CHAPTER 10

1. Explain the accounting for plant asset expenditures.

Plant 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 be of use to the company for a number of years. Except for land,
plant assets decline in service potential over their useful lives.
Determining the Cost of Plant Assets
The historical 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.
LAND
Companies often use land as a building site for a manufacturing plant or office building. 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.
When a company acquires vacant land, these costs include expenditures for clearing, draining,
filling, and grading. Sometimes the land has a building on it that must be removed before
construction of a new building. In this case, the company debits to the Land account all
demolition and removal costs, less any proceeds from salvaged materials.

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. As a result, companies expense (depreciate) the cost of land
improvements over their useful lives.
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.
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.
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.
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.

Expenditures During Useful Life

During the useful life of a plant asset, a company may incur costs for ordinary repairs, additions,
or improvements.
Ordinary repairs are expenditures to maintain the operating efficiency and productive life
of the unit. They usually are small amounts that occur frequently. Because they are immediately
charged as an expense against revenues, these costs are often referred to as revenue
expenditures.
Additions and improvements are costs incurred to increase the operating efficiency,
productive capacity, or useful life of a plant asset. They are usually material in amount and
occur infrequently. Companies generally debit these amounts to the plant asset affected. They are
often referred to as capital expenditures.

2. Apply depreciation methods to plant assets.

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 fair value.
Depreciation applies to three classes of plant assets: land improvements, buildings, and
equipment. The usefulness to the company and revenue-producing ability of each asset will
decline over the asset’s useful life. Depreciation does not apply to land because its usefulness
and revenue-producing ability generally remain intact over time.
Factors in Computing Depreciation

Depreciation Methods
Depreciation is generally computed using one of the following methods:
1. Straight-line
2. Units-of-activity
3. Declining-balance
Management selects the method(s) it believes to be appropriate.
Once a company chooses a method, it should apply it consistently over the useful life of the
asset.
STRAIGHT-LINE METHOD
Under the straight-line method, companies expense the same amount of depreciation for
each year of the asset’s useful life.
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.
Under the straight-line method, to determine annual depreciation expense, we divide
depreciable cost by the asset’s useful life.

Alternatively, we also can compute an annual rate of depreciation. In this case, the rate is 20%
(100%:5 years). When a company uses an annual straightline rate, it applies the percentage rate
to the depreciable cost of the asset. Illustration 10-10 shows a depreciation schedule using an
annual rate.

Note that the depreciation expense of $2,400 is the same each year.
UNITS-OF-ACTIVITY METHOD
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. This method can also be used for
such assets as delivery equipment (miles driven) and airplanes (hours in use). 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 depreciable
cost per unit. The depreciable cost per unit is then applied to the units of activity during the year
to determine the annual depreciation expense.

The units-of-activity depreciation schedule:

This method is easy to apply for assets purchased mid-year. In such a case, the company
computes the depreciation using the productivity of the asset for the partial year.
DECLINING-BALANCE METHOD
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.
Unlike the other depreciation methods, the declining-balance method does not use depreciable
cost in computing annual depreciation expense. That is, it ignores salvage value in
determining the amount to which the declining-balance rate is applied.
Salvage value, however, does limit the total depreciation that can be taken. Depreciation stops
when the asset’s book value equals expected salvage value.
A common declining-balance rate is double the straight-line rate.The method is often called
the double-declining-balance method.

40% (2 x the straight-line rate of 20%). The depreciation schedule under this method is as
follows.

COMPARISON OF METHODS
Annual depreciation varies considerably among the methods, but total depreciation expense is
the same ($12,000) for the five-year period under all three methods.
Each method is acceptable in accounting because each recognizes in a rational and systematic
manner the decline in service potential of the asset.
Depreciation and Income Taxes
Many corporations use straight-line in their financial statements to maximize net income.
At the same time, they use a special accelerated-depreciation method on their tax returns to
minimize their income taxes.
Revising Periodic Depreciation
When a change in an estimate is required, the company makes the change in current and future
years. It does not change depreciation in prior periods.
Assume that Barb’s Florists decides on January 1, 2020, to extend the useful life of the truck one
year (a total life of six years) and increase its salvage value to $2,200. The company has used the
straight-line method to depreciate the asset to date. Depreciation per year was $2,400 [($13,000 -
$1,000) : 5]. Accumulated depreciation after three years (2017–2019) is $7,200 ($2,400 x 3), and
book value is $5,800 ($13,000 - $7,200). The new annual depreciation is $1,200.

Barb’s Florists makes no entry for the change in estimate. On December 31, 2020, during the
preparation of adjusting entries, it records depreciation expense of $1,200.

3. Explain how to account for the disposal of plant assets.

Companies dispose of plant assets that are no longer useful to them.

Whatever the disposal method, the company must determine the book value of the plant
asset at the disposal date to determine the gain or loss.
Retirement of Plant Assets
Assume that Hobart Company retires its computer printers, which cost $32,000. The
accumulated depreciation on these printers is $32,000.
 The equipment, therefore, is fully depreciated (zero book value).

If a company retires a plant asset before it is fully depreciated and no cash is received for scrap
or salvage value, a loss on disposal occurs.

Companies report a loss on disposal of plant assets in the “Other expenses and losses”
section of the income statement.
Sale of Plant 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.
GAIN ON SALE
Companies report a gain on disposal of plant assets in the “Other revenues and gains”
section of the income statement.
LOSS ON SALE
Assume that instead of selling the office furniture for $16,000, Wright sells it for $9,000.

