Plant Asset Disposals, Natural Resources, and Intangible Assets

Learning objectives

After studying this chapter, you should be able to:

• Calculate and prepare entries for the sale, retirement, and destruction of plant assets.
• Describe and record exchanges of nonmonetary assets.
• Determine the periodic depletion cost of a natural resource and calculate depreciation of plant assets located on extractive industry property.
• Prepare entries for the acquisition and amortization of intangible assets.
• Analyze and use the financial results-total assets turnover.

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A company accountant's role in measuring intangibles

Many assets have no physical substance. These assets are referred to as intangible. Even though these assets have no substance, the accountant still must spend time measuring the value of these assets to corporation and how these assets contribute to the cash flow of the entity.

The accountant must first place a value on something that cannot be seen by the naked eye. Then the accountant must determine if the asset is making a contribution toward cash flow of the entity (if so and how long) and finally, the accountant must determine if and when this benefit has indeed expired.

As we move ever more toward an information based economy, the percent of intangible assets to total assets also increases. In many cases, intangible assets compose a significant majority of total assets. Thus, the earning power of such companies is primarily based on the valuation of assets that cannot be seen or touched. Some intangible assets, such as human assets and internally generated intangibles, are not even recorded on the company's books. This makes it even more difficult to value the assets and determine their contribution to earnings.

Investors and analysts often compare book value per share with the market price per share for a corporation. This ratio is referred to as the price to book ratio (PB). It measures the market's beliefs about the value of net assets as compared to the recorded amount of net assets. In 1998 Tootsie Roll had a PB ratio of approximately 5.2. The recorded net assets were approximately USD 400 million, yet the market perceived Tootsie Roll to have net assets worth over USD 2,000 million. What is the nature of those unrecorded (intangible) assets? In 1998, Microsoft had a PB ratio of approximately 12.4. The real value of Microsoft's net assets exceeded those reported in the accounting records by a factor of 12.4. It is reasonable to assume that a large portion of the unrecorded assets of Microsoft must be intangible. How does the accountant value something that has no physical substance and in many cases has not been recorded? It is similar to walking around in a dark closet wearing a blindfold.

This function is closely related to the work of the plant asset accountant. Many of the same questions must be addressed when accounting for intangible assets. The question still remains, how can you measure something you cannot see?

Your study of long-term assets - plant assets, natural resources, and intangible assets - began in Chapter 10, which focused on determining plant asset cost, computing depreciation, and distinguishing between capital and revenue expenditures. This chapter begins by discussing the disposal of plant assets. The next topic is accounting for natural resources such as ores, minerals, oil and gas, and timber. The final topic is accounting for intangible assets such as patents, copyrights, franchises, trademarks and trade names, leases, and goodwill.

Note that accounting for all the long-term assets discussed in these chapters is basically the same. A company that purchases a long-term asset records it at cost. As the company receives benefits from the asset and its future service potential decreases, the accountant transfers the cost from an asset account to an expense account. Finally, the asset is sold, retired, or traded in on a new asset. Because the lives of long-term assets can extend for many years, the methods accountants use in reporting such assets can have a dramatic effect on the financial statements of many accounting periods.

Disposal of plant assets

All plant assets except land eventually wear out or become inadequate or obsolete and must be sold, retired, or traded for new assets. When disposing of a plant asset, a company must remove both the asset's cost and accumulated depreciation from the accounts. Overall, then, all plant asset disposals have the following steps in common:

• Bring the asset's depreciation up to date.
• Record the disposal by:

(a) Writing off the asset's cost.

(b) Writing off the accumulated depreciation.

(c) Recording any consideration (usually cash) received or paid or to be received or paid.

(d) Recording the gain or loss, if any.

As you study this section, remember these common procedures accountants use to record the disposal of plant assets. In the paragraphs that follow, we discuss accounting for the (1) sale of plant assets, (2) retirement of plant assets without sale, (3) destruction of plant assets, (4) exchange of plant assets, and (5) cost of dismantling and removing plant assets.

Sale of plant assets

Companies frequently dispose of plant assets by selling them. By comparing an asset's book value (cost less accumulated depreciation) with its selling price (or net amount realized if there are selling expenses), the company may show either a gain or loss. If the sales price is greater than the asset's book value, the company shows a gain. If the sales price is less than the asset's book value, the company shows a loss. Of course, when the sales price equals the asset's book value, no gain or loss occurs.

