Depreciation Lesson 2 - Alex Socratis Night College Pafos

Chapter 2

Fixed Assets and

Intangible AssetsAccounting

Alex Socratis

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1. Define fixed assets and describe the accounting for their cost.

2. Compute depreciation, using the following methods: straight-line method, units-of-production method, and declining-balance method.

3. Classify fixed asset costs as either capital expenditures or revenue expenditures.

4. Journalize entries for the disposal of fixed assets.

5. Define a lease and summarize the accounting rules related to the leasing of fixed assets.

Objectives

After studying this

chapter, you should

be able to:

6. Describe internal controls over fixed assets.

7. Compute depletion and journalize the entry for

depletion.

8. Describe the accounting for intangible assets,

such as patents, copyrights, and goodwill.

9. Describe how depreciation expense is

reported in an income statement, and prepare

a balance sheet that includes fixed assets and

intangible assets.

10. Compute and interpret the ratio of fixed assets

to long-term debt.

Objectives

Nature of Fixed Assets

Fixed assets are long term or

relatively permanent assets

Fixed assets are tangible assets

because they exist physically.

They are owned and used by the

business and are not held for sale

as part of normal operations.

Classifying Costs

Is the purchased

item long-lived?

Yes

Is the asset used in

a productive

purpose?

No

Expense

Yes

Fixed Assets

No

Investment

Land

• Purchase price

• Sales taxes

• Permits from government

agencies

• Broker’s commissions

• Title fees

• Surveying fees

Land

• Purchase price

• Sales taxes

• Permits from government

agencies

• Broker’s commissions

• Title fees

• Surveying fees

• Delinquent real estate taxes

• Razing or removing

unwanted buildings, less the

salvage

• Grading and leveling

• Paving a public street

bordering the land

Architects’ fees

Engineers’ fees

Insurance costs incurred during construction

Interest on money borrowed to finance construction

Walkways to and around the building

Buildings

Buildings

Sales taxes

Repairs (purchase of

existing building)

Reconditioning

(purchase of an existing

building)

Modifying for use

Permits from

governmental agencies

• Trees and shrubs

• Fences

• Parking areas

• Outdoor lighting

• Concrete sewers and drainage

• Paved parking areas

Land Improvements

Machinery and Equipment

• Sales taxes

• Freight

• Installation

• Repairs (purchase of used equipment)

• Reconditioning (purchase of used equipment)

Machinery and Equipment

• Insurance while in

transit

• Assembly

• Modifying for use

• Testing for use

• Permits from

governmental

agencies

Cost of Acquiring Fixed Assets Excludes:

Vandalism

Mistakes in installation

Uninsured theft

Damage during

unpacking and installing

Fines for not obtaining

proper permits from

government agencies

Nature of Depreciation

All fixed assets except land lose their capacity

to provide services. This loss of productive

capacity is recognized as Depreciation Expense.

Physical depreciation occurs from wear and tear

while in use and from the action of the weather.

Functional depreciation occurs when a fixed asset is

longer able to provide services at the level for

which it was intended, e.g., personal computer.

Depreciation Expense Factors

Initial Cost Residual Value- = Depreciable Cost

Useful Life

Periodic Depreciation

Expense

83%

4%8% 5%

Straight-Line

Declining-

Balance

Other Units-of-Production

Source: Accounting Trends & Techniques, 56th. ed., American Institute of

Certified Public Accountants, New York, 2002.

Use of Depreciation Methods

Facts

Original Cost.....………….. $24,000

Estimated Life in years….. 5 years

Estimated Life in hours….. 10,000

Estimated Residual Value... $2,000

Straight-Line Method

Cost – estimated residual value

Estimated life

= Annual depreciation


$24,000 – $2,000

5 years

= $4,400 annual depreciation

Straight-Line Rate

$24,000 – $2,000

5 years= $4,400

$4,400

$24,000= 18.3%


The straight-line method is widely used by

firms because it is simple and it provides a

reasonable transfer of cost to periodic

expenses if the asset is used about the

same from period to period.

