Reporting and Interpreting

Property, Plant and Equipment;

Natural Resources; and
Intangibles
Chapter 8

McGraw-Hill/Irwin

2009 The McGraw-Hill Companies, Inc.

Understanding The Business

Insufficient
capacity results
in lost sales.

How much
is enough?

Costly excess
capacity reduces
profits.

8-2

Classifying Long-Lived Assets

Actively Used in Operations
Examples
Value represented by rights
that produce benefits
Land
Expected to Benefit Future Periods
Examples
Assets subject to depreciation
Definite life
Buildings and equipment
Patents
Furniture and fixtures
Copyrights
Natural resource
assets
Intangible
Tangible
Franchises
subject to depletion
life
Indefinite
No Physical
Physical
Mineral deposits and timber
Trademarks
Substance
Substance
Goodwill
8-3

Fixed Asset Turnover

Fixed
=
Asset
Turnover

Net Sales Revenue

Average Net Fixed Assets

This
This ratio
ratio measures
measures aa companys
companys ability
ability to
to generate
generate sales
sales
given
given an
an investment
investment in
in fixed
fixed assets.
assets.
Southwest
Southwest Airlines
Airlines had
had $9,861
$9,861 of
of revenue.
revenue. End-of-year
End-of-year fixed
fixed
assets
assets were
were $10,874
$10,874 and
and beginning-of-year
beginning-of-year fixed
fixed assets
assets were
were
$10,094.
$10,094. (All
(All numbers
numbers in
in millions.)
millions.)
Fixed
$9,861
=
= 0.94
Asset
($10,094 + $10,874) 2
Turnover

8-4

Measuring and Recording Acquisition

Cost
Acquisition cost includes the purchase price and all
expenditures needed to prepare the asset for its intended use.
Acquisition cost does not include
financing charges and cash discounts.
Buildings
Buildings
Purchase
Purchase price
price
Renovation
Renovation and
and repair
repair costs
costs
Legal
Legal and
and realty
realty fees
fees
Title
Title fees
fees

8-5

Measuring and Recording Acquisition

Cost
Equipment
Equipment
Purchase
Purchase price
price

Installation
Installation costs
costs
Modification
Modification to
to building
building
necessary
necessary to
to install
install
equipment
equipment
Transportation
Transportation costs
costs

Land
Land
Purchase
Purchase price
price
Real
Real estate
estate commissions
commissions
Title
Title insurance
insurance premiums
premiums
Delinquent
Delinquent taxes
taxes
Surveying
Surveying fees
fees
Title
Title search
search and
and transfer
transfer fees
fees

Land
Land is
is not
not depreciable.
depreciable.
8-6

Measuring and Recording Acquisition

Cost
Acquisition On January 1, Southwest Air Lines purchased aircraft for
$70,000,000 cash.
for Cash

Acquisition
for Debt

On January 14, Southwest Air Lines purchased aircraft

for $1,000,000 cash and a $69,000,000 note payable.

8-7

Acquisition for Noncash Consideration

Record at the current market value of the consideration
given, or the current market value of the asset acquired,
whichever is more clearly evident.
On July 7, Southwest gave Boeing 9,000,000 shares of
$1.00 par value common stock with a market value of
$5.00 per share plus $25,000,000 in cash for aircraft.

8-8

Acquisition by Construction
Asset
Asset cost
cost includes:
includes:

All materials and

labor traceable to
the construction.

A reasonable
amount of
overhead.

Interest on debt
incurred during
the construction.

8-9

Repairs, Maintenance, and Additions

Type of
Capital or
Expenditure Revenue

Identifying Characteristics

Ordinary
Revenue 1. Maintains normal operating condition
repairs and
2. Does not increase productivity
maintenance
3. Does not extend life beyond original
estimate
Extraordinary
repairs

Capital

1. Major overhauls or partial

replacements
2. Extends life beyond original estimate

Additions

Capital

1. Increases productivity
2. May extend useful life
3. Improvements or expansions
8-10

Repairs, Maintenance, and Additions

Financial Statement Effect
Treatment

Statement

Expense

Current Current
Income Taxes

Capital
Expenditure

Balance sheet
account debited

Deferred

Higher

Higher

Revenue Income statement Currently

Expenditure account debited recognized Lower

Lower

To solve this problem, many companies have policies

regarding the expensing of all expenditures below a
certain amount according to the materiality constraint.
8-11

