Accounting for Long-term Assets

Fixed Assets: are resources that have three characteristics: they have a physical substance (a
definite size and shape), are used in the operations of a business, and are not intended for sale to
customers. They are also called property, plant, and equipment; plant and equipment; and
fixed assets. These assets are expected to provide services to the company for a number of years.
Except for land, plant assets decline in service potential over their useful lives.
This chapter deals with following topics:
1. Determining the cost of Plant assets
2. Allocating cost to expenses (Depreciation)
3. Disposal of fixed assets
4. Exchange of assets.
1. Determining the Cost of Plant Assets
The cost principle requires that companies record plant assets at cost. Cost consists of all
expenditures necessary to acquire the asset and make it ready for its intended use. For example,
the cost of factory machinery includes the purchase price, freight costs paid by the purchaser, and
installation costs. Once cost is established, the company uses that amount as the basis of accounting
for the plant asset over its useful life.
1.1 Land
Companies often use land as a building site for a manufacturing plant or office site. The cost of
land includes (1) the cash purchase price, (2) closing costs such as title and attorney’s fees, (3) real
estate brokers’ commissions, and (4) accrued property taxes and other liens assumed by the
purchaser.
To illustrate, assume that Hayes Manufacturing Company acquires real estate at a cash cost of
$100,000. The property contains an old warehouse that is razed at a net cost of $6,000 ($7,500 in
costs less $1,500 proceeds from salvaged materials). Additional expenditures are the attorney’s
fee, $1,000, and the real estate broker’s commission, $8,000. The cost of the land is $115,000,
computed as shown below:

1.2 Land Improvements

Land improvements are structural additions made to land. Examples are driveways, parking lots,
fences, landscaping, and underground sprinklers. The cost of land improvements includes all
expenditures necessary to make the improvements ready for their intended use. Land
improvements have limited useful lives, and their maintenance and replacement are the
responsibility of the company because of their limited useful life, companies expense (depreciate)
the cost of land improvements over their useful lives.
1.3 Buildings
Buildings are facilities used in operations, such as stores, offices, factories, warehouses, and
airplane hangars. Companies debit to the Buildings account all necessary expenditures related to
the purchase or construction of a building. When a building is purchased, such costs include the
purchase price, closing costs (attorney’s fees, title insurance, etc.) and real estate broker’s
commission. Costs to make the building ready for its intended use include expenditures for
remodeling and replacing or repairing the roof, floors, electrical wiring, and plumbing. When a
new building is constructed, cost consists of the contract price plus payments for architects’ fees,
building permits, and excavation costs.
1.4 Equipment
Equipment includes assets used in operations, such as store check-out counters, office furniture,
factory machinery, delivery trucks, and airplanes. The cost of equipment consists of the cash
purchase price, sales taxes, freight charges, and insurance during transit paid by the purchaser. It
also includes expenditures required in assembling, installing, and testing the unit. However, Rent-
A-Wreck does not include motor vehicle licenses and accident insurance on company vehicles in
the cost of equipment. These costs represent annual recurring expenditures and do not benefit
future periods. Thus, they are treated as expenses as they are incurred.
To illustrate, assume Merten Company purchases factory machinery at a cash price of $50,000.
Related expenditures are for sales taxes $3,000, insurance during shipping $500, and installation
and testing $1,000. The cost of the factory machinery is $54,500, computed as follows:

Merten makes the following summary entry to record the purchase and related expenditures.

For another example, assume that Lenard Company purchases a delivery truck at a cash price of
$22,000. Related expenditures consist of sales taxes $1,320, painting and lettering $500, motor
vehicle license $80, and a three-year accident insurance policy $1,600. The cost of the delivery
truck is $23,820, computed as follows.