Accum. Depr. Book Value Depr. Book Value

at Beginning at Beginning Expense at End

Year Cost of Year of Year for Year of Year

1 $24,000 $24,000 $4,400 $19,600

2 24,000 $ 4,400 19,600 4,400 15,200

3 24,000 8,800 15,200 4,400 10,800

4 24,000 13,200 10,800 4,400 6,400

5 24,000 17,600 6,400 4,400 2,000

Cost ($24,000) – Residual Value ($2,000)

Estimated Useful Life (5 years)=

Annual

Depreciation

Expense ($4,400)


Units-of-Production Method

Cost – estimated residual value

Estimated life in units, hours, etc.

= Depreciation per unit, hour, etc.

$24,000 – $2,000

10,000 hours

= Depreciation per unit, hour, etc.= $2.20 per hour


The units-of-production method

is more appropriate than the

straight-line method when the

amount of use of a fixed asset

varies from year to year.


Declining-Balance Method

Step 1

Ignoring residual value,

determine the straight-line rate

= $4,800$24,000 – $2,000

5 years

$4,800

$24,000= 20%

There’s a shortcut. Simply

divide one by the number of

years (1 ÷ 5 = .20).


Double the straight-line rate.

Step 2

.20 x 2 = .40

For the first year, the cost of the asset is

multiplied by 40 percent. After the first year,

the declining book value of the asset is

multiplied 40 percent.


Build a table.

Step 3


Book Value Accum.

Beginning Annual Deprec. Book Value

Year of Year Rate Deprec. Year-End Year-End

1 $24,000 40% $9,600


$24,000 x .40

Book Value Accum.



1 $24,000 40% $9,600 $9,600 $14,400


Book Value Accum.



1 $24,000 40% $9,600 $9,600 $14,400

2 14,400 40% 5,760


$14,400 x .40

Book Value Accum.



1 $24,000 40% $9,600 $9,600 $14,400

2 14,400 40% 5,760 15,360 8,640


Book Value Accum.



1 $24,000 40% $9,600 $9,600 $14,400

2 14,400 40% 5,760 15,360 8,640

3 8,640 40% 3,456 18,816 5,184


Book Value Accum.



1 $24,000 40% $9,600 $9,600 $14,400

2 14,400 40% 5,760 15,360 8,640

3 8,640 40% 3,456 18,816 5,184

4 5,184 40% 2,074 20,890 3,110


Book Value Accum.



1 $24,000 40% $9,600 $9,600 $14,400

2 14,400 40% 5,760 15,360 8,640

3 8,640 40% 3,456 18,816 5,184

4 5,184 40% 2,074 20,890 3,110

5 3,110 40% 1,244 22,134 1,866

STOP!


Book Value Accum.



1 $24,000 40% $9,600 $9,600 $14,400

2 14,400 40% 5,760 15,360 8,640

3 8,640 40% 3,456 18,816 5,184

4 5,184 40% 2,074 20,890 3,110

5 3,110 40% 1,244 22,134 1,866

Declining-Balance MethodIf we use this approach in Year 5, we will

end the year with a book value of $1,866.

Remember, the residual value at the end of

Year 5 is expected to be $2,000, so we must

modify our approach.

Book Value Accum.



1 $24,000 40% $9,600 $9,600 $14,400

2 14,400 40% 5,760 15,360 8,640

3 8,640 40% 3,456 18,816 5,184

4 5,184 40% 2,074 20,890 3,110

5 3,110 --- 1,110


$3,110 – $2,000

Book Value Accum.



1 $24,000 40% $9,600 $9,600 $14,400

2 14,400 40% 5,760 15,360 8,640

3 8,640 40% 3,456 18,816 5,184

4 5,184 40% 2,074 20,890 3,110

5 3,110 --- 1,110 22,000 2,000

Desired ending book

value


Comparing Straight-Line With the


Straight-Line

Method

Dep

reci

atio

n (

$)

5,000

4,000

3,000

2,000

1,000

0

Life (years)

Declining-Balance

Method

Life (years)

1 2 3 4 1 2 3 4

Revising Depreciation Estimates

A machine purchased for

$130,000 was originally

estimated to have a useful

life of 30 years and a

residual value of $10,000.

The asset has been

depreciated for ten years

using the straight- line

method.

