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Financial Accounting Unit 8: Long-Term Assets and Depreciation

Long-term operating assets such as equipment, buildings, natural resources and intangibles provide benefits for many years. This unit covers measuring their cost, depreciating or amortizing it, and recording disposals and impairments.

Covers: Cost of plant assets, Capital vs revenue expenditures, Straight-line, units-of-activity and DDB, Partial years and changes in estimates, Disposals and exchanges, Impairment, Natural resources and depletion, Intangibles, goodwill and R&D

Study guide

Property, plant and equipment (PP&E) are tangible assets used in operations for more than one year. They are recorded at cost, which includes every expenditure needed to acquire the asset and get it ready for its intended use. For equipment that means the price, sales tax, freight, installation and testing; insurance after the asset is in service is an expense. Land cost includes the price, legal and title fees, and the cost of removing old buildings, minus any salvage proceeds. Land improvements such as parking lots and fences are recorded separately because, unlike land, they wear out. When several assets are bought for one price, the cost is split by relative fair values.

Depreciation allocates the cost of PP&E, minus its salvage value, over its useful life. It is not a valuation process and does not create cash. Straight-line depreciation equals (cost − salvage) ÷ life, giving the same expense each year. Units-of-activity computes a rate per unit (per mile, hour or product) and multiplies by actual use. Double-declining-balance (DDB) multiplies the asset's beginning book value by twice the straight-line rate, ignoring salvage in the calculation but never depreciating below it. All methods produce the same total depreciation; they differ only in timing. Assets bought or sold mid-year are depreciated for the months they were used.

Companies must decide whether a later expenditure is capitalized or expensed. Ordinary repairs that keep an asset in normal condition, such as oil changes, are expensed. Capital expenditures, such as a new engine, an addition or a major overhaul, increase useful life, capacity or efficiency and are added to the asset. When estimates of life or salvage change, the company does not restate past years; instead it spreads the remaining book value minus the new salvage over the remaining life. If events show an asset's carrying amount may not be recoverable, GAAP requires an impairment test: if undiscounted future cash flows are below the carrying amount, write the asset down to fair value.

When an asset is sold, retired or exchanged, first record depreciation up to the disposal date. Then remove the asset's cost and its accumulated depreciation. Compare cash or fair value received with book value: receiving more gives a gain, less gives a loss. In an exchange with commercial substance, the new asset is recorded at the fair value of what was given up (old asset plus cash), and any gain or loss is recognized. Natural resources such as oil, minerals and timber are depleted using a per-unit rate: (cost − residual value) ÷ estimated units. Depletion on units extracted but not sold stays in inventory until sale.

Intangible assets lack physical substance but provide legal or economic rights. Patents, copyrights, trademarks and franchises are recorded at acquisition cost. Those with limited lives are amortized, usually straight-line, over the shorter of legal life and useful life. Those with indefinite lives, such as goodwill and some trademarks, are not amortized but are tested for impairment. Goodwill arises only when one company buys another and pays more than the fair value of the identifiable net assets. Research and development costs are expensed as incurred under U.S. GAAP. Analysts measure how well assets are used with asset turnover (net sales ÷ average total assets) and return on assets (net income ÷ average total assets).

Key ideas

• Capitalize all costs necessary to get an asset ready for use; expense costs after it is in service.
• Land is not depreciated, but land improvements are.
• Straight-line, units-of-activity and DDB give the same total depreciation but different timing.
• Changes in estimated life or salvage affect only current and future depreciation.
• On disposal, update depreciation, remove cost and accumulated depreciation, and record a gain or loss.
• Limited-life intangibles are amortized; goodwill is tested for impairment instead.
• R&D is expensed as incurred under U.S. GAAP.

Formulas and rules

Common mistakes

• Subtracting salvage value before applying the DDB rate.
• Forgetting to record depreciation up to the date of sale before computing a gain or loss.
• Restating prior years' depreciation when an estimate changes.
• Capitalizing routine repairs or first-year insurance.
• Amortizing a patent over its legal life when its useful life is shorter.

Before the test, make sure you can

• Determine which costs are capitalized for land, buildings, equipment and land improvements.
• Calculate depreciation under straight-line, units-of-activity and double-declining-balance, including partial years.
• Revise depreciation after a change in useful life or salvage value.
• Record the sale, retirement or exchange of an asset and compute the gain or loss.
• Compute depletion and amortization, and identify assets that are not amortized.
• Measure goodwill in a business acquisition and an impairment loss.
• Calculate and interpret asset turnover and return on assets.

Words to know

Property, plant and equipment

Tangible long-lived assets used in operations, such as land, buildings and machinery.

Capital expenditure

A cost that increases an asset's life, capacity or efficiency and is added to the asset account.

Ordinary repair

A routine cost to maintain an asset's operating condition; expensed when incurred.

Depreciation

The systematic allocation of a tangible asset's cost, less salvage, over its useful life.

Salvage value

The estimated amount an asset will be worth at the end of its useful life.

Straight-line method

Depreciation of an equal amount each year: (cost − salvage) ÷ life.

Units-of-activity method

Depreciation based on actual usage, such as miles driven or hours operated.

Double-declining-balance

An accelerated method that applies twice the straight-line rate to beginning book value.

Book value

Cost minus accumulated depreciation (or amortization).

Impairment

A permanent decline in an asset's value below its carrying amount, requiring a write-down to fair value.

Depletion

The allocation of a natural resource's cost to the units extracted.

Amortization

The allocation of a limited-life intangible asset's cost over its useful life.

Patent

An exclusive right to make, use and sell an invention, with a 20-year legal life.

Goodwill

The excess of the price paid for a business over the fair value of its identifiable net assets.

Commercial substance

An exchange that changes a company's future cash flows; gains and losses on such exchanges are recognized.

Lump-sum purchase

Buying several assets for one price, allocated by their relative fair values.

Return on assets

Net income divided by average total assets.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.