Long-Term Assets

1. Long-Term Assets

Figure 11.1 Long-Term Assets. A silk-screening machine used to create designs on clothing is a long-term asset. (credit: modification of "Flat Bed Silk Screen Printing Machine with LED UV Curing System2" by Benny Zheng/Flickr, Public Domain)

Liam is excited to be graduating from his MBA program and looks forward to having more time to pursue his business venture. During one of his courses, Liam came up with the business idea of creating trendy workout attire. For his class project, he started silk-screening vintage album cover designs onto tanks, tees, and yoga pants. He tested the market by selling his wares on campus and was surprised how quickly and how often he sold out. In fact, sales were high enough that he decided to go into business for himself. One of his first decisions involved whether he should continue to pay someone else to silk-screen his designs or do his own silk-screening. To do his own silk-screening, he would need to invest in a silk-screening machine.

Liam will need to analyze the purchase of a silk-screening machine to determine the impact on his business in the short term as well as the long term, including the accounting implications related to the expense of this machine. Liam knows that over time, the value of the machine will decrease, but he also knows that an asset is supposed to be recorded on the books at its historical cost. He also wonders what costs are considered part of this asset. Additionally, Liam has learned about the matching principle (expense recognition) but needs to learn how that relates to a machine that is purchased in one year and used for many years to help generate revenue. Liam has a lot of information to consider before making this decision.

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Source: https://openstax.org/books/principles-financial-accounting/pages/11-why-it-matters
This work is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 License.

1.1. Distinguish between Tangible and Intangible Assets

Assets are items a business owns. For accounting purposes, assets are categorized as current versus long term, and tangible versus intangible. Assets that are expected to be used by the business for more than one year are considered long-term assets. They are not intended for resale and are anticipated to help generate revenue for the business in the future. Some common long-term assets are computers and other office machines, buildings, vehicles, software, computer code, and copyrights. Although these are all considered long-term assets, some are tangible and some are intangible.

Tangible Assets

An asset is considered a tangible asset when it is an economic resource that has physical substance-it can be seen and touched. Tangible assets can be either short term, such as inventory and supplies, or long term, such as land, buildings, and equipment. To be considered a long-term tangible asset, the item needs to be used in the normal operation of the business for more than one year, not be near the end of its useful life, and the company must have no plan to sell the item in the near future. The useful life is the time period over which an asset cost is allocated. Long-term tangible assets are known as fixed assets.

Businesses typically need many different types of these assets to meet their objectives. These assets differ from the company's products. For example, the computers that Apple Inc. intends to sell are considered inventory (a short-term asset), whereas the computers Apple's employees use for day-to-day operations are long-term assets. In Liam's case, the new silk-screening machine would be considered a long-term tangible asset as he plans to use it over many years to help him generate revenue for his business. Long-term tangible assets are listed as noncurrent assets on a company's balance sheet. Typically, these assets are listed under the category of Property, Plant, and Equipment (PP&E), but they may be referred to as fixed assets or plant assets.

Apple Inc. lists a total of $33,783,000,000 in total Property, Plant and Equipment (net) on its 2017 consolidated balance sheet (see Figure 11.2). As shown in the figure, this net total includes land and buildings, machinery, equipment and internal-use software, and leasehold improvements, resulting in a gross PP&E of $75,076,000,000-less accumulated depreciation and amortization of $41,293,000,000-to arrive at the net amount of $33,783,000,000.

Figure 11.2 Apple Inc.’s Property, Plant and Equipment, Net. This report shows the company's consolidated financial statement details as of September 30, 2017, and September 24, 2016 (in millions). (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Link to Learning

Recently, there has been a trend involving an increase in the number of intangibles on companies' balance sheets. As a result, investors need a better understanding of how this will affect their valuation of these companies. Read this article on intangible assets from The Economist for more information.

Intangible Assets

Companies may have other long-term assets used in the operations of the business that they do not intend to sell, but that do not have physical substance; these assets still provide specific rights to the owner and are called intangible assets. These assets typically appear on the balance sheet following long-term tangible assets (see Figure 11.3.) Examples of intangible assets are patents, copyrights, franchises, licenses, goodwill, sometimes software, and trademarks (Table 11.1). Because the value of intangible assets is very subjective, it is usually not shown on the balance sheet until there is an event that indicates value objectively, such as the purchase of an intangible asset.

A company often records the costs of developing an intangible asset internally as expenses, not assets, especially if there is ambiguity in the expense amounts or economic life of the asset. However, there are also conditions under which the costs can be allocated over the anticipated life of the asset. (The treatment of intangible asset costs can be quite complex and is taught in advanced accounting courses.)

Figure 11.3 Consolidated Balance Sheets for Apple, Inc. in 2017 and 2016. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Types of Intangible Assets

Asset	Useful Life
Patents	Twenty years
Trademarks	Renewable every ten years
Copyrights	Seventy years beyond death of creator
Goodwill	Indefinite

Table 11.1

Think It Through

Categorizing Intangible Assets

Your company has recently hired a star scientist who has a history of developing new technologies. The company president is excited with the new hire, and questions you, the company accountant, why the scientist cannot be recorded as an intangible asset, as the scientist will probably provide more value to the company in the future than any of its other assets. Discuss why the scientist, and employees in general, who often provide the greatest value for a company, are not recorded as intangible assets.

Patents

A patent is a contract that provides a company exclusive rights to produce and sell a unique product. The rights are granted to the inventor by the federal government and provide exclusivity from competition for twenty years. Patents are common within the pharmaceutical industry as they provide an opportunity for drug companies to recoup the significant financial investment on research and development of a new drug. Once the new drug is produced, the company can sell it for twenty years with no direct competition.

