CH 07

7-1
Chapter 7
Long-Lived Assets
and Depreciation
© 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
7-2
Learning Objectives
After studying this chapter, you should be able to:
 Measure the acquisition cost of tangible assets such as
land, buildings, and equipment.
 Compute depreciation for buildings and equipment using
various depreciation methods.
 Differentiate financial statement depreciation from
income tax depreciation.
 Explain depreciation’s effects on cash flow.
7-3
Learning Objectives
After studying this chapter, you should be able to:
 Distinguish expenses from expenditures that should be
capitalized.
 Compute gains and losses on disposal of fixed assets.
 Interpret depletion of natural resources.
 Account for various intangible assets.
7-4
Overview of Long-Lived Assets

 Long-lived assets - resources that are held for an
extended time, such as land, buildings,
equipment, natural resources, and patents
• These assets help produce revenues over many
periods by facilitating the
production and sale of goods
or services to customers.
7-5

 Tangible assets - physical items that can be seen
and touched, such as land, natural resources,
buildings, and equipment
• Also known as fixed assets or plant assets
 Intangible assets - rights or economic benefits,

such as franchises, patents, trademarks,
copyrights, and goodwill that are not physical in
nature
7-6

 Terms for allocation of costs over time:
• Depreciation - allocation of the cost of tangible assets
to the periods in which the assets are used
• Depletion - allocation of the cost of natural resources
to the periods in which the resources are used
• Amortization - allocation of the cost of intangible
assets to the periods that benefit from these assets
 Land is not depreciated because it does not wear
out or become obsolete.
Acquisition Cost of
7-7
Tangible Assets
 The acquisition cost of long-lived assets is the
purchase price, including incidental costs
required to complete the purchase, to transport
the asset, and to prepare it for use.
Acquisition Cost of
7-8
Tangible Assets
 Land
• The acquisition cost of land includes
costs of land surveys, legal fees, title
fees, realtor commissions, transfer
taxes, and the demolition costs of old
structures.
• Under historical cost accounting, land is carried on
the balance sheet at its original cost even if the
market value of the land is many times that of the
original cost.
Acquisition Cost of
7-9
Tangible Assets
 Buildings and Equipment
• Costs should include all costs of acquisition and
preparation for use, such as sales taxes, transportation
costs, installation costs, and repairs to the asset prior
to use.
• Costs included in the cost of an asset are capitalized
(added to the asset account), as distinguished from
being expensed immediately.
Depreciation of Buildings
7 - 10
and Equipment
 Depreciation in the accounting sense is not a
process of valuation.
• Depreciation is a form of allocating the cost of an
asset to periods when the asset is used.
 Depreciation is one key factor that distinguishes
accrual accounting from cash-basis accounting.
• Under the accrual basis, the cost of the asset is
allocated to the periods benefited.
• Under the cash basis, the cost of the asset would be
expensed immediately.
7 - 11
and Equipment
 Depreciable value - the amount of acquisition
cost to be allocated as depreciation over the total
useful life of an asset
• The depreciable value is the difference between the
acquisition cost and the predicted residual value.
 Residual value - the amount received from
disposal of a long-lived asset at the end of its
useful life
7 - 12
and Equipment
 Useful life (economic life) - the time period over
which an asset is depreciated
• The useful life is the shorter of the physical life of the
asset before it wears out or the economic life of the
asset before it becomes obsolete.
• The useful life can be measured
in terms other than time. For
example, the life of a truck can
be measured in miles driven.
7 - 13
Straight-Line Depreciation
 Straight-line depreciation - a method that spreads
the depreciable value evenly over the useful life
of an asset
Depreciation Acquisition cost - Residual value


expense Years of useful life
7 - 14
Straight-Line Depreciation
 A truck with a cost of $41,000 and a residual
value of $1,000 has a useful life of 4 years.
Depreciation expense is calculated as follows:
($41,000 - $1,000) / 4 = $10,000*
*Depreciation is the same each year for the life of the asset .
7 - 15
Depreciation Based on Units

