Plant Assets

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 provide services to the company for a number of years. Except for land, plant assets decline in service potential over their useful lives.

Because plant assets play a key role in ongoing operations, companies keep plant assets in good operating condition. They also replace worn-out or outdated plant assets, and expand productive resources as needed. Many companies have substantial investments in plant assets. Illustration 9-1 shows the percentages of plant assets in relation to total assets of companies in a number of industries.

Illustration 9-1 Percentages of plant assets in relation to total assets

Determining the Cost of Plant Assets

In general, companies record plant assets at cost. Thus, Europcar records its vehicles at cost. Cost consists of all expenditures necessary to acquire the asset and make it ready for its intended use. For example, the cost of factory machinery includes the purchase price, freight costs paid by the purchaser, and installation costs. Once cost is established, the company generally uses that amount as the basis of accounting for the plant asset over its useful life.

In the following sections, we explain the application of the historical cost principle to each of the major classes of plant assets.

LAND

Companies often use land as a 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. For example, if the cash price is $50,000 and the purchaser agrees to pay accrued taxes of $5,000, the cost of the land is $55,000.

Companies record as debits (increases) to the Land account all necessary costs incurred to make land ready for its intended use. 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.

To illustrate, assume that Lew Company acquires real estate at a cash cost of HK$2,000,000. The property contains an old warehouse that is razed at a net cost of HK$60,000 (HK$75,000 in costs less HK$15,000 proceeds from salvaged materials). Additional expenditures are the attorney's fee, HK$10,000, and the real estate broker's commission, HK$80,000. The cost of the land is HK$2,150,000, computed as shown in Illustration 9-2.

Illustration 9-2 Computation of cost of land

When Lew records the acquisition, it debits Land for HK$2,150,000 and credits Cash for HK$2,150,000.

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. For example, the cost of a new parking lot for a Hero Supermarket (IDN) includes the amount paid for paving, fencing, and lighting. Thus, Hero Supermarket debits to Land Improvements the total of all of these costs.

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, costs consist of the contract price plus payments for architects' fees, building permits, and excavation costs.

In addition, companies charge certain interest costs to the Buildings account. Interest costs incurred to finance the project are included in the cost of the building when a significant period of time is required to get the building ready for use. In these circumstances, interest costs are considered as necessary as materials and labor. However, the inclusion of interest costs in the cost of a constructed building is limited to the construction period. When construction has been completed, the company records subsequent interest payments on funds borrowed to finance the construction as debits (increases) to Interest Expense.

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, such as Europcar vehicles, consists of the cash purchase price, sales taxes, freight charges, and insurance during transit paid by the purchaser. It also includes expenditures required in assembling, installing, and testing the unit. However, Europcar does not include motor vehicle licenses and accident insurance on company vehicles in the cost of equipment. These costs represent annual recurring expenditures and do not benefit future periods. Thus, they are treated as expenses as they are incurred.

To illustrate, assume Zhang Company purchases factory machinery at a cash price of HK$500,000. Related expenditures are for sales taxes HK$30,000, insurance during shipping HK$5,000, and installation and testing HK$10,000. The cost of the factory machinery is HK$545,000, computed in Illustration 9-3.

Illustration 9-3 Computation of cost of factory machinery

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

For another example, assume that Huang Company purchases a delivery truck at a cash price of HK$420,000. Related expenditures consist of sales taxes HK$13,200, painting and lettering HK$5,000, motor vehicle license HK$800, and a three-year accident insurance policy HK$16,000. The cost of the delivery truck is HK$438,200, computed as follows.

Illustration 9-4 Computation of cost of delivery truck

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

Depreciation

As explained in Chapter 3, 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, as shown in Illustration 9-5.

Illustration 9-5 Depreciation as a cost allocation concept

It is important to understand that depreciation is a process of cost allocation. It is not a process of asset valuation. No attempt is made to measure the change in an asset's fair value during ownership. So, the book value (cost less accumulated depreciation) of a plant asset may be quite different from its fair value. In fact, if an asset is fully depreciated, it can have a zero book value but still have a significant fair value.

Depreciation applies to three classes of plant assets: land improvements, buildings, and equipment. Each asset in these classes is considered to be a depreciable asset. Why? 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. In fact, in many cases, the usefulness of land is greater over time because of the scarcity of good land sites. Thus, land is not a depreciable asset.

During a depreciable asset's useful life, its revenue-producing ability declines because of wear and tear. A delivery truck that has been driven 100,000 miles will be less useful to a company than one driven only 800 miles.

Revenue-producing ability may also decline because of obsolescence. Obsolescence is the process of becoming out of date before the asset physically wears out. For example, major airlines moved from Chicago's Midway Airport to Chicago-O'Hare International Airport because Midway's runways were too short for jumbo jets. Similarly, many companies replace their computers long before they originally planned to do so because improvements in new computing technology make the old computers obsolete.

