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Chapter 9 – Long-Term Assets

This chapter will look at the topic of accounting for long-term assets which includes both tangible and
intangible assets. We will be looking at how to record the purchase of such assets, how to allocate their
cost over their useful lives, and how to record the sale or disposal of the assets. After you have finished
this chapter, you should be able to:
1. Compute the total cost of long-term assets and record their purchase.
2. Define depreciation, compute depreciation under the three methods covered in the text, and
record the annual depreciation entries.
3. Distinguish between capital and revenue expenditures.
4. Account for the disposal of depreciable assets by sale.
5. Identify the issues related to accounting for intangible assets, including research and development
costs and goodwill.
6. Discuss the process required each year to determine appropriate recording of the imparement of
long-term assets.

Key Points to Remember:

1. Accounting principles related to long-term assets


a. Cost principle should be followed when determining the cost of long-term assets
The cost principle states that the cost of the asset should equal the cash or cash equivalent
value of all expenditures reasonable and necessary to acquire the asset and get it ready
for its intended usage. Therefore, cost such as freight, installation, sales taxes, or legal
fees may be included in the cost of the asset and recorded as a debit to the asset account.
b. Matching principle should be followed to allocate the cost of the asset over the useful
life of the asset. The matching principle requires that you record the cost of long-term
assets as an asset and then record depreciation (depletion or amortization) when the asset
is used to help produce income.

2. Capital expenditures vs. revenue expenditures –


a. Capital expenditure -- expenditures for the purchase or expansion of long-term assets.
Capital expenditures benefit more than one accounting period. They may increase the
quality or quantity of output of an asset; they may improve the efficiency or usefulness of
an asset, and are not considered routine in nature. Capital expenditures are recorded as in
increase to an asset account. Additions, betterments and extraordinary repairs are
considered capital expenditures.
b. Revenue expenditures -- expenditures related to the maintenance and operation of long-
term asset necessary to keep a long-term asset in good operating condition. Revenue
expenditures benefit only the current accounting period. They are typically considered
routine in nature and tend to be smaller amounts than capital expenditures. Revenue
expenditures are recorded as an increase in an expense account.

3. Depreciation Methods – need to know all 3 methods!


a. Straight Line - results in equal depreciation each full year of usage of the asset

Cost - residual value


Estimated useful life = Depreciation per year

This is the most popular method for financial accounting purposes.


b. Production Method – results in equal depreciation each unit of usage during the assets
life

Cost - residual value


Estimated useful units = Depreciation per unit

Depreciation per unit * Units used in period = Depreciation

c. Declining-balance method – results in higher depreciation in the early years of the assets’ life
and lower depreciation each of the following years.
(Remember -Year 1 use Cost – 0)

2
Years in assets life * (Cost - Accum. Deprec.) = Depreciation for the year

4. Disposals of Depreciable Assets – Steps to record the sale


a. Record the depreciation expense for the current year up to the date of the disposal

b. Compute the gain or loss on the sale:


Net proceeds from the sale XXX
Book value of the assets XXX
Gain or loss on sale XXX

c. Record the sale:


Cash Net proceeds
Accum. depreciation Accum. deprec
Loss or Gain on Sale $$$ or $$$
Asset Original Cost

5. Special rules for natural resources –


a. Depletion – process used to allocate the cost of the natural resource over its useful life.
Depletion expense computed like production depreciation.
b. Assets used in relation to the extraction of natural resources should be depreciated. The
depreciation method chosen should take into account the useful life of the asset and the
usefulness of the asset after the natural resource has been recovered.

6. Special rules for intangible assets –


a. Amortization – process used to allocate the cost of intangible assets that are considered to
have a limited life. Amortization expense is computed like straight-line
depreciation.
b. Research and development costs – all research and development costs should be treated
as revenue expenditures and charged to expense in the period in which they are incurred.
c. Goodwill – is only recorded for accounting purposes when purchased. It should be
treated as a separated item on the balance sheet and reviewed annually for impairment.

7. Impairment of assets –
Each year, companies are required to determine the fair market value of their long-term assets to
determine if the carrying value of the long-term assets exceeds the present value of the fair
market value of the assets. (Fair market value is the amount for which the asset could be reasonably
expect to be bought/sold for at that time.) If necessary, a journal entry is made to record a loss
and to reduce the carrying value of the asset.
CHAPTER 9 REVIEW

I. VOCABULARY (Complete each of the following statement by filling in the appropriate word or words)

1. An expenditure for repairs, maintenance, or other services needed to maintain or operate plant
assets is a(n) _____________________ expenditure.