To illustrate accounting for the sale of a plant asset, assume that a company sells equipment costing USD 45,000 with accumulated depreciation of USD 14,000 for USD 35,000. The firm realizes a gain of USD 4,000:

The journal entry to record the sale is:

If on the other hand, the company sells the equipment for USD 28,000, it realizes a loss of USD 3,000 (USD 31,000 book value - USD 28,000 sales price). The journal entry to record the sale is:

If a firm sells the equipment for USD 31,000, no gain or loss occurs. The journal entry to record the sale is:

Accounting for depreciation to date of disposal When selling or otherwise disposing of a plant asset, a firm must record the depreciation up to the date of sale or disposal. For example, if it sold an asset on April 1 and last recorded depreciation on December 31, the company should record depreciation for three months (January 1-April 1). When depreciation is not recorded for the three months, operating expenses for that period are understated, and the gain on the sale of the asset is understated or the loss overstated.

To illustrate, assume that on 2011 August 1, Ray Company sold a machine for USD 1,500. When purchased on 2003 January 2, the machine cost USD 12,000; Ray was depreciating it at the straight-line rate of 10 percent per year. As of 2010 December 31, after closing entries were made, the machine's accumulated depreciation account had a balance of USD 9,600. Before determining a gain or loss and before making an entry to record the sale, the firm must make the following entry to record depreciation for the seven months ended 2011 July 31:

An accountant would compute the USD 200 loss on the sale as follows:

The journal entry to record the sale is:

When retiring a plant asset from service, a company removes the asset's cost and accumulated depreciation from its plant asset accounts. For example, Hayes Company would make the following journal entry when it retired a fully depreciated machine that cost USD 15,000 and had no salvage value:

 Occasionally, a company continues to use a plant asset after it has been fully depreciated. In such a case, the firm should not remove the asset's cost and accumulated depreciation from the accounts until the asset is sold, traded, or retired from service. Of course, the company cannot record more depreciation on a fully depreciated asset because total depreciation expense taken on an asset may not exceed its cost.

Sometimes a business retires or discards a plant asset before fully depreciating it. When selling the asset as scrap (even if not immediately), the firm removes its cost and accumulated depreciation from the asset and accumulated depreciation accounts. In addition, the accountant records its estimated salvage value in a Salvaged Materials account and recognizes a gain or loss on disposal. To illustrate, assume that a firm retires a machine with a USD 10,000 original cost and USD 7,500 of accumulated depreciation. If the machine's estimated salvage value is USD 500, the following entry is required:

An accounting perspective:
Uses of technology

The main advantages that companies give for having a home page on the Internet are (1) increased efficiency in the work environment, (2) increased revenue, and (3) faster customer access. A home page can be developed for a small company for a few hundred dollars and can be maintained for a fairly low monthly fee. The Small Business Administration has a website at http://www.sba.gov that provides helpful information to small businesses. One concern that companies have regarding Internet use by their employees is that they might visit interesting nonbusiness related sites on company time.

Sometimes accidents, fires, floods, and storms wreck or destroy plant assets, causing companies to incur losses. For example, assume that fire completely destroyed an uninsured building costing USD 40,000 with up-to-date accumulated depreciation of USD 12,000. The journal entry is:

If the building was insured, the company would debit only the amount of the fire loss exceeding the amount to be recovered from the insurance company to the Fire Loss account. To illustrate, assume the company partially insured the building and will recover USD 22,000 from the insurance company. The journal entry is:

Exchanges of nonmonetary assets Until late 2004, the rules according to APB Opinion No. 29 for recording exchanges of nonmonetary assets depended on whether they were exchanges of dissimilar assets such as a truck for a machine or were similar assets such as a truck for a truck. If the exchange classified as an exchange of dissimilar assets, the acquired asset would be recorded at its fair value and any gain or loss would be recognized. In late 2004, the FASB issued a new standard, Statement of Financial Accounting Standards No. 153, "Exchanges of Nonoperating Assets: an amendment of APB Opinion No. 29". This new standard was issued to bring about greater agreement between US Generally Accepted

Accounting Principles and International Financial Reporting Standards and is effective for exchanges occurring during fiscal periods beginning after 2005 June 15.

This change allows the financial statements of US companies to be more comparable to the financial statements of companies utilizing International Financial Reporting Standards.

