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Capital & Revenue Expenditures – Accounting 2

Capital & Revenue Expenditures – Accounting 2

1. Read Article 

https://www.investors.com/news/target-stock-spikes-to-11-month-high-on-earnings-beat/

Provide a measure of information about the topic’s significance to the current business climate. A minimum of 2 reference sources are required for full credit. The article review should be a minimum of 300 words and be submitted in proper APA format. 

I. The article review layout is simple. It should consist of the following three headings:

– Overview/Summary

– Opinion/Analysis

– Relevance to business climate.

Note: 

A. The Opinion/Analysis section should demonstrate your critical thinking and analysis of the subject matter.

B. The Relevance section should offer an insight-building summary, recommendations, findings and conclusions.

C. PPTX provided for reference (slide 21-)

NO AI, Chegg, Course Hero, etc. 

Horngren’s Accounting: The Financial Chapters

Twelfth Edition

Chapter 10

Plant Assets, Natural Resources, and Intangibles

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1

Learning Objectives (1 of 2)

10.1 Measure the cost of property, plant, and equipment

10.2 Account for depreciation using the straight-line, units-of-production, and double-declining-balance methods

10.3 Journalize entries for the disposal of plant assets

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2

Learning Objectives (2 of 2)

10.4 Account for natural resources

10.5 Account for intangible assets

10.6 Use the asset turnover ratio to evaluate business performance

10.7 Journalize entries for the exchange of plant assets (Appendix 10A)

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Learning Objective 10.1

Measure the cost of property, plant, and equipment

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How Does a Business Measure the Cost of a Property, Plant, and Equipment? (1 of 4)

Property, plant, and equipment (PP&E) are long-lived, tangible assets used in the operations of a business.

Examples:

Land

Buildings

Equipment

Furniture

Fixtures

Automobiles

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Plant assets are long-lived, tangible assets used in the operation of the business. These assets include land, buildings, equipment, furniture, fixtures, and automobiles. Often, property, plant, and equipment are referred to as plant assets, operational assets, or fixed assets in financial statements.

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How Does a Business Measure the Cost of a Property, Plant, and Equipment? (2 of 4)

Plant assets are different from other assets because plant assets are long term (lasting several years).

The cost of a plant asset is allocated to an expense over the years that the asset is expected to be used.

The allocation of a plant asset’s cost over its useful life is called depreciation and follows the matching principle.

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Plant assets are different from other assets, such as office supplies, because plant assets are long term (lasting several years). This requires a business to allocate the cost of the asset over the years that the asset is expected to be used. This allocation of a plant asset’s cost over its useful life is called depreciation and follows the matching principle. Depreciation is the process by which businesses spread the allocation of a plant asset’s cost over its useful life. The matching principle ensures that all expenses are matched against the revenues of the period. Because plant assets are used over several years, a business will record a portion of the cost of the asset as an expense in each of those years. All plant assets except land are depreciated. We record no depreciation for land because it does not have a definitive or clearly estimable life, so it is difficult to allocate the cost of land.

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How Does a Business Measure the Cost of a Property, Plant, and Equipment? (3 of 4)

Exhibit 10-1 Life Cycle of a Plant Asset

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Exhibit 10-1 summarizes the life cycle of a plant asset in a business. The business begins by acquiring the asset and recording the asset on its books. This involves determining the asset cost that is reported on the balance sheet. As the business uses the asset, it must record depreciation expense. In addition, the business incurs additional expenses (such as repairs and maintenance) related to the asset. Finally, when the asset has reached the end of its useful life, the business disposes of the asset. Each of these stages in the life of a plant asset must be recorded on the business’s books.

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How Does a Business Measure the Cost of a Property, Plant, and Equipment? (4 of 4)

A plant asset is recorded at historical cost—the amount paid for the asset.

This follows the cost principle, which states that acquired assets and services should be recorded at their actual costs.

The actual cost is the purchase price plus taxes, commissions, and other amounts paid to get the asset ready for its intended use.

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Plant assets are recorded at historical cost—the amount paid for the asset. This follows the cost principle, which states that acquired assets (and services) should be recorded at their actual cost. The actual cost of a plant asset is its purchase price plus taxes, purchase commissions, and all other amounts paid to ready the asset for its intended use.

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Land and Land Improvements (1 of 5)

The cost of land includes the following amounts paid by the purchaser:

Purchase price

Brokerage commission

Survey and legal fees

Delinquent property taxes

Title transfer fees

Cost of clearing the land

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The cost of land includes the purchase price, brokerage commissions, survey and legal fees, delinquent property taxes, title transfers fees, the cost of clearing the land, and the cost of removing old buildings from the land. Land is a unique kind of plant asset that is never depreciated.

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Land and Land Improvements (2 of 5)

The cost of land does not include:

Fencing

Paving

Sprinkler systems

Lighting

Signs

These separate plant assets are called land improvements and, unlike land, are subject to depreciation.

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The cost of land does not include fencing, paving, sprinkler systems, lighting, signs, and other improvements to the land such as landscaping. These costs are collectively referred to as land improvements. A land improvement is a depreciable improvement to land. These costs are separately identified from the land itself, and they are depreciated.

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Land and Land Improvements (3 of 5)

Smart Touch Learning purchases land on August 1, 2019, for $50,000 with a note payable. Other costs include $4,000 in delinquent property taxes, $2,000 in transfer taxes, $5,000 to remove an old building, and a $1,000 survey fee.

Exhibit 10-2 Measuring the Cost of Land

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Assume that Smart Touch Learning buys land on August 1 for $50,000 and pays for it with a note payable. Other costs related to this transaction include $4,000 in delinquent property taxes, $2,000 in property transfer taxes (or fees), $5,000 to remove an old building from the site, and $1,000 for a survey of the property. All other items are paid for with cash.