Think It Through

Research and Development Costs

Jane works in product development for a technology company. She just heard that her employer is slashing research and development costs. When she asks why, the marketing senior vice president tells her that current research and development costs are reducing net income in the current year for a potential but unknown benefit in future years, and that management is concerned about the effect on stock price. Jane wonders why research and development costs are not capitalized so that the cost would be matched with the future revenues. Why do you think research and development costs are not capitalized?

Trademarks and Copyrights

A company's trademark is the exclusive right to the name, term, or symbol it uses to identify itself or its products. Federal law allows companies to register their trademarks to protect them from use by others. Trademark registration lasts for ten years with optional 10-year renewable periods. This protection helps prevent impersonators from selling a product similar to another or using its name. For example, a burger joint could not start selling the "Big Mac". Although it has no physical substance, the exclusive right to a term or logo has value to a company and is therefore recorded as an asset.

A copyright provides the exclusive right to reproduce and sell artistic, literary, or musical compositions. Anyone who owns the copyright to a specific piece of work has exclusive rights to that work. Copyrights in the United States last seventy years beyond the death of the original author. While you might not be overly interested in what seems to be an obscure law, it actually directly affects you and your fellow students. It is one of the primary reasons that your copy of the Collected Works of William Shakespeare costs about $40 in your bookstore or online, while a textbook, such as Principles of Biology or Principles of Accounting, can run in the hundreds of dollars.

Goodwill

Goodwill is a unique intangible asset. Goodwill refers to the value of certain favorable factors that a business possesses that allows it to generate a greater rate of return or profit. Such factors include superior management, a skilled workforce, quality products or service, great geographic location, and overall reputation. Companies typically record goodwill when they acquire another business in which the purchase price is in excess of the fair value of the identifiable net assets. The difference is recorded as goodwill on the purchaser's balance sheet. For example, the goodwill of $5,717,000,000 that we see on Apple's consolidated balance sheets for 2017 (see Figure 11.3) was created when Apple purchased another business for a purchase price exceeding the book value of its net assets.

Your Turn

Classifying Long-Term Assets as Tangible or Intangible

Your cousin started her own business and wants to get a small loan from a local bank to expand production in the next year. The bank has asked her to prepare a balance sheet, and she is having trouble classifying the assets properly. Help her sort through the list below and note the assets that are tangible long-term assets and those that are intangible long-term assets.

• Cash
• Patent
• Accounts Receivable
• Land
• Investments
•  Software
•  Inventory
•  Note Receivable
•  Machinery
•  Equipment
•  Marketable Securities
•  Owner Capital
•  Copyright
•  Building
•  Accounts Payable
•  Mortgage Payable

Solution

Tangible long-term assets include land, machinery, equipment, and building. Intangible long-term assets include patent, software, and copyright.

1.2. Analyze and Classify Capitalized Costs versus Expenses

When a business purchases a long-term asset (used for more than one year), it classifies the asset based on whether the asset is used in the business's operations. If a long-term asset is used in the business operations, it will belong in property, plant, and equipment or intangible assets. In this situation the asset is typically capitalized. Capitalization is the process by which a long-term asset is recorded on the balance sheet and its allocated costs are expensed on the income statement over the asset's economic life. Explain and Apply Depreciation Methods to Allocate Capitalized Costs addresses the available methods that companies may choose for expensing capitalized assets.

Long-term assets that are not used in daily operations are typically classified as an investment. For example, if a business owns land on which it operates a store, warehouse, factory, or offices, the cost of that land would be included in property, plant, and equipment. However, if a business owns a vacant piece of land on which the business conducts no operations (and assuming no current or intermediate-term plans for development), the land would be considered an investment.

Your Turn

Classifying Assets and Related Expenditures

You work at a business consulting firm. Your new colleague, Marielena, is helping a client organize his accounting records by types of assets and expenditures. Marielena is a bit stumped on how to classify certain assets and related expenditures, such as capitalized costs versus expenses. She has given you the following list and asked for your help to sort through it. Help her classify the expenditures as either capitalized or expensed, and note which assets are property, plant, and equipment.

Expenditures:

• normal repair and maintenance on the manufacturing facility
• cost of taxes on new equipment used in business operations
• shipping costs on new equipment used in business operations
• cost of a minor repair on existing equipment used in business operations

Assets:

• land next to the production facility held for use next year as a place to build a warehouse
• land held for future resale when the value increases
• equipment used in the production process

Solution

Expenditures:

• normal repair and maintenance on the manufacturing facility: expensed
• cost of taxes on new equipment used in business operations: capitalized
• shipping costs on new equipment used in business operations: capitalized
• cost of a minor repair on existing equipment used in business operations: expensed

Assets:

• land next to the production facility held for use next year as a place to build a warehouse: property, plant, and equipment
• land held for future resale when the value increases: investment
• equipment used in the production process: property, plant, and equipment

Property, Plant, and Equipment (Fixed Assets)

Why are the costs of putting a long-term asset into service capitalized and written off as expenses (depreciated) over the economic life of the asset? Let's return to Liam's start-up business as an example. Liam plans to buy a silk-screening machine to help create clothing that he will sell. The machine is a long-term asset, because it will be used in the business's daily operation for many years. If the machine costs Liam $5,000 and it is expected to be used in his business for several years, generally accepted accounting principles (GAAP) require the allocation of the machine's costs over its useful life, which is the period over which it will produce revenues. Overall, in determining a company's financial performance, we would not expect that Liam should have an expense of $5,000 this year and $0 in expenses for this machine for future years in which it is being used. GAAP addressed this through the expense recognition (matching) principle, which states that expenses should be recorded in the same period with the revenues that the expense helped create. In Liam's case, the $5,000 for this machine should be allocated over the years in which it helps to generate revenue for the business. Capitalizing the machine allows this to occur. As stated previously, to capitalize is to record a long-term asset on the balance sheet and expense its allocated costs on the income statement over the asset's economic life. Therefore, when Liam purchases the machine, he will record it as an asset on the financial statements.