Depreciation Concepts
Depreciation
Depreciation is
is aa cost
cost allocation
allocation process
process that
that
systematically
systematically and
and rationally
rationally matches
matches acquisition
acquisition costs
costs
of
of operational
operational assets
assets with
with periods
periods benefited
benefited by
by their
their use.
use.
Balance Sheet
Acquisition
Cost
(Unused)

Income Statement
Cost

Expense

Allocation

(Used)

Depreciation
Expense

Depreciation for
the current year

Income
Statement

Accumulated
Depreciation

Total of depreciation
to date on an asset

Balance
Sheet
8-12

Depreciation Concepts
The
The calculation
calculation of
of depreciation
depreciation requires
requires
three
three amounts
amounts for
for each
each asset:
asset:

Acquisition
Acquisition cost.
cost.

Estimated
Estimated useful
useful life.
life.

Estimated
Estimated residual
residual value.
value.

Alternative
Alternative depreciation
depreciation methods:
methods:

Straight-line
Straight-line

Units-of-production
Units-of-production

Accelerated
Accelerated Method:
Method: Declining
Declining
balance
balance
8-13

Straight-Line Method
Depreciation
Expense per Year

Cost - Residual Value

Life in Years

At the beginning of the year, Southwest purchased ground

equipment for $62,500 cash. The equipment has an estimated
useful life of 3 years and an estimated residual value of $2,500.
Depreciation
Expense per Year

Depreciation
Expense per Year

$62,500 - $2,500
3 years
$20,000
8-14

Straight-Line Method
Depreciation Accumulated
Expense
Depreciation
Year
(debit)
(credit)
1
2
3

$ 20,000
20,000
20,000
$ 60,000

20,000
20,000
20,000
60,000

Accumulated
Depreciation
Balance
$

20,000
40,000
60,000

Undepreciated
Balance
(book value)
$
62,500
42,500
22,500
2,500

Residual Value
SL

More companies use the straight-line

method of depreciation in their financial
reports than all other methods combined.
8-15

Units-of-Production Method
Step 1:

Depreciation =
Rate

Cost - Residual Value

Life in Units of Production

Step 2:

Number of
Depreciation
Depreciation
Units Produced
=
Expense
Rate
for the Year
At the beginning of the year, Southwest purchased ground
equipment for $62,500 cash. The equipment has a 100,000
mile useful life and an estimated residual value of $2,500.
If the equipment is used 30,000 miles in the first year, what is
the amount of depreciation expense?
8-16

Units-of-Production Method
Step 1:

Depreciation = $62,500 - $2,500 = $.60 per mile

100,000 miles
Rate
Step 2:

Depreciation
= $.60 per mile 30,000 miles =
Expense
$18,000

Residual Value
8-17

Accelerated Depreciation
Accelerated depreciation matches higher
depreciation expense with higher revenues
in the early years of an assets useful life
when the asset is more efficient.

Depreciation
Expense
Early Years
High
Later Years

Low

Repair
Expense
Low
High

8-18

Declining-Balance Method
Declining balance rate
of 2 is double-decliningbalance (DDB) rate.

Cost Accumulated Depreciation

Annual
Depreciation =
expense

Net
Book
Value

2
Useful Life in Years

Annual
Annual computation
computation ignores
ignores residual
residual value.
value.
At the beginning of the year, Southwest purchased equipment
for $62,500 cash. The equipment has an estimated useful
life of 3 years and an estimated residual value of $2,500.
Calculate the depreciation expense for the first two years.
8-19

Declining-Balance Method
Annual
Depreciation
expense

Net
Book
Value

Year 1 Depreciation:
$62,500

2
3 years

) = $41,667

Year 2 Depreciation:
($62,500 $41,667)

2
Useful Life in Years

2
3 years

) = $13,889
8-20

Declining-Balance Method

Year
1
2
3

Depreciation
Expense
(debit)

