A company's acquisition of long-term operating assets represents a substantial investment.

Discover more about these assets, including tangible and intangible assets, and how they
are used to generate revenue over time.

Long-Term Operating Assets

The Dog Games R Us Company is in the process of constructing a new building to house its
operations and is considering the purchase of new, state-of-the-art pieces of machinery that
will allow it to make dog games using less plastic. The owner of the business, Mr. I. M.
Shaggy wants to learn all he can about long-term operating assets before committing the
company to this purchase.

An asset is something of value that a business owns. Assets can be classified as either
current or long-term. To be considered long-term, assets must provide future benefit to a
business for more than the next 365 days or the current year, will be used in the business,
and are not purchased with the intention of selling them to consumers.

Operating assets are acquired to produce income for a business. Long-term operating
assets are classified as tangible or intangible. Tangible assets have physical substance,
and intangible assets are those that cannot be touched or felt. Examples of tangible assets
include property, plant, and equipment and natural resources. A patent is an example of an
intangible asset. A patent granted by a government authority provides an inventor with the
exclusive right to use, produce, or sell his or her invention for a specified period of time.

Tangible Assets
Let's look at a few more examples of tangible assets.

Property, Plant, and Equipment

This category of tangible assets includes items like machinery, equipment, buildings,
company vehicles, and land. All of these assets, except for land, get used up as they are
being used to generate revenue for the company.

In order to satisfy the matching principle, the cost of using the asset must be recorded in
the same financial period as the revenue that it helped to earn. In accounting, the process of
allocating the cost of property, plant, and equipment assets as they are used to earn
revenue is known as depreciation. Land is not subject to depreciation as it has an infinite life
and its cost cannot be allocated to a particular time period.

When a company acquires an asset, the amount it records on the balance sheet (which
summarizes assets, liabilities, and shareholders' equity) is known as historical cost.
Historical cost reflects purchase price of the asset plus all costs incurred to get the asset
ready for its intended use. In the case of the Dog Games R Us Company, the cost of the new
building would include architectural fees for the drawings, the cost of building permits and
the cost to construct the new building. If Dog Games R Us decides to purchase the new
equipment, the cost could include transportation charges to get the piece of equipment to
the company's premises, costs incurred to upgrade wiring to accommodate the new piece
of machinery, and the costs incurred to build a base for the new piece of equipment to rest
on in the factory.
Natural Resources
Natural resources include standing timber and underground deposits of gas, oil, and
minerals. These type of assets are physically extracted in operations, such as mining or
cutting, and they are usually replaceable only by an act of nature. The cost basis for a
natural resource is the cash or cash equivalent price of acquiring the resource and costs
incurred in preparing it for its intended use. If the deposit on the property has already been
discovered, then the cost basis becomes the price that the company paid for the property.
The process of allocating the cost of natural resources over the periods in which they are
used to generate revenue is known as depletion. The amount of depletion recognized on an
annual basis is affected by how much of the resource is extracted, the residual value of the
natural resource (what it will be worth when the extraction process is completed), and the
cost of any future removal or restoration costs.

Intangible Assets
Intangible assets, such as patents and trademarks, have characteristics similar to those of
tangible assets. For example, they provide benefits to the company for more than one
period. Let's assume that Dog Games R Us has received a patent for its game design. On an
annual basis, the company would record amortization to allocate the cost of an intangible
asset in the same period as the revenue it is used to earn. Amortization is the same
concept as depreciation, but it is only used for intangible assets. The amortization period for
intangible assets is the shorter of their legal lives or their useful lives.

Revenue vs. Capital Expenditures

Once an asset is put into service, there are periodic costs that a company incurs to keep the
asset in good working order. For example, a piece of machinery requires annual
maintenance to replace parts that are worn out as it is used to produce and oil needs to be
changed in the company vehicles. The costs incurred to maintain assets are known as
revenue expenditures and they are expensed in the year they are incurred. They are not
added to the cost of the asset as they do not lengthen its useful life. If a company were to
incur an expenditure to make an asset last longer, then this cost would be added to the cost
of the asset and depreciated over its useful life. This type of an expenditure is known as a
capital expenditure.

Lesson Summary
Long-term operating assets are acquired and used by a company to generate revenue over
a number of years. These assets are classified as either tangible or intangible and the cost to
acquire them is the purchase price plus all costs necessary to get the asset ready for its
intended use by the company. Tangible assets are those assets that have physical
substance, such as a building or a piece of equipment. Intangible assets cannot be touched
or felt; examples include patents and trademarks.

What is a Plant Asset?

The plant assets definition in business accounting refers to fixed business assets that
depreciate over time. Sometimes plant assets can be referred to as fixed assets. Plant
assets can be any asset used to make money that has both a useful life of more than a year
and does not directly become part of the product itself. Plant assets are usually very difficult
to liquidate and turn into cash. This makes them different from other types of assets such
as liquid assets, inventory, or intellectual assets. The other non-fixed assets can be sold or
consumed relatively quickly because they are used for short term projects in a business.
Plant assets are 'fixed' in a business because of the amount of money invested to own and
operate them, the long-term role these assets play, and because a business cannot sell it
and turn it into cash quickly.

The reason fixed assets are often known as plant assets is because of the history of
business accounting connected to the Industrial Revolution. The largest forms of business
assets when it came to production were factory plants during this time. Today, however,
plant assets include more than just factories.

The most valuable fixed assets during the

Industrial Revolution were plants and factory
facilities. Many of these plants today are a
used many ways but still hold tremendous
value for whichever business owns them.

The importance of differentiating plant assets over other assets is for accounting practices,
in particular for tax reporting and financial planning. Plant assets are typically the largest
investments the business owns and the most significant when it comes to balancing the
financial books. Today, fixed assets or plant assets are considered Property, Plant, and
Equipment (PP&E). PP&E assets are long-term investments for a business that have a long
lifetime compared to other types of assets.

Plant Assets Examples

"What is a plant asset?" There are numerous plant assets examples that can be found on a
business's PP&E balance sheet. The most common examples are land, equipment and
machines, buildings, and capital improvements.

Land
The physical property where a business's operations are located is one of the most
important parts of plant assets. When a company owns its own land on which they conduct
business, they do not need to pay a third party for space to rent or do not need to ask
permissions from a landlord to perform a certain action. Typically, land is one of the most
valuable plant assets because it is highly appreciating. Land rarely depreciates in value so
businesses purchasing land hold tremendous value. Construction sites are also plant assets
because a construction site still has value and will contribute to profits.

Equipment and Machines

Capital goods, such as equipment and machines, hold significant value as well. Equipment is
unique to each business and is the most diverse of the plant asset types. Equipment plays
an integral role in the production of a product or the offering of a service. Equipment can
include crude mechanical tools such as hammers or be sophistical pieces of technology
such as computer systems. Machines also play a role in the production process or in
providing a service. Machines are often larger and in permanent positions as compared to
other equipment. Most equipment is lighter and more mobile, while machines are often
more difficult to move. Examples of machinery are large factory conveyer systems,
construction machines, or robotic arms.

The rise of mass transportation has increased

the focus for businesses to invest in their
vehicle fleets. Transportation is one of the
most valuable plant assets, but also one of the
most expensive the maintain.
Buildings
Buildings are assets that include any structure or facility that a business builds or owns on
their property. Buildings are typically one of the most valuable assets of a company in
addition to owned land. A business might own small buildings like office space or a small
storefront, or larger structures such as storage facilities, warehouses, or large headquarters
for their employees.

Capital Improvements
Part of an asset's value is connected to the health or the duration of the asset. This means
keeping equipment properly maintained, updating buildings, adding accessories to
machinery, or advancing property in other ways. Improving the capital goods not only can
maintain value of an asset, but certain improvements can even add value. Improvements
can be a large expense but are considered an investment, as maintaining and improving
capital goods adds considerable value to the business.

Improvement value is difficult to transfer over when new ownership takes over an asset.
This is especially difficult in a leasing relationship. For example, a business leases out an
asset with its improvements attached to an individual. In this case, the lessor gets
ownership over improvements at the end of a leasehold improvement. The lessee gets to
count the improvement value for the duration of the lease term.

Characteristics of Plant Assets

Plant assets have many diverse characteristics that play a role in the business. These roles
are revenue generation, tangibility, and useful lives.

Revenue Generation
Some assets are primarily used in a business to focus on generating revenue. These assets
help the company bring in money to fund other operations and to maintain profits.

Tangibility
Almost all plant assets are tangible assets meaning they are used in the production process.
Workers and operators of these assets need to be able to use assets to make a good,
provide a service, or to improve a product. The ease of use that asset have increase its
tangible value.

Useful Lives
An asset is more valuable if it has a has durability and can last a long time. A plant asset is
useful for more than one year and provides profits for a business.

How Are Plant Assets Accounted For?

Plant assets are important not only for the profits of a business but to their business
accounting as well. Plant assets are recorded differently on a balance sheet because of
depreciation. A balance sheet shows all the assets a company owns plus all the liabilities the
company has, including the depreciation value. Depreciation is the loss of value of an asset
due to use overtime. For example, a large robotic arm that is a plant asset on a factory floor
of a business will be listed on the balance sheet with its value beside it. Next to that value,
the robotic arm will also show how it is depreciating overtime and what the business needs
to do to pay for upkeep. Depreciation is the accounting way of showing how an asset
continues to have value. The depreciation value is used as a taxable expense to lower the
taxable burden.

Lesson Summary
Plant assets are those assets that can be used to create profits that have a useful life of
more than a year. Plant assets are also known as fixed assets because they are difficult to
liquidate into cash and hold their value for a long time. Plant assets get their name from the
industrial era because most fixed assets were factory plants. Today, plant assets are often
referred to as Property, Plant, and Equipment (PP&E). The four main examples of plant
assets, or PP&E, are land, equipment, buildings, and improvements. These assets provide
considerable value to a company, and they have a long lifespan. Transferring an asset
through a lease agreement can be difficult, especially if the asset comes with improvements.
In that case, the lessor gets the full worth of the asset plus improvements, but the lessee
can count the value until the end of the lease term.

The key characteristics of plant assets are their revenue generation focus, tangibility
usefulness, and how long an asset's usefulness can last. Plant assets are reported differently
than other assets on a business's accounting sheets. Plant assets lose value over time
through general use, which is called depreciation. Depreciation can be used as a business
expense to lower the tax burden. In a way, depreciation can be conceptualized as the
amount you need to pay if you did not have the asset.

What are Plant Assets?

Plant, as an asset category, is an old-fashioned way of classifying property used in an
industrial process such as a foundry, a factory, or a workshop. Effectively, plant, in the asset
sense, means a site where an industrial or manufacturing process takes place. In modern
times, items that would formerly go specifically to plant, will now be categorized in the
broader term property, plant, & equipment, which is another term for fixed assets.

Plant assets are generally large items like buildings, equipment, machinery, and land. As
assets, they are intended to provide future economic benefits to the firm for a certain
period of time, usually some years. The cost of plant assets in the financial record must be
in line with Generally Accepted Accounting Principles (GAAP). This usually means recording
the value of the asset at cost in the firm's books. Other measures of value for assets are fair
market value (FMV) and book value.

Plant Assets Examples

Some examples of plant assets are:

 Buildings - any edifice purchased or built for the purpose of conducting business is a
building asset.
 Office Equipment - this includes desks, chairs, computers, kitchen equipment, lamps,
dividers, etc.
 Plant Equipment - any kind of industrial equipment, like machinery or manufacturing
equipment. For example, a new conveyor belt for guiding products down an
assembly line would be a plant asset.
 Land - is pretty self-explanatory as long as the land's purpose is to be used in the
conduct of business.
 Improvements - any large-scale improvements that will materially affect the value of
the asset being improved.

Cost Principle Definition

The cost principle, recommended by US GAAP, requires that most assets held by a firm be
reported in their books at historical cost. Historical cost is the price a buyer pays for a good
at the time of purchase. If a company purchased a conveyor belt for $15,000 on May 1st,
2015, its historical cost is $15,000. Other ways to measure value are fair market value
(FMV) and book value.

Fair market value (FMV) assigns the current market value to the asset. If a firm purchased
land 25 years ago for $165,000 and the current market value of the property has
appreciated to $750,000, the fair market value of the property is $750,000. Book value is the
original cost of the asset minus depreciation and/or impairment. If an asset is impaired for
accidental reasons, like fire or a natural disaster, the asset's decrease in value must be
reported in the books.

Fair market value means the value of an asset based on a reasonable assessment of its
market value at the time of reporting. It is the amount of money a firm would get if it sold
the asset at the time of reporting. Historical cost is the purchase price of the asset at the
time of its acquisition. The difference between these can be enormous. One of the
drawbacks of the historical cost principle is its inability to account for the reality that such
major differences happen and are of material importance to entities evaluating a firm's
books.

Determining the Cost of Plant Assets

To determine the cost of a plant asset in order to report it in the books is fairly
straightforward and easy. All that needs to be done is to enter its original cost, as stated in
the invoice, in an asset account assigned to the asset or asset class. There are instances
when the value of the asset will be adjusted to include capital expenditures made in favor
of the asset. These are sometimes placed in a separate capital account. Capital expenditures
(CapEx) are monies used to buy, maintain or improve plant assets. When expenses are
added to the cost reported for an asset, these are said to be capitalized.

For example, if a firm buys a conveyor belt for its assembly line for $15,000 and five years
later it has some maintenance work done to improve performance and extend the life of the
conveyor belt by five years for $3,000, then the $3,000 will be capitalized, added to the
original cost of the asset, and depreciated over the extended useful life of the asset along
with what's left of the original cost. Some costs that could be added to a plant asset are
freight, installation costs, non-routine maintenance, and taxes.

If a firm purchases some equipment for $38,000 for its factory and it spends $2,000 to get it
to the firm and another $5,000 for installation of the equipment, then the cost of the
equipment in the books will be $45,000 because the transportation and installation are
necessary to get the equipment up and running. This would be reported on the balance
sheet and depreciated over the asset's useful life.

Revenue expenditures are general expenses that don't get capitalized. They are not for
assets which will provide a future benefit to the firm, the intrinsic assumption being that the
benefit of the purchase will be used up during the accounting period in which the purchase
was incurred. Amongst these are expenditures for ordinary repairs and maintenance.

It is important to distinguish between routine maintenance expenses and extraordinary

maintenance expenses incurred to extend the life of the asset. Other types of regular
expenses that would be absorbed during the accounting period incurred, rather than
capitalized, are annual insurance, oil changes for a delivery van, repairing a clogged toilet,
etc. None of these expenses will increase future revenues for the firm, and they therefore
cannot be capitalized.

When a number of assets are purchased together, usually for a better price than would be
obtained separately, this is called a basket purchase. When recording a basket purchase,
each of the assets in the purchase must be reported separately at its proportional value
from the fair market value of the purchase.

For example, if a car rental company buys three vehicles (a sedan, a minivan, and a sports
utility vehicle) from the same car dealer for its fleet for $120,000, where the fair market
value of the sedan is $65,000, the minivan is $45,000 and the SUV is $40,000, then the firm
must establish the proportional value of each vehicle to the total price in order to determine
its original cost to the firm.
In this case, had each item been purchased separately, the total cost would have been
$150,000. The sedan's value, then, would be 43.33% of the total value. The minivan would
be 30%, and the SUV would be 26.67%. In order to report each item's cost to the firm
separately in the firm's books, the accountant must find the prorated cost of each item
based on their percentage value of the total cost. This means:

 The sedan is ($120,000 * 43.33%) = $51,996.

 The minivan is ($120,000 * 30%) = $36,000.
 The SUV is ($120,000 * 26.67%) = $32,004.

Although the historical cost principle requires the reporting of the asset's original cost in the
books, there are times when circumstances require that adjustments be made in order to
more accurately reflect the true financial picture of the firm. These adjustments are:

 Impairments - when an asset suffers material damage that affects its value,
productivity, and useful life, this must be reported as an impairment that reduces
the value of the asset.
 Revaluations - an adjustment made to the book value of an asset in order to bring it
to fair market value.
 Depreciation - the expensing of cost of the asset over its useful life.

Cost Principle Examples

The historical cost principle requires that the cost of an asset be reported at its original or
historic cost. If a piece of equipment was purchased for $200,000 twelve years ago, the
historic cost principle requires the asset to be reported at $200,000 on the balance sheet.
Depreciation will be accounted for in a separate line item, and then the book value of the
asset will be reported.

The book value of an asset is its historical cost minus depreciation and/or impairment, if
there is any. If this piece of machinery depreciates at a rate of $10,000 per year, and has a
$0.00 salvage value, then its book value at the end of the second year will be $190,000. This
would continue for the 20 years that make up the useful life of the asset, at which point its
value would drop to zero, and it would no longer show up in the books.

Advantages and Disadvantages of the Cost

Principle
The cost principle is popular because of its many advantages. It is reliable, comparable, and
verifiable. It is also fairly objective. There is no speculation in the number; anyone can audit
the firm's books and see where the number came from. It can be consistently applied, rarely
needs adjustment, and is very easy to implement.

