Chapter Two
2. Accounting for PPE, Natural Resources and Intangible Assets
2.1. Accounting Property, Plant & Equipment (PPE)
2.1.1 Definition of PPE
PPE are tangible assets 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.
PPE are the tangible noncurrent assets that a company uses in the normal operations of its
business. PPE are long-term or relatively permanent assets such as equipment, machinery,
buildings, and land. PPE therefore includes land, building structures (offices, factories,
warehouses), and equipment (machinery, furniture, tools).
2.1.2 Nature/Characteristics of PPE
The major characteristics of PPE are as follows:
· They are acquired for use in operations and not for resale-Only assets used in normal
business operations are classified as PPE. For example, an idle building is more
appropriately classified separately as an investment. PPE held for possible price
appreciation are classified as investments. In addition, PPE held for sale or disposal are
separately classified and reported on the statement of financial position. Land developers
or sub dividers classify land as inventory.
· They are long-term in nature and usually depreciated-PPE yield services over a number of
years. Companies allocate the cost of the investment in these assets to future periods
through periodic depreciation charges. The exception is land, which is depreciated only if
a material decrease in value occurs, such as a loss in fertility of agricultural land because
of poor crop rotation, drought, or soil erosion.
· They possess physical substance-PPE are tangible assets characterized by physical
existence or substance. This differentiates them from intangible assets, such as patents
or copyrights. Unlike raw material, however, PPE do not physically become part of a
product held for resale.
2.1.3 Cost of PPE (Measurement at the time of recognition)
Most companies use historical cost as the basis for valuing PPE. Historical cost measures the
cash or cash equivalent price of obtaining the asset and bringing it to the location and condition
necessary for its intended use. Companies recognize property, plant, and equipment when the
cost of the asset can be measured reliably and it is probable that the company will obtain future
economic benefits.
In general, companies report the following costs as part of PPE:
· Purchase price, including import duties and non-refundable purchase taxes, less trade
discounts and rebates.
· Costs attributable to bringing the asset to the location and condition necessary for it to
be used in a manner intended by the company.
Companies value PPE in subsequent periods using either the cost method or fair value
(revaluation) method. Companies can apply the cost or fair value method to all the items of PPE
or to a single class or classes of PPE. For example, a company may value land (one class of
asset) after acquisition using the revaluation accounting method and, at the same time, value
buildings and equipment (other classes of assets) at cost.
Most companies use the cost method-it is less expensive to use because the cost of an
appraiser is not needed. In addition, the revaluation (fair value) method generally leads to higher
asset values, which means that companies report higher depreciation expense and lower net
income.
2.1.4 Measurement after recognition
I. Accounting for Depreciation
PPE, with the exception of land, lose their ability, over time, to provide services. Thus, the costs
of PPE such as equipment and buildings should be recorded as an expense over their useful
lives. This periodic recording of the cost of PPE as an expense is called depreciation.
Depreciation is the systematic allocation of the depreciable amount of an asset to expense over
its useful life.
The adjusting entry to record depreciation debits Depreciation Expense and credits a contra
asset account entitled Accumulated Depreciation. The use of a contra asset account allows the
original cost to remain unchanged in the PPE account.
Depreciation can be caused by physical or functional factors.
· Physical depreciation factors include wear and tear during use or from exposure to
weather.
· Functional depreciation factors include obsolescence and changes in customer needs
that cause the asset to no longer provide services for which it was intended. For example,
equipment may become obsolete due to changing technology.
Two common misunderstandings exist about depreciation as used in accounting include:
1. Depreciation does not measure a decline in the market value of a fixed asset. Instead,
depreciation is an allocation of a PPE cost to expense over the asset’s useful life. Thus,
the book value of a PPE (cost less accumulated depreciation) usually does not agree with
the asset’s market value. This is justified in accounting because a PPE is for use in a
company’s operations rather than for resale.
2. Depreciation does not provide cash to replace PPE as they wear out. This
misunderstanding may occur because depreciation, unlike most expenses, does not
require an outlay of cash when it is recorded.
