Chapter 8 Notes

Long-Lived Assets
Long-lived assets are tangible and intangible resources owned by a business and used in its
operations over several years; classified as noncurrent assets in the balance sheet
1. Tangible assets have physical substance (can be touched)
 Land used in operations
 Buildings, fixtures, and equipment used in operations (i.e., PPE, fixed assets)
 Natural resources used in operations (e.g., timber, mines, oil)
2. Intangible assets are long-lived assets without physical substance that confer
specific rights on their owner
 Examples: copyrights, patents, franchises, licenses, trademarks, goodwill

Ratio Analysis
Since fixed assets often require a substantial investment of capital, it is important for both
internal and external decision-makers to understand how well management is making these
investment decisions and using the assets once acquired

 How effectively is management utilizing fixed assets to generate revenue?

Net Sales(Operating Revenue)
¿ Asset Turnover Ratio= Assets¿
Average Net ¿
 Interpretation: Dollars of sales generated by each dollar of fixed assets used
 Higher turnover indicates more effective management of fixed assets
 Increasing turnover over time indicates more efficient use of fixed assets
 Caution: Need to investigate related activities
 Lower/declining ratio may indicate the company is expanding (buying assets
in anticipation of higher future sales increases denominator)
 Higher/increasing ratio may indicate the company is cutting back on capital
expenditures due to an expected downturn (decreasing the denominator)

Long-Lived Asset Life Cycle

Since long-lived assets exist at a company for a long period, there are generally multiple
transaction-generating events that occur of the life of the asset, including:
1. Acquisition of the asset – by purchase or construction
• Measure and record the acquisition cost (Ch. 2!)
• Measuring cost of constructed assets is similar to inventory (costs to bring to use)
2. Use of the asset
• Repairs and maintenance - maintain productive capacity  expense
• Improvements – increase productive life/operating efficiency/capacity  capitalize
• Depreciation – cost of using asset over its useful life  expense
3. Impairment of the asset
• Occurs when expected future benefits fall below book value
• Similar concept as testing for lower of cost or market with inventory
4. Disposal of the asset
• Record gain/loss as difference between cash received and book value

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Acquisition of the Asset
 When an asset is acquired, it should be recorded in the balance sheet as an asset
 Prior to recording the acquisition, the company must determine the acquisition cost of the
asset (the net cash equivalent amount paid or to be paid for the asset)
 Similar to inventory, all reasonable and necessary expenditures made in acquiring and
preparing an asset for use should be recorded as the cost of the asset
 Reasonable and necessary expenditures include:
1. Purchase price
2. Sales tax and legal fees
3. Transportation and installation costs
4. Less: discounts
 For constructed assets only:
 Cost also includes direct labor and materials
 Cost may include interest if it is incurred during the construction period
 If an expenditure is included in the acquisition cost, it is recorded as part of the long-lived
asset on the balance sheet (i.e., it is capitalized)
 If an expenditure is not included in the acquisition cost (e.g., insurance, interest), it is
recorded as a period expense (i.e., it is expensed)
 To record the acquisition (in the amount of the acquisition cost):
1. Debit the appropriate noncurrent asset account (e.g., Buildings, Equipment)
2. Credit the source of payment (e.g., Cash, Notes Payable, Common Stock)
 Note: When costs occur on different days, multiple journal entries may be recorded, but the
ending asset value should equal the total acquisition cost
 IFRS: Allows companies to record at fair value and record subsequent increases in value

Use of the Asset

As an asset is used, the company may need to make occasional repairs or perform regular
maintenance to keep the asset working as intended. They also may choose to perform more
substantial improvements to increase the capacity, life, or efficiency of the assets. Regardless,
they must match the “using up of the asset” (i.e., depreciation) with the revenue generated from
using the asset each reporting period. These three events are accounted for differently.