Lenard treats the cost of the motor vehicle license as an expense, and the cost of the insurance
policy as a prepaid asset. Thus, Lenard makes the following entry to record the purchase of the
truck and related expenditures:

2. Depreciation
Depreciation is the process of allocating to expense the cost of a plant asset over its useful (service)
life in a rational and systematic manner. Cost allocation enables companies to properly match
expenses with revenues in accordance with the expense recognition principle.
It is important to understand that depreciation is a process of cost allocation. It is not a process of
asset valuation. No attempt is made to measure the change in an asset’s fair value during
ownership. So, the book value (cost less accumulated depreciation) of a plant asset may be quite
different from its fair value. In fact, if an asset is fully depreciated, it can have a zero book value
but still have a significant fair value.
Depreciation does not apply to land because its usefulness and revenue-producing ability generally
remain intact over time. In fact, in many cases, the usefulness of land is greater over time because
of the scarcity of good land sites. Thus, land is not a depreciable asset.
During a depreciable asset’s useful life, its revenue-producing ability declines because of wear
and tear. Revenue-producing ability may also decline because of obsolescence. Obsolescence is
the process of becoming out of date before the asset physically wears out.
2.1 Factors in Computing Depreciation
Three factors affect the computation of depreciation:
2.1.1 Cost: Companies record plant assets at cost, in accordance with the cost principle.
2.1.2 Useful life: Useful life is an estimate of the expected productive life, also called service life,
of the asset for its owner. Useful life may be expressed in terms of time, units of activity (such as
machine hours), or units of output. Useful life is an estimate.
2.1.3 Salvage value: Salvage value is an estimate of the asset’s value at the end of its useful life.
This value may be based on the asset’s worth as scrap or on its expected trade-in value. Like useful
life, salvage value is an estimate.
2.2 Depreciation Methods
Depreciation is generally computed using one of the following methods:
1. Straight-line
2. Units-of-activity
3. Declining-balance
2.2.1 Straight-line
Under the straight-line method, companies expense the same amount of depreciation for each year
of the asset’s useful life. It is measured solely by the passage of time.
To compute depreciation expense under the straight-line method, companies need to determine
depreciable cost. Depreciable cost is the cost of the asset less its salvage value. It represents the
total amount subject to depreciation. Under the straight-line method, to determine annual
depreciation expense, we divide depreciable cost by the asset’s useful life.
2.2.2 Units-of-activity
Under the units-of-activity method, useful life is expressed in terms of the total units of
production or use expected from the asset, rather than as a time period. The units-of-activity
method is ideally suited to factory machinery. Manufacturing companies can measure production
in units of output or in machine hours. The units-of-activity method is generally not suitable for
buildings or furniture, because depreciation for these assets is more a function of time than of
use.
To use this method, companies estimate the total units of activity for the entire useful life, and
then divide these units into depreciable cost. The resulting number represents the depreciation
cost per unit. The depreciation cost per unit is then applied to the units of activity during the year
to determine the annual depreciation expense. Another term often used is the units-of-production
method.
2.2.3 Declining-balance
The declining-balance method produces a decreasing annual depreciation expense over the
asset’s useful life. The method is so named because the periodic depreciation is based on a
declining book value (cost less accumulated depreciation) of the asset. With this method,
companies compute annual depreciation expense by multiplying the book value at the beginning
of the year by the declining-balance depreciation rate. The depreciation rate remains constant
from year to year, but the book value to which the rate is applied declines each year.
At the beginning of the first year, book value is the cost of the asset. This is so because the
balance in accumulated depreciation at the beginning of the asset’s useful life is zero. A common
declining-balance rate is double the straight-line rate. The method is often called the double-
declining-balance method. Which is double of straight-line percentage. The method
recommended for an asset that is expected to be significantly more productive in the first half of
its useful life is the declining-balance method.
2.3 Depletion
Natural resources consist of standing timber and underground deposits of oil, gas, and minerals.
These long-lived productive assets have two distinguishing characteristics: (1) They are
physically extracted in operations (such as mining, cutting, or pumping). (2) They are
replaceable only by an act of nature.
The acquisition cost of a natural resource is the price needed to acquire the resource and prepare
it for its intended use. For an already-discovered resource, such as an existing coal mine, cost is
the price paid for the property. The allocation of the cost of natural resources to expense in a
rational and systematic manner over the resource’s useful life is called depletion. (That is,
depletion is to natural resources as depreciation is to plant assets.) Companies generally use the
units of-activity method (learned earlier in the chapter) to compute depletion. The reason is that
depletion generally is a function of the units extracted during the year.
3. Disposal of fixed assets
In a disposal by sale, the company compares the book value of the asset with the proceeds
received from the sale. If the proceeds of the sale exceed the book value of the plant asset, a gain
on disposal occurs. If the proceeds of the sale are less than the book value of the plant asset sold,
a loss on disposal occurs.

