CHAPTER 9

REPORTING AND ANALYZING LONG-LIVED ASSETS

PREVIEW OF CHAPTER 9

For airlines and many other companies, making the right decisions regarding long-lived assets is critical because these assets represent huge investments. Management must make many ongoing decisions about long-lived assets—what assets to acquire and when, how to finance them, how to account for them, and when to dispose of them.

In this chapter, we address these and other issues surrounding long-lived assets. The discussion is in two parts: plant assets and intangible assets. Plant assets are the property, plant, and equipment (physical assets) that commonly come to mind when we think of what a company owns. Companies also have many important intangible assets. These assets, such as copyrights and patents, lack physical substance but can be extremely valuable and vital to a company's success.

The content and organization of this chapter are as follows.

Plant Assets

Plant assets are resources that have 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 called various names—property, plant, and equipment; plant and equipment; and fixed assets. By whatever name, these assets are expected to provide service to the company for a number of years. Except for land, plant assets decline in service potential (ability to produce revenue) over their useful lives.

Plant assets are critical to a company's success because they determine the company's capacity and therefore its ability to satisfy customers. With too few planes, for example, JetBlue Airways and Southwest Airlines would lose customers to their competitors. But with too many planes, they would be flying with empty seats. Management must constantly monitor its needs and acquire assets accordingly. Failure to do so results in lost business opportunities or inefficient use of existing assets and is likely to show up eventually in poor financial results.

It is important for a company to (1) keep assets in good operating condition, (2) replace worn-out or outdated assets, and (3) expand its productive assets as needed. The decline of rail travel in the United States can be traced in part to the failure of railroad companies to maintain and update their assets. Conversely, the growth of air travel in this country can be attributed in part to the general willingness of airline companies to follow these essential guidelines.

For many companies, investments in plant assets are substantial. Illustration 9-1 shows the percentages of plant assets in relation to total assets in various companies in a recent year.

DETERMINING THE COST OF PLANT ASSETS

The historical cost principle requires that companies record plant assets at cost. Thus, JetBlue Airways and Southwest Airlines record their planes at cost. Cost consists of all expenditures necessary to acquire an asset and make it ready for its intended use. For example, when Boeing buys equipment, the purchase price, freight costs paid by Boeing, and installation costs are all part of the cost of the equipment.

Determining which costs to include in a plant asset account and which costs not to include is very important. If a cost is not included in a plant asset account, then it must be expensed immediately. Such costs are referred to as revenue expenditures. On the other hand, costs that are not expensed immediately but are instead included in a plant asset account are referred to as capital expenditures. JetBlue reported capital expenditures of $480 million during 2011.

This distinction is important; it has immediate, and often material, implications for the income statement. Some companies, in order to boost current income, have improperly capitalized expenditures that they should have expensed. For example, suppose that a company improperly capitalizes to a building account $1,000 of maintenance costs incurred at the end of the year. (That is, the costs are included in the asset account Buildings rather than being expensed immediately as Maintenance and Repairs Expense.) If the company is allocating the cost of the building as an expense (depreciating it) over a 40-year life, then the maintenance cost of $1,000 will be incorrectly spread across 40 years instead of being expensed in the current year. As a result, the company will understate current-year expenses by approximately $1,000, and will overstate current-year income by approximately $1,000. Thus, determining which costs to capitalize and which to expense is very important.

Cost is measured by the cash paid in a cash transaction or by the cash equivalent price paid when companies use noncash assets in payment. The cash equivalent price is equal to the fair value of the asset given up or the fair value of the asset received, whichever is more clearly determinable. Once cost is established, it becomes the basis of accounting for the plant asset over its useful life. Current fair value is not used to increase the recorded cost after acquisition. We explain the application of the historical cost principle to each of the major classes of plant assets in the following sections.

Land

Companies often use land as a building site for a manufacturing plant or office site. 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 on the land 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.

All necessary costs incurred in making land ready for its intended use increase (debit) the Land account. When a company acquires vacant land, its cost includes expenditures for clearing, draining, filling, and grading. If the land has a building on it that must be removed to make the site suitable for construction of a new building, the company includes all demolition and removal costs, less any proceeds from salvaged materials, in the Land account.

