Principles of financial accounting 12e by needles crosson chapter 10

CHAPTER

10

Long-Term Assets

Principles of
Accounting
12e
Needles
Powers
Crosson
©human/iStockphoto


Concepts Underlying Long-Term Assets
 Lo ng -te rm as s e ts have the following
characteristics:
– They have a useful life of more than one year.
– They are used in the operation of a business.
– They are not intended for resale to customers.

 Under accrual accounting, the cost of these
assets, with the exception of land and some
intangible assets, is allocated to the periods
they benefit.

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Valuation and Disclosure of Long-Term Assets

 Long-term assets are generally reported and
valued at carrying value.
– Carrying value (or book value ) is the unexpired
part of an asset’s cost.
– As s e t impairme nt occurs when the carrying
value of a long-term asset exceeds its fair value—
i.e., when an asset loses some or all of its
potential to generate revenue before the end of its
useful life.

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Recognition of the Acquisition Cost of
Long-Term Assets (slide 1 of 3)
 An e xpe nditure is a payment or an obligation to
make a future payment for an asset or a service.
Expenditures are classified as capital expenditures
or revenue expenditures.
– A c apital e xpe nditure is for the purchase or
expansion of a long-term asset.
 Capital expenditures are recorded in asset accounts.

– A re ve nue e xpe nditure is for the ordinary repairs
and maintenance needed to keep a long-term
asset in good operating condition.
 Revenue expenditures are recorded in expense
accounts.

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Recognition of the Acquisition Cost of
Long-Term Assets (slide 2 of 3)
 Capital expenditures include:
– outlays for plant assets, natural resources, and
intangible assets
– additio ns —enlargements to the physical layout
of a plant asset
– be tte rme nts —improvements to a plant asset but
not an addition to the plant’s physical layout
– e xtrao rdinary re pairs —repairs that significantly
enhance a plant asset’s estimated useful life or
residual value; recorded by reducing the
Accumulated Depreciation account

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Recognition of the Acquisition Cost of
Long-Term Assets (slide 3 of 3)
 The distinction between capital and revenue
expenditures is important in applying accrual
accounting.

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Acquisition Cost of Property, Plant, and
Equipment

 The acquisition cost of property, plant, and
equipment includes all expenditures
reasonable and necessary to get an asset in
place and ready for use.
Cost of Asset =Purchase Price +Additional Expenditures
(freight, installation, etc.)

– Interest charges incurred in purchasing an asset
are not a cost of the asset, but an operating
expense.
– Small expenditures for long-term assets may be
treated as expenses if they are not material.
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Determining the Acquisition Cost of Property, Plant,
and Equipment: Land and Land Improvements
 Land: Expenditures that should be debited to the
Land account include: purchase price of the land;
commissions to real estate agents; lawyer’s fees;
accrued taxes paid by the purchaser; costs of
preparing the land to build on, such as costs of
tearing down old buildings and grading the land;
assessments for local improvements; and
landscaping.
 Land Improvements: Improvements to real estate,
such as driveways, parking lots, and fences, that
have a limited life are subject to depreciation. They
are recorded in an account called Land
Improvements.

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Determining the Acquisition Cost of Property,
Plant, and Equipment: Buildings
 When a company buys a building, the cost
includes the purchase price and all
expenditures required to put the building in
usable condition.
 When a company cons tructs its own building,
the cost includes: costs of materials, labor,
and overhead; architects’ fees and lawyers’
fees; insurance during construction; interest
on construction loans during construction; and
building permits.
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Determining the Acquisition Cost of Property,
Plant, and Equipment: Leasehold Improvements
 Improvements to leased property, such as the
installation of carpet or walls, on the books of
the lessee that become the property of the
lessor (the owner of the property) at the end of
the lease are called le as e ho ld
impro ve me nts .
– These are usually classified in the property, plant,
and equipment section of the balance sheet.
– The cost of these improvements is depreciated
over the remaining term of the lease or the useful

life of the improvement, whichever is shorter.
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Determining the Acquisition Cost of Property, Plant,
and Equipment: Equipment and Group Purchases

 Equipment: The cost of equipment includes all
expenditures connected with purchasing the
equipment and preparing it for use. These
expenditures include: invoice price less cash
discounts; freight, including insurance; excise
taxes and tariffs; buying expenses; installation
costs; and test runs to ready the equipment for
operation.
 Group Purchases: Companies sometimes
purchase land and other assets for a lump sum.
The lump sum must be apportioned between the
land and other assets.
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Depreciation
 Depreciation refers to the allocation of the
cost of a plant asset over its estimated useful
life, not to the asset’s physical deterioration
or to its decrease in market value.
– The major factors that limit a depreciable asset’s
useful life are:
 Phys ic al de te rio ratio n—the result of use or exposure

to the elements, such as sun or wind
 Obs o le s c e nc e —the process of becoming out of date

– Depreciation is recorded even if an asset
increases in value.
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Factors in Computing Depreciation
 Factors in computing depreciation include:
– Co s t—the net purchase price of an asset plus all
expenditures to get it in place and ready for use
– Re s idual value (or s alvage , dis pos al, or trade -in
value )—the portion of an asset’s cost that a
company expects to recover when it disposes of
the asset
– De pre c iable c o s t—an asset’s cost less its
residual value
– Es timate d us e ful life —the total number of
service units expected from a long-term asset
(may be years used, units produced, or miles
driven)

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Computing Depreciation:
Declining-Balance Method
 An ac c e le rate d me tho d of depreciation
results in larger amounts of depreciation in

the early years of an asset’s life than in later
years.
– Thus, depreciation charges will be highest
in years when the asset is newest and
when revenue generation from the asset is
likely to be highest.

