This lesson deals with noncurrent assets. Categories of noncurrent assets include:
The major topics in this lesson are:
Measure the cost of a plant asset;
Compute depreciation, using various methods;
Select the best depreciation method, for financial accounting, or tax purposes;
Account for plant asset disposals;
Account for natural resources;
Account for intangible assets.
A good way to summarize this lesson's material is to think about the life cycle of any asset. An asset is purchased, then it is used for a period of time, and finally the owner disposes of it by sale, retirement or trade-in. From an accounting standpoint, we need to think about the cost of the asset when purchased, the depreciation of the asset while we are using it, and the manner in which we get rid of the asset--which may involve discarding it at a loss or selling it at a profit.
A basic question to ask yourself is: "how do we know what to debit when a cost is incurred?" This may seem like a trivial question, but it isn't. For example, if we pay rent on a building, we debit Rent Expense, but if we buy a building, we debit Building. In the first case, the debit goes to an Owner's Equity account (Rent Expense) which will be reported immediately on the income statement. In the second case, we debit an asset (Building), which will be reported on the balance sheet. How do we know when a cost is an expense (like Rent), and alternatively, when a cost is an asset (like the Building)?
To provide guidance on this question, let us think about what an expense is. Here's a simple definition: "an expense is a cost that expires quickly." Rent is paid on January 1 and the benefit of that cost (a roof over your head) expires during the month of January. Similarly, advertising costs for a newspaper advertisement expire in a very short time--the newspaper advertising is published in the newspaper for a few days, and the newspaper gets recycled. Salaries, likewise are paid to employees each month. The benefit of the employees' work only exists while the employee is on the job. We expense the salaries in the same way as we do rent and advertising, because the benefits of these costs are used up immediately.
An asset, on the other hand, is an asset, because its cost provides future benefits. So, even though we know that a Building wears out over time, it will not wear out completely in the first month of use. An asset can be defined as a cost that will benefit future periods. A building is debited to an asset account (rather than an expense) because of these future benefits.
Land, Buildings and Equipment are examples of assets. When we purchase these assets, the costs to acquire them are capitalized. The term "capitalize" means "debit an asset account", rather than an expense account. We capitalize the costs of buildings and equipment; we don't capitalize the costs of rent and advertising.
The cost of a building may involve a contract cost, refurbishment of plumbing and electrical systems in the building, the payment of back taxes, and the cost of real estate services or attorneys. All of these costs are permanent costs of acquiring the building and making it ready for our usage--and are debited to the Building account. To state this another way, the contract cost, refurbishment costs, payment of back taxes and attorneys' fees are "capitalized." None of these costs are expensed.
Your text points out that a self-constructed asset such as a building has one other capitalized cost--the cost of interest during the construction period. Although we think of interest as an expense, it can be capitalized under the right conditions.
There are four categories of Plant Assets:
There is much commonality among these four categories regarding accounting issues. You might ask the following questions regarding each category:
What assets does the category include?
How do you determine the cost of assets in this category?
Are the assets in this category depreciable?
To get you started, this table summarizes some of the characteristics of Plant Assets:
A significant portion of this chapter is devoted to depreciation concepts and calculations. Many people are confused about depreciation, because this term is used in colloquial language to refer to a loss in value. The typical example is that of the purchaser of a new car, who drives off the lot and "immediately loses $4,000 due to depreciation."
In financial accounting, depreciation refers something a little different:
the allocation of the asset's cost over its useful life. Example: A piece of
equipment is purchased for $10,000 and is expected to last 10 years, with no salvage value. The depreciation
schedule for this asset, assuming straight line depreciation, would require
the following adjusting entry at the end of each year:
From the standpoint of the general ledger (at the end of year 1), the depreciation entry would have the following effect:
Consider each of the following points:
The debit to Depreciation Expense reduces Net Income;
The credit to Accumulated Depreciation Equipment reduces the book value of the asset. After the depreciation entry for year 1, the book value for the asset = $9,000 (asset cost minus Accumulated Depreciation). After the tenth year of depreciation, the book value will be $10,000-10,000 or zero. If the asset continues in use for the company, the book value will continue to be 0, and no further depreciation can be taken.
Cash is not affected by the depreciation entry. Depreciation is considered a non-cash expense. The Cash account is included in the diagram above only to point out that it is not used in this type of transaction. In addition, depreciation does not "create a fund for replacing the asset." If a fund were being created, Cash would be increasing, wouldn't it?
The fact that Depreciation Expense reduces Net Income, and income tax is based on Net Income may result in a tax saving by virtue of the depreciation entry.