Nevertheless, the cost principle has some significant drawbacks. It can give a very inaccurate
representation of an asset's value in the real world. If an asset's real market value is 500% of
the original cost, what meaning does the original cost have in terms of reflecting the firm's
true worth? The cost principle also fails to make adjustments for inflation and deflation. This
means that the normal changes in asset prices are not incorporated into the figure.
This is unrealistic because a dollar in 2005 is not worth the same as a dollar in 2020. These
are known realities that the cost principle does not recognize. Another disadvantage is that
the cost principle cannot be used to account for certain types of intangible assets like brand
name recognition and goodwill. This is because there is no transaction record, as the asset
was cultivated by the firm over time, and its cost to the firm is difficult to estimate.

Lesson Summary
Plant assets are generally large items like buildings, equipment, machinery, and land. As
assets, they are intended to provide an economic benefit to the firm for a number of years.
The cost of plant assets in the financial record must be in line with the cost
principle recommended by Generally Accepted Accounting Principles (GAAP). This usually
means recording the value of the asset at its historical cost in the firm's books. Historical
cost is the price a buyer pays for a good at the time of purchase. Plant assets are generally
large items like buildings, equipment, machinery, and land. When the original cost of an
asset is reported in the firm's books, it may include some costs that are necessary to get the
asset up and running, such as freight, installation costs, and taxes. These extra expenses are
capitalized and then depreciated over the asset's useful life. Other possible measures of
value are fair market value (FMV) and book value. Fair market value (FMV) assigns the
current market value to the asset. Book value is the historic cost of the asset minus
depreciation and/or impairment.

There are instances when the value of the asset will be adjusted to include capital
expenditures made in favor of the asset. Capital expenditures (CapEx) are monies used to
buy, maintain, or improve plant assets. When expenses are added to the cost reported for
an asset, these are said to be capitalized. When expenses are capitalized, they are
depreciated along with the asset. Revenue expenditures are general expenses that don't
get capitalized. The intrinsic assumption is that the benefit of the purchase will be used up
during the accounting period in which the purchase was incurred. Amongst these are
expenditures for insurance, routine vehicle maintenance, and any type of ordinary repairs
and maintenance. None of these expenses will increase future revenues for the firm and
therefore cannot be capitalized. It is important to distinguish between routine maintenance
expenses and extraordinary maintenance expenses incurred to extend the life of the asset.
When a number of assets are purchased together, usually for a better price than would be
obtained separately, this is called a basket purchase. When recording a basket purchase,
each of the assets must be reported separately at its proportional value from the fair
market value of the purchase.

One of the main categories of long-term assets is known as property, plant, and equipment,
encompassing the location, buildings, and equipment needed in production. Learn how the
acquisition of property, plant, and equipment is recorded and documented through an
example of journaling.

Company Acquisitions
Imagine your friend Ella is about to open a new pet grooming shop. Ella begins to
brainstorm all the items she needs to purchase for her new shop. Ella's list looks something
like this:

 Dog treats
 Cat treats
 Dog hair bows
 Leashes
 Pet shampoo and fragrance

So far, Ella has a good list. These items will surely help, but what about the long-life
resources she will need in order to have continuous operations? These owned resources are
called property, plant, and equipment. Property, plant, and equipment are considered
long-term, tangible assets because they should benefit the business for more than one year.

The purchases of property, plant, and equipment could be Ella's biggest and most important
decisions related to her new pet grooming shop. Let's go over examples and discuss more
reasons why property, plant, and equipment are so important for the operation of a
business.

Property, Plant, and Equipment

Land purchased for a business is an example of property. In the above example, Ella may
want to purchase enough land to allow for a building and a small dog park area. The dog
park will be a nice, secure place for the animals visiting her shop to walk around before or
after their appointment. While considering property, Ella must take into account the location
and the price. As you can see, this purchase is very important for the success of Ella's shop,
and it should benefit her business for many years.

Examples of plant include a building acquired to house a business, a storage building used
to store inventory, and any other building purchased by the business to help provide
continuous operation. In our dog grooming example, Ella will need to purchase or construct
a building to house her shop. She must consider the type, size, and price of the building.
This decision is very important, as it will likely be her most expensive purchase. Like
property, plant is also tangible and will benefit the business for more than one year.

Looking over her list, Ella realizes she forgot about the equipment needed to provide an
awesome grooming experience. She will need special fur-drying machines, tools for
shearing, a cash register, and a computer to keep track of her appointments and customer
information. These are all examples of equipment. Ella should do research on the types and
brands of equipment she will need. She should consider equipment with high quality and
fair prices. Equipment must be tangible, and it should benefit the business for, you guessed
it, over a year.

Recording Acquisition
So how does Ella record the acquisition of property, plant, and equipment? Well, company
assets and liabilities appear on the company's balance sheet. Long-term assets including
property, plant, and equipment should be listed below current assets. When preparing the
general journal entry, the asset amount recorded should include the purchase price,
transportation cost, installation cost, and any other charge incurred while putting the asset
into use.

Next, the same amount should be recorded in the cash account, if cash was paid for the
asset, or the correct long-term liability account. Long-term liability accounts, including
mortgage payable, are for business debts that are due in more than one year. Depreciation,
which will be covered in another lesson, must also be recorded each year for plant and
equipment.

Journal Entry Example

Let's look at an example of a journal entry for land acquisition. Ella purchases two acres of
land for her new shop. The purchase price is $25,000. She paid in full using cash. Here is
what she would enter:

Debit the Land Account for $25,000

Credit the Cash Account for $25,000

Lesson Summary
Property, plant, and equipment are listed as long-term assets on the company balance
sheet. These assets must be tangible and they must benefit the business for more than one
year. The purchases of property, plant, and equipment will likely be the most important
purchases made by a company. These assets or owned resources will allow a business to
have continuous operations. The total amount recorded for the acquisition of property,
plant, and equipment should include the purchase price, transportation costs, installation
cost, and any other charge incurred while putting the asset into use.

What is Depreciation Expense?

To discuss depreciation expense one must first understand the depreciation definition.

Depreciation is a blanket term that refers to an item's diminishing value over time due to
wear and tear, depletion, or the availability of newer technology rendering the asset
obsolete. This means that over time the value of the item will decline until it is no longer
capable of producing revenue. In financial accounting, this refers to plant assets such as
buildings, machinery, and equipment. These assets are used long-term, covering many
accounting periods. Since these assets are typically quite expensive, it would be inaccurate
to account for the whole cost of acquisition in the year it was purchased. It is more feasible
to spread the expense over the time that the asset or equipment is predicted to be useful.
Hence, in business, the depreciation definition is: the allocation of the cost of buildings,
equipment, or other tangible asset, over the period of its assumed useful life.

Now that the depreciation meaning is understood, the question of, "what is depreciation
expense?" can be definitively answered: The depreciation expense is the predefined
portion of an assets loss in value during the current accounting period. In other words, it is
the amount of an item's depreciation for the current period and accounts for that portion of
the total expense initially paid for the asset. In this way it quantifies the loss in useful value
of the asset based on its use in the current period.

There are 2 types of depreciation to consider:

1. Physical depreciation
2. Economic depreciation

Physical Depreciation
Physical depreciation refers to the deterioration of an asset from age and use. This
deterioration begins once the asset is purchased and put into service.

A good example of this is a delivery van. As time passes and it is used for deliveries, the
van's components become worn and dated which slowly depletes the functionality of the
van and hence, its value. The longer the van is in use the more it will physically deteriorate
and its value depreciate. This is the type of depreciation that is used in accounting to justify
the depreciation expense.

This delivery van has seen a great deal of

physical depreciation and is nearing the end of
its useful life

Economic Depreciation
Economic depreciation refers to an asset's loss in market value due to external economic
factors. This loss in value is not due to deterioration or other predictable factors but by
changes in market conditions for various reasons.
An example of this type of depreciation would be the loss of value in land owned due to
negative market fluctuations or because the surrounding area has gone into decline.

Economic depreciation devalues the asset for reasons unrelated to its predictable loss of
usefulness or functionality. Since the cause of depreciation is not due to depletion or
common degradation of the asset, these types of depreciation are never included in a
business' income statement or when itemizing depreciation expenses in a journal or
balance sheet. For this reason, depreciation expense refers only to physical depreciation of
tangible assets and equipment.

The depreciation expense is for assets with

diminishing performance. Here, the building
can be depreciated but the land cannot as it is
considered to be perpetually useful.

How is the Depreciation Expense Calculated?

To understand how to calculate depreciation expense it is important to know that there are
many acceptable methods to calculate the depreciation expense.

However, there are 3 that are most commonly used in business today that cover most
circumstances.

They are:

 Straight-line method
 Double-declining balance method
 Units-of-production method

Regardless of the method selected, all require some basic information in order to utilize the
depreciation formula. All of the items below are important in calculating depreciation
expense:
  Original cost - refers to the asset's total cost necessary to put the asset into
productive use (purchase price, taxes, delivery, installation, modification, etc).
 Book value - Refers to the value of the asset after deducting all realized depreciation
from the asset's full original cost. When the asset has been fully depreciated, book
value and salvage value are equal.
 Useful life - The predicted length of time the asset can be used productively
 Salvage value - the value of the asset at the end of its useful life. This is also
called residual value.
 Depreciable base - refers to the original cost minus the salvage value of the asset. It
represents the total depreciation expense over the entire useful life of the asset.

Additionally, when using the unit-of-production method, it will be necessary to estimate how
many units can be produced during the assets useful life.

Straight-line Depreciation Method

This simple methods splits the asset's depreciable base into equal portions across its useful
life.

Example:

Suppose machinery is purchased at an original cost of $250,000. It's assumed that the
machinery will remain useful for 5 years after which it could be reasonably sold for $80,000.

The machinery's depreciable base is the original cost ($250,000) minus the salvage value
($80,000) = $170,000

Next, divide the depreciable base (170,000) by the machinery's useful life (5years) to
determine that $34,000 may be recorded as depreciation expense each of the five years the
equipment is in use.

Output or Production Method

The units-of-production depreciation formula bases the value of depreciation on the asset's
actual use throughout a period. Rather than measure depreciation over time, this methods
estimates the asset's useful life in terms of production.

Example:

Suppose the machinery in our last example is expected to be productive until it has
produced 1 million widgets and the amount of them that is sold varies from year to year.
Instead of dividing the equipment's depreciable base ($170,000) by years, determine the per
widget depreciation by dividing it by the productive maximum (1 million units) which gives
us a depreciation expense of $0.17 for each widget produced.

In this way, depreciation expense can be recorded according to annual widget production.
So, if one year 25,000 widgets are produced, a depreciation expense of $4,250 will be
recorded. If 85,000 are produced the next year, an entry of $14,550 will be made for
depreciation expense. This is done each year until the equipment has reached the end of its
useful life (1 million widgets produced).

Notice that the salvage value and total depreciation expense are the same as in the straight-
line method example. They both have the same depreciation expense, it's simply measured
differently over time.

Double-Declining Balance Method

Of the methods examined, the Double-declining balance is the most complicated because it
incorporates both considerations. First it considers time by calculating the percentage of
depreciation expense using the straight-line method. It does this by dividing 100% by the
number of years of useful service (5) = 20% Then it takes into account that fixed assets are
generally used more heavily when they are first acquired by doubling the percentage, this
case, to 40%. This percentage is then used to determine the depreciation expense for each
year.

It is important to note that in this method, the salvage value is not considered in the first
year of use before calculating the depreciation expense but in no year may an asset's book
value fall below its salvage cost.

See the table below as an example:

Accumulated
Year Depreciation Expense Book Value
Depreciation

$250,000

1: $250,000 x 40% = $100,000 $100,000 150,000

2: $150,000 x 40% = 60,000 160,000 90,000

3: $90,000 - $10,000 = 10,000 170,000 80,000

4 0 170,000 80,000

5 0 $170,000 $80,000
Observe that depreciation expense is capped at $10,000 in year 3. This is because book
value cannot fall below salvage value at any point. Opting for this method under the
circumstances provided in all examples means that no depreciation expense can be entered
for years 4 and 5 because the asset has already been depleted to its anticipated salvage
value by the end of year 3.

In all cases, the total depreciation expense over the life of the asset remains $170,00 and
the salvage value is fixed at $80,000.

How to Recognize Depreciation Expenses in

Financial Statements
Issued by the Financial Accounting Standards Board (FASB), the US Generally Accepted
Accounting Practices (GAAP) Codification Topic 360: Property, Plant, and Equipment
details the expense recognition principle that allows for the depreciation expense to
be recognized over the full period of the tangible asset's usable life.

Depreciation expense can be found on a company's income statement. It is found under the
Operating Expenses heading and is usually listed along with amortization, if any applies. It is
a non-cash entry that reduces total operating income.

Lesson Summary

Review of Depreciation Expense

 Depreciation is the allocation of the cost of buildings, equipment, or other tangible
asset, over the period of its assumed useful life.
 Depreciation expensethe predefined portion of an assets loss in value during the
current accounting period.
 Depreciation expense applies only to assets that undergo physical
depreciation such as buildings, machinery, and equipment.
 Depreciation expense does not apply to items that experience economic
depreciation alone, such as land, because they are considered to have an unlimited
useful lifespan.

Review of Depreciation Expense Formula

While there are many methods that are legal to use in calculating depreciation expense,
there are 3 that are used in the majority of cases:

1. Straight-line method: Equal portions of the depreciable value are recorded as

depreciation expense annually.
2. Units-of-production method - Depreciation expense is calculated as a per unit
expense, annually, until the total of all possible units has been produced.
3. Double-declining balance - Doubles the percentage of depreciation expense derived
from the straight-line method, annually, until the salvage value is reached.

Which method is ultimately used will depend on which one best suits the businesses
practices regarding its tangible assets and how they are utilized, annually.

Review of Recording the Depreciation Expense on

Company Financial Documents
  The US Generally Accepted Accounting Practices (GAAP) assures that, regardless
of method used, all depreciation methods provide the same expense recognition
principle_ in allowing the depreciable base of a qualified asset to be realized
proportionally, over time.
 The depreciation expense can be found on a company's income statement under the
heading Operational Expenses and is commonly combined with amortization,
assuming there is any to report.

When completing financial reports, depreciation, or a loss in value, can be reported using
three different methods: straight-line, double declining balance, and units of production.
Learn to calculate depreciation using each of these methods.

A 3D Printer
You are a designer, and you have a little design company. What you do is you make unique
designs for the home, and you print them out using a 3D printer. These printers let you print
3D objects using different materials. Yes, these printers print in space starting from the
bottom and working their way up. You can print vases, cups, and whatever other objects
you can think of as long it is one continuous piece and not two separate pieces. These
printers open up a whole new creative world to explore.

As part of your business, you use a 3D printer on a daily basis to print out new designs and
orders for customers. You bought this printer for $20,000. It has a life expectancy of 10
years, and it is expected to print about 150,000 3D items in its life.

Because you spent so much money on this printer, you want to make sure you account for
the loss in value of this printer with each passing year on your financial reports. Every year,
the printer loses value because of aging and wear and tear from use. This loss in value is
referred to as depreciation. There are three ways you can go about calculating
depreciation.

Straight-Line Depreciation
The first and most basic is the straight-line depreciation. This method is used when you
use the printer the same amount each year. This is when you calculate the depreciation
based on the life expectancy years.

What you do is you divide the cost of the printer by the number of years of its life
expectancy. This number then gives you the yearly depreciation of the printer.

For your 3D printer, you take $20,000 and divide it by 10. You get $2,000. So every year, you
calculate a $2,000 depreciation amount for this printer. If you take a depreciation of $2,000
for the first year, the value of the printer drops to $20,000 - $2,000, or $18,000. Claiming
another $2,000 depreciation for Year 2 drops the value of the printer to $18,000 - $2,000 =
$16,000 for the year after that. You keep going until the value reaches $0.

Double Declining Balance Depreciation

If you end up using the printer more often the first few years, you can then use the double
declining balance depreciation method. This method doubles the straight-line
depreciation percentage you take every year.

For example, because your printer has a life expectancy of 10 years, each year you can claim
10% (100% / 10 years) of the cost of the printer. With the double declining balance method,
you then take 20% of the current value of your printer each year.

So, the first year depreciation is $20,000 (the current value)*20% = $4,000. For Year 2, the
current value is $20,000 - $4,000 = $16,000. The depreciation for Year 2 then is calculated to
be $16,000*20% = $3,200. For Year 3, the current value is $16,000 - $3,200 = $12,800. The
depreciation is $12,800*20% = $2,560. You keep going until your value reaches 0.

Units of Production Depreciation

The third method we are going to discuss is the units of production depreciation method.
This method is used if you print different amounts from the printer each year. This method
calculates the cost to print each item. This printer can print 150,000 in its life, so the cost to
print each item is $20,000/150,000 = 0.13333, or approximately $0.13. Of course, this
doesn't include the cost of materials used to print each item, but this cost is included in your
financial reports elsewhere.

Using this method, your depreciation is based on the number of items you print each year.
So, if in Year 1 you print 10,000 items, then your depreciation for this year is 10,000*0.13 =
$1,300. In Year 2, if you print 20,000 items, your depreciation is 20,000*0.13 = $2,600. You
keep going until the number of items reaches the number of items the printer is expected to
produce in its life.

