ACCT 2101 Principles of Accounting I
Chapter 7: Long-Term Assets
Property Plant and Equipment:
• Actively used in operations
• Long-term periods of service utility
• Have physical substance
• These assets often makeup the largest asset amounts
• PP&E include natural resources (e.g., timber track, coal mine, oil, and gas wells).
Report PPE on Balance Sheet:
• Reported at Historical Cost less Accumulated Depreciation (known as the book value or
carrying value)
• If impairment of value, write down to reflect lower fair market value (writing up assets is
not allowed under GAAP)
Which expenditures should we include in “Historical Cost”:
• All costs necessary to (1) acquire the asset and (2) make it ready for use.
• Historical Cost would include: purchase price, and other related costs such as sales tax,
transportation costs, installation, testing, legal fees to establish title, recording fees, and
any other costs to get the asset ready for use.
• For self-constructed assets, it also includes interests.
• Costs included in the asset account are called “capitalized costs”
Capitalization versus Expense
Key issue is whether resources spent on long-lived assets are capitalized (placed on the balance
sheet) or expensed (immediately reducing net income)
• Expenditures which have been capitalized are depreciated over the useful life of the asset
• Total effect on net income is the same over the life of the firm – the only difference is the
timing of reductions to net income
General rule
• Expenditures should be “capitalized” when the usefulness is expected to extend over
several accounting periods
o Expand the usefulness of a fixed asset
o Extend its useful life
• Expenditures should be “expensed” when they neither extend the useful life of a fixed
asset nor generate benefits beyond the current accounting period.
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ACCT 2101 Principles of Accounting I
How to initially record?
The general rule is to use the fair value of what you give up or the fair value of what you receive,
whichever one is more readily determinable and objectively measurable. Apply the same rule
for non-monetary asset exchanges.
• Cash amount, if paid for with cash
• Present value of note payable issued
• Market value of common stock issued
• If neither cash, PV of note payable, nor market value of common stock is available as a
basis for measurement, use the fair value of assets given up or the fair value of assets
received.
AND record all costs that are incurred that are necessary to obtain the asset and place it into to
useful state.
Depreciation, Depletion and Amortization
The conceptual framework indicates that the firm expenses items when the firm has consumed or
benefited from the asset. Below are the terms used to describe the process of allocating the cost
of an operating asset to periods in which the firm consumes or benefits from that asset.
Cost allocation for plant and equipment is known as depreciation
Cost allocation for natural resources is known as depletion
Cost allocation for intangibles is known as amortization
Depreciation: FASB defines depreciation as “a system of accounting which aims to distribute
the cost or other basic value of tangible capital assets, less salvage (if any), over the estimate life
of the unit (which may be a group of assets), in a systematic and rational manner. It is a process
of allocation, not of valuation.”
Depreciation requires the following estimates:
• Useful life – The period of time over which the asset is expected to generate cash inflows
• Salvage value – Expected disposal amount for the asset at the end of its useful life
• Depreciation rate – An estimate of how the asset will be used up over its useful life.
Depreciation Methods
• Straight-line method: Under the straight-line method, depreciation expense is recognized
evenly over the estimated useful life of the asset.
• Accelerated Methods (Double-declining-balance method)
Straight-line depreciation
Cost – Residual value
Depreciation Expense =
Estimated useful life
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ACCT 2101 Principles of Accounting I
Declining balance method
Depreciation Expense = Beginning net book value * Declining balance rate
1) Net book value = cost – accumulated depreciation
2) Ending net book value should be greater or equal to residual value.
3) When the declining balance rate is twice the straight-line rate, the method is called the
double-declining balance (DDB) method. Rate equals 2 divided by the number of years
of useful life.
Example: Depreciation
A $200,000 piece of equipment is acquired on 1/1/21 for cash. The residual value is estimated to
be $50,000 after a useful life of 5 years.
Straight-line Double- declining balance
(SL) (DDB)
2021
2022
2023
2024
2025
Total
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ACCT 2101 Principles of Accounting I
Practice: Depreciation
A $500,000 piece of equipment is acquired on 1/1/25 for cash. The residual value is estimated to
be $100,000 after a useful life of 4 years.
Straight-line Double- declining balance
(SL) (DDB)
2025
2026
2027
2028
Total
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ACCT 2101 Principles of Accounting I
On Depreciation Methods
• Most companies use straight-line for all or some of their assets. Why?
o Easy to use
o Easy to explain
o Smooths the expense recognition
o Compared with accelerated depreciation, SL gives higher income during the early
years of an asset’s life
• Unlike accounting for inventory, companies are allowed to choose one depreciation
method for financial reporting (GAAP) and another method for income tax computations
• Companies are allowed to use different depreciation method for different assets
• Revision of Depreciation Rates
o Changes in estimates are a continual and inherent part of any estimation process
o Accounted for in the current period and prospective periods
o No change to previously reported results
Impairment of Value:
• An operational asset should be written down if there has been a significant and permanent
impairment of value.
