Chapter 10: Fixed Assets and Intangible Assets

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1 Chapter 10: Fixed Assets and Intangible Assets Nature of Fixed Assets Fixed assets are long-term or relatively permanent assets, such as equipment, machinery, buildings, and land. Other descriptive titles for fixed assets are plant assets or property, plant, and equipment. Fixed assets have the following characteristics: They exist physically and, thus, are tangible assets. They are owned and used by the company in its normal operations. They are not offered for sale as part of normal operations. (A cost may be classified as a fixed asset, an investment or an expense) The cost of fixed assets (long-lived & used in normal operation): In addition to purchase price, cost of acquiring fixed assets include all amounts spent getting the asset in place and ready for use e.g. freight cost & installing equipment (p.448) è Unnecessary costs that do not increase the asset s usefulness are recorded as an expense. Vandalism Mistakes in installation Uninsured theft Damage during unpacking and installing Fines for not obtaining proper permits from government agencies Capital and Revenue Expenditures 1. Expenditures that benefit only the current period are called revenue expenditures. 2. Expenditures that improve the asset or extend its useful life are capital expenditures. On April 9, the firm paid $300 for a tune-up of a delivery truck. On May 4, a $5,500 hydraulic lift was installed on the delivery truck to allow for easier and quicker loading of heavy cargo. (As the cost of the track has increased, depreciation for the track would also change over its remaining useful life) Summarised by Shatha Al- Salem 1

2 Extraordinary Repairs The engine of a forklift that is near the end of its useful life is overhauled at a cost of $4,500, which extends its useful life by eight years. Work on the forklift was completed on October 14. Leasing Fixed Assets A Lease is a contract for the use of an asset for a period of time e.g. automobiles, computers, buildings and airplanes are often leased. è The two parties to a lease contract are as follows: The lessor is the party who owns the asset. The lessee is the party to whom the rights to use the asset are granted by the lessor. Leasing Fixed Assets (A lease contract can be classified as either a:) è A capital lease is accounted for as if the lessee has purchased the asset. The asset is then amortized (written off as an expense) over the life of the capital lease. è A lease that is not classified as a capital lease for accounting purposes is classified as an operating lease. An operating lease is treated as an expense, because the lessee is renting the asset for the lease term. Depreciation Over time, most fixed assets (equipment, buildings, and machinery) lose their ability to provide services. The periodic recording of the cost of fixed assets as an expense is called depreciation. Accounting for Depreciation è Depreciation can be caused by physical or functional factors. Physical depreciation factors include wear and tear during use or from exposure to the weather. Functional depreciation factors include obsolescence and changes in customer needs that cause the asset to no longer provide services for which it was intended. Factors in Computing Depreciation è Three factors determine the depreciation expense for a fixed asset. These three factors are: 1. The asset s initial cost 2. The asset s expected useful life 3. The asset s estimated residual value at the end of its useful life (The expected useful life and the residual value of a fixed asset are estimated at the time the asset is placed into service) The three Depreciation methods used more often è Straight line method è Units-of-production deprecation è Double declining balance method Summarised by Shatha Al- Salem 2

3 1. Straight-Line Method The straight-line method provides for the same amount of depreciation expense for each year of the asset s useful life. è Initial cost $24,000 è Expected useful life 5 years è Estimated residual value $2,000 The annual straight-line depreciation of $4,400 is computed as: (24,000-2,000) / 5 If the preceding equipment was purchased and placed into service on October 1, the depreciation for the first year of use would be $1,100, computed as follows: $4,400 x 3/12 = $1,100 (The computation of straight-line depreciation may be simplified by converting the annual depreciation to a percentage of depreciable cost: 100/useful life) = 22,000 x 20%. 2. Units-of-Production Method The units-of-production method provides the same amount of depreciation expense for each unit produced or each unit of capacity used by the asset. Step 1. Determine the depreciation per unit as: Depreciation per Unit = Cost Residual Value Total Units of Production Step 2. Compute the depreciation expense as: Depreciation Expense = Depreciation per Unit x Total Units of Production Used Example: A depreciable asset costs $24,000. Its estimated residual value is $2,000, and it is expected to have a useful life of 10,000 operating hours. During the year, the asset was operated 2,100 hours. Depreciation per hour= 24,000-2,000 = 2.20 per hour 10,000 Hours Depreciation expense= 2.20 x 2100 = $ 4, The double-declining-balance method The double-declining-balance method provides for a declining periodic expense over the expected useful life of the asset. The double-declining-balance method is applied in three steps: Step 1. Determine the straight-line percentage using the expected useful life: (A shortcut to determining the straight-line rate is to divide one by the number of years (for example 1 5 = 0.20). Step 2. Determine the double-declining-balance rate by multiplying the straight-line rate from Step 1 by 2 (doubling the straight-line rate). Step 3. Compute the depreciation expense by multiplying the double-declining-balance rate from Step 2 times the book value of the asset. Summarised by Shatha Al- Salem 3