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Special Issues in Determining Depreciation
 Gro up De pre c iatio n: Large companies group
similar assets, such as machines, to calculate
depreciation.
 It is often necessary to calculate depreciation for
partial years because assets are often purchased
mid-year.
 The tax law allows rapid write-offs of plant assets,
which differs from the depreciation methods most
companies use for financial reporting. A a result of
the Ec o no mic S timulus Ac t o f 2008, the tax law
allows a small company to expense the first
$250,000 of equipment expenditures.
 Sometimes the estimate of useful life is revised, so

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Disposal of Depreciable Assets
 When plant assets are no longer useful because

they have physically deteriorated or become
obsolete, a company can sell them, discard them, or
trade them in on the purchase of a new asset.
– A company must record depreciation expense for
the partial year up to the date of disposal.
– The carrying value of a fully depreciated asset is
zero if it has no residual value. When the asset is
discarded, no gain or loss results.
– For an asset with a carrying value, a loss equal to
the carrying value should be recorded when it is
discarded.
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Exchanges of Plant Assets
 Exchanges may involve similar assets, such
as an old machine traded in on a newer
model, or dissimilar assets, such as a cement
mixer traded in on a truck.
– In both cases, the purchase price is reduced by
the amount of the trade-in allowance.
 If the trade-in allowance is greater than the asset’s
carrying value, the company realizes a gain.
 If the allowance is less, it suffers a loss.

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Natural Resources
 Natural resources are long-term assets that are

converted to inventory by cutting, pumping,
mining, or other extraction methods.
– They are recorded at acquisition cost. As these
resources are converted to inventory, their asset
accounts must be proportionately reduced.
– The useful life of the plant assets used to extract
the natural resources may be longer than the time
it will take to extract the resources.
 If a company plans to abandon these assets after all the
resources have been extracted, they should be
depreciated on the same basis as depletion of the
natural resources.
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Depletion
 Depletion refers not only to the exhaustion of
a natural resource but also to the
proportional allocation of the cost of a natural
resource to the units extracted.
– When a natural resource is purchased or
developed, the total units that will be available,
such as tons of coal, must be estimated.
– The depletion cost per unit is computed as
follows.
Depletion Cost per Unit = Cost − Residual Value
Estimated Number of Units

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Development and Exploration Costs in the
Oil and Gas Industry
Exploring and developing oil and gas resources can be
accounted for under one of two methods:
 S uc c e s s ful e ffo rts
ac c o unting —Under
this method, the cost of
successful exploration
is a cost of the
resource.

 Full-c o s ting me tho d—
Under this method, all
costs of exploration are
recorded as assets and
depleted over the
estimated life of the
– It is recorded as an asset
resources.
and depleted over the
resource’s estimated life.
The cost of unsuccessful
exploration is written off
immediately as a loss.

– This includes the costs
of unsuccessful
exploration, such as the
cost of dry wells.

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Intangible Assets

 An intangible asset’s value comes from the
long-term rights it affords its owner.

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Purchase of Intangible Assets
 Intangible assets are accounted for at the
amount that a company paid for them and
should be included on a company’s balance
sheet only if purchased from another party at
a price established in the marketplace.
– The useful life of an intangible asset is the period over
which the asset is expected to contribute to the company’s
future cash flows. It may be:
 Definite—subject to a legal limit or can be reasonably
estimated
 Indefinite—not limited by legal, regulatory, contractual,
competitive, economic, or other factors (and not amortized)

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Research and Development Costs

 Research and development (R&D) activities include
development of new products, testing of existing and
proposed products, and pure research.
– The FASB requires that all R&D costs be charged to
expense in the period in which they are incurred.
– Costs that companies incur in developing software for sale
or lease or for their own use are considered R&D costs until
the product has proved feasible.
– Once proved feasible, all software production costs are
recorded as assets and amortized over the software’s
estimated useful life, using the straight-line method.

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Goodwill
 From an accounting standpoint, goodwill exists when
a purchaser pays more for a business than the fair
market value of the business’s net assets.
– Goodwill may reflect customer satisfaction, good
management, efficiency, having a monopoly, good
locations, and good employee relations.
– The FASB requires that purchased goodwill be reported as
a separate line item on the balance sheet and that it be
reviewed annually for impairment.
– A company should record goodwill only when it acquires a
controlling interest in another business.

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Management Decisions Relating to
Long-Term Assets
 A company may need to finance major
acquisitions of long-term assets with the issue of
stock, long-term notes, or bonds.
 A measure of a company’s success in funding
these acquisitions is free cash flow.
- Fre e c as h flo w is the amount of cash that
remains after deducting the funds a company
must commit to continue operating at its planned
level.
 The commitments include: current or continuing
operations, interest, income taxes, dividends, and net
capital expenditures (purchases of plant assets minus
sales of plant assets).
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