What is the cost of the land on Smart Touch Learning’s books? As you can see from the computation in Exhibit 10-2, the cost of the land is not only the acquisition cost of $50,000. It also includes an additional $12,000 of costs that bring the total cost of the land on the books to $62,000.

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Land and Land Improvements (4 of 5)

The entry to record the purchase of the land on August 1, 2019:

Smart Touch Learning capitalizes the cost of the land at $62,000.

Capitalized means that an asset account was debited (increased) because the company acquired an asset.

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The journal entry to record the acquisition of the land would include a debit to Land for $62,000 and credits to Notes Payable for $50,000 and to Cash for $12,000 (related to the additional costs).

We would say that Smart Touch Learning capitalized the cost of the land at $62,000. Capitalized means that an asset account was debited (increased) because the company acquired an asset. So, for our land example, Smart Touch Learning debited the Land account for $62,000, the capitalized cost of the asset.

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Land and Land Improvements (5 of 5)

Smart Touch Learning then pays $20,000 for fences, paving, lighting, and signs on August 15, 2019:

Land and land improvements are two entirely separate assets.

Land improvements are depreciated.

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Land and land improvements are two entirely separate assets. Recall that land is not depreciated. However, the cost of land improvements is depreciated over that asset’s useful life.

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Buildings

The costs of a building include:

Constructing a Building

Architectural fees

Building permits

Contractor charges

Payments for materials, labor, and miscellaneous costs

Purchasing an Existing Building

Purchase price

Costs to renovate the building to ready it for use, which may include any of the charges listed in the “Constructing a Building” column

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The costs of a building include:

Constructing a Building

Architectural fees

Building permits

Contractor charges

Payments for materials, labor, and miscellaneous costs

Purchasing an Existing Building

Purchase price

Costs to renovate the building to ready it for use, which may include any of the charges listed under “Constructing a Building”

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Machinery and Equipment

The cost of machinery and equipment includes:

Purchase price (less any discounts)

Transportation charges

Insurance while in transit

Sales tax and other taxes

Purchase commission

Installation costs

Testing costs (prior to use of the asset)

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The cost of machinery and equipment includes the purchase price, transportation charges, insurance while in transit, sales tax and other taxes, purchase commission, installation, and testing costs. After the asset is up and running, the company no longer capitalizes the cost of insurance, taxes, ordinary repairs, and maintenance to the Equipment account. From that point on, insurance, taxes, repairs, and maintenance costs are recorded as expenses.

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Furniture and Fixtures

Examples of furniture and fixtures include:

Desks

Chairs

File cabinets

Display racks and shelving

The costs of furniture and fixtures include:

Basic cost of each asset (less any discounts)

All other costs to ready the asset for its intended use

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Furniture and fixtures include desks, chairs, file cabinets, display racks, shelving, and so forth. The cost of furniture and fixtures includes the basic cost of each asset (less any discounts) plus all other costs to ready the asset for its intended use. For example, for a desk, this may include the cost to ship the desk to the business and the cost paid to a laborer to assemble the desk.

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Lump-Sum Purchase (1 of 4)

A company may pay a single price for several assets as a group; this is called a lump-sum purchase.

Also called a basket purchase

The company must identify the cost of each asset purchased.

The total cost paid is divided among the assets according to their relative fair market values. This is called the relative-market-value method.

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A company may pay a single price for several assets as a group; this is called a lump-sum purchase (or a basket purchase). For example, Smart Touch Learning may pay a single price for land and a building. For accounting purposes, the company must identify the cost of each asset purchased. The total cost paid (100%) is divided among the assets according to their relative market values. The relative-market-value-method is a method of allocating the total cost (100%) of multiple assets purchased at one time. Total cost is divided among the assets according to their relative market values.

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Lump-Sum Purchase (2 of 4)

Suppose Smart Touch Learning paid $100,000 on August 1, 2019, for the land and building. An appraisal indicates the land’s market value is $30,000, and the building’s market value is $90,000.

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Suppose Smart Touch Learning paid a combined purchase price of $100,000 on August 1, 2019, for the land and building. An appraisal indicates that the land’s market value is $30,000, and the building’s market value is $90,000. How will the accountant allocate the $100,000 paid for both assets?

First, calculate the ratio of each asset’s market value to the total market value for both assets. The total appraised value is $120,000. The land represents 25% ($30,000 / $120,000) of the purchase, and the building represents 75% ($90,000 / $120,000) of the purchase.

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For Smart Touch Learning, the land is assigned a cost of $25,000, and the building is assigned a cost of $75,000, calculated as follows:

Lump-Sum Purchase (3 of 4)

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In our example, 25% of the cost should be allocated to the land (25% × $100,000 = $25,000), and 75% of the cost should be assigned to the building (75% × $100,000 = $75,000).

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Lump-Sum Purchase (4 of 4)

Assume that Smart Touch Learning purchased the assets by signing a note payable. The entry to record the purchase of the land and building is:

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The journal entry will include a debit of $25,000 to Land, a debit of $75,000 to Building, and a credit of $100,000 to Notes Payable.

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Capital and Revenue Expenditures (1 of 4)

Accountants divide spending on plant assets after the acquisition into two categories:

Capital expenditures increase the asset’s capacity or efficiency or extends the asset’s useful life.

Includes extraordinary repairs, which are repairs that extend the asset’s useful life

Revenue expenditures are expenses incurred to maintain the asset in working order.

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Accountants divide spending on plant assets after the acquisition into two categories: capital expenditures and revenue expenditures.

A capital expenditure is an expenditure that increases the capacity or efficiency of a plant asset or extends its useful life. A capital expenditure is also called a balance sheet expenditure because the cost of the expenditure is reported on the balance sheet as an asset. A capital expenditure is debited to an asset account because it increases the asset’s capacity or efficiency or extends the asset’s useful life. Examples of capital expenditures include the purchase price plus all the other costs to bring an asset to its intended use. An extraordinary repair is a capital expenditure because it extends the asset’s capacity or useful life.