 Unit depreciation - a depreciation method based
on units of service when physical wear and tear is
the dominating influence on the useful life of the
asset
• A depreciation rate per unit is determined by dividing
the depreciable value (cost less residual value) by the
useful life in units.
• To determine depreciation expense, the actual usage
of the asset is multiplied by the depreciation rate.
7 - 16
Depreciation Based on Units

value of $1,000 has a useful life of 200,000
miles. During the year, the truck is driven for
45,000 miles. Depreciation expense is calculated
as follows:
($41,000 - $1,000) / 200,000 = $.20 per
mile
45,000 x $.20 = $9,000*
*Depreciation over the life of the asset will fluctuate as the usage
of the asset fluctuates.
7 - 17
Declining-Balance Depreciation
 Accelerated depreciation - any depreciation
method that writes off depreciable costs more
quickly than the ordinary straight-line method
based on expected useful life
 Double-declining-balance (DDB) depreciation -
the most popular form of accelerated depreciation
• It is computed by doubling the straight-line rate and
multiplying the resulting DDB rate by the beginning
book value.
7 - 18
 Computing DDB depreciation:
• Compute a rate by dividing 100% by the number of
years of useful life.
• Double the rate.
• Ignore the residual value, and multiply the asset’s
book value at the beginning of the year by the DDB
rate.
– Stop depreciation when the book value
reaches the residual value.
7 - 19
value of $1,000 has a useful life of 4 years.
Double-declining-balance depreciation expense is
calculated as follows:
100% / 4 = 25% x 2 = 50% per year
Year 1: $41,000 x 50% = $20,500*
Year 2: ($41,000 - $20,500) x 50% = $10,250*
*Depreciation over the life of the asset declines each year.

7 - 20
Written Down Value Method

 In the written down value method (WDV),
depreciation is computed at a fixed rate on an
asset’s carrying amount at the beginning of a
reporting period. Thus, the depreciation expense
for year 1 will be a certain percent of the
beginning carrying amount, which is cost. From
year 2 onwards, the depreciation charge would be
related to the cost of the asset less accumulated
depreciation at the beginning of the year.
7 - 21
Depreciation Schedule Written
7 - 22
down value method
Year Cost Depreciation Exp Accumulated Carrying

Depreciation Amount
1 800000 254960 254960 545040
2 800000 173705 428665 371335
3 800000 118345 547010 252990
4 800000 80629 627639 172361
5 800000 54933 682572 117428
6 800000 37428 720000 80000
The sum-of-the-years’-digits
7 - 23
(SYD)
 The sum-of-the-years’-digits (SYD) is method is
rarely used in India. Being an accelerated
depreciation method, it charges a large part of the
cost of an asset in the early years. Under this
method, we calculate depreciation expense for a
year as the product of the depreciable amount and
the factor, (K/S).
7 - 24
Depreciation Schedule Sum of
7 - 25
the years’ digits methods
Year Cost Depreciation Expense Accumulated Carrying

Depreciation Amount
1 800000 205714 205714 594286
2 800000 171429 377143 422857
3 800000 137143 514286 285714
4 800000 102857 617143 182857
5 800000 68571 685714 114286
6 800000 34286 720000 80000
Comparing and Choosing
7 - 26
Depreciation Methods
 Straight-line gives the same
depreciation expense each year
of the useful life of the asset.
 DDB gives accelerated depreciation expense
(more than regular straight-line) in the first years
of the useful life of the asset.
• Companies will often switch from DDB to straight-
line part way through the life of the asset to
compensate for the fact the DDB may not fully
depreciate the asset.
Comparing and Choosing
7 - 27
Depreciation Methods
 Companies do not always use the same
depreciation methods for all types of depreciable
assets.
 The choice of depreciation alternatives comes
from several places:
• Tradition or use by other companies in the industry
• Better matching of expenses with revenues
• The nature of the industry and the equipment and the
goals of management
Contrasting Income Tax and
7 - 28
Shareholder Reporting
 Reports to stockholders must follow GAAP, but
reports to income tax authorities must follow the
income tax rules and regulations.
• These rules are usually alike, but sometimes they
differ.
• These difference cause business to keep two sets of
books – one for financial statements and one for taxes.
Financial
Taxes
Statements
7 - 29
Depreciation on Tax Reports

 Tax laws require the use of the
Modified Accelerated Cost Recovery
System (MACRS) for computing
accelerated depreciation.
• MACRS uses tax lives that are much shorter than the
real economic life of most assets.
• These short lives produce very accelerated
depreciation in the early years of the life of the asset,
which lowers taxable income in those years.
7 - 30
Shareholder Reporting
 Shareholder reporting is driven by efforts to
match the cost of assets to the periods in which
the assets generate revenues.
• Most companies use straight-line depreciation to
accomplish this.
 Companies also want higher earnings in their
financial statements.
• Straight-line produces lower depreciation in the early
years than accelerated depreciation.
7 - 31
Depreciation and Cash Flow

 Depreciation does not generate cash.
• Depreciation allocates the original cost of an asset to
the periods when the asset is used.
• Accumulated depreciation is merely the total amount
that an asset has been depreciated throughout its life.
2002
7 - 32
Effects of Depreciation on Cash