Partial Year Depreciation and Salvage Value

These examples assume, however, the that company will own the printer until the end of its
useful life. But what happens if in the middle of year 5 the printer breaks and is not worth
the cost or repairing it? For that year, using straight line depreciation you would not be able
to claim the entire $2,000 depreciation. Instead your depreciation in year five would only be
$1,000.

Another consideration that would affect depreciation calculations would be its salvage value
Companies also sell tangible assets when they have reached the end of their useful life. In
this case, the company may plan to sell off the printer at the end of its useful life to a
company that buys and repairs out of date printers. For example while the company paid
$20,000 for the printer, at the end of it's useful life they can sell it off for $3,000. That $3,000
is its salvage value. Now the total depreciation over the useful life of the printer would be
$17,000. ($20,000 - $3,000 = $17,000). Now the most the company can claim as depreciation
is $1,700 per year ($17,000/10 = $1,700).

Lesson Summary
Let's review what we've learned now. Depreciation is loss in value. You report this in your
financial reports. We discussed three different ways to report this depreciation.
The first is straight-line depreciation. Using this method assumes that you use the printer
the same amount each year. To calculate this depreciation, you divide the cost of the printer
by its life expectancy.

The second method is the double declining balance depreciation method. This method is
used if you use the printer more in the beginning of its life. To calculate this depreciation,
you double the percentage of your straight-line depreciation. The percentage of your
straight-line depreciation is 100% divided by the life expectancy. Double this percentage to
get the percentage for your double declining balance depreciation. Then, your yearly
depreciation is the current value of your item times the percentage.

The third method, units of production depreciation, is used if you print different amounts
each year. This method divides the cost of the machine by the number of items it can
produce in its life. Then, the depreciation each year is calculated by multiplying the number
of items printed that year by the cost per item.

Partial Year Depreciation would occur when the asset is not in use for the full year. To
calculate that, the annual depreciation would be divided by the number of months the asset
was in use.

Also affecting depreciation is Salvage Value or the what an asset could be sold for at the
end of its useful life. If there is a plan to sell the asset in the future, the salvage value would
be estimated and deducted from the original cost of the asset. Depreciation would be based
on that lower amount.

Learning Outcomes
Once you are done with this lesson you should be able to:

 Define depreciation
 Calculate depreciation using one of three methods

Taxes and Depreciation

When a piece of equipment or other large asset (also known as a fixed asset) is acquired
and used by an organization, they must appropriately account for normal wear, tear, and
use. This concept is called depreciation. As an asset loses its value, depreciation must be
recorded for accounting and tax purposes. Each year, the organization will reduce their
asset values by the depreciation expense based on a calculation that is determined by
company accounting policies. As the values are decreased, an expense is taken to decrease
the organization's taxable income and therefore, reduces their taxable liability.

From an accounting perspective, this would look as follows:

DEBIT Depreciation Expense

CREDIT Accumulated Depreciation

Assets are depreciated over a certain number of years (or units/hours in some cases) based
on how long the "life" expectancy is (also known as useful life). There are guidelines
available to help businesses determine this. Certain assets may be predicted to last 5 years,
while others may be able to last for 10 years.

Depreciation Example
When a company purchases a large piece of machinery or equipment (fixed asset) for
$50,000, eventually that asset will lose value. It will not stay worth $50,000 for years to
come. Each day that the equipment is used, it becomes less valuable to the organization.
Eventually, the asset will be obsolete or unusable for its intended purposes. Since this is the
case, each year depreciation is recorded and the expense is taken to reduce the gross profit
of the company. Fewer taxes due makes for a happy business owner.

Another relatable example would be the purchase of a vehicle. When someone buys a car, it
loses value. The more it is driven, the less it is worth. When looking for a used car to
purchase, one of the first things to take note of is the mileage. Those cars have depreciated
over time. They are not worth what they were worth when they drove off the lot years ago.

What is Partial-Year Depreciation?

If an asset is not owned for an entire year, then an entire year of depreciation can not be
taken. In this case, partial-year depreciation is the appropriate course of action. The
organization can not take a full year of depreciation (expense) if the asset was not
purchased until the end of the year. This is because it has not been used for the full year.

Basic Depreciation Formula

First things first, let's start with the basic depreciation formula. Understanding this is a
prerequisite to understanding partial-year depreciation.

A fixed asset is purchased on January 1, 20XX for $50,000. This asset has an estimated life of
5 years (useful life). The salvage value, or the value that will be left once all depreciation has
been taken and what the company believes they can salvage from it when sold, is $5,000.

On the simplest of terms (straight-line depreciation), the depreciation would be calculated

as follows:

(Asset Purchase Price - Salvage Value) / Estimated Life = Depreciation for 20XX

($50,000 - $5,000) / 5 = $9,000 depreciation expense per year

Partial-Year Depreciation Formula

Using the same example above, but changing the purchase date to March 31, 20XX, partial-
year depreciation would be calculated as follows:
Asset Purchase Price - Salvage Value / Estimated Life in MONTHS = Depreciation for 20XX

($50,000 - $5,000) / (5 x 12) = $750 depreciation expense per MONTH

$750 x 3 months = $2,250 year 1 depreciation

Change in Estimate
Without a doubt, there will be times when an organization later realizes that an estimated
life or salvage value is misstated. When this occurs, a correction needs to be made in order
to properly record the depreciation expenses.

If the current value of an asset (i.e., machinery in the above example) significantly increases
or decreases, that would be a reason to adjust the accounting records for a change in
estimate. This is done by taking the book value (the asset value minus any depreciation
taken at the time) and then spreading that figure out over the new estimated life.

Let's clarify with an example. We'll keep it similar to the example above for simplicity.

On January 1, 20X3 of owning the asset, it is determined that the estimated life is 7 years
instead of 5 years. We know that for the last 2 years the asset has been depreciating $9,000
per year.

At this point, the book value is: $50,000 - ($9,000 x 2) = $32,000

We now need to spread the $32,000 out over the next 5 years (versus the original 3 that
were left).

Using the same formula we covered above, this is calculated as follows:

($32,000 - $5,000) / 5 years = $5,400 depreciation each month moving forward.

Lesson Summary
Depreciation is an important expense that organizations rely on in order to decrease their
taxable income, and therefore their tax liability. As fixed assets are purchased, they must be
depreciated each year to account for their time in use. A full-year of depreciation
expense is calculated by dividing the asset value by the estimated useful life. When an asset
is purchased in the middle of a year, a separate calculation is needed to account for
the partial-year depreciation. The formula involves converting the estimated useful life of
an asset into months (e.g., 5 years x 12 months = 60 months). Once that is done, divide the
asset value by the previously calculated figure. This will give a monthly depreciation rate
that can then be multiplied by the number of months owned in a given year.

The only thing that ever stays the same, is change. There could be a change in estimate for
the estimated useful life or the salvage value of a fixed asset. When a significant increase or
decrease in current value occurs, a correction needs to be made. This adjustment will
realign the depreciation expense with the proper current value. In order to do this, the book
value (the asset value minus any depreciation taken at the time) must first be determined.
Once that is complete, the book value is then spread out over the new estimated life.
Depreciation, or the decrease in value of a company asset, is reported on financial
statements. Learn the definition of depreciation and explore the differences between
reporting depreciation on the balance sheet and the income statement.

A Company Asset
You own a landscaping company where people come to you to design their yards. You have
the experience and the creative talent to design the best-looking yards anyone has ever
seen. You have received many top landscaper awards over the years and have a waiting list
of customers. You are certainly not hurting for money. Because the company is so
successful, you have a number of company assets, equipment that is used in business.

Part of your assets include a rather large fleet of landscaper trucks. You purchased the top
of the line of trucks for your company and had your company logo and information painted
on the trucks. You purchased these trucks for $60,000 each. You are planning on keeping
these trucks for their whole life expectancy of 10 years. You know though, as the trucks age
and as you use them, they begin to lose value. Each year they lose a bit more money and
their value drops.

Depreciation
As part of your financial reporting, you report this drop in value as your depreciation. The
easiest method to report your depreciation is called the straight-line depreciation method.
This method divides the cost of your truck by the number of years it is expected to be used
(life expectancy). This number then gives you your annual depreciation.

To calculate the monthly depreciation, you then divide the annual depreciation by 12, the
number of months in a year. So, our trucks have a yearly depreciation of $60,000/10 or
$6,000. Each month, the depreciation is $500. This means that each month, the truck's value
drops by $500 and each year the truck's value drops by $6,000. So, in Year 2, the value of
the truck is $60,000 - $6,000 or $54,000. Year 3, the truck's value is $54,000 - $6,000 or
$48,000.

On the Balance Sheet

As part of accurate reporting and financial bookkeeping, you report the depreciation in two
places. The first place is in the balance sheet, the statement of what the company owns
and owes. The balance sheet gives an overview of what the company is worth and what kind
of debt the company is in.

As far as our depreciation is concerned, the balance sheet gives you the total depreciation
you have taken so far. So, the depreciation for one truck for Year 1 of owning the truck is
$6,000. For Year 2, the depreciation will show $12,000, the total depreciation taken after two
years. For example, if you purchased the truck in 2014, the depreciation will be $6,000 in
2015 and $12,000 in 2016.

Depreciatio
Year
n
$6,000 2015
 $12,000 2016

On the Income Statement

The next spot where you report your depreciation is in the income statement, a report of
the income and expense of the company during a certain period. Because our income
statement only covers a certain period, usually each month of each year, the amounts on
the income statement will most likely differ from those on the balance sheet. The
depreciation shown on our annual income statement for each year is $6,000, because each
year we only take $6,000 depreciation for each truck.

Depreciatio
Year
n
$6,000 2015
$6,000 2016
On our monthly income statement, our depreciation changes to $500 for each month.

Depreciation Month
$500 January
$500 February
We don't write the accumulated depreciation on the income statement because it only
covers a certain period and does not give a glimpse of a company's overall performance.
The income statement gives a glimpse of what happens to the company during a certain
period. Now you can move on to reporting other financial matters.

Lesson Summary
Let's review what we've learned:

A company's assets can be equipment or property that is used in business. Assets are
resources owned by the company and can include: cash, land, buildings and equipment..
This equipment loses value over time. This loss in value is reported as depreciation. This
depreciation is reported in both the balance sheet, the statement of what the company
owns and owes, and the income statement, a report of the income and expense of the
company during a certain period. The balance sheet will show the total depreciation over
time, while the income statement only shows the depreciation for the current period. These
two numbers will most likely not be the same.

Learning Outcomes
Once you've completed this lesson, display your ability to:

 Contrast the terms company assets and depreciation

 Understand the way in which depreciation is calculated and where it is reported
 Note the purposes of the income statement and the balance sheet
  Remember that the numbers reported will be different in the balance sheet and
income statement

Revenue and capital expenditures are expenses ingrained in the daily operation of a
business. In this lesson, compare and contrast these types of expenditures, including
examples of each and how they are considered on a balance sheet.

Types of Expenditures
Congratulations on starting your new widget company! Of course, before you will make the
first penny off your widgets, you will have to make sure that your accounting practices are
up to standards. After all, what's the point of making money if you don't know where it is
going?

Getting into the widget business has been an expensive endeavor. As a result, you've
already got a stack of receipts for everything that you've had to buy. You did save those
receipts, right? Okay, good.

Anyway, you've got a big pile of receipts and are starting to put all of it together in order to
make sure that your newly-hired accountant isn't swamped with work. She said that as long
as you can sort it between capital expenditures and revenue expenditures that she'd be
happy to do the rest.

Luckily for you, that won't take much time at all! That's because you remember the basic
difference between the two types of expenditures. Capital expenditures are any expense
that comes from gaining the ability to produce a product or service, whereas revenue
expenditures are expenses that are involved in the actual manufacture of goods.

Capital Expenditures
Understanding what a capital expenditure is is important because the rules of accounting let
you treat capital expenditures differently. This is because the cost of capital expenditures
can be spread out across accounting periods.

Most obviously, you don't have to charge them all right away. After all, you'll be using these
implements for quite some time, if all goes as planned. Instead, capital expenditures are
often filed as property, plant, and equipment. This comes with some significant advantages.

For starters, you can spread out paying for these expenses over time. This is because they
are considered to be assets, not inputs. Also, you can take a depreciation expense every
year for anything that is a capital expenditure, except land. This is to make up for the fact
that these assets are losing value.

Revenue Expenditures
Still, not everything that you have purchased is a capital expenditure. There are many
revenue expenditures still to be considered, like wages, supply costs, utilities, and repair
costs. These costs are really only useful in that particular moment and have no further
effective life.
The wages that you pay your employees only really guarantee that they will come to work
on days that you pay them. Sure, many of them may love working for your widget factory,
but they aren't going to come in and work on Saturday for free! Likewise, paying your
electric and water bills does not guarantee that there will be electricity and water without
payment in the future. As such, it's best to clear these items off the ledger and match them
with revenues from the same period.

Examples of Expenditures
So back to your widget factory. Chances are that when you built your widget factory, you
didn't get it for free. All the construction costs of building the factory are considered capital
expenditures. So, too, are all the costs with equipping the factory with what is needed to
make widgets. All of that fancy machinery used to produce the best widgets around can be
categorized as a capital expenditure. In fact, as long as you weren't having the workers bring
their own tools, any tools that you provide can be considered to be capital expenditures.

From earlier, you probably figured out that the electricity and water needed to make your
widget factory work are revenue expenditures. So, too, are all the raw materials needed to
make widgets. Whether it's just old-fashioned plastic or computer chips for 'smart' widgets,
anything that can be directly turned into a widget is a revenue expenditure.

Think about it like this. If you were making a sandwich, the bread, mayonnaise, meat,
cheese, and electricity to light the room would all be revenue expenditures, while the knife
and plate would be capital expenditures. You consume the bread, mayonnaise, meat,
cheese, and electricity in making the sandwich, but the knife and plate are reusable.

Comparing Expenditures on a Balance Sheet

So how does all that factor in on a balance sheet? Let's say that during the first quarter, you
sold your widgets for a total of $3 million. Your factory cost $40 million to set up, which is
your capital expenditure. Meanwhile, all your revenue expenditures, the cost for actually
producing the goods, was only $1 million.

If you treated all those losses equally, it would look like you had lost $39 million in just three
months. In other words, no one would want to invest in your company! However, by treating
the setup costs as capital expenditures, you could spread that debt around.

Since there are four quarters in a year and your factory has a useful life of 10 years, you
could divide the $40 million by 40 for your quarterly capital expenditure cost, giving you $1
million. So now you have $3 million in profit minus $1 million each in revenue expenditures
and $1 million in capital expenditures, which gives you a profit of $1 million. Suddenly, your
factory is making a million dollars a quarter. Now, that is profit!

Lesson Summary
In this lesson, we look at the difference between capital expenditures and revenue
expenditures by looking at the operation of a widget factory.

Capital expenditures are those expenditures that are made to secure the ability to provide
goods or services. These expenditures do not form part of the good or service. For example,
land, the physical building, and any equipment used to manufacture the goods in question
are all purchased as capital expenditures.

On the other hand, revenue expenditures are those costs that are justified by the revenue
that they bring in immediately. These are most often used in the direct manufacture of a
product, such as raw materials, wages, and electricity.

Vocabulary & Definitions

Capital expenditures are any expense that comes from gaining the ability to produce a
product or service.

Revenue expenditures are expenses that are involved in the actual manufacture of goods.

Learning Outcomes
With knowledge of this lesson, you'll have the ability to:

 Discern the difference between capital and revenue expenditures

 Provide examples of each type of expenditure

This lesson provides an overview on how to account for the disposal of capital assets. Learn
about the value of an asset, as well as how to account for asset sales, retirement, and
exchanges.

The Value of an Asset

Your daughter's school is organizing a garage sale and each child has been asked to provide
five items for the fundraiser. She goes through her closet and presents you with five items.
After reviewing the selections, you determine that two of the items are markers that have
run out of ink, but the remaining three items would be suitable for the sale.

Just like a garage sale, some assets, or things that a company owns, have value when they
are disposed of while others do not.

Sale of an Asset
Depending on the proceeds received, selling a capital asset can result in a gain or loss on
disposal, or no impact at all. In order to determine if there is a gain or loss, the original cost
of the capital asset and its accumulated depreciation, or the amount of depreciation taken
on the asset since it was put into use by the company, must be known. If the proceeds
received are greater than the net book value, the asset value less accumulated
depreciation of the asset, then there is a gain on disposal. If the proceeds received are less
than the net book value, then there is a loss on disposal.

Let's assume that a vehicle that cost $30,000 with accumulated depreciation of $10,000 was
sold for $25,000. The net book value of the vehicle was $20,000 ($30,000 - $10,000), and the
proceeds received were $25,000, so there would be a gain of $5,000 ($25,000 - $20,000). The
accounting entry would look like this:

Now let's assume that instead of receiving proceeds of $25,000, the company sold the car
for only $15,000. The net book value of the vehicle would still be $20,000 ($30,000 - $10,000)
and there would be a loss of $5,000 ($15,000 - $20,000). The accounting entry would look
like this:

Retirement of an Asset
An asset is usually retired because it is at the end of its useful life and cannot provide any
more value to the company. The asset may have a net book value of zero, which suggests
that it is fully depreciated, or it could have a net book value that is greater than zero.

