Accounting for Long term Assets

Long term assets such as patents and trademarks and long term financial assets such as shares held in other companies. In this tutorial I focus on long term tangible assets. Many of the principles discussed here can be applied to Long term assets.

Nature of fixed assets and their cost allocation

Almost any company utilizes long-term assets. Examples of such assets are trucks for transportation companies or computers, tables and chairs for software development companies. What does “long term” mean? As a rule, “long term” refers to more than a year. So, long-term assets are those whose economic life (the period of their being used by a company) is longer than a year.

Long-term operational assets are defined as resources with economic lives of more than a year that a business possesses and uses in generating revenue.

The cost of long-term assets is recognized as an expense in the accounting periods in which they are used. So, if a table is expected to have an economic life of three years, then the table cost will be allocated over this three-year period.

Long-term assets can be tangible and intangible.

Tangible assets are those which one can touch and include natural recourses, machinery, tools, equipment, buildings and land, among others.

Intangible assets may be represented by a piece of paper or document. The real value of such assets is the rights and privileges extended to their owners. Examples of intangible assets can be patents, trademarks and customer lists.

Categories of fixed assets

Tangible assets are divided into three categories: property, plant and equipment; natural resources; and land.

Property, plant, and equipment include furniture, cash registers, computers, and others. In order to keep track of all assets in this category an entity can assign subcategories for a particular item or items of similar nature. The process of expense recognition for property, plan, and equipment is called depreciation.

Depreciation is allocation of the cost of property, plant, and equipment to expenses over their useful (economic) life in a systematic and rational manner.

Natural recourses consist in (but not limited to) gas reserves, reserves of timber, mines, and so on. These assets are sometimes called wasting recourses because their value diminishes as the recourses are removed and used. The process of expense recognition for natural recourses is called depletion.

Depletion is allocation of the cost of natural resources to expenses in a systematic and rational manner over the resources useful life.

Land is classified as a separate category for one major reason – land is not a subject to depreciation or depletion. Land is considered to have an infinite life, which makes it impossible to estimate its depreciation or depletion.

Intangible assets also fall into a few categories: specifically identifiable intangible assets, and goodwill and intangible assets with indefinite lives.

Specifically identifiable intangible assets can be acquired individually. They include patents, copyrights, etc. The process of expense recognition for this category of assets is called amortization.

Amortization is allocation of the cost of intangible assets to expense in a systematic and rational manner over the useful life of the asset.

Goodwill and identifiable intangible assets with indefinite lives represent the second group of intangible assets. A company can record goodwill only by purchasing another company with good reputation, established clientele, or other features that provide an above-average profit potential. Identifiable intangible assets with indefinite lives do not have definite useful lives or such lives are not practicable to determine. Examples of such intangibles may be renewable broadcast licenses or trademarks (in certain circumstances).

Neither goodwill nor intangibles with indefinite lives are subject to amortization. However, those assets are subject to the impairment test as defined by generally accepted accounting standards. We will not cover impairment in this tutorial as it extends beyond the principles level.

Historical cost of fixed assets

All assets are recorded at their historical cost.

A historical cost includes the purchase price and any additional costs necessary to obtain the asset and prepare it for the intended use. Additional costs (costs besides the purchase price) may include transportation costs, insurance for asset delivery and others.

The following are some costs usually included in the historical cost of an asset:

1. Purchase of a building: purchase price, title search and transfer documents, real estate fees, and remodeling costs.
2. Purchase of equipment: purchase price, delivery costs, installation, and costs for modifications to prepare the asset for intended use.
3. Purchase of land: purchase price, removal of old buildings, title search and transfer documents, and real estate fees.

There are a number of expenditures that cannot be included into the cost of an asset. Such expenditures include payments for fines, damages, and so on, which are not considered normal costs of acquiring an asset.

Lump sum acquisitions of fixed assets

Sometimes a company buys several assets for a lump sum. The total of market values of individual assets included in the purchase may be greater than the total price paid by the company. Such a purchase is called a basket purchase. The company must determine how much of the total price should be assigned to each asset. This can be done by using the relative fair market method. Look at the example below.

