ch2: Accounting Cycle For SGB

Fundamentals of Accounting-II 2023
Chapter Two
Property, Plant, equipment, Intangible Assets and natural resource
1.1. Nature of plant assets
Businesses use a variety of fixed assets, such as equipment, furniture, tools, machinery,
buildings, and land. Fixed assets are long-term or relatively permanent assets. They are tangible
assets because they exist physically. They are owned and used by the business and are not
offered for sale as part of normal operations. Other descriptive titles for these assets are plant
assets or property, plant, and equipment.
An asset to be considered as a plant asset;
a) The asset must be held for use and not for sale or investment
Only assets used in the normal course of business should be included. However, it does not
include idle land or buildings; these should be reported as investments.
b) The asset must have an expected life of more than one year
The asset represents a bundle of future services that the company will receive over the life of the
asset. To be included in plant asset, the benefits must extend for more than one year or the
normal operating cycle. Therefore, a company distinguishes the asset from other assets, such as
supplies, that it expects to consume within the current year.
c) The asset must be tangible in nature
There must be a physical substance (a definite size and shape) that can be seen and touched. In
contrast, intangible assets such as goodwill or patents are assets without a physical feature that
can be charged in the operations of business for long period of time.
Recognition of property, plant and equipment
Property, plant and equipment are tangible items that are held for use in the production or supply
of goods or services, for rental to others or for administrative purposes; and are expected to be
used during more than one period.
IAS 16 states that the cost of an item of property, plant and equipment shall be recognized as an
asset if and only if:
8 It is probable that future economic benefits associated with the item will flow to the entity.
8 The cost of the item can be measured reliably.
This recognition principle shall be applied to all costs at the time they are incurred both incurred
initially to acquire or construct an item of property, plant and equipment and incurred
subsequently after recognition to add to replace part of or service it.
Measurement
Initial Measurement
An item of property, plant and equipment that qualifies for recognition as an asset shall be
measured at its cost.
The cost of an item of property, plant and equipment comprises:
8 Its purchase price including import duties, non-refundable purchase taxes, after deducting
trade discounts and rebates
8 Any costs directly attributable to bringing the asset to the location and condition necessary
for it to be capable of operating in the manner intended by management. Examples of these
costs are: costs of site preparation, professional fees, initial delivery and handling,
installation and assembly, etc.
8 The initial estimate of the costs of dismantling and removing the item and restoring the
site on which it is located.
The cost principle requires that companies record plant assets 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 cost principle to each of the major classes of plant assets.
i. The acquisition cost of land
The cost of land includes the negotiated cash price plus other costs such as the cost of land
surveys, legal fees, title fees, Broker’s commissions, cost of preparing the land to build on, and
even the demolition costs of old structures. However, any proceeds obtained in the process of
getting the land ready for its intended use, such as salvage receipts on the demolition of an old
building are treated as reductions in the price of the land.
Illustration 2.1
Assume that ZB Manufacturing Company acquires real estate at a cash cost of Br.100, 000. The
property contains an old warehouse that is realized at a net cost of Br.6, 000 (Br.7, 500 in costs
less Br.1, 500 proceeds from salvaged materials). Additional expenditures are the attorney’s fee,
Br.1, 000, and the real estate Broker’s commission, Br.8, 000.
The cost of the land is Br.115, 000. When ZB records the acquisition, it debits Land for Br.115,
000 and credits Cash for Br.115, 000(Br.100, 000+Br.6, 000+Br.1, 000+Br.8, 000).
ii. The Acquisition Cost of Building
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 an existing building is purchased its cost
includes, the purchase price plus all repairs and other expenses required to put it in a usable
condition.
When a business constructs a new building, the cost includes all reasonable and necessary
expenditures, such as those for materials, labor, part of the overhead and other indirect costs,
engineers and architects’ fees, insurance during construction, interest incurred on construction
loans during the period of construction, lawyers' 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.
iii. The Acquisition Cost of Equipment
The term “equipment” refers to office equipment, store equipment, factory equipment, delivery
equipment, machinery, furniture and fixtures, and similar fixed assets. The cost of such assets
includes the invoice (purchase) price, transportation and handling charges, insurance on the
equipment while in transit, assembling and installation costs, and costs of conducting trail runs.
However, costs incurred for acquisition of plant asset but due to carelessness or
negligence/vandalism are not included in cost of the asset.
Illustration 2.2
Assume ABC Company purchases factory machinery at a cash price of Br.50,000. Related
expenditures are for sales taxes Br.3,000, insurance during shipping Br.500, and installation and
testing Br.1,000. The cost of the factory machinery is Br.54,500
(Br.50000+Br.3000+Br.500+Br.1000).
OSB makes the following summary entry to record the purchase and related expenditures.
Equipment………………………… 54,500
Cash………………................. 54,500
(To record purchase of factory machine)
1.2. Accounting for Depreciation