Let's assume that a piece of computer equipment that cost $25,000 to purchase was retired.
The amount of depreciation taken on the computer equipment was also $25,000, which
means the net book value is $0 ($25,000 - $25,000). Since the net book value is $0 and the
company did not receive any proceeds upon disposal, there is no gain or loss for this
transaction. However, an accounting entry is still necessary to take the computer equipment
out of the asset account. The accounting entry would look like this:

An asset that is being retired could also have a net book value that is greater than $0. In this
case, the retirement of the asset would result in a gain or a loss to the company. Let's
assume a vehicle that cost $20,000 and had accumulated depreciation of $17,000 was
retired. The company did not receive any money for the vehicle at disposal, and the net
book value was $3,000 ($20,000 - $17,000). Since the net book value is greater than the
proceeds received, there is a loss of $3,000 upon the retirement of the vehicle. The
accounting entry would look like this:

Exchange of an Asset
Sometimes a company trades an existing asset for a newer asset. In these situations, the
asset being traded still has some use and has a net book value that is greater than $0. A
gain or loss on exchange could occur as a result of this transaction. Let's assume that a
vehicle that cost $20,000 with accumulated depreciation of $15,000 and a net book value of
$5,000 ($20,000 - $15,000) was traded for a new vehicle that cost $35,000. The dealership
provided a trade-in allowance of $6,000 on the old vehicle and the balance owed by the
company was paid in cash. In this case, the company would record a gain on sale since the
proceeds received for the old vehicle, $6,000, were greater than the net book value of the
old vehicle, $5,000. We would expect a $1,000 gain ($6,000 - $5,000). The accounting entry
would look like this:
Lesson Summary
Assets are things that a company owns. Capital assets can be disposed of by sale,
retirement, or exchange. Each of these transactions could result in a gain, a loss, or no
impact to the company depending on the net book value of the asset at disposal, which is
the asset value less accumulated depreciation. Accumulated depreciation is the amount
of depreciation taken on the asset since it was put into use by the company.

Depletion is the adjustment of value, typically of natural resource assets, due to their
diminishing supply. Follow the steps in computing depletion, and learn how this is applied
through an example.

Natural Resource Assets

You should be familiar with the definition of an asset in a company and how to account for
them on the balance sheet. However, you may not know how an asset such as land with
minerals is handled in accounting. For this lesson, we will travel with Lydia, who is the owner
of Profits, Inc., as she goes into the business of purchasing land and selling the natural
resources.

For her first purchase, Lydia finds a plot of land that consists of 1,000 acres and is estimated
to contain 600,000 tons of coal. She purchases the land through her company for a price of
$300,000.

Depreciation and Depletion

When a company purchases a piece of machinery, the value of the machine decreases as it
is used until it eventually reaches its salvage value. The salvage value is what the item is
worth at the end of its useful life. The process of decreasing the value of equipment is
called depreciation. Accepted accounting procedures allow many methods of depreciation,
such as the straight-line method, the double-declining method, and the sum of years'
method.

When the asset happens to involve land with an estimated amount of natural resources, the
same concept of depreciation applies but in this case, it is called depletion because the
resources are being depleted (removed) from the land. Depletion is also different because it
does not depend on any length of time but is directly related to the amount of resources
removed. Depletion would be used when resources such as coal, precious metals, timber, or
petroleum are to be extracted.

Accounting for Depletion

When the land was purchased on October 11 by Profits, Inc., the accountants created and
debited the Land account for $300,000 and credited the Cash account for the same amount.
At the end of the year, Profits, Inc. removed 100,000 tons of coal from the land. Lydia knows
that the land is not worth the same amount now as when she purchased it, but she needs to
figure out how much it is worth as she begins to prepare her taxes.

Steps to Compute Depletion

Lydia knows she must follow three steps to make her calculations:

1. She must divide the amount paid for the land by the estimated units of measure of
the natural resource (in Lydia's case, tons)
2. The result of that computation will give you the price for each unit of measure (the
price per ton for Lydia)
3. She must multiply the number of units of measure extracted by the cost for each
unit

In this case Lydia, would divide the $300,000 she paid for the land by 600,000 tons of
estimated coal to come up with $.50 per ton. She would now multiply the $.50 per ton times
the number of tons removed (100,000) to come up with a depletion amount of $50,000.

Lydia can now update the value of her land by debiting the Depletion Expense account and
credit the Accumulated Depletion - Land account. The Accumulated Depletion - Land
account is considered a contra-asset account and will offset the asset 'Land' on her balance
sheet. A contra-asset account typically has a credit balance and is attached to an asset to
give it its current value. Note that the asset account itself (Land) still has a debit balance of
$300,000, but its true value can only be found when taking the contra-asset account into
consideration, as well. The real value of the Land account is the $300,000 minus its
associated Accumulated Depletion account of $50,000 for an end-of-year value of $250,000.

Additional Examples
Here's a question for you: What is the value of the land Lydia purchased at the end of the
second year after her company has removed another 250,000 tons of coal?

Remember that we have already completed the first two steps of the process to figure out
the cost per ton; therefore, we only need to follow the last step. The amount used for each
ton is still $.50 and we would just need to multiply that by the amount of tons extracted the
second year.

$.50 x 250,000 tons = $125,000

The $125,000 represents the amount of depletion expense for year two. At the end of the
year, Lydia would debit the Depletion Expense account for $125,000 and credit the
Accumulated Depletion - Land account for the same amount. The balance in the
Accumulated Depletion - Land account would be a credit balance of $175,000 ($50,000 from
year one and $125,000 from year two). The Land account does not change and still has a
debit balance of $300,000. The value of the land is $300,000 minus the total accumulated
depletion of $175,000 for a value at the end of year two of $125,000.

If you were able to answer the previous question, congratulations! Here is another challenge
for you! What if the original estimate for 600,000 tons of coal is wrong? At the end of year
two, Profits, Inc. has extracted a total of 350,000 tons. An expert states now that they have a
better view of the site, they see only an estimated 200,000 tons remaining (instead of the
250,000 tons that they thought should be there). What should Lydia do?

At this point, it is too late to adjust any of the previous years' expenses. The only thing that
is left is to adjust the depletion amount based on the revised estimate. This means that we
take the value calculated at the end of year two ($125,000) and divide it by the remaining
quantity of coal (200,000 tons) and come up with a revised depletion rate.

$125,000 divided by 200,000 tons is $.625 per ton. Lydia would then use $.625 as the base
cost per ton in calculating the depletion expense for year three.

Lesson Summary
Depletion is the process of adjusting the value of a natural resource asset so that it
accounts for the removal of the natural resources during the asset's life. Depletion differs
from depreciation in that it is not linked to any length of time and changes based on the
amount of resources removed.

The three steps to compute depletion expense are:

1. Divide the cost of the asset by the amount of natural resources it contains
2. Determine the cost per unit
3. Multiply the cost per unit times the number of units depleted (removed) to
determine the depletion expense for that year.

The accumulated depletion account is a contra-asset account that contains the total
depletion amount for the life of the asset and must be subtracted from the asset's original
debit balance in order to obtain the current asset value.

What are Intangible Assets?

The intangible assets definition refers to the non-physical valuable resources of an
organization or individual. A business can have non-physical assets that have the potential
of being converted to cash when sold. The distinctiveness of intangible assets is that it is
difficult to value them — most people have a difficult time conceptualizing things that they
can't see and touch. However, it can be vital to have accurate knowledge regarding the
nature of intangible assets regardless of their intangibility. These assets are significant to a
business' success and are long-term, meaning that their usefulness to the company goes
beyond one year.

Intangible assets are easily identified from contracts or legal matters and can be sold,
transferred from one entity to another, and licensed. Patents, a business' brand name,
licenses, computer software, and copyrights are examples of intangible assets. They also
include the intellectual property of the individual or business. Service businesses are
involved in selling intangible assets or products — products that are not physical — to the
client. For example, a company that sells software to a buyer is considered a service
company.

Tangible vs Intangible Assets

Businesses invest in intangible and tangible assets, which are distinct from each other, but
both generate income for the company. Both types of assets can be vital to the company in
the short-term or long-term. Tangible assets include current assets, including cash and
inventory, and fixed assets, including buildings, trucks, land, and equipment. These are the
primary type of assets responsible for creating goods and services.

A building is an example of tangible assets

Intangible assets, on the other hand, are non-existent physically and represent potential
income and include intellectual property, franchises, goodwill, copyright, and patents
essential to the company. These intangible assets cannot be destroyed by physical disasters,
while tangible assets that can be consumed by fire or swept away by floods. A bakery, a
farmer, and a firm selling cell phones deal with tangible assets, while a motivational speaker
sells an intangible asset.
 A motivational speaker sells intangible assets

Intangible Assets Characteristics

Fulfilling the entire vision of the company entails gathering intangible resources, including
strategic information and other intangible assets. When a business acquires intangible
assets, such as a copyright to a particular song from a musician, they need to understand
the nature and characteristics of the asset. The song is the intangible property of the
musician. Characteristics of intangible assets are as follows:

 The primary characteristic of intangible assets is their non-physical nature. When a

scientist comes up with an idea and patents it, the patented idea is not physical, but
it is still an asset to the scientist.
 Value determination of intangible assets is difficult. They have significant long-term
value to the owners, but the value is never immediately apparent. The value
determination process entails understanding how much the asset brings to the
company. The question becomes: how much does the company make because of
the specified asset? Time and effort put into creating the asset would also be
included. Companies often define the value of an asset through an expense booking.
 Another characteristic of intangible assets is amortization. This means that the
assets can hold a particular value for some time, but they are subject to periodic
value reduction. After a given period, the cost of the asset becomes reduced.
It is not easy to trade or transfer intangible resources across firms because of the difficulty
in agreeing on an asset value. Understanding amortization is also a critical part of acquiring
intangible assets.

Intangible Assets Types

Intangible assets are divided into two major categories: definite and indefinite intangible
assets. These categories are based on the lifespan of the intangible assets in the company.

Definite Intangible Assets

Definite intangible assets are also called limited-life because they have foreseeable ends,
mainly due to expiration on a given date. These types of assets are subject to amortization
at the end of their lifespan. A patent is an excellent example of a definite intangible asset
given for a specific period according to a stipulated agreement. Its lifespan is dependent on
the extension or end of the agreed plan. The asset value stands until the termination date.

Indefinite Intangible Assets

Indefinite intangible assets have no limitation on their lifespan. Contracts and regulations
do not limit them nor any factor affecting their usefulness, though they may still lose value.
For an intangible asset to be considered indefinite, it must be proven that there is no set
limit to its lifespan. However, it is still necessary to test indefinite tangible assets as time
goes on for any developed impairments. For example, a brand name cannot be affected by
contracts or any regulatory obligations, making it an indefinite intangible asset. It can,
however, become less valuable over time due to scandal or loss of market share.

Businesses invest in both categories of asset over time according to the decisions made by
the management in generating income. Building a company's brand name, getting a
business license, and filing patents are an example of management decisions to build
intangible assets that affect the company's growth.

Intangible Assets Examples

Intangible assets can be very significant to a business or an individual in bringing income.
Creative things such as songs and designs can be essential intellectual property which can
generate income. A company should never downplay its reputation in the market because
that reputation can be worth millions when used to sell other assets. other examples of
intangible assets include:

 Copyrights. A copyright grants rights to the owner and anyone with the owner's
permission to access, copy, and sell a given service or product. For example, when
an artist creates an original song, it becomes his intellectual property. Subjecting it to
 copyright gives the proper access, copy, and sales rights to anyone who purchases
the copyright.
 Patents. A manufacturing or research company can develop new designs and ideas,
and patents give the company control in using and selling the given designs. For
example, a business can have a patent that allows it to dominate the market with a
specific product. For another company to produce or oversee the exact product, they
must purchase the patent and claim ownership of the product's manufacturing and
production.
 Goodwill. When one business buys another, the goodwill is the excess amount paid
to the company above the specific business value. The excess amount is paid with
considerations of factors such as customer loyalty, built reputation etc., of the
company over the company that gives it an edge in the market. For example,
company X can pay $18 million for company Y, which is worth $16 million. In that
case, the goodwill paid was $2 million.

Lesson Summary
Intangible assets are resources in a business that are not physical. They hold a potential
future value for the company when used to generate income. It is essential to understand
that the fact that they are non-physical does not make intangible assets less significant
than tangible assets in a company, such as buildings, land, and equipment. They serve a
similar purpose to the business: generating income. Intangible assets include intellectual
property, brand names, patents, licenses, goodwill, and other non-physical assets. Tangible
assets are those assets which can be touched or seen. For example, companies such as
bakeries sell tangible assets, but a motivational speaker only sells intangible assets like
teamwork and motivation. It is easier to determine a tangible asset's value than an
intangible asset's. Tangible assets can also be destroyed by natural disasters, while
intangible assets cannot physically be destroyed.

It is not easy to define the value of intangible assets, and certain kinds of intangible assets
are subject to amortization. Intangible assets can be categorized into definite and
indefinite. Definite intangible assets are subject to a specific time when they lose their value
— patents, for example, can expire. Indefinite intangible assets, such as goodwill, are not
limited by time.

This lesson looks at how companies measure property, plant, and equipment asset
efficiency to improve sales revenue. Learn how to measure equipment efficiency, calculate
an asset turnover ratio, and generally improve efficiency.

Measuring Equipment Efficiency

Urban Sneaks is a shoe company that's been in business for 30 years, enjoys considerable
success and is known for a high-quality product. Some of Urban Sneaks' equipment is
getting quite old, and the owner of the company, Ms. B. Shue, is wondering if it's time to
replace it. She needs a way to measure how efficient her equipment is in making money for
her business.
Calculating Asset Turnover Ratio
Since resources are finite, it is important for every business to use its assets (items that it
owns) as efficiently as possible. Property, plant, and equipment assets are defined as large
items (like machinery, equipment, and buildings) that a company uses to generate sales
revenue. Since property, plant and equipment assets usually represent a significant
monetary investment for any company, it's important to determine whether or not the
company is using these assets in an efficient manner to produce sales.

The best way to measure the efficiency with which a company is using its property, plant,
and equipment assets is to calculate the asset turnover ratio. The formula for the asset
turnover ratio is net sales divided by average property, plant, and equipment assets.

Let's assume that the Urban Sneaks Company had property, plant, and equipment assets of
$500,000 last year and $650,000 this year, with net sales of $2,500,000 in the current year.
The asset turnover ratio would be 4.35: $2,500,000 / (($500,000 + $650,000) / 2). A ratio of
4.35 means that the company generates $4.35 of sales for each dollar that it spends on
property, plant, and equipment assets. Generally, the higher the ratio, the more efficiently
the company is using its property, plant, and equipment assets to generate sales revenue.

The asset turnover ratio should always be compared with a company's past performance, as
well as other companies in the same industry. For example, Ms. B. Shue would want to
compare this year's asset turnover ratio for Urban Sneaks to the prior year's results, and
also to that of her largest competitor, Quality Shoes 4 You. The industry in which the
company operates is important because different industries have different needs for
property, plant, and equipment assets. For example, an insurance company would not need
to spend as much money on property, plant, and equipment as a large airplane
manufacturing company.

Improving Efficiency
There are several steps that a company can take to improve the efficiency with which it's
using its property, plant, and equipment assets. For example, the company could review its
current listing of property, plant, and equipment assets and identify those assets that
are obsolete, or no longer useful, and those which are underutilized or simply not used at
all. Property, plant, and equipment assets that are not used to generate sales should be
liquidated. In some cases, it may be better for a company to lease some of its assets to
avoid problems with obsolescence. This strategy is useful when dealing with technology, as
obsolescence occurs very quickly with these assets.

Lesson Summary
Companies must ensure that their property, plant, and equipment assets are used in the
most efficient manner possible. Calculating the asset turnover ratio and comparing it with
information from prior years, as well as with its competitors' results, will assist a company in
determining how efficient its property, plant, and equipment assets are in generating sales
revenue for the company.
What is Accelerated Depreciation?
Depreciation is a cost of doing business. For a business to be profitable, it needs to know its
costs. Depreciation occurs when assets lose value over time until the value goes to zero.
Some types of assets that depreciate are office equipment, computers, machinery,
buildings, etc. One type of asset that does not depreciate is real estate.

Accelerated depreciation is one of the depreciation methods where the asset decreases
in value faster than the traditional depreciation method such as the straight-line method.
Accelerated depreciation is more in the earlier years than in the later years. Accelerated
depreciation is often used to reduce taxes.

Depreciation Rate Formula

One of the methods of calculating depreciation is by using the depreciation rate
formula for the Straight Line Method:

In this method, the depreciation expense will equal the cost of the machinery minus any
salvage value. And the result of that calculation will be divided by the total life span.
The depreciation percentage will equal 1 divided by the total life span years.

Depreciation Expense = ( Cost of the Machinery minus Salvage Value ) / Total Life Span

The salvage value is the value of the machinery when its total life span is complete.

Delivery Truck

Example 1
For example, if the cost of a delivery truck (Cost of the Machinery) is $50,000, (Salvage Value)
is $0 and (Total Life Span) is 10 years, then (Depreciation Expense) equals ($50,000 - $0)/10 .
Then ($50,000)/10 = $5,000. The Depreciation Expense is $5,000 per year using the Straight
Line Method. (Cost of Machinery) x (Depreciation percentage) = $50,000 x .10 = $5,000 =
(Depreciation Expense)
Methods of Calculating Accelerated
Depreciation
There are two depreciation methods for calculating accelerated depreciation. The double-
declining balance method and the sum of the years digits (SYD) method.