Suppose, Nokle’s Company acquired a machine and related tooling by paying $600. The asset market values, provided they were acquired separately, are $700 and $300 respectively. So, the total fair market value is $1,000 ($700 +$300). We can see that the machine is worth 70% ($700 / $1,000 x 100%), and the tooling is worth 30% ($300 / $1,000 x 100%) of the price paid. By applying these percentages, we can calculate the cost of each asset as shown below:

Illustration 8-1: Allocation of the purchase price in a basket purchase

 Depreciation as a means of fixed assets cost allocation

When an asset is acquired, its cost is not expensed at the acquisition time because the asset is used for more than a year. Instead, the asset cost is allocated over its useful life. In another lesson we have seen how the straight-line method is applied. This method is appropriate when an asset is used evenly over its useful life. However, some assets can be used more extensively during their first years of operation. Other assets are used more during one year, but less during another year, and so on. This kind of assets requires accelerated depreciation methods, which charge more of the assets costs in the years of their more extensive use.

To demonstrate application of different depreciation methods, let us look at the following example. A computer science graduate student decided to start his own business. The student, Mr. Serfy, will develop software for small businesses. In order to create reliable products, Mr. Serfy acquired a computer that cost $23,000 in 20X7. The computer is expected to have a salvage value of $3,000 and a 4-year useful life. Mr. Serfy has made predictions that the revenue stream will be $9,000 per year.

Straight-line method of depreciation

Provided that the revenue will remain the same each year, it is reasonable to employ straight-line depreciation method.

Straight-line depreciation is a depreciation method in which periodic depreciation is the same for each period of the asset useful life.

Accounting for Long-term Assets

Before Mr. Serfy can buy a computer, he needs to make a capital contribution to his company. Let us assume that the owner contributes $25,000 cash. The later increases assets (Cash) and equity (Contributed Capital) which is an asset source transaction:

Illustration: Effect of a capital contribution of the horizontal model

After the capital contribution, Mr. Serfy can acquire a computer for $23,000. The effect of this investment on the accounting equation is as follows:

Illustration : Effect of a computer acquisition on the horizontal model

As it was stated, the revenue is expected to be $9,000 per year. While helping to generate this revenue, the computer gets partially used. Recognizing depreciation expense reflects the process of recording the used computer part. The amount of depreciation expense in accordance with the straight-line method is determined by subtracting the salvage value from the historical cost and dividing the result by the number of years the computer will be in use. Taking our numbers, we get $5,000 ([($23,000 – $3,000] / 4 years) of depreciation expense per year. The revenue ($9,000) and expense ($5,000) recognition is repeated for 4 years as shown below via two entries. Note that depreciation is accumulated in a contra asset account called Accumulated Depreciation:

Illustration : Effect of revenue and depreciation on the horizontal model

Note that recognition of depreciation expense affects the balance sheet and income statement, but does not affect the statement of cash flows. The reason is because cash had already been paid when Mr. Serfy bought the computer. The invested amount is allocated to expense in equal parts over the computer useful life. The effects of depreciation occur throughout the life cycle of the asset (4 years). Indeed, the amount of depreciation expense each year remains at the $5,000 level; however, the amount of accumulated depreciation increases every year which in effect decreases the computer book value:

Illustration : Schedule of straight-line depreciation for Mr. Serfy’s computer

The final stage of the asset is its retirement and removal from the company’s records. Suppose that the company sold the computer at the very end of 20X0 for $4,000. Because the carrying value of the computer was $3,000, the company recognized a gain of $1,000 ($4,000 – $3,000):

Illustration : Effect of Mr. Serfy’s computer retirement on the horizontal model

The total cash inflow from the computer amounted to $40,000 ([$9,000 revenue x 4 years] + 4,000 salvage value). At the same time the acquisition cost was only $23,000. So, the computer not only recovered the investment, but also helped generate $17,000 ($40,000 – $23,000) of return on investment.

Below you will find the financial statements and journal entries for the four years in which the computer was used and the straight-line depreciation method was employed.

Illustration : Financial statements under the straight-line depreciation method

Illustration : Journal entries posted by Mr. Serfy

* These entries are repeated annually from 20X7 to 20X0.

 Double-declining balance method of depreciation

It is well known that any computer value declines with time. A computer may be considered “obsolete” in one or two years after acquisition. So, it is appropriate to assume that a computer will be used more extensively during the first few years of operation. In such situations, to calculate depreciation expense, a double-declining depreciation method may be more appropriate to apply.

Double-declining method is used to record higher depreciation expense in the earlier stages of an asset’s life and respectively lower depreciation expense as the asset ages. This method is sometimes called accelerated depreciation method.

Double-declining method applies a constant rate (double of the straight-line rate) to the net book value of the asset and produces a decreasing annual depreciation expense over the asset useful life. The decrease in depreciation relates to the decrease in the asset’s net book value in each subsequent period.

