Copyright 2009 The Learning House, Inc. Fixed and Intangible Assets Page 1 of 13

Copyright 2009 The Learning House, Inc. Fixed and Intangible Assets Page 1 of 13

Introduction This lesson focuses on the long-term assets used to operate a company. These assets can be grouped into fixed assets and intangible assets. Fixed assets refer to major investments for most companies. They make up a large part of most companies total assets on their balance sheets, and they yield depreciation, often one of the largest expenses on most companies income statements. The acquisition of a fixed asset is often referred to as a capital expenditure. Capital expenditures stand as important for most companies because they impact the overall success of the company. Intangible assets make similar impacts. This lesson describes the purchase and use of these assets. This lesson also explains what distinguishes these assets from other types of assets, how to determine their costs, how to allocate their costs to the periods of time that most benefit from their use, and how to dispose of them. Defining Fixed Assets Fixed assets are tangible assets used in a company's operations that have a useful life of more than one accounting period or year. They are tangible because they exist physically. They have a long life and are used to produce or sell products and services. Fixed assets are Fixed assets are also called plant and equipment assets ; property, plant, and equipment assets ; or plant assets. For many companies, fixed assets make up the single largest group of assets they own. also called plant and equipment assets ; property, plant, and equipment assets ; or plant assets. For many companies, fixed assets make up the single largest group of assets they own. A fixed asset can be classified as land, buildings, or equipment. In the order listing in the chart of accounts, assets are usually ordered from most liquid or easily convertible to cash, to least liquid, such as equipment and machinery to buildings and land. Fixed assets stand as unique from other assets because of two important features. First, operation of the company involves use of the fixed assets. This makes fixed assets different from, for instance, inventory that is held for sale and not used in operations. The distinctive feature here is use, not type of asset. A company that purchases a copy machine to resell it would report the matching on the balance sheet as inventory. If the same company purchases this copy machine to use in operations, however, they would classify it is a fixed asset. The second unique feature of fixed assets is that their useful life extends over more than one accounting period. This makes fixed assets different from current assets such as supplies that are normally consumed in a short period of time after purchase. Types of Fixed Assets Major classes of fixed assets include machinery and equipment, buildings, and land. Fixed assets are recorded at cost when acquired. Cost includes all of the normal and reasonable expenditures necessary to put the asset in place and ready it for its intended use. The cost of a factory machine, for instance, includes its invoice cost less any cash discount for early payment, plus any necessary freight, unpacking, assembling, installing, and testing costs. Examples include the cost of building a base or foundation for a machine, providing electrical hookups, and testing the asset before using it in operations. Copyright 2009 The Learning House, Inc. Fixed and Intangible Assets Page 2 of 13

The costs of machinery and equipment consist of all costs normal and necessary to purchase and prepare them for their intended use. To be recorded as part of the cost of a fixed asset, an expense must be deemed normal, reasonable, and necessary to prepare the asset for its intended use. If an asset is damaged during unpacking, one does not add the repairs to the asset s cost.. Instead, one charges the repairs to an expense account. Nor is a paid traffic fine for moving heavy machinery on city streets without a proper permit part of the machineries cost; however, the cost of the machinery includes payment for a proper permit. Charges are sometimes incurred to modify or customize a new fixed asset. These charges are added to the asset s cost. Machinery and Equipment The costs of machinery and equipment consist of all costs normal and necessary to purchase and prepare them for their intended use. These costs include the purchase price, taxes, transportation charges, and insurance costs, as well as the installing, assembling, and testing of the machinery and equipment. Buildings A company charges a building account for the cost of purchasing or constructing a building that is used in operations. When purchased, a building s cost usually includes its purchase price, brokerage fees, taxes, title fees, and attorney fees. A building s cost also includes all expenses to prepare the building for use, including any necessary repairs or renovations such as wiring, lighting, flooring, and wall coverings. When a company constructs a building or any fixed asset for its own use, its costs include materials and labor, plus a reasonable amount of indirect overhead cost. Overhead cost includes the cost of items such as heat, lighting, power, and depreciation on machinery used to construct the asset. Costs of construction also include design fees, building permits, and insurance during construction. However, costs such as insurance to cover the asset after it is placed in use are considered operating expenses, not costs of construction. Land When a company purchases land for a building site, its cost includes the total amount paid for the land, including any real estate commissions, title insurance fees, legal fees, and accrued property taxes paid by the purchaser. Payments for surveying, clearing, grading, and training are also included in the cost of land. Land purchased as a building site sometimes includes structures that must be removed. In such cases, the total purchase price is charged to the Land account, as is cost of removing the structure, less any amounts recorded through sale of salvaged materials. To illustrate, assume that Starbucks paid $167,000 in cash to acquire land for a retail store. This land included an old service garage that was removed at a cost of $13,000 ($15,000 in costs less $2,000 proceeds from salvage materials). Additional closing costs totaled $10,000, which included brokerage fees ($8000), legal fees ($1500), and title costs ($500). Thus, the cost of this land to Starbucks was $190,000 and is computed as shown: When a company purchases land for a building site, its cost includes the total amount paid for the land, including any real estate commissions, title insurance fees, legal fees, and accrued property taxes paid by the purchaser. Copyright 2009 The Learning House, Inc. Fixed and Intangible Assets Page 3 of 13