When capitalizing an asset, the total cost of acquiring the asset is included in the cost of the asset. This includes additional costs beyond the purchase price, such as shipping costs, taxes, assembly, and legal fees. For example, if a real estate broker is paid $8,000 as part of a transaction to purchase land for $100,000, the land would be recorded at a cost of $108,000.

Over time as the asset is used to generate revenue, Liam will need to depreciate the asset.

Depreciation is the process of allocating the cost of a tangible asset over its useful life, or the period of time that the business believes it will use the asset to help generate revenue. This process will be described in Explain and Apply Depreciation Methods to Allocate Capitalized Costs.

Ethical Considerations

How WorldCom's Improper Capitalization of Costs Almost Shut Down the Internet

In 2002, telecommunications giant WorldCom filed for the largest Chapter 11 bankruptcy to date, a situation resulting from manipulation of its accounting records. At the time, WorldCom operated nearly a third of the bandwidth of the twenty largest US internet backbone routes, connecting over 3,400 global networks that serviced more than 70,000 businesses in 114 countries.

WorldCom used a number of accounting gimmicks to defraud investors, mainly including capitalizing costs that should have been expensed. Under normal circumstances, this might have been considered just another account fiasco leading to the end of a company. However, WorldCom controlled a large percentage of backbone routes, a major component of the hardware supporting the internet, as even the Securities and Exchange Commission recognized. If WorldCom's bankruptcy due to accounting malfeasance shut the company down, then the internet would no longer be functional.

If such an event was to happen today, it could shut down international commerce and would be considered a national emergency. As demonstrated by WorldCom, the unethical behavior of a few accountants could have shut down the world's online businesses and international commerce. An accountant's job is fundamental and important: keep businesses operating in a transparent fashion.

Investments

A short-term or long-term asset that is not used in the day-to-day operations of the business is considered an investment and is not expensed, since the company does not expect to use up the asset over time. On the contrary, the company hopes that the assets (investment) would grow in value over time. Short-term investments are investments that are expected to be sold within a year and are recorded as current assets.

Continuing Application

Investment in Property in the Grocery Industry

To remain viable, companies constantly look to invest in upgrades in long-term assets. Such acquisitions might include new machinery, buildings, warehouses, or even land in order to expand operations or make the work process more efficient. Think back to the last time you walked through a grocery store. Were you mostly focused on getting the food items on your list? Or did you plan to pick up a prescription and maybe a coffee once you finished?

Grocery stores have become a one-stop shopping environment, and investments encompass more than just shelving and floor arrangement. Some grocery chains purchase warehouses to distribute inventory as needed to various stores. Machinery upgrades can help automate various departments. Some supermarkets even purchase large parcels of land to build not only their stores, but also surrounding shopping plazas to draw in customers. All such investments help increase the company's net profit.

Concepts In Practice

Vehicle Repairs and Enhancements

Automobiles are a useful way of looking at the difference between repair and maintenance expenses and capitalized modifications. Routine repairs such as brake pad replacements are recorded as repair and maintenance expenses. They are an expected part of owning a vehicle. However, a car may be modified to change its appearance or performance. For example, if a supercharger is added to a car to increase its horsepower, the car's performance is increased, and the cost should be included as a part of the vehicle asset. Likewise, if replacing the engine of an older car extends its useful life, that cost would also be capitalized.

Repair and Maintenance Costs of Property, Plant, and Equipment

Long-term assets may have additional costs associated with them over time. These additional costs may be capitalized or expensed based on the nature of the cost. For example, Walmart's financial statements explain that major improvements are capitalized, while costs of normal repairs and maintenance are charged to expense as incurred.

An amount spent is considered a current expense, or an amount charged in the current period, if the amount incurred did not help to extend the life of or improve the asset. For example, if a service company cleans and maintains Liam's silk-screening machine every six months, that service does not extend the useful life of the machine beyond the original estimate, increase the capacity of the machine, or improve the quality of the silk-screening performed by the machine. Therefore, this maintenance would be expensed within the current period. In contrast, if Liam had the company upgrade the circuit board of the silk-screening machine, thereby increasing the machine's future capabilities, this would be capitalized and depreciated over its useful life.

Think It Through

Correcting Errors in Classifying Assets

You work at a business consulting firm. Your new colleague, Marielena, helped a client organize his accounting records last year by types of assets and expenditures. Even though Marielena was a bit stumped on how to classify certain assets and related expenditures, such as capitalized costs versus expenses, she did not come to you or any other more experienced colleagues for help. Instead, she made the following classifications and gave them to the client who used this as the basis for accounting transactions over the last year. Thankfully, you have been asked this year to help prepare the client's financial reports and correct errors that were made. Explain what impact these errors would have had over the last year and how you will correct them so you can prepare accurate financial statements.

