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Accounting 311

Unit 1
Chapter 11

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THE CONCEPTUAL FRAMEWORK


CONNECTION
Property, Plant, and Equipment

Capitalization is the process of recording an


expenditure asMeasurement
an asset.
A capital expenditure is a cost recorded by a
company as an asset rather than an expense.

In the U.S. GAAP Conceptual Framework, the


definition of an asset includes three essential
characteristics:
1. It represents probable future economic benefits.
2. The firm can obtain the benefit of the asset and can
also control others access to it.
3. The transaction or other event giving rise to the
entitys right to the benefit or control of the benefit
has already occurred.
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THE CONCEPTUAL FRAMEWORK


CONNECTION
Property, Plant, and Equipment

Firms require reliable measurement methods to


Measurement
record a cost as an asset.
Firms must differentiate between costs with
probable future economic benefits and costs
that have expired without the ability to generate
revenue in subsequent accounting periods.
Firms must also consider the cost-benefit
tradeoff and materiality when measuring PPE.
Firms may prefer to capitalize expenditures
whenever possible in order to avoid the larger
decrease in earnings from an expense in the
first year.
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Subsequent Measurement of
Property, Plant, and Equipment

New machinery must be maintained,


depreciated over time, or impaired if its
value falls.
Events and transactions affect long-term
fixed assets after acquisition, including:
Subsequent expenditures
Depreciation
Impairments

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Subsequent Expenditures

The decision to capitalize or expense


expenditures made after acquisition of a fixed
asset depends on the definition of an asset.
Firms expense noncapital expenditures
immediately, such as ordinary repairs, which are
expenditures to maintain the operating efficiency
of an asset that do not extend its original useful
life.
If an expenditure provides future economic
benefit and, therefore, qualifies as an asset, the
firm capitalizes the cost by adding the cost of the
expenditure to the carrying value of the long-term
fixed asset.
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Example
Subsequent Expenditures
11.11

PROBLEM: Cunningham Bakeries needs new racks


and a refrigeration unit in its existing delivery van
to begin delivering ice cream cakes. It paid the total
cost of the asset modification, $15,000, in cash. In
addition, Cunningham took its delivery van in for
service and paid $60 cash for an oil change and tire
rotation. What journal entries are needed to record
these two transactions?
SOLUTION: Because the $15,000 expenditure
increased delivery capacity and productivity and
thus changed the assets revenue-generating
ability, Cunningham will consider it a capital
expenditure. The journal entry to record the capital
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expenditure is:
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Example
Subsequent Expenditures
11.11

The cost of the oil change and tire rotation is not a


capital expenditure, so Cunningham will expense
the $60 immediately. The journal entry to record the
event is:

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Depreciation of Tangible Fixed


Assets
Depreciation is the systematic and
rational allocation of the cost of a longterm plant asset to expense over the
assets expected useful life.
As the asset is depreciated, the firm
reports depreciation expense on the
income statement and reduces the
carrying value of the asset on the balance
sheet.

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THE CONCEPTUAL FRAMEWORK


CONNECTION
The Cost-Allocation Process

Depreciation is a process of allocating costs to the


periods in which the benefits are consumed.
Depreciation is therefore consistent with the
conceptual frameworks guidance for expense
recognition.
The loss of asset value through utilization toward
revenue generation meets the definition of an
expense.
Similarly, as firms use tangible fixed assets, the
future economic benefits they provide to the
company generally decline.
It would not be appropriate to allocate the cost of
land over time through depreciation because land is
not consumed in operations.
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Overview of the Depreciation Process


for Property, Plant, and Equipment

Allocating the cost of a fixed asset through


depreciation requires that management estimate
the assets useful life and its scrap value and
choose the depreciation method.
1. Estimate Useful Life: Management must consider
several factors, such as prior experience, relevant
industry practice, maintenance policy, usage, and
obsolescence. Useful life varies by type of asset.
2. Estimate Scrap Value: The scrap value (also
referred to as residual or salvage value) is the
amount the firm expects to realize on disposal of the
fixed asset at the end of its productive service to the
firm. Scrap value reduces the depreciable base and
minimizes any gain or loss on disposal.
3. Select Depreciation Method: Management selects
a depreciation method with the goal of reflecting a 11-10
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Depreciation Guidelines

Depreciation expense is an end-of-period


adjustment included on the income statement in
the computation of operating income.
It is generally reported as part of selling, general,
and administrative expenses, unless it is part of
product costs and then is included in inventory
value.
On the balance sheet, firms reduce the tangible
fixed asset by increasing accumulated
depreciation.
Firms subtract accumulated depreciation from the
original cost of the fixed asset and report net
book value (NBV), also referred to as net fixed
assets (NFA), in the noncurrent asset section of
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the balance sheet.
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Depreciation Guidelines

The t-accounts below illustrate the changes in the


assets cost and accumulated depreciation
accounts.

