Chapter 8: Highlights
1.
Long-lived tangible assets, sometimes called plant assets or fixed assets, are assets that
provide benefits beyond the current year and include land, buildings, machinery, and
equipment.
2.
The cost of a plant asset includes all costs necessary to prepare it for rendering services. For
an asset such as equipment, the total cost includes the invoice price (less any discount),
transportation costs, installation charges, and any other costs before the equipment is ready
for use.
3.
When a firm constructs its own building or equipment, the asset's costs include the costs of
material, labor, and overhead during construction. In addition, FASB Statement No. 34
requires the firm to capitalize interest paid during construction. The amount capitalized is
the portion of interest cost incurred during the asset's construction periods that the firm
theoretically could have avoided if it had had not constructed the asset.
4.
If there are specific borrowings in connection with a self-constructed asset, the firm uses the
interest rate on that borrowing. If expenditures on plant assets exceed the specific
borrowing, the interest rate applied to the excess is a weighted average of rates applicable
to other borrowings of the firm. The total amount of interest capitalized cannot exceed the
total interest costs for the period.
5.
The cost of an asset with a limited life is the price paid for a series of future benefits--a
purchase of so many hours or units of service. The plant asset accounts, other than land, are
therefore similar in many respects to prepaid rent or insurance--payments in advance for
benefits to be received in the future. As the firm uses assets in each period, it treats a
portion of the investment in the assets as a cost of the benefits received.
6.
Depreciation refers to periodic write-off of the acquisition cost of tangible long-lived assets
(other than land). Amortization refers to the process of writing off the cost of intangible
assets.
7.
Measuring the amount of depreciation for any year is not an exact process, because the cost
of plant assets is a joint cost of several periods. Each period of the asset's use benefits from
the services, but there is usually no single correct way to allocate a joint cost. Accounting
attempts to assign periodic depreciation charges that reflect systematic calculations.
8.
Basing depreciation on acquisition costs enables a business to expense an amount equal to
its initial investment in the asset. Because prices of the services generally increase over
time, depreciation will not necessarily provide an expense equal to the cost of replacing the
physical capacity initially acquired.
9.
Common terminology characterizes depreciation as a decline in the market value of assets.
Although there is certainly a decline in value of an asset from the time a firm acquires it
until it retires the asset from service, the yearly decline in value is an unsatisfactory
description of the charge for depreciation made to the operations of each accounting period.
Depreciation is a process of cost allocation and not one of valuation.
10. There are three principal accounting issues in allocating the cost of an asset over time.
They are: (a) measuring the depreciable or amortizable basis of the asset, (b) estimating its
useful service life, and (c) deciding on the pattern of expiration of asset cost over the useful
service life.
11. Historical cost accounting bases depreciation and amortization charges on the difference
between acquisition cost and the asset's estimated salvage value (or net residual value).
Salvage value represents the estimated proceeds on disposition of an asset less all removal
and selling costs.
12. The causes of the process requiring depreciation are the same causes of decline in service
potential. The decline results from either physical or functional causes. Physical factors
include the normal wear and tear, decay, and deterioration from use. The most important
functional cause is obsolescence. Identification of specific causes of depreciation can help
when estimating the useful life of an asset. The estimate of service life must take into
consideration both the physical and functional causes of depreciation. Past experience with
similar assets, corrected for differences in the planned intensity of use or alterations in
maintenance policy, is usually the best guide for the estimate.
13. Income tax laws allow firms to use shorter lives in computing depreciation for tax reporting.
For income tax reporting, firms generally use the Modified Accelerated Cost Recovery
System (MACRS). MACRS specifies accelerated depreciation charges based on the class of
asset. Under MACRS, almost all assets are grouped in one of seven classes of write-off
periods. They are:
(a)
(b)
3 years
5 years
(c)
(d)
(e)
(f)
(g)
7 years
10 years
20 years
27.5 years
39 years
Some racehorses; almost no others.
Computers, cars, trucks, some manufacturing equipment, research and
development property.
Office equipment, railroad cars, locomotives.
Vessels, barges, land improvements
Municipal sewers.
Residential rental property.
Nonresidential buildings acquired after 1993; otherwise 31.5 years.
14. When the depreciable lives used for tax reporting are shorter than the economic service
lives of the assets, firms must use the estimated service lives for financial reporting.
15. There are three basic allocation patterns for depreciation and amortization. They are:
(a) Straight-line method;
(b) Accelerated method;
(c) Decelerated method.
Accelerated and decelerated are terms describing depreciation patterns in comparison with
straight-line depreciation. GAAP does not allow decelerated depreciation. Firms do not
depreciate land because it has an unlimited life. Most firms amortize intangible assets using
the straight-line method.
16. The GAAP acceptable depreciation methods are:
(a) Straight-line (time) method;
(b) Production or use (straight-line use) method;
(c) Accelerated depreciation methods:
(1) Declining-balance methods;
(2) Sum-of-the-years'-digits method.