Expenses incurred to maintain an asset in working order, such as repair or maintenance expenses, are not debited to an asset account. Examples include the cost of maintaining equipment, such as repairing the air conditioner on a truck, changing the oil filter, and replacing its tires. These ordinary repairs are called revenue expenditures and are debited to Repairs and Maintenance Expense. Revenue expenditures are often called income statement expenditures, do not increase the capacity or efficiency of an asset or extend its useful life, and are reported on the income statement as an expense in the period incurred.

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Capital and Revenue Expenditures (2 of 4)

Spending $3,000 to rebuild the engine on a five-year-old truck is an extraordinary repair because it extends the asset’s life past the normal expected life.

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Spending $3,000 to rebuild the engine on a five-year-old truck is an extraordinary repair because it extends the asset’s life past the normal expected life. The $3,000 is capitalized by debiting Truck and crediting Cash.

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Capital and Revenue Expenditures (3 of 4)

Smart Touch Learning paid $500 cash to replace tires on the truck. This expenditure does not extend the useful life of the truck or increase its efficiency.

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Smart Touch Learning paid $500 cash to replace tires on the truck. This expenditure does not extend the useful life of the truck or increase its efficiency. The $500 is expensed by debiting Repairs and Maintenance Expense and crediting Cash.

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Capital and Revenue Expenditures (4 of 4)

Exhibit 10-3 Delivery Truck Expenditures—Capital Expenditure and Revenue Expenditure

Capital Expenditure: Debit an Asset Account Revenue Expenditure: Debit an Expense Account
Capital Expenditures: Revenue Expenditures:
Major engine or transmission overhaul Repair of transmission or engine
Modification for new use Oil change, lubrication, and so on
Addition to storage capacity Replacement of tires or windshield
Anything that increases the life of the asset Paint job

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Exhibit 10-3 shows some capital expenditures and revenue expenditures for a delivery truck.

Treating a capital expenditure as an expense, or vice versa, creates an accounting error. Suppose a business replaces the engine in a truck. This would be an extraordinary repair because it increases the truck’s life. If the company expenses the cost by debiting Repairs and Maintenance Expense rather than capitalizing it (debiting the asset), the company would be making an accounting error. This error has the following effects: overstates Repairs and Maintenance Expense, understates net income, understates owner’s equity, and understates the Truck account (asset) on the balance sheet. Incorrectly capitalizing an expense creates the opposite error.

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Learning Objective 10.2

Account for depreciation using the straight-line, units-of-production, and double-declining-balance methods

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What Is Depreciation, and How Is It Computed?

Depreciation matches the expense against the revenue generated from using an asset.

All assets, except land, wear out as they are used.

Some assets may become obsolete before they wear out. An asset is obsolete when a newer asset can perform the job more efficiently.

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Depreciation is the allocation of a plant asset’s cost to expense over its useful life. Depreciation matches the expense against the revenue generated from using the asset to measure net income. All assets, except land, wear out as they are used. In addition, physical factors, like age and weather, can cause depreciation of assets. Some assets, such as computers and software, may become obsolete before they wear out. An asset is considered obsolete when a newer asset can perform the job more efficiently than the old.

Depreciation is not a process of valuation. Businesses do not record depreciation based on changes in the asset’s market value. Depreciation does not mean that the business sets aside cash to replace an asset when it is used up. Depreciation has nothing to do with cash.

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Factors in Computing Depreciation

Depreciation of a plant asset is based on three main factors:

Capitalized cost

Estimated useful life, which is how long the company expects it will use the asset.

Estimated residual value, which is the expected value of a depreciable asset at the end of its useful life.

Cost minus estimated residual value is called depreciable cost.

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To compute depreciation for a period, we need to consider three primary factors: the capitalized cost of the asset, the estimated useful life, and the estimated residual value of the asset at the end of its estimated useful life.

The useful life is the length of the service period expected from an asset. It may be expressed in time, such as months or years, or usage, such as units produced, hours used (for machinery), or miles driven (for a truck). The residual value is the expected value of a depreciable asset at the end of its useful life.

When a company decides to dispose of an asset, the company sells or scraps it. The residual value is the amount the company expects to receive when it disposes of the asset. Residual value can sometimes be zero if a company does not expect to receive anything when disposing of an asset. If a company plans on trading in an asset for a new asset, the residual value will be the expected trade-in value. Estimated residual value is not depreciated because the company expects to receive this amount at the end. The depreciable cost is the cost of a plant asset minus its estimated residual value.

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Depreciation Methods

most commonly used depreciation methods:

Straight-line method

Units-of-production method

Double-declining-balance method

Exhibit 10-4 Data for Truck

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The three common most depreciation methods are straight-line depreciation, units-of-production depreciation, and double-declining-balance depreciation.

As we work through each method, we will use the following information. Smart Touch Learning purchases a truck on January 1, 2019. The truck has a cost of $41,000 and an estimated residual value of $1,000. The estimated useful life of the truck is five years or 100,000 miles.

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Straight-Line Method (1 of 3)

The straight-line method allocates an equal amount of depreciation to each year and is computed as follows:

The entry to record the year’s depreciation expense:

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Under the straight-line method, residual value is deducted from the depreciable cost and then divided by the estimated useful life of the asset. The straight-line method is a depreciation method that allocates an equal amount of depreciation each period.

Straight-line depreciation = (Cost – Residual value) / Useful life

In the Smart Touch Learning example, the depreciable cost is $40,000. Divided by an estimated useful life of five years, the annual depreciation for the truck is $8,000 per year.

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Straight-Line Method (2 of 3)

Depreciation expense is reported on the income statement.

The book value of the asset, cost minus accumulated depreciation, is reflected on the balance sheet.

