CHAPTER 10
Plant Assets and Intangible Assets
Chapter Overview
This chapter begins by explaining which assets are included in the categories of plant assets and intangible assets. Students learn how to determine the cost of various plant assets and how to capitalize interest on constructed assets. The relative-sales-value method is used to divide a lump-sum purchase of assets into component parts (land, building, and so on) in order to identify the cost of each asset. Capital expenditures are compared to ordinary repairs.
A detailed discussion of depreciation begins by explaining that depreciation is a method of matching expenses against revenue and not a valuation process nor a fund of cash for replacing assets. Estimated useful life and residual value are explained. Acceptable depreciation methods are presented, including straight-line, units-of-production, and double-declining balance. The methods are illustrated and compared, showing that an equal amount of depreciation is taken over the total useful life of the asset. A mid-chapter summary problem allows the student to practice using the different depreciation methods.
A discussion of depreciation and income taxes follows, explaining how the accelerated method has a cash-flow advantage over the straight-line method. Partial-year depreciation and changing the useful life of an asset are illustrated. Next, students learn about the gain or loss on disposal of plant assets that are junked, sold, or traded in. Disposal of plant assets is illustrated, including junked assets, selling assets and exchanging plant assets.
The chapter continues with coverage of depletion of natural resources and amortization, the write-off of intangible assets. Special issues related to plant assets, international accounting for goodwill and research and development costs are discussed, and followed by ethical issues in accounting for plant assets. Decision guidelines related to plant assets and related expenses, and a final summary problem covering tax considerations in depreciation, partial-year calculations, and sale of plant assets, conclude the chapter.
Learning Objectives
After studying Chapter 10, your students should be able to:
1. Measure the cost of a plant asset
Chapter Outline
Objective 1: Measure the cost of a plant asset
1. The cost of the asset includes all amounts paid to acquire the asset and prepare it for its intended use in the business, including purchase price (net of all discounts), taxes, fees, installation cost, and so on.
2. Types of tangible assets and related costs include:
a. Land and land improvements –
(1) Land cost includes its purchase price, brokerage commission, survey and legal fees, back property taxes, and the cost of clearing the land and removing unwanted buildings. Land is not depreciated.
(2) Land improvements include fencing, paving, sprinkler systems, and lighting. Land improvements are depreciated.
b. Buildings – cost includes architectural fees, building permits, contractors’ charges, and cost of material, labor and overhead for constructed buildings. Buildings are subject to depreciation.
c. Machinery and equipment – cost includes purchase price less discounts, plus transportation charges, insurance while in transit, sales tax, purchase commissions, installation costs, and cost to test the machine before use. Machinery and equipment are subject to depreciation.
d. Leasehold improvements – cost includes alterations to assets the company is leasing. Leasehold improvements are amortized (depreciated) over the term of the lease.
e. Construction in progress and capital leases
(1) For constructed buildings: Costs related to self-constructed assets are recorded in the asset account, Construction in Progress, before they are placed in service or during construction.
(2) A capital lease is an arrangement similar to an installment purchase of the leased asset. The asset being leased is reported as an asset on the balance sheet of the party using the asset. An operating lease differs in that it is an ordinary rental arrangement with lease payments that are expensed.
(3) Interest costs during construction should be capitalized (added to the asset’s cost), rather than being expensed during the current period. During construction, both building costs and capitalized interest are debited to the Building account.
3. For a lump-sum (or basket) purchase of several assets, the relative-sales-value method is used to allocate that cost among the various assets acquired. The allocation is based on the assets’ appraised or market values.
C. Expenditures relating to an asset can be classified as either capital expenditures or ordinary repairs. Refer to Exhibit 10-3 for a comparison.
1. A capital expenditure is one made to increase the capacity or efficiency of an asset or to extend its useful life. Examples are: the cost of a new engine that is put into a truck or a major overhaul.
a. Repair work that generates a major repair is an extraordinary repair.
b. Record this type of expenditure with a debit to the asset account.
2. An ordinary repair maintains the asset or restores it to good working order. This type of repair does not extend the useful life of the asset. Examples are: the cost of new tires for the truck or the cost of replacing a dead battery on the truck. Debit an expense account, such as Repair and Maintenance Expense.
3. It is important to record capital expenditures and ordinary repair and maintenance expenses correctly, as an error in recording causes errors on both the income statement and the balance sheet.
D. Depreciation is the process of allocating a plant asset’s cost to expense over the asset’s useful life. Depreciation is based on the matching principle. It matches the cost of an asset with the revenue generated by the use of that asset. (Refer to Exhibit 10-4.)
1. Depreciation is not a process of valuation of the plant asset. It is based on historical cost, not on current appraisal values.
2. Depreciation does not represent a fund of cash set aside to replace worn or obsolete assets.
3. Accumulated Depreciation, a contra-asset account, equals the portion of the asset’s cost that has already been depreciated (or expensed).
4. The causes of depreciation include physical wear and tear and obsolescence.
5. The asset’s cost (covered previously), estimated useful life, and estimated residual value must all be known in order to measure depreciation.
a. The useful life is an estimate of how many years the asset will be useful to the business, not an estimate of its actual physical life. Useful life may be limited by wear and tear or by obsolescence.
b. Residual value (salvage or scrap value) is the estimated expected cash value at the end of the asset’s useful life.
c. Cost minus residual value = depreciable cost.
Objective 2: Account for depreciation
A. Three basic methods are used for computing depreciation—straight-line, units-of-production, and double-declining-balance. (Exhibit 10-5 presents data used to illustrate the three methods.)
Cost - Residual value = Annual depreciation expense
Useful life in years
Cost - Res idual value = Depreciation expense/unit
Useful life in units
and, Depr./unit x Units of output = Annual depreciation expense
(current year) (current year)
Twice the straight-line rate x Book value = Annual depreciation expense
(DDB rate) at beg. of year
b. Book value (cost minus accumulated depreciation) declines each year.
c. Residual value is not considered until near the last year of useful life.
(1) When book value approaches residual value, depreciation expense for that year is the amount required to bring remaining book value to salvage value.
(2) This adjustment usually occurs in the last year of the asset’s useful life, but may occur before then.
B. Regardless of the method used, the same total amount of depreciation will be recorded over the useful life of the asset.
1. The three methods merely cause timing differences in recording annual depreciation expense. All are acceptable under GAAP. Exhibit 10-9 graphs depreciation patterns through time for the three methods.