Financial Accounting: Plant Assets, Natural Resources, and Intangibles

Financial Accounting
Eleventh Edition
Chapter 7
Plant Assets,
Natural Resources,
and Intangibles
Copyright © 2017, 2015, 2013 Pearson Education, Inc. All Rights Reserved.
Exhibit 7-1 Long-Lived Assets and
Related Expense Accounts
Learning Objectives (1 of 2)
7.1 Measure and account for the cost of plant assets
7.2 Distinguish a capital expenditure from an
immediate expense
7.3 Measure and record depreciation on plant assets
7.4 Analyze the effect of a plant asset disposal
7.5 Apply GAAP for natural resources and intangible
assets
Learning Objectives (2 of 2)
7.6 Explain the effect of an asset impairment on the
financial statements
7.7 Analyze rate of return on assets
7.8 Analyze the cash flow impact of long-lived asset
transactions
Learning Objective 7.1
Measure and account for the cost of plant assets
Measure and Account for the Cost of
Plant Assets (1 of 12)
Working rule for measuring the cost of an asset:
The cost of any asset is the sum of all the costs
incurred to bring the asset to its intended use.
• Costs include:
‒ Purchase price
‒ Taxes
‒ Commissions
‒ Other costs to make the asset ready for use
Land
• Costs include:
– Purchase price
– Brokerage commission
– Survey fees
– Legal fees
– Back property taxes
– Expenditures for grading and clearing land
– Removing any unwanted buildings
FedEx signs a $300,000 note payable to purchase 20 acres
of land. FedEx also pays $10,000 for real estate
commission, $8,000 of back property tax, $5,000 for removal
of an old building, a $1,000 survey fee, and $260,000 to
pave the parking lot—all in cash. What is FedEx’s cost of
this land?
FedEx signs a $300,000 note payable to purchase 20
acres of land. FedEx also pays $10,000 for real estate
commission, $8,000 of back property tax, $5,000 for
removal of an old building, a $1,000 survey fee, and
$260,000 to pave the parking lot—all in cash.
Building, Machinery, and Equipment
• Cost of constructing a building includes:
– Architectural fees
– Building permits
– Contractors’ charges
– Payment for material, labor, and overhead
– Interest on money borrowed to finance
construction
• Cost of purchasing a building includes:
– Purchase price
– Brokerage commission
– Sales and other taxes
– Expenditures to repair and renovate building for its
intended purpose
• Cost of equipment:
– Purchase price (less any discounts)
– Transportation from the seller
– Insurance while in transit
– Sales and other taxes
– Purchase commission
– Installation costs
– Expenditures to test the asset before it’s placed in
service
– Cost of any special platforms
Land Improvements and Leasehold Improvements
• Cost of land improvements:
– Driveways signs
– Fences
– Sprinkler systems
– Other similar items
Land Improvements and Leasehold Improvements
• Leasehold improvements:
– Improvements made to leased property
– Depreciated or amortized over the lease term
• Lump-Sum (or Basket) Purchases of Assets
– Purchase several assets for a single lump-sum
amount
– Total cost divided among the assets based on
relative market values
– Technique is called the relative-sales-value
method
FedEx purchases land and a building in Denver. The
building sits on two acres of land, and the combined
purchase price of land and building is $2,800,000. An
appraisal indicates that the land’s market value is
$300,000 and that the building’s market value is
$2,700,000.
FedEx purchases land and a building in Denver. The
building sits on two acres of land, and the combined
purchase price of land and building is $2,800,000. An
appraisal indicates that the land’s market value is
$300,000 and that the building’s market value is
$2,700,000.
Distinguish a capital expenditure from an immediate
expense
Distinguish a Capital Expenditure
From an Immediate Expense
• Capital expenditure → increase the asset’s capacity
or extends its useful life
• Capitalized means the cost is added to an asset
account rather than being expensed immediately
Exhibit 7-2 Capital Expenditures vs.
Immediate Expenses
Measure and record depreciation on plant assets
Measure and Record Depreciation on
Book Value
Plant assets are recorded on the balance sheet at their
book value.
Book Value = Cost − Accumulated Depreciation
Measure and Record Depreciation on
• Depreciation
– Process of allocating a plant asset’s cost to
expense over its life
– Necessary as plant assets wear out, grow
obsolete, and lose value over time
– Allocates cost against revenue it helps earn each
period
– Depreciation expense is reported on the income
statement
– Land is not depreciated
Exhibit 7-3 Depreciation: Allocating Costs to
Periods in Which Revenues Are Generated
How to Measure Depreciation
• Cost
‒ Purchase price and all costs to get plant asset
ready for use, known amount
• Estimated Useful Life
‒ Length of service expected from using the asset,
estimated amount
• Estimated Residual Value
‒ Expected cash value of an asset at the end of its
useful life, estimated amount
Depreciation Methods (1 of 6)
• Three main depreciation methods:
– Straight line
– Units of production
– Double-declining balance
Exhibit 7-4 Depreciation Computation
Data (1 of 4)
• Straight-Line Method
– Equal amount of depreciation assigned each
period
– Depreciable cost divided by useful life to determine
annual depreciation expense
Data (2 of 4)
Cost  Residual value