Disposing of Fixed Assets Cash price of land $167,000 Net cost of garage removal 13,000 Closing costs 10,000 Cost of land $190,000 Companies dispose of fixed assets for several reasons. Some are disposed when they wear out or become obsolete; others are sold because of changing business plans. Regardless of the reason, disposals of fixed assets occur in one of three basic ways: through discarding, by sale, or by exchange. The general steps and accounting for a disposal of fixed assets is described below: 1. Record the depreciation up to the date of disposal this also updates the accumulated depreciation. 2. Record the removal of the disposed assets account balances Including its accumulated depreciation. 3. Record any cash (and/or other assets) received or paid in the disposal. 4. Record any gain or loss computed by comparing the disposed assets book value with the market value of any assets received. Regardless of the reason, disposals of fixed assets occur in one of three basic ways: through discarding, by sale, or by exchange. Fixed assets that are no longer useful may be discarded, sold, or traded for other fixed assets. The details of the entry to record disposal will vary. In all cases, however, the book value of the asset must be removed from the accounts. The entry for this purpose debits the assets accumulated appreciation account for its balance on the date of disposal and credits the asset account for the cost of the asset. A fixed asset should only be removed from the general ledger accounts when it has been fully depreciated. If the business still uses the asset, the cost and accumulated depreciation should remain in the general ledger. This maintains accountability for the asset in the ledger. If the book value of the asset were removed from the ledger, the accounts would contain no evidence of the continued existence of the asset. The cost and the accumulated depreciation data on such assets are often needed for property tax and income tax reporting. Consider the following example that illustrates when a fixed asset is discarded because it is no longer useful to the company and has no market value. Assume that a machine costing $9000 with acute depreciation of $9000 is discarded. When accumulated depreciation equals the asset s cost, the asset is said to be fully depreciated (zero book value). The entry to record the discarding of the asset is: Accumulated depreciation-machinery 9,000 Machinery 9,000 Copyright 2009 The Learning House, Inc. Fixed and Intangible Assets Page 4 of 13