Expenditures:

• Normal repair and maintenance on the manufacturing facility were capitalized.
• The cost of taxes on new equipment used in business operations was expensed.
• The shipping costs on new equipment used in business operations were expensed.
• The cost of a minor repair on existing equipment used in business operations was capitalized.

Assets:

• Land next to the production facility held for use next year as a place to build a warehouse was depreciated.
• Land held for future resale when the value increases was classified as Property, Plant, and Equipment but not depreciated.
• Equipment used in the production process was classified as an investment.

Link to Learning

Many businesses invest a lot of money in production facilities and operations. Some production processes are more automated than others, and they require a greater investment in property, plant, and equipment than production facilities that may be more labor intensive. Watch this video of the operation of a Georgia-Pacific lumber mill and note where you see all components of property, plant, and equipment in operations in this fascinating production process. There's even a reference to an intangible asset-if you watch and listen closely, you just might catch it.

1.3. Explain and Apply Depreciation Methods to Allocate Capitalized Costs

In this section, we concentrate on the major characteristics of determining capitalized costs and some of the options for allocating these costs on an annual basis using the depreciation process. In the determination of capitalized costs, we do not consider just the initial cost of the asset; instead, we determine all of the costs necessary to place the asset into service. For example, if our company purchased a drill press for $22,000, and spent $2,500 on sales taxes and $800 for delivery and setup, the depreciation calculation would be based on a cost of $22,000 plus $2,500 plus $800, for a total cost of $25,300.

We also address some of the terminology used in depreciation determination that you want to familiarize yourself with. Finally, in terms of allocating the costs, there are alternatives that are available to the company. We consider three of the most popular options, the straight-line method, the units-of-production method, and the double-declining-balance method.

Your Turn

Calculating Depreciation Costs

Liam buys his silk screen machine for $10,000. He estimates that he can use this machine for five years or 100,000 presses, and that the machine will only be worth $1,000 at the end of its life. He also estimates that he will make 20,000 clothing items in year one and 30,000 clothing items in year two. Determine Liam's depreciation costs for his first two years of business under straight-line, units-of-production, and double-declining-balance methods. Also, record the journal entries.

Solution

Straight-line method: ($10,000 – $1,000)/5 = $1,800 per year for both years.

Units-of-production method: ($10,000 – $1,000)/100,000= $0.09 per press

Year 1 expense: $0.09 × 20,000 = $1,800

Year 2 expense: $0.09 × 30,000 = $2,700

Double-declining-balance method:

Year 1 expense: [($10,000 – 0)/5] × 2 = $4,000

Year 2 expense: [($10,000 – $4,000)/5] × 2 = $2,400

Fundamentals of Depreciation

As you have learned, when accounting for a long-term fixed asset, we cannot simply record an expense for the cost of the asset and record the entire outflow of cash in one accounting period. Like all other assets, when purchasing or acquiring a long-term asset, it must be recorded at the historical (initial) cost, which includes all costs to acquire the asset and put it into use. The initial recording of an asset has two steps:

1. Record the initial purchase on the date of purchase, which places the asset on the balance sheet (as property, plant, and equipment) at cost, and record the amount as notes payable, accounts payable, or an outflow of cash.
2. At the end of the period, make an adjusting entry to recognize the depreciation expense. Companies may record depreciation expense incurred annually, quarterly, or monthly.

Following GAAP and the expense recognition principle, the depreciation expense is recognized over the asset's estimated useful life.

Recording the Initial Purchase of an Asset

Assets are recorded on the balance sheet at cost, meaning that all costs to purchase the asset and to prepare the asset for operation should be included. Costs outside of the purchase price may include shipping, taxes, installation, and modifications to the asset.

The journal entry to record the purchase of a fixed asset (assuming that a note payable is used for financing and not a short-term account payable) is shown here.

Applying this to Liam's silk-screening business, we learn that he purchased his silk-screening machine for $5,000 by paying $1,000 cash and the remainder in a note payable over five years. The journal entry to record the purchase is shown here.

Concepts In Practice

Estimating Useful Life and Salvage Value

Useful life and salvage value are estimates made at the time an asset is placed in service. It is common and expected that the estimates are inaccurate with the uncertainty involved in estimating the future. Sometimes, however, a company may attempt to take advantage of estimating salvage value and useful life to improve earnings. A larger salvage value and longer useful life decrease annual depreciation expense and increase annual net income. An example of this behavior is Waste Management, which was disciplined by the Securities and Exchange Commission for fraudulently altering its estimates to reduce depreciation expense and overstate net income by $1.7 billion.

Components Used in Calculating Depreciation

The expense recognition principle that requires that the cost of the asset be allocated over the asset's useful life is the process of depreciation. For example, if we buy a delivery truck to use for the next five years, we would allocate the cost and record depreciation expense across the entire five-year period. The calculation of the depreciation expense for a period is not based on anticipated changes in the fair market value of the asset; instead, the depreciation is based on the allocation of the cost of owning the asset over the period of its useful life.

The following items are important in determining and recording depreciation:

• Book value: the asset's original cost less accumulated depreciation.
• Useful life: the length of time the asset will be productively used within operations.
• Salvage (residual) value: the price the asset will sell for or be worth as a trade-in when its useful life expires. The determination of salvage value can be an inexact science, since it requires anticipating what will occur in the future. Often, the salvage value is estimated based on past experiences with similar assets.
• Depreciable base (cost): the depreciation expense over the asset's useful life. For example, if we paid $50,000 for an asset and anticipate a salvage value of $10,000, the depreciable base is $40,000. We expect $40,000 in depreciation over the time period in which the asset was used, and then it would be sold for $10,000.

