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Feature Story

Plant Assets

Plant assets are resources that have three characteristics. They have a physical substance (a definite size and shape), are used in the operations of a business, and are not intended for sale to customers. They are also called property, plant, and equipment; plant and equipment; and fixed assets. These assets are expected to be of use to the company for a number of years. Except for land, plant assets decline in service potential over their useful lives.

Because plant assets play a key role in ongoing operations, companies keep plant assets in good operating condition. They also replace worn-out or outdated plant assets, and expand productive resources as needed. Many companies have substantial investments in plant assets. Illustration 10-1 shows the percentages of plant assets in relation to total assets of companies in a number of industries.

Illustration 10-1
Percentages of plant assets in relation to total assets

Determining the Cost of Plant Assets

The historical cost principle requires that companies record plant assets at cost. Thus, Rent-A-Wreck records its vehicles at cost. Cost consists of all expenditures necessary to acquire the asset and make it ready for its intended use. For example, the cost of factory machinery includes the purchase price, freight costs paid by the purchaser, and installation costs. Once cost is established, the company uses that amount as the basis of accounting for the plant asset over its useful life.

In the following sections, we explain the application of the historical cost principle to each of the major classes of plant assets.

LAND

Companies often use land as a building site for a manufacturing plant or office building. The cost of land includes (1) the cash purchase price, (2) closing costs such as title and attorney's fees, (3) real estate brokers’ commissions, and (4) accrued property taxes and other liens assumed by the purchaser. For example, if the cash price is $50,000 and the purchaser agrees to pay accrued taxes of $5,000, the cost of the land is $55,000.

Helpful Hint Management's intended use is important in applying the historical cost principle.

Companies record as debits (increases) to the Land account all necessary costs incurred to make land ready for its intended use. When a company acquires vacant land, these costs include expenditures for clearing, draining, filling, and grading. Sometimes the land has a building on it that must be removed before construction of a new building. In this case, the company debits to the Land account all demolition and removal costs, less any proceeds from salvaged materials.

To illustrate, assume that Hayes Company acquires real estate at a cash cost of $100,000. The property contains an old warehouse that is razed at a net cost of $6,000 ($7,500 in costs less $1,500 proceeds from salvaged materials). Additional expenditures are the attorney's fee, $1,000, and the real estate broker's commission, $8,000. The cost of the land is $115,000, computed as shown in Illustration 10-2.

Illustration 10-2
Computation of cost of land

When Hayes records the acquisition, it debits Land for $115,000 and credits Cash for $115,000.

LAND IMPROVEMENTS

Land improvements are structural additions made to land. Examples are driveways, parking lots, fences, landscaping, and underground sprinklers. The cost of land improvements includes all expenditures necessary to make the improvements ready for their intended use. For example, the cost of a new parking lot for Home Depot includes the amount paid for paving, fencing, and lighting. Thus, Home Depot debits to Land Improvements the total of all of these costs.

Land improvements have limited useful lives, and their maintenance and replacement are the responsibility of the company. As a result, companies expense (depreciate) the cost of land improvements over their useful lives.

BUILDINGS

Buildings are facilities used in operations, such as stores, offices, factories, warehouses, and airplane hangars. Companies debit to the Buildings account all necessary expenditures related to the purchase or construction of a building. When a building is purchased, such costs include the purchase price, closing costs (attorney's fees, title insurance, etc.), and real estate broker's commission. Costs to make the building ready for its intended use include expenditures for remodeling and replacing or repairing the roof, floors, electrical wiring, and plumbing. When a new building is constructed, cost consists of the contract price plus payments for architects’ fees, building permits, and excavation costs.

In addition, companies charge certain interest costs to the Buildings account. Interest costs incurred to finance the project are included in the cost of the building when a significant period of time is required to get the building ready for use. In these circumstances, interest costs are considered as necessary as materials and labor. However, the inclusion of interest costs in the cost of a constructed building is limited to the construction period. When construction has been completed, the company records subsequent interest payments on funds borrowed to finance the construction as debits (increases) to Interest Expense.

EQUIPMENT

Equipment includes assets used in operations, such as store check-out counters, office furniture, factory machinery, delivery trucks, and airplanes. The cost of equipment, such as Rent-A-Wreck vehicles, consists of the cash purchase price, sales taxes, freight charges, and insurance during transit paid by the purchaser. It also includes expenditures required in assembling, installing, and testing the unit. However, Rent-A-Wreck does not include motor vehicle licenses and accident insurance on company vehicles in the cost of equipment. These costs represent annual recurring expenditures and do not benefit future periods. Thus, they are treated as expenses as they are incurred.

To illustrate, assume Merten Company purchases factory machinery at a cash price of $50,000. Related expenditures are for sales taxes $3,000, insurance during shipping $500, and installation and testing $1,000. The cost of the factory machinery is $54,500, computed in Illustration 10-3.

Illustration 10-3
Computation of cost of factory machinery

Merten makes the following summary entry to record the purchase and related expenditures.

For another example, assume that Lenard Company purchases a delivery truck at a cash price of $22,000. Related expenditures consist of sales taxes $1,320, painting and lettering $500, motor vehicle license $80, and a three-year accident insurance policy $1,600. The cost of the delivery truck is $23,820, computed as follows.

Illustration 10-4
Computation of cost of delivery truck

Lenard treats the cost of the motor vehicle license as an expense, and the cost of the insurance policy as a prepaid asset. Thus, Lenard makes the following entry to record the purchase of the truck and related expenditures:

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Depreciation

As explained in Chapter 3, depreciation is the process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systematic manner. Cost allocation enables companies to properly match expenses with revenues in accordance with the expense recognition principle, as shown in Illustration 10-5.

Illustration 10-5
Depreciation as a cost allocation concept

It is important to understand that depreciation is a process of cost allocation. It is not a process of asset valuation. No attempt is made to measure the change in an asset's fair value during ownership. So, the book value (cost less accumulated depreciation) of a plant asset may be quite different from its fair value. In fact, if an asset is fully depreciated, it can have a zero book value but still have a significant fair value.

Depreciation applies to three classes of plant assets: land improvements, buildings, and equipment. Each asset in these classes is considered to be a depreciable asset. Why? Because the usefulness to the company and revenue-producing ability of each asset will decline over the asset's useful life. Depreciation does not apply to land because its usefulness and revenue-producing ability generally remain intact over time. In fact, in many cases, the usefulness of land is greater over time because of the scarcity of good land sites. Thus, land is not a depreciable asset.

During a depreciable asset's useful life, its revenue-producing ability declines because of wear and tear. A delivery truck that has been driven 100,000 miles will be less useful to a company than one driven only 800 miles.

Revenue-producing ability may also decline because of obsolescence. Obsolescence is the process of becoming out of date before the asset physically wears out. For example, major airlines moved from Chicago's Midway Airport to Chicago-O’Hare International Airport because Midway's runways were too short for jumbo jets. Similarly, many companies replace their computers long before they originally planned to do so because improvements in new computing technology make the old computers obsolete.

Recognizing depreciation on an asset does not result in an accumulation of cash for replacement of the asset. The balance in Accumulated Depreciation represents the total amount of the asset's cost that the company has charged to expense. It is not a cash fund.

Note that the concept of depreciation is consistent with the going-concern assumption. The going-concern assumption states that the company will continue in operation for the foreseeable future. If a company does not use a going-concern assumption, then plant assets should be stated at their fair value. In that case, depreciation of these assets is not needed.

FACTORS IN COMPUTING DEPRECIATION

Three factors affect the computation of depreciation, as shown in Illustration 10-6.

Illustration 10-6
Three factors in computing depreciation

Helpful Hint Depreciation expense is reported on the income statement. Accumulated depreciation is reported on the balance sheet as a deduction from plant assets.

1. Cost. Earlier, we explained the issues affecting the cost of a depreciable asset. Recall that companies record plant assets at cost, in accordance with the historical cost principle.