17. Financial reporting most commonly uses the straight-line method, which provides a uniform
pattern of depreciation per year. The calculation of the annual depreciation is:
Annual Depreciation =
Cost Less Estimated Salvage Value
Estimated Life in Years
18. Firms often do not use assets uniformly over time, as straight-line depreciation implies.
Where assets are not likely to receive the same amount of use in each month or year of their
lives, the straight-line method may result in an illogical charge for such assets. Instead, a
depreciation charge based on actual usage during the period may be justified. The
production method uses a uniform cost per unit of activity that is multiplied by the units of
production for the period. The depreciation cost per unit of activity is:
Depreciation Cost per Unit =
Cost Less Estimated Salvage Value
Estimated Number of Units
19. The efficiency and earning power of many plant assets decline as the assets grow older.
These assets provide more and better services in early years, with increasing amounts of
maintenance as the assets grow older. These cases justify an accelerated method in which
depreciation charges in early years are greater than in later years. Declining balance, sumof-the-years'-digits, and MACRS are three types of accelerated methods.
20. The depreciation charge under the declining-balance method results from multiplying the
net book value of the asset at the start of each period (cost less accumulated depreciation)
by a fixed rate. The firm then subtracts the depreciation charge from the net book value to
calculate the depreciation base for the next year. Firms do not subtract the salvage value
from the cost in making this depreciation calculation. However, the total depreciation taken
over an asset's useful life cannot exceed the asset's cost less salvage value. Firms
sometimes use the 200-percent declining-balance method, in which the rate multiplied times
the net book value is 200 percent of the straight-line rate. Under declining-balance
methods, the firm switches to straight-line depreciation of the remaining book value when
the straight-line depreciation charge is higher than the declining-balance charge for
depreciation.
21. Another accelerated method is sum-of-the-years' digits. Under this method, the depreciation
charge results from applying a fraction, which diminishes from year to year, to the cost less
salvage value of the asset. The numerator of the fraction is the number of periods of
remaining life at the beginning of the year for which the firm computes depreciation. Thus,
the numerators for Years 1 to 5 of an asset with a 5-year life are 5, 4, 3, 2, 1, respectively.
The denominator of the fraction, which remains the same for each year, is the sum of all
such numbers. For an asset with a 5-year life, the denominator is 15 (=1 + 2 + 3 + 4 + 5).
The formula n(n+1)/2, where n is the asset's depreciable life, is useful in determining the
sum-of-the year's digits denominator.
22. MACRS, used for tax purposes, is an accelerated method for three reasons. First, the
depreciable lives specified by class of asset are generally shorter than the economic lives.
Second, the rates employed for assets other than buildings are similar to the 150-percent and
200-percent declining-balance methods, which are more rapid than straight-line. Third,
MACRS allows firms to ignore salvage value in calculating depreciation, which results in
writing off the entire depreciable basis. Firms rarely judge MACRS appropriate for
financial reporting.
23. The goal in depreciation accounting for tax purposes should be to maximize the present
value of the reductions in tax payments from deducting depreciation. Earlier deductions are
worth more than later ones (if tax rates do not change) because a dollar saved today is worth
more than a dollar saved later. For tax purposes, firm should endeavor to write off the asset
as quickly as possible. Use of MACRS accomplishes this purpose.
24. The goal in financial reporting for long-lived assets is to provide a statement of income that
is realistic in measuring the expiration of these assets. In order to accomplish this purpose,
the depreciation reported and the method selected should report depreciation charges based
upon reasonable estimates of asset expirations. Most U.S. firms use the straight-line
method for financial reporting.
25. The journal entry to record depreciation involves a debit either to Depreciation Expense or,
in the case of a manufacturer, to a product cost account such as Work-in-Process Inventory,
and a credit to a contra asset account, Accumulated Depreciation. The Accumulated
Depreciation account appears on the balance sheet as a deduction from the asset account to
which it relates. The term book value refers to the difference between the balance of the
asset account and the balance of its accumulated depreciation account.
26. The original depreciation schedule for a particular asset may require changing due to new
information about the asset's useful life or salvage value. If the misestimate is material,
firms must take corrective action. The generally accepted procedure for handling this
problem is to make no adjusting entry for the past misestimate but to spread the
undepreciated balance minus the revised estimate of the salvage value over the revised
estimate of the remaining service life of the asset.
27. Depreciation is not the only cost of using a depreciating asset. There will almost always be
some repair and maintenance costs incurred during the life of the asset. Repairs include the
costs of restoring an asset’s service potential after breakdowns or other damage.
Maintenance includes routine costs such as cleaning and adjusting. Firms charge repair and
maintenance costs to expense as they incur these costs.
28. Improvements involve making an asset subsequently better by improving its productive
capacity. Whereas repairs maintain or restore service potential, improvements extend
service beyond what the firm originally anticipated. Expenditures for improvements are
sometimes called betterments. Accountants treat costs of improvements as an asset
acquisition.
29. Firms incur research and development costs to develop a new product or process, to
improve existing products or processes, or to develop new information that may be useful at
some future time. Whatever the reason, research costs yield their benefits, if any, in future
periods. The accounting issue, therefore, is whether to expense these costs immediately or
to capitalize them and amortize them over future periods. Theoretically, firms should match
research costs with the benefits produced by their expenditure, which suggests capitalizing
the research costs as an asset and amortizing that cost over the benefited periods. GAAP,
however, requires the immediate expensing because of the uncertainty of future benefits.