Companies report a loss on disposal of plant assets in the “Other expenses and losses”
section of the income statement.

4. Describe how to account for natural resources and intangible assets.

Natural Resources
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.
Depletion
The allocation of the cost of natural resources 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 to compute depletion. The reason is that
depletion generally is a function of the units extracted during the year. Under the units-of-
activity method, companies divide the total cost of the natural resource minus salvage value
by the number of units estimated to be in the resource. The result is a depletion cost per
unit. To compute depletion, the cost per unit is then multiplied by the number of units
extracted.
Assume that Lane Coal Company invests $5 million in a mine estimated to have 1 million tons
of coal and no salvage value.

If Lane extracts 250,000 tons in the first year, then the depletion for the year is $1,250,000
(250,000 tons x $5).

Accumulated Depletion is a contra asset similar to Accumulated Depreciation.

Intangible Assets
Intangible assets are rights, privileges, and competitive advantages that result from the
ownership of long-lived assets that do not possess physical substance.
Evidence of intangibles may exist in the form of contracts or licenses.
Intangibles may arise from the following sources:
1. Government grants, such as patents, copyrights, licenses, trademarks, and trade names.
2. Acquisition of another business, in which the purchase price includes a payment for
goodwill.
3. Private monopolistic arrangements arising from contractual agreements, such as
franchises and leases.
Accounting for Intangible Assets
Companies record intangible assets at cost.
Intangibles are categorized as having either a limited life or an indefinite life.
If an intangible has a limited life, the company allocates its cost over the asset’s useful life using
a process similar to depreciation. The process of allocating the cost of intangibles is referred
to as amortization.
The cost of intangible assets with indefinite lives should not be amortized.
Intangible assets are typically amortized on a straight-line basis.

There is a difference between intangible assets and plant assets in determining cost. For plant
assets, cost includes both the purchase price of the asset and the costs incurred in designing and
constructing the asset.
In contrast, the initial cost for an intangible asset includes only the purchase price.
PATENTS
A patent is an exclusive right issued by the U.S. Patent Office that enables the recipient to
manufacture, sell, or otherwise control an invention for a period of 20 years from the date
of the grant. A patent is nonrenewable.
But, companies can extend the legal life of a patent by obtaining new patents for improvements
or other changes in the basic design.
The initial cost of a patent is the cash or cash equivalent price paid to acquire the patent.
The patent holder amortizes the cost of a patent over its 20-year legal life or its useful life,
whichever is shorter.
COPYRIGHTS
The federal government grants copyrights, which give the owner the exclusive right to
reproduce and sell an artistic or published work. Copyrights extend for the life of the creator
plus 70 years. The cost of a copyright is the cost of acquiring and defending it. The cost may be
only the small fee paid to the U.S. Copyright Office. Or, it may amount to much more if an
infringement suit is involved.
The useful life of a copyright generally is significantly shorter than its legal life. Therefore,
copyrights usually are amortized over a relatively short period of time.
TRADEMARKS AND TRADE NAMES
A trademark or trade name is a word, phrase, jingle, or symbol that identifies a particular
enterprise or product.
Such registration provides 20 years of protection. The registration may be renewed indefinitely
as long as the trademark or trade name is in use.
If a company purchases the trademark or trade name, its cost is the purchase price. If a company
develops and maintains the trademark or trade name, any costs related to these activities are
expensed as incurred. Because trademarks and trade names have indefinite lives, they are
not amortized.
FRANCHISES
A franchise is a contractual arrangement between a franchisor and a franchisee. The
franchisor grants the franchisee the right to sell certain products, perform specific services, or use
certain trademarks or trade names, usually within a designated geographic area. Another type of
franchise is a license. A license granted by a governmental body permits a company to use
public property in performing its services
When a company can identify costs with the purchase of a franchise or license, it should
recognize an intangible asset. Companies should amortize the cost of a limited-life franchise (or
license) over its useful life. If the life is indefinite, the cost is not amortized. Annual payments
made under a franchise agreement are recorded as operating expenses in the period in which
they are incurred.
GOODWILL
Usually, the largest intangible asset that appears on a company’s balance sheet is goodwill.
Goodwill represents the value of all favorable attributes that relate to a company that are
not attributable to any other specific asset.
These include exceptional management, desirable location, good customer relations, skilled
employees, high-quality products, and harmonious relations with labor unions. Goodwill is
unique. Unlike assets such as investments and plant assets, which can be sold individually in the
marketplace, goodwill can be identified only with the business as a whole.
Therefore, companies record goodwill only when an entire business is purchased. In that case,
goodwill is the excess of cost over the fair value of the net assets (assets less liabilities)
acquired.
Goodwill is not amortized because it is considered to have an indefinite life. Companies
report goodwill in the balance sheet under intangible assets.
Research and Development Costs
Research and development costs are expenditures that may lead to patents, copyrights, new
processes, and new products.
Many companies spend considerable sums of money on research and development (R&D).
 Companies usually record R&D costs as an expense when incurred, whether the research
and development is successful or not.

5. Discuss how plant assets, natural resources, and intangible assets are
reported and analyzed.
Presentation
Usually, companies combine plant assets and natural resources under “Property, plant, and
equipment” in the balance sheet.
They show intangibles separately.
Analysis
The asset turnover analyzes the productivity of a company’s assets.
It tells us how many dollars of sales a company generates for each dollar invested in assets.

If a company is using its assets efficiently, each dollar of assets will create a high amount of
sales.
This ratio varies greatly among different industries—from those that are asset-intensive (utilities)
to those that are not (services).