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Depreciation expense is reported on the income statement. Accumulated Depreciation is a contra asset account that is reported on the balance sheet. The book value is a depreciable asset’s cost minus accumulated depreciation. The book value is reported on the balance sheet.

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Straight-Line Method (3 of 3)

Exhibit 10-5 Straight-Line Depreciation Schedule

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A straight-line depreciation schedule for the truck is shown in Exhibit 10-5. The final column on the right shows the asset’s book value, which is cost less accumulated depreciation. Notice that the depreciation expense amount is the same every year, and the accumulated depreciation is the sum of all depreciation expense recorded to date for the depreciable asset. As an asset is used, accumulated depreciation increases and book value decreases. At the end of its useful life, the asset is said to be fully depreciated. An asset’s final book value is its residual value.

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Units-of-Production Method (1 of 3)

The units-of-production method allocates a varying amount of depreciation each year, based on the asset’s usage.

When a plant asset’s usage varies by year, the units-of-production method better matches expenses with revenues.

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The units-of-production method allocates a varying amount of depreciation each year, based on an asset’s usage. Units-of-production depreciates by units rather than by years. A unit of output can be miles, units, hours, or output, depending on which unit type best defines the asset’s use. When a plant asset’s usage varies every year, the units-of-production method does a better job of matching expenses with revenues.

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Units-of-Production Method (2 of 3)

Smart Touch Learning expects to drive the truck 20,000 miles the first year, 30,000 miles the second, 25,000 the third, 15,000 the fourth, and 10,000 the fifth—for a total of 100,000 miles.

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Continuing with the truck example, the truck is estimated to be driven 20,000 miles the first year, 30,000 the second, 25,000 the third, 15,000 the fourth, and 10,000 the fifth—for a total useful life of 100,000 miles.

The first step is to compute the depreciation per unit of use. In this case, the asset is expected to have a useful life of 100,000 miles. The depreciable cost of the truck is $40,000. So the truck will be depreciated $0.40 per mile for every mile driven.

In Step 2, we compute the amount of depreciation for the current period based on the depreciation per unit of use and the actual use. In this case, $0.40 per mile for 20,000 miles results in depreciation in Year 1 of $8,000. That this is the same depreciation amount given by the straight-line method is only a coincidence. Because the units-of-production method is so unpredictable, we have no idea how much depreciation will be in Year 2. It might be as much as $32,000 (if the truck is driven as much as 80,000 miles in Year 2) or $0 (if the truck is not used at all in Year 2).

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Units-of-Production Method (3 of 3)

Exhibit 10-6 Units-of-Production Depreciation Schedule

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Units-of-production depreciation for the truck is illustrated in Exhibit 10-6.

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Double-Declining Balance Method (1 of 3)

An accelerated depreciation method expenses more of the asset’s cost near the start of an asset’s life and less at the end of its useful life.

The main accelerated method of depreciation is the double-declining-balance method.

The double-declining-balance method multiplies an asset’s decreasing book value by a constant percentage that is twice the straight-line depreciation rate.

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Accelerated depreciation is a method that expenses more of an asset’s cost near the start of its useful life and less at the end of its useful life. The main accelerated method of depreciation is the double-declining-balance method. This accelerated depreciation method computes annual depreciation by multiplying the depreciable asset’s decreasing book value by a constant percentage that is two times the straight-line depreciation rate.

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Double-Declining Balance Method (2 of 3)

Double-declining-balance amounts can be computed using the following formula:

For the first year of the truck:

In year 2:

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Note that residual value is not included in the formula. Residual value is ignored until the depreciation expense takes the book value below the residual value. When this occurs, the final year depreciation is calculated as the amount needed to bring the asset to its residual value.

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Double-Declining Balance Method (3 of 3)

Exhibit 10-7 Double-Declining-Balance Depreciation Schedule

*Last year depreciation is the “plug figure” needed to reduce book value to the residual amount ($5,314 – $1,000 = $4,314).

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Exhibit 10-7 shows the double-declining-balance depreciation schedule. It reflects the calculations for Year 1 and Year 2, shown on the prior slide. Notice that, after Year 4 (December, 31, 2022), the truck’s book value is $5,314. By definition, the truck is to last five years, which ends on December 31, 2023. At the end of the asset’s life, its book value should equal the residual value. Therefore, in the final year, depreciation is book value, $5,314, less the $1,000 residual value, or $4,314 in depreciation expense.

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Comparing Depreciation Methods (1 of 2)

Method Asset Characteristics Effect on Depreciation Example Assets
Straight-line Generates revenue evenly over time Equal amount each period Building
Units-of-production Depreciates due to wear and tear rather than obsolescence More usage causes larger depreciation Vehicles (miles) Machinery (machine hours)
Double-declining-balance Produces more revenue in early years Higher depreciation in early years, less later Computers

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Annual depreciation expense amounts vary, but total accumulated depreciation is $40,000 for all three methods.

Deciding which method is best depends on the asset. A business should match an asset’s expense against the revenue that the asset produces.

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Comparing Depreciation Methods (2 of 2)

Exhibit 10-8 Annual Depreciation by Method

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Exhibit 10-8 shows the three methods in one graph for additional comparison. Notice that the straight-line method produces a straight line on the graph because there is an equal amount of depreciation expense each year. The double-declining-balance method produces a line that is decreasing, and the units-of-production method’s line varies based on usage.

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Depreciation for Tax Purposes

The Internal Revenue Service (IRS) requires that companies use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes.

Under MACRS, assets are divided into specific classes such as 3-year, 5-year, 7-year, and 39-year property.

The IRS specifies the life of the asset.

Residual value ignored

MACRS is not acceptable for GAAP

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The Internal Revenue Service (IRS) requires that companies use a specific depreciation method for tax purposes, the Modified Accelerated Cost Recovery System (MACRS). Under MACRS, assets are divided into specific classes, such as 3-year, 5-year, 7-year, and 39-year property. Businesses do not get to choose the useful life of an asset. Instead, the IRS specifies the useful life based on the specific classes. For example, office furniture has a 7-year life for tax purposes but might only be depreciated for 5 years for book purposes. MACRS is not acceptable for financial reporting under GAAP.