30. A patent is a right obtained from the federal government to exclude others from the use of
the benefits of an invention. A firm amortizes purchased patent costs over the shorter of (a)
the remaining legal life (as long as 20 years), or (b) the estimated economic life. A firm
expenses internally developed patent costs as incurred as it does for all research and
development costs.
31. Intangible assets lack physical form but nonetheless may provide future benefits. Examples
are research costs, advertising costs, patents, trade secrets, know-how, trademarks, and
copyrights. The first problem with intangibles is to decide whether the expenditures have
future benefits, which firms should capitalize and then amortize over time, or whether they
have no measurable future benefits, which firms should expense in the period incurred. The
second problem is how to amortize the cost if firms capitalize them. Firm usually amortize
capitalized intangibles using the straight-line method, but can use other methods if they
seem appropriate.
32. Firms incur advertising expenditures to increase sales. A lag often occurs, however,
between the incurrence of advertising costs and their impact on sales, probably extending
into subsequent periods. Even though advertising often benefits more than the period of
expenditure, GAAP requires firms to immediately expense almost all advertising costs
because of the uncertainty of future benefits.
33. Goodwill is an intangible asset that arises when one company acquires another company.
The acquiring firm measures goodwill as the difference between the amount paid for the
acquired company as a whole and the current value of its individual identifiable net assets
and liabilities. The firm making the acquisition recognizes goodwill. The acquired
company that developed the goodwill over time does not recognize the goodwill on its
books.
34. The expected future benefits of an asset change, sometimes increasing and sometimes
decreasing. GAAP does no permit firms to write up the book value of their tangible and
intangible long-lived assets when market values increase. GAAP on the other hand does
not allow assets whose values have declined substantially to remain on the balance sheet at
amortized acquisition cost. GAAP distinguishes three categories of assets for purposes of
measuring and recognizing impairment losses:
a. All assets except intangibles that do not require amortization.
b. Intangibles other than goodwill that do not require amortization.
c. Goodwill.
35. The test for an impairment loss on all assets except intangibles that do not require
amortization (a. above) compares the undiscounted cash flows from the assets with their
book values. Asset impairment occurs when the current book value exceeds the sum of
remaining expected undiscounted cash flows. Accounting requires a firm to write down the
book value of an impaired asset to its then-current fair value (market value) or, if the firm
cannot measure the market value reliably, the expected net present value of the future cash
flows. The test for impairment loss of intangibles that do not require amortization other than
goodwill (b. above) compares the book values of the assets to their market value. The loss
is the excess of the book values over their market values. Firms are not required to amortize
goodwill in measuring net income each period. However, firms must test annually for
impairment in the value of goodwill and write down goodwill if an impairment loss occurs.
36. When a firm retires an asset from service, it makes an entry to bring depreciation up to date.
Then it removes the cost of the asset and its related accumulated depreciation from the
books. The difference between the proceeds received on retirement (if any) and the book
value (acquisition cost less accumulated depreciation) is either a gain or a loss.
37. Instead of selling an asset, a firm may trade it in on a new one. One might view the trade-in
transaction as a sale of an old asset followed by the purchase of a new asset. The
accounting for trade-in transactions determines simultaneously the gain or loss on disposal
of the old asset and the acquisition costs recorded for the new asset.
38. Property, plant, and equipment accounts appear in the balance sheet among noncurrent
assets. Firms generally disclose the assets' cost and accumulated depreciation in one of
three ways: (a) the balance sheet contains the acquisition cost less accumulated
depreciation; (b) the balance sheet omits the acquisition costs, presenting the accumulated
depreciation and book value; and (c) the balance sheet omits the acquisition cost and
accumulated depreciation, presenting only the book value (details appear in notes).
39. Depreciation expense appears in the income statement, sometimes disclosed separately and
sometimes, particularly for manufacturing firms, as part of cost of goods sold.
40. In most developed countries, accounting for plant assets, depreciation, and intangible assets
parallels that in the United States. In Great Britain firms can place a valuation on their
brand names and include this item among the assets on the balance sheet. Independent
appraisers might base their brand names valuation on premium prices charged customers for
a branded over a nonbranded product, or the promotion and other costs likely to be incurred
in launching a new branded product, or on the price paid in recent mergers and acquisitions
for branded product firms.
41. The statement of cash flows reports the cash used for acquisition of plant and intangible
assets and cash provided by their retirement among the investing activities. On the
statement of cash flows using the indirect approach, net income is the starting point in
computing cash flow from operations. If a firm sells plant or intangible assets for an
amount different from their book value, then a gain or loss results. Because this sale is
nonoperating, firm must add back any loss and subtract any gain from net income in
calculating cash flow from operations. The statement of cash flows also shows addbacks to
net income for depreciation and amortization in deriving cash from operations. When firms
acquire plant and intangible assets using cash from new financing, they report them as
separate investing and financing activities. When firms acquire such assets by bartering (not
involving a cash exchange), they do not report the transaction in the statement of cash flows
but instead disclose it in a supplemental schedule or note.