Depreciation records an expense for the value of an asset consumed and removes that portion of the asset from the balance sheet. The journal entry to record depreciation is shown here.

Depreciation expense is a common operating expense that appears on an income statement. Accumulated depreciation is a contra account, meaning it is attached to another account and is used to offset the main account balance that records the total depreciation expense for a fixed asset over its life. In this case, the asset account stays recorded at the historical value but is offset on the balance sheet by accumulated depreciation. Accumulated depreciation is subtracted from the historical cost of the asset on the balance sheet to show the asset at book value. Book value is the amount of the asset that has not been allocated to expense through depreciation.

In this case, the asset's book value is $20,000: the historical cost of $25,000 less the accumulated depreciation of $5,000.

It is important to note, however, that not all long-term assets are depreciated. For example, land is not depreciated because depreciation is the allocating of the expense of an asset over its useful life. How can one determine a useful life for land? It is assumed that land has an unlimited useful life; therefore, it is not depreciated, and it remains on the books at historical cost.

Once it is determined that depreciation should be accounted for, there are three methods that are most commonly used to calculate the allocation of depreciation expense: the straight-line method, the units-of-production method, and the double-declining-balance method. A fourth method, the sum-of-the-years-digits method, is another accelerated option that has been losing popularity and can be learned in intermediate accounting courses. Let's use the following scenario involving Kenzie Company to work through these three methods.

Assume that on January 1, 2019, Kenzie Company bought a printing press for $54,000. Kenzie pays shipping costs of $1,500 and setup costs of $2,500, assumes a useful life of five years or 960,000 pages. Based on experience, Kenzie Company anticipates a salvage value of $10,000.

Recall that determination of the costs to be depreciated requires including all costs that prepare the asset for use by the company. The Kenzie example would include shipping and setup costs. Any costs for maintaining or repairing the equipment would be treated as regular expenses, so the total cost would be $58,000, and, after allowing for an anticipated salvage value of $10,000 in five years, the business could take $48,000 in depreciation over the machine's economic life.

Concepts In Practice

Fixed Assets

You work for Georgia-Pacific as an accountant in charge of the fixed assets subsidiary ledger at a production and warehouse facility in Pennsylvania. The facility is in the process of updating and replacing several asset categories, including warehouse storage units, fork trucks, and equipment on the production line. It is your job to keep the information in the fixed assets subsidiary ledger up to date and accurate. You need information on original historical cost, estimated useful life, salvage value, depreciation methods, and additional capital expenditures. You are excited about the new purchases and upgrades to the facility and how they will help the company serve its customers better. However, you have been in your current position for only a few years and have never overseen extensive updates, and you realize that you will have to gather a lot of information at once to keep the accounting records accurate. You feel overwhelmed and take a minute to catch your breath and think through what you need. After a few minutes, you realize that you have many people and many resources to work with to tackle this project. Whom will you work with and how will you go about gathering what you need?

Straight-Line Depreciation

Straight-line depreciation is a method of depreciation that evenly splits the depreciable amount across the useful life of the asset. Therefore, we must determine the yearly depreciation expense by dividing the depreciable base of $48,000 by the economic life of five years, giving an annual depreciation expense of $9,600. The journal entries to record the first two years of expenses are shown, along with the balance sheet information. Here are the journal entry and information for year one:

After the journal entry in year one, the press would have a book value of $48,400. This is the original cost of $58,000 less the accumulated depreciation of $9,600. Here are the journal entry and information for year two:

Kenzie records an annual depreciation expense of $9,600. Each year, the accumulated depreciation balance increases by $9,600, and the press's book value decreases by the same $9,600. At the end of five years, the asset will have a book value of $10,000, which is calculated by subtracting the accumulated depreciation of $48,000 (5 × $9,600) from the cost of $58,000.

Units-of-Production Depreciation

Straight-line depreciation is efficient, accounting for assets used consistently over their lifetime, but what about assets that are used with less regularity? The units-of-production depreciation method bases depreciation on the actual usage of the asset, which is more appropriate when an asset's life is a function of usage instead of time. For example, this method could account for depreciation of a printing press for which the depreciable base is $48,000 (as in the straight-line method), but now the number of pages the press prints is important.

In our example, the press will have a total depreciation of $48,000 over its useful life of 960,000 pages. Therefore, we would divide $48,000 by 960,000 pages to get a cost per page of $0.05. If Kenzie printed 180,000 pages in the first year, the depreciation expense would be 180,000 pages × $0.05 per page, or $9,000. The journal entry to record this expense would be the same as with straight-line depreciation: only the dollar amount would have changed. The presentation of accumulated depreciation and the calculation of the book value would also be the same. Kenzie would continue to depreciate the asset until a total of $48,000 in depreciation was taken after printing 960,000 total pages.

Think It Through

Deciding on a Depreciation Method

Liam is struggling to determine which depreciation method he should use for his new silk-screening machine. He expects sales to increase over the next five years. He also expects (hopes) that in two years he will need to buy a second silk-screening machine to keep up with the demand for products of his growing company. Which depreciation method makes more sense for Liam: higher expenses in the first few years, or keeping expenses consistent over time? Or would it be better for him to not think in terms of time, but rather in the usage of the machine?

