A. No. Since the basis of the new asset is reduced by the unrecognized gain, there will be less depreciation expense over the life of the new asset. Copyright © by Houghton Mifflin Company. All rights reserved. 62 Accounting for Natural Resources OBJECTIVE 7 Identify the issues related to accounting for natural resources and compute depletion. Accounting for Natural Assets Natural resources are shown on the balance sheet as long-term assets. These assets are converted into inventory by cutting, pumping, or mining. They are recorded at acquisition cost. As the asset is converted to inventory, the asset account must be proportionally reduced. Copyright © by Houghton Mifflin Company. All rights reserved. 64 Depletion Depletion is used to describe not only the exhaustion of a natural resource but also the proportional allocation of the cost of a natural resource to the units extracted. Costs are allocated much like the production method of depreciation. Dec. 31 Depletion Expense, Coal Deposits 115,000 Accumulated Depletion, Coal Deposits 115,000 To record depletion of coal mine: $1 per ton for 115,000 tons mined and sold Copyright © by Houghton Mifflin Company. All rights reserved. 65 Depreciation of Closely Related Long-Term Assets Closely related long-term assets are those assets necessary to extract the resource. If the life of the asset is longer than the life of the resource, it is depreciated on the same basis as the depletion is computed. If the life of the asset is shorter than the life of the resource, it is depreciated over a shorter life. Copyright © by Houghton Mifflin Company. All rights reserved. 66 Development and Exploration Costs in the Oil and Gas Industry Successful efforts accounting. Cost recorded as an asset and depleted over the estimated life of the resource. For an unsuccessful exploration, written off immediately as a loss. More conservative method. Full-costing method. All costs, including costs of dry wells, are recorded as assets and depleted over the estimated life of the producing resources. Improves earnings performance in the early years. Either method is allowed under GAAP. Copyright © by Houghton Mifflin Company. All rights reserved. 67 Discussion Q. Under what circumstances can a mining company depreciate its long-term assets over a period of time that is less than their useful lives? A. A mining company may depreciate its plant assets over a period of time that is less than their useful lives when the long-term assets are so closely associated with the natural resource that they cannot be used after the resource is depleted and the depletion period is shorter than the useful lives of the assets. Copyright © by Houghton Mifflin Company. All rights reserved. 68 Accounting for Intangible Assets OBJECTIVE 8 Apply the matching rule to intangible assets, including research and development costs and goodwill. Intangible Assets Intangible assets are long term but have no physical substance. Value comes from the long-term rights or advantages that it offers to its owners. Intangible assets include patents, copyrights, leaseholds, leasehold improvements, trademarks and brand names, franchises, licenses, and goodwill. They are accounted for at acquisition cost. Goodwill and trademarks should not appear on the balance sheet unless they have been purchased from another party at a price established in the marketplace. Copyright © by Houghton Mifflin Company. All rights reserved. 70 Accounting Issues for Intangible Assets Accounting issues are similar to other long-term assets. APB Opinion 17 lists them as follows: Determining an initial carrying amount. Accounting for periodic write-off or amortization. Accounting for that amount if the value declines substantially and permanently. Because of its intangibility, its value and useful life may be quite hard to estimate. Copyright © by Houghton Mifflin Company. All rights reserved. 71 Intangible assets developed by a company for its own benefit should be expensed. Intangible assets should be amortized over the shorter of their useful life or their legal life (not to exceed 40 years.) FASB is considering a proposal to eliminate goodwill amortization. If an intangible asset become worthless before it is fully amortized, the remaining carrying value should be written off as a loss. Copyright © by Houghton Mifflin Company. All rights reserved. 72 Related Journal Entries for Intangible Assets Patent Cash Purchase of patent 18,000 Amortization Expense Patent Annual amortization 18,000 3,000 3,000 $18,000 ÷ 6 years = $3,000 Loss on Patent 15,000 Patent Loss resulting from patent’s becoming worthless Copyright © by Houghton Mifflin Company. All rights reserved. 15,000 73 Research and Development Costs The FASB has stated that: 1. Research and Development expenditures should be treated as revenue expenditures and charged to expense in the period when incurred. 2. Costs of Research and Development are continuous and necessary for the success of a business and should be treated as current expenses. 3. Research and Development costs do not necessarily result in future benefits (assets). Copyright © by Houghton Mifflin Company. All rights reserved. 74 Computer Software Costs Costs incurred in creating computer software for sale or lease to others are considered R&D costs until the product has been proved to be technologically feasible. Costs incurred up to this point are expensed as incurred. After the working program has been developed, all software production costs are recorded as assets and amortized over the estimated economic life of the product using the straight-line method. Software developed for internal use by a company may be amortized over its estimated economic life. Copyright © by Houghton Mifflin Company. All rights reserved. 