Chapter 5
Acquisitions: Purchase and Use
of Business Assets
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Classification of Operational Assets

Operational assets are used by a
business to generate revenue.

Tangible operational assets have
physical substance.
 Land, buildings, fixtures,
and equipment
 Natural resources
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Long-term Operational Assets...


Long-term assets will be
used more than one
year.
Tangible operational
assets are reported on
the balance sheet in a
classification called
Property, Plant, and
Equipment.
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Classification of Operational Assets

Intangible operational assets lack
physical substance and confer specific
use rights on the owner.
 Patents
 Copyrights
 Franchises
 Licenses
 Trademarks
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Measuring and Recording
Acquisition Cost
Purchased operational assets are recorded at
cost, an amount that includes all normal and
reasonable expenditures necessary to get the asset
in place and ready for its intended use.
Invoice price
 Sales
taxes
 Transportation costs
 Installation costs
 Renovation and repair cost incurred prior to use.
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Measuring Acquisition Cost

Acquisition cost is the net cash
equivalent amount paid for the asset.

Financing charges are excluded from
the acquisition cost but should be
reported as interest expense.
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Basket Purchase of Acquisitions
When land and building are purchased
together, the land cost and the building
cost are placed in separate accounts.
The total cost of the purchase is
separated on the basis of relative
market values.
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Basket Purchase of Acquisitions
Example: On March 1, Arco Co. purchased
land and building for $200,000 cash. The
appraised value of the building was $172,500,
and the land was appraised at $57,500. How
much of the $200,000 purchase price will be
allocated to each account?
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Basket Purchase of Acquisitions
Fair Market Values:
Building
Land
$ 172,500
$ 57,500
Total market value
$ 230,000
Allocation of cost:
Building
Land
* $200,000 =
* $200,000 =
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Basket Purchase of Acquisitions
Fair Market Values:
Building
Land
$ 172,500
$ 57,500
Total market value
$ 230,000
Allocation of cost:
Building
Land
172,500/230,000 * $200,000 =
57,500/230,000 * $200,000 =
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Basket Purchase of Acquisitions
Fair Market Values:
Building
Land
$ 172,500
$ 57,500
Total market value
$ 230,000
Allocation of cost:
Building
Land
.75 * $200,000 = 150,000
.25 * $200,000 = 50,000
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Nature of Depreciation, Depletion,
and Amortization
The matching principle requires that part of
the acquisition cost be expensed in periods
when the future revenues are earned.
Cost of asset
on Balance
Sheet
...as the asset
is used.....
Expense on
Income
Statement
[expense]
[capitalize]
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Terminology: Write-off….amortize
The most general term for writing off an asset is
amortization. However, specific terms are used for
certain assets:
 Depreciation:


Amortization:

Property, plant,
equipment
Intangible assets

Depletion:
–Natural resources
franchise
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Depreciation Methods
 Straight-line
 Production method
 (Double) Declining balance
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Straight-Line Method
Depreciation
Expense per Year
=
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Cost - Residual Value
Life in Years
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Straight-Line Method: Example
On January 1, 2003, equipment was
purchased for $55,000 cash. The
equipment has an estimated useful
life of 5 years and an estimated
residual value of $10,000.
What is the annual straightline depreciation expense?
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Straight-Line Method: Example
Depreciation
Expense per Year
=
Depreciation
Expense per Year
=
Depreciation
Expense per Year
=
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Cost - Residual Value
Life in Years
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Straight-Line Method: Example
Depreciation
Expense per Year
=
Depreciation
Expense per Year
=
Depreciation
Expense per Year
=
Cost - Residual Value
Life in Years
55,000 - 10,000
5
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Straight-Line Method: Example
Depreciation
Expense per Year
Depreciation
Expense per Year
Depreciation
Expense per Year
=
=
Cost - Residual Value
Life in Years
55,000 - 10,000
5
=
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9,000
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Straight-Line Method: Example
Calculate depreciation expense for the
fourth year of the asset’s life.
$9000
Depreciation expense is the same
amount each year of the asset’s life
using the straight-line method.
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Units-of-Production Method
Step 1:
Depreciation
Rate
=
Cost - Residual Value
Estimated units of useful life
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Units-of-Production Method
Step 1:
Depreciation
Rate
=
Cost - Residual Value
Estimated units of useful life
=
Number of
Depreciation
× Units Produced
Rate
for the Year
Step 2:
Depreciation
Expense
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Units of Production Method:
Example
Given the same information [asset cost
$55,000, a residual value of $10,000, and a
useful life of five years] plus the asset is
estimated to have a total productive capacity
of 100,000 units during the useful life:
If 22,000 units were produced this year,
what is the amount of depreciation
expense?
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Production Method: Example
Step 1:
Depreciation =
Rate
Cost - salvage value
45,000
=
Productive output
100,000
Step 2:
Depreciation
=
Expense
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Production Method: Example
Step 1:
Depreciation =
Rate
Cost - salvage value
Productive output
45,000
=
100,000
Step 2:
Dep. rate * units produced
Depreciation
= $ .45/unit * 22,000
=
Expense
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9,900
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Production Method: Example

If 15,000 units are produced during the
second year of the asset’s life, what is
the amount of depreciation expense?
.45 * 15000 =
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6750
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Accelerated Depreciation

Accelerated depreciation methods result in
more depreciation expense in the early
years of an asset’s useful life and less
depreciation expense in later years of the
an asset’s useful life.
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Double-Declining Balance Method