To illustrate, assume that Hayes Company acquires real estate at a cash cost of $100,000. The property contains an old warehouse that is razed at a net cost of $6,000 ($7,500 in costs less $1,500 proceeds from salvaged materials). Additional expenditures are for the attorney's fee $1,000 and the real estate broker's commission $8,000. Given these factors, the cost of the land is $115,000, computed as shown in Illustration 9-2.

When Hayes records the acquisition, it debits Land and credits Cash for $115,000.

Land Improvements

Land improvements are structural additions made to land, such as 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 company parking lot includes the amount paid for paving, fencing, and lighting. Thus, the company would debit the total of all of these costs to Land Improvements.

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 charge to the Buildings account all necessary expenditures relating 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 consist of expenditures for remodeling rooms and offices and replacing or repairing the roof, floors, electrical wiring, and plumbing. When a new building is constructed, its cost consists of the contract price plus payments made by the owner for architects' fees, building permits, and excavation costs.

In addition, companies add certain interest costs to the cost of a building. Interest costs incurred to finance a construction project are included in the cost of the asset when a significant period of time is required to get the asset 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 interest costs incurred during the construction period. When construction has been completed, subsequent interest payments on funds borrowed to finance the construction are recorded as increases (debits) to Interest Expense.

Equipment

Equipment includes assets used in operations, such as store check-out counters, office furniture, factory machinery, and delivery trucks. JetBlue Airways' equipment includes aircraft, in-flight entertainment systems, and trucks for ground operations. 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. However, companies treat as expenses the costs of motor vehicle licenses and accident insurance on company trucks and cars. Such items are annual recurring expenditures and do not benefit future periods. Two criteria apply in determining the cost of equipment: (1) the frequency of the cost—one time or recurring, and (2) the benefit period—the life of the asset or one year.

To illustrate, assume that Lenard Company purchases a delivery truck at a cash price of $22,000. Related expenditures are 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, computed as shown in Illustration 9-3.

Lenard treats the cost of a motor vehicle license as an expense and the cost of an insurance policy as a prepaid asset. Thus, the company records the purchase of the truck and related expenditures as follows.

For another example, assume Merten Company purchases factory machinery at a cash price of $50,000. Related expenditures are sales taxes $3,000, insurance during shipping $500, and installation and testing $1,000. The cost of the factory machinery is $54,500, computed as in Illustration 9-4.

Thus, Merten records the purchase and related expenditures as follows.

TO BUY OR LEASE?

In this chapter, we focus on purchased assets, but we want to expose you briefly to an alternative—leasing. A lease is a contractual agreement in which the owner of an asset (the lessor) allows another party (the lessee) to use the asset for a period of time at an agreed price. In many industries, leasing is quite common. For example, one-third of heavy-duty commercial trucks are leased.

Some advantages of leasing an asset versus purchasing it are:

1. Reduced risk of obsolescence. Frequently, lease terms allow the party using the asset (the lessee) to exchange the asset for a more modern one if it becomes outdated. This is much easier than trying to sell an obsolete asset.
2. Little or no down payment. To purchase an asset, most companies must borrow money, which usually requires a down payment of at least 20%. Leasing an asset requires little or no down payment.
3. Shared tax advantages. Startup companies typically earn little or no profit in their early years, and so they have little need for the tax deductions available from owning an asset. In a lease, the lessor gets the tax advantage because it owns the asset. It often will pass these tax savings on to the lessee in the form of lower lease payments.
4. Assets and liabilities not reported. Many companies prefer to keep assets and especially liabilities off their books. Reporting lower assets improves the return on assets (discussed later in this chapter). Reporting fewer liabilities makes the company look less risky. Certain types of leases, called operating leases, allow the lessee to account for the transaction as a rental, with neither an asset nor a liability recorded.

Airlines often choose to lease many of their airplanes in long-term lease agreements. In recent financial statements, JetBlue Airways stated that it leased 60 of its 169 planes under operating leases. Because operating leases are accounted for as rentals, these 60 planes were not presented on its balance sheet.

Under another type of lease, a capital lease, lessees show both the asset and the liability on the balance sheet. The lessee accounts for capital lease agreements in a way that is very similar to debt-financed purchases: The lessee shows the leased item as an asset on its balance sheet, and the obligation owed to the lessor as a liability. The lessee depreciates the leased asset in a manner similar to purchased assets. Only four of JetBlue's aircraft were held under capital leases. We discuss leasing further in Chapter 10.