2. Useful life. Useful life is an estimate of the expected productive life, also called service life, of the asset for its owner. Useful life may be expressed in terms of time, units of activity (such as machine hours), or units of output. Useful life is an estimate. In making the estimate, management considers such factors as the intended use of the asset, its expected repair and maintenance, and its vulnerability to obsolescence. Past experience with similar assets is often helpful in deciding on expected useful life. We might reasonably expect Rent-A-Wreck and Avis to use different estimated useful lives for their vehicles.

3. Salvage value. Salvage value is an estimate of the asset's value at the end of its useful life. This value may be based on the asset's worth as scrap or on its expected trade-in value. Like useful life, salvage value is an estimate. In making the estimate, management considers how it plans to dispose of the asset and its experience with similar assets.

Alternative Terminology
Another term sometimes used for salvage value is residual value.

DEPRECIATION METHODS

Depreciation is generally computed using one of the following methods:

1. Straight-line

2. Units-of-activity

3. Declining-balance

Each method is acceptable under generally accepted accounting principles. Management selects the method(s) it believes to be appropriate. The objective is to select the method that best measures an asset's contribution to revenue over its useful life. Once a company chooses a method, it should apply it consistently over the useful life of the asset. Consistency enhances the comparability of financial statements. Depreciation affects the balance sheet through accumulated depreciation and the income statement through depreciation expense.

We will compare the three depreciation methods using the following data for a small delivery truck purchased by Barb's Florists on January 1, 2014.

Illustration 10-7
Delivery truck data

Illustration 10-8
Use of depreciation mehtods in large U. S. companies

Illustration 10-8 (in the margin) shows the use of the primary depreciation methods in a sample of the largest companies in the United States.

STRAIGHT-LINE Under the straight-line method, companies expense the same amount of depreciation for each year of the asset's useful life. It is measured solely by the passage of time.

To compute depreciation expense under the straight-line method, companies need to determine depreciable cost. Depreciable cost is the cost of the asset less its salvage value. It represents the total amount subject to depreciation. Under the straight-line method, to determine annual depreciation expense, we divide depreciable cost by the asset's useful life. Illustration 10-9 (page 478) shows the computation of the first year's depreciation expense for Barb's Florists.

Illustration 10-9
Formula for straight-line method

Alternatively, we also can compute an annual rate of depreciation. In this case, the rate is 20% (100% ÷ 5 years). When a company uses an annual straight-line rate, it applies the percentage rate to the depreciable cost of the asset. Illustration 10-10 shows a depreciation schedule using an annual rate.

Illustration 10-10
Straight-line depreciation schedule

Note that the depreciation expense of $2,400 is the same each year. The book value (computed as cost minus accumulated depreciation) at the end of the useful life is equal to the expected $1,000 salvage value.

What happens to these computations for an asset purchased during the year, rather than on January 1? In that case, it is necessary to prorate the annual depreciation on a time basis. If Barb's Florists had purchased the delivery truck on April 1, 2014, the company would own the truck for nine months of the first year (April–December). Thus, depreciation for 2014 would be $1,800 ($12,000 × 20% × 9/12 of a year).

The straight-line method predominates in practice. Such large companies as Campbell Soup, Marriott, and General Mills use the straight-line method. It is simple to apply, and it matches expenses with revenues when the use of the asset is reasonably uniform throughout the service life.

Alternative Terminology
Another term often used is the units-of-production method.

UNITS-OF-ACTIVITY Under the units-of-activity method, useful life is expressed in terms of the total units of production or use expected from the asset, rather than as a time period. The units-of-activity method is ideally suited to factory machinery. Manufacturing companies can measure production in units of output or in machine hours. This method can also be used for such assets as delivery equipment (miles driven) and airplanes (hours in use). The units-of-activity method is generally not suitable for buildings or furniture because depreciation for these assets is more a function of time than of use.

Helpful Hint Under any method, depreciation stops when the asset's book value equals expected salvage value.

To use this method, companies estimate the total units of activity for the entire useful life, and then divide these units into depreciable cost. The resulting number represents the depreciable cost per unit. The depreciable cost per unit is then applied to the units of activity during the year to determine the annual depreciation expense.

To illustrate, assume that Barb's Florists drives its delivery truck 15,000 miles in the first year. Illustration 10-11 shows the units-of-activity formula and the computation of the first year's depreciation expense.

Illustration 10-11
Formula for units-of-activity method

The units-of-activity depreciation schedule, using assumed mileage, is as follows.

Illustration 10-12
Units-of-activity depreciation schedule

This method is easy to apply for assets purchased mid-year. In such a case, the company computes the depreciation using the productivity of the asset for the partial year.

The units-of-activity method is not nearly as popular as the straight-line method (see Illustration 10-8, page 477) primarily because it is often difficult for companies to reasonably estimate total activity. However, some very large companies, such as Chevron and Boise Cascade (a forestry company), do use this method. When the productivity of an asset varies significantly from one period to another, the units-of-activity method results in the best matching of expenses with revenues.

DECLINING-BALANCE The declining-balance method produces a decreasing annual depreciation expense over the asset's useful life. The method is so named because the periodic depreciation is based on a declining book value (cost less accumulated depreciation) of the asset. With this method, companies compute annual depreciation expense by multiplying the book value at the beginning of the year by the declining-balance depreciation rate. The depreciation rate remains constant from year to year, but the book value to which the rate is applied declines each year.

At the beginning of the first year, book value is the cost of the asset. This is because the balance in accumulated depreciation at the beginning of the asset's useful life is zero. In subsequent years, book value is the difference between cost and accumulated depreciation to date. Unlike the other depreciation methods, the declining-balance method does not use depreciable cost in computing annual depreciation expense. That is, it ignores salvage value in determining the amount to which the declining-balance rate is applied. Salvage value, however, does limit the total depreciation that can be taken. Depreciation stops when the asset's book value equals expected salvage value.

A common declining-balance rate is double the straight-line rate. The method is often called the double-declining-balance method. If Barb's Florists uses the double-declining-balance method, it uses a depreciation rate of 40% (2 × the straight-line rate of 20%). Illustration 10-13 shows the declining-balance formula and the computation of the first year's depreciation on the delivery truck.

Illustration 10-13
Formula for declining-balance method

The depreciation schedule under this method is as follows.

Illustration 10-14
Double-declining-balance depreciation schedule

Helpful Hint The method recommended for an asset that is expected to be significantly more productive in the first half of its useful life is the declining-balance method.

The delivery equipment is 69% depreciated ($8,320 ÷ $12,000) at the end of the second year. Under the straight-line method, the truck would be depreciated 40% ($4,800 ÷ $12,000) at that time. Because the declining-balance method produces higher depreciation expense in the early years than in the later years, it is considered an accelerated-depreciation method. The declining-balance method is compatible with the expense recognition principle. It matches the higher depreciation expense in early years with the higher benefits received in these years. It also recognizes lower depreciation expense in later years, when the asset's contribution to revenue is less. Some assets lose usefulness rapidly because of obsolescence. In these cases, the declining-balance method provides the most appropriate depreciation amount.

When a company purchases an asset during the year, it must prorate the first year's declining-balance depreciation on a time basis. For example, if Barb's Florists had purchased the truck on April 1, 2014, depreciation for 2014 would become $3,900 ($13,000 × 40% × 9/12). The book value at the beginning of 2015 is then $9,100 ($13,000 − $3,900), and the 2015 depreciation is $3,640 ($9,100 × 40%). Subsequent computations would follow from those amounts.

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COMPARISON OF METHODS Illustration 10-15 compares annual and total depreciation expense under each of the three methods for Barb's Florists.

Illustration 10-15
Comparison of depreciation methods

Annual depreciation varies considerably among the methods, but total depreciation expense is the same ($12,000) for the five-year period under all three methods. Each method is acceptable in accounting because each recognizes in a rational and systematic manner the decline in service potential of the asset. Illustration 10-16 graphs the depreciation expense pattern under each method.

