Topic 7 Reporting Property,

Plant, and Equipment;

Intangibles
Learning Objectives
AfterAfter
studying this topic,
studying you should
this chapter, be ablebeto:
you should able to:

7-1 Define, classify, and explain the nature of long-lived productive assets.
7-2 Apply the cost principle to measure the acquisition and maintenance of
property, plant, and equipment.
7-3 Apply various cost allocation methods as assets are held and used over
time.
7-4 Explain the effect of asset impairment on the financial statements.
7-5 Analyze the disposal of property, plant, and equipment.
7-6 Apply measurement and reporting concepts for intangible assets.

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Understanding the Business

Insufficient
capacity results
in lost sales.
Costly excess
capacity reduces
profits.

How much
is enough?

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Classifying Long-Lived Assets

Tangible Intangible
Physical No Physical
Substance Substance

 Land  Patents
 Buildings, fixtures, and equipment  Copyrights
 Natural resources  Franchises
 Licenses
 Trademarks

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Asset Section of the Balance Sheet

SOUTHWEST AIRLINES CO.

Consolidated Balance Sheets (partial)
December 31, 2014 and 2013
Assets (dollars in millions) 2014 2013
Current assets: (summarized) $ 4,404 $ 4,456
Property and equipment, at cost:
Flight equipment 18,473 16,937
Ground property and equipment 2,853 2,666
Deposits on flight equipment purchase contracts 566 764
Assets constructed for others 621 453
22,513 20,820
Less allowance for depreciation and amortization 8,221 7,431
Total property and equipment 14,292 13,389
Goodwill 970 970
Other assets 534 530
Total assets $20,200 $19,345

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Measuring and Recording Acquisition Cost

Acquisition cost includes the purchase price and all expenditures needed
to prepare the asset for its intended use. This does not include
financing charges associated with the purchase.

Acquisition Costs
• Purchase price
• Sales taxes
• Transportation costs
• Legal and realty fees
• Installation costs

Note - We say that the expenditures are capitalized

when they are recorded as an asset.

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Measuring and Recording Acquisition Cost

Acquisition for Cash - Southwest Airlines purchased aircraft for $75 million cash.

Flight Equipment (+A) ….….……………………………………………….. 75,000,000

Cash (-A) ………………………………………………………………………… 75,000,000

Acquisition for Debt - Southwest Airlines purchased aircraft for $1 million cash
and a $74 million note payable.

Flight Equipment (+A) ….….……………………………………………….. 75,000,000

Cash (-A) ………………………………………………………………………… 1,000,000
Notes Payable (+L) ………………………………………………………… 74,000,000

Acquisition for Equity - Southwest gave Boeing 1 million shares of $1 par

value common stock with a market value of $50 per share plus $25 million in
cash for aircraft.
Flight Equipment (+A) ….….……………………………………………….. 75,000,000
Common Stock (+SE) ……………………………………………………… 1,000,000
Additional Paid-in Capital (+SE) …………………………………….. 49,000,000
Cash (-A) ………………………………………………………………………… 25,000,000

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Acquisition by Construction

Asset cost includes:

A reasonable
All materials and amount of Interest on debt
labor traceable to overhead. incurred during
the construction. the construction.

Building

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Repairs, Maintenance, and Improvements

Type of Accounting
Expenditure Identifying Characteristics Treatment
Ordinary 1. Maintains normal operating condition Expense
repairs and 2. Does not increase productivity in the
maintenance 3. Does not extend useful life period
4. Recurring in nature incurred
5. Involves small amounts

Improvements 1. Represents major overhaul or partial replacement Add to

2. Occurs infrequently asset
3. Increases efficiency account
4. May extend useful life (Capitalize)

5. Involves large amounts of money

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Repairs, Maintenance, and Improvements

To aid with capitalize/expense decisions, many companies record all

expenditures below a certain dollar amount as expenses.

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WorldCom: Hiding Billions in Expenses through
Capitalization

• When expenditures that should be recorded as current

period expenses are improperly capitalized as part of
the cost of the asset, the effects on the financial
statements can be enormous.

• In one of the largest accounting frauds in history,

WorldCom inflated its income and cash flows from
operations by billions of dollars. This fraud turned
WorldCom’s actual losses into large profits.

• During 2001 and 2002 WorldCom capitalized $3.8

billion of operating expenses.

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Depreciation Concepts

Depreciation is the process of allocating the cost of buildings and

equipment over their productive lives using a systematic and rational
method.

Balance Sheet Income Statement

Cost Allocation
Acquisition Cost Expense

(Unused) (Used)

Depreciation Depreciation Income

Expense (current year) Statement

Accumulated Total depreciation Balance

Depreciation (to date) Sheet

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Key Depreciation Concepts

 Depreciation is a process of cost allocation, not a process of

determining market value.

 The remaining balance sheet amount probably does not represent

market value.

 The undepreciated costs is not measured on a fair value basis.

