Fundamental of Accounting II (ACFn-2012) Handout

UNIT 2: ACCOUNTING FOR PLANT ASSETS, INTANGIBLE ASSETS AND NATURAL

RESOURCES
2.1 Nature of Plant assets
Companies use assets of a durable nature. Such assets are called property, plant, and equipment. Other
terms commonly used are plant assets and fixed assets. Property, plant, and equipment include land,
building structures (offices, factories, warehouses), and equipment (machinery, furniture, tools). The
major characteristics of property, plant, and equipment are as follows:
1. They are acquired for use in its operations
2. They are not intended for resale to customers in the normal course of operation
3. They are long term in nature and usually subject to depreciation.
4. They possess physical substance
The four main accounting issues with plant assets are:
1. Computing the cost of plant assets
2. Allocating the cost of plant assets against revenues for the period they benefit
3. Accounting for expenditures such as repair and improvement to plant assets and
4. Recording the disposal of plant assets
2.1.1 Computing the Cost of Plant Assets:
Plant assets are recorded at cost when purchased. This is consistent with the cost principle. Cost includes
all normal and reasonable expenditures necessary to get the asset in place and ready for its intended use.
The following summarizes many of the expenditures that are capitalized (added to the purchase price of
the plant asset) to determine the cost of the plant asset:
Example, assume that Hayes Hotel Company acquires land for Br200, 000. An old warehouse on the
property is razed at a net cost of Br6, 000 (Br7, 500 in costs less Br1, 500 proceeds from salvaged
materials). Other expenditures are the attorney’s fee, Br1, 000, and the real estate broker’s commission,
Br8, 000. The cost of the land is Br215, 000
Cash price of property Br200, 000
Net removal cost of warehouse 6,000
Attorney’s fee 1,000
Real estate broker’s commission 8,000
Cost of land Br215, 000
In recording the acquisition, Land is debited for Br215, 000 and Cash is credited for Br215, 000.

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Cost of Buildings: The cost of buildings should include all expenditures related directly to their
acquisition or construction. These costs include:
1) Materials, labor, and overhead costs incurred during construction, and
2) Professional fees and building permits. Companies consider all costs incurred, from excavation to
completion, as part of the building costs.
Example 2, assume Merten Hotels purchases kitchen equipment at a cash price of Br100, 000. Related
expenditures consist of sales taxes Br15, 000, insurance during shipping Br5000, and installation and
testing Br10, 000. The cost of the kitchen equipment is Br130, 000
Kitchen Equipment
Cash price Br100, 000
Sales taxes 15,000
Insurance during shipping 5,000
Installation and testing 10,000
Cost of kitchen equipment Br130, 000
A summary entry is made to record the purchase and related expenditures:
Kitchen equipment ……………….130, 000
Cash………………………………………130,000
(To record purchase of kitchen equipment)
2.2 Accounting for Depreciation of plant assets
Depreciation is the accounting process of allocating the cost of tangible assets to expense in a systematic
and rational manner to those periods expected to benefit from the use of the asset. Depreciation applies to
three classes of plant assets: land improvements, buildings, and equipment. Each asset in these classes is
considered to be a depreciable asset because 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.
Revenue-producing ability of depreciable fixed assets will decline because of: physical factors (such as
casualty or expiration of physical life) and economic factor (obsolescence). Physical factors are the wear
and tear, decay, and casualties that make it difficult for the asset to perform indefinitely. These physical
factors set the outside limit for the service life of an asset.
Factors in Computing Depreciation
1. Cost: The cost of plant asset consists of all necessary and reasonable expenditure to acquire it and to
prepare the asset for its intended use.