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Partial-Year Depreciation (1 of 2)

When a business purchases an asset during the year (other than January 1), it should record depreciation for only the portion of the year that the asset was used in the operations of the business.

The modified half-month convention is used for assets purchased during the month

Record depreciation for the entire month if the asset was purchased on or before the 15th.

Do not record depreciation in the purchase month if the asset was purchased after the 15th.

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Partial-year depreciation also applies to disposal of assets (which we will cover later in this chapter). If an asset is disposed of during the year, the business must calculate depreciation for only the time period the asset was in service before the asset was disposed, not the entire year.

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Partial-Year Depreciation (2 of 2)

Assume a truck costing $41,000 was placed into service on July 1, 2019. It has a $1,000 residual value and a 5 year life.

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Returning to our example, assume that the truck was placed into service on July 1, 2019. Therefore, the truck was in service for six months in 2019, from July 1 through December 31. Because the business used the asset for six months of the year, we record only 6/12 (6 out of 12 months) of straight-line depreciation expense, or $4,000, in 2019.

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Changing Estimates of a Depreciable Asset (1 of 4)

As the asset is used, the business may change its estimated useful life or estimated residual value.

If this happens, the business must recalculate depreciation expense.

Current year and future depreciation expense are recalculated

Prior years are not restated

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For example, the business may find that its truck lasts eight years instead of five. This is a change in estimated useful life. Accounting changes like this are common because useful life and residual value are estimates and, as a result, are not based on perfect foresight. When a company makes an accounting change, Generally Accepted Accounting Principles require the business to recalculate the depreciation for the asset in the year of change and in future periods. They do not require that businesses restate prior years’ financial statements for this change in estimate.

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Changing Estimates of a Depreciable Asset (2 of 4)

Smart Touch Learning used the truck purchased on January 1, 2019, for two full years. The truck cost $41,000 and had a $1,000 residual value and a five-year life.

The remaining depreciable book value (cost less accumulated depreciation) is $25,000 ($41,000 – $16,000).

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Smart Touch Learning used the truck purchased on January 1, 2019, for two full years. The truck cost $41,000 and had a $1,000 residual value and a five-year life. Straight-line depreciation for two years = ($41,000 – $1,000) / 5 years = $8,000 per year × 2 years = $16,000.

The remaining depreciable book value (cost less accumulated depreciation) is $25,000 ($41,000 – $16,000).

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Changing Estimates of a Depreciable Asset (3 of 4)

Smart Touch Learning believes the truck will remain useful for six more years (for a total of eight years). Residual value is unchanged. At the start of 2021, the company would recompute depreciation as follows:

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Smart Touch Learning believes the truck will remain useful for six more years (for a total of eight years). Residual value is unchanged. At the start of 2021, the company would recompute depreciation: ($25,000/$1000) / 6 years = $4,000 per year.

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Changing Estimates of a Depreciable Asset (4 of 4)

In years 2021 to 2026, the yearly depreciation entry based on the new useful life would be as follows:

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In years 2021 to 2026, the yearly depreciation entry based on the new useful life would debit Depreciation Expense―Truck and credit Accumulated Depreciation―Truck for $4,000.

46

Reporting Property, Plant, and Equipment (1 of 2)

Property, plant, and equipment are reported at book value on the balance sheet.

Companies may report plant assets as a single amount, with the cost and the related accumulated depreciation disclosed in the notes.

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Plant assets are reported at book value on the balance sheet. Companies may choose to report plant assets as a single amount, with a note to the financial statements that provides detailed information, or provide detailed information on the face of the statement. The cost of the asset and the related accumulated depreciation should be disclosed. Exhibit 10-9 shows the two alternative reporting treatments for plant assets.

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Reporting Property, Plant, and Equipment (2 of 2)

Exhibit 10-9 Reporting Property, Plant, and Equipment

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Exhibit 10-9 shows the two alternative reporting treatments for plant assets.

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Learning Objective 10.3

Journalize entries for the disposal of plant assets

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How Are Disposals of Plant Assets Recorded? (1 of 2)

Eventually, an asset wears out or becomes obsolete. The business then has several options:

Discard the plant asset.

Sell the plant asset.

Exchange the plant asset for another asset.

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Eventually, an asset wears out or becomes obsolete. The business can discard the plant asset, sell the plant asset, or exchange the plant asset for another plant asset. Plant assets remain on the business’s books until they are disposed of. If an asset is still useful, the company may continue using it even though no additional depreciation is recorded. If the asset is no longer useful, it is disposed of. This requires the business to remove the asset and associated accumulated depreciation from the books. In addition, a gain or loss might be recognized by the company.

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How Are Disposals of Plant Assets Recorded? (2 of 2)

Regardless of the type of disposal, there are four steps:

Bring the depreciation up to date.

Remove the old, disposed-of asset and associated accumulated depreciation from the books.

Record the value of any cash received (or paid) in the disposal of the asset.

Determine the amount of any gain or loss.

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Regardless of the type of disposal, there are four steps:

Bring the depreciation up to date.

Remove the old, disposed-of-asset and associated accumulated depreciation from the books.

Record the value of any cash received (or paid) in the disposal of the asset.

Determine the amount of any gain or loss. Gain or loss is determined by comparing the cash received and the market value of any other assets received with the book value of the asset disposed of.

51

Discarding Plant Assets (1 of 5)

On July 1, Smart Touch Learning discards equipment with a cost of $10,000 and accumulated depreciation of $10,000.

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Discarding plant assets involves disposing of the asset for no cash.

