CHAPTER 21
REPORTING PROPERTY,
PLANT, AND
EQUIPMENT, AND
INTANGIBLES
1
Chapter Overview
 What type of assets does a company include
in its property, plant, and equipment, and
how does the company compute its
historical costs?
 Why does a company depreciate its
property, plant, and equipment, and what are
the causes of depreciation?
 How does a company calculate its
depreciation expense, and why does it
compute depreciation expense differently for
financial reporting than for income taxes?
2
Chapter Overview
 How does a company evaluate the
impairment of its property, plant, and
equipment?
 How does a company record and report the
disposal of property, plant, and equipment?
 How do external users evaluate information
about a company’s property, plant, and
equipment?
 What are intangible assets and natural
resource assets, and what does a company
report about them?
3
Reporting Property, Plant,
and Equipment
 A company using GAAP is required to base its
reporting of property, plant, and equipment (PPE)
on two accounting concepts we discussed in
earlier chapters: historical cost and matching.
 Historical cost states that a company records its
transactions on the basis of the dollars
exchanged; in other words, the cost of the
property, plant, and equipment purchased.
 Historical cost provides the most reliable value
and the most conservative value for PPE,
reflecting GAAP’s emphasis on conservatism.
4
Reporting Property, Plant,
and Equipment
 The matching principle states that the cost of
producing revenues for an accounting period
must be deducted from the revenue earned.
 Therefore, a company allocates the cost of
using property, plant and equipment to
revenues by recording depreciation expense,
and reports PPE at its net book value on the
balance sheet.
 PPE is one of the most ideal illustration of
how the GAAP matching principle is applied.
5
Computing the Cost of PPE
 The cost of PPE includes all of the costs a
company incurs to acquire the asset and get
it ready for use.
 Cost includes the purchase price (less
purchase discounts), sales tax, applicable
transportation costs, insurance, installation
costs and similar costs.
 A company determines the cost by reviewing
the source documents (i.e., invoices) used to
record the purchase.
6
Underlying Reasons for
Depreciating PPE
 PPE provides a company with benefits for
more than one year – these are long-lived
productive assets. Thus, over the useful life,
PPE contributes to producing revenues for
the business.
 PPE is depreciated for two reasons: (1) to
reflect the systematic cost of producing
revenues over the useful life of the PPE, and
(2) to reflect physical wear and tear by use,
passage of time, damage or other means.
7
Depreciation Issues
Exhibit 21-2
8
Service Life and Residual Value
 Three factors are involved in the calculation
of the depreciation amount:
1. The cost of the asset,
2. Estimated useful life over which a company
expects the asset to be useful, and
3. Estimated residual value, the cash the
company estimates it will receive from the
sale or disposal of the asset at the end of its
useful life.
9
Nature of Depreciation
 A company does not record depreciation in an
attempt to estimate the value of the asset.
 Depreciation is an estimation process, a
systematic means to ensure that the cost of
producing revenues is not determined in an
arbitrary manner.
 The method of depreciation represents a
rational means to relate the benefit of the
asset in any given accounting period.
10
Nature of Depreciation
 Two different depreciation methods are used
as a systematic means of calculating
depreciation.
 The straight-line method is used when it is
likely that the asset will produce equal
benefits over its service life.
 An accelerated method is used when it is
likely that the asset will produce higher
benefits in the early part of its service life and
lesser benefits in succeeding periods.
11
Straight-Line Method
of Depreciation
 A company uses the straight-line method by
allocating the cost of the asset, less its
estimated residual value, equally to each
period of the asset’s estimated service life.
 The formula can be expressed as follows:
Depreciation
per Year
(Cost – Estimated Residual Value)
=
Estimated Service Life
12
Recording Straight-Line
Depreciation
 If Unlimited Decadence buys a blending
machine for $25,000 on 1/1/04 and estimates its
residual value is $2,500 and its service life to be
5 years, what is the straight-line depreciation
expense and how is it recorded?
Depreciation for the year = $25,000 $2,500/5, or $4,500 per year
Assets
-$4,500
(+Accumulated
Depreciation:
Blending
Machine)
=
Liabilities + Stockholders’ Equity
Remember that
accumulated
depreciation is a “contraasset – as it increases,
assets decrease
-$4,500
(+Depreciation
Expense:
Blending
Machine)
13
Straight-Line
Depreciation:
Unlimited
Decadence
Blending
Machine
Exhibit 21-3
14
Accelerated Depreciation
Methods
 GAAP allows company managers to choose
among several accelerated methods of
depreciation: (1) double-declining balance
method, or (2) sum-of-the-years digits
method.