The new FASB standard no longer distinguishes between dissimilar and similar asset exchanges. Instead it differentiates between exchanges that have commercial substance and those that do not have commercial substance. An exchange has commercial substance if, as a result of the exchange, future cash flows are expected to change significantly. For instance, if a company exchanges a building for land (a dissimilar exchange), the timing and the future cash flows are likely to be different than if the exchange had not occurred. Most exchanges qualify as having commercial substance. However, if the exchange is not expected to create a significant change in future cash flows, the exchange does not result in commercial substance. For example, if a company exchanges one truck for another truck (a similar exchange) that will perform the same function as the old truck and for the same time period so that the future cash flows are not significantly different, then the exchange does not result in commercial substance. However, if the future cash flows are likely to be significantly different, then the exchange of similar assets has commercial substance.

Exchanges of nonmonetary assets having commercial substance For exchanges of nonmonetary assets that have commercial substance, accountants record the new asset at the fair market value of the asset received or the asset(s) given up, whichever is more clearly evident. When the cash price of the new asset is stated, they use the cash price to record the new asset. If the cash price is not stated, they assume that the fair market value of the old asset plus any cash paid would equate to the cash price of the new asset and use that value to record the new asset. Thus, accountants would normally record the asset received at either (1) the stated cash price of the new asset or (2) a known fair market value of the asset given up plus any cash paid.

Debiting accumulated depreciation and crediting the old asset removes the book value of the old asset from the accounts. The firm credits the Cash account for any amount paid. If the amount at which the new asset is recorded exceeds the book value of the old asset plus any cash paid, a company records a gain to balance the journal entry. If the situation is reversed, it records a loss to balance the journal entry. To illustrate such an exchange having commercial substance, assume a company exchanges an old machine for a new delivery truck. The future cash flows from the exchange are expected to be significantly different and, therefore, the exchange has commercial substance. The machine cost USD 45,000 and had an upto-date accumulated depreciation balance of USD 38,000. The truck had a USD 55,000 cash price and was acquired by trading in the machine with a fair value of USD 3,000 and paying USD 52,000 cash. The journal entry to record the exchange is:

Another way to compute the USD 4,000 loss on the exchange is to use the book value of the old asset less the fair market value of the old asset. The calculation is as follows:

To illustrate the recognition of a gain from such an exchange having commercial substance, assume that the fair market value of the machine was USD 9,000 instead of USD 3,000, and that only USD 46,000 was paid in cash. The journal entry to record the exchange would be:

Another way to compute the gain of USD 2,000 on the exchange is to use the fair market value of the old asset less the book value of the old asset. The calculation is as follows:

Remember, when the book value and the market value of the old asset are different, companies always recognize a gain or a loss on an exchange of nonmonetary assets having commercial substance. As discussed earlier, they do not recognize a gain or loss on an exchange of nonmonetary assets not having commercial substance.

Exchanges of nonmonetary assets not having commercial substance Often firms exchange plant assets such as automobiles, trucks, and office equipment by trading the old asset for a similar new one. Once in a while, such an exchange does not result in an expected change in future cash flows and therefore lacks commercial substance. When such an exchange occurs, the company receives a trade-in allowance for the old asset, and pays the balance in cash. Usually, the cash price of the new asset is stated. If not, accountants assume the cash price of the new asset is the fair market value of the old asset plus the cash paid.

When such assets are exchanged, we must modify the general rule that new assets are recorded at the fair market value of what is given up or received, whichever is clearer. Thus, companies record the new asset at the book value of the old asset plus the cash paid. When applying this rule to exchanges of assets where no commercial substance results, firms recognize no losses or gains.

To illustrate the accounting for exchanges of nonmonetary assets that do not have commercial substance, assume that a delivery service exchanged USD 50,000 cash and truck No. 1 - which cost USD 45,000, had USD 38,000 of up-to-date accumulated depreciation, and had a USD 5,000 fair market value - for truck No. 2. The new truck has a cash price (fair market value) of USD 55,000. The delivery service realized a loss of USD 2,000 on the exchange which cannot be recorded. The loss is calculated as follows:

The journal entry to record the exchange is:

However, if a loss is indicated and is added to the recorded value of the new asset, the asset may later be written down because of rules of impairment (as required by FASB Standard No. 144), a topic left to Intermediate Accounting texts.