Accelerated Depreciation Method: Double-

Declining Balance Method
The Double-declining balance depreciation method or double depreciation
method results in more depreciation in the earlier years than the later years of the
machinery's useful life. This can reflect a real-world condition of the cost of machinery being
more valuable in the early years than in the later years. For example, when first buying a
car, it loses more value in the first years of its use. With the double-declining balance
method, the depreciation factor is twice that of the straight-line expense method. To
compute the double-declining balance depreciation, first, the depreciation percentage is
computed which is one divided by the total life span years.

Next, the double-declining balance depreciation for the first year is computed which equals
the cost of the machinery for the first year multiplied by 2 and then multiplied by the
depreciation percentage. This step is continued by subtracting the depreciation from the
previous cost of the machinery to get a new value. This value is then used as the new value
of the machinery. The new value of the machinery is then multiplied by 2 times the
depreciation percentage to determine the new depreciation. These steps continue for each
year of the total life span years.

Double Declining Balance Method Example

Equations for computing the Double Declining Balance Depreciation:

(Depreciation percentage) = 1 / (Total Life Span years)

Double-declining balance depreciation N = Double declining balance depreciation for year

N,

N goes from 1 to (Total Life Span Years)

 Computer

Example 2
In this double-declining balance method example a computer has a cost of $10,000.
The accelerated depreciation using the double-declining balance method will be
computed for the first 2 years as follows:

The depreciation percentage for the first year equals 1 divided by total life span years which
will be 1 divided by 5, equaling .20. The depreciation for the first year will be the cost of the
machinery ($10,000) times 2 times .20, resulting in $4,000. For the second year, the
depreciation is the cost of the machinery ($10,000) minus the depreciation the first year
($4,000) results in $6,000. That is then multiplied by 2 times the depreciation percentage
(.20). That will equal $2,400 for the depreciation for year two.

(Cost of MachineryN) = $10,000 , N starts at year 1

(Depreciation percentage) = 100% / (Total Life Span years) = 100% / (5 years) = .20

(Double-declining-depreciationN) = Double declining depreciation for year N

For first year:

(Double-declining-balance-dep1) = (Cost of Machinery1) x 2 x (Depreciation percentage)

(Double-declining-balance-dep1) = ($10,000) x 2 x (.20)

(Double-declining-balance-dep1) = $4,000

For second year:

(Double-declining-balance-dep2) = [ (Cost of Machinery1) - (Double-declining-

balance-dep1 ) ]] x 2 x (Depreciation percentage)

(Double-declining-balance-dep2) = [ ($10,000) - ($4,000 ) ]] x 2 x (.20)

= $6,000 x 2 x (.20) = $2400

Below is a table showing the beginning value of the computer and double-declining balance
depreciation for 5 years.

Table 2. Example 2

Year
Year 1 Year 2 Year 3 Year 5
4

Beginning Asset $2,16

$10,000 $6,000 $3,600 $1,296
Value 0

Depreciation Expense $4,000 $2,400 $1,440 $864 $518

$1,29
Ending Asset Value $6,000 $3,600 $2,160 $778
6
Useful Life of Asset = 5 years

Salvage Value = 0

Depreciation Rate = .20

Accelerated Depreciation Method: The Sum of The

Years Digits (SYD)
The sum of the years digits method is another accelerated depreciation method. And
similar to the double declining depreciation method, higher depreciation occurs in the early
years and a lower amount in the latter years.

In the sum of the years digits depreciation method, the remaining life of an asset is divided
by the sum of the digits of the years and then multiplied by the cost of the machinery or
asset to determine the depreciation.

Depreciation Percentage Using SYD Method

The following formulas will be used in calculating N, the sum of the SYD digits.

N = sum of the digits of total life span

n = is the last year and number of digits

1 = the first year term

Then

N = n (n + 1) / 2

SYD depreciation =

(Remaining life / Sum years digits) x (Cost of machinery)

 Industrial Oven

Example 3
An industrial oven costs $15,000. It has a useful life of 5 years. The accelerated depreciation
using the SYD method will be calculated for the first 2 years:

To sum the digits 1 + 2 + 3 + 4 + 5, let N = n x (n+1) / 2 from the formula, n = 5 . Calculating,

we get N = 5 x (5+1)/2 = 5 x (6)/2 = 5 x 3 = 15 . The SYD depreciation for the first year equals

the remaining life-years ( 5) divided by the sum of years digits (15) which equals .3333. That
is multiplied by the cost of the machinery ($15,000) which equals $4995.50, rounding off to
$5,000.

The remaining value of the machinery after SYD depreciation for the first year will be
($15,000)

Minus SYD depreciation ($5,000) equals $10,000. The SYD depreciation for the second year
equals the remaining life-years ( 4) divided by the sum of years digits (15) which
equals .2666. That is multiplied by the cost of the machinery ($15,000) which equals $3,999,
rounding off to $4,000.

The remaining value of the machinery after the SYD depreciation for the second year will be
($10,000) minus the SYD depreciation for the second year ($4,000) equals $6,000.

Table 3. Example 3

Year Depreciation Asset Value

- $15,000

-1 $5,000 $10,000

-2 $4,000 $ 6,000

-3 $3,000 $ 3,000

-4 $2,000 $ 1,000

-5 $1,000 $0
Cost of Asset = $15,000
Salvage = 0

Useful Life = 5 years

Lesson Summary
Depreciation occurs when assets lose value over time until the value goes to zero. The main
types of depreciation methods are traditional, double-declining balance depreciation
method, and sum of years digits. The depreciation rate formula for traditional
depreciation is:

Traditional depreciation = ( Cost of the Machinery ) / Total Life Span. Letting Salvage value =
zero.

The double-declining balance depreciation method and Sum of the years digits (SYD)
method are forms of accelerated depreciation. Accelerated depreciation is when assets
lose more value in the earlier years than in later years.

In the double-declining balance depreciation method or Double depreciation method,

compute the Depreciation percentage first. The depreciation percentage equals 1 divided
by the total life span years. Then double the depreciation percentage. Multiply the doubled
depreciation percentage times the current cost of the machinery to get the double-declining
depreciation for year 1. To find the double-declining depreciation for the following year,
subtract the double-declining depreciation from the current cost of the machinery and
multiply it by the doubled depreciation percentage. Repeat until you get to the last year of
the life span.

The sum of years digits (SYD) method is the second accelerated depreciation method. It is
similar to the double-declining depreciation method, higher depreciation occurs in the early
years and a lower amount in the latter years. In the SYD method, the remaining years of life
of an asset are divided by the sum of the digits of the years and then multiplied by the cost
of the machinery to determine the depreciation for the first year. For the next year, 1 is
subtracted from the remaining years of life of an asset and divided by the sum of the digits
of the years. This is multiplied by the cost of the machinery to get the SYD depreciation for
the second year. The process is repeated until the last year. These are some of the methods
of calculating depreciation.

What are Current Liabilities?

Liabilities are obligations that are owed. Current liabilities are liabilities that need to be
paid in the near future. Legal and regulatory requirements often require liabilities to be
settled on time. For current liabilities, the payments are due within the next year.

What are Long-Term Liabilities?

Long-term liabilities are obligations that can wait more than one year to be paid. These
obligations are liabilities owed to third parties. For long-term liabilities, the payments are
due in more than one year. Long-term liabilities are also known as noncurrent liabilities, or
because these liabilities are often in the form of debt, they can be called long-term debt.

It is possible to have a liability without knowing the exact timing or amount coming due. This
is known as a contingent liability. For example, if a company is sued after a customer is hurt
while using their product, a potential liability could arise. Accounting rules dictate when
contingent liabilities are estimated and included in the financial statements. These are often
classified as long-term liabilities because they are expected to take more than a year to
resolve.

Current Liabilities vs. Long-Term Liabilities

The required repayment date for liabilities is used to determine if those obligations are
current liabilities versus long-term liabilities. The current portion of an individual's or
company's liabilities is repaid within one year. Alternatively, if liabilities are due more than
one year in the future, these are long-term liabilities.

Current liabilities are typically repaid without additional interest. In contrast, additional
interest payments are usually required for long-term debt. This interest compensates the
third party for the risk involved in loaning funds over a longer period of time.

A liability's classification as current or long-term is used to provide information about the

company's liquidity and the ability to repay debts when they are due. Current liabilities
represent a more immediate need for cash and a company should have resources available
to repay current liabilities to be considered in good financial health. Long-term liabilities
represent debts the company has more time to repay, or arrange alternative options, such
as refinancing to push out the time needed to produce cash to repay the liability.

Current Liabilities Characteristics

Current liabilities are commonly used in the day-to-day operations of the business.
Characteristics include:

 Amounts owed to a third party

 Mandatory repayment
 Coming due within one year

On a company's financial statements, liabilities are listed on the right side of the balance
sheet. Current liabilities are listed at the top of the right side in the order of repayment.

Maintaining current liabilities can help in running an efficient business. For example, a
restaurant may not want to repay a supplier each time the supplier makes a delivery.
Instead, allowing the amounts due to the supplier increases its current liability, and settling
the amount less frequently can lower the restaurant's administrative burden. Similarly, it is
easier for the supplier to collect payment once amounts accrue and not insist that delivery
drivers collect at each delivery.

Long-Term Liabilities Characteristics

Long-term liabilities are typically used to finance the overall business, especially fixed assets,
such as buildings or equipment. Characteristics of long-term liabilities include:

 Amounts owed to a third party

 Mandatory repayment
 Due in more than 12 months (this is a difference between current vs long-term
liabilities)

Long-term liabilities are listed on the right side of the balance sheet after the current
liabilities. Additional detail regarding the repayment schedule and financial terms of the
long-term liabilities can be found in the notes to the financial statements.

Long-term liabilities are used to fund business assets that are used over and over again
such that a company can exploit the benefits over a long period. Examples in a restaurant
would include ovens to cook the food, tables to seat patrons, and even the building to house
the restaurant. A restaurant would want to pay for these long-life assets over time, and here
using long-term liabilities are useful. This better matches the time to finance the asset with
the time the assets are useful.

The third parties that lend funds to companies over these longer terms may also include
specific limitations in the lending agreement that protect the lender. In addition to requiring
periodic interest payments, lenders might require an asset to be secured or a financial
covenant. A mortgage loan that gives the lender the right to take the property if the debt is
not repaid is an example of securing an asset to the liability. An example of a financial
covenant would be a requirement to limit future debt levels.

Current Liabilities Examples

Current liabilities examples include:

 Accounts payable - amounts due to vendors and suppliers

 Salaries payable - amounts due to employees for hours worked and not yet paid
 Taxes payable - amounts that are owed to the government yearly
 Current portion of long-term debt - if any portion of a long-term liability is due within
the next 12 months, it is listed with current liabilities

Long-Term Liabilities Examples

Examples of long-term liabilities include:

 Bonds payable - often issued to finance long-term assets

 Long-term loans - amounts borrowed for more than 12 months, such as a mortgage
loan
 Pension obligations - amounts due to employees after they retire in more than 12
months

Lesson Summary
Liabilities are obligations that are owed. Current liabilities are due within the next 12
months. Liabilities due in more than 12 months are called long-term liabilities. Examples
of current liabilities include accounts payable, salaries payable, taxes payable, and the
current portion of long-term debt. Long-term liability examples are bonds payable,
mortgage loans, and pension obligations.

On a company's financial statements, liabilities are listed in the column on the right starting
with current liabilities and followed by long-term liabilities. Understanding this breakout
between current and long-term can help the reader of financial statements better
understand the company's ability to repay debts and measure its liquidity. Maintaining
some level of liabilities helps the business run more effectively, such as reducing the
number of payments needed to be made, or matching the time to finance assets with the
life of assets.

In business, known liabilities are expenses with prespecified dollar amounts that are
recognized upfront, before the expenses occur. Explore the definition and types of known
liabilities, including those created by agreement, contract, and law.

What are Known Liabilities?

Sam is interested in starting a computer repair business. He talks to a loan officer about
borrowing money to start the business. The loan officer tells Sam he needs to provide a
balance sheet of the known assets and liabilities. Sam tells the loan officer he's familiar
with known assets, which are owned items with a specific value, but he's unclear about
known liabilities. The loan officer starts by defining liabilities, which are obligations the
business will owe.

Known liabilities are liabilities that have a specific dollar amount that he will need to pay.
These types of liabilities are created by agreement, contract, or law.

For the remainder of this lesson, we'll explain which financial statement you'll find known
liabilities listed on. You'll also learn about the three categorizations of known liabilities:
agreement, contract, and law, and we'll discuss examples of each.

Known Liabilities by Agreement

Liabilities are obligations that are owed. These obligations are found on the balance sheet
and are created by agreement, contract, or law. Let's first look at liabilities by agreement.

A liability by agreement is an arrangement between two or more parties that is not

enforceable by law. For example, let's say Sam's Computer Repair decides to partner with
another computer repair shop to fix more complicated repairs brought in by their
customers. Rather than turn those customers away, Sam's will take in the item and then
send it to the other shop for repair. Sam and the computer repair shop casually make an
agreement; they do not have any specific terms on the time frame for repair or payment.

Once the other computer repair shop fixes the item, they call Sam and tell him how much
he owes, which creates a liability by agreement. You will see this type of liability listed on the
balance sheet as an accounts payable. Now let's look at a known liability by contract.
Known Liabilities by Contract
Another type of known liability is a liability by contract. For example, Sam would like to
start selling new computers to customers whose computer cannot be fixed. Sam contacts a
computer manufacturer. The computer manufacturer gives Sam a contract to review their
terms. Sam signs the contract and thanks them for the approval. Being able to sell new
computers will definitely increase his sales.

Once Sam purchases computer systems and starts receiving bills, an obligation or liability by
contract has been created. Sam is expected to pay the bill based on the terms of the legally
binding contract. This type of liability is also listed as an accounts payable.

The loan Sam requests from the bank is also considered a liability by contract since there
are terms Sam must legally abide by. This type of liability is listed as a notes payable. Let's
review the last type of liability, liabilities created by law.

Known Liabilities by Law

Businesses are required by law or regulation to pay certain types of taxes. Can you think of
two type of taxes Sam might owe? If you guessed sales tax, you're right! Sales tax is a tax
imposed on the buyer that the seller must collect and send to the state tax collecting
agency. Since this tax is not sent daily, but usually monthly or more commonly quarterly, the
amount due creates a sales tax liability line item on the balance sheet.

Another type of liability created by law is a federal tax liability. If Sam makes enough
profit, he will be required to pay a portion of profit in taxes. For example, let's say Sam's
accountant prepares the business taxes on January 1st, but the tax return and payment is
not due until April 15th. If a monthly balance sheet is constructed for the month of
February, it will list the taxes owed as a federal tax liability on the balance sheet.

Lesson Summary
Liabilities are obligations owed by a business and can be found on a balance sheet. There
are three ways liabilities can be created: by agreement, contract, or law. Liabilities by
agreement are obligations owed by an agreement between two or more parties but not
enforceable by law. In the above example, Sam agrees to pay another computer repair store
to perform more complicated repairs. This type of liability is categorized as an accounts
payable.

Another type of liability is one created by a contract. Sam obtaining a loan from the bank is
an example of a liability by contract, otherwise known as a notes payable. This type of
liability has enforceable terms and conditions.

The last type of liability is an obligation created by law. An example of a liability created by
law is a tax. We discussed two types: sales tax and federal tax. In sum, known liabilities are
obligations with a specific amount that a business is aware they need to pay.

Learning Outcomes
When you are finished, you should be able to:
  Explain what known liabilities are
 Name and describe the three types of known liabilities

Estimated Liabilities
A liability can be defined as an obligation an entity owes. Most of a company's current
liabilities are determinable, that is, they are of a known amount. Known liabilities include
notes payable, dividends payable, accounts payable, and long-term debt. However,
companies also accrue liabilities whose total amount is unknown. These unknown liabilities
are equally important as determinable liabilities. Unknown liabilities are referred to
as estimated liabilities, and, since their actual amount is uncertain, are approximations of
obligations owed. The three main estimated liabilities are:

 Estimated retirement liability

 Estimated warranty liability
 Estimated property tax liability

The amount owed for each of these estimated liabilities is uncertain since it will depend on a
future event or another variable that has yet to be determined. Companies approximate, or
estimate, the cost of these obligations to account for them in their financial statements.

Estimated Retirement Liability

An estimated retirement liability is the sum that an organization must set aside to cover
future retirement benefits. A company may easily account for current retirees and their
benefits because they already have the retirees' exact number and the amount they receive
in retirement benefits. However, due to the uncertainty around the future number of
employees retiring and their benefits, retirement becomes an estimated liability.

Estimated retirement liability must be recorded in the balance sheet as a liability. It is based
on the number of employees eligible for retirement and their pension benefits. A pension is
a retirement plan in which the employer agrees to make regular deductions from
employees' paychecks in the form of contributions to support payments provided to the
employee after they retire. The overall retirement liability is difficult to calculate accurately
since eligible employees may not do so at the anticipated period. As a result, estimates can
be overstated.