Accumulated
Depreciation
Balance

41,667
13,889
4,629
60,185

41,667
55,556
60,185

Undepreciated
Balance
(book value)
$
62,500
20,833
6,944
2,315

Below residual value

($62,500 $55,556)

2
3 years

) = $4,629
8-21

Declining-Balance Method

Year
1
2
3

Depreciation
Expense
(debit)

Accumulated
Depreciation
Balance

41,667
13,889
4,444
60,000

41,667
55,556
60,000

Undepreciated
Balance
(book value)
$
62,500
20,833
6,944
2,500

Depreciation expense is limited to the amount that

reduces book value to the estimated residual value.
8-22

Measuring Asset Impairment

Impairment is the loss of a significant portion
of the utility of an asset through . . .
Casualty.
Obsolescence.
Lack of demand for the assets services.

Recognize a
loss when
an asset
suffers a
permanent
impairment.

Disposal
Disposal of
of Property,
Property, Plant
Plant and
and Equipment
Equipment
Voluntary
Voluntary disposals:
disposals:
Sale
Sale
Trade-in
Trade-in
Retirement
Retirement
Involuntary
Involuntary disposals:
disposals:
Fire
Fire
Accident
Accident
8-23

Disposal of Property, Plant, and

Equipment
Update depreciation
to the date of disposal.
Journalize disposal by:
Recording cash
received (debit)
or paid (credit).

Recording a
gain (credit)
or loss (debit).

Writing off accumulated

depreciation (debit).

Writing off the

asset cost (credit).
8-24

Disposal of Property, Plant, and

Equipment
If Cash > BV, record a gain (credit).
If Cash < BV, record a loss (debit).
If Cash = BV, no gain or loss.
Southwest
Southwest Airlines
Airlines sold
sold flight
flight equipment
equipment
for
for $5,000,000
$5,000,000 cash
cash at
at the
the end
end of
of its
its
17th
17th year
year of
of use.
use. The
The flight
flight equipment
equipment originally
originally cost
cost
$20,000,000,
$20,000,000, and
and was
was depreciated
depreciated using
using the
the straight-line
straight-line
method
method with
with zero
zero residual
residual value
value
and
and aa useful
useful life
life of
of 20
20 years.
years.
Lets
Lets answer
answer the
the following
following questions.
questions.
8-25

Disposal of Property, Plant, and

Equipment
The
The amount
amount of
of depreciation
depreciation expense
expense
recorded
recorded at
at the
the end
end of
of the
the 17th
17th year
year to
to
bring
bring depreciation
depreciation up
up to
to date
date is:
is:
a.
a.
b.
b.
c.
c.
d.
d.

$0.
$0.
$1,000,000.
$1,000,000.
$2,000,000.
$2,000,000.
$4,000,000.
$4,000,000.

Annual Depreciation:
($20,000,000 - $0) 20 Years.
= $1,000,000

8-26

Disposal of Property, Plant, and

Equipment
Accumulated Depreciation =
(17yrs. $1,000,000)
= $17,000,000
After
the
After updating
updating
the depreciation,
depreciation,
the
book
value
end
the equipments
equipments
book
value at
at the
theDepreciation
end of
of
BV = Cost
- Accumulated
the
17th
year
is:
the
17th
year
is:
BV = $20,000,000 - $17,000,000
= $3,000,000

a.
a.
b.
b.
c.
c.
d.
d.

$3,000,000.
$3,000,000.
$16,000,000.
$16,000,000.
$17,000,000.
$17,000,000.
$4,000,000.
$4,000,000.
8-27

Disposal of Property, Plant, and

Equipment
The
The equipments
equipments sale
sale resulted
resulted in:
in:
a.
a.
b.
b.
c.
c.
d.
d.

aa gain
gain of
of $2,000,000.
$2,000,000.
aa gain
gain of
of $3,000,000.
$3,000,000.
aa gain
gain of
of $4,000,000.
$4,000,000.
aa loss
loss of
of $2,000,000.
$2,000,000.
Gain = Cash Received - Book Value
Gain = $5,000,000 - $3,000,000 = $2,000,000
8-28

Disposal of Property, Plant, and

Equipment
Prepare the journal entry to record Southwests sale of
the equipment at the end of the 17th year.