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Depreciation Methods

U.S. GAAP states that the method of


depreciation should result in a systematic
allocation of the cost of the asset.
The following are examples of depreciation
methods used by the vast majority of firms:
1.Straight-line method
2.Accelerated Methods:
a. Sum of the Years Digits
b. Declining balance
3. Units of Output (or Production)
In recent years, U.S. firms depreciated more
than 90% of tangible fixed assets using the
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straight-line method.
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Depreciation Methods

Straight-Line Method (SL): The straight-line


method applies a constant rate of depreciation
against a constant depreciable cost.

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Example
11.12

Straight-Line
Depreciation

PROBLEM: On January 1, Naylor Company acquired


a piece of heavy equipment at a total cost of
$670,000. The firm estimates that the asset will
have a useful life of five years and expects a
$70,000 scrap value at the end of its useful life.
Compute the annual depreciation for Naylor over
the life of the asset and prepare the journal entry
that Naylor will record each year.

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Example
11.12

Straight-Line
Depreciation

SOLUTION: Using the data provided, Naylor


Companys straight-line depreciation is as follows:

The journal entry at the end of the first year is:

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Units-of-Output (Prod.)
Method

The units-of-output (production) method


derives a rate of depreciation per unit produced and
applies that rate against the actual number of units
produced each period.

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Example
11.13

Units-of-Output (Prod)
Depreciation

PROBLEM: On January 1, Naylor Company acquired


a piece of heavy equipment at a total cost of
$670,000. The firm estimates that the asset will
have a useful life of 100,000 units of output and
expects a $70,000 residual value at the end of its
useful life. The company manufactures 30,000,
45,000 and 25,000 units in the first, second, and
third year of use, respectively. Compute the annual
depreciation for Naylor over the life of the asset
under the units-of-output method.
SOLUTION: The depreciation rate per unit of output
is $6 per unit as computed below:
Depreciable Base/Estimated Total Units of Output =
$600,000/100,000 = $6 per unit.
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Example
11.13

Units-of-Output (Prod)
Depreciation

The depreciation schedule is as follows:

The journal entry at the end of the first year is:

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Accelerated Methods

Decreasing-charge methods are depreciation


methods that take more depreciation in the early
years than in the late years of the assets useful
life.
An asset is often most productive in its early
years of service.
Decreasing-charge methods match higher
depreciation expense with higher related
revenues in the early years of the assets life and
match lower depreciation charges against lower
related revenues in the later years.
Accelerated depreciation generally results in
constant total annual usage costs (depreciation
expense and repair and maintenance expense)
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charged against income over the life of the asset.
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Accelerated Methods

Sum of the Years Digits method adds the


numerals for the years of service (a 5 year life
would equal 15 (1+2+3+4+5)) and uses that as a
denominator. Each year is then a numerator (1/5,
2/5 and so forth). That fraction is then applied to
the depreciable base.
Declining Balance methods apply a constant
fraction (or percentage) to a decreasing book
value of the asset. The fraction is derived as a
multiple of the straight line fraction. (So, a 5 year
live for SL is 1/5 or 20%. For declining methods,
this would be multiplied by a factor (2 for Double
Declining Balance, increasing the factor to 2/5 or
40%).
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Double-Declining Balance
Method

The double-declining balance method (DDB) is a


decreasing-charge method that applies a constant rate of
depreciation against a declining net book value (defined as
cost less accumulated depreciation).
The constant rate used in declining balance methods is a
multiple of the straight-line rate.
Note that the assets net book value is the depreciable base
for DDB and not the cost less scrap value.
The firm reduces the depreciation expense in the last year
to the necessary amount to arrive at an ending book value
equal to the scrap value.

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Example Double-Declining Balance


Depreciation
11.14

PROBLEM: On January 1, Naylor Company acquired


a piece of heavy equipment at a total cost of
$670,000. The firm estimates that the asset will
have a useful life of five years and expects a
$70,000 residual value at the end of its useful life.
Prepare the depreciation schedule for Naylor over
the life of the asset under the double-declining
balance method.
SOLUTION: The double-declining balance rate is as
follows: Straight-line Rate = 1/Useful Life = 1/5
Years = 20% DDB Rate = 2 20% = 40%

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Example Double-Declining Balance


Depreciation
11.14

At the end of year 5, the equipments net book


value is $70,000, its residual value.
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Partial-Year Depreciation

Firms purchase PPE throughout the year.