Illustration 10-16
Patterns of depreciation

DEPRECIATION AND INCOME TAXES

The Internal Revenue Service (IRS) allows taxpayers to deduct depreciation expense when they compute taxable income. However, the IRS does not require taxpayers to use the same depreciation method on the tax return that is used in preparing financial statements.

Many corporations use straight-line in their financial statements to maximize net income. At the same time, they use a special accelerated-depreciation method on their tax returns to minimize their income taxes. Taxpayers must use on their tax returns either the straight-line method or a special accelerated-depreciation method called the Modified Accelerated Cost Recovery System (MACRS).

REVISING PERIODIC DEPRECIATION

Depreciation is one example of the use of estimation in the accounting process. Management should periodically review annual depreciation expense. If wear and tear or obsolescence indicate that annual depreciation estimates are inadequate or excessive, the company should change the amount of depreciation expense.

When a change in an estimate is required, the company makes the change in current and future years. It does not change depreciation in prior periods. The rationale is that continual restatement of prior periods would adversely affect confidence in financial statements.

Helpful Hint Use a step-by-step approach: (1) determine new depreciable cost; (2) divide by remaining useful life.

To determine the new annual depreciation expense, the company first computes the asset's depreciable cost at the time of the revision. It then allocates the revised depreciable cost to the remaining useful life.

To illustrate, assume that Barb's Florists decides on January 1, 2017, to extend the useful life of the truck one year (a total life of six years) and increase its salvage value to $2,200. The company has used the straight-line method to depreciate the asset to date. Depreciation per year was $2,400 [($13,000 − $1,000) ÷ 5]. Accumulated depreciation after three years (2014−2016) is $7,200 ($2,400 × 3), and book value is $5,800 ($13,000 − $7,200). The new annual depreciation is $1,200, computed as shown in Illustration 10-17.

Illustration 10-17
Revised depreciation computation

Barb's Florists makes no entry for the change in estimate. On December 31, 2017, during the preparation of adjusting entries, it records depreciation expense of $1,200. Companies must describe in the financial statements significant changes in estimates.

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Expenditures During Useful Life

During the useful life of a plant asset, a company may incur costs for ordinary repairs, additions, or improvements. Ordinary repairs are expenditures to maintain the operating efficiency and productive life of the unit. They usually are fairly small amounts that occur frequently. Examples are motor tune-ups and oil changes, the painting of buildings, and the replacing of worn-out gears on machinery. Companies record such repairs as debits to Maintenance and Repairs Expense as they are incurred. Because they are immediately charged as an expense against revenues, these costs are often referred to as revenue expenditures.

In contrast, additions and improvements are costs incurred to increase the operating efficiency, productive capacity, or useful life of a plant asset. They are usually material in amount and occur infrequently. Additions and improvements increase the company's investment in productive facilities. Companies generally debit these amounts to the plant asset affected. They are often referred to as capital expenditures.

Companies must use good judgment in deciding between a revenue expenditure and capital expenditure. For example, assume that Rodriguez Co. purchases a number of wastepaper baskets. Although the proper accounting would appear to be to capitalize and then depreciate these wastepaper baskets over their useful life, it would be more usual for Rodriguez to expense them immediately. This practice is justified on the basis of materiality. Materiality refers to the impact of an item's size on a company's financial operations. The materiality concept states that if an item would not make a difference in decision-making, the company does not have to follow GAAP in reporting that item.

Plant Assets Disposals

Companies dispose of plant assets that are no longer useful to them. Illustration 10-18 shows the three ways in which companies make plant asset disposals.

Whatever the disposal method, the company must determine the book value of the plant asset at the disposal date to determine the gain or loss. Recall that the book value is the difference between the cost of the plant asset and the accumulated depreciation to date. If the disposal occurs at any time during the year, the company must record depreciation for the fraction of the year to the date of disposal. The company then eliminates the book value by reducing (debiting) Accumulated Depreciation for the total depreciation associated with that asset to the date of disposal and reducing (crediting) the asset account for the cost of the asset.

Illustration 10-18
Methods of plant asset disposal

In this chapter, we examine the accounting for the retirement and sale of plant assets. In the appendix to the chapter, we discuss and illustrate the accounting for exchanges of plant assets.

RETIREMENT OF PLANT ASSETS

To illustrate the retirement of plant assets, assume that Hobart Company retires its computer printers, which cost $32,000. The accumulated depreciation on these printers is $32,000. The equipment, therefore, is fully depreciated (zero book value). The entry to record this retirement is as follows.

Helpful Hint When a company disposes of a plant asset, the company must remove from the accounts all amounts related to the asset. This includes the original cost in the asset account and the total depreciation to date in the accumulated depreciation account.

What happens if a fully depreciated plant asset is still useful to the company? In this case, the asset and its accumulated depreciation continue to be reported on the balance sheet, without further depreciation adjustment, until the company retires the asset. Reporting the asset and related accumulated depreciation on the balance sheet informs the financial statement reader that the asset is still in use. Once fully depreciated, no additional depreciation should be taken, even if an asset is still being used. In no situation can the accumulated depreciation on a plant asset exceed its cost.

If a company retires a plant asset before it is fully depreciated and no cash is received for scrap or salvage value, a loss on disposal occurs. For example, assume that Sunset Company discards delivery equipment that cost $18,000 and has accumulated depreciation of $14,000. The entry is as follows.

Companies report a loss on disposal of plant assets in the “Other expenses and losses” section of the income statement.

SALE OF PLANT ASSETS

In a disposal by sale, the company compares the book value of the asset with the proceeds received from the sale. If the proceeds of the sale exceed the book value of the plant asset, a gain on disposal occurs. If the proceeds of the sale are less than the book value of the plant asset sold, a loss on disposal occurs.

Only by coincidence will the book value and the fair value of the asset be the same when the asset is sold. Gains and losses on sales of plant assets are therefore quite common. For example, Delta Airlines reported a $94,343,000 gain on the sale of five Boeing B727-200 aircraft and five Lockheed L-1011-1 aircraft.

GAIN ON SALE  To illustrate a gain on sale of plant assets, assume that on July 1, 2014, Wright Company sells office furniture for $16,000 cash. The office furniture originally cost $60,000. As of January 1, 2014, it had accumulated depreciation of $41,000. Depreciation for the first six months of 2014 is $8,000. Wright records depreciation expense and updates accumulated depreciation to July 1 with the following entry.

After the accumulated depreciation balance is updated, the company computes the gain or loss. The gain or loss is the difference between the proceeds from the sale and the book value at the date of disposal. Illustration 10-19 shows this computation for Wright Company, which has a gain on disposal of $5,000.

Illustration 10-19
Computation of gain on disposal

Wright records the sale and the gain on disposal of the plant asset as follows.

Companies report a gain on disposal of plant assets in the “Other revenues and gains” section of the income statement.

LOSS ON SALE Assume that instead of selling the office furniture for $16,000, Wright sells it for $9,000. In this case, Wright computes a loss of $2,000 as follows.

Illustration 10-20
Computation of loss on disposal

Wright records the sale and the loss on disposal of the plant asset as follows.

Companies report a loss on disposal of plant assets in the “Other expenses and losses” section of the income statement.

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Natural Resources

Natural resources consist of standing timber and underground deposits of oil, gas, and minerals. These long-lived productive assets have two distinguishing characteristics: (1) They are physically extracted in operations (such as mining, cutting, or pumping). (2) They are replaceable only by an act of nature.

The acquisition cost of a natural resource is the price needed to acquire the resource and prepare it for its intended use. For an already-discovered resource, such as an existing coal mine, cost is the price paid for the property.

Helpful Hint On a balance sheet, natural resources may be described more specifically as timberlands, mineral deposits, oil reserves, and so on.

Depletion

The allocation of the cost of natural resources to expense in a rational and systematic manner over the resource's useful life is called depletion. (That is, depletion is to natural resources as depreciation is to plant assets.) Companies generally use the units-of-activity method (learned earlier in the chapter) to compute depletion. The reason is that depletion generally is a function of the units extracted during the year.