Depreciation is periodic transfer of cost to expense. The adjusting entry to record depreciation is
usually made at the end of each month or at the end of the year. This entry debits Depreciation
Expense and credits a contra asset account entitled Accumulated Depreciation or Allowance for
Depreciation. The use of a contra asset account allows the original cost to remain unchanged in
the fixed asset account.
Factors that cause a decline in the ability of a fixed asset to provide services may be identified as
physical depreciation or functional depreciation. Physical depreciation occurs from wear and tear
while in use and from the action of the weather. Functional depreciation occurs when a fixed
asset is no longer able to provide services at the level for which it was intended.
The term depreciation as used in accounting is often misunderstood because the same term is
also used in business to mean a decline in the market value of an asset. However, the amount of a
fixed asset’s unexpired cost reported in the balance sheet usually does not agree with the amount
that could be realized from its sale. Fixed assets are held for use in a business rather than for sale.
It is assumed that the business will continue as a going concern. Thus, a decision to dispose of a
fixed asset is based mainly on the usefulness of the asset to the business and not on its market
value.
Three factors are considered in determining the amount of depreciation expense to be recognized
each period. These three factors are (a) the fixed asset’s initial cost, which is all expenditures
necessary to acquire the asset and make it ready for intended use (b) its expected useful life,
which is estimate of the expected life based on need for repair, service life, and vulnerability to
obsolescence, and (c) its estimated value at the end of its useful life, which is estimate of the
asset's value at the end of its useful life. This third factor is called the residual value, scrap value,
salvage value, or trade in value. A fixed asset’s residual value at the end of its expected useful
life must be estimated at the time the asset is placed in service. If a fixed asset is expected to
have little or no residual value when it is taken out of service, then its initial cost should be
spread over its expected useful life as depreciation expense. If, however, a fixed asset is expected
to have a significant residual value, the difference between its initial cost and its residual value,
called the asset’s depreciable cost, is the amount that is spread over the asset’s useful life as
depreciation expense.
A fixed asset’s expected useful life must also be estimated at the time the asset is placed in
service. Estimates of expected useful lives are available from various trade associations and other
publications.
In practice, many businesses use the guideline that all assets placed in or taken out of service
during the first half of a month are treated as if the event occurred on the first day of that month.
That is, these businesses compute depreciation on these assets for the entire month. Likewise, all
fixed asset additions and deductions during the second half of a month are treated as if the event
occurred on the first day of the next month.
Example: An asset acquired and placed in operation on September 15 treated as it acquired and
placed on September 1 and depreciate for full months of September. Similarly, if an asset placed
in or retired from operation in the second half of the month it considered as the asset placed in or
retired from operation on the first day of the next month.
It is not necessary that a business use a single method of computing depreciation for all its
depreciable assets. The methods used in the accounts and financial statements may also differ
from the methods used in determining income taxes and property taxes. The four methods used
most often are straight line, units of production, declining-balance sum of the years’ digit.
i. Straight-line method:
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. The depreciation expense for each
period is computed by dividing the depreciable cost (cost of the asset less its estimated residual
value) by the number of accounting periods in the asset’s estimated useful life.
Illustration 2.3
Assume that the cost of a depreciable asset is Br.24, 000, its estimated residual value is Br.2,
000, and its estimated life is 5 years. The annual depreciation is computed as follows:
Br .24,000 cost−Br .2,000 estimated residual value
=Br .4,400 annual depreciation
5 years , estimated life
When an asset is used for only part of a year, the annual depreciation is prorated. For example,
assume that the fiscal year ends on December 31 and that the asset in the above example is
placed in service on October 1.
The depreciation for the first fiscal year of use would be Br.1, 100 (Br.4,400 x 3/12).
For ease in applying the straight-line method, the annual depreciation may be converted to a
percentage of the depreciable cost. This percentage is determined by dividing 100% by the
number of years of useful life. For example, a useful life of 20 years converts to a 5% rate
(100%/20), 8 years converts to a 12.5% rate (100%/8), and so on. In the above example, the
annual depreciation of Br.4, 400 can be computed by multiplying the depreciable cost of Br.22,
000 by 20% (100%/5).
Check your progress: Exercise 2.1.
A plant asset is purchased for Br. 14,000, expected to have a residual value of Br. 2,000 at the
end of its estimated useful life of 4 years. The accounting period consists of 12 months and ends
on each December 31.
Required: Determine periodic deprecation under straight line method of deprecation;
1. If the asset acquired and placed in operation on January13
2. If the asset acquired and placed in operation on June 18
ii. Units-of-production
How would you depreciate a fixed asset when its service is related to use rather than time? When
the amount of use of a fixed asset varies from year to year, the units-of-production method is
more appropriate than the straight-line method. In such cases, the units-of-production method
better matches the depreciation expense with the related revenue. The units-of-production
method provides for the same amount of depreciation expense for each unit produced or each
unit of capacity used by the asset. To apply this method, the useful life of the asset is expressed
in terms of units of productive capacity such as hours, miles number of units to be produced. The
total depreciation expense for each accounting period is then determined by multiplying the unit
depreciation by the number of units produced or used during the period.
Asset cost−Estimated salvage value
The deprecation per hour=
Estimated operating hours
Deprecation per period = Depreciation per hour X Actual number of operating hours during the
period
Illustration 2.4.
Assume that a machine with a cost of Br.24, 000 and an estimated residual value of Br.2, 000 is
expected to have an estimated life of 10,000 operating hours. The depreciation for a unit of one
hour is computed as follows:
Br .24000 cost−Br .2,000 estimated residual value
=Br .2.2 hourly depreciation
10000 estimated hours
Assuming that the machine was in operation for 2,100 hours during a year, the depreciation for
that year would be Br.4, 620 (Br.2.20 x 2,100 hours).
iii. Declining-balance
It is an accelerated method of depreciation, results large amount of depreciation in the early years
of an asset’s life and smaller amounts in later years. It results a declining periodic depreciation
expense over the estimated useful life of the asset. It uses time as a factor of deprecation rather
than use of plant asset.
The periodic depreciation is a fixed percentage of the ‘book value’ (the declining balance) of the
asset at the beginning of the year. In the last periods of an asset’s useful life, the periodic
depreciation is limited to the amount necessary to reduce book value to residual value. The book
value is equal to the original cost less total accumulated depreciation to date. Though any fixed
rate might be used, the most common rate is a percentage equal to twice the straight-line
deprecation percentage. When twice the straight-line rate is used, the method is called the double
decline balance method. Double-declining-balance depreciation allocates to depreciation expense
twice the straight-line rate times the book value of an asset. To apply this method, the annual
straight-line depreciation rate is doubled. For example, the declining-balance rate for an asset
with an estimated life of 5 years is 40%, which is double the straight-line rate of 20% (100%/5).
For the first year of use, the cost of the asset is multiplied by the declining balance rate. After the
first year, the declining book value (cost minus accumulated depreciation) of the asset is
multiplied by this rate.
Illustration 2.5
Assume that the cost of a depreciable asset is Br.24, 000, its estimated residual value is Br.2, 000
with the estimated life is 5 years.
Yea Cost Accumulated Book Value Rate Depreciatio Book Value