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2. Salvage Value: Is the estimated net recoverable amount from disposal or trade-in of the asset. Salvage
value, also called residual value or scrap value or trade-in value.
 It is the portion of an asset’s acquisition cost not consumed through use.
3. Useful /Economic/Service life: The useful life of a plant asset is the length of time it is productively
used in a company’s operations
Depreciable cost equals an asset's total cost minus the asset's expected salvage value. The total amount of
depreciation expense assigned to an asset never exceeds the asset's depreciable cost.
Net book value is an asset's total cost minus the accumulated depreciation assigned to the asset. Net book
value rarely equals market value, which is the price someone would pay for the asset. In fact, the market
value of an asset, such as a building, may increase while the asset is being depreciated. Net book value
simply represents the portion of an asset's cost that has not been allocated to expense.
2.2.1 Methods of Depreciation
The third factor involved in the depreciation process is the method of cost apportionment. The profession
requires that the depreciation method employed be “systematic and rational.”
Companies may use a number of depreciation methods, as follows.
1 Straight-line method (SLM)
2 Activity method (units of use or production)
3 Decreasing charge methods (accelerated): (a) Declining-balance method (DB)
(b) Sum-of-the-years’-digits (SYD)
Example: Assume that Medroc Coal Mines recently purchased an additional crane for digging purposes.
The following is data concerning this purchase.
Cost of crane Birr 500,000
Estimated useful life 5 years
Estimated salvage value Birr 50,000
Productive life in hours 30,000 hours
1. Straight-Line Method
 Straight line method charges equal amount of depreciation expense over its useful life.
 Companies widely use this method because of its simplicity.
 it matches expenses with revenues when the use of the asset is reasonably uniform throughout the
service life. The formula for computing periodic straight-line depreciation is:

Annual straight-line depreciation =

Example, the depreciation charge for the Medroc’s crane can be computed as follows.

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Annual depreciation expense = = Br. 90,000

At the end of each year, depreciation expense of this crane is recorded as follows:
Depreciation Expense……………………….90, 000
Accumulated depreciation-crane…………….90, 000
2. Activity Method (units of use or production)
 Determine depreciation expense per unit of output by using a straight line method.
 The life of an asset is measured in units of activity, i.e. miles, or hours used.
Two Step Processes 1 Compute depreciation per unit
2. Compute depreciation expense for the period

Depreciation expense = x Hours of this year

= x 4, 000 = Br. 60,000

3. Decreasing-Charge (Accelerated) Methods

 The decreasing-charge methods provide for a higher depreciation cost in the earlier years and lower
charges in later periods.
 Because these methods allow for higher early-year charges than in the straight-line method, they are
often called accelerated depreciation methods.
 Generally, companies use one of two decreasing-charge methods:
a) The sum-of-the-years’-digits method, or
b) The declining-balance method.
a) Declining Balance method
 A higher amount of depreciation expense is charged in earlier useful life of plant asset and then a
continuously declining amount in subsequent periods.
 Double declining balance rate is twice the straight line method.
 Salvage value is not considered in declining balance method
DDB in three steps
1) Compute the asset’s straight line deprecation Rate
2) Double the straight line rate
3) Compute depn on expense; by multiplying this rate by the asset’s beginning of period book value.
The formula for computing depreciation expense is:
Book Value at Beginning of Year X Declining Balance Rate = Depreciation Expense
To illustrate, using the doubles declining approach the deprn expense per year for Medroc is as follow:

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Year Book value (beginning Depreciation rate Annual Depreciation Accumulated Book value
of year) expenses depreciation (end of year)
1 Br. 500, 000 40% Br. 200, 000 Br. 200, 000 Br. 300, 000
2 300, 000 40% 120, 000 320, 000 180, 000
3 180, 000 40% 72, 000 392, 000 108, 000
4 108, 000 40% 43, 200 435, 200 64, 800
5 64, 800 40% 14, 800** 450, 000 50, 000
* Based on twice the straight-line rate of 20% (Birr 90,000/Birr 450,000 =20%; 20% x 2 = 40%).
** Limited to Br. 14, 800 because book value should not be less than salvage value
b) Sum-of-years-digit method (SYD)
Under this method depreciable cost is determined by deducting salvage value from original cost and it
will be the same for all years of useful life of a plant asset.
Fraction = Numerator
Denominator
Numerator:-the number of years remains in the useful life at the beginning of the period.
Denominator:-the sum of the integers from 1 up to the number of years of useful life (the sum of the
year’s digits.) Assuming the same data above:
Denominator = n (n+1) = =5(5+1) =15
2 2
To illustrate this method of computing deprecation let’s consider the case of Medroc’s crane again.
Depreciation Depreciation remaining life Depreciation Depreciation Book value
Year Base in year Fraction Expense End of year
1 Br. 450, 000 5 5/15* Br. 150, 000 Br. 350, 000
2 450, 000 4 4/15 120, 000 230, 000
3 450, 000 3 3/15 90, 000 140, 000
4 450, 000 2 2/15 60, 000 80, 000
5 450, 000 1 1/15 30, 000 50, 000
N.B The depreciation rate under the sum-of-years’-digits-method should be used for one full year (12
months)
2.2.2 Revising Depreciation Rates
Depreciation is one example of the use of estimation in the accounting process. Annual depreciation
expense should be reviewed periodically by management. If wear and tear or obsolescence indicates that
annual depreciation estimates are inadequate or excessive, a change should be made. When a change in an