The book value of the asset may be far different from the asset's fair market value. In the example above, the asset's book value at year 1 is $9,000. The asset may really be worth $15,000 or $3,000 on the open market. Depreciation is a cost allocation concept, not an estimate of fair value.
There are three depreciation methods described in your text:
Straight Line Depreciation -- the depreciation amount is equal each year;
Units of Activity-- depreciation is based on asset's productivity rather than time passage--for example we could use the miles driven this year as the measure of a truck's productivity;
Declining Balance -- an accelerated method which uses a fixed percentage of the asset's declining book value each year.
In order to calculate depreciation, you need three things:
The asset's cost;
The asset's expected salvage value, which is the amount that the asset can be sold for at the end of its useful life;
The number of years of useful life.
Keep in mind that the depreciation entry is usually performed as an adjustment
at the end of an accounting period. The depreciation entry is as follows, and as stated earlier, reduces net income and also reduces the book value of the asset:
In addition to recording depreciation at the end of each accounting period, a depreciation entry would be made at the moment that an asset is sold, retired, or traded in. Example: Johnson Company purchased a $10,000 truck that is estimated to last 10 years with no salvage value. On December 31 of each year, Johnson will record depreciation of $1,000. Suppose this process continues for 8 years, resulting in $8,000 of Accumulated Depreciation. Then, on July 1 of the 9th year, Johnson sells the truck. In order to correctly calculate the gain or loss on disposal of the asset, Johnson must record 1/2 year of depreciation on the date of sale. Debit Depreciation Expense and credit Accumulated Depreciation for $500. The Accumulated Depreciation is now $8,500, reflecting 8.5 years of use.
The text examples are quite clear in depicting the depreciation calculations for the various methods. It will help you greatly if you keep in mind the following definitions while you are studying depreciation:
An asset's book value equals the asset cost minus Accumulated Depreciation. If the cost is $10,000 and accumulated depreciation is $3,000, the book value is $7,000.
An asset's depreciable cost equals the asset cost minus salvage value. Tony purchases a truck with cost of $20,000 and salvage value of $4,000. The depreciable cost would be $16,000.
For management purposes, it is wise to consider the pattern of depreciation that results from each depreciation method. Straight line depreciation provides an equal depreciation amount each year. This is like saying that the same amount of wear-and-tear or obsolescence occurs each year that the asset is used. Note: straight line depreciation is the most often-used method of depreciation, probably because it is the most well-understood method.
The Declining Balance method is considered an "accelerated" method of depreciation because there is more depreciation on the asset in the earlier years. This translates to higher depreciation expense in the earlier years, and a reduced net income. The reduced net income can reduce federal income taxes. However, most managers are in business to maximize net income for the benefit of owners or stockholders.
The Units of Activity method of depreciation has one particular strength: the depreciation expense is directly correlated with the usage of the asset. This method would be desirable if you are trying to determine the cost of a manufactured product--the depreciation would be figured based on the number of units produced by the asset.
As you probably have surmised, sometimes our careful estimation of useful life may be in error. An asset may wear out prematurely or last longer than management intended. Generally Accepted Accounting Principles classify depreciation as an estimate. Estimates are a necessary aspect of accounting, and run counter to the public's perception of an accountant being a meticulous "bean-counter". Depreciation can be revised from time to time, as long as the revision is carried out in the current period or future periods. The basic method is to take the revised remaining depreciable cost (less salvage value) and spread it out over the revised remaining useful life.
Repairs, Additions, and Improvements all involve spending money on a plant asset. Here is a brief distinction among the three items:
1. A repair maintains the operational efficiency of the asset. For example, if a machine is repaired, that repair just restores the machine to its original capability. The entry would be:
2. An addition "adds" to the productive capacity of the asset. Johnson Consulting enlarges its office to include a new meeting room, or installs a lift on a truck. In either case, an asset account is debited:
3. An improvement or extraordinary repair is more significant than just repairing the asset. The key question is whether the expenditure increases the useful life of the asset. If so, some of the Accumulated Depreciation may be taken off, as follows:
If the improvement does not result in an increase in useful life, account for it as an addition; that is, debit the asset account. In comparing the handling of expenditures for assets, note that a repair expense goes directly to the income statement, whereas additions and improvements add to the cost of the asset.
Sooner or later, various plant assets are disposed of. In this section, you should focus upon the book value of the asset at the time of disposal. It is the book value (Asset cost minus Accumulated Depreciation) that is compared to assets received, if any, to determine if a gain or loss occurred. Methods of plant asset disposal are:
Sale of the Asset -- Cash or other assets will be received;
Retirement of the Asset -- the Asset is discarded or thrown away and nothing is received;
Exchange of the Asset -- for a similar one, or a different type of noncash asset. Cash might be paid in addition to giving up the old asset.