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Adjusting for Depreciation

An adjusting journal entry is needed at the end of each period to reflect

the use of buildings and equipment for the period:
Debit Credit
Depreciation Expense (+E, -SE) ….….……………………………………… x,xxx
Accumulated Depreciation (+XA, -A) …………………………………. x,xxx

Cost XX
Less Accumulated Depreciation - XX
Net Book Value XX

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Book Value as an Approximation of
Remaining Life

Some analysts compare the book value of assets to their

original cost as an approximation of their remaining life.
Example:
 If book value of an asset is 100 percent of its cost,
it is a new asset.
 If book value of an asset is 25 percent of its cost, it
only has around 25 percent of its life remaining.

Book Value as a Percentage of Original Cost

Southwest
63%
United Continental
71%
JetBlue
78%

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Differences in Estimated Lives within
a Single Industry

Company Estimated Life (in years)

Southwest 23 to 25
United Continental 25 to 30
Singapore Airlines 15

• Differences in estimated lives of assets may be attributable to a

number of factors such as the type of aircraft used by each company,
equipment replacement parts, operational differences, and the degree
of management’s conservatism.

• Differences in estimated lives and residual values of assets can have a

significant impact on a comparison of the profitability of the competing
companies.

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Depreciation Concepts

The calculation of depreciation requires three amounts for each

asset:
Acquisition cost
Estimated useful life
Estimated residual value (salvage value)

Alternative depreciation methods:

 Straight-line
 Units-of-production
 Declining-balance

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Data for Illustrating the Computation of Depreciation

SOUTHWEST AIRLINES CO.

Acquisition of a New Service Vehicle
Cost, purchased on January 1, 2016 $62,500
Estimated residual value $2,500
Estimated useful life 3 Years OR 100,000 miles
Actual miles driven in: Year 2016 30,000 miles
Year 2017 50,000 miles
Year 2018 20,000 miles

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 Straight-Line Method

Depreciation Expense = (Cost - Residual Value) X 1/Useful Life

Depreciation Expense = ($62,500 - $2,500) X 1/3 Years = $20,000 per year

Notice that:
 Depreciation expense is a constant amount each year.
 Accumulated depreciation increases by an equal
amount each year.
 Net book value decreases by the same amount each
year until it equals the estimated residual value.

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Units-of-Production Method

Southwest purchased ground equipment for

$62,500 cash. The equipment has an estimated
useful life of 100,000 miles and an estimated
residual value of $2,500.

If the equipment is used 30,000 miles in the first

year, what is the amount of depreciation
expense?

Units-of-Prodection Formula:

Depreciation = (Cost – Residual Value) Actual

X
Expense Estimated Total Production Production

Depreciation = ($62,500 - $2,500) × 30,000 miles = $18,000

Expense
100,000 miles

Depreciation = $0.60 per mile × 30,000 miles = $18,000

Expense

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Declining-Balance Method

The accelerated depreciation methods match higher depreciation

expense with higher revenues in the early years of an asset’s useful life
when the asset is more efficient.

Depreciation Expense Repair Expense

Early Years High Low
Later Years Low High

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Double Declining-Balance Method

At the beginning of the year, Southwest purchased equipment

for $62,500 cash. The equipment has an estimated useful life
of three years and an estimated residual value of $2,500.
Calculate the depreciation expense for the first two years.

2
Depreciation
Expense
= (Cost – Accumulated Depreciation) ×
Useful Life

Annual computation ignores residual value.

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Double Declining-Balance Method

2
Depreciation
Expense
= (Cost – Accumulated Depreciation) ×
Useful Life

2
Depreciation
= ( $62,500 – $0 ) × = $41,667
Expense (2016) 3

2
Depreciation = $13,889
Expense (2016)
= ( $62,500 – $41,667 )×
3

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Double-Declining-Balance Method

Computation Depreciation Accumulated Net

[(Cost-Accumulated Expense Depreciation Book
Year Depreciation) X 2/Useful Life] Balance Value
At acquisition $62,500
2016 ($62,500-$0) X 2/3 $ 41,667 $ 41,667 20,833
2017 ($62,500-$31,667) X 2/3 13,889 55,556 6,944
2018 ($62,500-$55,556) X 2/3 4,629 60,185 2,315
4,444 60,000 2,500
$ 60,000

Computed amount Equal to estimated

is too large residual value at
end of useful life

Depreciation expense is limited to the amount that

reduces book value to the estimated residual value.

( )
2
($62,500 – $55,556) × = $4,629
3 years

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Impact of Alternative Depreciation Methods

• Accelerated depreciation methods report higher

depreciation and, therefore, lower net income during
the early years of an asset’s life. As the age of the asset
increases, this effect reverses.

• The graph shown

illustrates the
relationship
between the
double-declining-
balance method
and the straight-
line method of
depreciation.

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Increased Profitability Due to
an Accounting Adjustment?
Reading the Notes

• Financial analysts are particularly interested in

changes in accounting estimates because they can
have a large impact on a company’s before-tax
operating income.

• In 2001, Singapore Airlines disclosed in its annual

report that it had increased the estimated useful life
of its aircraft from 10 to 15 years to reflect a change in
its aircraft replacement policy.

• The change reduced depreciation expense by $265

million each year.