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estimate is required, the change is made in current and future years. It is not made retroactively to prior
periods. Thus, there is no correction of previously recorded depreciation expense.
To determine the new annual depreciation expense, we first compute the asset’s depreciable cost at the
time of the revision. We then allocate the revised depreciable cost to the remaining useful life. Illustration:
A small delivery truck purchased by hope plc on January 1, 2018.
Cost Br13, 000
Expected salvage value Br1, 000
Estimated useful life 5 years
Estimated useful life in miles 100,000
Assume that hope decides on January 1, 2018, to extend the useful life of the truck one year because of its
excellent condition. The company has used the straight-line method to depreciate the asset to date, and
book value is Br5, 800 (Br13, 000 - Br7, 200). The new annual depreciation is Br1, 600,
Book value, 1/1/18 Br5, 800
Less: Salvage value 1,000
Depreciable cost Br4, 800
Remaining useful life 3 years (2018–2021)
Revised annual depreciation (Br4, 800 /3) Br1, 600
2.3Costs Subsequent to Acquisition
After installing plant assets and readying them for use, a company incurs additional costs that range from
ordinary repairs to significant additions. In general, costs incurred to achieve greater future benefits
should be capitalized, whereas expenditures that simply maintain a given level of services should be
expensed. The major types of expenditures subsequent to acquisition are:
1) Capital expenditures and 2) Revenue expenditures
1. Capital expenditures: also called balance sheet expenditures, are additional costs of plant assets that
provide benefits extending beyond the current period. They are debited to asset accounts and reported
on the balance sheet. Capital expenditures increase or improve the type or amount of service an asset
provides. Examples: roofing replacement, plant expansion, and major overhauls of machinery and
equipment.
Types of Capital Expenditures
a. Addition to fixed assets: the cost of an addition to a fixed asset should be debited to the related
fixed asset account.
b. Betterments/Improvements: are expenditures making a plant asset more efficient or productive.
An expenditure that improves a fixed asset’s operating efficiency or capacity for its remaining

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useful life is called betterment. Example: replacing manual control on a machine with automatic
controls to reduce labor costs
c. Extraordinary Repairs: are expenditures extending the asset’s useful life beyond its original
estimate. They benefit future periods.
2. Revenue expenditures: also called income statement expenditures, are additional costs of plant assets
that do not materially increase the asset’s life or productive capabilities. They are recorded as expenses
and deducted from revenues in the current period’s income statement. Examples of revenue expenditures
are cleaning, repainting, adjustments, and lubricants. N.B: Ordinary repairs are expenditures to keep the
asset in normal, good operating condition, and treated as revenue expenditures.
2.4 Disposal of plant assets
Plant assets are disposed of for several reasons. Some are discarded because they wear out or become
obsolete. Others are sold because of changing business plans. Regardless of the reason, disposals of plant
assets occur in one of three basic ways: discarding, sale, or exchange. In All Cases
1. Accumulated depreciation and depreciation expense must be brought up to date before recording the
disposal.
2. The asset and its accumulated depreciation must be removed from the accounting records.
3. Book Value = Cost – Accumulated Depreciation
1. Discarding (retirement) of a long-term asset: In accounting for a disposal by retirement,
a) Update depreciation to date of disposal.
b) If the asset is fully depreciated, the entry is a debit to Accumulated Depreciation and a credit to the
plant asset account.
c) If the asset is retired before it is fully depreciated and no scrap or salvage value is received, a loss
on disposal occurs.
d) The loss on disposal is reported in the Other Expenses and Losses section of the income statement.
Example: On January 2 discarded Machine #1, which originally cost Br10, 000 and has accumulated
depreciation of Br10, 000.
Accumulated Depreciation…………10,000
Machinery……………………10,000
On January 2 discarded Machine #2, which originally cost Br25, 000 and has accumulated depreciation of
Br20, 000.
Accumulated Depreciation…………20,000
Loss on Disposal……………………..5,000
Machinery………………………………25,000