 Under an accelerated method of depreciation,
depreciation expense is not recorded equally
over the service life.
 Instead, depreciation expense is higher in the
first half of the asset’s service life and lower in
subsequent years.
15
Double Declining Balance
Method of Depreciation
 A company uses the double declining balance
(DDB) method by computing depreciation
expense each year on the declining book value of
the asset.
 DDB means “double the straight-line” rate. In
addition, residual value is ignored in computing
depreciation but depreciation cannot be recorded
below it.
Depreciation
per Year
200%
=
Estimated Service Life
X
Book Value at the
Beginning of Year
16
Recording DDB Depreciation
 If Unlimited Decadence buys a blending
machine for $25,000 on 1/1/04 and estimates its
residual value is $2,500 and its service life to be
5 years, what is the DDB depreciation expense
and how is it recorded?
Depreciation for the year = $25,000 X
40%, or $10,000 in year 1
Assets
-$10,000
(+Accumulated
Depreciation:
Blending
Machine)
=
Liabilities + Stockholders’ Equity
Remember that
accumulated
depreciation is a “contraasset – as it increases,
assets decrease
-$10,000
(+Depreciation
Expense:
Blending
Machine)
17
Recording DDB Depreciation
 Each year, 40% of the declining balance book
value of the blending machine would be
recorded as depreciation until the residual value
is reached.
Year
2004
2005
2006
2007
2008
Book Value
Beg. Year
$ 25,000
$ 15,000
$ 9,000
$ 5,400
$ 3,240
Depreciation Depreciation Accumulated Book Value
Calculation
Expense Depreciation End. Year
40%*$25,000 $ 10,000
$ 10,000
$ 15,000
40%*$15,000 $ 6,000
$ 16,000
$ 9,000
40%*$9,000
$ 3,600
$ 19,600
$ 5,400
40%*$5,400
$ 2,160
$ 21,760
$ 3,240
$ 740
$ 22,500
$ 2,500
Notice that in the last year, depreciation expense is limited to the amount
which will bring the accumulated depreciation to $22,500, leaving a book
(residual) value of $2,500.
18
Depreciation and Income Taxes
 The depreciation rules for GAAP financial
reporting and for Federal income tax reporting are
not the same.
 The objectives are different. Under GAAP, the
objective is to prepare income statements that
fairly present the income-producing activities of a
company which are useful for decision makers.
 The income tax rules are based on the Internal
Revenue Code. Taxes are the primary source of
governmental revenues and the tax rules provide
incentives for business investment.
19
Depreciation and Income Taxes
 Managers of a corporation have the responsibility
to the stockholders to minimize income taxes
without violating the law.
 A corporation takes advantage of accelerated
methods allowed under the tax rules, a system
called the Modified Accelerated Cost Recovery
System (MACRS).
 As an example, General Motors, ExxonMobil, and
General Electric have together saved around $17
billion in taxes by using MACRS.
20
Percentage of an Asset’s Cost Used to
Compute MACRS Depreciation
21
Subsequent Expenditures
 After purchasing an asset, a company often
makes additional expenditures on the asset
during its economic life.
 A capital expenditure is a cost that increases
benefits from the asset by increasing its
usefulness or extending its service life, such as
adding a new wing to a building. Capital
expenditures are added to the cost of the asset
and depreciated.
 An operating expenditure is a cost that maintains
the benefits originally expected from the asset,
such as routine repair and maintenance costs.
Operating expenditures are expenses in the year
incurred.
22
Impairment of PPE
 An asset is an economic resource that will provide
future benefits to the company, such as the net
operating cash flows that the company will
receive from using the asset.
 If the historical book value of an asset is less than
its expected future net operating cash flows, longlived assets like PPE are said to be “impaired.”
 If the book value of an asset is not recoverable
through its future net operating cash flows, a
company must reduce the book value of the asset
and record an impairment loss on its income
statement.
23
Impairment of PPE
 Impairment is a complex concept because it
involves a two-step process. First, an impairment
must exist. Second, an impairment loss must be
calculated.
 The amount of the impairment loss is the
difference between the fair market value and book
value of the asset.
 If Unlimited Decadence determines there is an
impairment loss on building and machinery with a
fair market value of $2.0 million and book value of
$2.5 million, a $500,000 impairment loss is
recognized. The book value of the asset is
reduced to $2.0 million.