Recognizing depreciation on an asset does not result in an accumulation of cash for replacement of the asset. The balance in Accumulated Depreciation represents the total amount of the asset's cost that the company has charged to expense. It is not a cash fund.

Note that the concept of depreciation is consistent with the going-concern assumption. The going-concern assumption states that the company will continue in operation for the foreseeable future. If a company does not use a going-concern assumption, then plant assets should be stated at their fair value. In that case, depreciation of these assets is not needed.

FACTORS IN COMPUTING DEPRECIATION

Three factors affect the computation of depreciation, as shown in Illustration 9-6.

Illustration 9-6 Three factors in computing depreciation

1. Cost. Earlier, we explained the issues affecting the cost of a depreciable asset. Recall that companies record plant assets at cost, in accordance with the historical cost principle.
2. Useful life. Useful life is an estimate of the expected productive life, also called service life, of the asset for its owner. Useful life may be expressed in terms of time, units of activity (such as machine hours), or units of output. Useful life is an estimate. In making the estimate, management considers such factors as the intended use of the asset, its expected repair and maintenance, and its vulnerability to obsolescence. Past experience with similar assets is often helpful in deciding on expected useful life. We might reasonably expect Rent-A-Wreck and Europcar to use different estimated useful lives for their vehicles.
3. Residual value. Residual value is an estimate of the asset's value at the end of its useful life. This value may be based on the asset's worth as scrap or on its expected trade-in value. Like useful life, residual value is an estimate. In making the estimate, management considers how it plans to dispose of the asset and its experience with similar assets.

DEPRECIATION METHODS

Depreciation is generally computed using one of the following methods:

1. Straight-line
2. Units-of-activity
3. Declining-balance

Each method is acceptable under IFRS. Management selects the method(s) it believes to be appropriate. The objective is to select the method that best measures an asset's contribution to revenue over its useful life. Once a company chooses a method, it should apply it consistently over the useful life of the asset. Consistency enhances the comparability of financial statements. Depreciation affects the statement of financial position through accumulated depreciation and the income statement through depreciation expense.

We will compare the three depreciation methods using the following data for a small delivery truck purchased by Barb's Florists on January 1, 2014.

Illustration 9-7 Delivery truck data

STRAIGHT-LINE Under the straight-line method, companies expense the same amount of depreciation for each year of the asset's useful life. It is measured solely by the passage of time.

To compute depreciation expense under the straight-line method, companies need to determine depreciable cost. Depreciable cost is the cost of the asset less its residual value. It represents the total amount subject to depreciation. Under the straight-line method, to determine annual depreciation expense, we divide depreciable cost by the asset's useful life. Illustration 9-8 shows the computation of the first year's depreciation expense for Barb's Florists.

Illustration 9-8 Formula for straight-line method

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 straight-line rate, it applies the percentage rate to the depreciable cost of the asset. Illustration 9-9 shows a depreciation schedule using an annual rate.

Illustration 9-9 Straight-line depreciation schedule

Note that the depreciation expense of €2,400 is the same each year. The book value (computed as cost minus accumulated depreciation) at the end of the useful life is equal to the expected €1,000 residual value.

What happens to these computations for an asset purchased during the year, rather than on January 1? In that case, it is necessary to prorate the annual depreciation on a time basis. If Barb's Florists had purchased the delivery truck on April 1, 2014, the company would own the truck for nine months of the first year (April–December). Thus, depreciation for 2014 would be €1,800 (€12,000 × 20% × 9/12 of a year).

The straight-line method predominates in practice. Large companies such as Daimler (DEU), Anheuser-Busch InBev (BEL), and General Mills (USA) use the straight-line method. It is simple to apply, and it matches expenses with revenues when the use of the asset is reasonably uniform throughout the service life.

UNITS-OF-ACTIVITY Under the units-of-activity method, useful life is expressed in terms of the total units of production or use expected from the asset, rather than as a time period. The units-of-activity method is ideally suited to factory machinery. Manufacturing companies can measure production in units of output or in machine hours. 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.

To illustrate, assume that Barb's Florists drives its delivery truck 15,000 miles in the first year. Illustration 9-10 shows the units-of-activity formula and the computation of the first year's depreciation expense.

Illustration 9-10 Formula for units-of-activity method

The units-of-activity depreciation schedule, using assumed mileage, is as follows.

Illustration 9-11 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.

The units-of-activity method is not nearly as popular as the straight-line method primarily because it is often difficult for companies to reasonably estimate total activity. However, some very large companies, such as Chevron (USA), do use this method. When the productivity of an asset varies significantly from one period to another, the units-of-activity method results in the best matching of expenses with revenues.