Annual

Depreciation

$130,000 – $10,000

30 years

$4,000 per year

Equipment

130,000

Accumulated

Depreciation

4,000

4,0004,0004,0004,0004,0004,0004,0004,0004,000

40,000Before revising

Book value = $90,000


During the eleventh year, it is estimated that the

remaining useful life is 25 years (rather than 20) and

that the revised estimated residual value is $5,000.

Book value – revised residual value

Revised estimated remaining life


$90,000 – $5,000

25 years

$3,400 revised

annual depreciation=

Expenditures made to

acquire new plant

assets are known as

capital expenditures.

Capital and Revenue Expenditures

Expenditures to repair or

maintain plant assets that do

not extend the life or enhance

the value are known as

revenue expenditures.


EXPENDITURE

Increases

operating

efficiency or adds

to capacity?

Capital

Expenditure

(Debit fixed asset

account)

Yes


Increases

useful life

(extraordinary

repairs)?

No

Capital Expenditure

(Debit accumulated

depreciation account)

Yes

Revenue

Expenditure

(Debit expense

account for

ordinary

maintenance

and repairs)

No

LIABILITIES

OWNER’S

EQUITY

REVENUES

ASSETS

EXPENSES

CAPITAL

EXPENDITURES

1. Initial cost

2. Additions

3. Betterments

4. Extraordinary

repairs

net income


LIABILITIES

OWNER’S

EQUITY

REVENUES

ASSETS

EXPENSES

net income

Normal and

ordinary repairs

and maintenance

REVENUE

EXPENDITURES


Accounting for Fixed Asset Disposals

When fixed assets lose their usefulness they may be disposed of in one of the following ways:

1. discarded,

2. sold, or

3. traded (exchanged) for similar assets.

Required entries will vary with type of disposition and circumstances, but the following entries will always be necessary:

An asset account must be credited to remove the assetfrom the ledger, and the related Accumulated Depreciation account must be debited to remove it’s balance from the ledger.

A piece of equipment

acquired at a cost of

$25,000 is fully

depreciation. On February

14, the equipment is

discarded.

Discarding Fixed Assets


Feb. 14 Accumulated Depr.—Equipment 25 000 00

To write off fully depreciated

equipment.

Equipment 25 000 00

Equipment costing $6,000 is depreciation at an

annual straight-line rate of 10%. After the

adjusting entry, Accumulated Depreciation—

Equipment had a $4,750 balance. The equipment

was discarded on March 24.

Mar. 24 Depreciation Expense.—Equipment 150 00

To record current depreciation

on equipment discarded.

Accum. Depreciation—Equipment 150 00


$600 x 3/12

Equipment costing $6,000 is depreciation at an annual straight-line rate of 10%. After the

adjusting entry, Accumulated Depreciation—Equipment had a $4,750 balance. The equipment was discarded on March 24.

Mar. 24 Accumulated Depr.—Equipment 4 900 00

Loss on Disposal of Fixed Asset 1 100 00

To write off equipment

discarded.

Equipment 6 000 00


Gain or loss will be reported in the income statement as Other Income or Other Loss.

When fixed assets are sold, the owner may

break even, sustain a loss, or realize a gain.

1. If the sale price is equal to book value, there

will be no gain or loss.

2. If the sale price is less than book value, there

will be a loss equal to the difference.

3. If the sale price is more than book value,

there will be a gain equal to the difference.

Sale of Fixed Assets


Equipment costing $10,000 is depreciated at an

annual straight-line rate of 10%. The

equipment is sold for cash on October 12.

Accumulated Depreciation (last adjusted

December 31) has a balance of $7,000.

Oct. 12 Depreciation Expense—Equipment 750 00

To record current depreciation

on equipment sold.

Accumulated Depr.—Equipment 750 00

$10,000 x ¾

x10%


Assumption 1: The equipment is sold

for $2,250, so there is

no gain or loss.

Oct. 12 Cash 2 250 00

Sold equipment.

Accumulated Depr.—Equipment 7 750 00

Equipment 10 000 00



for $1,000, so there is a

loss of $1,250.

Oct. 12 Cash 1 000 00

Sold equipment.


Equipment 10 000 00

Loss on Disposal of Fixed Assets 1 250 00



for $2,800, so there is a

gain of $550.