4 Using the double-declining-balance method, a five-year life results in a 40 percent rate (0.20 2). For the first year, the book value of the equipment is its initial cost of $24,000. After the first year, the book value (cost minus accumulated depreciation) declines and, thus, the depreciation also declines. If the preceding equipment was purchased and placed into service on October 1, depreciation for the year ending December 31 would be $2,400, computed as follows: First year partial depreciation = $9,600 x 3/12 = $2,400 The depreciation for the second year would then be $8,640, computed as follows: Second year depreciation = [40% x ($24,000 $2,400)] Second year depreciation= $8,640 *The double-declining-balance method provides a higher depreciation in the first year of the asset s use, followed by declining depreciation amounts. Thus, it is called an accelerated depreciation method. Disposal of Fixed Assets Fixed assets that are no longer useful may be discarded or sold. In such cases, the fixed asset is removed from the accounts. Just because a fixed asset is fully depreciated, however, doesn t mean that it should be removed from the accounts (as long as asset is being used) Discarding Fixed Assets If a fixed asset is no longer used and has no residual value, it s discarded. Equipment acquired at a cost of $25,000 is fully depreciation at December 31, On February 14, 2012, the equipment is discarded. Note: The entry to record the disposal of a fixed asset removes the cost of the asset and its accumulated depreciation from the accounts. Summarised by Shatha Al- Salem 4

5 Equipment costing $6,000, with no residual value, is depreciated at an annual straight-line rate of 10%. After the December 31, 2011, adjusting entry, Accumulated Depreciation- Equipment has a $4,750 balance. On March 24, 2012, the asset is removed from service and discarded The discarding of the equipment is then recorded as shown below. (Note that this is the second of two entries on March 24) Selling Fixed Assets The entry to records the sale of the fixed assets is similar to the entries for discarding an asset. The only difference is recording the receipt of cash. è If selling price > book value à Gain è If selling price < book value à Loss Equipment was purchased at a cost of $10,000. It had no estimated residual value and was depreciated at a straight-line rate of 10%. The equipment is sold for cash on October 12 of the eighth year of its use. The balance of the accumulated depreciation account as of the preceding December 31 is $7,000. The entry to update the depreciation for the nine months of the current year is as follows: After the current depreciation is recorded, the book value of the asset is $2,250 ($10,000 $7,750). Sold below book value for $1,000. Loss of $1,250. Summarised by Shatha Al- Salem 5

6 After the current depreciation is recorded, the book value of the asset is $2,250 ($10,000 $7,750). Sold above book value for $2,800. Gain of $550. Intangible Assets Patents, copyrights, trademarks, and goodwill are long-lived assets that are used in the operations of a business and not held for sale. These assets are called intangible assets because they do not exist physically. The accounting for intangible assets is similar to that for fixed assets Intangible assets Description Amortization Period Periodic Expense Patent Exclusive right to benefit from an innovation Estimated useful life not to exceed legal life Amortization expense Copyright Exclusive right to benefit from a literary, artistic, or musical composition Estimated useful life not to exceed legal life. Amortization Trademark Exclusive use of a name, term, or symbol. None Impairment loss if fair value less than carrying value (impaired) Goodwill Excess of purchase price of a business over the fair value of its net assets (assets-liabilities) None Impairment loss if fair value less than carrying value (impaired). Financial reporting for Fixed Assets and Intangible Assets In the Income Statement, depreciation expense should be reported separately. A description of the methods used in computing depreciation should also be reported In the Balance sheet, each class of fixed assets should be disclosed on the face of the statement or in the notes. The related accumulated deprecation should be disclosed, either by class or total Intangible assets are usually reported in the balance sheet in a separate section following fixed asset Summarised by Shatha Al- Salem 6