DECLINING-BALANCE The declining-balance method produces a decreasing annual depreciation expense over the asset's useful life. The method is so named because the periodic depreciation is based on a declining book value (cost less accumulated depreciation) of the asset. With this method, companies compute annual depreciation expense by multiplying the book value at the beginning of the year by the declining-balance depreciation rate. The depreciation rate remains constant from year to year, but the book value to which the rate is applied declines each year.

At the beginning of the first year, book value is the cost of the asset. This is because the balance in accumulated depreciation at the beginning of the asset's useful life is zero. In subsequent years, book value is the difference between cost and accumulated depreciation to date. Unlike the other depreciation methods, the declining-balance method does not use depreciable cost in computing annual depreciation expense. That is, it ignores residual value in determining the amount to which the declining-balance rate is applied. Residual value, however, does limit the total depreciation that can be taken. Depreciation stops when the asset's book value equals expected residual value.

A common declining-balance rate is double the straight-line rate. The method is often called the double-declining-balance method. If Barb's Florists uses the double-declining-balance method, it uses a depreciation rate of 40% (2 × the straight-line rate of 20%). Illustration 9-12 shows the declining-balance formula and the computation of the first year's depreciation on the delivery truck.¹

Illustration 9-12 Formula for declining-balance method

The depreciation schedule under this method is as follows.

Illustration 9-13 Double-declining-balance depreciation schedule

The delivery equipment is 69% depreciated (€8,320 ÷ €12,000) at the end of the second year. Under the straight-line method, the truck would be depreciated 40% (€4,800 ÷ €12,000) at that time. Because the declining-balance method produces higher depreciation expense in the early years than in the later years, it is considered an accelerated-depreciation method. The declining-balance method is compatible with the expense recognition principle. It matches the higher depreciation expense in early years with the higher benefits received in these years. It also recognizes lower depreciation expense in later years, when the asset's contribution to revenue is less. Some assets lose usefulness rapidly because of obsolescence. In these cases, the declining-balance method provides the most appropriate depreciation amount.

When a company purchases an asset during the year, it must prorate the first year's declining-balance depreciation on a time basis. For example, if Barb's Florists had purchased the truck on April 1, 2014, depreciation for 2014 would become €3,900 (€13,000 × 40% × 9/12). The book value at the beginning of 2015 is then €9,100 (€13,000 − €3,900), and the 2015 depreciation is €3,640 (€9,100 × 40%). Subsequent computations would follow from those amounts.

COMPARISON OF METHODS Illustration 9-14 compares annual and total depreciation expense under each of the three methods for Barb's Florists.

Illustration 9-14 Comparison of depreciation methods

Annual depreciation varies considerably among the methods, but total depreciation is the same 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. Illustration 9-15 graphs the depreciation expense pattern under each method.

Illustration 9-15 Patterns of depreciation

COMPONENT DEPRECIATION

Thus far, we have assumed that plant assets use a single depreciation rate. However, IFRS requires component depreciation for plant assets. Component depreciation requires that any significant parts of a plant asset that have significantly different estimated useful lives should be separately depreciated.

To illustrate component depreciation, assume that Lexure Construction builds an office building for HK$4,000,000, not including the cost of the land. If the HK$4,000,000 is allocated over the 40-year useful life of the building, Lexure reports HK$100,000 (HK$4,000,000 ÷ 40) of depreciation per year, assuming straight-line depreciation and no residual value. However, assume that HK$320,000 of the cost of the building relates to personal property and HK$600,000 relates to land improvements. Because the personal property has a depreciable life of 5 years and the land improvements have a depreciable life of 10 years, Lexure must use component depreciation. It must reclassify HK$320,000 of the cost of the building to personal property and HK$600,000 to the cost of land improvements. Assuming that Lexure uses straight-line depreciation, component depreciation for the first year of the office building is computed as follows.

Illustration 9-16 Component depreciation computation

DEPRECIATION AND INCOME TAXES

Tax laws allow corporate taxpayers to deduct depreciation expense when they compute taxable income. However, tax laws often do not require taxpayers to use the same depreciation method on the tax return that is used in preparing financial statements.

Many corporations use straight-line in their financial statements to maximize net income. At the same time, they use an accelerated-depreciation method on their tax returns to minimize their income taxes.

REVISING PERIODIC DEPRECIATION

Depreciation is one example of the use of estimation in the accounting process. Management should periodically review annual depreciation expense. If wear and tear or obsolescence indicate that annual depreciation estimates are inadequate or excessive, the company should change the amount of depreciation expense.

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. The rationale is that continual restatement of prior periods would adversely affect confidence in financial statements.