This entry reflects all four steps for disposal of an asset. Step one is unnecessary since the machine is fully depreciated. Step two is reflected in the debit to accumulated depreciation and credit to machinery. Since no other asset is involved, step three proves irrelevant. Finally, since the book value stands as zero and no other asset is involved, no gain or loss is recorded in step four. The following example illustrates the accounting for an asset that is not fully depreciated or one whose depreciation is not up to date. Consider equipment costing $8000 with accumulated appreciation of $6000 on December 31 of the prior fiscal year end. This equipment is being depreciated using the straight line method over eight years with zero salvage value. On July 1 of the current year, the asset is discarded. Step one involves bringing the depreciation up to date. Depreciation expense 500 Accumulated depreciation-equipment 500 To record 6 months depreciation ($1000 x 6/12) Steps two through four are reflected in the second entry: Accumulated depreciation-equipment 6,500 Loss on disposal of equipment 1,500 Equipment 8,000 To discard equipment with a $1500 book value One computes the loss by comparing the equipment s $1500 book value ($8000 - $6000 - $500) with the zero net cash proceeds. This loss is reported in the other expenses and losses section of the income statement. Discarding an asset can sometimes require a cash payment that increases the loss. The income statement reports any loss from discarding an asset, and the balance sheet reflects the changes in the asset and accumulated depreciation accounts. Revenue Expenditures and Capital Expenditures Managers must be careful when classifying the cost of fixed asset expenditures because accounting decision can affect financial statements for several years.. This decision is based on whether these expenditures are identified as ordinary repairs, improvements, or extraordinary repairs. Revenue expenditures, also called income statement expenditures, exist as additional costs of fixed assets that do not materially increase the life of the asset or increase its productivity. Sometimes called ordinary repairs, these expenditures exist to keep fixed assets in normal, good operating condition. They enable the asset to perform to expectations over its useful life. Ordinary repairs do not extend the fixed asset s useful life beyond its original estimate or increase productivity beyond the original expectations. Examples include the normal costs of cleaning, lubricating, adjusting, and replacing small parts of a machine. The costs are reported as expenses and deducted from revenues in the current period income statement. Examples of revenue expenditures for machinery include general maintenance, cleaning, repainting, adjustments, and lubricants. Capital expenditures, also called balance sheet expenditures, are additional costs of fixed assets that provide benefits that extend beyond the current accounting period. They are debited Copyright 2009 The Learning House, Inc. Fixed and Intangible Assets Page 5 of 13

to asset accounts and reported on the balance sheet. Capital expenditures increase or improve the length or amount of service an asset provides. Examples include roofing replacement, plant expansion, and major overhauls of machinery and equipment to increase their life. Accounting for improvements and extraordinary repairs is similar. Improvements are expenditures that make a fixed asset more efficient or productive. An improvement often involves adding a component to an asset or replacing one of its old components with a better one, and does not always increase the asset s useful life. Replacing manual controls on a machine with automatic controls offers one example. One special type of improvement is an addition, such as adding a new wing or dock to a warehouse. Since an improvement benefits future periods, it is debited to the asset account as a capital expenditure. The new value (less salvage value) is then depreciated over the asset s remaining useful life. To illustrate, suppose a company pays $8000 for a machine with an eight-year useful life and no salvage value. After three years and $3000 of depreciation, the company adds an automated control system to the machine at a cost of $1800. This addition results in reduced labor cost in the future. The cost of the improvement is added to the machinery account with this entry. Jan. 2 Machinery 1,800 Cash 1,800 After the improvement, the remaining cost to be depreciated is $6800, computed as $8000 minus $3000 plus $1800. Depreciation expense for the remaining five years is $1360 per year, computed as $6800 divided by five years. Extraordinary repairs are expenditures that extend the asset s useful life beyond its original estimate. Extraordinary repairs are capital expenditures because they benefit future periods. Their costs are debited to the asset account. To illustrate, Veradis Company owns a building that appears on its prior year-end balance sheet at its original $572,000 cost, less $429,000 accumulated depreciation. The building is depreciated on a straight-line basis assuming a 20- year life and no salvage value. During the first week of January of the current calendar year, the company completes major structural repairs on the building at a $68,350 cost. The repairs extend the building s useful life 7 years beyond the 20 years originally estimated. The first step would be to calculate the building s age at the prior year-end balance sheet date. Given the original cost of $572,000 depreciated using straight-line depreciation for 20 years, one could calculate the annual depreciation expense each year at $28,600 ($572,000/20 years). Accumulated depreciation on the year-end balance sheet is $429,000 divided by $28,600, which shows that the building has been depreciated for 15 years. The next step would be to record the extraordinary repairs as follows: Building 68,350 Cash 68,350 The book value of the building immediately after the repairs are recorded would then be $211,350, summarized as: Cost of the building for the repairs $529,000 Add cost of repairs 68,350 640,350 Less accumulated depreciation 429,000 Revised book value of building $211,350 Copyright 2009 The Learning House, Inc. Fixed and Intangible Assets Page 6 of 13