Firms employ a large variety of methods to
compute partial-year depreciation that assume
the firm purchased the asset at certain fixed
points during the year.
With a half-year convention, the firm records a
half year of depreciation for an asset acquired
during the year of purchase (the assumption is
that the firm acquired the asset at the midpoint of
the year).
The company also records a half-years
depreciation in the final year of the assets life.
Other approaches assume that the firm acquired
the asset at the beginning or the middle of the
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month it was placed in service.
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Example Partial-Year Depreciation:


Straight-Line Method
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PROBLEM: On May 8 the Naylor Company (a


calendar-year firm) acquired a piece of heavy
equipment at a total cost of $670,000. Naylor
estimates that the asset has a useful life of five
years. Naylor expects a $70,000 scrap value at the
end of its useful life. The company uses a
simplifying assumption that all assets are placed in
service on the first day of the month in which they
were actually placed into service. What is the
depreciation expense in the first year using the
straight-line method? What is the depreciation
schedule using the straight-line method?
SOLUTION: Under Naylors simplifying assumption,
we account for the asset as if it was acquired on 11-26
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Example Partial-Year Depreciation:


Straight-Line Method
11.15

Second, we develop the depreciation schedule


using the straight-line method, applying the partialperiod assumption in the first and last year of the
assets useful life. Thus, in the first year,
depreciation expense is the full-year amount times
8/12, because we are assuming that Naylor holds
the asset for eight months in the first year. So, the
first years depreciation expense is $80,000.
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Example Partial-Year Depreciation:


Straight-Line Method
11.15

In the last year, depreciation expense is the fullyear amount times 4/12, because we are assuming
that Naylor holds the asset for four months in the
last year. In the last year, depreciation expense is
$40,000. The depreciation schedule is shown below:

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Example
11.16

Partial-Year Depreciation:
Double-Declining Balance
Method

PROBLEM: On May 8 the Naylor Company (a


calendar-year firm) acquires a piece of heavy
equipment at a total cost of $670,000. Naylor
estimates that the asset has a useful life of five
years. Naylor expects a $70,000 scrap value at the
end of its useful life. The company uses a
simplifying assumption that all assets are placed in
service on the first day of the month in which they
were actually placed into service. What is the
depreciation schedule using the double-declining
balance method?

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Example
11.16

Partial-Year Depreciation:
Double-Declining Balance
Method

SOLUTION: Under Naylors simplifying assumption,


we account for the asset as if it was acquired on
May 1. So, we allocate 8/12 of the full first-year DDB
depreciation expense to the first year. The table
below shows that the first years depreciation
expense is $178,667. We then use the 40% rate for
the following years. Depreciation expense in year 5
is reduced in order to bring the end-of-year net book
value to $70,000, the original estimated scrap
value.

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IFRS
Component Depreciation
IFRS requires that firms separately depreciate
each part or component of a fixed asset that is
significant in relation to the assets total cost.
For example, the purchase of a building would
involve a number of different components, such
as the foundation and frame, heating and air
conditioning systems, and other non-weightbearing parts.
U.S. GAAP allows the components-based
approach but does not require it.
Most firms that report under U.S. GAAP do not
separate their depreciable assets into
components.
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Example
11.17

IFRS Component
Depreciation Expense

PROBLEM: FastAir Corporation, an IFRS reporter,


identified three major components of its new
airplane purchased on January 1 for $10,000,000. It
allocates $5,000,000 of the cost to the airframe,
$4,000,000 to engines, and $1,000,000 to the
interior. The airframe has a useful life of 20 years
and $500,000 salvage value. The engines have a
16-year useful life and $200,000 salvage value. The
interior has a 5-year useful life and no salvage
value. FastAir uses the straight-line method for all
components. What is the annual depreciation
expense for the first year?
SOLUTION: Annual depreciation expense is
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$662,500. For each component, we calculate annual
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Example
11.17

IFRS Component
Depreciation Expense

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Disclosures of Property, Plant, and


Equipment

Companies commonly report the carrying value of


property, plant, and equipment in total or by
major class of long-term assets on the balance
sheet.
Companies must disclose:
The balances of depreciable assets by major
classes at the end of the fiscal year, either on the
face of the financial statements or in the footnotes.
The accumulated depreciation on property, plant,
and equipment at the end of the fiscal year by
major class or in total.
A general description of the method or methods
used in computing depreciation with respect to
major classes of depreciable assets.
The amount of depreciation expense for the period.
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Disclosures of Property, Plant, and


Equipment

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IFRS
Disclosures
IFRS disclosure requirements are more
comprehensive than U.S. GAAP.
For each class of property, plant, and
equipment, a company must disclose the
historical cost and its accumulated depreciation
at the beginning and the end of the period.
The company is required to provide a
reconciliation of the carrying amount at the
beginning of the period to the end of the period.
Companies must also disclose the depreciation
method and useful lives (or equivalently the
depreciation rate).
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Intangible Assets:
Characteristics and Types

The second major long-term operating asset class


is intangible assets.
Intangible assets are assets without physical
substance that have economic value because of
the contractual or legal rights they confer upon
the holder.
There are two general classes of intangible
assets:
Finite-life (also referred to as definite-life)
intangible assets.
Indefinite-life intangible assets.