To determine depreciation expense under double-declining method, accountants do the following:

1. Calculate the straight-line rate. It is calculated by dividing 100% by the number of years the asset is expected to be in use. So, in Mr. Serfy’s example, the rate is 25% (100% / 4 years).
2. Determine the double-declining balance rate by multiplying the straight-line rate by two: 25% x 2 = 50%.
3. Apply the double-declining balance rate to the book (carrying) value of the asset at the beginning of each period.

The table below depicts the depreciation expense computations under double-declining balance method:

Illustration : Schedule of double-declining depreciation for Mr. Serfy’s computer

Note that the book value of an asset cannot be depreciated below its salvage value. The computer historical cost is $23,000 and the salvage value is $3,000, so the amount to be depreciated is $20,000. Because $17,250 ( $11,500 + $5,750) is depreciated after two periods 20X7 and 20X8, only $2,750 more ($20,000 – $17,250) can be depreciated. Accordingly, the $2,875 is ignored in the third year because it exceeds $2,750 limit. Basing on the aforementioned considerations, the $1,500 is also ignored in the fourth year. Observe that the depreciation expense amounts diminished as the computer aged.

Let us assume in this example that the revenue also changes during the 4-year useful life and amounts to $15,500 in 20X7, $9,750 in 20X8, $6,750 in 20X9, and $4,000 in 20X0. Financial statements for those periods are presented below.

Illustration : Financial statements under the double-declining depreciation method

Units-of-production method of depreciation

This method was designed to better match expenses with revenues when expenses change greatly from one year to another.

Units-of-production method determines the useful life of an asset based on the units of production. Each period, the units of production determine the depreciation expense.

To illustrate this situation, assume that the computer use varies from one year to another. We will take hours of computer use as the basis for our computations of depreciation expense. During 20X7 the computer was in use for 8,000 hours, in 20X8 – for 12,000 hours, in 20X9 – for 4,000 hours, and in 20X0 – for 16,000 hours (totaling 40,000 hours). The first step in determining depreciation expense under the units-of-production method is to calculate the cost per unit of production (usage, in our example). This cost can be calculated by dividing the total depreciable cost (historical cost – salvage value) by the number of hours the computer is expected to be in use over its useful life. The cost per hour is $0.5 ($20,000 / 40,000 hours). Then the depreciation expense for every year is determined by multiplying the cost per hour by the number of hours the computer was in use. The table below shows the computation results:

Illustration : Schedule of units-of-production depreciation for Mr. Serfy’s computer

Let us assume that the revenues during the four accounting periods were as follows: for 20X7 – $8,000, for 20X8 – $10,000, for 20X9 – $6,000, and for 20X0 – $12,000. Look at the financial statements under the units-of-production depreciation method presented below:

Illustration : Financial statements under the units-of-production depreciation method

 Sum-of-the-years-digits method of depreciation

This method is similar to the double-declining method because it also assumes that an asset is used more extensively during the first years of operation. Under this method, an important consideration is given to the number of years in the asset’s useful life.

Sum-of-the-years-digits method applies a decreasing rate to the asset depreciable value and produces a decreasing depreciation expense over the useful life of the asset. The decreasing rate equals the fraction of a current year’s digit to the total of all year digits in the asset useful life.

The following steps are to be taken to determine the amounts of depreciation expense:

1. Sum up the year digits, beginning with the number of years the asset will be in use and going down to 1. For example, if an asset will be used for 5 years, the resulting total will be 15 = 5 + 4 + 3 + 2 + 1.
2. Determine the depreciation for each year by multiplying the depreciable cost (historical cost – salvage value) by the fraction of each year digit to the total of all year digits (from step one). For instance, the depreciation expense for the first year will be Depreciable Cost x 5 / 15, for the second the expense will be Depreciable Cost x 4 / 15, and so on till Depreciable Cost x 1 / 15 in the last year.

The table below shows the depreciation expense computations for our example. Note that the total of all year digits is 10. The number of years the computer will be in use is 4, then 10 = 4 + 3 + 2 + 1:

Illustration : Schedule of sum-of-the-year-digits depreciation for Mr. Serfy’s computer

The entire depreciable cost is depreciated over the four years without a remainder or surplus. This is achieved because the factor for each year (i.e., 4, 3, 2, and 1) represents a part of a whole (i.e., 10). The four digits together equal the total (i.e., 4 + 3 + 2 + 1 = 10), and respectively, the entire depreciable cost is allocated to expense.