Under the units-of-activity method, companies divide the total cost of the natural resource minus salvage value by the number of units estimated to be in the resource. The result is a depletion cost per unit of product. They then multiply the depletion cost per unit by the number of units extracted and sold. The result is the annual depletion expense. Illustration 10-21 shows the formula to compute depletion expense.

Illustration 10-21
Formula to compute depletion expense

To illustrate, assume that Lane Coal Company invests $5 million in a mine estimated to have 10 million tons of coal and no salvage value. In the first year, Lane extracts and sells 800,000 tons of coal. Using the formulas above, Lane computes the depletion expense as follows.

$5,000,000 ÷ 10,000,000 = $0.50 depletion cost per ton
$0.50 × 800,000 = $400,000 annual depletion expense

Lane records depletion expense for the first year of operation as follows.

Presentation

The company reports the account Depletion Expense as a part of the cost of producing the product. Accumulated Depletion is a contra asset account, similar to accumulated depreciation. It is deducted from the cost of the natural resource in the balance sheet, as Illustration 10-22 shows.

Illustration 10-22
Statement presentation of accumulated depletion

Many companies do not use an Accumulated Depletion account. In such cases, the company credits the amount of depletion directly to the natural resources account.

Sometimes, a company will extract natural resources in one accounting period but not sell them until a later period. In this case, the company does not expense the depletion until it sells the resource. It reports the amount not sold as inventory in the current assets section.

Intangible Assets

Intangible assets are rights, privileges, and competitive advantages that result from the ownership of long-lived assets that do not possess physical substance. Evidence of intangibles may exist in the form of contracts or licenses. Intangibles may arise from the following sources:

1. Government grants, such as patents, copyrights, licenses, trademarks, and trade names.

2. Acquisition of another business, in which the purchase price includes a payment for goodwill.

3. Private monopolistic arrangements arising from contractual agreements, such as franchises and leases.

Some widely known intangibles are Microsoft's patents, McDonald's franchises, Apple's trade name iPod, J.K. Rowling's copyrights on the Harry Potter books, and the trademark Rent-A-Wreck in the Feature Story.

Accounting for Intangible Assets

Companies record intangible assets at cost. Intangibles are categorized as having either a limited life or an indefinite life. If an intangible has a limited life, the company allocates its cost over the asset's useful life using a process similar to depreciation. The process of allocating the cost of intangibles is referred to as amortization. The cost of intangible assets with indefinite lives should not be amortized.

Helpful Hint Amortization is to intangibles what depreciation is to plant assets and depletion is to natural resources.

To record amortization of an intangible asset, a company increases (debits) Amortization Expense, and decreases (credits) the specific intangible asset. (Unlike depreciation, no contra account, such as Accumulated Amortization, is usually used.)

Intangible assets are typically amortized on a straight-line basis. For example, the legal life of a patent is 20 years. Companies amortize the cost of a patent over its 20-year life or its useful life, whichever is shorter. To illustrate the computation of patent amortization, assume that National Labs purchases a patent at a cost of $60,000. If National estimates the useful life of the patent to be eight years, the annual amortization expense is $7,500 ($60,000 ÷ 8). National records the annual amortization as follows.

Companies classify Amortization Expense as an operating expense in the income statement.

There is a difference between intangible assets and plant assets in determining cost. For plant assets, cost includes both the purchase price of the asset and the costs incurred in designing and constructing the asset. In contrast, the initial cost for an intangible asset includes only the purchase price. Companies expense any costs incurred in developing an intangible asset.

PATENTS

A patent is an exclusive right issued by the U.S. Patent Office that enables the recipient to manufacture, sell, or otherwise control an invention for a period of 20 years from the date of the grant. A patent is nonrenewable. But, companies can extend the legal life of a patent by obtaining new patents for improvements or other changes in the basic design. The initial cost of a patent is the cash or cash equivalent price paid to acquire the patent.

The saying, “A patent is only as good as the money you're prepared to spend defending it,” is very true. Many patents are subject to litigation by competitors. Any legal costs an owner incurs in successfully defending a patent in an infringement suit are considered necessary to establish the patent's validity. The owner adds those costs to the Patents account and amortizes them over the remaining life of the patent.

The patent holder amortizes the cost of a patent over its 20-year legal life or its useful life, whichever is shorter. Companies consider obsolescence and inadequacy in determining useful life. These factors may cause a patent to become economically ineffective before the end of its legal life.

COPYRIGHTS

The federal government grants copyrights, which give the owner the exclusive right to reproduce and sell an artistic or published work. Copyrights extend for the life of the creator plus 70 years. The cost of a copyright is the cost of acquiring and defending it. The cost may be only the small fee paid to the U.S. Copyright Office. Or, it may amount to much more if an infringement suit is involved.

The useful life of a copyright generally is significantly shorter than its legal life. Therefore, copyrights usually are amortized over a relatively short period of time.

TRADEMARKS AND TRADE NAMES

A trademark or trade name is a word, phrase, jingle, or symbol that identifies a particular enterprise or product. Trade names like Wheaties, Monopoly, Big Mac, Kleenex, Coca-Cola, and Jeep create immediate product identification. They also generally enhance the sale of the product. The creator or original user may obtain exclusive legal right to the trademark or trade name by registering it with the U.S. Patent Office. Such registration provides 20 years of protection. The registration may be renewed indefinitely as long as the trademark or trade name is in use.

If a company purchases the trademark or trade name, its cost is the purchase price. If a company develops and maintains the trademark or trade name, any costs related to these activities are expensed as incurred. Because trademarks and trade names have indefinite lives, they are not amortized.

FRANCHISES

When you fill up your tank at the corner Shell station, eat lunch at Subway, or rent a car from Rent-A-Wreck, you are dealing with franchises. A franchise is a contractual arrangement between a franchisor and a franchisee. The franchisor grants the franchisee the right to sell certain products, perform specific services, or use certain trademarks or trade names, usually within a designated geographic area.

Another type of franchise is a license. A license granted by a governmental body permits a company to use public property in performing its services. Examples are the use of city streets for a bus line or taxi service, the use of public land for telephone and electric lines, and the use of airwaves for radio or TV broadcasting. In a recent license agreement, FOX, CBS, and NBC agreed to pay $27.9 billion for the right to broadcast NFL football games over an eight-year period. Franchises and licenses may by granted for a definite period of time, an indefinite period, or perpetually.

When a company can identify costs with the purchase of a franchise or license, it should recognize an intangible asset. Companies should amortize the cost of a limited-life franchise (or license) over its useful life. If the life is indefinite, the cost is not amortized. Annual payments made under a franchise agreement are recorded as operating expenses in the period in which they are incurred.

GOODWILL

Usually, the largest intangible asset that appears on a company's balance sheet is goodwill. Goodwill represents the value of all favorable attributes that relate to a company that are not attributable to any other specific asset. These include exceptional management, desirable location, good customer relations, skilled employees, high-quality products, and harmonious relations with labor unions. Goodwill is unique. Unlike assets such as investments and plant assets, which can be sold individually in the marketplace, goodwill can be identified only with the business as a whole.

If goodwill can be identified only with the business as a whole, how can its amount be determined? One could try to put a dollar value on the factors listed above (exceptional management, desirable location, and so on). But, the results would be very subjective, and such subjective valuations would not contribute to the reliability of financial statements. Therefore, companies record goodwill only when an entire business is purchased. In that case, goodwill is the excess of cost over the fair value of the net assets (assets less liabilities) acquired.

In recording the purchase of a business, the company debits (increases) the identifiable acquired assets, credits liabilities at their fair values, credits cash for the purchase price, and records the difference as goodwill. Goodwill is not amortized because it is considered to have an indefinite life. Companies report goodwill in the balance sheet under intangible assets.