8-29

Acquisition and Depletion of Natural

Resources
Extracted from
the natural
environment.

A noncurrent
asset presented
at cost less
accumulated
depletion.

Total cost of
asset is the cost
of acquisition,
exploration,
and development.

Total cost is
allocated over
periods benefited
by means of
depletion.

Examples: oil, coal, gold

Depletion is like units-of-production depreciation.

8-30

Acquisition and Depletion of Natural

Resources
The unit depletion rate is calculated as follows:
Acquisition and
Development Cost

Residual
Value

Estimated Recoverable Units

Depletion cost for a period is:
UNIT DEPLETION
RATE

Depletion
cost

NUMBER OF UNITS
EXTRACTED IN PERIOD

Inventory
for sale

Cost of
goods sold
Unsold
Inventory
8-31

Acquisition and Amortization of

Intangible Assets
Noncurrent
Noncurrent assets
assets
without
without physical
physical
substance.
substance.
Useful
Useful life
life is
is
often
often difficult
difficult
to
to determine.
determine.

Intangible
Assets

Often
Often provide
provide
exclusive
exclusive rights
rights
or
or privileges.
privileges.
Usually
Usually acquired
acquired
for
for operational
operational
use.
use.

Record at current cash equivalent cost, including

purchase price, legal fees, and filing fees.
8-32

Acquisition and Amortization of

Intangible Assets
Definite
Definite Life
Life

Indefinite
Indefinite Life
Life

Amortize
Amortize over
over shorter
shorter of
of
economic
economic life
life or
or legal
legal
life,
life, subject
subject to
to rules
rules
specified
specified by
by GAAP.
GAAP.
Use
Use straight-line
straight-line method.
method.

Not
Not amortized.
amortized.
Tested
Tested at
at least
least annually
annually for
for
possible
possible impairment,
impairment, and
and
book
book value
value is
is reduced
reduced to
to
fair
fair value
value ifif impaired.
impaired.

Amortization is a cost allocation process

similar to depreciation and depletion.

8-33

Acquisition and Amortization of

Intangible Assets
Goodwill
Occurs when one
company buys
another company.

Only purchased
goodwill is an
intangible asset.

The amount by which the purchase price exceeds

the fair market value of net assets acquired.
Goodwill
Goodwill is
is not
not amortized.
amortized. Its
Its value
value must
must be
be reviewed
reviewed
at
at least
least annually
annually for
for possible
possible impairment,
impairment, and
and the
the
book
book value
value is
is reduced
reduced to
to fair
fair value
value ifif impaired.
impaired.
8-34

Acquisition and Amortization of

Intangible Assets
Arpec Company paid $2,000,000 to purchase
all of Utek Companys assets and assumed liabilities of $400,000.
The acquired assets were appraised at a fair value of $1,800,000.

What
What amount
amount of
of goodwill
goodwill should
should be
be
recorded
recorded on
on Arpec
Arpec Company
Company books?
books?
a.
a.
b.
b.
c.
c.
d.
d.

$200,000
$200,000
$400,000
$400,000
$600,000
$600,000
$800,000
$800,000
8-35

Acquisition and Amortization of

Intangible Assets
Trademarks
Trademarks

Copyrights
Copyrights

AA symbol,
symbol, design,
design, or
or
logo
logo associated
associated with
with
aa business.
business.

The
The exclusive
exclusive right
right to
to
publish,
publish, use,
use, and
and sell
sell aa
literary,
literary, musical,
musical, or
or artistic
artistic
work.
work.

An
An exclusive
exclusive legal
legal right
right
to
to use
use aa name,
name, image
image
or
or slogan.
slogan.
Purchased
Purchased trademarks
trademarks
are
are recorded
recorded at
at cost.
cost.

Legal
Legal life
life is
is life
life of
of creator
creator
plus
plus 70
70 years.
years.
Amortize
Amortize cost
cost over
over the
the
period
period benefited.
benefited.