Accounting for Plant Assets

DEPRECIATION

As explained in Chapter 4, 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. Such cost allocation is designed to properly match expenses with revenues. (See Illustration 9-5.)

Depreciation affects the balance sheet through accumulated depreciation, which companies report as a deduction from plant assets. It affects the income statement through depreciation expense.

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

Depreciation applies to three classes of plant assets: land improvements, buildings, and equipment. Each of these classes is considered to be a depreciable asset because the usefulness to the company and the revenue-producing ability of each class decline over the asset's useful life. Depreciation does not apply to land because its usefulness and revenue-producing ability generally remain intact as long as the land is owned. In fact, in many cases, the usefulness of land increases over time because of the scarcity of good 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.

A decline in revenue-producing ability may also occur because of obsolescence. Obsolescence is the process by which an asset becomes out of date before it physically wears out. The rerouting of major airlines from Chicago's Midway Airport to Chicago-O'Hare International Airport because Midway's runways were too short for giant jets is an example. Similarly, many companies replace their computers long before they originally planned to do so because improvements in new computers make their old computers obsolete.

Recognizing depreciation for an asset does not result in the 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 to date; it is not a cash fund.

FACTORS IN COMPUTING DEPRECIATION

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

1. Cost. Earlier in the chapter, we explained the considerations that affect the cost of a depreciable asset. Remember 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, repair and maintenance policies, and vulnerability of the asset to obsolescence. The company's past experience with similar assets is often helpful in deciding on expected useful life.
3. Salvage value. Salvage value is an estimate of the asset's value at the end of its useful life for its owner. Companies may base the value on the asset's worth as scrap or on its expected trade-in value. Like useful life, salvage 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

Although a number of methods exist, depreciation is generally computed using one of three methods:

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

Like the alternative inventory methods discussed in Chapter 6, each of these depreciation methods is acceptable under generally accepted accounting principles. Management selects the method it believes best measures an asset's contribution to revenue over its useful life. Once a company chooses a method, it should apply that method consistently over the useful life of the asset. Consistency enhances the ability to analyze financial statements over multiple years.

Illustration 9-7 shows the distribution of the primary depreciation methods in a sample of the largest U.S. companies. Clearly, straight-line depreciation is the most widely used approach. In fact, because some companies use more than one method, straight-line depreciation is used for some or all of the depreciation taken by more than 95% of U.S. companies. For this reason, we illustrate procedures for straight-line depreciation and discuss the alternative depreciation approaches only at a conceptual level. This coverage introduces you to the basic idea of depreciation as an allocation concept without entangling you in too much procedural detail. (Also, note that many hand-held calculators are preprogrammed to perform the basic depreciation methods.) Details on the alternative approaches are presented in Appendix 9A (pages 476–478).

Our illustration of depreciation methods, both here and in the appendix, is based on the following data relating to a small delivery truck purchased by Bill's Pizzas on January 1, 2014.

Straight-Line

Under the straight-line method, companies expense an equal amount of depreciation each year of the asset's useful life. Management must choose the useful life of an asset based on its own expectations and experience.

To compute the annual depreciation expense, we divide depreciable cost by the estimated useful life. Depreciable cost represents the total amount subject to depreciation; it is calculated as the cost of the plant asset less its salvage value. Illustration 9-8 shows the computation of depreciation expense in the first year for Bill's Pizzas' delivery truck.

Alternatively, we can compute an annual rate at which the company depreciates the delivery truck. In this case, the rate is 20% (100% ÷ 5 years). When an annual rate is used under the straight-line method, the company applies the percentage rate to the depreciable cost of the asset, as shown in the depreciation schedule in Illustration 9-9.

Note that the depreciation expense of $2,400 is the same each year. The book value at the end of the useful life is equal to the estimated $1,000 salvage value.

What happens when an asset is purchased during the year, rather than on January 1 as in our example? In that case, it is necessary to prorate the annual depreciation for the portion of a year used. If Bill's Pizzas had purchased the delivery truck on April 1, 2014, the company would use the truck for 9 months in 2014. The depreciation for 2014 would be $1,800 ($12,000 × 20% × of a year).