Example

A phone manufacturing firm has 100 employees. Five of its employees are eligible to retire
at the end of the month. The firm's accounting officer includes the five employees in the
retirement liabilities. However, only four of the five employees opt to retire, while one
decides to stay on the job. Since one employee did not retire, the accounting officer's
estimated retirement liability calculations overestimated the actual cost.
Estimated Warranty Liability
A warranty is a pledge made by a company to a buyer to fix, refund, or replace a product
that fails to operate as expected or promised. A company may provide warranties that last
for a specified period depending on the product type. Companies must therefore allocate
funds to compensate for warranty expenses. Since the number of warranty claims
customers will present is not determined, the funds a company sets aside must be
estimated. Hence, companies consider warranties as estimated liabilities.
Estimated warranty liability is an expense that indicates the anticipated amount set aside
for a company to fix, refund or replace a product during its warranty term.

To estimate the number of warranty claims a company receives, the company needs to
approximate the number of products returned and multiply the number by the expense of
fixing or replacing the product based on previous experiences.

Example

A phone manufacturing firm offers a one-year warranty on the phone they manufacture,
which costs $1,000 each. The company manufactures 500 phones a year. If the firm
forecasts that customers will return 50 phones under warranty for $1,000, the firm will
debit warranty expense by $50,000 and credit accrued warranty liability by $50,000. The
accounts are modified when the year ends to reveal the actual warranty cost incurred.

Estimated Property Tax Liability

Property tax is a charge on property owned by a person, a business, or a legal entity. The
local government computes this tax according to the area where the property is situated,
and the owner is responsible for paying the tax. Both real and tangible personal property
are subject to property taxes. Real property includes land, structures, or other fixed
buildings, while tangible personal property includes cars and boats. Usually, property taxes
are calculated based on a property's value and current market rate.

Property taxes are considered estimated liabilities because a property's value can change,
which causes the local government to adjust tax rates. Estimated property tax
liability refers to the amount a property holder forecasts to pay in tax, subject to changes in
property value. A property holder should multiply the property's estimated market value by
its tax rate to determine the amount they will owe in property tax.

Example

Sally owns real estate in Minnesota valued at $400,000 at the start of the year. The
property tax rate at the time is 1.08%. Sally forecasts that the property will be worth
$450,000 at the end of the year, increasing its tax rate to 1.10%. To determine the
estimated property tax rate liability, she should multiply the forecasted market value by
the forecasted tax rate of the real estate, which will be $4,950. Sally should add this
estimate to her property tax liabilities to reflect the current financial soundness.

Lesson Summary
A liability incorporates obligations that an entity, such as a company, owes. Estimated
liabilities are obligations for which the amount owed is unknown. While the exact liabilities
are unknown, one must make the best estimate possible. Estimated liabilities include:

 Retirement liability, estimated because the number of retirees and benefits is

uncertain. Estimated retirement liability is the amount a company has to set aside to
pay for future pension benefits that support employees once they retire.
 Warranty liability, estimated because a business cannot know how many claims
will be made and accepted. Estimated warranty liability covers the expenses a firm
may incur during the warranty period to either replace, fix or refund a product sold.
 Property tax liability, estimated since a property's value may fluctuate and its tax
rates fluctuate accordingly. Estimated property tax liability is the amount of tax a
property owner anticipates paying based on changes in property value.

Estimated liabilities are as important as known liabilities in company financial

Contingent liabilities are circumstances where a company may owe obligations to other
parties. Explore three common types of contingent liabilities: product recalls, pending
lawsuits, and changes in legislation.

What Are Contingent Liabilities?

Bob just landed his dream job as an auditor for the largest accounting firm in the United
States. One of his job responsibilities will be reviewing company financial statements to
make sure the calculations are accurate and all important information has been disclosed.

The accounting firm sent Bob to audit the financial statements of Ocean World Amusement
Park. Bob starts by speaking with the executives and reviewing the balance sheet. Bob
specifically focuses on the liabilities section of the balance sheet. Liabilities are obligations
owed by the amusement park.

In his conversation with the executives, they told Bob there may be a product recall on
rabbit ears they manufactured this year. In addition to the recall, a lawsuit is pending
against the company and legislation may change regarding healthcare for employees.

Bob tells the executives that these situations are considered contingent
liabilities. Contingent liabilities are possible obligations the company may owe. Based on
their probabilities of occurring, they may need to be estimated and added to the financial
statements.

For the remainder of this lesson, we'll explore three types of contingent liabilities: product
recall, lawsuits, and changes in legislation. You'll also learn where this information should be
reported on the balance sheet.

Product Recalls
As Bob continues to explain contingent liabilities to the executives, he reviews the balance
sheet to see where they are reported. Bob asks the executives, 'Where are these situations
you just mentioned on the balance sheet?' The executives tell Bob since they have not
occurred, they did not list them.

Bob tells the executives that if the contingencies have a high probability of occurring, they
must list them as a footnote on the balance sheet to provide more of an accurate picture of
possible future obligations. The executives look confused. Bob says, 'Let's take the product
recall as an example, but first tell me what happened.'

The executives explain to Bob that they manufactured and sold battery-operated bunny
ears for kids to purchase and wear at the park. As the kids wore the bunny ears and the day
got hotter, the bunny ears overheated and caught fire. Some of the kids' hair was singed,
but no serious injuries occurred. As a result of several bunny ears catching fire, the
executives were seriously thinking about recalling the bunny ears and giving everyone their
money back.

Bob explained to them that if they anticipated recalling the bunny ears, they would need to
estimate how many refunds they would give and note that dollar amount on the balance
sheet. He then asked about the pending lawsuit.

Pending Lawsuits
After Bob clarified how the amusement park needs to account for the possible product
recall, he asked them about the pending lawsuit. The executives explained to Bob that the
amusement park was being sued by some of the parents whose kids' hair got singed by the
bunny ears catching on fire.

Bob asked them to bring in their attorney to discuss the probability of the amusement park
losing the lawsuit. The attorney walked in the room and told Bob that they were more than
likely going to lose the lawsuit and would need to pay the parents millions of dollars.

Bob told the executives, since there was such a high probability of loss, they would need to
include this information on the balance sheet also as a footnote. Now, for the change in
legislation, Bob asks, 'What is that about?'

Changes in Legislation
The executives explained to Bob that federal law may mandate that all employers provide
health insurance to their employees. The executives all agreed health insurance was
important and wanted each and every employee to be covered; however, the costs to the
company would be astronomical.

Bob asks his typical question again, 'Is there a possibility this legislation will pass?' 'Do you
think employers will be required to provide health insurance coverage to all employees?'
The executives all agreed; they believed the legislation would pass. Bob said, 'Well then, you
must estimate the costs and include it as a footnote on the balance sheet.'

Lesson Summary
Liabilities are obligations a company owes. Contingent liabilities are obligations a
company may possibly owe. As resounded above, Bob told the executives if there's a high
probability the liability will occur, then it needs to be recorded and footnoted on the balance
sheet to provide an accurate picture of their future liabilities.

In this lesson, we discussed three types of contingent liabilities: product recalls, pending
lawsuits, and changes in legislation. Liabilities with a high probability of occurring need to be
accurately estimated and added as a note on the balance sheet.

Lesson at a Glance
When discussing your liabilities, it's important to include not just what you owe, but also
other obligations that have a possibility of occurring, known as contingent liabilities. This will
give a more accurate account on your balance sheet. Some examples of contingent liabilities
include product recalls, pending lawsuits, and changes in legislation.

Product recalls can lead to lawsuits, both of which

are contingent liabilities.

Learning Outcomes
After reviewing this lesson, you should be able to complete these tasks:

 Describe the difference between a liability and a contingent liability

 Provide examples of contingent liabilities

Long-term liabilities are those held longer than one year, paid in a series of scheduled
payments over time known as an annuity. Examine long-term liabilities and annuities in
detail, seeing how they apply to measuring bonds.

Long-Term Liabilities & Annuities

Dan is a senior at the University of Financial Management. He's enrolled in Accounting III
and his first day of class starts in two weeks. The professor has given the class a summer
project due the first day of fall classes.
Dan's a little apprehensive about the project because he's unfamiliar with the topic:
measuring long-term liabilities and annuities. Dan knows long-term liabilities are
obligations owed for more than a year. He also remembers an annuity represents a series
of payments. However, he's unclear about the correlation between the two and how to
measure them. Dan decides to schedule a tutoring session to learn more about the subject.
For the rest of this lesson, we'll explore examples of a long-term liability and an annuity, and
discuss how they are measured.

Long-Term Liabilities
Liabilities are categorized on the balance sheet as current or long term. Current means the
obligation will be paid within a year. Long term, on the other hand, means obligations take
more than a year to pay. Examples of long-term liabilities are a mortgage on a building,
which usually has a term of 15 to 30 years, and a company car loan, which usually has a
term of three to five years.

These types of liabilities are easy to calculate and are spelled out in a loan contract. To
measure long term liabilities we simply find the balance, which is the difference between the
dollar amount of payments we've made and remaining principal and interest. Principal is
the amount borrowed, and interest is the cost associated with borrowing the money.

The balance is listed on our statement from the financial institution, and if we're
constructing a balance sheet, we use that dollar figure as our remaining long term liability.
Now that we've discussed examples of long-term liabilities and how they are measured, let's
discuss annuities.

Annuities
An example of an annuity is a bond. A bond is similar to an IOU. Let's say your neighbor
wants to borrow $1,000 and will pay you ten percent interest until he pays you back in five
years. You think that's a pretty good deal, so you agree to the terms. Each of the five years,
your neighbor pays you $100 ($1,000 * .10) interest. Then at the end of year five, your
neighbor pays you the $1,000 back. In financial terms, the $1,000 is considered the principal
and $100 is interest.

Now, from a corporate perspective, when a company wants to expand and grow, invest in
research and develop or create a new product, they may issue bonds to investors. Investors
purchase the bonds with a promise to receive periodic, regular interest payments and the
principal at maturity. The reason why it's considered a liability for the corporation is because
it's a long term obligation they owe to the investor. In order to determine how much
investors will pay for a bond, the corporation estimates how much the bond is worth by
calculating the present value.

Measuring Bonds
In simple terms, the present value is the value of a bond now, in present time, discounted
by an interest rate. Let's look at an example. Let's say BQB Corporation wants to issue
$100,000 of bonds and pay coupon interest of $9,000 annually with an 11% interest rate due
in five years. What will buyers pay for this bond issue? To find out how much the bonds are
worth, we must calculate the present value of an annuity.

There are several ways to calculate the present value of an annuity: manually, by a financial
calculator, spreadsheet or online calculator. To calculate manually we need financial tables.
These are found in the back of an accounting or finance textbook or online. The financial
tables show a 3-digit decimal that allows us to discount a number to the present value
based on the bond's interest rate and maturity or number of years.

Below is the present value of $1-table. Based on the bond above, find 11% in the column
and five periods in the row. Where they intersect, we have a factor of .593. We multiply .593
* $100,000 to derive at $59,345. Thus, $100,000 discounted five years to the present is
$59,300.

Step two of this calculation is finding the present value of the coupon interest payments. We
need to access the present value of an annuity table. An annuity is a series of payments, and
since we'll receive the coupon interest payments annually for five years, we need to use the
present value of an annuity table to discount these payments to the present value.

You will use 11% at five periods to find a factor of 3.69 and multiply the factor times $9,000.
Therefore, the present value of $9,000 of payments for five years is $33,210. Add the
present value of the principal to the present value of the coupon interest payments to
derive at the current price of $92,510 ($59,300 + $33,210). This is how much the investors
would be willing to pay for this bond, and as a result, when constructing a balance sheet, we
would list this figure under bonds payable.

Lesson Summary
Long-term liabilities are obligations owed for more than a year. Examples of long-term
liabilities are a mortgage or car loan. These are pretty easy to calculate since we must pay
back the principal, the amount borrowed, and the cost associated with borrowing the
money, which is considered interest.

Bonds are also long-term liabilities. Bonds are considered an IOU and are issued when
corporations want to expand and grow. Bonds are also considered an annuity because the
corporation must pay a series of regular payments to the investor. Before they announce
the dollar amount of the bond issue, the corporation calculates the present value of the
bond to determine how much investors would be willing to pay today.

To find the present value, we use financial tables and discount the principal using the
present value of $1-table and discount the annuity by using the present value of an annuity
table.

Key Terms

long-term liabilities: obligations owed for more than a year

principal: the amount borrowed

interest: the cost associated with borrowing money

bonds: an IOU that is issued when a corporation wants to expand and grow

annuity: a series of regular payments

present value: the value of the bond, determined by how much investors would be willing
to pay today

Learning Outcomes
Completing this lesson should help you meet the following goals:

 Define long-term liabilities and other related terms

 Describe how long-term liabilities are calculated and managed

Long-term liabilities are financial obligations with a due date that is at least one year in the
future. Learn about the processes used in accounting to document and manage long-term
liabilities. Review the definition and explore types of long-term liabilities, including bonds,
pensions, long-term leases, and mortgages.

What Are Long-Term Liabilities?

Jan just graduated from the University of Pacific and has landed her dream job. She meets
with her boss on the first day, and he asks her if she could give a presentation on long-term
liabilities to the summer interns.

Of course, Jan agrees, but she feels a little uneasy about what to present. She
remembers long-term liabilities are obligations owed by a company for more than a year.
However, beyond that she's a little rusty.
She decides to visit her former college professor for some help. He tells her she should
include in her presentation some of the more purposeful long-term liabilities, such as
bonds, pensions, long-term leases and mortgages. This jogs Jan's memory, and she starts
preparing for the seminar.

For the rest of this lesson, we'll explore how to account for bonds, pensions, long-term
leases, and mortgages.

Bonds
When a company wants to create a new product line, expand their operations, or invest in
another geographical area, they have three main financing options: take a loan from a
financial institution, sell stock, or sell bonds.

A bond is similar to an IOU or loan. The company issues bonds, and investors purchase
those bonds with a promise of repayment years in the future. What makes a bond attractive
to the investor is that they receive periodic payments until the full amount is paid back.

The amount the company borrowed is called the principal, and the periodic annual
payments made to the investor are called interest payments. When an investor purchases
the bond at a value less than the principal, the bond is considered sold at a discount.

For example, if the bond's purchase price is $100,000 but the principal amount to be repaid
is $125,000, then the investor purchased the bond at a discount.

However, if the bond purchase price is $150,000 but the principal amount to be repaid is
$135,000, the investor purchased the bond at a premium. In sum, premium means
purchasing the bond at a greater value than the principal. Why would an investor purchase
a bond for less than it's worth? Remember, investors receive annual interest payments.
Sometimes these payments can total more than the loss of principal once the bond matures
and can result in a substantial net profit for the investor.

Regardless of whether the investor purchases the bond at a premium or discount, the
company issuing the bond must carry the principal, the amount to be repaid as a long-term
liability on the balance sheet. Now, let's define pension and see how they are accounted for.

Pensions
A pension is an arrangement whereby an employer provides lifetime payments to an
employee after they retire. While the employee is working, the employer deducts a
percentage of the employee's paycheck and has the amounts invested in a pension fund.

Although the explanation of a pension sounds simple, it's a complicated process, and there
are many important factors to consider when accounting for pensions. One factor is called
vesting. In order for an employee to be eligible for pension benefits, they must be
vested. Vesting requires a certain number of service years before the employee is entitled
to pension benefits. The vested benefits are listed as a long-term liability on the balance
sheet.

Pensions also have associated expenses, such as the cost of maintaining the pension plans,
so be careful not to include those as a long-term liability on the balance sheet. Remember,
expenses are the cost of doing business and should be reported on the income statement.
Now, let's move on to long-term leases.

Long-Term Leases
When companies want to purchase expensive equipment, they often calculate the benefits
of purchasing the equipment vs. leasing. While there are advantages and disadvantages of
both, we'll explore two types of leases and discuss how to account for them.

Leasing provides a contractual arrangement between the company and the lessor that
gives the company the right to use the equipment in exchange for periodic payments for a
specific period of time.

There are two types of leases: capital and operating. It's important for you to know the
difference as they are reported differently from an accounting perspective.

Capital leases are where the company retains the equipment after the lease ends. In
essence, it's similar to a rent to own concept. The equipment is an asset, an item owned by
the company, and the lease payments are a liability, an obligation owed. Both are listed on
the balance sheet.

The next type of lease is an operating lease. An operating lease is where the lessor keeps
the equipment after the lease ends, meaning the company uses the equipment for a specific
period of time, and after the lease ends, they have no ownership rights. Operating lease
payments are listed as an expense on the income statement. Now, let's move on to another
type of long-term liability.

Mortgages
When a company wants to purchase a building, they typically do not pay cash. They seek a
mortgage loan from a financial institution. Since the mortgage loan is an obligation owed,
it's listed on the balance sheet as a liability.

Liabilities are categorized as current and long term. Current represents the mortgage
payments that will be paid within a year, while long-term are payments that will be paid
after that year, essentially the balance of the loan.

Lesson Summary
Long-term liabilities are obligations owed by a company for more than a year. Examples of
long-term liabilities are bonds, pensions, long-term leases, and mortgages.