r Depreciation at the at the Beg. n For Year at End of
Beg. of year of year year
1 Br.24,00 Br.24,000.0 40% Br.9,600.00 Br.14,400.0

0 0 0
2 24,000 Br. 9,600.00 14,400.00 40% 5,760.00 8,640.00
3 24,000 15,360.00 8,640.00 40 3,456.00 5,184.00

%
4 24,000 18,816.00 5,184.00 40% 2,073.60 3,110.40
5 24,000 20,889.60 3,110.40 _ 1,110.40 2,000.00
You should note that when the declining-balance method is used, the estimated residual value is
not considered in determining the depreciation rate. It is also ignored in computing the periodic
depreciation. However, the asset should not be depreciated below its estimated residual value. In
the above example, the estimated residual value was Br.2, 000. Therefore, the depreciation for
the fifth year is Br.1, 110.40 (Br.3, 110.40-Br.2, 000.00) instead of Br.1, 244.16 (40% x Br.3,
110.40). In the example above, we assumed that the first use of the asset occurred at the
beginning of the fiscal year. This is normally not the case in practice, however, and depreciation
for the first partial year of use must be computed. For example, assume that the asset above was
in service at the end of the third month of the fiscal year. In this case, only a portion (9/12) of the
first full year’s depreciation of Br.9, 600 is allocated to the first fiscal year. Thus, depreciation of
Br.7, 200 (9/12 x Br.9, 600) is allocated to the first partial year of use. The depreciation for the
second fiscal year would then be Br.6, 720 [40% x (Br.24, 000 -Br.7, 200)].
iv. The sum-of- the years-digits method of deprecation
The sum-of- the years-digits method yields results like those obtained by use of declining-
balance method. The periodic charge for depreciation declines steadily over the estimated life of
the asset because a successively smaller fraction is applied each year to the original cost of the
asset less the estimated residual value. The denominator of the fraction, which remains the same,
is the sum of the digits representing the years of life. The numerator of the fraction, which
changes each year, is the number of years’ life remaining at the begging of the year for which
depreciation is being computed. For an asset with an estimated life of 5 years, the denominator is
5+4+3+2+1 or 15. For first year numerator is 5 for the second year 4 and so on.
Illustration 2.6.
The method is illustrated by the following depreciation schedule for an asset with an assumed
cost of Br.16000, residual value of Br.1000 and life of five years.
Year Cost less Rate Depreciation Accumulated depreciation Book value at
residual value for year at end of year end of year
1 Br.15000 5/15 Br.5000 Br.5000 Br.11000
2 15000 4 /15 4000 9000 7000
3 15000 3/15 3000 12000 4000
4 15000 2/15 2000 14000 2000
5 15000 1/15 1000 15000 1000
When first use of the asset does not coincide with the beginning of a fiscal year, it is necessary
to allocate each full year’s depreciation between the two fiscal years benefited. Assume that the
asset in the example was placed in service after three months of the fiscal year had elapsed, the
depreciation for that fiscal year would be Br.3,750 ( 9 /12 x 5 /15 x 15000). The depreciation for
the second year would be Br.4, 250 (3/12 x 5 /15 x 15000+ ¿).
 Composite Depreciation Methods
Many business enterprises find it means to account for depreciation of certain kinds of plant
assets on a composite or group basis, to minimize the record keeping for individual assets.
Composite or group depreciation is a process of averaging the economic lives of a number of
plant assets and computing depreciation on the entire class of assets as if it were an operating
unit. The term composite generally refers to a collection of somewhat dissimilar plant assets; the
term group usually refers to a collection of similar assets. The procedures for the computation of
periodic depreciation are essentially the same in either case.
Several methods may be used to develop a composite or group depreciation rate to be applied to
the total cost of a group of plant assets.
Illustration 2.7.
The computation of a straight-line composite depreciation rate for a group of machines owned by
XYZ Company is illustrated as follows:
XYZ Company
Computation of Straight-Line Composite Depreciation Rate for Machinery
Machin Cost Net Residual Value Depreciation Est. Life Annual Deprn.
e
A Br. 60,000 - Br. 60,000 5 Br. 12,000
B 100,000 12,000 88,000 8 11,000
C 150,000 10,000 140,000 10 14,000
D 190,000 10,000 180,000 12 15,000
Total Br. 500,000 Br. 32,000 Br. 468,000 Br. 52,000
Composite Depreciation Rate based on Cost: Br. 52,000 / 500,000 =10.4%
Composite Economic Life of Machines: Br. 468,000 / Br. 52,000 = 9 Years.
The composite depreciation rate is 10.4%, and the composite rate to the cost of Br. 5,00,000 will
reduce the composite net residual value of the machines to Br. 32,000 in exactly 9 years [Br.
5,00,000 – (52,000 X 9) = Br. 32,000}.
Once the composite depreciation rate is computed, it is continued in use until a material change
occurs in the composition of plant assets or in the estimate of their economic lives. The
assumption underlying the use of composite depreciation methods are (1) plant assets are