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Finite-Life Intangible Assets

Finite-life intangible assets are intangible assets


that can be individually identified and have limited
useful lives.
Finite-life intangible assets are subject to
amortization.
Patents grant the holder an exclusive right to
use a formula, product, or process for a fixed
period of time, usually 20 years.
A copyright is an exclusive right to reproduce
and sell an original work for the creators life plus
70 years.
A leasehold is the right to use a specific piece of
property for a fixed period of time in exchange for
a certain payment.
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Leasehold improvements are permanent
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Finite-Life Intangible Assets

A customer list consists of information about


customers, such as their names and contact
information.
May be in the form of a database that includes other
information about the customers.
Because customer lists can be difficult to value reliably,
some companies choose not to record them as assets.

A franchise represents the right or privilege to


sell a product or deliver a service of another
entity, such as a business or government.
The owner of the product or service (the franchisor)
enters into a contractual relationship that gives the
franchisee the right to conduct business under the
franchisors name in exchange for a fee.
The contractual relationship can be limited by time or
may be continually renewable.
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Indefinite-Life Intangible Assets


Other than Goodwill

An indefinite-life intangible asset has no


identifiable legal, regulatory, contractual, or
competitive factors that limit the assets revenuegenerating term.
Indefinite-life intangible assets are not subject to
amortization.
Renewable licenses and permits are subject
to renewal on a regular basis, and renewal is
reasonably certain.
A trademark or trade name represents the
firms product or service; the firm has the legal
right to protect the trademark and trade name
from any unauthorized use by outside parties.
The federal government grants a registered trademark
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for 10 years with an indefinite number of future 10-year
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Goodwill

Goodwill is an intangible asset created by


factors that are typically difficult to identify and
measure.
Examples: Product quality, reputation, ability to
generate earnings above the industry average, quality of
management, preferred physical location, or employee
training programs

Firms may only record goodwill as an asset when


a firm is acquired.
Goodwill is the premium paid at acquisition
when one firm buys another firm and the
purchase price is higher than the fair value of the
acquired net assets.
Goodwill has an indefinite life and is not subject
to amortization.
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Initial Measurement of Intangible


Assets
The initial measurement of intangible
assets differs according to the method by
which they are acquired.
To determine whether expenditures
incurred to generate an intangible asset
qualify for asset recognition, firms:
1. Assess if there is an identifiable asset
that will generate probable future
economic benefits.
2. Determine if they can reliably measure
that assets value.
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THE CONCEPTUAL FRAMEWORK


CONNECTION
Intangible Asset Measurement

The most important concept underlying the


initial valuation of an intangible asset is whether
the firm can reliably measure its value.
If measurements of internal expenditures are
not faithful representations, an asset is not
recorded.
Firms must differentiate between costs with
probable future economic benefits and costs
that have expired without the ability to generate
revenue in subsequent accounting periods.
Expenditures, such as advertising or research,
may have future economic benefits that are too
uncertain to capitalize.
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Internally Generated
Intangibles

Companies expense most expenditures for


internally generated intangibles due to the
uncertainty of future benefits.
Firms can recognize some direct costs,
including legal fees, as the intangible
asset.
The company can capitalize legal fees
from successfully defending a patent
because the patent will generate
probable future economic benefits.
If the patent is not successfully
defended, no asset is recorded.
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Intangibles Acquired Individually or


with a Group of Assets

Companies can purchase intangible assets


from an outside party, either individually
or as a group of assets.
The firm recognizes acquired intangibles
as assets because they will likely generate
future economic benefits and their values
are reliably measureable at cost.
When a company purchases a group of
intangible assets in a basket purchase, it
allocates the cost to the individual assets
based on their relative fair values.
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Intangibles Acquired in a Business


Acquisition

When a company purchases another


company, it measures all assets and
liabilities acquired, including any
intangible assets, at fair value.
Accountants report these intangible assets
at fair value on the consolidated balance
sheet because they were acquired and
measured in an objective transaction.