To calculate the new depreciation: Revised book value of building $211,350 New estimate of useful life (20 15 + 7 years) 12 New depreciation expense $ 17,613 The journal entry for the current year s depreciation would be as follows: Depreciation Expense 17,613 Accumulated Depreciation Building 17,613 Depreciation Depreciation refers to the process of allocating the cost of a fixed asset to expense in the accounting periods benefiting from the asset s use. Depreciation does not measure the decline in the asset s market value each period, nor does it measure the asset s physical deterioration. Since depreciation reflects the cost of using a fixed asset, depreciation charges are only recorded when the asset is actually in service. Factors that determine depreciation include cost, salvage value, and useful life. The cost of a plant asset consists of all necessary and reasonable expenditures to acquire and prepare the asset for its intended use. The total amount of depreciation expense to be charged off over the fixed asset s useful life equals the asset s cost, minus its salvage value. Salvage value, also called residual value or scrap value, refers to an estimate of the asset s value at the end of its useful life. This is the amount the owner expects to receive from disposing of the asset. If one expects to trade the asset for a new asset, then its salvage value is the expected trade-in value. The useful life of a fixed asset is the length of time of the asset s productive use in a company's operations. Useful life, also called The cost of a plant asset consists of all necessary and reasonable expenditures to acquire and prepare the asset for its intended use. service life, might not be as long as the asset s total productive life. For example, the productive life of a computer can be eight years or more. Some companies, however, trade-in old computers for new ones every two years. In this case, these computers have a two-year useful life, meaning the cost of these computers (less expected trade-in values) is charged to a depreciation expense over a two-year period. Depreciation methods are used to allocate a fixed asset s cost over the accounting periods in its useful life. The most frequently used method of depreciation is the straight-line method. Other common depreciation methods include the double-declining-balance method and the units-of-production method. Straight line depreciation charges the same amount of expense to each period of the fixed asset s useful life. A two-step process is used. First, one computes the depreciable cost of the asset; this amount is also called the cost to be depreciated. This amount is computed by subtracting the asset s estimated value from its total cost. Second, one divides depreciable cost Copyright 2009 The Learning House, Inc. Fixed and Intangible Assets Page 7 of 13

by the number of periods or years in the asset s useful life. To illustrate, assume that a company purchases a machine that inspects athletic shoes. Cost Salvage value Depreciable cost $10,000 1,000 $ 9,000 Useful life: Accounting periods Units inspected 5 years 36,000 shoes The formula for straight-line depreciation, along with its computation for the inspection machine described above, is shown below: (Cost Salvage value)/useful life in periods = ($10,000 1,000)/5 years = $1800 per year. If a company purchases this machine on December 31 and uses it throughout its predicted useful life of five years, the straight-line method allocates an equal amount of depreciation to each of the next five years. One would make the following adjusting entry at the end of each of the five years to record the annual straight-line depreciation of this machine: Depreciation expense 1800 Accumulated depreciation-machinery 1800 The $1800 depreciation expense is reported on the income statement as an operating expense. The $1800 accumulated depreciation is a contra asset account to the machinery account in the balance sheet. The net balance sheet amount is the asset s book value and is computed as the asset s total cost less its accumulated depreciation. For example, at the end of year two, the asset s book value stands as $6400 and is reported on the balance sheet as follows: Machinery $10,000 Less accumulated depreciation 3,600 Book value $6,400 An accelerated depreciation method yields larger depreciation expense in the early years of an asset s life and less depreciation in later years. A common depreciation rate for the decline in balance method is double the straight-line rate; this is called the double-declining-balance method. One applies this method in three steps. Step one involves computing the asset s straight-line depreciation rate. Step two requires doubling the straight-line rate. Step three involves computing the depreciation expense by multiplying this rate by the asset s beginningof-the-period book value. To illustrate, consider again the machine example and apply the double-declining-balance method to compute the depreciation expense. Step one: 100% divided by useful life = 100%/5 years = 20% Step two: 2 x straight-line rate = 2 x 20% = 40% Step three: 40% x $10,000 = $4000 (for first year) Copyright 2009 The Learning House, Inc. Fixed and Intangible Assets Page 8 of 13