A bond is similar to an IOU. The company issues bonds, and investors purchase those
bonds with a promise of repayment years in the future. The amount the company borrowed
is called the principal, and the periodic annual payments made to the investor are called
interest payments.

When an investor purchases the bond at a value less than the principal, the bond is
considered sold at a discount.
Bonds can also be purchased at a premium, purchasing the bond at a greater value than
the principal. Remember, the interest payments can more than make up for the loss in
principal. Nevertheless, bonds must be listed on the balance sheet as a long-term liability.

A pension is an arrangement whereby an employer provides lifetime payments to an

employee after they retire. Vesting is an important component as it relates to listing the
benefit as a liability. Vesting requires a certain number of service years before the
employee is entitled to pension benefits. Those vested benefits are listed on the balance
sheet as a long-term liability.

Leasing provides a company the right to use equipment. There are types of leases which
have different accounting treatments. Capital leases are where the company retains the
equipment after the lease ends; the equipment is listed as an asset, and the payments are
listed as a liability. On the other hand, an operating lease is where the lessor keeps the
equipment after the lease ends, and those payments are listed as an expense on the
income statement.

Lastly, there are mortgage loans where the company has borrowed money for a building.
Mortgage loans are long-term in nature; however, the payments due within a year should be
listed in the current liabilities section of the balance sheet.

Accounting for Long-Term Liabilities: Vocabulary

Table

Terms Explanations
Long-term
obligations owed by a company for more than a year
liabilities
similar to an IOU; company issues bonds, and investors purchase those
Bond
bonds with a promise of repayment years in the future
Principal amount the company borrowed
Discount an investor purchases the bond at a value less than the principal
Premium purchasing the bond at a greater value than the principal
Pension an arrangement whereby an employer provides lifetime payments to an
 employee after they retire
requires a certain number of service years before the employee is entitled
Vesting
to pension benefits
Leasing provides a company the right to use equipment
where the company retains the equipment after the lease ends (payments
Capital leases
are listed as a liability)
the lessor keeps the equipment after the lease ends (payments are listed as
Operating lease
an expense)
Mortgage loans where the company has borrowed money for a building
Current represents the mortgage payments that will be paid within a year
Long-term payments that will be paid after that year

Learning Outcomes
You've finished this lesson and now you are able to:

 Recognize what long-term liabilities are

 Identify, describe and discuss the types of long-term liabilities

Bond Relationships
A bond is a financial agreement between two entities where one entity agrees to lend
money to the other in exchange for an interest payment. A bond relationship refers to the
relationship between the price of a bond and its interest rate. The characteristics of this
relationship can be studied in its nature, economic impact, and behavior.

 Nature: Bond prices and interest rates have an inverse relationship, meaning when
bond prices rise, their interest rates drop and vice versa.
 Economic Impact: Bond relationships have economic impacts. When bonds become
more attractive investments compared to stocks, capital tends to migrate from the
stock market to the bond market. This inherently causes the stock market to decline.
 Behavior: Similar to how bond relationships can impact the economy, they also
behave in correlation with certain economic events. For example, when the stock
market is expected to peak soon and start to decline, bond prices stand to increase
in value as investors flock to safe assets. This influences bond relationships since
their prices will rise under demand, and their interest will drop.

The four main categories of bonds include secured and unsecured bonds, term, and
serial bonds, registered and bearer bonds, and convertible and callable bonds.
Explanations of all four are detailed in the following headers.

Secured vs. Unsecured Bonds

What does a secured bond mean? A secured bond definition refers to a bond that is
collateralized. This means that the bond is secured by an asset that equates to the value of
the principal amount of money. Government bonds, though not collateralized by an asset,
are still considered secured bonds since they are backed by the full faith of the government.
Although this does not equate to much with respect to weak and unstable governments, it is
very valuable in the United States, considering the power and influence of the federal
government.

Unsecured bonds are defined as the opposite of secured bonds. These bonds are not
secured by any asset or faith like in the case of government bonds. Unsecured bonds are
simply loans that borrowers have to repay to lenders with interest. The only similarity
between secured and unsecured bonds basically extends to how they are both agreements
whereby one party lends money to another in exchange for an interest payment. The first
difference is found in the underlying assets that collateralize secured bonds, whereas
unsecured bonds do not have collateral. This makes unsecured bonds riskier than secured
bonds, meaning they have higher interest rates (as a reward to the lender for taking on the
higher risk).

A secured bond is illustrated in the following example. Tom wants to borrow $1 million. John
agrees to offer Tom his needed money. John thus buys a bond from Tom for $1 million, and
they agree to a 5% interest rate. To secure the bond, Tom posts a piece of property that he
owns as collateral. Tom will then go on to repay John $1.05 million, and if he fails to meet
this obligation, John will be compensated with Tom's $1 million pieces of property.

An unsecured bond can be illustrated in the same way, just without the factor of collateral.
In such a case, John would demand a higher interest rate since he will not be receiving any
compensation when Tom defaults on his loan.

Term and Serial Bonds

A term bond is simply defined by how it matures on a specific date as agreed by both the
issuer and bondholder. A serial bond, on the other hand, is a bond that is made up of a
number of bonds. Portions of these outstanding bonds mature or become due at several
dates, which typically fall in a series. When comparing term bonds vs. serial bonds, their
similarities are limited to how they are both fully matured after a specific date. Their biggest
distinction is found in the number of times they each mature, where term bonds fully
mature once and serial bonds fractionally mature multiple times.

A single example can illustrate both securities. Pat buys a 30-year serial bond for $1 million.
Portions of $200,000 will mature every six years until the amount is repaid. In the case of a
term bond, the $1 million will only mature after 30 years.

Registered and Bearer Bonds

A registered bond is defined by how the holder's details are registered so that the issuer is
ensured that they are repaying the correct individual. Details can include the holder's name,
address, and relevant banking details. Bearer bonds are types of bonds that are payable to
whoever holds them. Anyone can claim ownership of a bearer bond. This risk that is
associated with bearer bonds results in very few being in circulation today. Contrary to
registered bonds, bearer bonds do not archive the holder's details. Whoever has the bond
has the right to collect the payment for it. An extreme example of theft clearly illustrates the
differences between the two. Traditionally, if a registered bond was to be stolen, the fraud
would not be able to collect payment from the issuer since their details do not match those
on the bond. However, a fraud would easily be able to successfully steal a bearer bond since
payment goes to whoever holds the bond. Bearer bonds are essentially easier to trade than
registered bonds.

Convertible and Callable Bonds

A convertible bond provides the bondholder with the right to exchange the bond for a
specific number of shares of the company's common stock before the maturity date. This
means that they are somewhat secured by company securities. For example, if the
bondholder expects the issuing company to fail in repaying its loan, it can convert the bond
into company stock and sell the stock on the open market, assuming it is a publicly-traded
company. By selling the stock, the holder will essentially get their full principal back.

A callable bond enables the issuer to repay the loan prior to the maturity date. This allows
the issuer to capitalize on lower interest rates that might be available before the bond's
maturity date. Callable bonds provide room for bond issuers to be flexible in their approach
to repaying the loan. For example, a company sells a callable bond to an investor at a
certain interest rate. However, after a year, market interest rates drop significantly. The
company is now in a position to borrow cheaper money to instantly repay the initial bond
and pay off the new bond at a lower interest rate.

Lesson Summary
A bond is a financial agreement between two entities where one entity agrees to lend
money to the other in exchange for an interest payment. Bonds comprise an asset class of
their own. There are four categories of bonds: secured and unsecured bonds, term and
serial bonds, registered and bearer bonds, and convertible and callable bonds.
Unsecured bonds are riskier than secured bonds. Term bonds mature on a specific date as
agreed by both the issuer and bondholder. Serial bonds relate to how a portion of the
outstanding bonds matures or becomes due at several dates, which typically fall in a series.
A bearer bond is a type of bond that is payable to whoever holds it. As such, anyone can
claim ownership of a bearer bond. Because of the risk associated with bearer bonds, very
few are in circulation today. A convertible bond provides the bondholder with the right to
exchange the bond for a specific number of shares in the company before the maturity
date.

Bonds are IOUs an investor purchases from a company for cash with interest. Explore the
basics of bond financing, how to use bond financing, and the advantages of bond financing
in this lesson.

Using Bond Financing

Sally Sweets has dreamed of sharing her passion for baking with the world ever since she
got her first Easy Bake oven. At only 10 years old, she knew that she wanted to open a
bakery where she could spend her days in chocolate, cookie, and custard heaven. After
spending many years dreaming, she was ready to make her dream a reality. In order for
Sally Sweets to begin building her bakery, she first had to figure out how she is going to pay
for it.

As a recent college grad, Sally Sweets lacks the collateral to fund it herself, so she needs to
explore her options. Sally Sweets quickly discovered a great way to fund this large project
was through bond issuances, whereby the company sells bonds to an investor for a specific
dollar amount and interest rate for a predetermined length of time.

Bond Financing Basics

A bond is basically an IOU issued by a company (in this case Sally Sweets Bakery) and
purchased by an investor for cash with interest. Essentially, the borrower (Sally Sweets)
agrees to pay whatever amount of money she borrows (let's say $50,000) plus interest. The
initial amount borrowed (the $50,000) is also known as the par value of a bond, face value,
or face amount, and is paid back by the borrower at a specific date in the future known as
the bond's maturity date.

It is on this maturity date that the bond issuer must pay back the principle balance of the
bond. The interest earned over the length of the bond (for example 20 years) is typically
paid by the borrower in semiannual payments (every six months) to whoever issued the
bond; this interest payment, known as a coupon, is received by the bondholder during the
time between bond issuance and maturity. Here are the specifics of Sally Sweet's bond:

Par value of the bond = $50,000

Interest rate = 10%

Coupon amount = $5,000 annually or $2,500 every 6 months

Maturity date = 20 years from date the bond was issued

Total amount Sally Sweets will pay back = $150,000 ($100,000 in interest + $50,000 par
value)

Advantages of Bond Financing

There are three main advantages of bond financing for those issuing the bond that I like to
call money, power, and tax deduction.

Money refers to the first advantage of how bonds can increase return on equity though a
process called financial leverage or trading on equity. These two terms refer to the
degree to which a company is utilizing borrowed money. When a company is able to use
borrowed money to help them make more money than they have to pay for borrowing that
money (i.e. interest payments) it will have increased its return on equity.

For example, let's say that by borrowing the $50,000, Sally Sweets was able to open her
bakery, which yielded a $150,000 profit in her first year. Because she only paid $5,000
during that year in interest, she will have had a high return on equity. Of course, if Sally
Sweets Bakery experiences a period of low income or net losses and earns a lower return
with the borrowed funds than it pays in interest, it would decrease its return on equity.

Power, or, more specifically, control, is the second advantage of bond financing. Because
bonds do not affect owner control, such as in the case with equity financing, Sally Sweets
will not have to surrender any ownership rights for her company to the investor. The
investor earns interest plus the par value of the bond when it matures and nothing more.

The final advantage of bond financing is tax deduction, or the ability to deduct the interest
payments of the bond. Some bonds like those issued by municipalities are tax deductible.
But remember this is not true of all bonds. Interest on corporate or US Government bonds
is fully taxable.

Lesson Summary
Let's review. Bond issuances are a great way for companies to fund large projects.
A bond is an IOU issued by a company and purchased by an investor for cash with interest.
The initial amount borrowed is also known as the par value of a bond, face value, or face
amount and is paid back by the borrower at a specific date in the future known as the
bond's maturity date. The interest earned over the length of the bond is typically paid by
the borrower in semiannual payments to the lender who issued the bond; this interest
payment is known as a coupon.

There are three main advantages of bond financing, which include:

 Bonds can increase return on equity if the company who issues a bond makes more
money as a result of having those borrowed funds than it pays in interest.
 Bonds do not affect owner control so that the issuer will not have to surrender any
ownership rights for company to the investor.
 The interest of bonds is tax deductible on the issuer's U.S. income tax return.

Learning Outcomes
As you finish studying this video lesson's concepts, you may determine your ability to:

 Define key terms related to bond financing

 Contrast the face value of the bond and the total amount paid
 Recall how a company can increase or decrease its return on equity
 Discuss the benefits of bond financing

A bond is a loan given to a technology firm by an investor, who expects the money to be
paid back with interest. Learn how to determine a bond's issuance price by studying
demand, risk, and market conditions.

What Are Bonds?

Bob has owned a technology firm for ten years. The business has done very well, and now
he wants to expand and invest in more research and development to offer more product
lines.

When a company wants to expand and grow, they have three options to finance the
expansion: sell stock, seek a loan from a financial institution, and sell bonds. Bob's firm has
several outstanding loans, and he's already spoken with an investment banker about selling
stock. Now, he's interested in issuing bonds. He makes another appointment with the
investment banker to discuss selling bonds.

The investment banker explains to him that a bond is similar to an IOU, where investors
loan the technology firm money with the expectation of annual interest payments and
repayment at maturity. He also says that the initial price of the bond issue would be
determined by three factors: demand, risk, and market conditions. For the rest of this
lesson, we'll examine how these factors affect the initial price of the bond.

Demand
Demand represents how interested investors are in the company. If Bob's firm is on the
cutting edge of technology and in the process of developing the most technologically-
advanced widgets, then investors may be interested. However, if Bob's firm has an idea to
bring back the analog TV era, then there may be little interest in his company.

Let's say Bob's firm is in the process of developing the world's most advanced widget, and
investors are lining up to purchase the bonds. With the help of the investment banker, Bob
decides he will issue $100,000 bonds with $9,000 as the annual payment payable to the
investor for five years. At the end of the fifth year, Bob's firm will pay the $100,000 back.

In this instance, $100,000 represents the principal, $9,000 are the annual coupon payments,
and five years are considered the maturity date. Based on demand and other factors which
we'll discuss later, the bonds can sell at discount or a premium.

If the bonds sell at a discount, the investors will purchase the bonds at a price less than the
principal. For example, they may purchase the bonds at $98,000. In year one through five,
they'll receive $9,000 each year, and at the end of the fifth year, they'll receive the profit of
$2,000 ($100,000 - $98,000). For purchasing the bond, they receive $47,000 ($2,000 in profit
+ (5 years * $9,000)) in total.

Now, what if the bonds are in great demand, and investors are willing to pay $125,000 for
the bonds? Keep in mind that they'll only receive $100,000 of principal at maturity. These
bonds are being sold at a premium, which means bonds are sold at a price greater than the
principal. Why would an investor lose money on the principal? Good question; remember
the interest payments? Typically, the coupon payments will be higher when bonds are sold
at a premium.

For example, let's say the firm will issue $100,000 bonds with $15,000 annual coupon
payments and five years to maturity. While we know the investor will lose $25,000 from the
principal ($100,000 - $125,000), they will make $75,000 ($15,000 * 5) in coupon payments for
a net profit of $50,000 ($75,000 - $25,000). Now, let's look at another factor of the price,
which is risk.
Risk
Risk is the chance of financial loss. Investors know there's a possibility of losing money
when they invest. However, investors have different risk tolerances. Some are willing to lose
a lot of money, we call these investors 'risk tolerant.' While others are considered 'risk
averse,' meaning they do not want to lose very much money, if any.

In order to assess a bond's risk level, bond ratings are assigned based on the company's
financial health. Bond ratings are similar to school grades, an A is excellent, B is good, C
represents average and a D needs improvement. An A-rated bond would be considered a
good, low risk investment, and a D-rated bond would be considered high risk. A bond that
carries a rating lower than BB by Standard & Poor's or lower than Ba by Moody's is called
a junk bond.

Remember, there's a correlation between risk and return, the higher the risk the higher the
return. Therefore, investors who purchase a D-rated bond would have a much higher
annual coupon payment than those who purchased an A-rated bond. They also would most
likely purchase the bond at a discount. The next factor that affects price is market interest
rates.

Market Conditions
Market conditions refer to the financial state of our economy. There are many factors that
affect our economy, and the analysis is extremely complicated. However, in the investment
world, we can classify market conditions as bull or bear. A bull market signifies a buying
market, where investors are interested in purchasing bonds and few are willing to sell.
Therefore, if we apply the concept of supply and demand, we know that when supply is low
and demand is high, the price increases. Conversely, in a bear market investors are willing
to sell rather than buy.

Lesson Summary
A bond is similar to an IOU, where investors loan the technology firm money with the
expectation of annual interest payments and repayment at maturity. There are several
factors that affect a bond's price: demand, risk and market conditions.

Demand represents the investor's interest in the buying the bond. Based on demand,
bonds can sell at a discount, where the purchase price is less than the repayment principal,
or bonds can sell at a premium, where the purchase price is more than the repayment
principal. Investors are willing to lose money on the principal to receive a large annual
coupon payment when buying a bond at premium.

The next factor that affects bond prices is risk. Risk is the chance of financial loss. Based on
an investor's 'risk tolerance,' they may choose a lower rated bond, which can be considered
so risky they are called junk bonds. However, high risk means high return and investors will
look to purchase the bond at a discount.