The time at which the disposal occurs may be at the beginning, middle, or end of the year. If the disposal is not at the end of the year, you must remember to record any depreciation for the asset up to the time of the disposal. Depreciation usually occurs with the passage of time, and if depreciation is not updated, the Asset's book value and the resulting gain or loss will be misstated.
Suppose a company owns a piece of Equipment originally costing $10,000 that
currently has Accumulated Depreciation of $6,000. The situation could be diagrammed
Verify that the book value of the Equipment is $4,000. I have included two T-accounts in the Owner's Equity section. These are Loss on Disposal (similar to an Expense account), and Gain on Disposal (similar to a Revenue account). To determine the amount of Gain or Loss, compare the assets received with the Book Value of the Asset given up. Here are some examples:
1. Suppose the asset is sold for $5,000. Close out the asset account and it's
accumulated depreciation. Since $5,000 is greater than the Book Value of $4000,
a Gain of $1,000 is realized:
2. If the same asset were sold for $3,000, a Loss of $1,000 occurs:
3. If the asset is simply retired (taken out of service), with no assets received, you still close out the asset account and the Accumulated Depreciation account. If the Asset has a book value greater than zero (i.e., it is not fully depreciated), there will be a Loss recorded:
The subject of Plant Asset exchanges is a complex one in Accounting. The information presented in your text simply introduces the subject. You may wish to read this material, but you will not be held responsible for it.
Natural Resources are considered "wasting" assets, such as timberlands, oil wells, gravel pits, gold mines, etc., that involve extraction of a resource. The basic problem is to account for the units taken out of the resource. You will find that computation of depletion expense is similar to computing units-of-activity depreciation.
Depletion is a concept that is identical to depreciation, that is, the allocation of the cost of the natural resource to the periods in which it is productive. In order to calculate depletion, one must know the cost of the natural resource, as well as the expected volume of the resource that exists. As with the units-of-activity method of depreciation, a unit cost can be determined, which is then multiplied by the number of units extracted.
Analogous to equipment or other kinds
of plant assets, each natural resource account would have its own Accumulated
As you might expect, the expense account for depletion is called Depletion Expense. It represents a noncash expense, similar to depreciation.
Intangible Assets represent rights, privileges, and competitive advantages owned by a business. They are intangible only in the sense that they have no physical substance. Very often, their legal status may be of critical importance to the longevity of a company. Examples of intangible assets include: patents, copyrights, franchises, trademarks, and goodwill. Similar to plant assets (which depreciate) and natural resources (which deplete), intangibles are amortized. Normally, however, no Accumulated Amortization account is used; the credit is made to the Asset account itself.
Straight line amortization is the norm. Unlike depreciation and depletion, you may credit the asset account directly; no need for an "accumulated" account.
There has been great debate among accounting practitioners, theorists, and standards-setting bodies regarding the proper accounting for Research and Development Costs. Notice that R & D Expenditures are not listed above with the intangible assets. This is because the Financial Accounting Standards Board has declared that Research and Development expenditures cannot be capitalized (placed into an asset account). Such expenditures must be expensed when incurred.
The following paragraphs summarize the characteristics of several of the intangible assets:
Patent: the right to manufacture, sell, or control an invention. A patent is granted by the U.S. Patent Office for a period of 17 years. Debit Patent Amortization Expense and credit Patent.
Copyright: Right to reproduce or sell an artistic creation such as a book, song, or other work. Debit Copyright Expense, credit the Copyright account. The life of a copyright is the creator's life plus 70 years.
Trademark: Word, phrase or other mark protected by the U.S. Patent Office. Trademarks are normally for 20 years.
Goodwill: Arises when an entire business is purchased. If the buyer of a business pays more than the fair market value of the (assets minus liabilities) of the acquired company, it is presumed that another asset exists--Goodwill. Please read my additional handout on Goodwill.
Note that patents, copyrights and trademarks achieve their status as assets due to legal protection by an arm of the United States. Goodwill does not have such legal protection. In fact, if the buyer of a business is unwise, the extra amount paid to acquire a business may be a result of being uninformed regarding the future of that company. In such a case, although Goodwill might be recorded, its status as an asset could be questionable.
To summarize the focus of this lesson, consider that Plant Assets, Natural Resources, and Intangible Assets are long-lived assets that appear in the balance sheet, net of accumulated depreciation, accumulated depletion, or accumulated amortization.