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Goodwill

Firms generally compute goodwill as a


residualspecifically, the acquisition cost
of a business in excess of the fair values
of the identifiable net assets acquired
(including identifiable intangible assets):
Acquisition Cost
Less: Fair Value of Identifiable Net Assets
Equals: Goodwill

The acquiring company records goodwill


and all other assets and liabilities
acquired at their fair values.
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Subsequent Measurement and


Derecognition of Intangible Assets

The majority of subsequent expenditures


related to an intangible asset maintain the
existing future economic benefits, as
opposed to enhancing future economic
benefits, and are expensed as incurred.
Amortization is the systematic and rational
allocation of the cost of a finite-life intangible
asset to expense over the assets expected
useful life or legal life, whichever is shorter.
Firms report amortization expense on the
income statement and reduce the carrying
value of the finite-life intangible asset on the
balance sheet.
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THE CONCEPTUAL FRAMEWORK


CONNECTION
The Cost-Allocation Process

The conceptual framework treats the principles of


cost allocation of finite-life intangible assets and
tangible fixed assets in the same way.
Finite-life intangible assets consumed in the
revenue-generating process over their useful lives
meet the definition of an expense.
As the firm uses these assets, their future
economic benefits decline.
The asset carrying amount is reduced to reflect this
decline in value and provides an accurate report of
total assets on the balance sheet.
Firms do not depreciate land because it has an
unlimited life. Similarly, goodwill and other indefinitelife intangibles are not subject to amortization.
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Amortization Method

Only finite-life intangible assets are subject to


amortization: Firms do not amortize goodwill and
other indefinite-life intangible assets.
Firms may include estimated residual values in
the computations, although they are rarely used
in practice.
The period of amortization should be either the
useful life or legal life, whichever is shorter.
The method of amortization should reflect the
pattern in which the firm utilizes the assets
economic benefits.
If the firm cannot reasonably estimate a
revenue stream, it should use the straight-line
method.
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Example
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Amortization of Finitelife Intangible Assets

PROBLEM: JJ Inc. currently leases an office


building. It initiated the original 20-year lease
15_years ago, so five years remain on the lease. On
January 1, JJ paid $20,000 to install a new heating
and cooling system with a 10-year estimated useful
life that it expects to use ratably over the remaining
term of the lease. What is the journal entry to
record the expenditure? How much amortization will
JJ report and for how many years? What is the
journal entry for the first year?
SOLUTION: The $20,000 expenditure is for a
leasehold improvement, a finite-life intangible
asset. The journal entry to record the expenditure
made in the current period is presented on the 11-51
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Example
11.23

Amortization of Finitelife Intangible Assets

We compute the amortization on a straight-line


basis because JJ expects the usage of the system to
occur ratably. The useful life is five years, the
remaining life of the lease. Thus, amortization each
year is $4,000 (i.e., $20,000/5 years). The journal
entry made at the end of the current period is as
follows:

Note that the credit in this journal entry is made to


the finite-life intangible asset directly. Alternatively,
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Derecognition of Intangible
Assets

Firms remove intangible assets from their


books upon disposal or when they expect
no further economic benefits from the use
of the asset.
If the firm sells the intangible asset, it
recognizes a gain or loss on the income
statement, measured as the difference
between the sales proceeds and the
carrying value of the asset.

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Disclosures of Intangible Assets

U.S. GAAP requires significant disclosures


for intangible assets by major class of
intangibles, such as brand names, licenses
and franchises, copyrights, patents, and
development costs. These disclosures
include:
Whether the assets have an indefinite or
finite useful life.
If the asset has a finite useful life, the
useful life or the amortization rates used.
The amortization methods used for
intangible assets with finite useful lives. 11-54
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Disclosures of Intangible Assets

Required intangible asset disclosures


continued:
The gross carrying amount and any
accumulated amortization at the
beginning and end of the period.
The aggregate amortization expense for
the current period as well as the
estimated aggregate amortization
expense for each of the next five years.
Any goodwill and the changes in the
carrying amount of the goodwill, including
goodwill acquired, goodwill impaired, and11-55
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Disclosures of Intangible Assets

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Disclosures of Intangible Assets

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IFRS
Intangible Asset Disclosure
IFRS requires that a company disclose significant
classes of intangible assets.
Firms must distinguish between internally generated
intangible assets and other intangible assets,
including the historical cost and accumulated
amortization at the beginning and the end of the
period.
The company must provide a reconciliation of the
carrying amount at the beginning of the period to
the end of the period.
For each class, the company should also identify
whether the useful lives are indefinite or finite and,
if finite, the useful lives and amortization methods
used.
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