regularly retired near the end of their economic lives (2) retired plant assets are regularly
replaced with similar assets, and (3) proceeds on retirement are approximately equal to the net
residual value for the computation of the composite depreciation rate. If the assets are not
replaced, for example, the use of 10.4% rate computed above eventually would result in the
recording of excessive depreciation.
In the determination of yearly depreciation, the 10.4% rate is applied to the balance of the
Machinery ledger account at the beginning of the year, which balance excludes the original cost
of all machines retired prior to the beginning of the year. Thus, for each of the first five years,
annual depreciation is Br. 52,000; and in the sixth year (assuming machine X was replaced at the
end of the fifth year with a similar machine costing Br. 90,000), depreciation would be Br.
55,120 [Br. 5,00,000 – Br. 60,000 + Br. 90,000) X 10.4% = Br. 55, 120]. The composite
depreciation rate is not revised when plant assets are replaced with comparable assets, and the
asset group should not be depreciated below net residual value at any time.
When composite depreciation procedures are employed, a record is not maintained for
accumulated depreciated or individual plant assets. When an asset is retired from use or sold, a
journal entry is required to remove the original cost from the plant asset account, and any
difference between original cost and the proceeds received is debited to Accumulated
depreciation; a gain or loss is not recognized because gains or losses are assumed to offset over
time. As for example: If machine were sold at the end of the fourth year for Br. 15,000, the
journal entry to record the sale would be as follows:
Cash Account ……………………………………… 15,000
Accumulated Depreciation of Machinery………… 45,000
To Machinery Account…………… 60,000
To record sale of machine XYZ Company depreciation method is used; therefore, no gain or loss
is recognized.
The primary advantage of the composite depreciation method is that the averaging procedure
may obscure significant variations from average. The accuracy of the straight line composite
depreciation rate may be verified by re-computing depreciation on the straight line basis for
individual plant assets. Any significant discrepancies between the two results require a change in
the composite depreciation rate.
The advantages claimed for the composite method are simplicity, convenience, and a reduction
in the amount of detail involved in plant asset records and depreciation computations. The
availability of computers has reduced the force of this argument. In many cases unit plant asset
records are now feasible, although composite methods previously were considered a necessity.
The requisites for the successful operation of composite depreciation procedures are that there
are a large number of homogeneous plant assets, of relatively small individual value, with similar
economic lives. Telephone and Electricity transmission poles, underground cables, railroad
tracks, and hotel furniture are examples of plant assets for which composite depreciation
methods may give satisfactory results.
 Revising Periodic Depreciation
If wear and tear or obsolescence indicates 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. 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.
Illustration2.8
Assume ABC Company purchased a fixed asset on Jan 1, 2012 for Br.13, 000 was originally
estimated to have a useful life of 5 years and a residual value of Br.1, 000. Then, ABC decides
on January 1, 2015, to extend the useful life of the plant asset one year (a total life of six years)
and increase its salvage value to Br.2, 200. The company has used the straight-line method to
depreciate the asset to date. Depreciation per year was Br.2, 400 ((Br.13, 000-Br.1, 000) ÷5).
Accumulated depreciation after three years (2012–2014) is Br.7, 200 (Br.2, 400×3), and book
value is Br.5, 800 (Br.13, 000 -Br.7, 200). The new annual depreciation is Br.1, 200, computed
as follows.
Book value, 1/1/15 Br.5, 800
Less: Salvage value 2,200
Depreciable cost Br.3, 600
Remaining useful life 3 years (2015–2017)
Revised annual depreciation (Br.3, 600 ÷ 3) Br.1, 200
2.3. Capital and Revenue Expenditures
The costs of acquiring fixed assets, adding to a fixed asset, improving a fixed asset, or extending
a fixed asset’s useful life are called capital expenditures. Such expenditures are recorded by
either debiting the asset account or its related accumulated depreciation account. They are
usually material in amount and occur infrequently. Capital expenditures may involve;
i. Additions to Plant Assets: it is an enlargement to the physical layout of a plant asset or
additions of new part or separate part which increase capacity to existing plant asset.
ii. Betterments it involves substitution of better component, a new part for an old one. It
increases operating efficiency, quantity and quality of services obtained for the remaining
service life
iii. Extraordinary Repairs: it involves restoring to the old good state of conditions. It prolongs