Straight-line depreciation per year 
Useful life, in years
$41,000  $1,000

5
 $8,000
Straight-Line Method
Exhibit 7-5 Straight-Line Depreciation
Schedule for Truck
• Units-of-Production Method
– Fixed amount of depreciation is assigned to each
unit of output produced by the asset
– Depreciable cost is divided by useful life–in units of
production–to determine fixed amount per unit
– Per-unit amount then multiplied by number of units
produced each period to compute depreciation
expense
Data (3 of 4)
Units-of-production depreciation per unit of output

Cost  Residual value

Useful life, in units of production
$41,000  $1,000
  $0.40 per mile
100,000 miles
Exhibit 7-6 Units-of-Production (UOP)
Depreciation Schedule for Truck
Assume that FedEx expects to drive the truck 20,000
miles during the first year, 30,000 during the second,
25,000 during the third, 15,000 during the fourth, and
10,000 during the fifth. Exhibit 7-6 shows the UOP
depreciation schedule.
• Double-Declining-Balance Method
– Writes off a larger amount of cost near the start of
asset’s useful life
– Most frequently used accelerated depreciation
method
– Multiplies asset’s declining book value at the
beginning of the year by a constant percentage,
two times the straight-line depreciation rate
Data (4 of 4)
1
DDB depreciation rate per year  2
Useful life, in years
1
 2
5 years
 20%  2  40%
Exhibit 7-7 Double-Declining-Balance
(DDB) Depreciation Schedule for Truck
• DDB method differs from others in two ways:
– Residual value is ignored initially
– Final year depreciation is a “plug”
Comparing Depreciation Methods (1 of 2)
• Straight-line
‒ Best for plant assets that generate revenue evenly
over time
• Units-of-production
‒ Best for assets that wear out because of use
• Double-declining-balance
‒ Best for assets that generate more revenue earlier
in their useful life
Comparing Depreciation Methods (2 of 2)
Exhibit 7-8 Depreciation Patterns
Through Time
Exhibit 7-9 Depreciation Methods
Used by 600 Companies
Other Issues in Accounting for Plant
Assets
• Plant assets are complex because
– They have long lives
– Depreciation affects income taxes
– Companies may have gains or losses when they
sell plant assets
– Possible international accounting changes in the
future
Depreciation for Tax Purposes
• Most companies use straight-line depreciation for
financial reporting, but the double-declining-balance
method for tax purposes.
• Accelerated depreciation provides fastest tax
deductions → Tax deductions reduce income taxes →
Reduced income taxes helps conserve cash
Exhibit 7-10 The Cash Flow Advantage of
Accelerated Depreciation for Tax Purposes
Exhibit 7-11 Modified Accelerated
Cost Recovery System (MACRS)
Depreciation for Partial Years
Suppose FedEx purchases a warehouse building on
September 1 for $500,000. The building’s estimated life
is 20 years, and its estimated residual value is $80,000.
FedEx’s accounting year ends on May 31.
$500,000  $80,000
Full-year depreciation  $21,000
20
9
Partial year deprecitaion $21,000   $15,750
12
Changing the Useful Life of a
Depreciable Asset (1 of 2)
• After an asset is in use, managers may change its
useful life based on experience or new information.
– Called a change in accounting estimate
Changing the Useful Life of a
Depreciable Asset (2 of 2)
Assume a Disney hot dog stand cost $50,000 and originally had a
useful life of 10 years (no residual value). Disney used the asset
for four years, resulting in accumulated depreciation of $20,000
and a remaining book value of $30,000. Management now
believes the asset will remain useful for an additional 10 years.
Asset's remaining depreciable book value

