Plant Assets, Natural Resources, and Intangible Assets
For most companies plant assets (also called fixed assets or long lived assets) are extremely important as they constitute a large percentage of total assets on the balance sheet and the related expenses of depreciation and amortization amount to a substantial expense on the income statement.
The general model for accounting for fixed assets is as follow:
The acquisition cost of fixed assets includes all expenditures reasonable and necessary to get the asset in place and ready for use. See Text Pages 427-429.
Note that land and building are often purchased for a single lump sum. Since land has an unlimited life and therefore is not depreciated, the accountant must allocate the purchase price between land and building.
Depreciation expense can be defined as the allocation of the cost of an asset over its useful life. In order the properly measure depreciation expense, the accountant needs to know the cost of the asset, and estimate its life and its residual (salvage) value. The adjusting entry to record depreciation takes the following form:
Accumulated depreciation is a contra account (its matching pair is the asset account). The use of a contra account allows the original cost to remain unchanged on the balance sheet.
GAAP provides for several acceptable methods of depreciation. In this course, we will study three methods: straight line, units of activity, and double declining balance.
Straight line depreciation = (Cost – Residual Value)/Life
SL Depreciation allocates an equal amount of expense each year. It can be expressed in dollar of percentage terms. Study the example on Pages 432-3.
The units of activity method of depreciation involves a two step process:
1. Calculate the UOP Rate which =
(Cost – Residual Value)/Life in Units
Study the example on Pages 433-4.
The double declining balance method provides for large write-offs in early years of an asset’s life and smaller write-offs in later years. Thus it is termed an accelerated method. Double declining balance is calculated as twice the straight line rate and involves a three step process:
1. Double Declining Balance Rate = (1/Useful Life) * 2
2. Asset beginning book value * DDB Rate (computed in Step 1 above)
3. In final year depreciate only down to residual value
Asset book value (declining book value) is cost minus accumulated depreciation. Note that with the DDB method, residual value is ignored in the first year’s depreciation computation. It is considered in the last year, however, as residual value should not be depreciated. See the DDB example on Pages 434-5.
Please study the comparison of straight line, units of production, and DDB depreciation calculations on Page 436. If you were trying to minimize income tax expense, which method would you select?
Since assets are typically not purchased on the first day of the year it is necessary to calculate partial year depreciation as follows:
1. Calculate depreciation expense for a full year
2. Multiply full year depreciation by the fraction of the year the asset was in use.
Since the asset’s life is an estimate made at the time of purchase, it may be necessary to change this life in later years based on experience or new information. The authors discuss this subject on Pages 436-7 and provide an example of how to account for a change in the life of an asset.
The difference between a revenue expenditure and a capital expenditure is discussed on Page 438. Revenue expenditures are those incurred for normal wear and tear expenses and are debited to expense accounts. Capital expenditures, on the other hand, are those costs which improve an asset or extend its life and are usually debited to the asset account.
At some point fixed assets are no longer useful and are either discarded, sold, or traded in (exchanged) for another asset. Regardless of the disposition of the asset, the old asset account must be credited and the old accumulated depreciation account must be debited as all accounts relating to the old asset must be removed from the books and records.
The accounting for retiring an asset is discussed on Page 439. If the asset is fully depreciated, accumulated depreciated is debited and the asset account is credited thus removing it from the books and records.
Accounting for sales of a plant asset is discussed on Pages 439-41. Note that if the asset is sold mid-year the depreciation account must be updated. Also note that if the sales price is greater than book value, a gain is realized. Similarly if the sales price is less than book value, a loss is realized.
The accounting for natural resources is discussed on Pages 442. The related expense account is called depletion and the depletion expense is calculated similar to computing units of production depreciation. The journal entry takes the following form:
Accumulated Depletion is a contra asset account whose matching pair is the natural resource asset account.
Accounting for intangible assets is discussed on Pages 443-446. The related expense for intangible assets is called Amortization and it is ordinarily computed by the straight-line method. The journal entry takes the following form:
Note that this entry results in directly crediting the intangible asset thus reducing its basis.
There is a brief discussion of Goodwill on Pages 445-6. Goodwill is recorded only when it is purchased. Goodwill is calculated as the excess of purchase price over the market values of the individual net assets (assets minus liabilities). Goodwill is recorded as an asset and is not amortized. The FASB (SFAS 142) requires that goodwill be evaluated annually to see if it has increased or decreased in value. If it has decreased (usually the case) it must be written down by debiting a loss account and crediting Goodwill.
Exchanges (trade-ins) are discussed in the Chapter 10 Appendix, Pages 452-3. As the authors state, ordinarily companies record a gain or loss on the exchange of plant assets. This is because most exchanges have commercial substance (the future cash flows change as a result of the exchange). The authors provide an example of an exchange which results in a loss and an exchange which results in a gain. Please study these examples carefully.