the service life beyond original estimates.
Costs that benefit only the current period or costs incurred for normal maintenance and repairs
are called revenue expenditures. To properly match revenues and expenses, it is important to
distinguish between capital and revenue expenditures. Capital expenditures will affect the
depreciation expense of more than one period, while revenue expenditures will affect the
expenses of only the current period.
Generally, when capital expenditures are made, the revised net book value must be used to
calculate depreciation expense in subsequent accounting periods.
2.4. Disposal of Plant Assets
Fixed assets that are no longer useful may be discarded, sold, or traded for other fixed assets. The
details of the entry to record a 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 asset’s
accumulated depreciation account for its balance on the date of disposal and credits the asset
account for the cost of the asset.
A fixed asset should not be removed from the accounts only because it has been fully
depreciated. If the asset is still used by the business, the cost and accumulated depreciation
should remain in the ledger. This maintains accountability for the asset in the ledger. If the book
value of the asset was removed from the ledger, the accounts would contain no evidence of the
continued existence of the asset.
2.4.1. Discarding Fixed Assets
When fixed assets are no longer useful to the business and have no residual or market value, they
are discarded.
Illustration 2.9
To illustrate, assume that an item of equipment acquired at a cost of Br.25, 000 is fully
depreciated at December 31, the end of the preceding fiscal year. On February 14, the equipment
is discarded.
Feb 14 Accumulated Depreciation-Equipment …………. 25000
Equipment …………………………......................25000
To write off equipment discarded.
If an asset has not been fully depreciated, depreciation should be recorded prior to removing it
from service and from the accounting records.
Illustration 2.10.
To illustrate, assume that equipment costing Br.6,000 is depreciated at an annual straight-line
rate of 10%. In addition, assume that on December 31 of the preceding fiscal year, the
accumulated depreciation balance, after adjusting entries, is Br.4,750. Finally, assume that the
asset is removed from service on the following March 24. The entry to record the depreciation
for the three months of the current period prior to the asset’s removal from service is as follows:
Mar 24. Depreciation Expense - Equipment ……………………. 150
Accumulated Depreciation - Equipment………… 150
To record current depreciation on equipment discarded (Br.600 x 3/12).
The discarding of the equipment is then recorded by the following entry:
Mar 24 Accumulated Depreciation - Equipment 4900
Loss on Disposal of Fixed Assets 1100
Equipment 6000
To write off equipment discarded.
The loss of Br.1, 100 is recorded because the balance of the accumulated depreciation account
(Br.4, 900) is less than the balance in the equipment account (Br.6, 000). Losses on the
discarding of fixed assets are non-operating items and are normally reported in the Other
Expense section of the income statement.
2.4.2. Selling Fixed Assets
The entry to record the sale of a fixed asset is similar to the entries illustrated above, except that
the cash or other asset received must also be recorded. If the selling price is more than the book
value of the asset, the transaction results in a gain. If the selling price is less than the book value,
there is a loss.
Illustration 2.11
To illustrate, assume that equipment is acquired at a cost of Br.10, 000 and is depreciated at an
annual 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 Br.7, 000. The entry to update the depreciation for the nine months of the current year is as
follows:
Oct 12 Depreciation Expense–Equipment …………... 750
Accumulated Depreciation–Equipment …... 750
To record current depreciation on equipment sold (Br.10, 000 x ¾ x 10%).
After the current depreciation is recorded, the book value of the asset is Br.2, 250 (Br.10, 000 -
Br.7, 750).
The entries to record the sale, assuming three different selling prices, are as follows:
a. Sold at book value, for Br.2, 250. No gain or loss.
Oct. 12 Cash 2250
Accumulated Depreciation–Equipment 7750
Equipment 10000
b. Sold below book value, for Br.1, 000. Loss of Br.1, 250.
Oct. 12 Cash 1000
Loss on Disposal of Fixed Assets 1250
Equipment 10000
c. Sold above book value, for Br.2, 800. Gain of Br.550.
Oct. 12 Cash 2800
Equipment 10000
Gain on Disposal of Fixed Assets 550
2.4.3. Exchanging Similar Fixed Assets
Old equipment is often traded in for new equipment having a similar use. In such cases, the seller
allows the buyer an amount for the old equipment traded in. This amount, called the trade-in
allowance, may be either greater or less than the book value of the old equipment. The remaining
balance-the amount owed-is either paid in cash or recorded as a liability. It is normally called
boot.
If the trade-in allowance received is greater than the carrying value (book value) of the assets
surrendered, there has been a gain. If the trade-in allowance is less than the carrying value, there