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2. Sale of a long-term asset: Update depreciation to date of disposal, record the cash received, remove
asset and its accumulated depreciation from records, and record a gain or loss
a) If the proceeds of the sale exceed the book value, a gain on disposal occurs which is reported in the
Other Revenues and Gains section of the income statement.
b) If the proceeds of the sale are less than the book value of the asset, a loss on disposal occurs which is
reported in the Other Expenses and Losses section of the income statement.
Example: On October 1, a machine that cost Br50, 000 was sold for Br16, 000. The accounting records
revealed that accumulated depreciation as of January 1 was Br35, 000 and annual depreciation is Br5,
000.
1. Update Depreciation
5,000 * 9/12 = Br3, 750
Depreciation Expense…………………..3,750
Accumulated Depreciation………………3,750
New Balance of Accumulated Depreciation: 35,000 + 3,750 = Br38, 750
2. Calculate the gain or loss.
Selling Price Br16,000
Less: Book value(50,000 – 38,750) 11,250
Gain Br4,750
Entry:
Cash…………………………………….16, 000
Accumulated Depreciation……………..38,750
Machinery……………………………………50,000
Gain on Disposal……………………………....4,750
4. Exchanges: Ordinarily companies account for the exchange of assets on the basis of the fair value of
the asset given up or the fair value of the asset received, whichever is clearly more evident, with a
gain or loss immediately recognized.
To illustrate, a Company exchanged a number of used trucks plus cash for a semi-truck. The used trucks
have a combined book value of Birr 42,000 (cost birr 64,000 less birr 22,000 accumulated depreciation).
The company’s purchasing agent, experienced in the second hand market, indicates that the used trucks
have a fair value of birr 49,000. In addition to the trucks, the company must pay birr 11,000 cash for the
semi-truck. The company computes the cost of the semi-truck as follows.
Fair value of trucks exchanged Birr 49,000
Add: Cash paid 11,000

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Cost of semi-truck Birr 60,000
The exchange transaction is recorded as follows.
Trucks (semi)………………………………….60, 000
Accumulated Depreciation—Trucks………….22, 000
Trucks (used)……………………………………….64, 000
Gain on Disposal of Trucks………………………….7, 000
Cash………………………………………………...11,000
The gain is the difference between the fair value of the used trucks and their book value. We verify the
computation as follows.
Fair value of used trucks Birr 49,000
Cost of used trucks Birr 64,000
Less: Accumulated depreciation 22,000
Book value of used trucks (42,000)
Gain on disposal of used trucks Birr7,000

2.5 Leasing of plant assets

A business can rent a property for a specified period of time under a contract known as a lease. The lessor
is the owner of the property, and the lessee is the party that has the right to use the property. Leases which
extent over most of the asset life, and which transfer ownership to the lessee at the end of the lease are
called capital leases. Assets held under capital lease must be shown on the balance sheet, and therefore,
the Plant Assets is debited and a lease liability account is credited. Operating leases tend to be more short-
term, and the lessee does not acquire the leased property at the end of the lease.
A lease is a contractual agreement between a lessor and a lessee that gives the lessee the
right to use specific property, owned by the lessor, for a specified period of time. Largest
group of leased equipment involves: Information technology, Transportation (trucks,
aircraft, and rail), Construction and Agriculture.
Conceptual Nature of a Lease
1. Capital lease: capitalize a lease that transfers substantially all of the benefits and risks of
property ownership, provided the lease is non-cancelable. A lease that transfers
substantially all of the benefits and risks of property ownership should be capitalized
(only non-cancellable leases may be capitalized). To record a lease as a capital lease, the
lease must be non-cancelable. One or more of four criteria must be met:
(a)Transfers ownership to the lessee