The uses of some fixed assets vary greatly from one period to the next. For example, a builder might use a piece of construction equipment for a month and then not use it again for several months. When equipment use varies from period to period, the units of production depreciation method can better match expenses with revenues. Units of production depreciation involves charging a varying amount to expense for each period of an asset s useful life, depending on its usage. One uses a two-step process to compute units of production depreciation expense. One first computes depreciation per unit by subtracting the asset s salvage value from its total cost and then dividing by the total number of units expected to be produced during its useful life. Units of production can be expressed in product or other units, such as hours used or miles driven. The second step is to compute the depreciation expense for the period by multiplying the units produced in the period by the depreciation per unit. The formula for units of production depreciation, along with its computation for the inspection machine used in the example, is shown below (assume 7,000 shoes are inspected and sold the first year): Step one Step two Depreciation per unit = cost - salvage value/total units of production $10,000 - $1,000/36,000 shoes = $0.25 per share Depreciation expense = depreciation per unit x units produced in period $0.25 per shoe x 7,000 shoes = $1,750 While the amount of depreciation expense per period differs for different methods, total depreciation expense stands as the same over the machine s useful life. Each method starts with the total cost of $10,000 and ends with the salvage value of $1000. The difference is the pattern in depreciation expense over the useful life. The book value of the asset when using straight-line depreciation always proves greater than the value found when using doubledeclining-balance, except at the beginning and end of the asset s useful life when it is the same. Also the straight-line method yields a steady pattern of depreciation expense, while the unit of production depreciation method depends on the number of units produced. Each of these methods is acceptable because it allocates costs in a systematic and rational manner. Intangible Assets Intangible assets are non-physical assets. Examples include patents, copyrights, licenses, leasehold, franchises, goodwill, and trademarks. Lack of physical substance does not necessarily make an asset intangible. Notes and accounts receivables, for instance, lack physical substance, but are not intangibles. One records an intangible asset at cost when purchased. Its costs are systematically allocated to expense over its estimated useful life through the process of amortization. If an intangible asset has an indefinite useful life, meaning that no legal, regulatory, contractual, competitive, economic, or other factor limits Intangible assets are non-physical assets such as trademarks like the one pictured above. Copyright 2009 The Learning House, Inc. Fixed and Intangible Assets Page 9 of 13

its useful life, it should not be amortized. Amortization of intangible assets is similar to depreciation of fixed assets in that it is a process of cost allocation. Only the straight-line method is used for amortizing intangibles, unless the company can show that another method is preferred. One records the effects of amortization in a contra account called accumulated amortization. The eventual disposal of an intangible asset involves removing its book value, recording any other assets received or given up, and recognizing any gain or loss for the difference. Many intangibles offer limited useful life due to laws, contracts, or other asset characteristics. Examples include patents, copyright, and leasehold. Other intangibles, such as goodwill, trademarks, and trade names, offer useful life that one cannot easily determine. The cost of intangible assets is amortized over the periods expected to benefit from their use, but in no case can this period be longer than the asset s legal existence. The values of some intangible assets, such as goodwill, continue indefinitely into the future and are not amortized. Intangible assets are often shown in a separate section of the balance sheet immediately after fixed assets. Companies usually disclose their amortization periods for their intangibles as notes to the financial statements. The federal government grants patents to encourage the invention of new technology, mechanical devices, and production processes. A patent is an exclusive right granted to a owner to manufacture and sell a patented idea or to use a process for 20 years. When patent rights are purchased, the cost to acquire the right is debited to an account called patents. If the owner engages in lawsuits to successfully defend a patent, the cost of the lawsuits is debited to the patent account. However the costs of research and development leading to a new patent are expensed when incurred. A patent s cost is amortized over its estimated useful life (not to exceed 20 years). If one purchased a patent costing $25,000 with a useful life of 10 years, the following adjusting entry would be made at the end of each of the 10 years to amortize one-tenth of its cost: Amortization expense-patents 2,500 Accumulated amortization-patents 2,500 The $2,500 debit to amortization expense appears on the income statement as a cost of the product or service provided under protection of the patent. The Accumulated amortizationpatent account is a contra asset account to Patents. A copyright gives its owner the exclusive right to publish and sell a musical, literary, or artistic work during the life of the creator plus 70 years, although the useful life of most copyrights is much shorter. The costs of a copyright are amortized over its useful life. The only identifiable cost of many copyrights is the fee paid to the copyright office of the federal government or international agency granting the copyright. If this fee is immaterial, it is charged directly to an expense account, but if the identifiable cost of the copyright is material, it is capitalized (recorded in an asset account) and periodically amortized by debiting an account called amortization expense-copyright. Goodwill has a specific meaning in accounting. Goodwill is the amount by which a company s value exceeds the value of its individual assets and liabilities. It usually implies that the company as a whole has certain valuable attributes not measured among its individual assets and liabilities. These can include superior management, skilled workforce, good supplier or Copyright 2009 The Learning House, Inc. Fixed and Intangible Assets Page 10 of 13