As indicated earlier, the straight-line method predominates in practice. For example, such large companies as Campbell Soup, Marriott, and General Mills use the straight-line method. It is simple to apply, and it matches expenses with revenues appropriately when the use of the asset is reasonably uniform throughout the service life. The types of assets that give equal benefits over useful life generally are those for which daily use does not affect productivity. Examples are office furniture and fixtures, buildings, warehouses, and garages for motor vehicles.

Declining-Balance

The declining-balance method computes depreciation expense using a constant rate applied to a declining book value. This method is called an accelerated-depreciation method because it results in higher depreciation in the early years of an asset's life than does the straight-line approach. However, because the total amount of depreciation (the depreciable cost) taken over an asset's life is the same no matter what approach is used, the declining-balance method produces a decreasing annual depreciation expense over the asset's useful life. In early years, declining-balance depreciation expense will exceed straight-line, but in later years, it will be less than straight-line. Managers might choose an accelerated approach if they think that an asset's utility will decline quickly.

Companies can apply the declining-balance approach at different rates, which result in varying speeds of depreciation. A common declining-balance rate is double the straight-line rate. Using that rate, the method is referred to as the double-declining-balance method.

If we apply the double-declining-balance method to Bill's Pizzas' delivery truck, assuming a five-year life, we get the pattern of depreciation shown in Illustration 9-10. Illustration 9A-2, page 477, presents the computations behind these numbers. Again, note that total depreciation over the life of the truck is $12,000, the depreciable cost.

Units-of-Activity

As indicated earlier, useful life can be expressed in ways other than a time period. Under the units-of-activity method, useful life is expressed in terms of the total units of production or the use expected from the asset. The units-of-activity method is ideally suited to factory machinery: Companies can measure production in terms of units of output or in terms of machine hours used in operating the machinery. It is also possible to use the method for such items as delivery equipment (miles driven) and airplanes (hours in use). The units-of-activity method is generally not suitable for such assets as buildings or furniture because activity levels are difficult to measure for these assets.

Applying the units-of-activity method to the delivery truck owned by Bill's Pizzas, we first must know some basic information. Bill's expects to be able to drive the truck a total of 100,000 miles. Illustration 9-11 shows depreciation over the five-year life based on an assumed mileage pattern. Illustration 9A-4, page 478, presents the computations used to arrive at these results.

As the name implies, under units-of-activity depreciation, the amount of depreciation is proportional to the activity that took place during that period. For example, the delivery truck was driven twice as many miles in 2015 as in 2014, and depreciation was exactly twice as much in 2015 as it was in 2014.

Management's Choice: Comparison of Methods

Illustration 9-12 (page 458) compares annual and total depreciation expense for Bill's Pizzas under the three methods.

Annual depreciation expense varies considerably among the methods, but total depreciation expense is the same ($12,000) for the five-year period. Each method is acceptable in accounting because each recognizes the decline in service potential of the asset in a rational and systematic manner. Illustration 9-13 graphs the depreciation expense pattern under each method.

Depreciation and Income Taxes

The Internal Revenue Service (IRS) allows corporate taxpayers to deduct depreciation expense when computing taxable income. However, the tax regulations of the IRS do not require the taxpayer to use the same depreciation method on the tax return that it uses in preparing financial statements.

Consequently, many large corporations use straight-line depreciation in their financial statements in order to maximize net income; at the same time, they use a special accelerated-depreciation method on their tax returns in order to minimize their income taxes. For tax purposes, taxpayers must use on their tax returns either the straight-line method or a special accelerated-depreciation method called the Modified Accelerated Cost Recovery System (MACRS).

Depreciation Disclosure in the Notes

Companies must disclose the choice of depreciation method in their financial statements or in related notes that accompany the statements. Illustration 9-14 shows excerpts from the “Property and equipment” notes from the financial statements of Southwest Airlines.

From this note, we learn that Southwest Airlines uses the straight-line method to depreciate its planes over periods of 20 to 25 years.

REVISING PERIODIC DEPRECIATION

Management should periodically review annual depreciation expense. If wear and tear or obsolescence indicates that annual depreciation is either inadequate or excessive, the company should change the depreciation expense amount.

When a change in an estimate is required, the company makes the change in current and future years but not to prior periods. Thus, when making the change, the company (1) does not correct previously recorded depreciation expense, but (2) revises depreciation expense for current and future years. The rationale for this treatment is that continual restatement of prior periods would adversely affect users' 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 Bill's Pizzas decides at the end of 2017 (prior to the year-end adjusting entries) to extend the estimated 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 (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, computed on December 31, 2017, as follows.