• For most long-term assets an impairment test is done whenever there is a triggering
event.
• Triggering event – certain events or changes in circumstances that raise the possibility
that certain long-lived assets may be impaired.
Impairment Test:
Step 1: Determine if write-down is required – Write-down is required when the current book
value of the asset is greater than the undiscounted total future cash flows.
Step 2: Determine the amount of write-down – the write down loss is measured as the book value
of the asset minus the fair value of the asset (fair value is based on market price of the asset, or
the discounted present value of future cash flows).
Note: We only write assets down. We don’t write them up. We cannot restore previously
recognized impairment losses.
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ACCT 2101 Principles of Accounting I
Example 1 – West Technology Inc acquired a machine for use in its computer chip
manufacturing operations at a cost of $35,000,000. The firm expected the machine to have a
seven-year useful life and a zero salvage value. The company has been using straight-line
depreciation for the asset. Due to the rapid rate of technological change, at the beginning of year
4, the firm estimates that the machine is capable of generating (undiscounted) future cash flows
of $17,000,000, and will be disposed of at the end of year 6. Based on the quoted market prices
of similar asset, the firm estimates the machine to have a fair market value of $14,000,000.
Should the company recognize an impairment of this asset? Why or why not? If yes, what is the
amount of the impairment loss that should be recognized?
Example 2 – Re-do example 1 assuming that the estimated future undiscounted cash flows is
$21,000,000, and the fair market value of the asset is $17,000,000.
Disposition of Operational Assets
• Original cost of assets and any related accumulated depreciation are removed.
• Any cash inflow (i.e. sales price) is recorded.
• Difference between net book value of assets and sales price is recorded as a gain or loss.
Example: David Company purchased a machine on 1/1/2019 at a cost of $50,000 with an
estimated useful life of 5 years and no salvage value. The straight-line method was used. The
machine was sold in the beginning of 2022 for $18,000.
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ACCT 2101 Principles of Accounting I
Intangible Assets
• Have no physical substance
• Not financial instruments
• Convey certain legal and economic rights
• Uncertainty associated with future economic benefits
How to initially record?
Depends on what kind of intangible and how it is acquired.
Classification:
• Identifiable: patents, copyrights, trademarks, franchises, licenses
• Unidentifiable: goodwill (goodwill happens only when purchase another business)
How intangibles are acquired:
• Acquired externally: can capitalize purchase cost and other related costs (e.g., legal fees)
• Developed internally: if identifiable then capitalize (EXCEPT R&D), if unidentifiable
(e.g., goodwill) then expense.
o Only direct costs (like legal fees) are capitalized
Overall accounting for intangibles is very conservative. Huge problem for many companies
whose primary assets are intangibles (high market-to-book ratio).
Amortization of Intangible Assets:
• Intangibles subject to amortization: intangibles with a finite useful life. For example,
some intangibles have a legal life: patents, copyrights, franchises.
• Intangibles not subject to amortization: intangibles with an indefinite useful life (e.g.,
goodwill, trademarks). Will be subject to periodic testing for impairment.
• Under SFAS No. 142: goodwill is no longer amortized
• Straight-Line Method almost always is used
Research and Development (R&D)
• SFAS 2 (1974) requires all research and development costs to be charged to expense
when incurred. Rationale?
• Research is the planned search or critical investigation aimed at the discovery of new
knowledge.
• Development is the translation of research findings or other knowledge into a plan or
design for a new product or process or for significant improvement to an existing product
or process.
• R&D costs pertain to activities that occur prior to the start of commercial production:
expense.
• The costs incurred after commercial production: not considered R&D cost; expense or
capitalize in inventory cost.
• Disclosure of R&D expense is required (either as a separate line item on I/S or in
footnote)
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ACCT 2101 Principles of Accounting I
Software Development Costs: An exception to R&D rules: (SFAS 86, 1985)
For computer software to be sold, leased or otherwise marketed:
• Expense R&D costs until achieving “technological feasibility”.
• After “technological feasibility” is achieved, all subsequent development costs are
capitalized and amortized over estimated product life.
• Once production begins, the costs are capitalized as inventory and charge to cost of goods
sold when sold.
Goodwill Impairment:
Goodwill should not be amortized, but instead should be tested for impairment on an annual
basis (and between annual tests in certain circumstances such as loss of key personal, adverse
regulatory action, etc).