Accounting for any gain resulting from exchanges of nonmonetary assets having no commercial substance is similar to the case where a loss is present but unrecorded. To illustrate, assume that in the preceding example, the delivery service gave truck No. 1 (now with a fair market value of USD 9,000) and USD 46,000 cash in exchange for truck No. 2. The gain on the exchange is USD 2,000, but would be unrecorded.

The company would record the new asset at the book value of the old asset (USD 7,000) plus cash paid (USD 46,000). The company deducts the gain from the cost of the new asset (USD 55,000). Thus, the cost basis of the new delivery truck is equal to USD 55,000 less than the USD 2,000 gain, or USD 53,000. The delivery service uses this USD 53,000 cost basis in recording depreciation on the truck and determining any gain or loss on its disposal.

The journal entry to record the exchange is:

Firms would realize the gain on an exchange of nonmonetary assets not having commercial substance in future accounting periods as increased net income resulting from smaller depreciation charges on the newly acquired asset. In the preceding example, annual depreciation expense is less if it is based on the truck's USD 53,000 cost basis than if it is based on the truck's USD 55,000 cash price. Thus, future net income per year will be larger.

In Exhibit 17, we summarize the rules for recording nonmonetary asset exchanges.

An accounting perspective:

Uses of technology

Although sophisticated computer systems automatically compute the gain or loss on the disposal of assets, such programs depend on human input. If an error was made in inputting the type of disposal or exchange, or if the life of the asset was estimated inaccurately, the calculated gain or loss would be incorrect.

Exhibit 17: Summary of rules for recording exchanges of plant assets

Companies incur removal costs when dismantling and removing old plant assets. They deduct these costs from salvage proceeds to determine the asset's net salvage value. (The removal costs could be greater than the salvage proceeds). Accountants associate removal costs with the old asset, not the new asset acquired as a replacement.

The next section discusses natural resources. Note the underlying accounting principle of matching the expenses with the revenues earned in that same accounting period.

Natural resources

Intangible assets

Although they have no physical characteristics, intangible assets have value because of the advantages or exclusive privileges and rights they provide to a business. Intangible assets generally arise from two sources: (1) exclusive privileges granted by governmental authority or by legal contract, such as patents, copyrights, franchises, trademarks and trade names, and leases; and (2) superior entrepreneurial capacity or management know-how and customer loyalty, which is called goodwill.

All intangible assets are nonphysical, but not all nonphysical assets are intangibles. For example, accounts receivable and prepaid expenses are nonphysical, yet classified as current assets rather than intangible assets. Intangible assets are generally both nonphysical and noncurrent; they appear in a separate long-term section of the balance sheet entitled "Intangible assets".

Initially, firms record intangible assets at cost like most other assets. However, computing an intangible asset's acquisition cost differs from computing a plant asset's acquisition cost. Firms may include only outright purchase costs in the acquisition cost of an intangible asset; the acquisition cost does not include cost of internal development or self-creation of the asset. If an intangible asset is internally generated in its entirety, none of its costs are capitalized. Therefore, some companies have extremely valuable assets that may not even be recorded in their asset accounts. To explain the reasons for this practice, we discuss the history of accounting for research and development costs next.

Research and development (R&D) costs are costs incurred in a planned search for new knowledge and in translating such knowledge into new products or processes. Prior to 1975, businesses often capitalized research and development costs as intangible assets when future benefits were expected from their incurrence. Due to the difficulty of determining the costs applicable to future benefits, many companies expensed all such costs as incurred. Other companies capitalized those costs that related to proven products and expensed the rest as incurred.

As a result of these varied accounting practices, in 1974 the Financial Accounting Standards Board in Statement No. 2 ruled that firms must expense all research and development costs when incurred, unless they were directly reimbursable by government agencies and others. Immediate expensing is justified on the grounds that (1) the amount of costs applicable to the future cannot be measured with any high degree of precision; (2) doubt exists as to whether any future benefits will be received; and (3) even if benefits are expected, they cannot be measured. Thus, research and development costs no longer appear as intangible assets on the balance sheet. The Board applies the same line of reasoning to other costs associated with internally generated intangible assets, such as the internal costs of developing a patent.