Factors in Computing Depreciation Expense
Three factors determine the depreciation expense for a PPE. These three factors are as follows:
· Depreciable Base for the Asset
· Estimated useful life
· Method of cost apportionment/Depreciation Method
Depreciable Base for the Asset
The base established for depreciation is a function of two factors:
· The original cost and
· Residual value - Residual value (often referred to as salvage value) is the estimated
amount that a company will receive when it sells the asset or removes it from service. It
is the amount to which a company writes down or depreciates the asset during its useful
life.
Estimated useful life
The service life of an asset often differs from its physical life. A piece of machinery may be
physically capable of producing a given product for many years beyond its service life. But a
company may not use the equipment for all that time because the cost of manufacturing the
product in later years may be too high.
Methods of Depreciation
The third factor involved in the depreciation process is the method of cost apportionment. The
profession requires that the depreciation method employed be “systematic and rational.” To be
systematic and rational, the depreciation method should reflect the pattern in which the asset’s
future economic benefits are expected to be consumed by the company. Companies may use a
number of depreciation methods, as follows:
1. Straight-line method
2. Activity method (units of use or production)
3. Diminishing (accelerated)-charge methods:
a. Declining-balance method
b. Sum-of-the-Years-Digits method
1. Straight-Line Method
The straight-line method considers depreciation as a function of time rather than as a function
of usage. Companies widely use this method because of its simplicity. The straight-line method
provides for the same amount of depreciation expense for each year of the asset’s useful life.
To illustrate, assume that equipment was purchased on January 1 as follows:
Initial cost $500,000
Expected useful life 5 years
Estimated residual value $50,000
The annual straight-line depreciation of $90,000 is computed below.
Annual Depreciation = Original Cost – Salvage Value = 500,000 – 50,000 =
$90,000
If an asset is used for only part of a year, the annual depreciation is prorated. For example,
assume that the preceding equipment was purchased and placed into service on October 1. The
depreciation for the year ending December 31 would be $22,500, computed as follows:
First-Year Partial Depreciation = $90,000 x 3/12 = $22,500
As shown above, the straight-line method is simple to use. When an asset’s revenues are about
the same from period to period, straight-line depreciation provides a good matching of
depreciation expense with the asset’s revenues.
2. Activity or Units-of-Production Method
The activity method (also called the variable-charge or units-of-production approach) assumes
that depreciation is a function of use or productivity, instead of the passage of time. A company
considers the life of the asset in terms of either the output it provides (units it produces) or an
input measure such as the number of hours it works. Conceptually, the proper cost association
relies on output instead of hours used, but often the output is not easily measurable. In such
cases, an input measure such as machine hours is a more appropriate method of measuring the
dollar amount of depreciation charges for a given accounting period.
The units-of-production method is applied in two steps.
Step 1- Determine the depreciation per unit as:
Depreciation Rate (per unit) = Cost – Residual Value
Total units of production
Step 2- Compute the depreciation expense as:
Depreciation Expense = Depreciation per Unit x Total Units of Production Used
To illustrate, assume that equipment was purchased on January 1 as follows:
Initial cost $500,000
Estimated residual value 50,000
Assume that the equipment expected to have a useful life of 30,000 operating hours. During the
year, the equipment was operated 4,000 hours. The units-of-production depreciation for the year
is $60,000, as shown below.
Depreciation Rate (per unit) = Cost – Residual Value = 500,000- 50,000 = $15 per hours
Total units of production 30,000 hours
Depreciation Expense = Depreciation per Unit x Total Units of Production Used
Depreciation Expense = $15 per Hour x 4,000 Hours = $60,000
The units-of-production method is often used when a fixed asset’s in-service time (or use) varies
from year to year. In such cases, the units-of-production method matches depreciation expense
with the asset’s revenues.
Exercise
Equipment acquired at a cost of $180,000 has an estimated residual value of $10,000, has an
estimated useful life of 40,000 hours, and was operated 3,600 hours during the year. Determine
(a) the depreciable cost, (b) the depreciation rate, and (c) the units-of-production depreciation
for the year.