Research and Development Costs

Research and development costs are expenditures that may lead to patents, copyrights, new processes, and new products. Many companies spend considerable sums of money on research and development (R&D). For example, in a recent year, IBM spent over $5.1 billion on R&D.

Helpful Hint Research and development (R&D) costs are not intangible assets. But because they may lead to patents and copyrights, we discuss them in this section.

Research and development costs present accounting problems. For one thing, it is sometimes difficult to assign the costs to specific projects. Also, there are uncertainties in identifying the extent and timing of future benefits. As a result, companies usually record R&D costs as an expense when incurred, whether the research and development is successful or not.

To illustrate, assume that Laser Scanner Company spent $3 million on R&D that resulted in two highly successful patents. It spent $20,000 on legal fees for the patents. The company would add the lawyers’ fees to the patent account. The R&D costs, however, cannot be included in the cost of the patent. Instead, the company would record the R&D costs as an expense when incurred.

Many disagree with this accounting approach. They argue that expensing R&D costs leads to understated assets and net income. Others, however, argue that capitalizing these costs will lead to highly speculative assets on the balance sheet. Who is right is difficult to determine.

DO IT!

Statement Presentation and Analysis

Presentation

Usually, companies combine plant assets and natural resources under “Property, plant, and equipment” in the balance sheet. They show intangibles separately. Companies disclose either in the balance sheet or the notes the balances of the major classes of assets, such as land, buildings, and equipment, and accumulated depreciation by major classes or in total. In addition, they should describe the depreciation and amortization methods that were used, as well as disclose the amount of depreciation and amortization expense for the period.

Illustration 10-23 shows a typical financial statement presentation of property, plant, and equipment and intangibles for The Procter & Gamble Company (P&G) in its 2011 balance sheet. The notes to P&G's financial statements present greater details about the accounting for its long-term tangible and intangible assets.

Illustration 10-23
P&G's presentation of property, plant, and equipment, and intangible assets

Illustration 10-24 shows another comprehensive presentation of property, plant, and equipment from the balance sheet of Owens-Illinois. The notes to the financial statements of Owens-Illinois identify the major classes of property, plant, and equipment. They also indicate that depreciation and amortization are by the straight-line method, and depletion is by the units-of-activity method.

Illustration 10-24
Owens-Illinois’ presentation of property, plant, and equipment, and intangible assets

Analysis

Using ratios, we can analyze how efficiently a company uses its assets to generate sales. The asset turnover analyzes the productivity of a company's assets. It tells us how many dollars of sales a company generates for each dollar invested in assets. This ratio is computed by dividing net sales by average total assets for the period. Illustration 10-25 shows the computation of the asset turnover for The Procter & Gamble Company. P&G's net sales for 2011 were $82,559 million. Its total ending assets were $138,354 million, and beginning assets were $128,172 million.

Illustration 10-25
Asset turnover formula and computation

Thus, each dollar invested in assets produced $0.62 in sales for P&G. If a company is using its assets efficiently, each dollar of assets will create a high amount of sales. This ratio varies greatly among different industries—from those that are asset-intensive (utilities) to those that are not (services).

Comprehensive DO IT! 1

Comprehensive DO IT! 2

SUMMARY OF LEARNING OBJECTIVES

1 Describe how the historical cost principle applies to plant assets. The cost of plant assets includes all expenditures necessary to acquire the asset and make it ready for its intended use. Once cost is established, the company uses that amount as the basis of accounting for the plant assets over its useful life.

2 Explain the concept of depreciation and how to compute it. Depreciation is the allocation of the cost of a plant asset to expense over its useful (service) life in a rational and systematic manner. Depreciation is not a process of valuation, nor is it a process that results in an accumulation of cash.

Three depreciation methods are:

Companies make revisions of periodic depreciation in present and future periods, not retroactively. They determine the new annual depreciation by dividing the depreciable cost at the time of the revision by the remaining useful life.

3 Distinguish between revenue and capital expenditures, and explain the entries for each. Companies incur revenue expenditures to maintain the operating efficiency and productive life of an asset. They debit these expenditures to Maintenance and Repairs Expense as incurred. Capital expenditures increase the operating efficiency, productive capacity, or expected useful life of the asset. Companies generally debit these expenditures to the plant asset affected.

4 Explain how to account for the disposal of a plant asset. The accounting for disposal of a plant asset through retirement or sale is as follows. (a) Eliminate the book value of the plant asset at the date of disposal. (b) Record cash proceeds, if any. (c) Account for the difference between the book value and the cash proceeds as a gain or loss on disposal.

5 Compute periodic depletion of natural resources. Companies compute depletion cost per unit by dividing the total cost of the natural resource minus salvage value by the number of units estimated to be in the resource. They then multiply the depletion cost per unit by the number of units extracted and sold.

6 Explain the basic issues related to accounting for intangible assets. The process of allocating the cost of an intangible asset is referred to as amortization. The cost of intangible assets with indefinite lives is not amortized. Companies normally use the straight-line method for amortizing intangible assets.

7 Indicate how plant assets, natural resources, and intangible assets are reported. Companies usually combine plant assets and natural resources under property, plant, and equipment. They show intangibles separately under intangible assets. Either within the balance sheet or in the notes, companies should disclose the balances of the major classes of assets, such as land, buildings, and equipment, and accumulated depreciation by major classes or in total. They also should describe the depreciation and amortization methods used, and should disclose the amount of depreciation and amortization expense for the period. The asset turnover measures the productivity of a company's assets in generating sales.

GLOSSARY

Accelerated-depreciation method Depreciation method that produces higher depreciation expense in the early years than in the later years. (p. 480).

Additions and improvements Costs incurred to increase the operating efficiency, productive capacity, or useful life of a plant asset. (p. 483).

Amortization The allocation of the cost of an intangible asset to expense over its useful life in a systematic and rational manner. (p. 489).

Asset turnover A measure of how efficiently a company uses its assets to generate sales; calculated as net sales divided by average total assets. (p. 493).

Capital expenditures Expenditures that increase the company's investment in productive facilities. (p. 483).

Copyrights Exclusive grant from the federal government that allows the owner to reproduce and sell an artistic or published work. (p. 489).

Declining-balance method Depreciation method that applies a constant rate to the declining book value of the asset and produces a decreasing annual depreciation expense over the useful life of the asset. (p. 479).

Depletion The allocation of the cost of a natural resource to expense in a rational and systematic manner over the resource's useful life. (p. 487).

Depreciable cost The cost of a plant asset less its salvage value. (p. 477).

Depreciation The process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systematic manner. (p. 475).

Franchise (license) A contractual arrangement under which the franchisor grants the franchisee the right to sell certain products, perform specific services, or use certain trademarks or trade names, usually within a designated geographic area. (p. 490).

Going-concern assumption States that the company will continue in operation for the foreseeable future. (p. 476).

Goodwill The value of all favorable attributes that relate to a company that is not attributable to any other specific asset. (p. 490).

Intangible assets Rights, privileges, and competitive advantages that result from the ownership of long-lived assets that do not possess physical substance. (p. 488).

Materiality concept If an item would not make a difference in decision-making, a company does not have to follow GAAP in reporting it. (p. 483).

Natural resources Assets that consist of standing timber and underground deposits of oil, gas, and minerals. (p. 486).

Ordinary repairs Expenditures to maintain the operating efficiency and productive life of the unit. (p. 483).

Patent An exclusive right issued by the U.S. Patent Office that enables the recipient to manufacture, sell, or otherwise control an invention for a period of 20 years from the date of the grant. (p. 489).

Plant assets Tangible resources that are used in the operations of the business and are not intended for sale to customers. (p. 472).

Research and development (R&D) costs Expenditures that may lead to patents, copyrights, new processes, or new products. (p. 491).

Revenue expenditures Expenditures that are immediately charged against revenues as an expense.(p. 483).

Salvage value An estimate of an asset's value at the end of its useful life. (p. 477).

Straight-line method Depreciation method in which periodic depreciation is the same for each year of the asset's useful life. (p. 477).