2. An expenditure for the purchase or expansion of a long-term asset is a(n)


_____________________ expenditure.

3. _________________ is the periodic allocation of the cost of a tangible long-term assets (other
than land, natural resources, or intangible assets) over its estimated useful life.

4. The allocation of the cost of a natural resource to those periods in which the firm receives the
resource's benefits is called ____________________, and the similar allocation of the cost of an
intangible is called ____________________.

5. The _________________ method of depreciation applies a fixed percentage rate to an asset's


book value as of the beginning of each period.

6. The __________________ method of depreciation assumes that depreciation depends only on the
passage of time and this method allocates an equal amount of depreciation to each period of time.

7. The estimated net scrap, salvage, or trade-in value of a tangible assets at the estimated date of
disposal is the ___________________ of the asset.

II. MULTIPLE CHOICE (Circle the letter that best completes each of the following statements)

1. Which of the following would not be classified as property, plant and equipment?
a. a warehouse that is no longer in use
b. a building containing the administrative offices
c. equipment on the floor of the main production facility
d. land on which the production facility is built

2. Expenditures such as ordinary repairs, maintenance, and fuel represent


a. capital expenditures.
b. either capital or revenue expenditures.
c. revenue expenditures.
d. none of the above.

3. If a capital expenditures is recorded as a revenue expenditure, future periods' incomes are


a. understated.
b. overstated.
c. not affected.
d. (a) or (b).

4. The historical cost of acquiring an asset includes


a. acquisition cost plus all costs necessary to bring it to the condition and location necessary
for its intended use.
b. only the acquisition cost.
c. only those costs incurred to bring it to the condition and location necessary for its
intended use.
d. no shipping charges.
5. A one year old building was purchased for $150,000 and has accumulated depreciation of
$20,000 and a residual value of $50,000. Assuming straight-line depreciation is being used, its
estimated useful life is
a. five years.
b. ten years.
c. fourteen years.
d. impossible to determine from the given information.

6. Which of the following methods ignores residual value initially but eventually considers it in the
calculation of depreciation?
a. Straight-line
b. Units-of-activity
c. Double-declining-balance
d. MACRS

7. Marshall Company has just purchased a depreciable asset with a useful life of six years. The
company will be choosing either the straight-line (SL) or double-declining-balance (DDB)
method of depreciation. Which one of the following statements correctly describes what will
happen under the SL or DDB depreciation?
a. DDB will result in a higher net income figure in the first year than will SL.
b. Depreciation expense in the second year will be higher under SL than under DDB.
c. Net income in the fifth year will be higher under SL than DDB.
d. Depreciation expense will be lower in the sixth year under DDB than SL.

8. Straight-line depreciation is most appropriate for an asset


a. whose depreciation is based on use rather than on the passage of time.
b. whose benefits diminish on a fairly uniform basis.
c. that produces greater benefits in its earlier years.
d. that produces greater benefits in its later years.

9. When an asset is sold, a gain occurs when the


a. sales price exceeds the carrying value of the asset sold.
b. sales price is less than the carrying value of the asset sold .
c. carrying value exceeds the sales price of the asset sold.
d. sales price exceeds the depreciable cost of the asset sold.

III. QUESTIONS/PROBLEMS

1. Why must the cost of long-term assets be allocated to futures accounting period? What are some
of the problems with this allocation process?

2. Explain the meaning of capital expenditures. How does it differ from revenue expenditures?
From an accounting perspective, describe the consequences of recording a capital expenditure as
a revenue expenditure.

3. Explain the accountant's concept of depreciation. Is depreciation a cost allocation or asset


valuation process?

4. Briefly describe the accounting procedures for the sale or retirement of plant assets. How is the
gain or loss on the sale or retirement of plant assets determined?
5. The Empire Corporation purchased a new machine at a cost of $11,000 on January 1, 20X1. The
expected useful life of the new machine is 5 years and a salvage value of $1,000. If the useful life
was measured in units, it is expected that a total of 50,000 units will be produced by the machine
over its life. Empire has an accounting year ending December 31. Complete the following table
assuming the machine produced a total of 15,000 units in year 20X1, 22,000 units in year 20X2,
and 13,000 units in year 20X3.