3. Diminishing (accelerated)-charge methods
The diminishing-charge methods provide for a higher depreciation cost in the earlier years and
lower charges in later periods. Because these methods allow for higher early- year charges than
in the straight-line method, they are often called accelerated depreciation methods. The
rationale is that companies should charge more depreciation in earlier years because the asset
is most productive in its earlier years. Furthermore, the accelerated methods provide a constant
cost because the depreciation charge is lower in the later periods, at the time when the
maintenance and repair costs are often higher. Generally, companies use one of two
diminishing-charge methods: the sum-of-the-years’-digits method or the declining-balance
method.
a. Declining Balance Method
The declining-balance method (often referred to as the reducing-balance method) utilizes a
depreciation rate (expressed as a percentage) that is some multiple of the straight-line rate.
Unlike other methods, the declining-balance method does not deduct the residual value in
computing the depreciable base. The declining-balance rate is multiplied by the book value of
the asset at the beginning of each period. Since the depreciation charge reduces the book value
of the asset each period, applying the constant-declining-balance rate to a successively lower
book value results in lower depreciation charges each year.
This process continues until the book value of the asset equals its estimated residual value. At
that time, the company discontinues depreciation.
For the first year, the book value of the equipment is its initial cost of $500,000. After the first
year, the book value (cost minus accumulated depreciation) declines and, thus, the depreciation
also declines. The double-declining-balance depreciation for the full five-year life of the
equipment is shown below.
a. Based on twice the straight-line rate of 20% ($90,000÷$450,000=0.20; 0.20×2=0.40, or 40%).
b. Limited to $14,800 because book value should not be less than residual value.
b. Sum-of-the-Years-Digits Depreciation
The sum-of-the-years’-digits method results in a decreasing depreciation charge based on a
decreasing fraction of depreciable cost (original cost less residual value). Each fraction uses the
sum of the years as a denominator (5 + 4 + 3 + 2 + 1 = 15). The numerator is the number of
years of estimated life remaining as of the beginning of the year. In this method, the numerator
decreases year by year, and the denominator remains constant (5⁄15, 4⁄15, 3⁄15, 2⁄15, and
1⁄15). At the end of the asset’s useful life, the balance remaining should equal the residual
value.
To illustrate, the equipment was purchased on January 1 as follows:
Initial cost $500,000
Expected useful life 5 years
Estimated residual value $50,000
Using the sum-of-the-years-digits method, the depreciation is computed as shown below.
Comparing Depreciation Methods
The three depreciation methods are summarized in table. All three methods allocate a portion of
the total cost of an asset to an accounting period, while never depreciating an asset below its
residual value.
II. Capital and Revenue Expenditures
Once a PPE has been acquired and placed in service, costs may be incurred for ordinary
maintenance and repairs. In addition, costs may be incurred for improving an asset or for
extraordinary repairs that extend the asset’s useful life. Costs that benefit only the current period
are called revenue expenditures. Costs that improve the asset or extend its useful life are capital
expenditures.
Improvements and Replacements
Companies substitute one asset for another through improvements and replacements. An
improvement (betterment) is the substitution of a better asset for the one currently used (say, a
concrete floor for a wooden floor). A replacement, on the other hand, is the substitution of a
similar asset (a wooden floor for a wooden floor). If the expenditure increases the future service
potential of the asset, a company should capitalize it. The company should simply remove the
cost of the old asset and related depreciation and recognize a loss, if any. It should then add the
cost of the new substituted asset.
To illustrate, Instinct Enterprises decides to replace the pipes in its plumbing system. A plumber
suggests that the company use plastic tubing in place of the cast iron pipes and copper tubing.
The old pipe and tubing have a book value of $15,000 (cost of $150,000 less accumulated
depreciation of $135,000), and a residual value of $1,000. The plastic tubing system costs
$125,000. If Instinct pays $124,000 for the new tubing after exchanging the old tubing, it makes
the following entry.