Trademark (trade name) A word, phrase, jingle, or symbol that identifies a particular enterprise or product. (p. 490).

Units-of-activity method Depreciation method in which useful life is expressed in terms of the total units of production or use expected from an asset. (p. 478).

Useful life An estimate of the expected productive life, also called service life, of an asset. (p. 477).

APPENDIX 10A Exchange of Plant Assets

Ordinarily, companies record a gain or loss on the exchange of plant assets. The rationale for recognizing a gain or loss is that most exchanges have commercial substance. An exchange has commercial substance if the future cash flows change as a result of the exchange.

To illustrate, Ramos Co. exchanges some of its equipment for land held by Brodhead Inc. It is likely that the timing and amount of the cash flows arising from the land will differ significantly from the cash flows arising from the equipment. As a result, both Ramos and Brodhead are in different economic positions. Therefore, the exchange has commercial substance, and the companies recognize a gain or loss in the exchange. Because most exchanges have commercial substance (even when similar assets are exchanged), we illustrate only this type of situation, for both a loss and a gain.

Loss Treatment

To illustrate an exchange that results in a loss, assume that Roland Company exchanged a set of used trucks plus cash for a new semi-truck. The used trucks have a combined book value of $42,000 (cost $64,000 less $22,000 accumulated depreciation). Roland's purchasing agent, experienced in the second-hand market, indicates that the used trucks have a fair value of $26,000. In addition to the trucks, Roland must pay $17,000 for the semi-truck. Roland computes the cost of the semi-truck as follows.

Illustration 10A-1
Cost of semi-truck

Roland incurs a loss on disposal of plant assets of $16,000 on this exchange. The reason is that the book value of the used trucks is greater than the fair value of these trucks. The computation is as follows.

Illustration 10A-2
Computation of loss on disposal

In recording an exchange at a loss, three steps are required: (1) eliminate the book value of the asset given up, (2) record the cost of the asset acquired, and (3) recognize the loss on disposal of plant assets. Roland Company thus records the exchange on the loss as follows.

Gain Treatment

To illustrate a gain situation, assume that Mark Express Delivery decides to exchange its old delivery equipment plus cash of $3,000 for new delivery equipment. The book value of the old delivery equipment is $12,000 (cost $40,000 less accumulated depreciation $28,000). The fair value of the old delivery equipment is $19,000.

The cost of the new asset is the fair value of the old asset exchanged plus any cash paid (or other consideration given up). The cost of the new delivery equipment is $22,000, computed as follows.

Illustration 10A-3
Cost of new delivery equipment

A gain results when the fair value of the old delivery equipment is greater than its book value. For Mark Express, there is a gain of $7,000 on disposal of plant assets, computed as follows.

Illustration 10A-4
Computation of gain on disposal

Mark Express Delivery records the exchange as follows.

In recording an exchange at a gain, the following three steps are involved: (1) eliminate the book value of the asset given up, (2) record the cost of the asset acquired, and (3) recognize the gain on disposal of plant assets. Accounting for exchanges of plant assets becomes more complex if the transaction does not have commercial substance. This issue is discussed in more advanced accounting classes.

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 10A

8 Explain how to account for the exchange of plant assets. Ordinarily, companies record a gain or loss on the exchange of plant assets. The rationale for recognizing a gain or loss is that most exchanges have commercial substance. An exchange has commercial substance if the future cash flows change as a result of the exchange.

PROBLEMS: SET B

P10-1B Russo Company was organized on January 1. During the first year of operations, the following plant asset expenditures and receipts were recorded in random order.

Determine acquisition costs of land and building.
(LO 1)

Instructions

Analyze the foregoing transactions using the following column headings. Insert the number of each transaction in the Item space, and insert the amounts in the appropriate columns. For amounts entered in the Other Accounts column, also indicate the account title.

Item    Land    Buildings    Other Accounts

Totals

Land $128,500
Buildings $518,000

P10-2B In recent years, Darnell Company purchased three machines. Because of heavy turnover in the accounting department, a different accountant was in charge of selecting the depreciation method for each machine, and each selected a different method. Information concerning the machines is summarized below.

Compute depreciation under different methods.
(LO 2)

For the declining-balance method, the company uses the double-declining rate. For the units-of-activity method, total machine hours are expected to be 25,000. Actual hours of use in the first 3 years were 2014, 2,000; 2015, 4,500; and 2016, 5,500.

Instructions

(a) Machine 2, 2013, $78,750

(a) Compute the amount of accumulated depreciation on each machine at December 31, 2014.

(b) If Machine 2 had been purchased on May 1 instead of January 1, what would be the depreciation expense for this machine in (1) 2012 and (2) 2013?

P10-3B On January 1, 2014, Bourgeois Company purchased the following two machines for use in its production process.

Compute depreciation under different methods.
(LO 2)

Instructions

(a) (2) $14,000

(a) Prepare the following for Machine A.

(1) The journal entry to record its purchase on January 1, 2014.

(2) The journal entry to record annual depreciation at December 31, 2014, assuming the straight-line method of depreciation is used.

(b) Calculate the amount of depreciation expense that Bourgeois should record for Machine B each year of its useful life under the following assumption.

(1) Bourgeois uses the straight-line method of depreciation.

(2) Bourgeois uses the declining-balance method. The rate used is twice the straight-line rate.

(3) Bourgeois uses the units-of-activity method and estimates the useful life of the machine is 25,000 units. Actual usage is as follows: 2014, 5,500 units; 2015, 7,000 units; 2016, 8,000 units; 2017, 4,500 units.

(c) Which method used to calculate depreciation on Machine B reports the lowest amount of depreciation expense in year 1 (2014)? The lowest amount in year 4 (2017)? The lowest total amount over the 4-year period?

P10-4B At the beginning of 2012, Sullivan Company acquired equipment costing $300,000. It was estimated that this equipment would have a useful life of 6 years and a salvage value of $30,000 at that time. The straight-line method of depreciation was considered the most appropriate to use with this type of equipment. Depreciation is to be recorded at the end of each year.

Calculate revisions to depreciation expense.
(LO 2)

During 2014 (the third year of the equipment's life), the company's engineers reconsidered their expectations, and estimated that the equipment's useful life would probably be 7 years (in total) instead of 6 years. The estimated salvage value was not changed at that time. However, during 2017 the estimated salvage value was reduced to $5,000.

Instructions

Indicate how much depreciation expense should be recorded for this equipment each year by completing the following table.

2018 depreciation expense, $48,500

P10-5B At December 31, 2014, Torrealba Company reported the following as plant assets.

Journalize a series of equipment transactions related to purchase, sale, retirement, and depreciation.
(LO 2, 4, 7)

During 2015, the following selected cash transactions occurred.

April 1	Purchased land for $1,200,000.
May 1	Sold equipment that cost $450,000 when purchased on January 1, 2011. The equipment was sold for $260,000.
June 1	Sold land purchased on June 1, 2005, for $1,000,000. The land cost $340,000.
July 1	Purchased equipment for $1,500,000.
Dec. 31	Retired equipment that cost $300,000 when purchased on December 31, 2005. No salvage value was received.

Instructions

(a) Journalize the above transactions. Torrealba uses straight-line depreciation for buildings and equipment. The buildings are estimated to have a 50-year useful life and no salvage value. The equipment is estimated to have a 10-year useful life and no salvage value. Update depreciation on assets disposed of at the time of sale or retirement.

(b) Record adjusting entries for depreciation for 2015.

(c) Prepare the plant assets section of Torrealba's balance sheet at December 31, 2015.

(b) Depreciation Expense—Buildings $400,000; Equipment $3,000,000

(c) Total plant assets $38,660,000

P10-6B Dickey's has equipment that cost $45,000 and that has been depreciated $26,000.

Record disposals.
(LO 4)

Instructions

Record the disposal under the following assumptions.

(a) It was scrapped as having no value.

(b) It was sold for $29,000.

(c) It was sold for $10,000.