customer relations, good location, quality products or services, or other competitive advantages. To keep accounting information from being too subjective, goodwill is not recorded unless an entire company or business segment is purchased. Purchased goodwill is measured by taking the purchase price of the company and subtracting the market value of the individual net assets (excluding goodwill). Goodwill is measured as the excess of the cost of an acquired entity over the value of the acquired net assets. One records goodwill as an asset, and it is not amortized. Reporting on an Income Statement and Balance Sheet The amount of depreciation and amortization expense of a period should be reported separately in the income statement or disclosed in a note. A general description of the method or methods used in computing depreciation should also be reported. One should disclose the amount of each major class of fixed assets in the balance sheet or on a note. The related accumulated depreciation should also be disclosed, either by major class or in total. The fixed assets may be shown after book value (cost less accumulated depreciation), which can also be described as their net amount. If too many classes of fixed assets exist, a single amount may be presented in the balance sheet, supported by a separate detailed listing. Fixed assets are normally presented under the more descriptive caption termed property, plant, and equipment. Intangible assets are usually reported on the balance sheet in a separate section immediately following fixed assets. One should disclose the balance of each major class of intangible assets at amount net of amortization taken to date. To illustrate, the following is the asset section of a balance sheet for Discovery Tree Company. Copyright 2009 The Learning House, Inc. Fixed and Intangible Assets Page 11 of 13

Glossary Amortization Process of allocating the cost of an intangible asset to expense over its estimated useful life. Book value -- Asset's acquisition cost less its accumulated depreciation (or depletion, or amortization); also sometimes used synonymously as the carrying value of an account. Capital expenditures Additional costs of plant assets that provide material benefits extending beyond the current period; also called balance sheet expenditures. Copyright Right giving the owner the exclusive privilege to publish and sell musical, literary, or artistic work during the creator's life plus 70 years. Cost All normal and reasonable expenditures necessary to put an asset in place and ready it for intended use. Double-declining-balance method Method that determines depreciation charge for the period by multiplying a depreciation rate (often twice the straight-line rate) by the asset's beginningperiod book value. Depreciation Expense created by allocating the cost of plant and equipment to periods in which they are used; represents the expense of using the asset. Extraordinary repairs Major repairs that extend the useful life of a plant asset beyond prior expectations; treated as a capital expenditure. Fixed assets Tangible long-lived assets used to produce or sell products and services; also called property, plant, and equipment (PP&E) or plant assets. Goodwill Amount by which a company's value exceeds the value of its individual assets less its liabilities. Improvements Expenditures that make a fixed asset more efficient or more productive. Intangible assets Long-term assets (resources) used to produce or sell products or services; usually lack physical form and have uncertain benefits. Ordinary repairs Repairs to keep a plant asset in normal, good, operating condition; treated as revenue expenditure and immediately expensed. Patent Exclusive right granted to its owner to produce and sell an item or to use a process for 17 years. Revenue expenditures Expenditures reported on the current income statement as an expense because they do not provide benefits in future periods. Salvage value Estimate of amount to be recovered at the end of an asset's useful life; also called residual value or scrap value. Copyright 2009 The Learning House, Inc. Fixed and Intangible Assets Page 12 of 13

Straight-line depreciation method Method that allocates an equal portion of the depreciable cost of plant asset (cost minus salvage) to each accounting period in its useful life. Units-of-production depreciation method Method that charges a varying amount to depreciation expense for each period of an asset's useful life depending on its usage. Useful life -- Length of time an asset will be productively used in the operations of a business; also called service life. Copyright 2009 The Learning House, Inc. Fixed and Intangible Assets Page 13 of 13