8-36

Acquisition and Amortization of

Intangible Assets
Patents
Patents
Exclusive
Exclusive right
right granted
granted by
by the
the federal
federal government
government to
to sell
sell or
or
manufacture
manufacture an
an invention.
invention.
Cost
Cost is
is purchase
purchase price
price plus
plus legal
legal cost
cost to
to defend.
defend.
Amortize
Amortize cost
cost over
over the
the shorter
shorter of
of useful
useful life
life or
or 20
20 years.
years.
Research
Research and
and development
development costs
costs that
that might
might result
result in
in aa patent
patent are
are
normally
normally expensed
expensed as
as incurred.
incurred.
Technology
Technology
AA category
category of
of intangible
intangible assets
assets that
that includes
includes aa companys
companys website
website
and
and any
any computer
computer programs
programs written
written by
by its
its employees.
employees.
8-37

Acquisition and Amortization of

Intangible Assets
Franchises
Franchises
Legally
Legally protected
protected right
right
purchased
purchased by
by aa franchisee
franchisee
to
to sell
sell products
products or
or provide
provide
services
services for
for aa specified
specified
period
period and
and purpose.
purpose.
Purchase
Purchase price
price is
is an
an
intangible
intangible asset
asset that
that is
is
amortized.
amortized.

Licenses
Licenses and
and Operating
Operating
Rights
Rights
Limited
Limited permissions
permissions to
to use
use
aa product
product or
or service
service
according
according to
to specific
specific terms
terms
and
and conditions.
conditions.
You
You may
may be
be using
using
computer
computer software
software that
that is
is
made
made available
available to
to you
you
through
through aa campus
campus
licensing
licensing agreement.
agreement.

8-38

Focus on Cash Flows

Operating Activity
(Indirect method)
Depreciation and amortization
Gain on sale
Loss on sale
Loss due to impairment

Investing Activities
Purchases of long-lived assets
Sales of long-lived assets

Effect on
Cash Flows

+
+

+
8-39

Chapter Supplement A Changes in

Depreciation Estimates
Depreciation Expense is based on . . .
ESTIMATED
ESTIMATED
ESTIMATED useful
useful
ESTIMATED
life
residual
life
residual value
value

IfIf the
theestimates
estimateschange,
change,the
thebook
bookvalue
valueless
less any
anyresidual
residualvalue
value
at
atthe
thedate
dateof
ofchange
changeis
isdepreciated
depreciatedover
overthe
theremaining
remaininguseful
useful
life.
life.
Southwest
Southwestpurchased
purchasedan
anaircraft
aircraftfor
for$60,000,000.
$60,000,000. The
Theaircraft
aircraftisis depreciated
depreciated
using
usingthe
thestraight-line
straight-linemethod
methodwith
withaauseful
usefullife
lifeof
of20
20years
yearsand
andan
anestimated
estimated
residual
residualvalue
valueof
of$3,000,000.
$3,000,000. In
Inyear
year5,
5,Southwest
Southwestchanged
changedthe
theestimated
estimated
useful
usefullife
lifeto
to25
25years
years and
andlowered
loweredthe
theresidual
residualvalue
valueto
to$2,400,000.
$2,400,000.
Calculate
Calculate depreciation
depreciationexpense
expensefor
for the
thefifth
fifthyear
yearusing
usingthe
thestraight-line
straight-line
method.
method.
8-40

Chapter Supplement A Changes in

Depreciation Estimates
Asset
Asset cost
cost
Accumulated
Accumulated depreciation
depreciation
($2,850,000
($2,850,000 per
per year
year 44 years)
years)
Remaining
Remaining book
book value
value
Less
Lessestimated
estimated residual
residual value
value
Depreciable
Depreciable base
base
Divide
Divide by
by remaining
remaining life
life
Revised
Revised annual
annual depreciation
depreciation

$$ 60,000,000
60,000,000
11,400,000
11,400,000
48,600,000
48,600,000
2,400,000
2,400,000
46,200,000
46,200,000
21
21
$$ 2,200,000
2,200,000

8-41

End of Chapter 8

McGraw-Hill/Irwin

2009 The McGraw-Hill Companies, Inc.