has been a loss.
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. 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.
A. Gains on Exchanges
Gains on exchanges of similar fixed assets are not recognized for financial reporting purposes.
This is based on the theory that revenue occurs from the production and sale of goods produced
by fixed assets and not from the exchange of similar fixed assets. When the trade-in allowance
exceeds the book value of an asset traded in and no gain is recognized, the cost recorded for the
new asset can be determined in either of two ways:
i. Cost of new asset = List price of new asset - Unrecognized gain or
ii. Cost of new asset = Cash given (or liability assumed) + Book value of old asset
Illustration 2.12
To illustrate, assume the following exchange:
Similar equipment acquired (new):
List price of new equipment . . . . . . . . . . . . . . . . . . . . .. Br.5, 000
Trade-in allowance on old equipment . . . . . . . . . . . . . . . 1,100
Cash paid at June 19, date of exchange . . . . . . . . . . . ….Br.3, 900
Equipment traded in (old):
Cost of old equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . Br.4, 000
Accumulated depreciation at date of exchange . . . . . .... 3,200
Book value at June 19, date of exchange . . . . . . . . . . . .. Br. 800
Recorded cost of new equipment:
Method One:
List price of new equipment . . . . . . . . . . . . . . . . . . . . .. Br.5, 000
Trade-in allowance . . . . . . . . . . . . . . . . . . . . . . . . . . .... Br.1, 100
Book value of old equipment . . . . . . . . . . . . . . . . . . . . . 800
Unrecognized gain on exchange . . . . . . . . . . . . . . . . . .. (300)
Cost of new equipment . . . . . . . . . . . . . . . . . . . . . . . .... Br.4, 700
Method Two:
Book value of old equipment . . . . . . . . . . . . . . . . . . . . .. Br. 800
Cash paid at date of exchange . . . . . . . . . . . . . . . . . . . . . 3,900
Cost of new equipment . . . . . . . . . . . . . . . . . . . . . . . .... Br.4, 700
The entry to record this exchange and the payment of cash is as follows:
June 19 Accumulated Depreciation—Equipment …. 3200
Equipment (new equipment) ……………… 4700
Equipment (old equipment) …………………………… 4000
Cash …………………………………………………... 3900
(To record exchange of equipment)
Not recognizing the Br.300 gain (Br.1, 100 trade-in allowance minus Br.800 book value) at the
time of the exchange reduces future depreciation expense. That is, the depreciation expense for
the new asset is based on a cost of Br.4, 700 rather than on the list price of Br.5, 000. In effect,
the unrecognized gain of Br.300 reduces the total amount of depreciation taken during the life of
the equipment by Br.300.
B. Losses on Exchanges
For financial reporting purposes, losses are recognized on exchanges of similar fixed assets if the
trade-in allowance is less than the book value of the old equipment. When there is a loss, the cost
recorded for the new asset should be the market (list) price.
Illustration 2.13.
To illustrate, assume the following exchange:
Similar equipment acquired (new):
List price of new equipment . . . . . . . . . . . . . . .. Br.10, 000
Trade-in allowance on old equipment . . . . . . . . . 2,000
Cash paid at September 7, date of exchange . . .. Br.8,000
Equipment traded in (old):
Cost of old equipment . . . . . . . . . . . . . . . . . . . . . . . Br.7, 000
Accumulated depreciation at date of exchange . . . . 4,600
Book value at September 7, date of exchange . . .... Br.2, 400
Trade-in allowance on old equipment . . . . . . . . . . . . 2,000
Loss on exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . Br.400
The entry to record the exchange is as follows
Sep 7 Accumulated Depreciation––Equipment …………………. 4600
Equipment ………………………………………………... 10000
Loss on Disposal of Fixed Assets…………………………… 400
Equipment …………………………………………… 7000
Cash…………………………………………………… 8000
To record exchange of equipment, with loss
2.5. Leasing Fixed Asset
A lease is a contract for the use of an asset for a stated period of time. Leases are frequently used
in business. For example, automobiles, computers, medical equipment, buildings, and airplanes
are often leased. The two parties to a lease contract are the lessor and the lessee. 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. The lessee is obligated to make periodic rent payments for the lease term. All
leases are classified by the lessee as either capital leases or operating leases.
A capital lease is accounted for as if the lessee has, in fact, purchased the asset. The lessee debits
an asset account for the fair market value of the asset and credits a long-term lease liability
account. The asset is then written off as expense (amortized) over the life of the capital lease.
A lease that is not classified as a capital lease for accounting purposes is classified as an
operating lease. The lessee records the payments under an operating lease by debiting Rent
Expense and crediting Cash. Neither future lease obligations nor the future rights to use the
leased asset are recognized in the accounts. However, the lessee must disclose future lease