The last factor is market conditions. In a bull market, investors are willing to buy, which
may increase the price of the bond; however, in a bear market, investors are more
interested in selling, which can have an opposite effect on the initial price of the bond.
Key Terms
 Bond: similar to an IOU; investors loan money with the expectation of annual
interest payments and repayment at maturity
 Demand: how interested investors are in the company
 Discount: investors will purchase the bonds at a price less than the principal
 Premium: bonds are sold at a price greater than the principal
 Risk: the chance of financial loss
 Junk bonds: D-rated bonds and are considered high risk
 Market conditions: the financial state of our economy
 Bull market: a buying market, where investors are interested in purchasing bonds
and few are willing to sell
 Bear market: a selling market

Regarding risk, investors can either be risk tolerant

or risk averse.

Learning Outcomes
Learn the particulars of this lesson in preparation to prove your ability to:

 Identify the three factors that would determine the initial price of the bond issue
 Explain the how discounts and premiums impact the selling of bonds
 Contrast a bull market with a bear market

What Are Bonds?

Bonds are fixed income instruments representing different loans, or a single loan made by
a particular investor to a borrower, usually a government or a firm. This means a bond may
be used to provide a financial solution when the investor decides to take up the role of a
lender. Also, a business or corporation may decide to take a bond since the average money
provided by the bank in the form of a loan is not enough for the desired investment goals.

Some of the characteristics of bonds include coupon rates, callability, maturity, and being
long-term in nature. Coupon rates are the amount of interest paid to a bondholder.
Normally, before the bond is paid back, investors usually look forward to being paid the cost
of borrowing money in the form of annual coupon interest payments. Callability refers to
the issuer deciding to pay a bond off before the date of maturity. This depends on the
interest rates. Maturity is when the bond is paid to the investor, meaning the bond
obligation has ended. Bonds are long-term in nature, meaning the investor will be receiving
regular interest, hence, more profits.

What Are Discount Bonds?

A discount bond is issued to an investor for less than its original value. So, a simple answer
to the question, "What is a discount bond?" is a bond whose future value is less than the
purchase value. These bonds may be trading less than what is traded in the secondary
market, meaning the value has to be reduced for them to sell quickly. A discount bond can
become a deep-discount bond when its selling price is significantly sold to less than 20% or
more.

Bonds are issued and traded considering the $1,000 face value, which would be paid at
maturity. The face value is also referred to as the principal amount. Thus, the principal
refers to the sum the lender will receive from the issuer upon the expiration of the bond.
This means the bond can be traded at a value lower than the face value using coupons or if
the market price is below the expected or par bond value. For instance, the market price is
$950, below par value. Therefore, the bond discount will be $1,000-$950 = $50 and a rate of
5%.

What Are Premium Bonds?

The definition of premium bonds is a bond that trades above its original or face value. In
short, premium bonds refer to bonds whose future value is higher than their purchase
price. A particular bond may be traded at a premium because of its higher interest
compared to the current market interest. Also, a company or a business credit rating may
be a factor in pushing the bond's price higher than market interest rates.

The face value of the bond can be traded at a higher price or premium rate because of its
current value. For example, a bond may be issued at an original or face value of $2,000 and
trade at $2,100, meaning the premium "status" is $100. Even if the bond has not reached its
maturity, it can be sold in a secondary market, meaning an investor may purchase a 15-year
bond before it matures within this period.

Premium vs. Discount Bonds

A premium bond often has a higher coupon rate than the existing credit quality rate and the
bond's final maturity. In contrast, when considering the credit quality and bond maturity,
the discount bond has a lower coupon rate than the existing interest rates. However,
premium bonds with a much higher price than the face value and a lower rating would still
earn more in the market compared to a discount bond with a lower yield. This means an
investor must be keen on the future value of selling bonds at a premium rate because the
interest rate environment keeps changing, meaning the value keeps changing, becoming
difficult to sell the bond.
Discount Bonds Advantages
Some of the advantages of this type of bond include:

 Better returns: Discounted bonds offer an investor a better chance to get a higher
return if he or she decides to hold them until maturity. This means the investor can
have an opportunity to have efficient financial planning.
 Regular cash flow: An investor who wants a short-term option of investment by
receiving regular or steady capital gains cash may opt for discounted bonds. It gives
them the chance to call off the bond before its maturity, for instance, within one year
or less.
 Market control: An investor can opt for discount bonds when market prices are
unfair or it is difficult to determine different face values.

Discount Bonds Disadvantages

Despite the benefits mentioned above, discount bonds have some cons such as:

 High risk of default: Discount bonds may indicate the chances of an issuer defaulting
or poor performance in dividends. The business is in financial distress, indicating
that investors may not be willing to buy the existing debt.
 Maturity problems: Discount bonds with longer maturities may have higher
expectations or chances of default because of an uncomfortable place in the current
market for buying or selling bonds.
 Lower ratings: Discount bonds may lower the issuer rates in the discount bonds
process, a sign of financial distress. However, this depends on the future market
interest rates.

Premium Bonds Advantages

Some of the advantages of premium bonds entail:

 Tax-free: Premium bonds are not included in income tax, which is a good investment
for investors with higher taxpaying rates.
 Accessible: Premium bonds are readily available because they are provided with a
government guarantee to purchase back with the face value price, meaning you can
opt out of your investments without incurring any charges.
 Auto-investment option: Premium bonds offer an investor to make big wins. This
means you can make more investments using the bond's gains to earn more.

The price of a premium bond is impacted by variables such as the borrower's credit ratings,
that is, their creditworthiness. Typically, the scale of businesses' credit scores ranges from 0-
100. The higher the score, the higher the creditworthiness of a firm. Among the firms with a
solid credit rating include Johnson & Johnson, Apple, and Microsoft.

Premium Bonds Disadvantages

Some of the drawbacks of this type of bond include:

 No interest: Premium bonds do not have interest if they are not chosen in the
market prices in the monthly draws.
 Risk of overpaying: The chances of bondholders overpaying are high, meaning
making something significant out of the bond may take longer.
 Inflation: Premium bonds are affected by the rising cost of living. This means the
level of investment power of an investor may decrease over time, making premium
bonds unnecessary due to high-level risk during the inflation period.

Examples of Discount Bonds

Some examples of discount bonds include:

 Distressed bond: This discount bond may not involve interest in payments, or there
might be a delay in payments. In other words, investors of these are always in
speculating mode. A minimum price of the distressed bond may result in a high-
yielding bond.
 Zero-Coupon bond: A discount bond is given at a 20% discount or more when the
maturity levels are high. This means the bond price may rise significantly towards
the end of the maturity period.

Examples of Premium Bonds

Some examples of this type of bond include:

 Target Corp's bonds: This premium bond matures in 2031 after being issued in 2001.
It has a coupon of 7.05%, meaning the investor earns the same percentage every
year. The face value in 2001 was $ 99.37.
 NS&I Premium Bonds: These are premium bonds controlled by the United Kingdom
treasury. It guarantees no risk for the investors' capital, meaning you can buy a bond
costing two pounds and have a high chance to improve it.

Lesson Summary
Discount and premium bonds are important investment channels that investors may
consider in improving their net worth. A discount bond is issued to the investor at a
minimum or lower price compared to the face value; that is, its future value is less than the
purchase value. It can guarantee the investor better returns and a regular cash
flow. Premium bonds trade at a higher price in the market compared to the face value; that
is, their purchase price is greater than the future value. It may be a good investment if the
investor wants to reap big interest rates in the market. This means that when deciding on
the type of bond to choose, a bond sold at a premium may be more advantageous as it
accrues more profit in the long run. However, it is up to the investor to which one suits their
business needs and the prevailing market conditions.

Nevertheless, in bond transactions, investors are usually paid annual coupon interest
payments. This is defined as the cost a corporation pays borrowing money from the
investors. Other characteristics of bonds include the fact that they are safe and long-term,
making them a worthwhile investment.

Bond retirement involves the cashing out of a bond that has been invested in, which must
be accounted for. Explore the process of recording bonds that are sold and those retiring at
maturity and early retirement.

What Are Bonds?

Jan is an investment banker at one of the top firms in the country. Her largest client called
and asked if she could provide a seminar to newly hired accountants on the retirement of
bonds. Jan told her client she would be more than happy to facilitate the seminar.

The following week she starts her presentation by asking, 'Does everyone remember how to
define a bond?' A few people raised their hand. So, Jan said, 'A bond is an investment
instrument whereby an investor loans a company money in return for periodic interest
payments.

As accountants, your main function, as it relates to bonds, is to record the retirement of

bonds. There are three different ways to report the retirement of bonds: at maturity, early
retirement at a loss and early retirement with a gain. For the rest of this lesson, we'll discuss
the components of a bond and explore how to report the retirement of bonds based on
maturity, a gain or loss.

Selling Bonds
When a company wants to expand and grow, they have three options to finance the
expansion: sell stock, receive a loan from a financial institution or sell bonds. Bonds are
similar to an IOU. A bond is a contractual arrangement between a company and investor
whereby the investor loans the company money. The loan is considered the principal. The
agreed upon date the bond will be paid back is called the maturity date.

Even though the investor will receive the principal back once the bond matures, the
company must incur a cost of borrowing the money; the company must pay interest to the
investor. Investors expect annual interest payments, called coupon payments, until the
bond matures.

Let's look at an example. Company XYZ issues bonds for $1,000 with annual coupon interest
payments of $150 and a maturity date of five years. The bonds will be listed as a long-term
liability on the balance sheet. A liability is an obligation the company owes. Most bonds are
listed as long-term liabilities since they will be paid back sometime in the future, usually
longer than a year.

Retire Bonds at Maturity

Once the bond reaches maturity, after the five years in our example, the bond is retired,
and the investors are repaid in full and the liability is removed from the balance sheet. Now
let's see what happens if the bond is retired before the 5-year maturity date.
Early Retirement at a Loss
Since bonds are held for quite some time, they have various features to help minimize
losses for the issuer. One of those features is called a callable. A callable bond allows the
issuer to retire the bond early. Companies sometimes pay off the bond early due to market
conditions, investment opportunities or interest rates. Interest rates are the most common
reason why bonds are called in or retired early.

Let's look at Company XYZ's bond issuance. They issued $1,000 bonds with $150 annual
coupon interest payments or a coupon interest rate of 15% ($150 / $1,000). If a similar bond
goes on the market for 7.5% coupon interest rate or a $75 annual coupon interest payment,
the company may call the bond in and retire it. Then reissue a new bond at the lower rate of
7.5% coupon interest instead of 15%.

When a company retires the bond early, they may pay more than the bond is worth. For
example, in year three, the company decides to call in the bond for $1,200. The journal entry
will look like this:

Item debit credit

Bonds payable $1,000
Extraordinary loss $200
Cash $1,200
The $1,000 debit to bonds payable reduces the bonds payable liability. The $1,200 credit to
cash represents payment to the bondholder. The extraordinary loss is the difference.

In this instance, the company will lose $200 ($1,000 - $1,200) in repaying the principal. The
extraordinary loss is reported on the income statement item below the operating section.
Even though the company loses a little money on the principal, they save quite a bit on the
coupon interest payments.

Early Retirement at a Gain

Conversely, if the company has the same outstanding bond of $1,000 but decides to call the
bond at $900 in year three, they will make $100 per bond on the principal and reduce their
coupon interest payments. Here are the journal entries:

Item debit credit

Bonds payable $1,000
Extraordinary
$100
gain
Cash $900
The $1,000 debit to bonds payable reduces the bonds payable liability. The $900 credit to
cash represents payment to the bondholder. The extraordinary gain is the difference. It will
again go on the income statement below the operating income section.
Lesson Summary
A bond is an investment instrument whereby an investor loans a company money in return
for periodic interest payments. Bonds are similar to an IOU. A bond is a contractual
arrangement between a company and investor whereby the investor loans the company
money. The loan is considered the principal. The agreed upon date the bond will be paid
back is called the maturity date.

Even though the investor will receive the principal back once the bond matures, the
company must incur a cost of borrowing the money; the company must pay interest to the
investor. Investors expect annual interest payments, called coupon payments, until the
bond matures. When a bond matures, the liability or obligation owed to the investors has
been paid off and is taken off the balance sheet.

Bonds also have features to minimize losses for the issuer. Callable is one type of feature
that allows the company to retire the bond early. Depending on market interest rates, the
company may retire the bond at a price greater than the principal or may call the bond for
less than the principal. In either case, the gain or loss must be reported in the income
statement.

Key Terms

bond: an investment instrument whereby an investor loans a company money in return for
periodic interest payments, also known as principal

maturity date: the agreed upon date the bond will be paid back

interest: cost of borrowing the money

callable: one type of feature that allows the company to retire the bond early

Learning Outcomes
After reviewing this lesson, you should be able to do the following:

 Define bond
 Explain 3 methods of bond retirement
 There are debt-related ratios that are useful in establishing eligibility for loans.
Discover how to calculate and interpret debt ratios and debt service coverage ratios
accounting for assets, liabilities, and income.
 What Is Debt?
 Jan's Upscale Resale is a clothing store that sells gently used ladies clothing. Jan
would like to expand by opening another store. She visits US Bank & Trust to see if
she can get a business loan. She meets with Mark, a loan officer at the bank, and
submits the business' financial statements.
 After Mark reviews the information, he tells Jan she's too far in debt to afford a
second location. Mark goes on to say there are several ratios that he uses to
determine if a business is eligible for financing. One of them is the debt ratio, which
shows the percentage of assets financed with debt. The other is the debt service
coverage ratio, which measures a company's ability to make their current debt
payments.
 For the remainder of this lesson, you'll learn which financial statement to use to find
the line items to calculate the debt ratios and formula. We'll also discuss how to
analyze the results.

 Debt Ratio
 Jan arrogantly tells Mark that her resale store was voted the #1 resale shop in the
city. She tells him she has more customers than many regionally-owned stores, so it
doesn't make sense that she can't get a loan.
 Mark asks Jan if she has a few minutes so he can explain the debt ratios that he
calculated for her business. Jan says, 'Of course, let's get started.' Mark starts by
explaining the components of a balance sheet, which are assets and liabilities.
 Assets are items owned by her business. Examples include cash, inventory, the
building, and cars. Liabilities are obligations she owes, an example could be a loan
for the building. Liabilities and the word 'debt' are used interchangeably and mean
the same thing.
 Mark goes on to tell her the debt ratio is calculated by taking total liabilities divided
by total assets. Both amounts can be found on the balance sheet. Mark pulls out
Jan's business balance sheet and shows her she has total liabilities of $200,000 and
total assets of $250,000, which results in a debt ratio of 80%. In sum, 80% of her
assets are financed with loans. She still has not paid off the building her store is
located in or the cars she and her employees drive around the city for business.
 Mark tells Jan the bank does not make loans to businesses with debt ratios greater
than 40%. He suggests she use some of her profit to pay down her debt. Jan asks
Mark hastily, 'You used one ratio to determine whether to give my business a loan?'
Mark replies, 'No, ma'am. There is another ratio I calculated that provides more
insight; it's called the debt service coverage ratio.'

 Debt Service Coverage Ratio

 Mark tells Jan the debt service coverage ratio is calculated by finding profit divided
by debt service. The business' income statement shows profit for a specific period
and the balance sheet shows debt service. Debt service refers to principal and
interest payments on all loans. Jan asks Mark to explain principal and interest before
he talks about the debt service coverage calculation. Mark says, 'Absolutely.'
 When a business requests a loan from the bank, the bank will loan the money they
requested, which is considered the principal. They'll also charge the business for
borrowing money; this is called interest. When a customer repays the loans, which is
usually done through monthly payments, they will pay a portion of the principal plus
interest in each payment.
 Mark asks Jan if she understands principal and interest now. She replies, 'Yes.
Thanks for the explanation. Now how did you calculate debt service coverage?'
 Mark says he found profit on the business income statement of $185,000 and the
principal and interest payments of $200,000 on the balance sheet. The result is .925,
which means there is only enough profit to cover 92.5% of her debt or loan
payments. Any calculation less than 1 (or 100%) means the business has negative
cash flow to cover its loan payments.
 After Mark explained all of this to Jan, she finally understood why the bank did not
offer her a loan and tells Mark she will spend the next few years paying off business
debt rather than trying to expand.

 Lesson Summary
 In sum, debt, also called liabilities, is the obligations a business owes. When a
business wants to get a loan, the bank looks at more than just their ability to make
money. They also analyze what they owe and if they're able to make the loan
payments. Two main ratios are used for this analysis: debt ratio and debt service
coverage ratio.
 Debt ratio is calculated by taking total liabilities divided by total assets. It shows
what percentage of business assets are financed with loans. The higher the ratio, the
more the business owes on the assets.
 The next ratio is the debt service coverage ratio, which is calculated by taking profit
divided by debt service costs. Debt service costs are principal and interest payments.
The debt service coverage ratio shows how well a business can make their loan
payments. A calculation less than 1 shows negative cash flow and the inability to
make loan payments.

 Lesson at a Glance
 When banks determine loan eligibility for a customer, they look at two main ratios in
their analysis. The first is known as a debt ratio, which is calculated by taking total
liabilities divided by total assets. The second is the debt service coverage ratio, which
is calculated by taking profit divided by debt service costs.

Any calculation less than 1 means the business has

negative cash flow to cover its loan payments.

 Learning Outcome
 Upon completing this lesson, you should be able to describe the two main ratios
banks use in their analysis to determine a customer's loan eligibility.