Amortization is the systematic write-off of the cost of an intangible asset to expense. A portion of an intangible asset's cost is allocated to each accounting period in the economic (useful) life of the asset. All intangible assets are not subject to amortization. Only recognized intangible assets with finite useful lives are amortized. The finite useful life of such an asset is considered to be the length of time it is expected to contribute to the cash flows of the reporting entity. (Pertinent factors that should be considered in estimating useful life include legal, regulatory, or contractual provisions that may limit the useful life). The method of amortization should be based upon the pattern in which the economic benefits are used up or consumed. If no pattern is apparent, the straight-line method of amortization should be used by the reporting entity.

Recognized intangible assets deemed to have indefinite useful lives are not to be amortized. Amortization will however begin when it is determined that the useful life is no longer indefinite. The method of amortization would follow the same rules as intangible assets with finite useful lives.

Straight-line amortization is calculated the same was as straight-line depreciation for plant assets. Generally, we record amortization by debiting Amortization Expense and crediting the intangible asset account. An accumulated amortization account could be used to record amortization. However, the information gained from such accounting would not be significant because normally intangibles do not account for as many total asset dollars as do plant assets.

A patent is a right granted by the federal government. This exclusive right enables the owner to manufacture, sell, lease, or otherwise benefit from an invention for a limited period. The value of a patent lies in its ability to produce revenue. Patents have a legal life of 17 years. Protection for the patent owner begins at the time of patent application and lasts for 17 years from the date the patent is granted.

When purchasing a patent, a company records it in the Patents account at cost. The firm also debits the Patents account for the cost of the first successful defense of the patent in lawsuits (assuming an outside law firm was hired rather than using internal legal staff). Such a lawsuit establishes the validity of the patent and thereby increases its service potential. In addition, the firm debits the cost of any competing patents purchased to ensure the revenue-generating capability of its own patent to the Patents account.

The firm would amortize the cost of a purchased patent over its finite life which reasonably would not exceed its legal life. If a patent cost USD 40,000 and has a useful life of 10 years, the journal entries to record the patent and periodic amortization are:

For a patent that becomes worthless before it is fully amortized, the company expenses the unamortized balance in the Patents account.

As noted earlier, all R&D costs incurred in the internal development of a product, process, or idea that is later patented must be expensed, rather than capitalized. In the previous example, the company amortized the cost of the purchased patent over its useful life of 10 years. If the patent had been the result of an internally generated product or process, the firm would have expensed its cost of USD 40,000 as incurred, in accordance with Statement No. 2 of the Financial Accounting Standards Board.

A copyright is an exclusive right granted by the federal government giving protection against the illegal reproduction by others of the creator's written works, designs, and literary productions. The finite useful life for a copyright extends to the life of the creator plus 50 years. Most publications have a limited (finite) life; a creator may amortize the cost of the copyright to expense on a straight-line basis or based upon the pattern in which the economic benefits are used up or consumed.

A franchise is a contract between two parties granting the franchisee (the purchaser of the franchise) certain rights and privileges ranging from name identification to complete monopoly of service. In many instances, both parties are private businesses. For example, an individual who wishes to open a hamburger restaurant may purchase a McDonald's franchise; the two parties involved are the individual business owner and McDonald's Corporation. This franchise would allow the business owner to use the McDonald's name and golden arch, and would provide the owner with advertising and many other benefits. The legal life of a franchise may be limited by contract.

The parties involved in a franchise arrangement are not always private businesses. A government agency may grant a franchise to a private company. A city may give a franchise to a utility company, giving the utility company the exclusive right to provide service to a particular area.

In addition to providing benefits, a franchise usually places certain restrictions on the franchisee. These restrictions generally are related to rates or prices charged; also they may be in regard to product quality or to the particular supplier from whom supplies and inventory items must be purchased.

If periodic payments to the grantor of the franchise are required, the franchisee debits them to a Franchise Expense account. If a lump-sum payment is made to obtain the franchise, the franchisee records the cost in an asset account entitled Franchise and amortizes it over the finite useful life of the asset. The legal life (if limited by contract) and the economic life of the franchise may limit the finite useful life.

A trademark is a symbol, design, or logo used in conjunction with a particular product or company. A trade name is a brand name under which a product is sold or a company does business. Often trademarks and trade names are extremely valuable to a company, but if they have been internally developed, they have no recorded asset cost. However, when a business purchases such items from an external source, it records them at cost and amortizes them over their finite useful life.

A lease is a contract to rent property. The property owner is the grantor of the lease and is the lessor. The person or company obtaining rights to possess and use the property is the lessee. The rights granted under the lease are a leasehold. The accounting for a lease depends on whether it is a capital lease or an operating lease.