To determine the new annual depreciation expense, the company first computes the asset's depreciable cost at the time of the revision. It then allocates the revised depreciable cost to the remaining useful life.

To illustrate, assume that Barb's Florists decides on January 1, 2017, to extend the useful life of the truck one year (a total life of six years) and increase its residual 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 (2014–2016) is €7,200 (€2,400 × 3), and book value is €5,800 (€13,000 − €7,200). The new annual depreciation is €1,200, as shown in Illustration 9-17.

Illustration 9-17 Revised depreciation computation

Barb's Florists makes no entry for the change in estimate. On December 31, 2017, during the preparation of adjusting entries, it records depreciation expense of €1,200. Companies must describe in the financial statements significant changes in estimates.

Revaluation of Plant Assets

IFRS allows companies to revalue plant assets to fair value at the reporting date. Companies that choose to use the revaluation framework must follow revaluation procedures. If revaluation is used, it must be applied to all assets in a class of assets. Assets that are experiencing rapid price changes must be revalued on an annual basis. Otherwise, less frequent revaluation is acceptable.

To illustrate asset revaluation accounting, assume that Pernice Company applies revaluation to equipment with a book (carrying) value of HK$1,000,000, a useful life of 5 years, and no residual value. Pernice makes the following journal entries in year 1, assuming straight-line depreciation.

After this entry, Pernice's equipment has a carrying amount of HK$800,000 (HK$1,000,000 − HK$200,000). At the end of year 1, independent appraisers determine that the asset has a fair value of HK$850,000. To report the equipment at fair value, or HK$850,000, Pernice eliminates the Accumulated Depreciation—Equipment account, reduces Equipment to its fair value of HK$850,000, and records Revaluation Surplus of HK$50,000. The entry to record the revaluation is as follows.

Thus, Pernice follows a two-step process. First, Pernice records depreciation based on the cost basis of HK$1,000,000. As a result, it reports depreciation expense of HK$200,000 on the income statement. Second, it records the revaluation. It does this by eliminating any accumulated depreciation, adjusting the recorded value of the equipment to fair value, and debiting or crediting the revaluation surplus account. In this example, the revaluation surplus is HK$50,000, which is the difference between the fair value of HK$850,000 and the book value of HK$800,000. Revaluation surplus is an example of an item reported as other comprehensive income, as discussed in Chapter 5. Pernice now reports the following information in its statement of financial position at the end of year 1.

Illustration 9-18 Statement presentation of plant assets (equipment) and revaluation surplus

As indicated, HK$850,000 is the new basis of the asset. Pernice reports depreciation expense of HK$200,000 in the income statement and HK$50,000 in other comprehensive income. Assuming no change in the total useful life, depreciation in year 2 will be HK$212,500 (HK$850,000 ÷ 4).

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 fairly small amounts that occur frequently. Examples are motor tune-ups and oil changes, the painting of buildings, and the replacing of worn-out gears on machinery. Companies record such repairs as debits to Maintenance and Repairs Expense as they are incurred. Because they are immediately charged as an expense against revenues, these costs are often referred to as revenue expenditures.

In contrast, 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. Additions and improvements increase the company's investment in productive facilities. Companies generally debit these amounts to the plant asset affected. They are often referred to as capital expenditures.

Companies must use good judgment in deciding between a revenue expenditure and capital expenditure. For example, assume that Rodriguez Co. purchases a number of wastepaper baskets. Although the proper accounting would appear to be to capitalize and then depreciate these wastepaper baskets over their useful life, it would be more usual for Rodriguez to expense them immediately. This practice is justified on the basis of materiality. Materiality refers to the impact of an item's size on a company's financial operations. The materiality concept states that if an item would not make a difference in decision-making, the company does not have to follow IFRS in reporting that item.

Plant Asset Disposals

Companies dispose of plant assets that are no longer useful to them. Illustration 9-19 shows the three ways in which companies make plant asset disposals.

Illustration 9-19 Methods of plant asset disposal

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. Recall that the book value is the difference between the cost of the plant asset and the accumulated depreciation to date. If the disposal occurs at any time during the year, the company must record depreciation for the fraction of the year to the date of disposal. The company then eliminates the book value by reducing (debiting) Accumulated Depreciation for the total depreciation associated with that asset to the date of disposal and reducing (crediting) the asset account for the cost of the asset.

In this chapter, we examine the accounting for the retirement and sale of plant assets. In the appendix to the chapter, we discuss and illustrate the accounting for exchanges of plant assets.

RETIREMENT OF PLANT ASSETS

To illustrate the retirement of plant assets, assume that Hobart Enterprises 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). The entry to record this retirement is as follows.