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(b) Contains a bargain purchase option.
(c) Lease term is equal to or greater than 75 percent of the estimated economic life of the
leased property.
(d)The present value of the minimum lease payments (excluding executor costs) equals or
exceeds 90% of the fair value (FV) of the leased property.
Journal Entry:
Leased equipment xxx
Lease obligation xxx
2. Operative lease: Leases that do not transfer substantially all the benefits and risks of
ownership. Journal Entry:
Rent expense xxx
Cash xxx
2.5 Internal controls of plant assets
Internal controls are the subset of the accounting system to aid in proper reporting of a company while
being remaining an internal risk. Usually, there are two types of key internal risks and controls. The first
is physical risks and the second is a financial risk. Both types of risks can be minimized with the help of
internal controls.
a.Physical risks and internal controls for fixed assets: The purpose of the physical controls is
assessing, verify the existence, condition, and custody of the fixed assets. Usually, fixed assets are
conceived as low risk for any type of financial defalcation meaning thereby that fixed assets are less
exposed to theft, misappropriation, or unrecorded damages.
b. Financial risks and internal controls for fixed assets: Financial controls are essential for every
company as they ensure that the correct values of the fixed assets are reported on the balance sheet.
Those values would be detrimental to depict the financial stability of the company. The financial risks
involved are being unable to account for the correct purchase price of the fixed assets. Imagine a
company records the purchase price of the asset in the value of the fixed asset and another company
report acquisition price of the same fixed asset. Now the acquisition price of the fixed assets might
include the delivery fee, tax payment, registration payment, fixation expenses, etc. Now the increase
of expenses incurred while acquiring the fixed has to be reported somewhere. The same is the case
while recording of depreciation of fixed assets
Without an adequate internal control system, an environment is created in which assets are
not protected against loss or misuse; good practices are not followed; goals and objectives
may not be accomplished; and individuals are not deterred from engaging in dishonest,

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illegal, or unethical acts. It is particularly important to have functioning internal controls in
Plant asset, including: financial control, internal audit and management control.
2.6 Intangible Assets
Intangible assets are rights, privileges, and competitive advantages that result from the ownership of
assets that do not possess physical substance.
Intangibles may arise from government grants, acquisition of another business, and private
monopolistic arrangements.
Characteristics of intangible assets
Intangible assets have characteristics that distinguish them from tangible assets:
 There is generally a higher degree of uncertainty regarding the future benefits to be
derived.
 Their value is subject to wider fluctuations because it may depend to a considerable
extent on competitive conditions.
 They may have value only to a particular company.
 They may have indeterminate (but not necessarily indefinite) lives
In general, accounting for intangible assets parallels the accounting for plant assets. Intangible assets
are: (a) recorded at cost,
a) Cost is written off over useful life in a rational and systematic manner, assuming the useful life is
limited, and
b) At disposal, book value is eliminated and gain or loss, if any, is recorded. If the life of the
intangible is indefinite, the cost of the intangible should not be allocated.
Amortization of Intangible Assets
 The periodic expensing of the cost of intangible assets.
 The Straight-line Method is used.
 Intangibles are amortized over their useful life, not to exceed 40 years.
 The accumulated amortization account is credited when the asset is amortized.
Amortization Expense XX
Patents XX
Classification and Accounting Valuation of Intangibles
1. Purchased Intangibles: Company’s record at cost intangibles purchased from another party. Cost
includes all acquisition costs plus expenditures to make the intangible asset ready for its intended use.
Typical costs include: Purchase price, Legal fees, and other incidental expenses.

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2. Internally Created Intangibles: Sometimes a company may incur substantial research and
development costs to create an intangible. Costs incurred internally to create intangibles are generally
expensed.
Identifiable Intangible Assets: Intangible assets such as patents, trademarks, and franchises are referred
to as 'identifiable.' The most significant distinction between 'identifiable' and 'unidentifiable' intangible
assets is separability. Identifiable intangible assets may be acquired singly, as a part of a group of assets,
or as part of an entire company.
To illustrate, assume that Harron Co. incurs birr 180,000 in legal costs on January 1, 2018, to successfully
defend a patent. The patent’s useful life is 20 years, amortized on a straight-line basis. Harron records the
legal fees and the amortization at the end of 2018 as follows.
January 1, 2018
Patents……………………….180, 000
Cash……………………………..180,000
(To record legal fees related to patent)
December 31, 2018
Amortization Expense………………………………………9,000
Patents (or Accumulated Patent Amortization)……………..9,000
(To record amortization of patent)