Smart Touch Learning discards equipment that cost $10,000. The accumulated depreciation on the asset is $10,000. In other words, the asset is fully depreciated. There is no cash involved in this transaction. To dispose of the equipment, Smart Touch Learning needs to credit the asset account, Equipment, and debit Accumulated Depreciation—Equipment.

52

Discarding Plant Assets (2 of 5)

On July 1, Smart Touch Learning discards equipment with a cost of $10,000 and accumulated depreciation of $10,000.

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On July 1, Smart Touch Learning discards equipment with a cost of $10,000 and accumulated depreciation of $10,000. After disposal, the Equipment and Accumulated Depreciation—Equipment accounts have a zero balance.

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Discarding Plant Assets (3 of 5)

Suppose, instead, that on July 1, Smart Touch Learning discarded the equipment, which has a cost of $10,000 but is not fully depreciated. Accumulated depreciation is $8,000, and annual depreciation is $1,000. The first step is to bring the asset up to date on depreciation.

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In the second example, Smart Touch Learning discards equipment that cost $10,000. Unlike in the previous example, the asset is not already fully depreciated. Because the asset sold in the middle of the year, we must compute and record a half year’s depreciation before recording the asset’s disposal. The asset already had $8,000 accumulated depreciation. There is no cash involved in this transaction.

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Discarding Plant Assets (4 of 5)

In this situation, there is a $1,500 loss calculated as follows:

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In this situation, there is a $1,500 loss due to the difference between the asset’s book value ($1,500) and the market value received ($0).

55

Discarding Plant Assets (5 of 5)

Smart Touch Learning records the following entry to dispose of the equipment:

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The account Loss on Disposal will be used. This account has a normal debit balance and is reported in the Other Income and (Expenses) section of the income statement, which includes gains and losses on the sale of plant assets.

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Selling Plant Assets

On July 1, the company sells equipment with a historical cost of $10,000 and accumulated depreciation, as of December 31 of the previous year, of $8,000. Annual depreciation is $1,000. The first step is to bring the depreciation up to date:

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On July 1, the company sells equipment with a historical cost of $10,000 and accumulated depreciation, as of December 31 of the previous year, of $8,000. Annual depreciation is $1,000. The first step is to bring the depreciation up to date by debiting Depreciation Expense and crediting Accumulated Depreciation—Equipment for $500.

57

Selling a Plant Asset at Book Value (1 of 2)

Suppose that Smart Touch Learning sells the equipment for $1,500.

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Suppose that Smart Touch Learning sells the equipment for $1,500. When a business sells an asset for book value, no gain or loss is recorded. This is because the cash received is equal to the book value of the asset sold.

58

Selling a Plant Asset at Book Value (2 of 2)

Smart Touch Learning records the sale of the equipment for $1,500 as follows:

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The entry to record the sale contains no gain or loss because the asset was sold for book value.

59

Selling a Plant Asset Above Book Value (1 of 2)

Suppose that Smart Touch Learning sells the equipment for $4,000.

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If Smart Touch Learning sells the equipment for $4,000, the company will record a gain on sale of the equipment. Notice that the cash received is more than the book value of the asset. When a business sells an asset for more than its book value, a gain is recorded.

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Selling a Plant Asset Above Book Value (2 of 2)

Smart Touch Learning records the sale of the equipment for $4,000 as follows:

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The account Gain on Disposal will be used. This account has a normal credit balance and is reported in the Other Income and (Expenses) section of the income statement. In recording the journal entry, Smart Touch Learning will remove the old equipment and accumulated depreciation from the books (Step 2), record a debit to Cash for $4,000 (Step 3), and then record a credit to Gain on Disposal (Step 4).

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Selling a Plant Asset Below Book Value (1 of 2)

Suppose that Smart Touch Learning sells the equipment for $500.

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If Smart Touch Learning sells the equipment for $500, the company will record a loss on the sale of the equipment. Notice that the cash received is less than the book value of the asset. When a business sells an asset for less than its book value, a loss is recorded.

62

Selling a Plant Asset Below Book Value (2 of 2)

Smart Touch Learning records the sale of the equipment for $500 as follows:

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In recording the journal entry, Smart Touch Learning will remove the old equipment and accumulated depreciation from the books (Step 2), record a debit to Cash for $500 (Step 3), and then record a debit to Loss on Disposal (Step 4).

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Summary (1 of 2)

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In each disposal illustrated, the company has decreased net income over the life of the asset by recording depreciation expense each year prior to the disposal. When the company records the disposal, the company will record a gain, a loss, or neither. Gains recorded at disposal increase net income, and losses recorded at disposal decrease net income. Over the life of the asset, the company records a net decrease in net income equal to the net cost of the asset. The net cost of the asset is the amount paid for the asset when it was purchased less the cash received at disposal.

Notice in each case that the net decrease in net income is equal to the net cost of the asset. We have, in effect, expensed the net cost of the asset over its life.

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Summary (2 of 2)

Exhibit 10-10 summarizes the journal entries for discarding and selling plant assets.

Exhibit 10-10 Disposals of Plant Assets

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Exhibit 10-10 summarizes the journal entries for discarding and selling plant assets.

65

Learning Objective 10.4

Account for natural resources

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How Are Natural Resources Accounted For? (1 of 4)

Natural resources are assets that come from the earth that are consumed.

Depletion is the process by which businesses spread the allocation of a natural resource’s cost to expense over its usage.

Depletion is computed by the units-of-production method.

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A natural resource is an asset that comes from the earth and is consumed. Examples include iron ore, natural gas, diamonds, gold, coal, and timber.

Natural resources are expensed through depletion. Depletion is the process by which businesses spread the allocation of a natural resource’s cost to expense over its usage. It is called depletion because the company is depleting (using up) a natural resource such that at some point in time, there will be nothing left to extract. Depletion is computed by the units-of-production method.