Equipment (plumbing system) 125,000
Accumulated Depreciation-Equipment 135,000
Loss on Disposal of Equipment 14,000
Equipment (plumbing system) 150,000
Cash ($125,000 − $1,000) 124,000
Repairs
Ordinary Repairs-A company makes ordinary repairs to maintain plant assets in operating
condition. It charges ordinary repairs to an expense account in the period incurred on the basis
that it is the primary period benefited. Maintenance charges that occur regularly include
replacing minor parts, lubricating and adjusting equipment, repainting, and cleaning. A company
treats these as ordinary operating expenses. Such expenditures are revenue expenditures and
are recorded as increases to Repairs and Maintenance Expense. For example, $600 paid for a
tune-up of a delivery truck is recorded as follows:
Repairs and Maintenance Expense 600
Cash 600
Extraordinary Repairs - After a PPE has been placed in service, costs may be incurred to extend
the asset’s useful life. For example, the engine of a forklift that is near the end of its useful life
may be overhauled at a cost of $5,000, extending its useful life by eight years. Such costs are
capital expenditures and are recorded as a decrease in an accumulated depreciation account. In
the case of the fork-lift, the expenditure is recorded as follows:
Accumulated Depreciation-Forklift 5,000
Cash 5,000
2.1.5 Disposal (Derecognition) of PPE
PPE that are no longer useful may be discarded or exchange or sold. In such cases, the PPE is
removed from the accounts. Just because a PPE is fully depreciated, however, does not mean
that it should be removed from the accounts. If a PPE is still being used, its cost and
accumulated depreciation should remain in the ledger even if the asset is fully depreciated.
This maintains accountability for the asset in the ledger. If the asset was removed from the
ledger, the accounts would contain no evidence of the continued existence of the asset. In
addition, cost and accumulated depreciation data on such assets are often needed for
property tax and income tax reports.
A PPE may be disposed-off by:
1. Discarding
2. Selling
3. Exchange/Trading in
1. Discarding of PPE
If a PPE is no longer useful to the business and has no market value, the asset is discarded
(thrown away or burnt).
There are two situations of discarding PPE:
a) Discarding a fully depreciated plant asset, and
b) Discarding a plant asset with book value
a) Discarding a fully depreciated PPE
When a fully depreciated PPE is discarded, no gain or loss occurs because there is no book
value. That is if a fully depreciated asset is discarded, the PPE account and its related
accumulated depreciation account are equal in amount.
Example
Assume that an item of equipment acquired at cost of Br 12,000 became fully depreciated at
December 31, 1994. On January10, 1995, the asset was discarded as worthless.
Required: Record the entry on January 10, 1995?
Solution
Book value =0, because the asset is fully depreciated, that is Cost = Accumulated depreciation
Thus,
Accumulated depreciation 12,000
Equipment 12,000
What is the accounting treatment for an asset that is fully depreciated, but continues to be used
in a business?
An asset that is fully depreciated and continues to be used in the business will be reported on the
balance sheet at its cost along with its accumulated depreciation. There will be no depreciation expense
recorded after the asset is fully depreciated. No entry is required until the asset is disposed of through
retirement, sale, salvage, etc.
To illustrate this, let’s assume that a machine with a cost of $100,000 was expected to have a useful life
of five years and no salvage value. The company depreciated the asset at the rate of $20,000 per year for
five years. If the machine is used for three more years, the depreciation expense will be $-0- in each of
those three years. During those three years, the balance sheet will report its cost of $100,000 and its
accumulated depreciation of $100,000 for a book value of $-0.
b) Discarding a PPE with a book value
When a PPE with a book value is discarded, a loss will result. The loss can be recognized for
both accounting and taxes purposes.
Example
A Corporation business owns an automobile that was purchased on January 4, 1992, at a cost of
Br 14,000. It has been depreciated using the straight line method at the rate of Br 2,400 a year.
On April 1, 1994, the automobile was damaged beyond repair in an accident. An insurance check
for Br 4,400 was received and the asset was discarded.
Required: Prepare journal entries to:
a) Record depreciation on date of disposal, April1, 1994?
b) Record the disposal of the plant asset?
Solution
If a PPE that is not fully depreciated is discarded, the first step in recording the disposal is to
determine the amount of depreciation to date of disposal. The second step is to record the
unrecorded depreciation to date of disposal .The third step is to determine the book value of the
asset on date of disposal. And the last step is to record the disposal of the plant asset.