 Depreciation has no effect on ending cash
balances because it is a noncash expense.
 Before taxes, changes in the depreciation method
affect only the Accumulated Depreciation and
Retained Earnings accounts.
Effects of Depreciation on
7 - 33
Income Taxes
 Depreciation is a deductible noncash expense for
income tax purposes.
• If depreciation expense is higher, taxes are lower, and
more cash can be kept for use in the business.
– Accelerated depreciation generally has higher depreciation
expense.
 Depreciation does not generate cash, but it does

have a cash benefit if it results in lower taxes.
Contrasting Long-Lived Asset
7 - 34
Expenditures With Expenses

 Expenditures - purchases of goods or services,
whether for cash or on credit
 Asset-related expenditures that will benefit more
than one year are capitalized.
• Capital expenditures add new fixed assets or increase
the capacity, efficiency, or useful life of an existing
fixed asset.
 Expenditures that provide a benefit lasting one
year or less are expensed in the current year.
7 - 35
The Decision to Capitalize

 No rules about when to expense or capitalize an
expenditure are definitive.
• An accountant might want to expense
something that a tax auditor might
want to capitalize.
 The tendency in practice is to charge an expense

for repairs, parts, and similar items.
• Most of these expenditures are minor, so the cost-
benefit and materiality concepts justify this choice.
Repairs and Maintenance Versus
7 - 36
Capital Improvements
 Repairs and maintenance are required to keep an
asset in good working order.
• Repairs include costs of fixing an asset after
a breakdown or accident.
• Maintenance includes routine costs of
keeping the asset in good condition, such as
oiling, painting, and adjusting.
 Both repairs and maintenance are period costs

and are treated as expenses.
7 - 37
 Improvement (betterment) - an expenditure that is
intended to add to the future benefits from an
existing fixed asset
• Improvements are generally capitalized.
• Examples are renovating an apartment
building so the rent can be increased or
rebuilding a packaging machine so the
capacity is increased or its useful life
extended.
7 - 38
 Improvements require adjustments to existing
accounting records of the asset.
• The book value of the asset must be increased by the
amount of the expenditure.
• The depreciation schedule must be
revised to account for the increased
book value and the increased
useful life of the asset.
Gains and Losses on Sales
7 - 39
of Tangible Assets
 Assets are often sold before the end of their
useful lives.
• When an asset is sold, a gain or loss usually occurs.
• The gain or loss is the difference between cash
received and the net book value of the asset given up.
7 - 40
Recording Gains and Losses

 Remember that when depreciation is recorded,
two accounts are affected, Depreciation Expense
and Accumulated Depreciation.
• Accumulated depreciation reduces the book value of
the fixed asset.
 The disposal of a fixed asset requires the removal

of its book value (carrying amount), which
appears in two accounts, the asset account and
Accumulated Depreciation.
7 - 41

A piece of equipment with an original cost of
$50,000 that has $20,000 of accumulated
depreciation is sold for $35,000 cash. The
journal entry to record this transaction is as
follows:
Cash 35,000
Accumulated depreciation 20,000
Equipment 50,000
Gain on sale of equipment* 5,000
*[35,000 - (50,000 - 20,000) = 5,000]
7 - 42

A piece of equipment with an original cost of
$50,000 that has $20,000 of accumulated
depreciation is sold for $23,000 cash. The
journal entry to record this transaction is as
follows:
Cash 23,000
Accumulated depreciation 20,000
Loss on sale of equipment* 7,000
Equipment 50,000
*[23,000 - (50,000 - 20,000) = -7,000]
7 - 43
Income Statement Presentation

 Gains and losses on sales of assets are usually
insignificant, so they are included as “other
income” on the income statement.

CH 07

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CH 07

Uploaded by

Copyright:

Available Formats

7-1

Overview of Long-Lived Assets

Overview of Long-Lived Assets

 Intangible assets - rights or economic benefits,

Overview of Long-Lived Assets

Depreciation Acquisition cost - Residual value

($41,000 - $1,000) / 4 = $10,000*

Depreciation Based on Units

Depreciation Based on Units

*Depreciation over the life of the asset declines each year.

Written Down Value Method

down value method

Year Cost Depreciation Exp Accumulated Carrying

the years’ digits methods

Year Cost Depreciation Expense Accumulated Carrying

Depreciation on Tax Reports

Depreciation and Cash Flow

Effects of Depreciation on Cash

 Depreciation does not generate cash, but it does

Expenditures With Expenses

The Decision to Capitalize

 The tendency in practice is to charge an expense

 Both repairs and maintenance are period costs

Recording Gains and Losses

 The disposal of a fixed asset requires the removal

Recording Gains and Losses

Recording Gains and Losses

Income Statement Presentation

You might also like