Depreciation Depreciation Expense


Method
Year 1 (20X1) Year 2 (20X2) Year 3 (20X3)

Straight-line
Units-of-activity
Double-declining-balance

Assume Empire sells the machine on April 1, 20X4 for $4,200. Prepare the journal entry(ies)
necessary to record any depreciation up to the date of the sale (assuming Empire uses the straight-
line method of the depreciation) and to record the sale of the machine.

6. A truck that cost $10,000 and on which $7,500 of accumulated depreciation had been recorded
was disposed of on July 1, the first day of the new fiscal year. Prepare the general journal entry
to record the disposal under each of the following assumptions:
a. It was discarded as having no value.
b. It was sold for $1,800 cash.
c. It was sold for $2,900 cash.
ANSWERS

I. VOCABULARY

1. revenue 5. declining-balance
2. capital 6. straight-line
3. Depreciation 7. residual value
4. depletion...amortization

II. MULTIPLE CHOICE

1. a 6. c
2. c 7. d
3. b 8. b
4. a 9. a
5. a
III. QUESTIONS/PROBLEMS

1. The cost of long-term assets must be allocated to future accounting periods because the firm
receives benefits in the future and the matching convention requires that allocations be made so
as to match the expired benefits with the resources they have helped to produce.

Problems inherent in the allocation process are distinguishing between a capital expenditures and
a revenue expenditure, measuring and recording the acquisition cost, estimating the useful life of
an asset, and estimating the value of the asset at the end of its useful life.

2. Capital expenditures are expenditures that produce an asset whose economic life extends beyond
the current period. Revenue expenditures are expenditures for services or assets whose economic
utility is completely consumed within the current period. IF a capital expenditure is classified in
error as a revenue expenditure, that period's expenses would be overstated and net income,
retained earnings, and total assets would be understated. In future periods expenses would be
understated and net income would be overstated.

3. Accountants view depreciation as an allocation of cost to the periods in which the enterprise
received benefits from the assets. Depreciation is the process that the cost of the asset is
gradually allocated to expense over the useful life of the asset. Depreciation is NOT done to
report the asset at its current market value. Asset impairment computations are reviewed annually
to adjust an assets value when the present value of the asset’s market value is lower than its
carrying value.

4. To record the sale or retirement of an asset, the asset account and the Accumulated Depreciation
account that relates to that asset are removed from (taken off) of the accounting records. Assets
received when the old asset is retired or sold are recognized and the appropriate gain or loss from
the sale or retirement should be recognized. The gain or loss on the disposal of the asset is
computed as the difference between the net proceeds from the sale or retirement and the book
value of the asset at the time of the sale or retirement. If the net proceeds exceed the book value,
a gain is recorded. If the book value exceeds the net proceeds, a loss is recorded.

5.

Depreciation Depreciation Expense


Method
Year 1 (20X1) Year 2 (20X2) Year 3 (20X3)

Straight-line $2,000 $2,000 $2,000


Units-of-activity $3,000 $4,400 $2,600
Double-declining-balance $4,400 $2,640 $1,584
Straight-line: ($11,000 - $1,000)/5 = $2,000 per year
Units-of-activity: ($11,000 - $1,000)/50,000 = $.20 per unit
Year 1 $.20 * 15,000 units = $3,000
Year 2 $.20 * 22,000 units = $4,400
Year 3 $.20 * 13,000 units = $2,600
Declining Balance: Declining balance rate = 2 * (1/5) = .4 or 40%
Year 1 .4 ($11,000 - 0) = $4,400
Year 2 .4 ($11,000 - $4,400) = $2,640
Year 3 .4 ($11,000 - $7,040) = $1,584
Entries to record deprecation and the sale of the asset in 20X4:
4/1 Depreciation Expense $ 500
Accum. Depreciation $ 500
4/1 Cash $ 4,200
Accum. Depreciation 6,500
Loss on Sale 350
Machine $ 11,000

6. Entries to record the sale/exchanges

a. Accum. Depreciation $ 7,500


Loss on Disposal 2,500
Truck $ 10,000
b. Cash $ 1,800
Accum. Depreciation 7,500
Loss on Disposal 700
Truck $ 10,000
c. Cash $ 2,900
Accum. Depreciation 7,500
Gain on Disposal 400
Truck $ 10,000