Capital leases A capital lease transfers to the lessee virtually all rewards and risks that accompany ownership of property. A lease is a capital lease if, among other provisions, it (1) transfers ownership of the leased property to the lessee at the end of the lease term or (2) contains a bargain purchase option that permits the lessee to buy the property at a price significantly below fair market value at the end of the lease term.

A capital lease is a means of financing property acquisitions; it has the same economic impact as a purchase made on an installment plan. Thus, the lessee in a capital lease must record the leased property as an asset and the lease obligation as a liability. Because a capital lease is an asset, the lessee depreciates the leased property over its useful life. The lessee records part of each lease payment as interest expense and the balance as a payment on the lease liability.

The proper accounting for capital leases for both lessees and lessors has been an extremely difficult problem. We leave further discussion of capital leases for an intermediate accounting text.

Operating leases A lease that does not qualify as a capital lease is an operating lease. A one-year lease on an apartment and a week's rental of an automobile are examples of operating leases. Such leases make no attempt to transfer any of the rewards and risks of ownership to the lessee. As a result, there may be no recordable transaction when a lease is signed.

In some situations, the lease may call for an immediate cash payment that must be recorded. Assume that a business signed a lease requiring the immediate payment of the annual rent of USD 15,000 for each of the first and fifth years of a five-year lease. The lessee would record the payment as follows:

Since the Leasehold account is actually a long-term prepaid rent account for the fifth year's annual rent, it is an intangible asset until the beginning of the fifth year. Then the Leasehold account becomes a current asset and may be transferred into a Prepaid Rent account. Accounting for the balance in the Leasehold account depends on the terms of the lease. In the previous example, the firm would charge the USD 15,000 in the Leasehold account to expense over the fifth year only. It would charge the balance in Prepaid Rent to expense in the first year. Thus, assuming the lease year and fiscal year coincide, the entry for the first year is:

The entry in the fifth year is:

The accounting for the second, third, and fourth years would be the same as for the first year. The lessee records the rent in Prepaid Rent when paid in advance for the year and then expenses it. As stated above, the lessee may transfer the amount in the Leasehold account to Prepaid Rent at the beginning of the fifth year by debiting Prepaid Rent and crediting Leasehold. If this entry was made, the previous entry would have credited Prepaid Rent.

In some cases, when a lease is signed, the lump-sum payment does not cover a specific year's rent. The lessee debits this payment to the Leasehold account and amortizes it over the life of the lease. The straight-line method is required unless another method can be shown to be superior. Assume the USD 15,000 rent for the fifth year in the example was, instead, a lump-sum payment on the lease in addition to the annual rent payments. An annual adjusting entry to amortize the USD 15,000 over five years would read:

In this example, the annual rental expense is USD 18,000: USD 15,000 annual cash rent plus USD 3,000 amortization of leasehold (USD 15,000/5).

The lessee may base periodic rent on current-year sales or usage rather than being a constant amount. For example, if a lease called for rent equal to 5 percent of current-year sales and sales were USD 400,000 in 2010, the rent for 2010 would be USD 20,000. The rent would either be paid or an adjusting entry would be made at the end of the year.

A leasehold improvement is any physical alteration made by the lessee to the leased property in which benefits are expected beyond the current accounting period. Leasehold improvements made by a lessee usually become the property of the lessor after the lease has expired. However, since leasehold improvements are an asset of the lessee during the lease period, the lessee debits them to a Leasehold Improvements account. The lessee then amortizes the leasehold improvements to expense over the period benefited by the improvements. The amortization period for leasehold improvements should be the shorter of the life of the improvements or the life of the lease. If the lease can (and probably will) be renewed at the option of the lessee, the life of the lease should include the option period.

As an illustration, assume that on 2010 January 2, Wolf Company leases a building for 20 years under a nonrenewable lease at an annual rental of USD 20,000, payable on each December 31. Wolf immediately incurs a cost of USD 80,000 for improvements to the building, such as interior walls for office separation, ceiling fans, and recessed lighting. The improvements have an estimated life of 30 years. The company should amortize the USD 80,000 over the 20-year lease period, since that period is shorter than the life of the improvements, and Wolf cannot use the improvements beyond the life of the lease. If only annual financial statements are prepared, the following journal entry properly records the rental expense for the year ended 2010 December 31:

Thus, the total cost to rent the building each year equals the USD 20,000 cash rent plus the amortization of the leasehold improvements.