Calculation of gain or loss on disposal

Proceeds from sale $16000
Less: book value of assets:
Cost $60000
Less: Accumulated depreciation -49000
Book value 11000
Gain on the disposal $5000
 Problems
Problem 01: Mick Ferguson Company incurs the following expenditures in purchasing a truck:
cash price $30,000, fire insurance $2,000, sales taxes $1,500, motor vehicle license $100, and
painting and lettering $400. What is the cost of the truck?
Problem 02: Tomorry Company acquires a delivery truck at a cost of $42,000. The truck is
expected to have a salvage value of $6,000 at the end of its 4-year useful life. Compute annual
depreciation for the first and second years using the straight-line method.
Problem 03: using the data in problem 02. Assuming the declining-balance depreciation rate is
double the straight-line rate, compute annual depreciation for the first and second years under the
declining-balance method.
Problem 04: Koman Taxi Service uses the units-of-activity method in computing depreciation
on its taxicabs. Each cab is expected to be driven 150,000 miles. Taxi no. 10 cost $33,500 and is
expected to have a salvage value of $500. Taxi no. 10 is driven 30,000 miles in year 1 and
20,000 miles in year 2. Compute the depreciation for each year.
Problem 05: Prepare journal entries to record the following.
(a) Twitter Tracker Company retires its delivery equipment, which cost $41,000. Accumulated
depreciation is also $41,000 on this delivery equipment. No salvage value is received.
(b) Assume the same information as (a), except that accumulated depreciation is $39,000, instead
of $41,000, on the delivery equipment.
Problem 06: Wing Pang Company sells equipment on September 30, 2012, for $20,000 cash.
The equipment originally cost $72,000 and as of January 1, 2012, had accumulated depreciation
of $42,000. Depreciation for the first 9 months of 2012 is $5,250. Prepare the journal entries to
(a) update depreciation to September 30, 2012, and (b) record the sale of the equipment.
Problem 07: Tumnus Company purchased a delivery truck for $30,000 on January 1, 2012. The
truck has an expected salvage value of $2,000, and is expected to be driven 100,000 miles over
its estimated useful life of 8 years. Actual miles driven were 15,000 in 2012 and 12,000 in 2013.
Instructions:
(a) Compute depreciation expense for 2012 and 2013 using (1) the straight-line method, (2) the
units-of-activity method, and (3) the double-declining-balance method.
(b) Assume that Tumnus uses the straight-line method.
1. Prepare the journal entry to record 2012 depreciation.
2. Show how the truck would be reported in the December 31, 2012, balance sheet.
Problem 08: Presented below are selected transactions at Kirke Company for 2012.
Jan. 1 Retired a piece of machinery that was purchased on January 1, 2002. The machine cost
$62,000 on that date. It had a useful life of 10 years with no salvage value.
June 30 Sold a computer that was purchased on January 1, 2009. The computer cost $40,000. It
had a useful life of 5 years with no salvage value. The computer was sold for $14,000.
Dec. 31 Discarded a delivery truck that was purchased on January 1, 2008. The truck cost
$39,000. It was depreciated based on a 6-year useful life with a $3,000 salvage value.
Instructions:
Journalize all entries required on the above dates, including entries to update depreciation, where
applicable, on assets disposed of. Kirke Company uses straight-line depreciation. (Assume
depreciation is up to date as of December 31, 2011.)
Problem 09: Edmund Company exchanges old delivery equipment for new delivery equipment.
The book value of the old delivery equipment is $31,000 (cost $61,000 less accumulated
depreciation $30,000). Its fair value is $19,000, and cash of $5,000 is paid.
a. Prepare the entry to record the exchange, assuming the transaction has commercial
substance.
b. Assume the same information as above, except that the fair value of the old delivery
equipment is $38,000. Prepare the entry to record the exchange.
Problem 10: On January 1, 2012, Zakiuddin Company purchased the following two machines for
use in its production process.
Problem 11: On July 1, 2012, Macready Inc. invested $720,000 in a mine estimated to have
800,000 tons of ore of uniform grade. During the last 6 months of 2012, 100,000 tons of ore were
mined and sold.
Instructions:
a. Prepare the journal entry to record depletion expense.
b. Assume that the 100,000 tons of ore were mined, but only 80,000 units were sold. How are
the costs applicable to the 20,000 unsold units reported?