Suppose that the following numbers represents the revenue steam: $12,000 for 20X7, $10,000 for 20X8, $8,000 for 20X9, and $6,000 for 20X0. Financial statements are shown below:

Illustration : Financial statements under the sum-of-the-years-digits depreciation method

 Changes in estimates related to depreciation of fixed assets

Sometimes there are revisions of salvage value, useful life, or asset total projected output. In such situations nothing should be done to correct the previously reported financial statements. However, the new information is taken into calculations of the present and future depreciation expenses.

Let us look at an example. A company bought a tool that cost $12,000 and has a salvage value of $3,000. The useful life is expected to be 3 years. Therefore, depreciation expense for the first year under straight-line method is $3,000 ([$12,000 – $3,000] / 3 years).

 Change in estimate from revision of useful life

Assume that the company obtained new information about the asset useful life after the asset first year of operation. It was determined that the useful life will be 6 years. So, as the tool has already been in use for one year, there is 5 more years during which depreciation will be charged. The salvage value remains the same, and the new depreciation expense is computed as follows:

Illustration : Change in depreciation from revision of useful life

Change in estimate from revision of salvage value

Now assume that the company got new information about the salvage value (the estimated useful life is not changed and remains 3 years). The new salvage value is considered to be $4,000 instead of $3,000. The useful life is the same:

Illustration : Change in depreciation from revision of salvage value

Depletion as a means of natural resources cost allocation

Natural resources are recorded on the books at their acquisition cost. The process of expense recognition for using natural resources is called depletion. Recall that depletion is allocation of a natural resource cost to expense in a rational and systematic manner over the resource useful life.

The units-of-production is the most common method to allocate the cost of natural resources. Suppose in 20X7 a mining company purchased a new mine for $6,700, plus real estate fees of $300 (totaling $7,000). No salvage value is expected. The mine is estimated to have approximately 14,000 tons of coal. So, the cost per ton is $0.5 (7,000 tons / $14,000). If the company extracts 4,000 tons in the first year, the depletion cost will be $2,000 (4,000 x $0.5). The depletion of a natural resource has the same effects on the accounting equation as depreciation of fixed assets has. Assets (Coal Mine) and equity (by increasing Depletion Expense) decrease.

Illustration: Effect of natural resources depletion on the horizontal model

The journal entries are shown below:

Illustration: Journal entries for mine acquisition and depletion expense

To show the decrease in assets, a contra asset account titled Allowance for Depletion could have been used instead of directly affecting the Coal Mine account. In such a case, Allowance for Depletion has the same relationship with natural recourses as Accumulated Depreciation has with property, plant, and equipment. Both decrease the historical cost of assets to their book value.

 Intangible assets and amortization

Intangible assets provide their owners with intellectual property rights, privileges, etc. When acquiring such assets, their cost is capitalized in asset accounts at historical cost. Depending on the asset classification, the cost may be expensed over the asset useful life. The expense recognition process for intangible assets is called amortization.

Intangible assets fall into two major categories:

• Specifically identifiable assets with definite useful lives, and
• Goodwill and specifically identifiable assets with indefinite useful lives.

Specifically identifiable intangible assets are trademarks, patents, copyrights, etc. They are normally amortized on a straight-line basis. In order to determine the number of years over which to allocate the intangible asset cost, a company should choose the shortest of the following periods:

1. Legal life of the intangible asset
2. Useful life of the intangible asset, or
3. Maximum amortization period fixed by the law of a particular country.

Suppose a company has acquired a trademark for $5,000 that is expected to have a useful life of 5 years, and the legal life of 7 years. The annual amortization charge will be $1,000 because the shortest period of 5 and 7 is 5 years and $5,000 / 5 years = $1,000. The effect of the purchase and amortization expense recognition for the first year is presented below:

Illustration : Effect of a trademark amortization on the horizontal model

The journal entries are shown below:

Illustration : Journal entries for trademark acquisition and amortization expense

Note that the Patent account was affected directly by the expense recognition; however, a contra asset account Allowance for Amortization could have been used.

Goodwill is the added value of a business because of favorable factors such as good reputation, location, etc. Specifically identifiable indefinite life assets are those for which a company cannot determine the useful life or such assets do not have a definite useful life.

Both goodwill and indefinite life intangibles are not amortized because there is no enough information to make required calculations. However, such assets are subject to impairment testing. We do not review accounting for goodwill and indefinite life intangibles here because they are usually explained in accounting courses above the principles level.

It is important to note that depreciation for property, plant, and equipment; depletion for natural recourses; and amortization for intangible assets are simply different terms used to refer to the process of expense allocation of different types of long-term assets.