What happens if a fully depreciated plant asset is still useful to the company? In this case, the asset and its accumulated depreciation continue to be reported on the statement of financial position, without further depreciation adjustment, until the company retires the asset. Reporting the asset and related accumulated depreciation on the statement of financial position informs the financial statement reader that the asset is still in use. Once fully depreciated, no additional depreciation should be taken, even if an asset is still being used. In no situation can the accumulated depreciation on a plant asset exceed its cost.

If a company retires a plant asset before it is fully depreciated, and no cash is received for scrap or residual value, a loss on disposal occurs. For example, assume that Sunset Company discards delivery equipment that cost €18,000 and has accumulated depreciation of €14,000. The entry is as follows.

Companies report a loss on disposal of plant assets in the “Other income and expense” 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.

Only by coincidence will the book value and the fair value of the asset be the same when the asset is sold. Gains and losses on sales of plant assets are therefore quite common. For example, Delta Airlines (USA) reported a $94,343,000 gain on the sale of ten aircraft.

GAIN ON SALE To illustrate a gain on sale of plant assets, assume that on July 1, 2014, Wright Company sells office furniture for €16,000 cash. The office furniture originally cost €60,000. As of January 1, 2014, it had accumulated depreciation of €41,000. Depreciation for the first six months of 2014 is €8,000. Wright records depreciation expense and updates accumulated depreciation to July 1 with the following entry.

After the accumulated depreciation balance is updated, the company computes the gain or loss. The gain or loss is the difference between the proceeds from the sale and the book value at the date of disposal. Illustration 9-20 shows this computation for Wright Company, which has a gain on disposal of €5,000.

Illustration 9-20 Computation of gain on disposal

Wright records the sale and the gain on disposal of the plant asset as follows.

Companies report a gain on disposal of plant assets in the “Other income and expense” 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. In this case, Wright computes a loss of €2,000 as follows.

Illustration 9-21 Computation of loss on disposal

Wright records the sale and the loss on disposal of the plant asset as follows.

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

Extractable Natural Resources

Common natural resources consist of standing timber and resources extracted from the ground, such as oil, gas, and minerals. Standing timber is considered a biological asset under IFRS. In the years before they are harvested, the recorded value of biological assets is adjusted to fair value each period. The additional details of accounting for biological assets are beyond the scope of this text.

IFRS defines extractive industries as those businesses involved in finding and removing natural resources located in or near the earth's crust. The acquisition cost of an extractable natural resource is the price needed to acquire the resource and prepare it for its intended use. For an already-discovered resource, such as an existing coal mine, cost is the price paid for the property.

The allocation of the cost of natural resources to expense in a rational and systematic manner over the resource's useful life is called depletion. (That is, depletion is to natural resources as depreciation is to plant assets.) Companies generally use the units-of-activity method (learned earlier in the chapter) to compute depletion. The reason is that depletion generally is a function of the units extracted during the year.

Under the units-of-activity method, companies divide the total cost of the natural resource minus residual value by the number of units estimated to be in the resource. The result is a depletion cost per unit of product. They then multiply the depletion cost per unit by the number of units extracted and sold. The result is the annual depletion expense. Illustration 9-22 shows the formula to compute depletion expense.

Illustration 9-22 Formula to compute depletion expense

To illustrate, assume that Lane Coal Company invests HK$50 million in a mine estimated to have 10 million tons of coal and no residual value. In the first year, Lane extracts and sells 800,000 tons of coal. Using the formulas above, Lane computes the depletion expense as follows.

Lane records depletion expense for the first year of operation as follows.

The company reports the account Depletion Expense as a part of the cost of producing the product. Accumulated Depletion is a contra asset account, similar to accumulated depreciation. It is deducted from the cost of the natural resource in the statement of financial position, as Illustration 9-23 shows.

Illustration 9-23 Statement presentation of accumulated depletion

Many companies do not use an Accumulated Depletion account. In such cases, the company credits the amount of depletion directly to the natural resources account.

Sometimes, a company will extract natural resources in one accounting period but not sell them until a later period. In this case, the company does not expense the depletion until it sells the resource. It reports the amount not sold as inventory in the current assets section.

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.

Some widely known intangibles are SAP's (DEU) patents, Spar (NLD) convenience store franchises, Apple's (USA) trade name iPod, J.K. Rowlings' copyrights on the Harry Potter books, and the trademark Europcar in the Feature Story.

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.

To record amortization of an intangible asset, a company increases (debits) Amortization Expense and decreases (credits) the specific intangible asset. (Unlike depreciation, no contra account, such as Accumulated Amortization, is usually used.)

