CHAPTER 6 - Accounting for Long-Term Operational Assets ANSWERS TO QUESTIONS 1. Long-term operational assets are those assets that are used by a business to generate revenue. In contrast, investments are simply held for the production of interest and dividends and/or for price appreciation. 2. Tangible assets are those assets that have a physical existence. Some examples include buildings and equipment. Intangible assets are those assets that represent some rights and privileges associated with owning the asset. Some examples include copyrights, leases, and trademarks. 3. Specifically identifiable intangible assets are those assets that are purchased for a specific value or have a known value. Examples include patents, leases, and copyrights. Intangible assets that are not specifically identifiable are those purchased as part of the purchase of a whole business or group of assets. The value of these assets are determined by the excess of the purchase price of the group over the value of the specifically identifiable assets. The most common assets in this group include goodwill and covenants not to compete. 4. Depreciation is the systematic allocation of the cost of property, plant and equipment to the accounting periods over which they are to be used. Some examples of assets that are depreciated include buildings, machinery, and office equipment. 5. Natural resources are assets that are produced by nature. Some examples include oil, coal, minerals, timber, etc. They are called wasting assets because their value "wastes away" as the resources are removed from the earth. 6. Land is not a depreciable asset because land has an infinite life. Land is not destroyed by its use. Natural resources can be removed but the land will remain. When land and natural resources are purchased together, the cost of each must be accounted for separately.
7. Amortization is the systematic allocation of the cost of intangible assets over their estimated useful lives. Examples of intangible assets that are amortized include patents, franchises and copyrights. 8. The historical cost concept requires that long-term operational assets be recorded at the amount paid for them. This is the amount that will be shown on the balance sheet as long as the asset is owned. As time passes the asset may increase or decline in value, but this change is not reflected on the books of the company. However, the historical cost of assets may be reduced by depreciation over their lives. 9. The cost of a building includes the amount paid for the building plus any amounts that are paid to put it to its intended use. Some common costs include the purchase price, title search fee, legal fees, sales commissions, remodeling, and improvements. 10. A basket purchase of assets is the purchase of a group of assets for a single purchase price. For example, building, land and equipment could be purchased for one price, $80,000. When a group of assets are purchased together, the purchase price must be allocated among the different assets. One of the more common methods of making the allocation is the relative fair market value method. The fair market value of each asset is determined and then its ratio to the total fair market value of all assets is applied to the total purchase price. 11. The life cycle of a long-term operational asset simply describes the process of acquiring, using, and retiring the asset. This process includes obtaining the funding to acquire the asset, acquiring the asset, using the asset, and disposing of the asset. 12. Straight-line depreciation. This method allocates an equal amount of depreciation to each period over the useful life of the asset. Example: Asset cost of $4,000 with a 4-year life and no salvage value would produce a depreciation expense of $1,000 per year. This method is appropriate when the usefulness of an asset is consistent over the asset's life.
Units-of-production depreciation. When this method of depreciation is used, depreciation is calculated for each estimated unit of use, e.g. cost per mile. This estimated unit cost is then applied to the actual use of the asset for the period. Example: Asset cost of $4,000 with estimated use of 20,000 miles would produce a cost per mile of $.20. If the asset was used 4,000 miles in the year, the depreciation would be $800 ($.20 x 4,000). This method is more appropriate when the usefulness of an asset is related to the amount of use. Double-declining balance depreciation. This is an accelerated depreciation method that allocates more of the cost of an asset to expense in the early years of the asset's life. It is called doubledeclining balance because the method applies twice the straight-line rate to the book value of the asset. Example: Asset cost of $4,000 with an estimated useful life of 4 years would produce an expense of $2,000 in the first year [$4,000 x (2 x.25)]. The amount of depreciation expense will decrease each year of the asset's life. This method is appropriate when the usefulness of an asset decreases more in the early years of life than it does in the later years of the asset's life. 13. Recognition of depreciation expense reduces total assets; while the asset account containing the asset that is being depreciated is not changed, the contra asset account, accumulated depreciation, is increased which, in turn, reduces total assets. Total equity is decreased when an expense is recognized. 14. The recognition of depreciation expense does not affect cash flows. Depreciation recognition is simply the allocation of part of a previously acquired asset to expense. Cash is affected when the asset is purchased, when an improvement is made to the asset, and when it is sold.