(b) 10,000 gain

P10-7B The intangible assets section of Willingham Company at December 31, 2014, is presented below.

Prepare entries to record transactions related to acquisition and amortization of intangibles; prepare the intangible assets section.
(LO 6, 7)

The patent was acquired in January 2014 and has a useful life of 10 years. The copyright was acquired in January 2011 and also has a useful life of 10 years. The following cash transactions may have affected intangible assets during 2015.

Jan. 2	Paid $36,000 legal costs to successfully defend the patent against infringement by another company.
Jan.–June	Developed a new product, incurring $230,000 in research and development costs. A patent was granted for the product on July 1. Its useful life is equal to its legal life.
Sept. 1	Paid $125,000 to an Xgames star to appear in commercials advertising the company's products. The commercials will air in September and October.
Oct. 1	Acquired a copyright for $300,000. The copyright has a useful life of 50 years.

Instructions

(a) Prepare journal entries to record the transactions above.

(b) Prepare journal entries to record the 2015 amortization expense for intangible assets.

(c) Prepare the intangible assets section of the balance sheet at December 31, 2015.

(d) Prepare the note to the financials on Willingham's intangibles as of December 31, 2015.

(b) Amortization Expense (patents) $14,000;
Amortization Expense (copyrights) $7,500

(c) Total intangible assets, $440,500

P10-8B Due to rapid turnover in the accounting department, a number of transactions involving intangible assets were improperly recorded by Farnsworth Company in 2014.

Prepare entries to correct errors made in recording and amortizing intangible assets.
(LO 6)

1. Farnsworth developed a new manufacturing process, incurring research and development costs of $110,000. The company also purchased a patent for $50,000. In early January, Farnsworth capitalized $160,000 as the cost of the patents. Patent amortization expense of $16,000 was recorded based on a 10-year useful life.

2. On July 1, 2014, Farnsworth purchased a small company and as a result acquired goodwill of $200,000. Farnsworth recorded a half-year's amortization in 2014, based on a 50-year life ($2,000 amortization). The goodwill has an indefinite life.

Instructions

Prepare all journal entries necessary to correct any errors made during 2014. Assume the books have not yet been closed for 2014.

R&D Exp. $110,000

P10-9B Auer Corporation and Marte Corporation, two corporations of roughly the same size, are both involved in the manufacture of canoes and sea kayaks. Each company depreciates its plant assets using the straight-line approach. An investigation of their financial statements reveals the following information.

Calculate and comment on asset turnover.
(LO 7)

Instructions

(a) For each company, calculate the asset turnover.

(b) Based on your calculations in part (a), comment on the relative effectiveness of the two companies in using their assets to generate sales and produce net income.

PROBLEMS: SET C

Visit the book's companion website, at www.wiley.com/college/weygandt, and choose the Student Companion site to access Problem Set C.

COMPREHENSIVE PROBLEM: Chapters 3 TO 10

CP10 Hassellhouf Company's trial balance at December 31, 2014, is presented below. All 2014 transactions have been recorded except for the items described on page 513.

Unrecorded transactions:

1. On May 1, 2014, Hassellhouf purchased equipment for $21,200 plus sales taxes of $1,600 (all paid in cash).

2. On July 1, 2014, Hassellhouf sold for $3,500 equipment which originally cost $5,000. Accumulated depreciation on this equipment at January 1, 2014, was $1,800; 2014 depreciation prior to the sale of the equipment was $450.

3. On December 31, 2014, Hassellhouf sold for $9,000 on account inventory that cost $6,300.

4. Hassellhouf estimates that uncollectible accounts receivable at year-end is $4,000.

5. The note receivable is a one-year, 8% note dated April 1, 2014. No interest has been recorded.

6. The balance in prepaid insurance represents payment of a $3,600 6-month premium on September 1, 2014.

7. The building is being depreciated using the straight-line method over 30 years. The salvage value is $30,000.

8. The equipment owned prior to this year is being depreciated using the straight-line method over 5 years. The salvage value is 10% of cost.

9. The equipment purchased on May 1, 2014, is being depreciated using the straight-line method over 5 years, with a salvage value of $1,800.

10. The patent was acquired on January 1, 2014, and has a useful life of 10 years from that date.

11. Unpaid salaries and wages at December 31, 2014, total $5,200.

12. The unearned rent revenue of $6,000 was received on December 1, 2014, for 3 months rent.

13. Both the short-term and long-term notes payable are dated January 1, 2014, and carry a 9% interest rate. All interest is payable in the next 12 months.

Instructions

(a) Prepare journal entries for the transactions listed above.

(b) Prepare an updated December 31, 2014, trial balance.

(c) Prepare a 2014 income statement and an owner's equity statement.

(d) Prepare a December 31, 2014, classified balance sheet.

(b) Totals $1,205,040

(d) Total assets $259,200

CONTINUING COOKIE CHRONICLE

(Note: This is a continuation of the Cookie Chronicle from Chapters 1 through 9.)

CCC10  Natalie is also thinking of buying a van that will be used only for business. Natalie is concerned about the impact of the van's cost on her income statement and balance sheet. She has come to you for advice on calculating the van's depreciation.

Go to the book's companion website, www.wiley.com/college/weygandt, to see the completion of this problem.

  A Look at IFRS

IFRS follows most of the same principles as GAAP in the accounting for property, plant, and equipment. There are, however, some significant differences in the implementation. IFRS allows the use of revaluation of property, plant, and equipment, and it also requires the use of component depreciation. In addition, there are some significant differences in the accounting for both intangible assets and impairments.

Key Points

• The definition for plant assets for both IFRS and GAAP is essentially the same.
• Both IFRS and GAAP follow the historical cost principle when accounting for property, plant, and equipment at date of acquisition. Cost consists of all expenditures necessary to acquire the asset and make it ready for its intended use.
• Under both IFRS and GAAP, interest costs incurred during construction are capitalized. Recently, IFRS converged to GAAP requirements in this area.
• IFRS, like GAAP, capitalizes all direct costs in self-constructed assets such as raw materials and labor. IFRS does not address the capitalization of fixed overhead although in practice these costs are generally capitalized.
• IFRS also views depreciation as an allocation of cost over an asset's useful life. IFRS permits the same depreciation methods (e.g., straight-line, accelerated, and units-of-activity) as GAAP. However, a major difference is that IFRS requires component depreciation. Component depreciation specifies that any significant parts of a depreciable asset that have different estimated useful lives should be separately depreciated. Component depreciation is allowed under GAAP but is seldom used.

  To illustrate, assume that Lexure Construction builds an office building for $4,000,000, not including the cost of the land. If the $4,000,000 is allocated over the 40-year useful life of the building, Lexure reports $100,000 of depreciation per year, assuming straight-line depreciation and no disposal value. However, assume that $320,000 of the cost of the building relates to personal property and $600,000 relates to land improvements. The personal property has a depreciable life of 5 years, and the land improvements have a depreciable life of 10 years. In accordance with IFRS, Lexure must use component depreciation. It must reclassify $320,000 of the cost of the building to personal property and $600,000 to the cost of land improvements. Assuming that Lexure uses straight-line depreciation, component depreciation for the first year of the office building is computed as follows.

  

• IFRS uses the term residual value rather than salvage value to refer to an owner's estimate of an asset's value at the end of its useful life for that owner.
• IFRS allows companies to revalue plant assets to fair value at the reporting date. Companies that choose to use the revaluation framework must follow revaluation procedures. If revaluation is used, it must be applied to all assets in a class of assets. Assets that are experiencing rapid price changes must be revalued on an annual basis, otherwise less frequent revaluation is acceptable.

  To illustrate asset revaluation accounting, assume that Pernice Company applies revaluation to plant assets with a carrying value of $1,000,000, a useful life of 5 years, and no residual value. Pernice makes the following journal entries in year 1, assuming straight-line depreciation.