Double-Declining-Balance Depreciation

The double-declining-balance depreciation method is the most complex of the three methods because it accounts for both time and usage and takes more expense in the first few years of the asset's life. Double-declining considers time by determining the percentage of depreciation expense that would exist under straight-line depreciation. To calculate this, divide 100% by the estimated life in years. For example, a five-year asset would be 100/5, or 20% a year. A four-year asset would be 100/4, or 25% a year. Next, because assets are typically more efficient and "used" more heavily early in their life span, the double-declining method takes usage into account by doubling the straight-line percentage. For a four-year asset, multiply 25% (100%/4-year life) × 2, or 50%. For a five-year asset, multiply 20% (100%/5-year life) × 2, or 40%.

One unique feature of the double-declining-balance method is that in the first year, the estimated salvage value is not subtracted from the total asset cost before calculating the first year's depreciation expense. Instead the total cost is multiplied by the calculated percentage. However, depreciation expense is not permitted to take the book value below the estimated salvage value, as demonstrated in the following text.

Notice that in year four, the remaining book value of $12,528 was not multiplied by 40%. This is because the expense would have been $5,011.20, and since we cannot depreciate the asset below the estimated salvage value of $10,000, the expense cannot exceed $2,528, which is the amount left to depreciate (difference between the book value of $12,528 and the salvage value of $10,000). Since the asset has been depreciated to its salvage value at the end of year four, no depreciation can be taken in year five.

In our example, the first year's double-declining-balance depreciation expense would be $58,000 × 40%, or $23,200. For the remaining years, the double-declining percentage is multiplied by the remaining book value of the asset. Kenzie would continue to depreciate the asset until the book value and the estimated salvage value are the same (in this case $10,000).

The net effect of the differences in straight-line depreciation versus double-declining-balance depreciation is that under the double-declining-balance method, the allowable depreciation expenses are greater in the earlier years than those allowed for straight-line depreciation. However, over the depreciable life of the asset, the total depreciation expense taken will be the same, no matter which method the entity chooses. For example, in the current example both straight-line and double-declining-balance depreciation will provide a total depreciation expense of $48,000 over its five-year depreciable life.

IFRS Connection

Accounting for Depreciation

Both US GAAP and International Financial Reporting Standards (IFRS) account for long-term assets (tangible and intangible) by recording the asset at the cost necessary to make the asset ready for its intended use. Additionally, both sets of standards require that the cost of the asset be recognized over the economic, useful, or legal life of the asset through an allocation process such as depreciation. However, there are some significant differences in how the allocation process is used as well as how the assets are carried on the balance sheet.

IFRS and US GAAP allow companies to choose between different methods of depreciation, such as even allocation (straight-line method), depreciation based on usage (production methods), or an accelerated method (double-declining balance). The mechanics of applying these methods do not differ between the two standards. However, IFRS requires companies to use "component depreciation" if it is feasible. Component depreciation would apply to assets with components that have differing lives. Consider the following example using a plane owned by Southwest Airlines. Let's divide this plane into three components: the interior, the engines, and the fuselage. Suppose the average life of the interior of a plane is ten years, the average life of the engines is fifteen years, and the average life of the fuselage is twenty-five years. Given this, what should be the depreciable life of the asset? In that case, under IFRS, the costs associated with the interior would be depreciated over ten years, the costs associated with the engines would be depreciated over fifteen years, and the costs associated with the fuselage would be depreciated over twenty-five years. Under US GAAP, the total cost of the airplane would likely be depreciated over twenty years. Obviously, component depreciation involves more record keeping and differing amounts of depreciation per year for the life of the asset. But the same amount of total depreciation, the cost of the asset less residual value, would be taken over the life of the asset under both US GAAP and IFRS.

Probably one of the most significant differences between IFRS and US GAAP affects long-lived assets. This is the ability, under IFRS, to adjust the value of those assets to their fair value as of the balance sheet date. The adjustment to fair value is to be done by "class" of asset, such as real estate, for example. A company can adjust some classes of assets to fair value but not others. Under US GAAP, almost all long-lived assets are carried on the balance sheet at their depreciated historical cost, regardless of how the actual fair value of the asset changes. Consider the following example. Suppose your company owns a single building that you bought for $1,000,000. That building currently has $200,000 in accumulated depreciation. This building now has a book value of $800,000. Under US GAAP, this is how this building would appear in the balance sheet. Even if the fair value of the building is $875,000, the building would still appear on the balance sheet at its depreciated historical cost of $800,000 under US GAAP. Alternatively, if the company used IFRS and elected to carry real estate on the balance sheet at fair value, the building would appear on the company's balance sheet at its new fair value of $875,000.

It is difficult to determine an accurate fair value for long-lived assets. This is one reason US GAAP has not permitted the fair valuing of long-lived assets. Different appraisals can result in different determinations of "fair value." Thus, the Financial Accounting Standards Board (FASB) elected to continue with the current method of carrying assets at their depreciated historical cost. The thought process behind the adjustments to fair value under IFRS is that fair value more accurately represents true value. Even if the fair value reported is not known with certainty, reporting the class of assets at a reasonable representation of fair value enhances decision-making by users of the financial statements.

Summary of Depreciation

Table 11.2 compares the three methods discussed. Note that although each time-based (straight-line and double-declining balance) annual depreciation expense is different, after five years the total amount depreciated (accumulated depreciation) is the same. This occurs because at the end of the asset's useful life, it was expected to be worth $10,000: thus, both methods depreciated the asset's value by $48,000 over that time period.

The units of production method is different from the two above methods in that while those methods are based on time factors, the units of production is based on usage. However, the total amount of depreciation taken over an asset's economic life will still be the same. In our example, the total depreciation will be $48,000, even though the sum-of-the-years-digits method could take only two or three years or possibly six or seven years to be allocated.