commitments in notes to the financial statements. The asset rentals described in earlier chapters
of this text were accounted for as operating leases.
2.6. Internal Control of Fixed Assets
Because of their dollar value and long-term nature, it is important to design and apply effective
internal controls over fixed assets. Such controls should begin with authorization and approval
procedures for the purchase of fixed assets. Controls should also exist to ensure that fixed assets
are acquired at the lowest possible costs. One procedure to achieve this objective is to require
competitive bids from preapproved vendors. As soon as a fixed asset is received, it should be
inspected and tagged for control purposes and recorded in a subsidiary ledger. This establishes
the initial accountability for the asset. Subsidiary ledgers for fixed assets are also useful in
determining depreciation expense and recording disposals. Operating data that may be recorded
in the subsidiary ledger, such as number of breakdowns, length of time out of service, and cost of
repairs, are useful in deciding whether to replace the asset. A company that maintains a
computerized subsidiary ledger may use bar-coded tags, so that fixed asset data can be directly
scanned into computer records. Fixed assets should be insured against theft, fire, flooding, or
other disasters. They should also be safeguarded from theft, misuse, or other damage. For
example, fixed assets that are highly open to theft, such as computers, should be locked or
otherwise protected when not in use. For computers, safeguarding also includes climate controls
and special fire-extinguishing equipment. Procedures should also exist for training employees to
properly operate fixed assets such as equipment and machinery. A physical inventory of fixed
assets should be taken periodically in order to verify the accuracy of the accounting records.
Such an inventory would detect missing, obsolete, or idle fixed assets. In addition, fixed assets
should be inspected periodically in order to determine their condition. Careful control should
also be exercised over the disposal of fixed assets. All disposals should be properly authorized
and approved. Fully depreciated assets should be retained in the accounting records until disposal
has been authorized and they are removed from service.
2.7. 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. Patents, copyrights, trademarks, and goodwill etc are long-lived
assets that are useful in the operations of a business and are not held for sale. The basic
principles of accounting for intangible assets are like those described earlier for fixed assets. The
major concerns are determining (1) the initial cost and (2) the amortization-the amount of cost to
transfer to expense. Amortization results from the passage of time or a decline in the usefulness
of the intangible asset. All intangible assets are non-physical, but not all non-physical assets
classified as intangible.
 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.
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.
Illustration 2.14
To illustrate the computation of patent amortization, assume that MBN Company purchases a
patent at a cost of Br.120, 000. If MBN estimates the useful life of the patent to be eight years,
the annual amortization expense is Br.15, 000 (Br.120, 000 ÷ 8). MBN records the annual
amortization as follows.
Dec. 31 Amortization Expense -Patents 15,000
Patents 15,000
(To record patent amortization)
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, cost for an intangible asset includes only the purchase price.
Companies expense any costs incurred in developing an intangible asset.
a. Patents
Manufacturers may acquire exclusive rights to produce and sell goods with one or more unique
features. Such rights are granted by patents, which the federal government issues to inventors.
These rights continue in effect for 20 years. A business may purchase patent rights from others,
or it may obtain patents developed by its own research and development efforts. The initial cost
of a purchased patent, including any related legal fees, is debited to an asset account. This cost is
written off, or amortized, over the years of the patent’s expected usefulness. This period of time
may be less than the remaining legal life of the patent. The estimated useful life of the patent
may also change as technology or consumer tastes change. The straight-line method is normally
used to determine the periodic amortization. When the amortization is recorded, it is debited to
an expense account and credited directly to the patents account. A separate contra asset account
is usually not used for intangible assets.
Rather than purchase patent rights, a business may incur significant costs in developing patents
through its own research and development efforts. Such research and development costs are
usually accounted for as current operating expenses in the period in which they are incurred.
Expensing research and development costs is justified because the future benefits from research
and development efforts are highly uncertain.