Bill's Pizzas does not make a special 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 disclose in the financial statements significant changes in estimates. Although a company may have a legitimate reason for changing an estimated life, financial statement users should be aware that some companies might change an estimate simply to achieve financial statement goals. For example, extending an asset's estimated life reduces depreciation expense and increases current period income.

In a recent year, AirTran Airways (now owned by Southwest Airlines) increased the estimated useful lives of some of its planes from 25 to 30 years and increased the estimated lives of related aircraft parts from 5 years to 30 years. It disclosed that the change in estimate decreased its net loss for the year by approximately $0.6 million, or about $0.01 per share. Whether these changes were appropriate depends on how reasonable it is to assume that planes will continue to be used for a long time. Our Feature Story suggests that although in the past many planes lasted a long time, it is also clear that because of high fuel costs, airlines are now scrapping many of their old, inefficient planes.

EXPENDITURES DURING USEFUL LIFE

During the useful life of a plant asset, a company may incur costs for ordinary repairs, additions, and improvements. Ordinary repairs are expenditures to maintain the operating efficiency and expected productive life of the unit. They usually are fairly small amounts that occur frequently throughout the service life. Examples are motor tune-ups and oil changes, the painting of buildings, and the replacing of worn-out gears on factory machinery. Ordinary repairs are debited to Maintenance and Repairs Expense as incurred.

In contrast, additions and improvements are costs incurred to increase the operating efficiency, productive capacity, or expected useful life of the plant asset. These expenditures are usually material in amount and occur infrequently during the period of ownership. Expenditures for additions and improvements increase the company's investment in productive facilities and are generally debited to the plant asset affected. Thus, they are capital expenditures. The accounting for capital expenditures varies depending on the nature of the expenditure.

Northwest Airlines at one time spent $120 million to spruce up 40 jets. The improvements were designed to extend the lives of the planes, meet stricter government noise limits, and save money. The capital expenditure was expected to extend the life of the jets by 10 to 15 years and save about $560 million compared to the cost of buying new planes. The jets were, on average, 24 years old.

IMPAIRMENTS

As noted earlier, the book value of plant assets is rarely the same as the fair value. In instances where the value of a plant asset declines substantially, its fair value might fall materially below book value. This may happen because a machine has become obsolete, or the market for the product made by the machine has dried up or has become very competitive. A permanent decline in the fair value of an asset is referred to as an impairment. So as not to overstate the asset on the books, the company writes the asset down to its new fair value during the year in which the decline in value occurs. Recently, Disney recorded a $200 million write-down on its action movie John Carter. Disney spent more than $300 million producing the film.

In the past, some companies improperly delayed recording losses on impairments until a year when it was “convenient” to do so—when the impact on the company's reported results was minimized. For example, in a year when a company has record profits, it can afford to write down some of its bad assets without hurting its reported results too much. As discussed in Chapter 4, the practice of timing the recognition of gains and losses to achieve certain income results is known as earnings management. Earnings management reduces earnings quality. To minimize earnings management, accounting standards now require immediate loss recognition on impaired assets.

Write-downs can create problems for users of financial statements. Critics of write-downs note that after a company writes down assets, its depreciation expense will be lower in all subsequent periods. Some companies improperly inflate asset write-downs in bad years, when they are going to report poor results anyway. (This practice is referred to as “taking a big bath.”) Then in subsequent years, when the company recovers, its results will look even better because of lower depreciation expense.

PLANT ASSET DISPOSALS

Companies dispose of plant assets that are no longer useful to them. Illustration 9-16 shows the three ways in which companies make plant asset disposals.

Whatever the disposal method, the company must determine the book value of the plant asset at the time of disposal in order 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 prior to the end of 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.

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 from the sale exceed the book value of the plant asset, a gain on disposal occurs. If the proceeds from 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 at the time the asset is sold. Gains and losses on sales of plant assets are therefore quite common. As an example, Delta Air Lines reported a $94 million gain on the sale of five Boeing B-727-200 aircraft and five Lockheed L-1011-1 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 and as of January 1, 2014, 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 as follows.