Step1. Depreciation expense to date of disposal:
· The automobile was used for 3 months during 1994. The amount of depreciation to date
of disposal would be:
Depreciation = Annual depreciation * No. of months used = 2,400*3/12 = Br 600
12
Step2. Recording the unrecorded depreciation:
Depreciation expense------------------------------600
Accumulated depreciation-automobile---------------600
Step3. Book value to date of disposal
The asset was used for 2years and 3 months.
Balance of accumulated depreciation to date of disposal = 2,400*2+600 = Br 5,400
Book Value = 14, 000-5, 400 = Br 8,600
Loss on disposal = 8, 600-4, 400 = 4, 200
Step4. Recording the disposal of the asset:
Cash 4,400
Loss on disposal 4,200
Accumulated depreciation- Automobile 5,400
Automobile 14,000
2. Sale of PPE
A PPE which is no longer useful to the business but useful to other businesses can be sold.
Three outcomes are possible when a PPE is sold. It may be sold:
1. For its book value-with no loss no gain
2. Above its book value- at a gain
3. Below its book value-at a loss
Exercise
On January 3, 1990, a XYZ Company purchased office equipment for Br 4,500. Since that time,
the office equipment has been depreciated at the rate of Br 900 a year. On May 1, 1994, midway
in to the fifth year of the asset's life, it is sold for:
1. Br 525 2. Br 800 3. Br 450
Required: Taking each case independently, record the necessary entry on date of sale?
Depreciation Expense- Equipment 375
Accumulated depreciation- Equipment 375
1. The sale of equipment for Br 600
Cash 525
Acc. Depreciation- Equipment 3,975
Equipment 4,500
2. The sale of equipment for Br 800
Cash 800
Acc. Depreciation- Equipment 3,975
Equipment 4,500
Gain on Disposal of plant assets 275
3. The sale of equipment for Br 450
Cash 450
Acc. Depreciation- Equipment 3,975
Loss on Disposal of plant assets 75
Equipment 4,500
3. Exchange of PPE
A business may exchange an old PPE for another new PPE. Exchange may involve similar assets
or dissimilar assets.
· Assets are similar when they perform the same function
· Assets are dissimilar when they perform different functions
When a plant asset is exchanged for another asset, a trade in allowance is received for the old
asset. The trade in allowance may be equal to, greater than, or less than the book value of the
old plant asset.
· Boot is the amount of money that the purchaser must pay. It is the difference between
the price of the new asset (list price of the new asset) and the trade- in allowance. Boot is
found with the following formula.
Boot = List price -
a) Determination of gain or loss on exchange
Ø Compare the book value of the old asset to date of disposal and the trade-in allowance
received for the old asset.
1. If the trade-in allowance equals the book value of the old asset to date of disposal, no
loss no gain occurs.
2. If the trade-in allowance received is greater than the book value of the old asset, gain
occurs.
3. If the trade-in allowance is less than the book value of the old asset, loss occurs.
b) Recognition of loss or gain on exchange
Recognition of loss or gain on exchange depends on the nature of the assets exchanged.
® If the exchange involves similar assets, don't recognize gain, but recognize any loss.
® If the exchange involves dissimilar assets, recognize any loss, or gain if any.
Entries on date of exchange/similar assets/
When there is loss on exchange, the exchange transaction is recorded with the following entry:
Cost of new asset---------------------------------xxx
Accumulated depreciation-old------------------xxx
Loss on exchange---------------------------------xxx
Cost of Asset-old----------------------------------------------xxx
Cash/Account payable----------------------------------------xxx
When there is gain (unrecognized gain), the exchange transaction is recorded with the following
entry:
Cost of new asset-------------------------xxx
Accumulated depreciation-old----------xxx
Asset-old-------------------------------------xxx
Cash/Accounts-------------------------------xxx
Example
Assume that and old equipment with recorded original cost of Br 4,000, and an accumulated depreciation
expense of Br 3,200 was exchanged with a cost of Br 5,000. The trade in allowance given to the old
equipment was Br 1,100.
Required:
a. Calculate the amount at which the new equipment will be recorded
b. Prepare the necessary journal entries to present the exchange.