 New annual depreciation
New estimated useful life
30,000
 $3,000
10
Fully Depreciated Assets
• Fully depreciated asset → asset that has reached the end
of its estimated useful life
• Can continue to use asset, but will not record anymore
depreciation
• Remove the asset’s cost and accumulated depreciation
when the asset is disposed of
EX: Suppose FedEx has fully depreciated equipment with no
residual value (cost of $60,000)
Analyze the effect of a plant asset disposal
Analyze the Effect of a Plant Asset
Disposal (1 of 8)
• Before accounting for disposal, the business should
bring the depreciation up to date to:
– Measure the asset’s final book value
– Record the expense up to the date of disposal
Disposal (2 of 8)
Disposing of a Fully Depreciated Asset for No
Proceeds. Suppose the final year’s depreciation
expense has just been recorded for a machine that cost
$60,000 and has a residual value of zero.
Disposal (3 of 8)
Disposing of a Not Fully Depreciated Asset for No
Proceeds. Suppose FedEx disposes of equipment that
cost $60,000. This asset only has $50,000 of
accumulated depreciation and a book value of $10,000.
Disposal (4 of 8)
Selling a Plant Asset. Suppose FedEx sells equipment
on September 30, 2016 for $7,300 cash. The equipment
cost $10,000 when purchased on January 1, 2013 and
has been depreciated straight-line. It had an estimated
life of 10 years with no residual value. The depreciation
entry on September 30, 2016 is:
Disposal (5 of 8)
Disposal (6 of 8)
Selling a Plant Asset. Suppose FedEx sells equipment
on September 30, 2016 for $7,300 cash. The equipment
cost $10,000 when purchased on January 1, 2013 and
has been depreciated straight-line. It had an estimated
life of 10 years with no residual value. The entry to
record the sale is:
Disposal (7 of 8)
• Exchanging a Plant Asset
– Trade in old assets for new ones
– Nonmonetary exchanges
– Based on fair values of assets involved
– Differences between fair values of old and new
assets results in a gain or loss
Disposal (8 of 8)
Exchanging a Plant Asset. Assume Papa John’s
Pizza’s old delivery car cost $9,000 with accumulated
depreciation of $8,000. Papa John’s trades the old
delivery car for a new one with a fair market value of
$15,000 and pays $10,000 of cash.
T-Accounts for Analyzing Plant Asset
Transactions (1 of 2)
T-Accounts for Analyzing Plant Asset
Transactions (2 of 2)
Suppose you started the year with buildings that cost
$100,000. During the year, you bought another building
for $150,000 and ended the year with buildings that cost
$180,000. What was the cost of the building you sold?
*
X  100,000  150,000  180,000
Apply GAAP for natural resources and intangible
assets
Apply GAAP for Natural Resources
and Intangible Assets (1 of 4)
• Natural Resources
– Long-term assets such as iron ore, petroleum (oil),
and timber
– Depletion – tracks the flow of a natural resource
from its raw state through inventory to cost of
goods sold
For example, an oil reserve may cost ExxonMobil
$100,000,000 and contain an estimated 10,000,000
barrels of oil. Upon purchase or development of the oil
reserve (assuming the company paid cash), the
following entry is made:
The depletion rate is $10 per barrel. If 3,000,000 barrels
are extracted and 1,000,000 are sold, the following
entries are made:
• Intangible Assets
– Long-term assets with no physical form
– Carry special rights
– Patents, copyrights, trademarks, franchises,
leaseholds, and goodwill
– Two categories
 Finite lives → Amortization recorded
 Indefinite lives → Checked annually for
impairment
Accounting for Specific
Intangibles (1 of 8)
• Patents
– Granted by the federal government
– Give the holder excusive right to produce and sell
invention
– Lasts for 20 years
Patents: Suppose Sony pays $170,000 to acquire a
patent on January 1, and the business believes the
useful life is 5 years.
• Copyrights
– Granted by the federal government
– Give the holder excusive right to reproduce and
sell a book, musical composition, film, or other
work of art
– Extend 70 years beyond the author’s life
• Trademarks and Trade names
– Distinctive identifications of products or services
– Useful life may be set by contract
– Amortize cost over useful life
 May have indefinite life and not be amortized
• Franchises and Licenses
– Granted by a private business or government
– Right to sell a product or service in accordance
with specified conditions
– Includes restaurant chains and sports
organizations
– Often have indefinite lives
• Goodwill
– The excess of the cost of purchasing another
company over the sum of the market values of the
acquired company’s net assets
– Only recorded when it is purchased, never when
created
– Perform impairment test (instead of amortization)
Goodwill. FedEx acquires Europa Company for $10
million. Europa has assets with a market value of $9
million and $2 million in liabilities, therefore, net assets
equals $7 million. FedEx paid $3 million for goodwill as
follows:
Goodwill. FedEx acquires Europa Company for $10
million. Europa has assets with a market value of $9
million and $2 million in liabilities, therefore, net assets
equals $7 million. The journal entry to record this
transaction is:
Explain the effect of an asset impairment on the
financial statements
Explain the Effect of an Asset Impairment
on the Financial Statements (1 of 2)
• Impairment
– Both tangible and intangible long-term assets must
be tested annually
– Occurs when expected future cash flows fall below
the asset’s net book value
– If impaired, must adjust the carrying value
downward to fair value
Exhibit 7-12 Normal Relationship and Impaired
Relationship Among Values of an Asset
Normal Impaired
Largest: Future cash flows Largest: Net book value
Middle: Fair value Middle: Future cash flows
Smallest: Net book value Smallest: Fair value
Explain the Effect of an Asset Impairment
on the Financial Statements (2 of 2)
Net book value = $100, Est. future cash flow = $80,
Fair market value = $70
Two-stage impairment process:
1. Impairment test: Is net book value > estimated
future cash flow? (Yes, so the asset is impaired)
2. Impairment loss = Net book value (100) − Fair
value (70) = 30
Analyze rate of return on assets
Analyze Rate of Return on Assets (1 of
3)
Return on Assets (ROA)