After the accumulated depreciation balance is updated, the company computes the gain or loss as the difference between the proceeds from sale and the book value at the date of disposal. Wright Company has a gain on disposal of $5,000, as computed in Illustration 9-17.

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

Companies report a gain on disposal of plant assets in the “Other revenues and gains” section of the income statement. Recently, the shares of Sears Holdings Corporation rose 19% when the company announced its intention to sell 1,200 stores to raise cash.

LOSS ON SALE. Assume that instead of selling the office furniture for $16,000, Wright sells it for $9,000. In this case, Wright experiences a loss of $2,000, as computed in Illustration 9-18.

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

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

Retirement of Plant Assets

Companies simply retire, rather than sell, some assets at the end of their useful life. For example, some productive assets used in manufacturing may have very specific uses, and they consequently have no ready market when the company no longer needs them. In such a case, the asset is simply retired.

Companies record retirement of an asset as a special case of a disposal where no cash is received. They decrease (debit) Accumulated Depreciation for the full amount of depreciation taken over the life of the asset and decrease (credit) the asset account for the original cost of the asset. The loss (a gain is not possible on a retirement) is equal to the asset's book value on the date of retirement.¹

Analyzing Plant Assets

The presentation of financial statement information about plant assets enables decision makers to analyze the company's use of its plant assets. We will use two measures to analyze plant assets: return on assets and asset turnover. We also show how profit margin relates to both.

RETURN ON ASSETS

An overall measure of profitability is the return on assets. This ratio is computed by dividing net income by average assets. (Average assets are commonly calculated by adding the beginning and ending values of assets and dividing by 2.) Return on assets indicates the amount of net income generated by each dollar of assets. Thus, the higher the return on assets, the more profitable the company.

Information is provided below related to JetBlue Airways.

Illustration 9-19 presents the 2011 and 2010 return on assets of JetBlue Airways, Southwest Airlines, and industry averages.

JetBlue's return on assets was better than that of Southwest's but significantly lower than the airline industry. The airline industry has experienced financial difficulties in recent years as it attempted to cover high labor, fuel, and security costs while offering fares low enough to attract customers. Such difficulties are reflected in the low industry average for return on assets and the very low values for JetBlue and Southwest. Recently, Southwest announced that it would not add additional planes beyond the 700 it already had until it met its investment-return targets. Instead, the company is adding seats to existing planes and replacing some smaller planes with larger ones.

ASSET TURNOVER

Asset turnover indicates how efficiently a company uses its assets to generate sales—that is, how many dollars of sales a company generates for each dollar invested in assets. It is calculated by dividing net sales by average total assets. When we compare two companies in the same industry, the one with the higher asset turnover is operating more efficiently. It is generating more sales per dollar invested in assets. Illustration 9-20 presents the asset turnovers for JetBlue Airways and Southwest Airlines.

These asset turnover values tell us that for each dollar of assets, JetBlue generates sales of $0.66 and Southwest $0.93. Southwest is more successful in generating sales per dollar invested in assets. The average asset turnover for the airline industry is 0.80 times. In recent years, airlines have reduced both the number of planes used and routes flown to try to pack more customers on a plane. This would increase the asset turnover.

Asset turnovers vary considerably across industries. During a recent year, the average asset turnover for electric utility companies was 0.34. The grocery industry had an average asset turnover of 2.89. Asset turnover values, therefore, are only comparable within—not between—industries.

PROFIT MARGIN REVISITED

In Chapter 5, you learned about profit margin. That ratio is calculated by dividing net income by net sales. It tells how effective a company is in turning its sales into income—that is, how much income each dollar of sales provides. Illustration 9-21 shows that return on assets can be computed as the product of profit margin and asset turnover.

This relationship has very important strategic implications for management. From Illustration 9-21, we can see that if a company wants to increase its return on assets, it can do so in two ways: (1) by increasing the margin it generates from each dollar of goods that it sells (the profit margin), or (2) by increasing the volume of goods that it sells (the asset turnover). For example, most grocery stores have very low profit margins, often in the range of 1 or 2 cents for every dollar of goods sold. Grocery stores, therefore, focus on asset turnover: They rely on high turnover to increase their return on assets. Alternatively, a store selling luxury goods, such as expensive jewelry, doesn't generally have a high turnover. Consequently, a seller of luxury goods focuses on having a high profit margin. Recently, Apple decided to offer a less expensive version of its popular iPod. This new product would provide a lower margin, but higher volume, than Apple's more expensive version.