Although leaseholds are intangible assets, leaseholds and leasehold improvements sometimes appear in the property, plant, and equipment section of the balance sheet.

In accounting, goodwill is an intangible value attached to a company resulting mainly from the company's management skill or know-how and a favorable reputation with customers. A company's value may be greater than the total of the fair market value of its tangible and identifiable intangible assets. This greater value means that the company generates an above-average income on each dollar invested in the business. Thus, proof of a company's goodwill is its ability to generate superior earnings or income.

A goodwill account appears in the accounting records only if goodwill has been purchased. A company cannot purchase goodwill by itself; it must buy an entire business or a part of a business to obtain the accompanying intangible asset, goodwill.

To illustrate, assume that Lenox Company purchased all of Martin Company's assets for USD 700,000. Lenox also agreed to assume responsibility for a USD 350,000 mortgage note payable owed by Martin. Goodwill is the difference between the amount paid for the business including the debt assumed (USD 700,000 + USD 350,000 = USD 1,050,000) and the fair market value of the assets purchased. Notice that Lenox would use the fair market value of the assets rather than book value to determine the amount of goodwill. The following computation is for the goodwill purchased by Lenox:

The USD 75,000 is the goodwill Lenox records as an intangible asset; it records all of the other assets at their fair market values, and the liability at the amount due.

Exhibit 18: Partial balance sheet

Specific reasons for a company's goodwill include a good reputation, customer loyalty, superior product design, unrecorded intangible assets (because they were developed internally), and superior human resources. Since these positive factors are not individually quantifiable, when grouped together they constitute goodwill. The journal entry to record the purchase is:

The intangible asset goodwill is not amortized. Goodwill is to be tested periodically for impairment. The amount of any goodwill impairment loss is to be recognized in the income statement as a separate line before the subtotal income from continuing operations (or similar caption). The goodwill account would be reduced by the same amount.

Look at Exhibit 18, a partial balance sheet for ANY company. Unlike plant assets or natural resources, intangible assets usually are a net amount in the balance sheet.

Analyzing and using the financial results - Total assets turnover

Understanding the learning objectives

Key terms

Amortization The term used to describe the systematic write-off of the cost of an intangible asset to expense.

Capital lease A lease that transfers to the lessee virtually all of the rewards and risks that accompany ownership of property.

Commercial substance The result if an exchange of nonmonetary assets causes future cash flows to differ significantly.

Copyright An exclusive right granted by the federal government giving protection against the illegal reproduction by others of the creator's written works, designs, and literary productions.

Depletion The exhaustion of a natural resource; an estimate of the cost of the resource that was removed from its natural setting during the period.

Finite Useful Life Length of time an intangible asset is expected to contribute to the cash flows of the entity.

Franchise A contract between two parties granting the franchisee (the purchaser of the franchise) certain rights and privileges ranging from name identification to complete monopoly of service.

Goodwill An intangible value attached to a company resulting mainly from the company's management skill or know-how and a favorable reputation with customers. Evidenced by the ability to generate an above-average rate of income on each dollar invested in the business.

Intangible assets Items that have no physical characteristics but are of value because of the advantages or exclusive privileges and rights they provide to a business.

Lease A contract to rent property. Grantor of the lease is the lessor; the party obtaining the rights to possess and use property is the lessee.

Leasehold The rights granted under a lease.

Leasehold improvement Any physical alteration made by the lessee to the leased property in which benefits are expected beyond the current accounting period.

Natural resources Resources supplied by nature, such as ore deposits, mineral deposits, oil reserves, gas deposits, and timber stands supplied by nature.

Operating lease A lease that does not qualify as a capital lease.

Patent A right granted by the federal government giving the owner the exclusive right to manufacture, sell, lease, or otherwise benefit from an invention for a limited period.

Research and development (R&D) costs Costs incurred in a planned search for new knowledge and in translating such knowledge into a new product or process.

Total assets turnover Equal to Net sales/Average total assets. This ratio indicates the efficiency with which a company uses its assets to generate sales. 

Trademark A symbol, design, or logo used in conjunction with a particular product or company.

Trade name A brand name under which a product is sold or a company does business.

Wasting assets See Natural resources.