FIXED ASSETS AND INTANGIBLE ASSETS

CHAPTER 9

NATURE OF FIXED ASSETS

Fixed assets are long-term or relatively permanent assets, such as equipment, machinery, buildings, and land. Other descriptive titles for fixed assets are plant assets or property, plant, and equipment.

Objective 1:

Define, classify, and account for the cost of fixed assets.

NATURE OF FIXED ASSETSFixed assets have the following characteristics:

They exist physically and, thus, are tangible assets.

They are owned and used by the company in its normal operations.

They are not offered for sale as part of normal operations.

CLASSIFYING COSTS

Costs of Acquiring Fixed Assets

Costs of Acquiring Fixed Assets

Costs of Acquiring Fixed Assets Unnecessary costs that do not increase the

asset’s usefulness are recorded as an expense. Vandalism Mistakes in installation Uninsured theft Damage during unpacking and installing Fines for not obtaining proper permits

from government agencies

Capital and Revenue Expenditures Revenue

Expenditures Normal and

ordinary repairs and maintenance

Capital Expenditures

Additions, improvements, and extraordinary repairs

Leasing Fixed Assets

The two parties to a lease contract:THE two parties to a lease contract:

The lessor is the party who owns the asset.The lessee is the party to whom the rights to use the asset are granted by the lessor.

LEASING FIXED ASSETS A capital lease is accounted for as if the

lessee has, in fact, purchased the asset. The asset is then amortized (written off as an expense) over the life of the capital lease.

A lease that is not classified as a capital lease for accounting purposes is classified as an operating lease. An operating lease is treated as an expense, because the lessee is renting the asset for the lease term

Depreciation:

Over time, most fixed assets (equipment, buildings, and land improvements) lose their ability to provide services. The periodic recording of the cost of fixed assets as an expense is called depreciation.

Objective 2: Compute depreciation, using the following methods: straight-line method, units-of-production method, and double-declining-balance method.

ACCOUNTING FOR DEPRECIATION Depreciation can be caused by physical or

functional factors. Physical depreciation factors include

wear and tear during use or from exposure to the weather.

Functional depreciation factors include obsolescence and changes in customer needs that cause the asset to no longer provide services for which it was intended.

ACCOUNTING FOR DEPRECIATION Two common misunderstandings that

exist about depreciation as used in accounting include:1. Depreciation does not measure a decline

in the market value of a fixed asset.2. Depreciation does not provide cash to

replace fixed assets as they wear out. Three factors determine the

depreciation expense for a fixed asset:

1. The asset’s initial cost

2. The asset’s expected useful life

3. The asset’s estimated residual value

The expected useful life of a fixed asset is estimated at the time the asset is placed into service. The residual value of a fixed asset at the end of its useful life is also estimated at the time the asset is placed into service.

Depreciation Methods The straight-line method provides for the

same amount of depreciation expense for each year of the asset’s useful life.

Annual Depreciation

Cost – Residual Value

Useful Life=

Initial cost

$24,000Expected useful life

5 yearsEstimated residual value

$2,000

STRAIGHT LINE METHOD EXAMPLE Initial cost $24,000 Expected useful life 5 years Estimated residual value $2,000

The annual straight-line depreciation of $4,400 is computed below:

Annual Depreciation =Cost – Residual Value

Useful Life

$24,000 - $2,000

5 years

= $4,400

If the preceding equipment was purchased and placed into service on October 1, the depreciation for the first year of use w

The straight-line percentage can be determined by dividing 100% by the number of years of expected useful life, as shown below.

$1,100, computed as follows:

If the preceding equipment was purchased and placed into service on October 1, the depreciation for the first year of use would be $1,100, computed as follows:

$4,400 x 3/12 = $1,100

Units-of-Production Method The units-of-production method provides the

same amount of depreciation expense for each unit produced or each unit of capacity used by the asset. Step 1. Determine the depreciation per unit

as:

Step 2. Compute the depreciation expense as:

Depreciation per Unit =

Cost – Residual Value

Total Units of Production

Depreciation Expense = Depreciation per Unit x Total Units of Production Used

Units-of-Production MethodA depreciable asset costs $24,000. Its estimated residual value is $2,000, and it is expected to have a useful life of 10,000 operating hours. During the year, the asset was operated 2,100 hours.

Double-Declining-Balance Method The double-declining-balance method

provides for a declining periodic expense over the expected useful life of the asset.

The double-declining-balance method is applied in three steps:Step 1. Determine the straight-line percentage using the expected useful life.Step 2. Determine the double-declining- balance rate by multiplying the straight-line rate from Step 1 by 2.Step 3. Compute the depreciation expense by multiplying the double-declining-balance rate from Step 2 times the book value of the asset.

The double-declining-balance rate is determined by doubling the straight-line rate.

A shortcut to determining the straight-line rate is to divide one by the number of years (for example, 1 ÷ 5 = 0.20).

Using the double-declining-balance method, a five-year life results in a 40 percent rate (0.20 × 2).

For the first year, the book value of the equipment is its initial cost of $24,000.

After the first year, the book value (cost minus accumulated depreciation) declines and, thus, the depreciation also declines.

The double-declining-balance depreciation for the full five-year life of the equipment is shown below.

DEPRECIATION STOPS WHEN BOOK VALUE EQUALS RESIDUAL VALUE!