Equipment (new) 4,700
Acc. Depreciation 3,200
Equipment 4,000
Cash 3,900
2.2 Accounting for Natural resources
A natural resource or wasting asset is a long-term asset that is purchased for the purpose of
removing or extracting natural resources, such as timber, oil, coal, gold, or gas.
►The expense resulting from the using up of natural resources is called depletion. The
calculation of depletion is similar to calculating depreciation by the units-of-production method.
That is:
1. Determine depletion expense per unit
Depletion expense per unit = Cost of resources
Estimated output
2. Determine depletion expense for a period
Depletion expense for a year= Depletion expense per unit * No. of units
►Once the depletion expense for a period is calculated, the period's depletion expense is
recorded with the following entry.
Depletion expense---------------------------------------xxx
Accumulated depletion-Natural resource-------------------xxx
Example
Assume that on April2, 2000, a Company purchased oil-drilling rights to a well for Br 10,000,000.
No salvage value is expected, and it is estimated that the well will produce 20,000, 000 barrels of
oil before it is exhausted. If 150,000 barrels of oil were removed during 2000, calculate the
depletion expense for the year (2000).
Solution
1. Depletion expense per barrel= br10, 000000/20, 000000 = Br 0.5/barrel
2. Depletion expense for 2000=br0.5 * 150, 000 = Br 75,000
Depletion expense-----------------------------75,000
Accumulated depletion-oil well---------------------75,000
2.3 Accounting for Intangible Assets
Intangible assets are long-term assets that lack physical substance
2.3.1 Characteristics of Intangible assets
Intangible assets have three main characteristics
Ø They are identifiable: To be identifiable, an intangible asset must either be separable from the
company (can be sold or transferred), or it arises from a contractual or legal right from which
economic benefits will flow to the company.
Ø They lack physical existence: Tangible assets such as property, plant, and equipment have
physical form. Intangible assets, in contrast, derive their value from the rights and privileges
granted to the company using them.
Ø They are not monetary assets: Assets such as bank deposits, accounts receivable, and
long-term investments in bonds and shares also lack physical substance. However, monetary
assets derive their value from the right (claim) to receive cash or cash equivalents in the
future. Monetary assets are not classified as intangibles.
In most cases, intangible assets provide benefits over a period of years. Therefore, companies
normally classify them as non-current assets.
2.3.2 Types of Intangible Assets
There are many different types of intangibles, often classified into the following six major
categories.
1. Marketing-related intangible assets
2. Customer-related intangible assets
3. Artistic-related intangible assets
4. Contract-related intangible assets
5. Technology-related intangible assets
6. Goodwill
1. Marketing-Related Intangible Assets
Companies primarily use marketing-related intangible assets in the marketing or promotion of
their products or services. Examples are trademarks or trade names, newspaper mastheads,
Internet domain names, and non-competition agreements. A trademark or trade name is a word,
phrase, or symbol that distinguishes or identifies a particular company or product.
2. Customer-Related Intangible Assets
Customer-related intangible assets result from interactions with outside parties. Examples
include customer lists, order or production backlogs, and both contractual and non-contractual
customer relationships.
3. Artistic-Related Intangible Assets
Artistic-related intangible assets involve ownership rights to plays, literary works, musical works,
pictures, photographs, and video and audiovisual material. Copyrights protect these ownership
rights. A copyright is a government-granted right that all authors, painters, musicians, sculptors,
and other artists have in their creations and expressions. A copyright is granted for the life of the
creator plus 70 years. It gives the owner or heirs the exclusive right to reproduce and sell an
artistic or published work. Copyrights are not renewable.
4. Contract-Related Intangible Assets
Contract-related intangible assets represent the value of rights that arise from contractual
arrangements. Examples are franchise and licensing agreements, construction permits,
broadcast rights, and service or supply contracts. A franchise is a contractual arrangement
under which the franchisor grants the franchisee the right to sell certain products or services, to
use certain trademarks or trade names, or to perform certain functions, usually within a
designated geographical area.
5. Technology-Related Intangible Assets
Technology-related intangible assets relate to innovations or technological advances. Examples
are patented technology and trade secrets granted by a governmental body. In many countries, a
patent gives the holder exclusive right to use, manufacture, and sell a product or process for a
period of 20 years without interference or infringement by others.