Declining-balance depreciation is based
on the straight-line rate multiplied by an
acceleration factor.
 For example, when the acceleration
factor is 200 percent, the method is
referred to as double-declining
balance depreciation.
Declining-balance depreciation
computations ignore residual value,
although the asset can’t be depreciated
below the residual value.
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Double-Declining Balance Method
First, calculate a rate by dividing 2 by the number
of years of useful life.
=
The annual depreciation amount is
calculated with the following formula:
Book Value × (2 × Straight-Line Rate)
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Double-Declining Balance Method
Annual depreciation expense is
calculated with
the following formula:
2
Book Value ×
(
Useful Life in Years
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Double-Declining-Balance Example
Using the same information from our
earlier example [asset cost $55,000,
residual value is $10,000, and useful life
is 5 years]:
Calculate the depreciation expense
for the first two years of the asset’s life.
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Double-Declining Balance Method
Rate = 2/5 = 40%
First year’s depreciation:
Second year’s depreciation:
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Double-Declining-Balance Example
Rate = 2/5 = 40%
First year’s depreciation:
55,000 * .40 =
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22,000
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Double-Declining-Balance Example
Rate = 2/5 = 40%
First year’s depreciation:
55,000 * .40 =
22,000
Second year’s depreciation:
33,000 * .40 =
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13,200
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Comparison of Methods

The total amount of depreciation recorded
over the useful life of an asset is the same
regardless of the method used.

Depreciation expense recorded in any one
period will vary according to method used.

The straight-line method is used by about
95 percent of companies because it is
easy to use and to explain.
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Depreciation and
Federal Income Tax

Most corporations use the Modified
Accelerated Cost Recovery System
(MACRS) for tax purposes.

MACRS provides for rapid
write-off of an asset’s cost in
order to stimulate investment
in modern facilities.
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Revising Estimates of Salvage
Value or of Useful Life



When an estimate is revised, no changes
are made to amounts reported in the
past.
The new estimates are incorporated into
the present and future calculations only.
Depreciation amounts are revised using
the book value and the estimated useful
life and salvage value at beginning of the
year of the revision.
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Continuing Expenditures
for Plant Assets


Expenditures made to keep
an asset in good working
order are expensed in the
period in which they are
incurred.
Substantial costs spent to
improve the quality or extend
the life of an asset are
capitalized.
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Accounting for Capital Expenditures

Extend the life?




viewed as canceling
some of the previous
depreciation
journal entry to reduce
(debit) accumulated
depreciation
new depreciation
amount will be
calculated
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Improve the quality?



viewed as an additional
cost of the equipment
journal entry to increase
(debit) the cost of the
asset
new depreciation
amount will be
calculated
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Disposal of Operational Assets


Voluntary disposal refers to situations
where a business gives up ownership of
an asset by:

Sale

Trade-in

Retirement
Involuntary disposal results because of
a casualty such as a fire or an accident.
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Disposal of Operational Assets
1. Update the depreciation on the asset to
the date of disposal.
2. Compare the book value of the asset to the
cash proceeds from the disposal. If the
proceeds > book value, there is a gain on
the disposal. If the book value > proceeds,
then there is a loss on the sale.
3. Gains and losses go on the income
statement.
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Asset Disposal: Example

Truck which was
purchased for
$10,000 and with
accumulated
depreciation of
$8,000 was sold for
$3,000.
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Compare the Book Value (10,0008,000) to the cash proceeds (3,000).
 The difference is a gain or loss on the
sale.
 Here it is a gain:
Proceeds of $3,000 > BV of $2,000
 Gain of $1,000 goes to the income
statement.

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Asset Disposal: Example

Truck which was
purchased for
$10,000 and with
accumulated
depreciation of
$8,000 was sold for
$1,000.
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Compare the Book Value (10,000-8,000) to
the cash proceeds (1,000).
 The difference is a gain or loss on the sale.
 Here it is a loss:
Book value of $2,000 > Proceeds of
$1,000
 Loss on disposal of $1,000 goes to the
income statement.

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Disposal of Operational Assets
Compare cash received for the asset with
the asset’s book value (BV).
If cash greater than BV, record a gain.
 If cash less than BV, record a loss.
 If cash equals BV, no gain or loss.

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Natural Resources

Assets supplied by nature

Examples: gold, oil, and coal

Presented on balance sheet as
non-current assets at cost less
depletion to date.

Depletion is just like “units of
production” depreciation.
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Natural Resources

Total cost of the asset is the cost of
acquisition, exploration and development.

Total cost is apportioned by means of
depletion over periods in which resulting
revenues are earned.
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Natural Resources
A depletion rate is calculated using
the units-of-production method.
Depletion Cost Per Unit Is Calculated As Follows:
Total Cost of Natural Resource
Estimated Number of Available Units
of Natural Resource
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Intangible Assets

Noncurrent assets without physical
substance that confer certain rights and
privileges on the owner of the asset.


Examples: patents, copyrights, franchises
and licenses, leaseholds, leasehold
improvements, trademarks, and goodwill.
Purchased intangible assets are recorded
at cost.
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Intangible Assets

Purchased intangible assets are amortized
over the shorter of their economic life or legal
life, subject to a maximum of 40 years.

Normally the straight-line method is used and
the asset is reported in the balance sheet at
book value without a related accumulated
amortization account.
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Intangible Assets: Patents

A patent is an exclusive right granted by
federal government to sell or
manufacture an invention.

A patent is amortized over the shorter of
its useful life or 17-year legal life.
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