Intangible assets are typically amortized on a straight-line basis. For example, the legal life of a patent is 20 years in many countries. Companies amortize the cost of a patent over its 20-year life or its useful life, whichever is shorter. To illustrate the computation of patent amortization, assume that National Labs purchases a patent at a cost of NT$720,000. If National estimates the useful life of the patent to be eight years, the annual amortization expense is NT$90,000 (NT$720,000 ÷ 8). National records the annual amortization as follows.

Companies classify Amortization Expense as an operating expense in the income statement. Similar to property, plant, and equipment, IFRS permits revaluation of intangible assets to fair value, except for goodwill.

When intangible assets are acquired through a purchase, the determination of cost is similar to that of property, plant, and equipment. Cost includes the purchase price, as well as costs incurred to get the asset ready for use. However, special rules are used to determine cost when an intangible asset is generated internally, as a result of a company's own research and development efforts. These rules are discussed in a later section.

PATENTS

A patent is an exclusive right issued by a patent office that enables the recipient to manufacture, sell, or otherwise control an invention for a specified number of years from the date of the grant. These “legal lives” sometimes vary across countries, but the legal life in many countries is 20 years. A patent is non-renewable. 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 saying, “A patent is only as good as the money you're prepared to spend defending it,” is very true. Many patents are subject to litigation by competitors. Any legal costs an owner incurs in successfully defending a patent in an infringement suit are considered necessary to establish the patent's validity. The owner adds those costs to the Patents account and amortizes them over the remaining life of the patent.

The patent holder amortizes the cost of a patent over its legal life or its useful life, whichever is shorter. Companies consider obsolescence and inadequacy in determining useful life. These factors may cause a patent to become economically ineffective before the end of its legal life.

COPYRIGHTS

Governments grant 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 a specified number of years which can vary by country but is commonly 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 a 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. Trade names like Wheaties, Monopoly, Big Mac, Kleenex, Coca-Cola, and Jetta create immediate product identification. They also generally enhance the sale of the product. The creator or original user may obtain exclusive legal right to the trademark or trade name by registering it with a patent office or similar governmental agency. Such registration provides a specified number of years of protection, which can vary by country but is commonly 20 years. 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 AND LICENSES

When you fill up your tank at the corner BP (GBR) station, eat lunch at Subway (USA), or rent a car from Europcar, you are dealing with franchises. A franchise is a contractual arrangement between a franchisor and a franchisee. The franchisor grants the franchisee the right to sell certain products, provide specific services, or use certain trademarks or trade names, usually within a designated geographic area.

Another type of franchise is that entered into between a governmental body (commonly municipalities) and a company. This franchise permits the company to use public property in performing its services. Examples are the use of city streets for a bus line or taxi service, use of public land for telephone and electric lines, and the use of airwaves for radio or TV broadcasting. Such operating rights are referred to as licenses. Franchises and licenses may by granted for a definite period of time, an indefinite period, or perpetually.

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 statement of financial position 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.

If goodwill can be identified only with the business as a whole, how can its amount be determined? One could try to put a monetary value on the factors listed above (exceptional management, desirable location, and so on). But, the results would be very subjective, and such subjective valuations would not contribute to the reliability of financial statements. 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.

In recording the purchase of a business, the company debits (increases) the identifiable acquired assets, credits liabilities at their fair values, credits cash for the purchase price, and records the difference as goodwill. Goodwill is not amortized because it is considered to have an indefinite life, but its value should be written down if impaired. Companies report goodwill in the statement of financial position 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). For example, in a recent year Bayer (DEU) spent over €2.6 billion on R&D.

Research and development costs present accounting problems. For example, it is sometimes difficult to assign these costs to specific projects. Also, there are uncertainties in identifying the amount and timing of future benefits. Costs in the research phase are always expensed as incurred. Costs in the development phase are expensed until specific criteria are met, primarily that technological feasibility is achieved. Development costs incurred after technological feasibility has been achieved are capitalized to Development Costs, which is considered an intangible asset.

To illustrate, assume that Laser Scanner Company spent NT$1 million on research and NT$2 million on development of new products. Of the NT$2 million in development costs NT$500,000 was incurred prior to technological feasibility and NT$1,500,000 was incurred after technological feasibility had been demonstrated. The company would record these costs as follows.

Statement Presentation and Analysis

Presentation

Usually, companies combine plant assets and natural resources under “Property, plant, and equipment” in the statement of financial position. They show intangibles separately. Companies disclose either in the statement of financial position or the notes to the financial statements the balances of the major classes of assets, such as land, buildings, and equipment, and accumulated depreciation by major classes or in total. In addition, they should describe the depreciation and amortization methods that were used, as well as disclose the amount of depreciation and amortization expense for the period.

Illustration 9-24 shows a typical financial statement presentation of property, plant, and equipment and intangibles. The notes to the company's financial statements present greater details about the accounting for its non-current tangible and intangible assets.