STOPSTOP

“Forced” depreciation for 5th year

DOUBLE DECLINING BALANCE METHODIf the preceding equipment was purchased and placed into service on October 1, depreciation for the year ending December 31 would be $2,400, computed as follows:

First year partial depreciation

= $9,600 x 3/12 = $2,400

The depreciation for the second year would then be $8,640, computed as follows:

Second year depreciation

= [40% x ($24,000 – $2,400)]

Second year depreciation

= $8,640

The double-declining-balance method provides a higher depreciation in the first year of the asset’s use, followed by declining depreciation amounts. Thus, it is called an accelerated depreciation method.

Comparing Depreciation Methods

Discarding Fixed Assets

Equipment acquired at a cost of $25,000 is fully depreciated at December 31, 2011. On February 14, 2012, the equipment is discarded.

Note: The entry to record the disposal of a fixed asset removes the cost of the asset and its accumulated depreciation from the accounts.

Objective 3: Journalize entries for the disposal of fixed assets.

Equipment costing $6,000, with no residual value, is depreciated at an annual straight-line rate of 10%. After the December 31, 2011, adjusting entry, Accumulated Depreciation—Equipment has a $4,750 balance. On March 24, 2012, the asset is removed from service and discarded.

$600 × 3/12

The discarding of the equipment is then recorded as shown below. (Note that this is the second of two entries on March 24.)

SELLING FIXED ASSETSEquipment was purchased at a cost of $10,000. It had no estimated residual value and was depreciated at a straight-line rate of 10%. The equipment is sold for cash on October 12 of the eighth year of its use. The balance of the accumulated depreciation account as of the preceding December 31 is $7,000.

The entry to update the depreciation for the nine months of the current year is as follows:

After the current depreciation is recorded, the book value of the asset is $2,250 ($10,000 – $7,750).

Sold at book value for $2,250. No gain or loss.Sold at book value for $2,250. No gain or loss.

After the current depreciation is recorded, the book value of the asset is $2,250 ($10,000 – $7,750).

Sold below book value for $1,000. Loss of Sold below book value for $1,000. Loss of $1,250.$1,250.

After the current depreciation is recorded, the book value of the asset is $2,250 ($10,000 – $7,750).

Sold below book value for $1,000. Loss of Sold below book value for $1,000. Loss of $1,250.$1,250.

Objective 4: Compute depletion and journalize the entry for depletion.

The fixed assets of some companies include :

TimberMetal oresMineralsOther natural resources

As the resource is harvested a portion of the cost is expensed.The process of transferring the cost of natural resources to an expense account is called depletion.

Patents, copyrights, trademarks, and goodwill are long-lived assets that are used in the operations of a business and not held for sale. These assets are called intangible assets because they do not exist physically. The accounting for intangible assets is similar to that for fixed assets. The major issues are: Determining the initial cost. Determining the amortization, which is the

amount of cost to transfer to expense.

Objective 5: Describe the accounting for intangible assets, such as patents, copyrights, and goodwill.

Patents The exclusive right granted by the federal

government to produce and sell goods with one or more unique features is called a patent. These rights continue in effect for 20 years.At the beginning of its fiscal year, a business acquires

patent rights for $100,000. The patent’s remaining useful life is estimated at 5 years. The entry to amortize the patent at the end of the year is as follows:

Examples of Patents

Copyrights and Trademarks The exclusive right granted by the federal

government to publish and sell a literary, artistic, or musical composition is called a copyright. A copyright extends for 70 years beyond the author’s death.

A trademark is a unique name, term, or symbol used to identify a business and its products. Most businesses identify their trademarks with ® in their advertisements and on their products. Trademarks can be registered for 10 years and renewed for 10-year periods thereafter.

Examples of Copyrights and Trademarks

Goodwill In business, goodwill refers to an intangible asset of a

business that is created from such favorable factors as location, product quality, reputation, and managerial skill.

Generally accepted accounting principles (GAAP) permit goodwill to be recorded in the accounts only if it is objectively determined by a transaction.A loss should be recorded if the business prospects of an

acquired firm (and the acquired goodwill) become significantly impaired. Assume that on December 31, FaceCard Company has determined that $250,000 of the goodwill created from the purchase of Electronic Systems is impaired.

Comparison of Intangible Assets

Fixed and Intangible AssetsObjective 6: Describe how depreciation expense is reported in an income statement and prepare a balance sheet that includes fixed assets and intangible assets.

Fixed and Intangible Assets

Intangible assets are usually reported in the balance sheet in a separate section following fixed assets.

The balance of each class of intangible assets should be disclosed net of any amortization.

The cost and related accumulated depletion of mineral rights are normally shown as part of the Fixed Assets section of the balance sheet.

Objective 7:

Describe and illustrate the fixed asset turnover ratio to assess the efficiency of a company’s use of its fixed assets.

Fixed Asset Turnover Ratio One measure of the revenue-generating

efficiency of fixed assets is the fixed asset turnover ratio. It measures the number of dollars of revenue earned per dollar of fixed assets and is computed as follows:

Fixed Asset Turnover

Ratio

Net Sales

Average Book Value of Fixed Assets

=

Assignments all due Friday, 12/051. PE 9-9A page 4342. PE 9-9B page 4343. Exercise 9-23 page 4394. Exercise 9-24 page 4395. CP 9-5 page 4466. Compute the fixed asset turnover for one of your companies. Use the most current year.All work is to be written or typed out clearly showing all work. Be sure to indicate each assignment by number and hand in when complete.