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How Are Natural Resources Accounted For? (2 of 4)

Assume that an oil well cost $700,000 and is estimated to hold 70,000 barrels of oil. There is no residual value. 3,000 barrels are extracted during the year.

Step 1:

Step 2:

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Assume that an oil well cost $700,000 and is estimated to hold 70,000 barrels of oil. There is no residual value. If 3,000 barrels are extracted during the year, depletion is calculated as (Cost – Residual value) / Estimated total units, so ($700,000 – 0) / 70,000 barrels = $10 per barrel. Then multiply the depletion per barrel by the number of barrels for the period, so $10 per barrel × 3,000 barrels = $30,000 of depletion in Year 1.

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How Are Natural Resources Accounted For? (3 of 4)

The depletion entry for the year is as follows:

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The depletion entry for the year debits Depletion Expense—Oil Reserves and credits Accumulated Depreciation—Oil Reserves for $30,000.

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How Are Natural Resources Accounted For? (4 of 4)

Accumulated Depletion is a contra asset account similar to Accumulated Depreciation.

Natural resources can be reported on the balance sheet as:

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Accumulated Depletion is a contra asset account similar to Accumulated Depreciation.

Natural resources can be reported on the balance sheet as the net of the natural resource asset account and the accumulated depletion account.

70

Learning Objective 10.5

Account for intangible assets

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How Are Intangible Assets Accounted For?

Intangible assets are assets that have no physical form.

Examples of intangible assets include:

Patents

Copyrights

Trademarks

Other creative works

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The final group of long-lived assets is intangible assets. An intangible asset is an asset with no physical form that is valuable because of the special rights it carries. Intangible assets convey special rights from patents, copyrights, trademarks, and other creative works.

In our technology-driven economy, intangibles are very important. The intellectual property of a business is difficult to measure. Intangibles can account for most of a company’s market value, so companies must value their intangibles just as they value other assets, such as merchandise inventory and equipment.

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Accounting for Intangibles (1 of 2)

Intangible assets that are purchased are recorded at cost.

Most purchased intangibles are expensed through amortization, the allocation of the cost of an intangible asset to expense over its useful life.

Only intangibles with a definite life are amortized.

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Intangible assets that are purchased are recorded at cost. If an intangible is not purchased, only some limited costs can be capitalized. Most purchased intangibles are expensed through amortization. Amortization is the process by which businesses spread the allocation of an intangible asset’s cost over its useful life.

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Accounting for Intangibles (2 of 2)

Intangible assets with an indefinite life are tested for impairment annually.

Impairment occurs when the fair value of an asset is less than the book value.

A company records a loss when an impairment occurs.

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Intangibles either have a definite life or an indefinite life. Intangibles with an indefinite life have factors (such as legal and contractual obligations) that limit the usage of the intangible asset. Only intangibles that have a definite life are amortized. Intangible assets with an indefinite life are tested for impairment annually. An impairment is a permanent decline in asset value. Impairment occurs when the fair value of an asset is less than the book value. In other words, there has been a permanent decline in the value of the asset. If an impairment occurs, the company records a loss in the period during which the decline is identified.

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Patents (1 of 4)

A patent is an intangible asset that is a federal government grant conveying an exclusive 20-year right to produce and sell an invention.

The invention may be a process, product, or formula.

The acquisition cost of a patent is debited to the Patent account.

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A patent is an intangible asset that is a federal government grant conveying an exclusive 20-year right to produce and sell a process, product, or formula.

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Patents (2 of 4)

Assume Smart Touch Learning pays $200,000 to acquire a patent on January 1. Acquisition entry:

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Suppose Smart Touch Learning pays $200,000 to acquire a patent on January 1. Amortization expense is calculated using the straight-line method.

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Patents (3 of 4)

Assume Smart Touch Learning pays $200,000 to acquire a patent on January 1. The useful life of the patent is determined to be five years.

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Suppose Smart Touch Learning pays $200,000 to acquire a patent on January 1. Amortization expense is calculated using the straight-line method.

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Patents (4 of 4)

Adjusting entry to record amortization:

A company may credit an intangible asset directly when recording amortization expense, or it may use Accumulated Amortization.

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Notice that Smart Touch Learning credited the amortization directly to the intangible asset, Patent, instead of using an Accumulated Amortization account. A company may credit an intangible asset directly when recording amortization expense, or it may use the account Accumulated Amortization.

Companies frequently choose to credit the asset account directly because the residual value is generally zero, and there is no physical asset to dispose of at the end of its useful life, so the asset essentially removes itself from the books through the process of amortization.

At the end of the first year, Smart Touch Learning will report this patent at $160,000 ($200,000 cost minus first-year amortization of $40,000), the next year at $120,000, and so forth. Each year for five years, the value of the patent will be reduced until the end of its five-year life, at which point its book value will be $0.

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Copyrights and Trademarks

A copyright is the exclusive right to reproduce and sell a book, a musical composition, a film, another work of art, or intellectual property.

Granted for the life of the creator plus 70 years.

A trademark (also called a trade name) is an asset that represents distinctive identifications of products or services, such as the Nike “swoosh” or the McDonald’s “golden arches.”

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A copyright is the exclusive right to reproduce and sell a book, a musical composition, a film, another work of art, or intellectual property. Copyrights also protect computer software programs, such as Microsoft Windows©. Issued by the federal government, a copyright is granted for the life of the creator plus 70 years.

A trademark (also called a trade name) is an asset that represents distinctive identifications of products or services, such as the Nike “swoosh” or the McDonald’s “golden arches.” The cost of a trademark or trade name is amortized over its useful life.

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Franchises and Licenses

Franchises are privileges granted by a business to sell goods or services under specified conditions.

McDonald’s and Subway are well-known business franchises.

Licenses are privileges granted by a government to use public property in performing services.

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Franchises are privileges granted by a business to sell goods or services under specified conditions. The Dallas Cowboys football organization is a franchise granted by the National Football League. McDonald’s and Subway are well-known franchises.