b. Copyrights and Trademarks
The exclusive right to publish and sell a literary, artistic, or musical composition is granted by a
copyright. Copyrights are issued by the federal government and extend for 70 years beyond the
author’s death. The costs of a copyright include all costs of creating the work plus any
administrative or legal costs of obtaining the copyright. A copyright that is purchased from
another should be recorded at the price paid for it. Copyrights are amortized over their estimated
useful lives.
A trademark is a name, term, or symbol used to identify a business and its products. Under
federal law, businesses can protect against others using their trademarks by registering them for
10 years and renewing the registration for 10-year periods thereafter. Like a copyright, the legal
costs of registering a trademark with the federal government are recorded as an asset. Thus, even
though the trademarks are extremely valuable, they are not shown on the balance sheet, because
the legal costs for establishing these trademarks are immaterial. If, however, a trademark is
purchased from another business, the cost of its purchase is recorded as an asset. The cost of a
trademark is in most cases considered to have an indefinite useful life.
c. Goodwill
It is an intangible asset that attached to a business as a result of such favorable factors as
location, product superiority, reputation, and successful business operations. From an accounting
standpoint, goodwill exists when an entire business or a part of a business purchased more than
the fair market value of the business’s net assets. Good will cannot be purchased by itself. The
value of goodwill is calculated by first subtracting the purchased company's liabilities from the
fair market value (not the net book value) of its assets and then subtracting this result from the
purchase price of the company.
Purchase price paid for MNO Company Br.10 million
Assets at market value 9 million
Less MNO’s liabilities 1 million
Market value of MNO’s net assets 8 million
Goodwill Br.2 million
2.8. Natural Resource
The fixed assets of some businesses include timber, metal ores, minerals, or other natural
resources. As these businesses harvest or mine and then sell these resources, a portion of the cost
of acquiring them must be debited to an expense account. This process of transferring the cost of
natural resources to an expense account is called depletion. The amount of depletion is
determined by multiplying the quantity extracted during the period by the depletion rate. This
rate is computed by dividing the cost of the mineral deposit by its estimated size. Computing
depletion is similar to computing units-of-production depreciation.
Illustration 2.16.
To illustrate, assume that a business paid Br.400, 000 for the mining rights to a mineral deposit
estimated at 1,000,000 tons of ore. The depletion rate is Br.0.40 per ton (Br.400, 000/1,000,000
tons). If 90,000 tons are mined during the year, the periodic depletion is Br.36, 000 (90,000 tons’
x 0.40). The depletion expense for the year of operation as follows.
Adjusting Entry
Dec 31 Depletion Expense 36000
Accumulated Depletion 36000
Like the accumulated depreciation account, Accumulated Depletion is a contra asset account. It
is reported on the balance sheet as a deduction from the cost of the mineral deposit.
2.9. Presentation of Fixed Assets and Intangible Assets on the 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.
The amount of each major class of fixed assets should be disclosed in the balance sheet or in
notes. The related accumulated depreciation should also be disclosed, either by major class or in
total. The fixed assets may be shown at their book value (cost less accumulated depreciation),
which can also be described as their net amount. If there are too many classes of fixed assets, 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 of property, plant, and
equipment.
The cost of mineral rights or ore deposits is normally shown as part of the fixed assets section of
the balance sheet. The related accumulated depletion should also be disclosed. In some cases, the
mineral rights are shown net of depletion on the face of the balance sheet, accompanied by a note
that discloses the amount of the accumulated depletion.
Intangible assets are usually reported in the balance sheet in a separate section immediately
following fixed assets. The balance of each major class of intangible assets should be disclosed
at an amount net of amortization taken to date.

ch2: Accounting Cycle For SGB

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ch2: Accounting Cycle For SGB

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Fundamentals of Accounting-II 2023

1.2. Accounting for Depreciation

Yea Cost Accumulated Book Value Rate Depreciatio Book Value

1 Br.24,00 Br.24,000.0 40% Br.9,600.00 Br.14,400.0

2 24,000 Br. 9,600.00 14,400.00 40% 5,760.00 8,640.00

3 24,000 15,360.00 8,640.00 40 3,456.00 5,184.00

4 24,000 18,816.00 5,184.00 40% 2,073.60 3,110.40

5 24,000 20,889.60 3,110.40 _ 1,110.40 2,000.00

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