Illustration 9-24 Presentation of property, plant, and equipment, and intangible assets

Analysis

Using ratios, we can analyze how efficiently a company uses its assets to generate sales. The asset turnover ratio analyzes the productivity of a company's assets. It tells us, as shown below for LG (KOR), how many Korean won of sales the company generates for each Korean won invested in assets. This ratio is computed by dividing net sales by average total assets for the period, as shown in Illustration 9-25. LG's net sales for a recent year were 90,222 billion. Its total ending assets were 64,782 billion, and beginning assets were 54,080 billion.

Illustration 9-25 Asset turnover formula and computation

Thus, each Korean won invested in assets produced 1.52 in sales for LG. If a company is using its assets efficiently, each investment in 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).

SUMMARY OF LEARNING OBJECTIVES

1 Describe how the historical cost principle applies to plant assets. The cost of plant assets includes all expenditures necessary to acquire the asset and make it ready for its intended use. Once cost is established, a company uses that amount as the basis of accounting for the plant asset over its useful life.

2 Explain the concept of depreciation and how to compute it. Depreciation is the allocation of the cost of a plant asset to expense over its useful (service) life in a rational and systematic manner. Depreciation is not a process of valuation, nor is it a process that results in an accumulation of cash.

Companies make revisions of periodic depreciation in present and future periods, not retroactively. They determine the new annual depreciation by dividing the depreciable cost at the time of the revision by the remaining useful life.

Three depreciation methods are:

3 Distinguish between revenue and capital expenditures, and explain the entries for each. Companies incur revenue expenditures to maintain the operating efficiency and productive life of an asset. They debit these expenditures to Maintenance and Repairs Expense as incurred. Capital expenditures increase the operating efficiency, productive capacity, or expected useful life of the asset. Companies generally debit these expenditures to the plant asset affected.

4 Explain how to account for the disposal of a plant asset. The accounting for disposal of a plant asset through retirement or sale is as follows.

(a) Eliminate the book value of the plant asset at the date of disposal.

(b) Record cash proceeds, if any.

(c) Account for the difference between the book value and the cash proceeds as a gain or loss on disposal.

5 Compute periodic depletion of extractable natural resources. Companies compute depletion cost per unit by dividing the total cost of the natural resource minus residual value by the number of units estimated to be in the resource. They then multiply the depletion cost per unit by the number of units extracted and sold.

6 Explain the basic issues related to accounting for intangible assets. The process of allocating the cost of an intangible asset is referred to as amortization. The cost of intangible assets with indefinite lives are not amortized. Companies normally use the straight-line method for amortizing intangible assets.

7 Indicate how plant assets, natural resources, and intangible assets are reported. Companies usually combine plant assets and natural resources under property, plant, and equipment; they show intangibles separately under intangible assets. Either within the statement of financial position or in the notes to the financial statements, companies should disclose the balances of the major classes of assets, such as land, buildings, and equipment, and accumulated depreciation by major classes or in total. They also should describe the depreciation and amortization methods used, and should disclose the amount of depreciation and amortization expense for the period. The asset turnover ratio measures the productivity of a company's assets in generating sales.

GLOSSARY

Accelerated-depreciation method Depreciation method that produces higher depreciation expense in the early years than in the later years. (p. 418).

Additions and improvements Costs incurred to increase the operating efficiency, productive capacity, or useful life of a plant asset. (p. 422).

Amortization The allocation of the cost of an intangible asset to expense over its useful life in a systematic and rational manner. (p. 428).

Asset turnover ratio A measure of how efficiently a company uses its assets to generate sales; calculated as net sales divided by average total assets. (p. 432).

Capital expenditures Expenditures that increase the company's investment in productive facilities. (p. 422).

Component depreciation Depreciation method in which any significant parts of a plant asset that have significantly different useful lives are separately depreciated. (p. 420).

Copyrights Exclusive grant from the government that allows the owner to reproduce and sell an artistic or published work. (p. 429).

Declining-balance method Depreciation method that applies a constant rate to the declining book value of the asset and produces a decreasing annual depreciation expense over the useful life of the asset. (p. 417).

Depletion The allocation of the cost of an extractable natural resource to expense in a rational and systematic manner over the resource's useful life. (p. 426).

Depreciable cost The cost of a plant asset less its residual value. (p. 415).

Depreciation The process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systematic manner. (p. 413).

Franchise (license) A contractual arrangement under which the franchisor grants the franchisee the right to sell certain products, provide specific services, or use certain trademarks or trade names, usually within a designated geographic area. (p. 429).

Going-concern assumption States that the company will continue in operation for the foreseeable future. (p. 414).