Ordinary Repairs and Maintenance

 Repairs and maintenance include expenditures that help keep the asset working as intended
 Typically recurring in nature and small in amount
 Do not improve the life, capacity, or efficiency of the asset
 Recorded as an expense (Dr Repairs and Maintenance Expense)
 Examples: oil changes, replacing lights, fixing tears

Improvements
 Improvements are expenditures that increase the productive life, operating efficiency, or
capacity of the asset
 Typically infrequent in nature and large in amount
 Recorded as a capital expenditure (debit (increase) the account of the improved asset)
 Examples: additions, major overhauls, complete reconditioning, major replacement

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Depreciation
 The purpose of investing in long-lived assets is to generate revenue over time
 The matching principle requires that companies match the “using up of the asset”
(i.e., expense) to the revenue earned each period
 For fixed assets, this is achieved through depreciation (similar to amortization for intangible
assets and depletion for natural resources – discussed later)
 Depreciation is the process of allocating the cost of buildings and equipment over the
productive lives of the asset using a systematic and rational method
 Depreciation is a process of cost allocation, not matching the fair value
 Land is never depreciated
 Depreciation is recorded as an expense (i.e., debit) and reduces total assets through a credit to
Accumulated Depreciation, a contra-asset account that offsets PPE and reduces total assets
ref Depreciation Expense (+E, -SE) $XX
Accumulated Depreciation (+XA, -A) $XX

 Net Book Value of an asset = Asset Cost – Accumulated Depreciation

 To calculate depreciation, you must know three items:
1. Acquisition cost
2. Estimated useful life to the company (service life)
3. Estimated residual (salvage) value (what can be recovered at end of asset’s life)
 There are three common methods to calculate depreciation
1. Straight-line
2. Units-of-production
3. Declining-balance

Straight-line Method
 Allocates the depreciable cost of an asset in equal periodic amounts over its useful life
 Allocates the cost on a basis of time, rather than activity
 Assumes that the asset is used evenly over its useful life
 Depreciable Cost =Cost −Residual Value
 Depreciable cost represents the portion of the asset used up in operations over time
 Residual value represents the amount you expect to be able to be able to recover when
the asset is disposed of at the end of its useful life (e.g., value of scrap metal from a car)
Cost −Residual Value
 Formula: Depreciation Expense=
Useful Life
 When applied, depreciation expense will be the same every year, accumulated depreciation
will increase by the same amount each year, and the net book value will decrease by the same
amount each year until it reaches its salvage value
 Example of asset with a useful life of 3 years
Year Depreciation Expense Accumulated Depreciation Ending Net Book Value
1 (Cost-Residual)/3 (Cost-Residual)/3 Cost – [(Cost-Residual)/3]
2 (Cost-Residual)/3 2*[(Cost-Residual)/3] Cost – [2*(Cost-Residual)/3]
(Cost-Residual)/3 3*[Cost-Residual/3] Cost – [3*(Cost-Residual)/3]
3
= Cost-Residual = Residual

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Units-of-Production Method
 Allocates the depreciable cost of an asset over its useful life based on the relationship of its
periodic output to its total estimated output
 Allocates the cost on a basis of activity, rather than time
 Assumes that the asset is not used evenly over its useful life
 More precisely matches use of an asset (i.e., depreciation expense) to the period where
the associated revenues are generated, but requires more extensive recordkeeping
Cost −Residual Value
 Formula: Depreciation Expense= × Actual Production
Estimated Total Production
 The first part of the formula calculates the depreciation rate per unit of production
 The second part applies the depreciation rate to the actual activity of the period
 When applied, depreciation expense, accumulated depreciation, and net book value will vary
with the number of units produced
 If the actual total production is ultimately different from the estimated total production, this
would be resolved with the final adjusting entry such that the ending net book value of the
asset is equal to its residual value
 Example of calculations over 3 years with estimated total production of “Est” and
actual production of “A1”, “A2”, and “A3”
Year Depreciation Expense Accumulated Depreciation Ending Net Book Value
1 [(Cost-Residual)/Est]*A1 [(Cost-Residual)/Est]*A1 Cost – [(Cost-Residual)/Est]*A1
[(Cost-Residual)/Est]*A1 + Cost – [(Cost-Residual)/Est]*A1
2 [(Cost-Residual)/Est]*A2
[(Cost-Residual)/Est]*A2 – [(Cost-Residual)/Est]*A2
[(Cost-Residual)/Est]*A3 [(Cost-Residual)/Est]*A1 + Cost – [(Cost-Residual)/Est]*A1
3 [(Cost-Residual)/Est]*A2 + – [(Cost-Residual)/Est]*A2
[(Cost-Residual)/Est]*A3 – [(Cost-Residual)/Est]*A3
 This table would continue until the sum of all actual production is equal to the total estimated
production or the asset is disposed of
 If A1 + A2 + A3 = Est, then Accumulated Depreciation in Year 3 would be equal to the
depreciable cost (Cost – Residual) and ending Net Book Value would equal the Residual