A license is a privilege granted by a government to use public property in performing services. A radio station might be granted permission by the federal government to use the airwaves to broadcast music. The acquisition cost of a franchise or license is amortized over its useful life.

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Goodwill (1 of 3)

Goodwill is the value paid above the net worth of a company’s assets and liabilities.

Special features of goodwill:

It is recorded by an acquiring company when it purchases another company for more than the market value of the net assets acquired.

Goodwill is not amortized.

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In accounting, goodwill is the excess of the cost of an acquired company over the sum of the market value of its net assets (that is, assets minus liabilities). Goodwill is the value paid above the net worth of the company’s assets and liabilities. Goodwill is recorded only by an acquiring company when it purchases another company and pays more for that company than the market value of the net assets acquired. An outstanding reputation may create goodwill, but that company never records goodwill for its own business.

According to GAAP, goodwill is not amortized. Instead, the acquiring company measures the fair value of its acquired goodwill each year.

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Goodwill (2 of 3)

White Company acquired Mocha Company on January 1, 2018. The sum of the market values of Mocha’s assets was $9 million, and its liabilities totaled $1 million, so Mocha’s net assets totaled $8 million. Suppose White paid $10 million to purchase Mocha.

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White paid $2 million above the market value of Mocha’s net assets. Therefore, that $2 million is considered goodwill.

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Goodwill (3 of 3)

White’s entry to record the purchase of Mocha:

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White’s entry to record the purchase of Mocha creates Goodwill with a debit of $2,000,000.

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Reporting of Intangible Assets

Exhibit 10-11 Assets and Their Related Expenses

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Exhibit 10-11 summarizes the types of assets and their related expense. Plant assets are assets that have physical characteristics and are used in operations. Natural resources are assets that come from the earth and can be ultimately used up. Intangible assets are assets whose value is not derived from their physical substance.

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Learning Objective 10.6

Use the asset turnover ratio to evaluate business performance

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How Do We Use the Asset Turnover Ratio to Evaluate Business Performance? (1 of 2)

The asset turnover ratio measures the amount of net sales generated for each average dollar of total assets invested.

To compute this ratio, we divide net sales by average total assets.

A high asset turnover ratio is desirable.

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The asset turnover ratio measures how efficiently a business uses its average total assets to generate sales.

Asset turnover ratio = Net sales / Average total assets

Average total assets = (Beginning of period total assets + End of period total assets) ÷ 2

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How Do We Use the Asset Turnover Ratio to Evaluate Business Performance? (2 of 2)

Asset turnover ratio based on Kohl’s 2015 Annual Report:

Blank January 30, 2016 January 31, 2015
Net sales revenue $ 19,204 $ 19,023
Total assets 13,606 14,333

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Using net sales revenue and total assets (in millions) from Kohl’s Corporation’s 2015 Annual Report (see www.pearsonhighered.com/Horngren for a link to the 2015 Annual Report), we can calculate the asset turnover ratio.

Suppose that the asset turnover ratio for the industry is 1.9 times. Kohl’s asset turnover ratio of 1.37 times is significantly lower than the industry average. This tells us that Kohl’s is only producing $1.37 of net sales revenue for each dollar ($1.00) of assets invested, while the average company in this industry is producing $1.90 in net sales revenue for every dollar invested in assets. Kohl’s should evaluate ways to improve its efficiency and increase its asset turnover ratio, such as increasing net sales revenue or decreasing average total assets.

87

Learning Objective 10.7

Journalize entries for the exchange of plant assets (Appendix 10A)

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How Are Exchanges of Plant Assets Accounted For?

A business may exchange a plant asset for another plant asset.

An exchange has commercial substance if the future cash flows change as a result of the transaction.

Exchanges that have commercial substance require any gain or loss on the transaction to be recognized.

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Sometimes plant assets are not simply sold or purchased, but instead a plant asset is exchanged for another plant asset. An exchange has commercial substance if the future cash flows change as a result of the transaction. Commercial substance is a characteristic of a transaction that causes a change in future cash flows. In other words, an exchange has commercial substance if, in the future, cash flows (receipts of revenue or payment of expenses) of the business will change because of the exchange. For example, exchanging an older asset for a new asset will increase productivity, thereby creating more revenue for the business.

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Exchange of Plant Assets—Gain Situation (1 of 2)

On December 31, Smart Touch Learning exchanges $2,000 cash plus used equipment with a historical cost of $10,000 and accumulated depreciation of $9,000 for new equipment. The new equipment has a market value of $8,000. The exchange has commercial substance.

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On December 31, Smart Touch Learning exchanges $2,000 cash plus used equipment with a historical cost of $10,000 and accumulated depreciation of $9,000 for new equipment. The new equipment has a market value of $8,000. The exchange has commercial substance. There is a $5,000 gain on this transaction.

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Exchange of Plant Assets—Gain Situation (2 of 2)

Journal entry to record the exchange:

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The journal entry removes the old equipment and its accumulated depreciation, records the new equipment and payment of cash, and recognizes the Gain on Disposal.

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Exchange of Plant Assets—Loss Situation (1 of 2)

On December 31, Smart Touch Learning exchanges $2,500 cash plus used equipment with a historical cost of $10,000 and accumulated depreciation of $9,000 for new equipment. The new equipment has a market value of $3,000. The exchange has commercial substance.

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On December 31, Smart Touch Learning exchanges $2,500 cash plus used equipment with a historical cost of $10,000 and accumulated depreciation of $9,000 for new equipment. The new equipment has a market value of $3,000. The exchange has commercial substance. There is a loss of $500 on this transaction.

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Exchange of Plant Assets—Loss Situation (2 of 2)

Journal entry to record the exchange:

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The journal entry removes the old equipment and its accumulated depreciation, records the new equipment and payment of cash, and recognizes the Loss on Disposal.

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Copyright

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