24
Disposing of PPE
 When a company disposes of a depreciable
asset, one of three things happens: (1) the
asset is sold for book value as of the date of
disposal, (2) the asset is sold for more or less
than book value as of the date of disposal, or
(3) the asset is traded for another asset.
 Regardless of the reason, a company records
and reports depreciation expense for the
current period up to the date of disposal.
 Then it removes the special asset account
and its related accumulated depreciation
account from the accounting records.
25
Recording An Asset Disposal
 If Unlimited Decadence sells office equipment
for $1,500 that originally cost $10,000 and had a
current book value of $1,000 (accumulated
depreciation of $9,000), how would this be
recorded?
Since $1,500 was received for an asset with a
book value of only $1,000, a gain of $500 is
recognized on the disposal.
Assets
+$1,500
(Cash)
-$10,000
(Office
Equipment)
Stockholders’ Equity
+$9,000
(-Accumulated
Depreciation:
Office
Equipment)
+$500 (Gain on
Sale of
Equipment)
26
Disclosure of Property, Plant and
Equipment: Pepsico
27
Using PPE Financial Information
28
Intangible Assets
 Intangible assets are a company’s long-term
assets that do not have physical substance (as
compared to property, plant and equipment).
 These assets have value because they provide
specific legal rights or economic benefits.
Examples include patents, trademarks,
tradenames, copyrights, franchises, and computer
software.
 For example, if Unlimited Decadence was a real
corporation, it would own the exclusive right for
the words “Unlimited Decadence”, “Empty
Decadence”, and “Pure Decadence.”
29
What Makes Intangible
Assets Unique?
 Intangible assets do not have physical substance
like tangible assets (I.e., property, plant, and
equipment).
 There is generally a higher degree of uncertainty
regarding their future benefits; value is subject to
wide fluctuations because it may depend on
competitive conditions.
 Intangible assets may have value only to a
particular company.
 They may have expected lives that are very
difficult to determine.
30
Recording Intangible Assets
 As with property, plant, and equipment, a
company initially records an intangible asset at its
acquisition cost.
 For some intangibles, the company then allocates
this cost as an expense over the asset’s useful life
using the matching principle. This expense is
called amortization expense and is the intangible
equivalent of depreciation expense for tangible
assets.
 For other intangibles, no amortization expense is
recognized. Instead, the company either
expenses the cost currently or reviews the asset
for impairment.
31
Expensing the Cost of Intangibles
Exhibit 21-14
32
Research and Development
(R&D) Costs
 Many companies engage in R&D to improve their
products or services.
 Research is aimed at the discovery of new
knowledge for use in new or improved product
development; development is the translation of
research into a plan or design for new or
improved product development.
 Since R&D inherently has a high degree of
uncertainty that any new or improved product will
be generated, companies are required to expense
these costs in the period incurred.
33
Patents
 A patent is an exclusive right granted by the U.S.
Government (or the government of another
country) giving the owner of an invention the
control of its manufacture or sale for 20 years
from the date of the patent application.
 The useful life may not be extended by
modifications or improvements of the original
invention.
 As a general rule, a company records the cost of
obtaining a patent, which are the external costs
such as the patent application and any legal costs
incurred, as an intangible asset. If purchased, the
patent is recorded at its cost.
34
Copyrights
 A copyright is an exclusive right granted by the
U.S. government (or the government of another
country) to publish or sell literary or artistic
products for the life of the author plus an
additional 70 years.
 Copyrights cover such items as books, music,
and films.
 As a general rule, a company records the cost of
obtaining a copyright, which are the external costs
such as the copyright application and any legal
costs incurred, as an intangible asset. If
purchased, the copyright is recorded at its cost.
35
Trademark and Tradenames
 A trademark or tradename is an exclusive right
granted by the U.S. government (or the government
of another country) to use a name or symbol for
product identification. The right lasts for 20 years
and is renewable indefinitely as long as it is being
used.
 Pepsi, Fritolay, Tropicana, Quaker and Gatorade are
all examples of tradenames owned by Pepsico.
 A company records the cost of obtaining a
trademark/tradename, which are the external costs
such as the application and any legal costs incurred,
as an intangible asset. If purchased, the
trademark/tradename is recorded at its cost.
36
Franchises
 A franchise is an agreement entered into by two
parties. For a fee, one party (the franchisor) gives
the other party (the franchisee) rights to perform
certain functions or sell certain products or
services over the legal life of the franchise.
 For example, many McDonald’s restaurants are
locally owned and operated under franchise
agreements with McDonalds Corporation.
 As with other intangibles, a company records the
cost of obtaining the franchise.