75 Goodwill Goodwill exists when a purchaser pays more for a business than the fair market value of the net assets if purchased separately. The payment above and beyond the fair market value is recorded in the Goodwill account. APB #17 states that Goodwill should be amortized over a reasonable number of future time periods, but not longer than 40 years. Goodwill should not be recorded unless it is paid for in connection with the purchase of a whole business. Goodwill = Purchase price - FMV of identifiable assets. Copyright © by Houghton Mifflin Company. All rights reserved. 76 Discussion Q. Why would a company spend thousands of dollars on goodwill? A. The company is paying for anticipated superior earnings and probably feels it will more than recoup the goodwill purchased. Copyright © by Houghton Mifflin Company. All rights reserved. 77 Special Problems of Depreciating Plant Assets SUPPLEMENTAL OBJECTIVE 9 Apply depreciation methods to problems of partial years, revised rates, groups of similar items, special types of capital expenditures, and cost recovery. Depreciation for Partial Years Assume an asset is purchased on September 5 and the yearly accounting period ends on December 31. Cost – Residual x Life in Years $3,600 - $600 x 6 years Number of Months 12 4 = $167 12 Typically, round off to the nearest whole month. Copyright © by Houghton Mifflin Company. All rights reserved. 79 Revision of Depreciation Rates Revision is made when it is determined that an asset will last for a longer or shorter period than originally thought. The remaining depreciable cost of the asset is spread over the remaining years of useful life. Depreciation expense is increased or decreased to reflect the asset’s changed life. Copyright © by Houghton Mifflin Company. All rights reserved. 80 Example Computation of Revised Depreciation Rates Initial Estimated Useful Life Cost (Depreciation Already Taken) (Residual Value) Remaining Depreciable Amount Divide by remaining useful life 6 years $7,000 (2,000) (1,000) $4,000 2 years Dec. 31 Deprec. Exp., Delivery Truck 2,000 Accum. Deprec., Delivery Truck 2,000 To record depreciation expense for the year Copyright © by Houghton Mifflin Company. All rights reserved. 81 Group Depreciation Group depreciation is widely used when like assets are grouped and depreciated together. This approach is convenient and includes assets such as trucks and office equipment. Copyright © by Houghton Mifflin Company. All rights reserved. 82 Special Types of Capital Expenditures An addition is an enlargement to the physical layout of a plant asset. The cost is charged to the asset account. A betterment is an improvement that does not add to the physical layout of a plant asset. The cost is charged to the asset account. Copyright © by Houghton Mifflin Company. All rights reserved. 83 Special Types of Capital Expenditures (continued) Ordinary repairs are expenditures necessary to keep an asset in good operating condition. Such repairs are a current expense. Extraordinary repairs are repairs of a more significant nature that increase the estimated residual value or estimated useful life of an asset. Recorded by debiting the Accumulated Depreciation account. Copyright © by Houghton Mifflin Company. All rights reserved. 84 Cost Recovery for Federal Income Tax Purposes First $17,500 ($25,000 by 2003) of equipment costs each year may be expensed rather than capitalized. Modified Accelerated Cost Recovery System (MACRS) discards the concepts of estimated useful life and residual value. MACRS requires that a cost recovery allowance be computed: On the unadjusted cost of property being recovered. Over a period of years prescribed by the law for all property of similar types. Copyright © by Houghton Mifflin Company. All rights reserved. 85 Cost Recovery for Federal Income Tax Purposes (continued…) Congress hoped to encourage businesses to invest in new plant and equipment by allowing them to write off assets rapidly. Tax methods of depreciation are not usually acceptable for financial reporting under GAAP. Copyright © by Houghton Mifflin Company. All rights reserved. 86 Discussion Q. What will be the effect on future years’ income of charging an addition to a building to repair expense? A. If an addition to a building is charged to repair expense, future years’ income will be overstated and the current year’s income will be understated. Copyright © by Houghton Mifflin Company. All rights reserved. 87 OK, LET’S REVIEW . . . 1. Identify the types of long-term assets and explain the management issues related to accounting for them. 2. Distinguish between capital and revenue expenditures, and account for the cost of property, plant, and equipment. 3. Define depreciation, state the factors that affect its computation, and show how to record it. Copyright © by Houghton Mifflin Company. All rights reserved. 88 CONTINUING OUR REVIEW . . . 4. Compute periodic depreciation under the straight-line method, production method, and decliningbalance method. 5. Account for the disposal of depreciable assets not involving exchanges. 6. Account for the disposal of depreciable assets involving exchanges. Copyright © by Houghton Mifflin Company. All rights reserved. 89 AND FINALLY . . . 7. Identify the issues related to accounting for natural resources and compute depletion. 8. Apply the matching rule to intangible assets, including research and development costs and goodwill. SUPPLEMENTAL OBJECTIVE 9. Apply depreciation methods to problems of partial years, revised rates, groups of similar items, special types of capital expenditures, and cost recovery. Copyright © by Houghton Mifflin Company. All rights reserved. 90