Calculation of Depreciation Expense

Depreciation Method	Calculation
Straight line	(Cost – salvage value)/Useful life
Units of production	(Cost – salvage value) × (Units produced in current period/Estimated total units to be produced)
Double declining balance	Book value × Straight-line annual depreciation percentage × 2

Table 11.2

Ethical Considerations

Depreciation Analysis Requires Careful Evaluation

When analyzing depreciation, accountants are required to make a supportable estimate of an asset's useful life and its salvage value. However, "management teams typically fail to invest either time or attention into making or periodically revisiting and revising reasonably supportable estimates of asset lives or salvage values, or the selection of depreciation methods, as prescribed by GAAP". This failure is not an ethical approach to properly accounting for the use of assets.

Accountants need to analyze depreciation of an asset over the entire useful life of the asset. As an asset supports the cash flow of the organization, expensing its cost needs to be allocated, not just recorded as an arbitrary calculation. An asset's depreciation may change over its life according to its use. If asset depreciation is arbitrarily determined, the recorded "gains or losses on the disposition of depreciable property assets seen in financial statements" are not true best estimates. Due to operational changes, the depreciation expense needs to be periodically reevaluated and adjusted.

Any mischaracterization of asset usage is not proper GAAP and is not proper accrual accounting. Therefore, "financial statement preparers, as well as their accountants and auditors, should pay more attention to the quality of depreciation-related estimates and their possible mischaracterization and losses of credits and charges to operations as disposal gains."  An accountant should always follow GAAP guidelines and allocate the expense of an asset according to its usage.

Partial-Year Depreciation

A company will usually only own depreciable assets for a portion of a year in the year of purchase or disposal. Companies must be consistent in how they record depreciation for assets owned for a partial year. A common method is to allocate depreciation expense based on the number of months the asset is owned in a year. For example, a company purchases an asset with a total cost of $58,000, a five-year useful life, and a salvage value of $10,000. The annual depreciation is $9,600 ([$58,000 – 10,000]/5). However, the asset is purchased at the beginning of the fourth month of the fiscal year. The company will own the asset for nine months of the first year. The depreciation expense of the first year is $7,200 ($9,600 × 9/12). The company will depreciate the asset $9,600 for the next four years, but only $2,400 in the sixth year so that the total depreciation of the asset over its useful life is the depreciable amount of $48,000 ($7,200 + 9,600 + 9,600 + 9,600 + 9,600 + 2,400).

Think It Through

Choosing Appropriate Depreciation Methods

You are part of a team reviewing the financial statements of a new computer company. Looking over the fixed assets accounts, one long-term tangible asset sticks out. It is labeled "USB" and valued at $10,000. You ask the company's accountant for more detail, and he explains that the asset is a USB drive that holds the original coding for a game the company developed during the year. The company expects the game to be fairly popular for the next few years, and then sales are expected to trail off. Because of this, they are planning on depreciating this asset over the next five years using the double-declining method. Does this recording seem appropriate, or is there a better way to categorize the asset? How should this asset be expensed over time?

Special Issues in Depreciation

While you've now learned the basic foundation of the major available depreciation methods, there are a few special issues. Until now, we have assumed a definite physical or economically functional useful life for the depreciable assets. However, in some situations, depreciable assets can be used beyond their useful life. If so desired, the company could continue to use the asset beyond the original estimated economic life. In this case, a new remaining depreciation expense would be calculated based on the remaining depreciable base and estimated remaining economic life.

Assume in the earlier Kenzie example that after five years and $48,000 in accumulated depreciation, the company estimated that it could use the asset for two more years, at which point the salvage value would be $0. The company would be able to take an additional $10,000 in depreciation over the extended two-year period, or $5,000 a year, using the straight-line method.

As with the straight-line example, the asset could be used for more than five years, with depreciation recalculated at the end of year five using the double-declining balance method. While the process of calculating the additional depreciation for the double-declining-balance method would differ from that of the straight-line method, it would also allow the company to take an additional $10,000 after year five, as with the other methods, so long as the cost of $58,000 is not exceeded.

As a side note, there often is a difference in useful lives for assets when following GAAP versus the guidelines for depreciation under federal tax law, as enforced by the Internal Revenue Service (IRS). This difference is not unexpected when you consider that tax law is typically determined by the United States Congress, and there often is an economic reason for tax policy.

For example, if we want to increase investment in real estate, shortening the economic lives of real estate for taxation calculations can have a positive increasing effect on new construction. If we want to slow down new production, extending the economic life can have the desired slowing effect. In this course, we concentrate on financial accounting depreciation principles rather than tax depreciation.

Fundamentals of Depletion of Natural Resources

Another type of fixed asset is natural resources, assets a company owns that are consumed when used. Examples include lumber, mineral deposits, and oil/gas fields. These assets are considered natural resources while they are still part of the land; as they are extracted from the land and converted into products, they are then accounted for as inventory (raw materials). Natural resources are recorded on the company's books like a fixed asset, at cost, with total costs including all expenses to acquire and prepare the resource for its intended use.

As the resource is consumed (converted to a product), the cost of the asset must be expensed: this process is called depletion. As with depreciation of nonnatural resource assets, a contra account called accumulated depletion, which records the total depletion expense for a natural resource over its life, offsets the natural resource asset account. Depletion expense is typically calculated based on the number of units extracted from cutting, mining, or pumping the resource from the land, similar to the units-of-production method. For example, assume a company has an oil well with an estimated 10,000 gallons of crude oil. The company purchased this well for $1,000,000, and the well is expected to have no salvage value once it is pumped dry. The depletion cost per gallon will be $1,000,000/10,000 = $100. If the company extracts 4,000 gallons of oil in a given year, the depletion expense will be $400,000.