37
Computer Software Costs
 A company that designs software for sale incurs
three type of costs: software production costs, unit
cost of producing the software, and maintenance
and customer-support costs.
 The first type of software production costs are R&D
costs, which establish the technological feasibility of
the product. Like other R&D costs, these are
expensed as incurred.
 Once technological feasibility has been established,
the software production costs can be capitalized as
an intangible asset.
 After the product is ready for sale, subsequent
software production costs are expensed.
38
Computer Software Costs
 Computer software companies are a specialized
industry with unique rules to determine the period
over which software can be amortized once it is
recorded as an intangible asset.
 In practice, most companies expense the
software production costs because technological
feasibility does not occur until the software is
produced.
 For many companies, software may be the only
revenue producing asset. One may argue that
the accounting rules do not adequately provide
the guidance that is needed.
39
Computer Software Costs
 The second type of cost is the unit cost of
producing the software, such as costs of the disks
and the duplication of the software, packaging,
documentation, etc.
 These unit costs are treated as inventory and
then as cost of goods sold when the software is
sold to customers.
 The third category is maintenance and customersupport costs after the software is released.
These costs are recorded as expenses when
incurred.
40
Goodwill
 Goodwill is intrinsic value embedded in a
business that causes a willing buyer to pay a
price greater than the identifiable net assets it
acquires.
 Goodwill is the most intangible of intangibles and
includes such items as a company’s reputation,
trained employees, brand recognition, market
share, high-quality products, innovative
marketing, etc. – all of those intangible things that
create earning power for a business.
 It can only be recorded as an intangible if
purchased. It is not subject to amortization but
must be tested for impairment.
41
Amortization and Impairment
of Intangible Assets
 Intangible assets that have a limited life (i.e., such
as a patent, copyright) are amortized over the
expected life of the benefits they produce.
 Amortization expense, like depreciation expense,
allocates a portion of the asset’s acquisition cost,
to expense on a systematic basis.
 Like PPE, intangible assets must also be
reviewed for impairment. It may be necessary to
record an impairment loss to adjust the value of
the intangible on a company’s books if an
impairment loss exists.
42
Recording Amortization
 If a company has a patent that cost $20,000
and has an estimated life of 10 years, how
does the company record the yearly
amortization?
Amortization for the year = $20,000/10
years = $2,000 per year
Assets
-$2,000
(+Accumulated
Amortization:
Patent)
=
Liabilities + Stockholders’ Equity
Remember that
accumulated amortization is
a “contra-asset” like its
accumulated depreciation
counterpart – as it
increases, assets decrease
-$2,000
(+Amortization
Expense:
Patent)
43
Disclosure of Intangibles: Pepsico
Exhibit 21-15
44
Natural Resource Assets
 In addition to property, plant and equipment
and intangible assets, some companies have
natural resource assets (sometimes called
wasting assets).
 A natural resource asset is an asset that is
used up as it is extracted, mined, dug up, or
chopped down. Examples of natural
resources assets include oil, coal, gravel, and
timber.
 A company accounts for these in the same
manner as other categories of physical, longterm assets.
45
Natural Resource Assets
 The cost of natural resources assets are also
allocated to expense over the expected
service life of the asset.
 The expense is called “depletion” expense
which is similar in nature to depreciation and
amortization expense – different labels for
different categories of assets.
 A company uses the units-of-production
method to compute depletion expense based
on the amount of a natural resource asset
that is used up.
46
Units-of-Production Method
of Depreciation
 A company uses the units-of-production method
to record annual depletion on natural resources
assets.
 A depletion rate is computed based on the total
expected units to be extracted from the natural
resource. This rate is then applied to the actual
units extracted during a period.
Depletion
Rate
(Cost – Estimated Residual Value)
=
Total Estimated Lifetime Activity Level
47
Units-of-Production Method
of Depreciation
 If the Deep Pit Mine Company purchased a copper
mine for $10 million (no residual value) and
estimates that the mine will produce 10,000 tons of
copper, how is the depletion rate calculated?
Depletion
Rate
(Cost – Estimated Residual Value)
=
Total Estimated Lifetime Activity Level
$10,000,000
10,000 tons of copper
=
$1,000 per
ton of copper
48
Units-of-Production Method
of Depreciation
 If the depletion rate is $1,000 per ton of
copper, how is the depletion calculated if
500 tons of copper are mined in 2004 from
the Deep Pit Mine?
500 tons of copper X $1,000
per ton = $500,000
The depletion expense for
2004 = $500,000.
49