Chapter 10 notes
The category Property, Plant, and Equipment (fixed assets) include all the assets that are depreciable
plus land. Based of the Cost principle, we assign the acquisition costs to all these assets. Acquisition
costs include any cost incurred in order to get the asset to be ready for its intended use. These costs
include price paid, sales tax, license fee, professional costs, modifying costs, commission, delivery costs,
installation, set up costs, and testing costs.
Depreciation
Depreciation can be explained in two ways:
1. Due to normal wear and tear (therefore reducing its book value) of the asset from daily use
2. It is a gradual way to recover initial investment
There are three ways of depreciation introduced (page 432):
1. Straight line
2. Unit of activity
3. Declining balance
There are three terms which are very important in depreciation:
a. Acquisition costs
b. Useful life ----- This is a very subject number. This is a period of time that you think you can use
this asset in your business to generate revenue
c. Salvage value ----- This is the estimated fair market value of the asset at the end of the useful
life
Under Straight line method, we use the following formula to calculate annual depreciation:
Annual depreciation = (cost – salvage value ) / useful life (in years)
Monthly depreciation will be ----- annual depreciation / 12
Under unit of activity method, we need to estimate the total units a machine can produce
throughout its useful life or total number of miles a truck can run throughout its useful life. Then we
get the cost per unit = (total cost – salvage) / total units
Every subsequent period, the depreciation amount will be:
Units produced in that period * cost per unit
Under declining balance method (page 435), for annual depreciation, we use twice the straight line
rate. e.g. If an asset has a life of 5 years, the straight-line rate will be 20% per year. Under the
declining balance method, the rate will be 40%. Let say the cost is 10,000. First year depreciation will
be 10,000 * 40% = 4000. Second year will be (10,000 – 4000) * 40% = 2400. In the third year, the
depreciation will be (10,000 – 4000 – 2400) * 40%. Notice the salvage is never used yet. The final
book value of the asset can never get below the salvage value (refer to P435).
When we dispose of assets either during its life or at the end of its life, we will need to zero out its
cost account, accumulated depreciation account (for that asset only), and recognize gain/loss from
the transaction.
Natural Resources
Instead of calling it depreciation expense, we call this depletion expense. The procedure is very
similar to units of activity method (refer to P442). Be aware of one thing, at the end of the year, we
figure how many pounds of minerals have been extracted, we multiply the depletion cost per
pounds with this total extracted poundage. The product will be debited to inventory. When the
minerals are sold then we pass the inventory cost to depletion expense.
Intangible Assets
Intangible assets include patents, copyrights, trademarks and trade names, franchises and licenses,
goodwill. We only amortize those with definite useful lives. Therefore, we do not amortize
trademarks/names and goodwill.
Patents ------- Accumulate costs primarily from buying a patent (new inventions) right from someone
else
Copyright -------- Accumulate costs primarily from buying a copyright (a book or a movie) from
someone else
Trademarks/names --------- Accumulate costs primarily from acquiring the trade mark or name from
someone else
Franchise --------- When you want to run a McDonald, you need to pay a large lump sum of money
to McDonald corporation in order to sign a lease (let say 10 years) to operate a McDonald fast food.
That money will be capitalized and amortized through the term of the lease.
Licenses ---------- Every cell phone company has to lease certain signal frequency range from the
government in order to provide cell phone services to customers. They need to pay an initial large
lump sum payment to the government or to another cell phone company. That money will be
capitalized and amortized through the lease term.
Good will ------- This is created only when a company acquires another company and the price paid
exceeds the net worth of the company being bought. Reasons for overpayment include exceptional
management team, company reputation, good relation with labor union.