Chapter 6 fixed assets

Learning ObjectivesAfter studying this chapter, you should be able to:  Measure the acquisition cost of tangible assets such as land, buildings, and equipment.. Overview of Long-Lived A

Chapter 6

Long-Lived Assets and Depreciation

Learning Objectives

After studying this chapter, you should be able to:

 Measure the acquisition cost of tangible assets such as land, buildings, and equipment

 Compute depreciation for buildings and

equipment using various depreciation methods

 Differentiate financial statement depreciation from income tax depreciation

 Explain depreciation’s effects on cash flow

Learning Objectives

After studying this chapter, you

should be able to:

 Distinguish expenses from expenditures that should be capitalized.

 Compute gains and losses on disposal

of fixed assets.

 Interpret depletion of natural resources.

 Account for various intangible assets.

Overview of Long-Lived Assets

 Long-lived assets - resources that are

held for an extended time, such as

land, buildings, equipment, natural

resources, and patents

 These assets help produce revenues over many periods by facilitating the production and sale of goods

or services to customers

Overview of Long-Lived Assets

 Tangible assets - physical items that can be seen and touched, such as land, natural

resources, buildings, and equipment

 Also known as fixed assets or plant assets

 Intangible assets - rights or economic

benefits, such as franchises, patents,

trademarks, copyrights, and goodwill that are not physical in nature

Overview of Long-Lived Assets

 Terms for allocation of costs over time:

 Depreciation - allocation of the cost of tangible assets

to the periods in which the assets are used

 Depletion - allocation of the cost of natural resources

to the periods in which the resources are used

 Amortization - allocation of the cost of intangible

assets to the periods that benefit from these assets

 Land is not depreciated because it does not wear out or become obsolete.

Acquisition Cost of

Tangible Assets

 The acquisition cost of long-lived assets

is the purchase price, including

incidental costs required to complete

the purchase, to transport the asset,

and to prepare it for use.

Acquisition Cost of

Tangible Assets

 The acquisition cost of land includes costs of

land surveys, legal fees, title fees, realtor

commissions, transfer taxes, and the demolition costs of old structures

 Under historical cost accounting, land is carried

on the balance sheet at its original cost even if the market value of the land is many times that

of the original cost

Acquisition Cost of

Tangible Assets

 Buildings and Equipment

 Costs should include all costs of acquisition and preparation for use, such as sales

taxes, transportation costs, installation

costs, and repairs to the asset prior to use

 Costs included in the cost of an asset are

capitalized (added to the asset account), as distinguished from being expensed

immediately

Depreciation of Buildings

and Equipment

 Depreciation in the accounting sense is not a process of valuation.

 Depreciation is a form of allocating the cost of an

asset to periods when the asset is used.

 Depreciation is one key factor that distinguishes accrual accounting from cash-basis accounting.

 Under the accrual basis, the cost of the asset is

allocated to the periods benefited.

 Under the cash basis, the cost of the asset would be

expensed immediately.

Depreciation of Buildings

and Equipment

 Depreciable value - the amount of acquisition cost

to be allocated as depreciation over the total useful life of an asset

 The depreciable value is the difference between the acquisition cost and the predicted residual value.

 Residual value - the amount received from disposal

of a long-lived asset at the end of its useful life

Depreciation of Buildings

and Equipment

 Useful life (economic life) - the time

period over which an asset is depreciated

 The useful life is the shorter of the physical life

of the asset before it wears out or the

economic life of the asset before it becomes

obsolete

 The useful life can be measured in terms other than time For example, the life of a truck can

be measured in miles

Straight-Line Depreciation

 Straight-line depreciation - a method that spreads the depreciable value evenly over the useful life of an asset

life useful

of Years

value Residual

cost

Straight-Line Depreciation

 A truck with a cost of $41,000 and a

residual value of $1,000 has a useful

life of 4 years Depreciation expense is calculated as follows:

($41,000 - $1,000) / 4 = $10,000 *

*Depreciation is the same each year for the life of the asset

Depreciation Based on Units

 Unit depreciation - a depreciation method based on units of service when physical wear and tear is the dominating influence on the useful life of the asset

 A depreciation rate per unit is determined by

dividing the depreciable value (cost less residual value) by the useful life in units.

 To determine depreciation expense, the actual

usage of the asset is multiplied by the

depreciation rate.

Depreciation Based on Units

 A truck with a cost of $41,000 and a

residual value of $1,000 has a useful life of 200,000 miles During the year, the truck is driven for 45,000 miles Depreciation

expense is calculated as follows:

($41,000 - $1,000)/200,000 = $.20 per mile

45,000 x $.20 = $9,000 *

*Depreciation over the life of the asset will fluctuate as

Declining-Balance

Depreciation

 Accelerated depreciation - any depreciation method that writes off depreciable costs more quickly than the ordinary straight-line method based on expected useful life

 Double-declining-balance (DDB) depreciation - the most popular form of accelerated depreciation

 It is computed by doubling the straight-line

rate and multiplying the resulting DDB rate by the beginning book value

Declining-Balance

Depreciation

 Computing DDB depreciation:

 Compute a rate by dividing 100% by the

number of years of useful life

 Double the rate

 Ignore the residual value, and multiply the asset’s book value at the beginning of the year by the DDB rate

 Stop depreciation when the book value reaches the residual value.

Declining-Balance

Depreciation

 A truck with a cost of $41,000 and a residual

value of $1,000 has a useful life of 4 years

Double-declining-balance depreciation expense

Comparing and Choosing

Depreciation Methods

 Straight-line gives the same depreciation

expense each year of the useful life of the asset

 DDB gives accelerated depreciation expense (more than regular straight-line) in the first years of the useful life of the asset

 Companies will often switch from DDB to straight-line part way through the life of the asset to compensate for the fact the DDB may not fully depreciate the asset

Comparing and Choosing

Depreciation Methods

 Companies do not always use the same depreciation

methods for all types of depreciable assets.

 The choice of depreciation alternatives comes from

several places:

 Tradition or use by other companies in the

industry

 Better matching of expenses with revenues

 The nature of the industry and the equipment and the goals of management

Depreciation and Cash Flow

 Depreciation does not generate cash.

 Depreciation allocates the original cost of

an asset to the periods when the asset is used

 Accumulated depreciation is merely the total amount that an asset has been

depreciated throughout its life

Effects of Depreciation on

Income Taxes

 Depreciation is a deductible noncash expense for income tax purposes.

 If depreciation expense is higher, taxes are

lower, and more cash can be kept for use in the business

 Accelerated depreciation generally has higher depreciation expense.

 Depreciation does not generate cash, but it does have a cash benefit if it results in lower taxes.

Gains and Losses on Sales

Recording Gains and Losses

 Remember that when depreciation is recorded,

two accounts are affected, Depreciation Expense and Accumulated Depreciation

 Accumulated depreciation reduces the book

value of the fixed asset

 The disposal of a fixed asset requires the removal

of its book value (carrying amount), which

appears in two accounts, the asset account and Accumulated Depreciation

Recording Gains and Losses

A piece of equipment with an original cost of

$50,000 that has $20,000 of accumulated

depreciation is sold for $35,000 cash The journal entry to record this transaction is as follows:

Recording Gains and Losses

A piece of equipment with an original cost of

$50,000 that has $20,000 of accumulated

depreciation is sold for $23,000 cash The journal entry to record this transaction is as follows:

Income Statement

Presentation

 Gains and losses on sales of assets are usually insignificant, so they are included as “other income” on the income statement.

References:

Horngren, Introduction to financial accounting