Let's evaluate the return on assets of JetBlue Airways for 2011 by evaluating its components—profit margin and asset turnover. See Illustration 9-22.

JetBlue's return on asset of 1.3% versus Southwest's 1.1% means that JetBlue generates 1.3 cents per each dollar invested in assets, while Southwest generates 1.1 cents. Illustration 9-22 reveals that although these two airlines have similar return on asset values, they achieve this return in a slightly different fashion. First, JetBlue's profit margin of 1.9% versus Southwest's of 1.2% means that for every dollar of sales, JetBlue generates approximately 1.9 cents of net income, while Southwest generates approximately 1.2 cents. Second, JetBlue's asset turnover of 0.66 means that it generates 66 cents of sales per each dollar invested in assets, while Southwest generates 93 cents. Therefore, in 2011, Southwest was more effective at generating sales from its assets, while JetBlue was better at deriving profit from those sales.

Intangible Assets

Intangible assets are rights, privileges, and competitive advantages that result from ownership of long-lived assets that do not possess physical substance. Many companies' most valuable assets are intangible. Some widely known intangibles are Microsoft's patents, McDonalds's franchises, the trade name iPod, and Nike's trademark “swoosh.”

Analysts estimated that in the early 1980s, the fair value of intangible assets to total assets was close to 40%. By 2000, the percentage was over 80%—quite a difference. What has happened is that research and development (e.g., hi-tech and bio-tech) has grown substantially. At the same time, many companies (e.g., Nike and Microsoft) have developed brand power which enables them to maintain their market position.

As you will learn in this section, financial statements do report numerous intangibles. Yet, many other financially significant intangibles are not reported. To give an example, according to its financial statements in a recent year, Google had total stockholders' equity of $22.7 billion. But its market value—the total market price of all its shares on that same date—was roughly $178.5 billion. Thus, its actual market value was about $155.8 billion greater than the amount reported for stockholders' equity on the balance sheet. It is not uncommon for a company's reported book value to differ from its market value because balance sheets are reported at historical cost. But such an extreme difference seriously diminishes the usefulness of the balance sheet to decision-makers. In the case of Google, the difference is due to unrecorded intangibles. For many high-tech or so-called intellectual-property companies, most of their value is from intangibles, many of which are not reported under current accounting rules.

Intangibles may be evidenced by contracts, licenses, and other documents. 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 to expense 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. 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 $60,000 on June 30. If National estimates the useful life of the patent to be eight years, the annual amortization expense is $7,500 ($60,000 ÷ 8) per year. National records $3,750 ($7,500 × ) of amortization for the six-month period ended December 31 as follows.

When a company has significant intangibles, analysts should evaluate the reasonableness of the useful life estimates that the company discloses in the notes to its financial statements. In determining useful life, the company should consider obsolescence, inadequacy, and other factors. These may cause a patent or other intangible to become economically ineffective before the end of its legal life.

For example, suppose Intel obtained a patent on a new computer chip it had developed. The legal life of the patent is 20 years. From experience, however, we know that the useful life of a computer chip patent is rarely more than five years. Because new superior chips are developed so rapidly, existing chips become obsolete. Consequently, we would question the amortization expense of Intel if it amortized its patent on a computer chip for a life significantly longer than a five-year period. Amortizing an intangible over a period that is too long will understate amortization expense, overstate Intel's net income, and overstate its assets.

TYPES OF INTANGIBLE ASSETS

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. 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. Most patents are subject to some type of litigation by competitors. A well-known example is the patent infringement suit brought by Amazon.com against Barnes & Noble.com regarding its online shopping software. If the owner incurs legal costs in successfully defending the patent in an infringement suit, such costs are considered necessary to establish the validity of the patent. Thus, the owner adds those costs to the Patent account and amortizes them over the remaining life of the patent.

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) in an ongoing effort to develop new products or processes. For example, in a recent year IBM spent over $5.1 billion on research and development. There are uncertainties in identifying the extent and timing of the future benefits of these expenditures. As a result, companies usually record research and development costs as an expense when incurred, whether the R&D is successful or not.