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Types of Legal life Cost Amortization entry

intangible Definition
Asset
Right to manufacture, sell, control an 17 years Acquisition Amortization expense -----xx
1. Patent invention; granted federal government cost Patent -------------xx
patent office
Right to reproduce, sell, an artistic or Artist’s Acquisition Amortization expense -----xx
2. Copyright published work life + litigation Accum. Amort.(copyright) xx
+50years cost.
Word, phrase, jingle protected federal 20 years Acquisition Amortization expense -----xx
3. Trademark government patent office + litigation Accum.amort.(Trademark) xx
cost.
Arise when an entire business is Price minus Amortization expense --xx
purchased. Not Fair market Accumu. amort. (Goodwill) xx
Represents an amount paid over and assigned value (FMV)
above the values of the assets & N/A of (A-L)
4. Goodwill
liabilities acquired indicating the acquired
business possesses unusual advantage:
location, customers, list, products,
reputation, etc.
5. Franchise Right to carry on an enterprise in Varied Cost of Amortization expense --xx
geographical area or in public property. franchise ,lic Accum.amort.(Franchise) xx
ense , permit

2.7 Natural Resources

Natural resources, often called wasting assets, include petroleum, minerals, and timber.
They have two main features:

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1) The complete removal (consumption) of the asset, and

2) Replacement of the asset only by an act of nature.
Unlike plant and equipment, natural resources are consumed physically over the period of use
and do not maintain their physical characteristics.
Depletion of Natural Resources
 Mining companies purchase rights to metal ore or mineral deposits. These rights are
recorded in an asset account when they are purchased.
As ore is mined, part of the cost must be removed from the asset account. This process is
called depletion. Thus, Depletion is the process of allocating the cost of natural resources.
 The depletion method is the same as Units of Production Method.
 The accumulated depletion account is credited when the asset is amortized.
Computation of the depletion base involves four factors:
(1) Acquisition cost of the deposit (2) Exploration costs, (3) Development costs, and
(2) Restoration costs.
1. Acquisition Costs: Acquisition cost is the price a company pays to obtain the property right
to search and find an undiscovered natural resource. It also can be the price paid for an
already discovered resource. A third type of acquisition cost can be lease payments for
property containing a productive natural resource; included in these acquisition costs are
royalty payments to the owner of the property.
2. Exploration Costs: As soon as a company has the right to use the property, it often incurs
exploration costs needed to find the resource. When exploration costs are substantial, some
companies capitalize them into the depletion base.
3. Development Costs: Companies divide development costs into two parts:
(1) Tangible equipment costs and
(2) Intangible development costs.
 Tangible equipment costs include all of the transportation and other heavy equipment
needed to extract the resource and get it ready for market.
 Intangible development costs are considered part of the depletion base.
4. Restoration Costs: Companies sometimes incur substantial costs to restore property to its
natural state after extraction has occurred. These are restoration costs. Companies consider

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restoration costs part of the depletion base. The amount included in the depletion base is the
fair value of the obligation to restore the property after extraction.
The formulas for computing depletion expense are:
a) Total Cost minus Salvage Value ÷ Total Estimated Units = Depletion Cost per Unit.
b) Depletion Cost per Unit X Number of Units Extracted and Sold = Depletion Expense.
To record depletion expense, Depletion Expense is debited and a contra asset account,
Accumulated Depletion, is credited.
a) Depletion expense is reported as a cost of producing the product.
b) Accumulated Depletion is deducted from the cost of the natural resource in the balance
sheet.
Example: The cost of certain mineral rights is Br. 400, 000 and that the deposit is estimated at 1,
000, 000 tons of ore of uniform grade.
a) What is the depletion rate?
b) If 90,000 tons are mined during the year, what is the amount of depletion expense for the
year?

a) The depletion rate = Br. 400, 000 1, 000, 000

= Br. 0.40/ton
b) Depletion expense for the current year is
= Br. 90, 000 x Br. 0.40/ton
= Br. 36, 000

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