Declining-Balance Method
 Allocates the net book value of an asset over its useful life based on a multiple of the
straight-line rate (usually 2x), thus assigning more depreciation to early years and less to later
years of an asset’s life
- Allocates the cost on a basis of time, but at an accelerated rate compared to straight-line
- Assumes that the asset is used more or higher revenues are earned earlier in its useful life
Cost −Accumulated Depreciation
 Formula: Depreciation Expense= × Rate
Useful Life
- One key formula difference is that the numerator is net book value, not depreciable cost
- Since the net book value decreases as depreciation is recorded, annual depreciation
expense will decline over time as accumulated depreciation increases
- A multiple of 2 is the most commonly used (called double-declining-balance rate)

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  Since residual value is not part of the declining-balance formula, the calculation may result in
a net book value less than the residual value. If this occurs, set the ending net book value to
the residual value and calculate the final year’s depreciation expense as the difference
between the previous year’s net book value and the residual value.
 Example of double-declining-balance method with a useful life of 3 years
Year Depreciation Expense Accumulated Depreciation (AD) Ending Net Book Value
1 [Cost/3]*2 [Cost/3]*2 Cost – [Cost/3]*2 = Cost/3
[(Cost-AD)/3]*2
[Cost/3]*2 + [Cost/9]*2
2 = [(Cost/3)/3]*2 Cost/3 – [Cost/9]*8 = Cost/9
= [Cost/9]*8
= [Cost/9]*2
[(Cost-AD)/3]*2
[Cost/9]*8 + [Cost/27]*2
3 = [(Cost/9)/3]*2 Cost/9 – [Cost/27]*26 = Cost/27
= [Cost/27]*26
= [Cost/27]*2
 If the residual value > Cost/27 (ending net book value), then replace Cost/27 with the
residual value and calculate depreciation expense for Year 3 as Cost/9 – Residual Value
 If the residual value < Cost/27 in the final year of the asset’s useful life (here, Year 3), again
replace Cost/27 with the residual value and calculate depreciation as Cost/9 – Residual Value

Financial Reporting Effects of Depreciation Method Choice

 Accounting standards require that managers choose the depreciation method for financial
reporting purposes that best matches revenues with the expenses from using the asset
 Straight-line is the most commonly used method because it is easy to apply, generally
does not require additional explanation to users (because it is so common), and results in
higher net income in the short-term compared to declining-balance methods
 Unlike inventory costing methods, managers are not required to use the same depreciation
costing methods for financial and tax reporting purposes
- Companies often use the Modified Accelerated Cost Recovery System (MACRS) for tax
reporting because it results in higher depreciation expense in early years
- Higher depreciation expense  Lower net income  Lower taxes
 Managers have discretion over the length of the useful life used to calculate depreciation
- Longer lives result in lower depreciation expense per year, but requires the expense to be
recognized over multiple periods
- Changes in estimates of useful lives can have material effects on net income since it
changes the amount of depreciation expense recognized that year and in the future

Impairment of the Asset

 An asset is considered impaired when it is no longer expected to generate future cash flows
equal to its book value (i.e., its probably future economic benefit has been reduced)
 Testing and adjusting for impairment involves two steps:
1. Test for Impairment
 Compare the net book value of the asset to its estimated future cash flows
 If estimated future cash flows < net book value  asset is impaired

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 2. Computation of Impairment Loss
 If the asset is impaired, a loss must be recognized (income statement effect) and the
value of the fixed asset must be reduced (balance sheet effect)
 Impairment Loss = Net book value – Fair value
 Market value is equal to what the company could sell the asset for on the market
 Impairment losses for assets used in operations are included in operating expenses
 The journal entry for impairment is:
ref Asset Impairment Loss (+Loss, -SE) $XX
Fixed Asset (-A) $XX