Sold equipment.

Equipment 10 000 00

Gain on Disposal of Fixed Assets 550 00


Oct. 12 Cash 2 800 00

Exchanges of Similar Fixed Assets

Trade-in Allowance (TIA) – amount allowed for old equipment toward the purchase price of similar new assets.

Boot – balance owed on new equipment after trade-in allowance has been deducted.

TIA > Book Value = Gain on Trade

TIA < Book Value = Loss on Trade

Gains are never recognized (not recorded).

Losses must be recognized (recorded).

CASE ONE (GAIN):

Trade-in allowance, $1,100

Cash paid, $3,900 ($5,000 – $1,100)

TIA > Book Value = Gain

$1,100 – $800 = $300

Boot + Book = Cost of New Equipment

$3,900 + $800 = $4,700

List price of new equipment acquired $5,000

Cost of old equipment traded in $4,000

Accum. depreciation at date of exchange 3,200

Book value at date of exchange $ 800


Gains are not

recognized for

financial reporting.


June 19 Accumulated Depr.—Equipment 3 200 00

Equipment (new equipment) 4 700 00

Equipment (old equipment) 4 000 00

Cash 3 900 00

On June 19, equipment exchanged

at a gain of $300.

CASE TWO (LOSS):

Trade-in allowance, $2,000

Cash paid, $8,000 ($10,000 – $2,000)

TIA<Book Value = Loss

$2,000 – $2,400 = $400

List price of new equipment acquired $10,000

Cost of old equipment traded in $7,000

Accum. depreciation at date of exchange 4,600

Book value at date of exchange $2,400


Losses are

recognized for

financial reporting.


Sept. 7 Accumulated Depr.—Equipment 4 600 00

Equipment (new equipment) 10 000 00

Loss on Disposal of Fixed Assets 400 00

On September 7, equipment

exchanged at a loss of $400.

Equipment (old equipment) 7 000 00

Cash 8 000 00

Natural Resources and

Depletion

Depletion is the process of

transferring the cost of natural

resources to an expense account.

Natural Resources and Depletion

A business paid

$400,000 for the

mining rights to a

mineral deposit

estimated at 1,000,000

tons of ore. The

depletion rate is $0.40

per ton ($400,000 ÷

1,000,000 tons).

Natural Resources and Depletion

Adjusting Entry

Accumulated Depletion 36 000 00

During the current year, 90,000 tons are

mined. The periodic depletion is

$36,000 (90,000 tons x $0.40).

Dec. 31 Depletion Expense 36 000 00

Date Description Debit Credit

Intangible Assets and Amortization

Dec. 31 Amortization Expense 20,000Patents 20,000

Paid $100,000 for patent rights. The patent life is 11

years and was issued 6 years prior to purchase.

Amortization is the periodic cost expiration of intangible

assets which do not have physical attributes and are not

held for sale (patents, copyrights, and goodwill).

11 years – 6 years = 5-year life

($100,000 / 5 years) = $20,000 per year

Alaska deposit $1,200,000 $ 800,000 $400,000

Wyoming deposit 750,000 200,000 550,000

$1,950,000 $1,000,000 950,000

Total property, plant, and equipment $1,629,000

Intangible assets:Patents $ 75,000Goodwill 50,000

Total intangible assets $ 125,000

Discovery Mining Co.Partial Balance Sheet

December 31, 2006

Accum. BookProperty, plant, and equipment: Cost Depr. Value

Land $ 30,000 $ 30,000Buildings 110,000 $ 26,000 84,000Factory equipment 650,000 192,000 458,000Office equipment 120,000 13,000 107,000

$910,000 $231,000 $ 679,000

Accum. BookMineral deposits: Cost Depr. Value

Ratio of Fixed Assets to Long-Term Liabilities

(in millions)

2002 2001Procter & Gamble

Fixed assets (net) $13,349 $13,095

Long-term debt $11,201 $9,792

Ratio of fixed assets to

long-term liabilities 1.2 1.3

Use: To indicate the margin of safety

to long-term creditors

The End

Chapter 2

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Depreciation Lesson 2 - Alex Socratis Night College Pafos