Goodwill The value of all favorable attributes that relate to a company that is not attributable to any other specific asset. (p. 430).

Intangible assets Rights, privileges, and competitive advantages that result from the ownership of long-lived assets that do not possess physical substance. (p. 428).

Licenses Operating rights to use public property, granted to a business by a governmental agency. (p. 429).

Materiality concept If an item would not make a difference in decision-making, a company does not have to follow IFRS in reporting it. (p. 423).

Natural resources Assets that consist of standing timber and underground deposits of oil, gas, or minerals. (p. 426).

Ordinary repairs Expenditures to maintain the operating efficiency and productive life of the plant asset. (p. 422).

Patent An exclusive right issued by a patent office that enables the recipient to manufacture, sell, or otherwise control an invention for a specified number of years from the date of the grant. (p. 428).

Plant assets Tangible resources that are used in the operations of the business and are not intended for sale to customers. (p. 410).

Research and development (R&D) costs Expenditures that may lead to patents, copyrights, new processes, or new products. (p. 430).

Residual value An estimate of an asset's value at the end of its useful life. (p. 415).

Revenue expenditures Expenditures that are immediately charged against revenues as an expense. (p. 422).

Straight-line method Depreciation method in which periodic depreciation is the same for each year of the asset's useful life. (p. 415).

Trademark (trade name) A word, phrase, jingle, or symbol that identifies a particular enterprise or product. (p. 429).

Units-of-activity method Depreciation method in which useful life is expressed in terms of the total units of production or use expected from an asset. (p. 416).

Useful life An estimate of the expected productive life, also called service life, of an asset. (p. 414).

APPENDIX 9A EXCHANGE OF PLANT ASSETS

Ordinarily, companies record a gain or loss on the exchange of plant assets. The rationale for recognizing a gain or loss is that most exchanges have commercial substance. An exchange has commercial substance if the future cash flows change as a result of the exchange.

To illustrate, Ramos Co. exchanges some of its equipment for land held by Brodhead Inc. It is likely that the timing and amount of the cash flows arising from the land will differ significantly from the cash flows arising from the equipment. As a result, both Ramos and Brodhead are in different economic positions. Therefore, the exchange has commercial substance, and the companies recognize a gain or loss in the exchange. Because most exchanges have commercial substance (even when similar assets are exchanged), we illustrate only this type of situation, for both a loss and a gain.

Loss Treatment

To illustrate an exchange that results in a loss, assume that Roland Company exchanged a set of used trucks plus cash for a new semi-truck. The used trucks have a combined book value of €42,000 (cost €64,000 less €22,000 accumulated depreciation). Roland's purchasing agent, experienced in the second-hand market, indicates that the used trucks have a fair value of €26,000. In addition to the trucks, Roland must pay €17,000 for the semi-truck. Roland computes the cost of the semi-truck as follows.

Illustration 9A-1 Cost of semi-truck

Roland incurs a loss on disposal of plant assets of €16,000 on this exchange. The reason is that the book value of the used trucks is greater than the fair value of these trucks. The computation is as follows.

Illustration 9A-2 Computation of loss on disposal

In recording an exchange at a loss, three steps are required: (1) eliminate the book value of the asset given up, (2) record the cost of the asset acquired, and (3) recognize the loss on disposal of plant assets. Roland Company thus records the exchange on the loss as follows.

Gain Treatment

To illustrate a gain situation, assume that Mark Express Delivery decides to exchange its old delivery equipment plus cash of €3,000 for new delivery equipment. The book value of the old delivery equipment is €12,000 (cost €40,000 less accumulated depreciation €28,000). The fair value of the old delivery equipment is €19,000.

The cost of the new asset is the fair value of the old asset exchanged plus any cash paid (or other consideration given up). The cost of the new delivery equipment is €22,000, computed as follows.

Illustration 9A-3 Cost of new delivery equipment

A gain results when the fair value of the old delivery equipment is greater than its book value. For Mark Express, there is a gain of €7,000 on disposal of plant assets, computed as follows.

Illustration 9A-4 Computation of gain on disposal

Mark Express Delivery records the exchange as follows.

In recording an exchange at a gain, the following three steps are involved: (1) eliminate the book value of the asset given up, (2) record the cost of the asset acquired, and (3) recognize the gain on disposal of plant assets. Accounting for exchanges of plant assets becomes more complex if the transaction does not have commercial substance. This issue is discussed in more advanced accounting classes.

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 9A

8 Explain how to account for the exchange of plant assets. Ordinarily, companies record a gain or loss on the exchange of plant assets. The rationale for recognizing a gain or loss is that most exchanges have commercial substance. An exchange has commercial substance if the future cash flows change as a result of the exchange.