15. Total assets will be lower at the end of the first year of the asset s life if MalMax chooses the double-declining balance method of computing depreciation rather than straight-line. This results because more expense is recognized in the early years of an asset s life when double-declining balance is used. However, at the end of the asset s life, total assets will be the same regardless of the method chosen because the amount of total depreciation recognized over the asset s life is the same regardless of the depreciation method chosen. 16. When the total cost of an asset is expensed in the year acquired, total expense will be overstated and net income will be understated. Because all of a plant asset's cost is erroneously expensed, assets will be understated and retained earnings will be understated because net income was understated. 17. Salvage value is the estimated value of a plant asset at the end of its useful life to the business. 18. Accumulated depreciation is a contra asset account. As the cost of a plant asset is expensed, a contra asset account is credited, rather than a direct reduction of the related asset account. This method is used because the cost allocation is an estimate, not an exact amount. In addition, this method provides more information to financial information users, in that the original cost is shown in the asset account and the allocated cost is shown as accumulated depreciation. 19. Book value of an asset is its historical cost less any accumulated depreciation. 20. Recording the depreciation recognized in the contra asset account allows the total cost of the asset and the total amount expensed to be shown in the accounts and on the balance sheet. This provides more information to the reader of the financial statements, e.g., some judgment can be made about the age and use of the asset. The use of the contra account is also required by GAAP.
21. Book value is computed as the cost of the equipment less the accumulated depreciation of that equipment, $5,000 $3,000 = $2,000. This does not represent the fair market value of the equipment because the accumulated depreciation is only an allocation of the cost based on estimates. In addition, the market value of the equipment may not be related to its original cost. 22. The method of depreciation chosen for a particular piece of equipment should represent as closely as possible the pattern of its usage of that piece of equipment. For instance, double-declining balance may be used for that piece of equipment whose usefulness declines more in the early years of its life. Straight-line depreciation should be used for that piece of equipment whose usefulness declines at a constant rate over its useful life. 23. When an asset is purchased and put into service, an estimate is made of the expected useful life of the asset. However, as the asset is used, it may become apparent that the estimate was incorrect or circumstances may have changed (e.g., the asset is used more than expected) to cause the estimate to be incorrect. When these situations arise, it is necessary to revise the estimated useful life of the asset and, consequently, the amount of depreciation expense per period. The revised estimated useful life will affect the amount of depreciation per year. If the estimated life is longer than originally expected, the amount of depreciation per year will decrease; if the estimated useful life is shorter than originally expected, the amount of depreciation per year will be larger. 24. When an expenditure improves the quality of an asset, this improvement is accounted for as if a new asset is purchased; the equipment account is debited. The improvement is depreciated over the remaining life of the original asset since the life of the asset is not extended; only the quality is improved. When an expenditure extends the life of the asset, this expenditure in effect reduces some of the depreciation already taken on the asset. This is accomplished by reducing the accumulated depreciation account (a debit to accumulated depreciation). Depreciation is recalculated by spreading the remaining book value, reduced by salvage value, over the remaining estimated life of the asset.
25. When a long-term operational asset is sold for a gain, total assets and equity increase by the amount of the gain. The gain is the amount the asset is sold for over the book value of the asset. However, the cash flow from the sale of the equipment is the amount the asset is sold for (assuming it is sold for cash). The total amount of cash received is shown as a cash inflow in the investing section of the statement of cash flows. 26. Depletion is the process of systematically allocating the cost of natural resources to expense based on estimated production of the asset. The most common method used to calculate depletion is unitsof-production. An estimated cost per unit of resource is determined by dividing the cost of the asset by the estimated production. The amount of expense for each period is based on the number of units extracted and sold. 27. Some of the most common intangible assets include patents, copyrights, and goodwill. Amortization is generally based on the legal life of the asset, the useful life of the asset, or, in the case of goodwill, the amount of any impairment. The asset is generally amortized over the shortest of these possible lives. The period over which an intangible asset can be amortized for tax purposes is generally determined according to terms specified by tax law. These terms are generally different from those used for financial accounting.