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How Managers Choose
Financial Reporting
The objective of financial
reporting is to provide
economic information about a
business that is useful in
projecting future cash flows of
the business. Financial reporting
rules follow IFRS.
Tax Reporting
The objective of the Tax Code is to
raise sufficient revenues to pay for
the expenditures of the federal
government. Many of the Code’s
provisions are designed to
encourage certain behaviors that
are thought to benefit society.
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Measuring Asset Impairment

Book value is impaired when the probable future benefits of

an asset are less than the asset’s book value.

Step 1: Test for Impairment Impairment occurs when events or changed

circumstances cause the estimated future cash flows (future benefits) of
these assets to fall below their book value.

If net book value > Estimated future cash flows, then the asset is impaired

Step 2: Computation of Impairment Loss For any asset considered to be

impaired, companies recognize a loss for the difference between the
asset’s book value and its fair value (a market concept).

Impairment Loss = Net Book Value – Fair Value

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Disposal of Property, Plant, and Equipment

Update depreciation expense through the date of disposal

Record disposal by:

Recording cash Recording a

received (debit) gain (credit)
or paid (credit). or loss (debit).

Writing off accumulated Writing off the

depreciation (debit). asset cost (credit).

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Disposal of Property, Plant, and Equipment

Southwest Airlines sold flight equipment for $11

million cash at the end of its 17th year of use. The
flight equipment originally cost $30 million and was
depreciated using the straight-line method with zero
residual value and a useful life of 25 years.

The amount of depreciation expense recorded at the end of the 17th

year to bring depreciation up to date is:

Annual Depreciation:
a. $0 ($30,000,000 – $0) ÷ 25 years
b. $1.2 million = $1,200,000
c. $1.5 million
d. $2 million

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Disposal of Property, Plant, and Equipment

Southwest Airlines sold flight equipment for $11

million cash at the end of its 17th year of use. The
flight equipment originally cost $30 million and was
depreciated using the straight-line method with zero
residual value and a useful life of 25 years.

After updating the depreciation,

the equipment’s book value at the end of the 17th year is:
Accumulated Depreciation =
a. $9.6 million
(17yrs. × $1,200,000) = $20,400,000
b. $20.4 million
c. $12.8 million BV = Cost – Accumulated Depreciation
d. $6.6 million BV = $30,000,000 – $20,400,000
= $9,600,000

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Disposal of Property, Plant, and Equipment

Southwest Airlines sold flight equipment for $11

million cash at the end of its 17th year of use. The
flight equipment originally cost $30 million and was
depreciated using the straight-line method with zero
residual value and a useful life of 25 years.

The equipment’s sale resulted in:

a. a gain of $1.4 million Gain = Cash Received – Book Value

b. a loss of $1.7 million Gain = $11,000,000 – $9,600,000 =
c. a gain of $3.8 million $1,400,000
d. a gain of $6.2 million

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Disposal of Property, Plant, and Equipment

Prepare the journal entry to record Southwest’s

sale of the equipment at the end of the 17th year.

Cash (+A) ….….………………………………………………………………….. 11,000,000

Accumulated Depreciation (-XA, +A) ………………………………. 20,400,000
Flight Equipment (-A) …………………………………………………… 30,000,000
Gain on Sale of Assets (+Gain, +SE) .……………………………… 1,400,000

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Nature of Intangible Assets

• Noncurrent assets without physical substance

• Often provide exclusive rights or privileges

Most common types of intangible assets:

Goodwill
Trademarks
Copyrights

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Amortization of Intangible Assets

Definite Life Indefinite Life

• Amortized over shorter of
economic life or legal life.
• Straight-line method used.
• Not amortized.
• Tested at least annually for
possible impairment, and
book value is reduced to
fair value if impaired.

Amortization is a cost allocation process similar to

depreciation and depletion.

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Common Intangibles
Goodwill:
• Occurs when one company buys another company
• Equals the amount by which the purchase price exceeds the fair
market value of net assets acquired
• Not amortized but reviewed annually for impairment

Trademarks :
• A symbol, design, or logo associated with a business
• An exclusive legal right to use a name, image, or slogan
• Usually internally developed

Copyrights:
• The exclusive right to publish, use, and sell a literary, musical, or
artistic work
• Legal life is life of creator plus 70 years

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Other Intangible Assets

Technology - A category of intangible assets that includes a

company’s website and any computer programs written by its
employees.
Patents - Exclusive right granted by the federal government to
sell or manufacture an invention.
Franchises - Legally protected right purchased by a franchisee to
sell products or provide services for a specified period and
purpose.
Licenses and Operating Rights - Limited permissions to use a
product or service according to specific terms and conditions.

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Differences in Accounting for Tangible and
Intangible Assets

International Perspective
US GAAP IFRS
Cost versus • Must record at cost • Choose between either cost or fair
Fair Value • Adjust for depreciation/ value
amortization and • Adjust for depreciation/
impairment amortization and impairment
• Do not record increases • If using fair value, record increases
in value in value
Research and • Expense all costs of • Expense research costs, but
Development researching and capitalize measurable costs of
developing intangible developing intangible assets
assets

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