Disposal of the Asset

 Companies sometimes choose or are forced to dispose of an asset (i.e., sell or retire it)
 There are two steps required to record the disposal of a fixed asset
1. Record an adjusting entry to catch up on depreciation expense for the year of disposal
ref Depreciation Expense (+E, -SE) $XX
Accumulated Depreciation (+XA, -A) $XX

2. Record the disposal:

 Remove the fixed asset (credit)
 Remove its associated accumulated depreciation to-date (debit)
 Gain/loss = Resources received – Net book value
 Record a gain (credit) if resources received for disposal (X) > net book value (Z-Y)
ref Cash/Resource (+A) $X
Accumulated Depreciation (-XA, +A) Y
Fixed Asset (-A) $Z
Gain on Sale of Assets (+Gain, +SE) X-(Z-Y)

 Record a loss (debit) if resources received for disposal (X) < net book value (Z-Y)
ref Cash/Resource (+A) $X
Accumulated Depreciation (-XA, +A) Y
Loss on Sale of Assets (+Loss, -SE) (Z-Y)-X
Fixed Asset (-A) $Z

Intangible Assets
 Intangible assets are assets that have no physical substance, but have value because they
confer rights and privileges on owner
 Examples of intangible assets:
 Goodwill - excess of the purchase price of a business over the fair value of the acquired
business’ net assets (assets – liabilities), typically due to a good reputation
 Goodwill = Purchase price – (Fair value of assets – Fair value of liabilities)
 Patents - granted by the federal government for an invention and give owners exclusive
rights to use, manufacture, and sell the subject of the patent
 Trademarks - exclusive legal right to use a special name, image, or slogan

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  Copyrights - exclusive right to publish, use, and sell a literary, musical, or artistic work
 Franchises - contractual right to sell certain products or services, use certain trademarks,
or perform activities in a geographical region
 Licenses & Operating Rights - Rights obtained through agreements with governmental
units/agencies permitting owners to use public property in performing their services
 Technology - costs for computer software and Web development (only capitalized when
technological feasibility is established)
 Costs to internally develop intangible assets are typically expensed
 IFRS: Allows capitalization of measurable development costs (but not research costs)
 Intangible assets are generally treated the same way as fixed assets, with a few exceptions:
1. Intangible assets are recorded at acquisition cost only if purchased
 This reflects the conservative approach of GAAP (special care not to overstate assets)
since the future economic benefits of intangible assets are difficult to predict
2. Amortization expense is recorded to account for use of the asset (like depreciation)
 If the asset has a definite life, then amortization is calculated using the straight-line
method and the journal entry would be:
ref Amortization Expense (+E, -SE) $XX
Accumulated Amortization (+XA, -A) $XX
or
ref Amortization Expense (+E, -SE) $XX
Intangible Asset (-A) $XX
 If the asset does not have a definite life (e.g., goodwill), it must be tested annually for
impairment
3. Impairment testing involves an extra step
1. Examine qualitative factors to determine whether impairment is likely
2. If likely (or if step 1 is skipped), then compare net book value to future cash flows
3. If future cash flows < net book value  record impairment as difference between
net book value and market value (just like fixed assets)
4. Disposal of intangible assets is identical to fixed assets

Natural Resources
 Natural resources are assets occurring in nature, such as mineral deposits, timber tracts, oil,
and gas (also called “wasting assets”)
 Accounting for natural resources is similar to fixed assets except for a few key differences:
1. Acquisition cost includes costs to acquire or develop the natural resources
2. Depletion expense is recorded to account for use of assets (typically units-of-production)
 If depletion is necessary to generate inventory (e.g., extract oil from a well to prepare
it for sale), then it is capitalized; otherwise it is expensed
ref Inventory (+A) $XX
Natural Resource (-A) or Accumulated Depletion (+XA, -A) $XX
or
ref Depletion Expense (+E, -SE) $XX
Natural Resource (-A) or Accumulated Depletion (+XA, -A) $XX

3. Test for impairment is identical to fixed assets

4. Disposal of natural resources is identical to fixed assets