Fundamentals of Amortization of an Intangible

Recall that intangible assets are recorded as long-term assets at their cost. As with tangible assets, many intangible assets have a finite (limited) life span so their costs must be allocated over their useful lives: this process is amortization. Depreciation and amortization are similar in nature but have some important differences. First, amortization is typically only done using the straight-line method. Second, there is usually no salvage value for intangible assets because they are completely used up over their life span. Finally, an accumulated amortization account is not required to record yearly expenses (as is needed with depreciation); instead, the intangible asset account is written down each period.

For example, a company called Patents-R-Us purchased a product patent for $10,000, granting the company exclusive use of that product for the next twenty years. Therefore, unless the company does not think the product will be useful for all twenty years (at that point the company would use the shorter useful life of the product), the company will record amortization expense of $500 a year ($10,000/20 years). Assuming that it was placed into service on October 1, 2019, the journal entry would be as follows:

Link to Learning

See Form 10-K that was filed with the SEC to determine which depreciation method McDonald's Corporation used for its long-term assets in 2017.

1.4. Describe Accounting for Intangible Assets and Record Related Transactions

Intangible assets can be difficult to understand and incorporate into the decision-making process. In this section we explain them in more detail and provide examples of how to amortize each type of intangible asset.

Fundamentals of Intangible Assets

Intangibles are recorded at their acquisition cost, as are tangible assets. The costs of internally generated intangible assets, such as a patent developed through research and development, are recorded as expenses when incurred. An exception is legal costs to register or defend an intangible asset. For example, if a company incurs legal costs to defend a patent it has developed internally, the costs associated with developing the patent are recorded as an expense, but the legal costs associated with defending the patent would be capitalized as a patent intangible asset.

Amortization of intangible assets is handled differently than depreciation of tangible assets. Intangible assets are typically amortized using the straight-line method; there is typically no salvage value, as the usefulness of the asset is used up over its lifetime, and no accumulated amortization account is needed. Additionally, based on regulations, certain intangible assets are restricted and given limited life spans, while others are infinite in their economic life and not amortized.

Copyrights

While copyrights have a finite life span of 70 years beyond the author's death, they are amortized over their estimated useful life. Therefore, if a company acquired a copyright on a new graphic novel for $10,000 and estimated it would be able to sell that graphic novel for the next ten years, it would amortize $1,000 a year ($10,000/ten years), and the journal entry would be as shown. Assume that the novel began sales on January 1, 2019.

Patents

Patents are issued to the inventor of the product by the federal government and last twenty years. All costs associated with creating the product being patented (such as research and development costs) are expensed; however, direct costs to obtain the patent could be capitalized. Otherwise, patents are capitalized only when purchased. Like copyrights, patents are amortized over their useful life, which can be shorter than twenty years due to changing technology. Assume Mech Tech purchased the patent for a new pump system. The patent cost $20,000, and the company expects the pump to be a useful product for the next twenty years. Mech Tech will then amortize the $20,000 over the next twenty years, which is $1,000 a year.

Trademarks

Companies can register their trademarks with the federal government for ten years with the opportunity to renew the trademark every ten years. Trademarks are recorded as assets only when they are purchased from another company and are valued based on market price at the time of purchase. In this case, these trademarks are amortized over the expected useful life. In some cases, the trademark may be seen as having an indefinite life, in which case there would be no amortization.

Goodwill

From an accounting standpoint, goodwill is internally generated and is not recorded as an asset unless it is purchased during the acquisition of another company. The purchase of goodwill occurs when one company buys another company for an amount greater than the total value of the company's net assets. The value difference between net assets and the purchase price is then recorded as goodwill on the purchaser's financial statements. For example, say the London Hoops professional basketball team was sold for $10 million. The new owner received net assets of $7 million, so the goodwill (value of the London Hoops above its net assets) is $3 million. The following journal entry shows how the new owner would record this purchase.

Goodwill does not have an expected life span and therefore is not amortized. However, a company is required to compare the book value of goodwill to its market value at least annually to determine if it needs to be adjusted. This comparison process is called testing for impairment. If the market value of goodwill is found to be lower than the book value, then goodwill needs to be reduced to its market value. If goodwill is impaired, it is reduced with a credit, and an impairment loss is debited. Goodwill is never increased beyond its original cost. For example, if the new owner of London Hoops assesses that London Hoops now has a fair value of $9,000,000 rather than the $10,000,000 of the original purchase, the owner would need to record the impairment as shown in the following journal entry.

Concepts In Practice

Microsoft's Goodwill

In 2016, Microsoft bought LinkedIn for $25 billion. Microsoft wanted the brand, website platform, and software, which are intangible assets of LinkedIn, and therefore Microsoft only received $4 billion in net assets. The overpayment by Microsoft is not necessarily a bad business decision, but rather the premium or value of those intangible assets that LinkedIn owned and Microsoft wanted. The $21 billion difference will be listed on Microsoft's balance sheet as goodwill.

Link to Learning

Apple Inc. had goodwill of $5,717,000,000 on its 2017 balance sheet. Explore Apple, Inc.’s U.S. Securities and Exchange Commission 10-K Filing for notes that discuss goodwill and whether Apple has had to adjust for the impairment of this asset in recent years.