  

  After this entry, Pernice's plant assets have a carrying amount of $800,000 ($1,000,000 − $200,000). At the end of year 1, independent appraisers determine that the asset has a fair value of $850,000. To report the plant assets at fair value, or $850,000, Pernice eliminates the Accumulated Depreciation—Plant Assets account, reduces Plant Assets to its fair value of $850,000, and records Revaluation Surplus of $50,000. The entry to record the revaluation is as follows.

  

  Thus, Pernice follows a two-step process. First, Pernice records depreciation based on the cost basis of $1,000,000. As a result, it reports depreciation expense of $200,000 on the income statement. Second, it records the revaluation. It does this by eliminating any accumulated depreciation, adjusting the recorded value of the plant assets to fair value, and debiting or crediting the Revaluation Surplus account. In this example, the revaluation surplus is $50,000, which is the difference between the fair value of $850,000 and the book value of $800,000. Revaluation surplus is an example of an item reported as other comprehensive income, as discussed in the A Look at IFRS section of Chapter 5. Pernice now reports the following information in its statement of financial position at the end of year 1.

  

  As indicated, $850,000 is the new basis of the asset. Pernice reports depreciation expense of $200,000 in the income statement and $50,000 in other comprehensive income. Assuming no change in the total useful life, depreciation in year 2 will be $212,500 ($850,000 ÷ 4).

• Under both GAAP and IFRS, changes in the depreciation method used and changes in useful life are handled in current and future periods. Prior periods are not affected. GAAP recently conformed to international standards in the accounting for changes in depreciation methods.
• The accounting for subsequent expenditures, such as ordinary repairs and additions, are essentially the same under IFRS and GAAP.
• The accounting for plant asset disposals is essentially the same under IFRS and GAAP.
• Initial costs to acquire natural resources are essentially the same under IFRS and GAAP.
• The definition of intangible assets is essentially the same under IFRS and GAAP.
• As in GAAP, under IFRS the costs associated with research and development are segregated into the two components. Costs in the research phase are always expensed under both IFRS and GAAP. Under IFRS, however, costs in the development phase are capitalized as Development Costs once technological feasibility is achieved.

  To illustrate, assume that Laser Scanner Company spent $1 million on research and $2 million on development of new products. Of the $2 million in development costs, $500,000 was incurred prior to technological feasibility and $1,500,000 was incurred after technological feasibility had been demonstrated. The company would record these costs as follows.

  

• IFRS permits revaluation of intangible assets (except for goodwill). GAAP prohibits revaluation of intangible assets.
• IFRS requires an impairment test at each reporting date for plant assets and intangibles and records an impairment if the asset's carrying amount exceeds its recoverable amount. The recoverable amount is the higher of the asset's fair value less costs to sell or its value-in-use. Value-inuse is the future cash flows to be derived from the particular asset, discounted to present value. Under GAAP, impairment loss is measured as the excess of the carrying amount over the asset's fair value.
• IFRS allows reversal of impairment losses when there has been a change in economic conditions or in the expected use of the asset. Under GAAP, impairment losses cannot be reversed for assets to be held and used; the impairment loss results in a new cost basis for the asset. IFRS and GAAP are similar in the accounting for impairments of assets held for disposal.
• The accounting for exchanges of nonmonetary assets has recently converged between IFRS and GAAP. GAAP now requires that gains on exchanges of nonmonetary assets be recognized if the exchange has commercial substance. This is the same framework used in IFRS.

Looking to the Future

With respect to revaluations, as part of the conceptual framework project, the Boards will examine the measurement bases used in accounting. It is too early to say whether a converged conceptual framework will recommend fair value measurement (and revaluation accounting) for plant assets and intangibles. However, this is likely to be one of the more contentious issues, given the longstanding use of historical cost as a measurement basis in GAAP.

The IASB and FASB have identified a project that would consider expanded recognition of internally generated intangible assets. IFRS permits more recognition of intangibles compared to GAAP. Thus, it will be challenging to develop converged standards for intangible assets, given the long-standing prohibition on capitalizing internally generated intangible assets and research and development costs in GAAP.

IFRS Practice

IFRS Self-Test Questions

1. Which of the following statements is correct?

(a) Both IFRS and GAAP permit revaluation of property, plant, and equipment and intangible assets (except for goodwill).

(b) IFRS permits revaluation of property, plant, and equipment and intangible assets (except for goodwill).

(c) Both IFRS and GAAP permit revaluation of property, plant, and equipment but not intangible assets.

(d) GAAP permits revaluation of property, plant, and equipment but not intangible assets.

2. International Company has land that cost $450,000 but now has a fair value of $600,000. International Company decides to use the revaluation method specified in IFRS to account for the land. Which of the following statements is correct?

(a) International Company must continue to report the land at $450,000.

(b) International Company would report a net income increase of $150,000 due to an increase in the value of the land.

(c) International Company would debit Revaluation Surplus for $150,000.

(d) International Company would credit Revaluation Surplus by $150,000.

3. Francisco Corporation is constructing a new building at a total initial cost of $10,000,000. The building is expected to have a useful life of 50 years with no residual value. The building's finished surfaces (e.g., roof cover and floor cover) are 5% of this cost and have a useful life of 20 years. Building services systems (e.g., electric, heating, and plumbing) are 20% of the cost and have a useful life of 25 years. The depreciation in the first year using component depreciation, assuming straight-line depreciation with no residual value, is:

(a) $200,000.

(b) $215,000.

(c) $255,000.

(d) None of the above.

4. Research and development costs are:

(a) expensed under GAAP.

(b) expensed under IFRS.

(c) expensed under both GAAP and IFRS.

(d) None of the above.

5. Under IFRS, value-in-use is defined as:

(a) net realizable value.

(b) fair value.

(c) future cash flows discounted to present value.

(d) total future undiscounted cash flows.

IFRS Exercises

IFRS10-1 What is component depreciation, and when must it be used?

IFRS10-2 What is revaluation of plant assets? When should revaluation be applied?

IFRS10-3 Some product development expenditures are recorded as development expenses and others as development costs. Explain the difference between these accounts and how a company decides which classification is appropriate.

IFRS10-4 Beckham Company constructed a warehouse for $280,000. Beckham estimates that the warehouse has a useful life of 20 years and no residual value. Construction records indicate that $50,000 of the cost of the warehouse relates to its heating, ventilation, and air conditioning (HVAC) system, which has an estimated useful life of only 10 years. Compute the first year of depreciation expense using straight-line component depreciation.

IFRS10-5 At the end of its first year of operations, Escobar Company chose to use the revaluation framework allowed under IFRS. Escobar's ledger shows Plant Assets $475,000 and Accumulated Depreciation—Plant Assets $60,000. Prepare journal entries to record the following.

(a) Independent appraisers determine that the plant assets have a fair value of $460,000.

(b) Independent appraisers determine that the plant assets have a fair value of $400,000.

IFRS10-6 Odessa Industries spent $350,000 on research and $600,000 on development of a new product. Of the $600,000 in development costs, $400,000 was incurred prior to technological feasibility and $200,000 after technological feasibility had been demonstrated. Prepare the journal entry to record research and development costs.

International Financial Statement Analysis: Zetar plc

IFRS10-7 The financial statements of Zetar plc are presented in Appendix F. Instructions for accessing and using the company's complete annual report, including the notes to its financial statements, are also provided in Appendix F.

Instructions

Use the company's annual report to answer the following questions.

(a) According to the notes to the financial statements, what method or methods does the company use to depreciate “plant and equipment?” What rate does it use to depreciate plant and equipment?

(b) According to the notes to the financial statements, how often is goodwill tested for impairment?

(c) Using the notes to the financial statements, as well as information from the statement of cash flows, prepare the journal entry to record the disposal of property, plant, and equipment during 2011. (Round your amounts to the nearest thousand.)

Answers to IFRS Self-Test Questions

1. b    2. d    3. c ($10,000,000 ×.05/20) + ($10,000,000 × .20/25) + ($10,000,000 × .75/50)    4. a    5. c