Net income
ROA 
Average total assets
Where Average total assets 

 Beginning total assets  Ending total assets 
2
3)
DuPont Analysis
Net income
Net profit margin ratio 
Net sales
Net sales
Total asset turnover 
Average total assets
3)
ROA using DuPont Analysis
ROA  Net profit margin ratio  Total asset turnover
Net income Net sales Net income

ROA   
Net sales Average total assets Average total assets
Analyze the cash flow impact of long-lived asset
transactions
Analyze the Cash Flow Impact of
Long-Lived Asset Transactions
• Three main types of long-lived asset transactions
on the Statement of Cash Flows
– Acquisitions → Investing activities
 Added to net income as a reconciling item
– Sales → Investing activities
 Cash proceeds from sale of plant assets (inflow)
– Depreciation (Amortization) → Operating activities
 Cash purchases (outflow)
Exhibit 7-13 Reporting Investing Activities on
FedEx Corporation’s Statement of Cash Flows

Financial Accounting: Plant Assets, Natural Resources, and Intangibles

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Financial Accounting: Plant Assets, Natural Resources, and Intangibles

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Financial Accounting

Cost  Residual value

Units-of-production depreciation per unit of output

Asset's remaining depreciable book value

Return on Assets (ROA)

Where Average total assets 

ROA using DuPont Analysis

ROA  Net profit margin ratio  Total asset turnover

Net income Net sales Net income

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