6. Goodwill
In many business combinations, the purchasing company records goodwill. Goodwill is
measured as the excess of the cost of the purchase over the fair value of the identifiable net
assets (assets less liabilities) purchased.
For example, if Portofino paid $2,000,000 to purchase Aquinas’s identifiable net assets (with a
fair value of $1,500,000), Portofino records goodwill of $500,000. Goodwill is therefore
measured as a residual rather than measured directly. That is why goodwill is sometimes
referred to as a plug, a gap filler, or a master valuation account.
Conceptually, goodwill represents the future economic benefits arising from the other assets
acquired in a business combination that are not individually identified and separately
recognized. It is often called “the most intangible of the intangible assets” because it is
identified only with the business as a whole. The only way to sell goodwill is to sell the business.
2.3.3 Recognition and measurement at the time of acquisition
Purchased Intangibles:
Company’s record at cost intangibles purchased from another party. Cost includes all
acquisition costs plus expenditures to make the intangible asset ready for its intended use.
Typical costs include purchase price, legal fees, and other incidental expenses. Sometimes
companies acquire intangibles in exchange for shares or other assets. In such cases, the cost of
the intangible is the fair value of the consideration given or the fair value of the intangible
received, whichever is more clearly evident.
What if a company buys several intangibles, or a combination of intangibles and tangibles? In
such a “basket purchase,” the company should allocate the cost on the basis of relative fair
values. Essentially, the accounting treatment for purchased intangibles closely parallels that for
purchased tangible assets.
Internally Created Intangibles
Businesses frequently incur costs on a variety of intangible resources, such as scientific or
technological knowledge, market research, intellectual property, and brand names. These costs
are commonly referred to as research and development (R&D) costs. Intangible assets that
might arise from these expenditures include patents, computer software, copyrights, and
trademarks.
2.3.4 Measurement after acquisition
A. Amortization of Intangibles
The allocation of the cost of intangible assets in a systematic way is called amortization.
Intangibles have either a limited (finite) useful life or an indefinite useful life.
For example, a company may have both types of intangibles. A company amortizes its
limited-life intangible assets and it does not amortize indefinite-life intangible assets.
Limited-Life Intangibles
Companies amortize their limited-life intangibles by systematic charges to expense over their
useful life. The useful life should reflect the periods over which these assets will contribute to
cash flows.
Indefinite-Life Intangibles
If no factors (legal, regulatory, contractual, competitive, or other) limit the useful life of an
intangible asset, a company considers its useful life indefinite. An indefinite life means that
there is no foreseeable limit on the period of time over which the intangible asset is expected to
provide cash flows. A company does not amortize an intangible asset with an indefinite life.
Since intangible assets will provide benefits for an estimated number of years (maximum 40
years), it is appropriate that the cost of an intangible asset be written off over that number of
years. The periodic write- off of an intangible asset is called Amortization.
►Intangible assets are amortized using the straight line method. And the period's amortization
expense is recorded with the following entry.
Amortization expense--------------xxx
Intangible asset---------------------xxx
Example
Assume that on January 9, 2002, a company purchased a patent for a new exercise machine at a
cost of Br 96,000. Further assume that the owner estimates that the patent will benefit the
company for 10 years. Show the entry to record the cost of the patent, and the 2002
amortization expense.
Solution
Yearly Amortization expense = Br 96,000/10years = Br 9,600/year
Amortization expense---------------------9,600
Patent----------------------------------------------9,600
Note
* A contra asset account is not used in an entry for amortization
* The asset account is credited directly
2.3.5 Presentation of Intangible Assets on the balance sheet
The reporting of intangible assets is similar to the reporting of property, plant, and equipment.
However, contra accounts may not be shown for intangibles on the statement of financial
position. As indicated, on the statement of financial position, companies should report as a
separate item all intangible assets other than goodwill. If goodwill is present, companies should
report it separately. The IASB concluded that since goodwill and other intangible assets differ
significantly from other types of assets, such disclosure benefits users of the statement of
financial position.