To illustrate, assume that Laser Scanner Company spent $3 million on research and development that resulted in two highly successful patents. It spent $20,000 on legal fees for the patents. It can include the legal fees in the cost of the patents but cannot include the R&D costs in the cost of the patents. Instead, Laser Scanner records the R&D costs as an expense when incurred.

Many disagree with this accounting approach. They argue that to expense these costs leads to understated assets and net income. Others argue that capitalizing these costs would lead to highly speculative assets on the balance sheet. Who is right is difficult to determine.

Copyrights

The federal government grants copyrights, which give the owner the exclusive right to reproduce and sell an artistic or published work. Copyrights last for the life of the creator plus 70 years. The cost of the copyright consists of 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 a great deal more if a copyright is acquired from another party. The useful life of a copyright generally is significantly shorter than its legal life.

Trademarks and Trade Names

A trademark or trade name is a word, phrase, jingle, or symbol that distinguishes or identifies a particular enterprise or product. Trade names like Wheaties, Monopoly, Sunkist, Kleenex, Coca-Cola, Big Mac, and Jeep create immediate product identification and generally enhance the sale of the product. The creator or original user may obtain the exclusive legal right to the trademark or trade name by registering it with the U.S. Patent Office. Such registration provides 20 years' protection and may be renewed indefinitely as long as the trademark or trade name is in use.

If a company purchases the trademark or trade name, the cost is the purchase price. If the company develops the trademark or trade name itself, the cost includes attorney's fees, registration fees, design costs, successful legal defense costs, and other expenditures directly related to securing it. Because trademarks and trade names have indefinite lives, they are not amortized.

Franchises

When you purchase a RAV4 from a Toyota dealer, fill up your tank at the corner Shell station, eat lunch at Subway, or make reservations at a Marriott hotel, you are dealing with franchises. A franchise is a contractual arrangement under which the franchisor grants the franchisee the right to sell certain products, to perform specific services, or to use certain trademarks or trade names, usually within a designated geographic area.

Another type of franchise is a license. Licenses granted by a governmental body permit a business to use public property in performing its services. Examples are the use of city streets for a bus line or taxi service; the use of public land for telephone, electric, and cable television lines; and the use of airwaves for radio or TV broadcasting. In a recent license agreement, Fox, CBS, and NBC agreed to pay $27.9 billion for the right to broadcast NFL football games over an eight-year period.

Franchises and licenses may be granted for a definite period of time, or the time period may be indefinite or perpetual. When a company can identify costs with the acquisition of the franchise or license, it should recognize an intangible asset. Companies record as operating expenses annual payments made under a franchise agreement in the period in which they are incurred. In the case of a limited life, a company amortizes the cost of a franchise (or license) as operating expense over the useful life. If the life is indefinite or perpetual, the cost is not amortized.

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, fair pricing policies, and harmonious relations with labor unions. Goodwill is unique because unlike other assets such as investments, plant assets, and even other intangibles, 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 it be determined? Certainly, many business enterprises have many of the factors cited above (exceptional management, desirable location, and so on). However, to determine the amount of goodwill in these situations would be difficult and very subjective. In other words, to recognize goodwill without an exchange transaction that puts a value on the goodwill would lead to subjective valuations that do not contribute to the reliability of financial statements. Therefore, companies record goodwill only when there is an exchange transaction that involves the purchase of an entire business. When an entire business is purchased, 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, a company debits the identifiable acquired assets and credits liabilities at their fair values, credits cash for the purchase price, and records the difference as the cost of goodwill. Goodwill is not amortized because it is considered to have an indefinite life. However, it must be written down if a company determines the value of goodwill has been permanently impaired.

Financial Statement Presentation of Long-Lived Assets

Usually, companies show plant assets in the financial statements under “Property, plant, and equipment,” and they show intangibles separately under “Intangible assets.” Illustration 9-23 shows a typical balance sheet presentation of long-lived assets, adapted from a recent The Coca-Cola Company balance sheet.

Intangibles do not usually use a contra asset account like the contra asset account Accumulated Depreciation used for plant assets. Instead, companies record amortization of intangibles as a direct decrease (credit) to the asset account.

Either within the balance sheet or in the notes, companies should disclose the balances of the major classes of assets, such as land, buildings, and equipment, and of accumulated depreciation by major classes or in total. In addition, they should describe the depreciation and amortization methods used and disclose the amount of depreciation and amortization expense for the period.