References Keiso text chapter 10 pages 481- 482, 501 – 502,
Larson text chapter 10 and 11When you have studied this topic, try an interactive quiz
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This category includes assets like land, building and equipment. Capital assets and fixed assets are other names for property, plant and equipment.
They are used in operations (and are not for resale).
They are long term assets that will be depreciated (Land is the only asset in this category that is not depreciated because it is never used up).
They have physical substance. (long term assets that do not have physical substance are called "intangibles")
Cost = the price of purchasing the asset plus any costs needed to bring the asset to the appropriate location and get it ready for use. These costs are included in the account balance (capitalized) and are depreciated over time as we use the asset to earn revenue. (this treatment follows the matching principle) Depreciation also follows the going concern principle since we assume that the asset will be used in the business for a long period of time.
Unnecessary costs are expensed. For example, if an asset is dropped while it is being delivered and some money is spent to make repairs, this cost is expensed – not added to the cost of the asset because it is not necessary.
When land is purchased for use as a building site, all the costs needed to get the land ready to use would be included in the cost of the land:
Examples:
 | Real estate commission |
| Survey fees |
| Legal fees |
| Costs for clearing and leveling the land |
| Taxes |
| Costs for removing old buildings (less any money received from selling the materials). |
| Permanent landscaping (including trees, bushes, grass, rocks, paths - but not flowers) |
All costs needed to get the building ready to use are capitalized. (eg. Painting and renovating) However, once the building is in use, costs to maintain the building are expensed. (eg. Painting and re-carpeting)
Examples:
| Excavation fees |
| Architectural fees |
| Building permit fee |
| Cost of insurance, interest, and taxes during construction (but not after construction) |
This account includes items that are attached to the land but have a limited life. Examples are parking lots, fences and lighting systems. Since these items will be used up, they must be depreciated.
This account includes all the costs of purchasing the equipment and getting it ready to use.
Examples:
| Purchase price, taxes and freight charges (less any cash discounts) |
| Insurance while in transit (but not after) |
| Installation costs |
| Testing costs |
Sometimes assets are bought in a group and the actual cost for each asset is not known. It is important to establish the separate cost for each asset so that they can be shown correctly on the balance sheet and so that depreciation can be correctly calculated.
If appraisal values are known for the assets, these can be used to determine the purchase cost for each asset.
Example :
ABC Company purchased land and a building for AED 120,000 cash. The land was appraised at AED 50,000 and the building was appraised at AED 100,000.
Prepare the journal entry to record this purchase.
Solution:
| Debit | Credit | |
| Land (120,000 * 50,000/150,000) | 40,000 | |
| Building (120,000 * 100,000/ 150,000) | 80,000 | |
| Cash | 120,000 |
Costs incurred after an asset has been purchased are either:
(1) Capitalized (added to the cost of the asset) if they provide future benefits.
Additions - these are new parts added on to existing assets and are added to the asset account. (example - adding a new wing to a building or adding a printer to a computer system)
Extraordinary repairs - these increase the useful life of the asset so they are either added to the cost of the asset or deducted from the accumulated depreciation. (example - putting a new engine in a car)
Betterments - these make the asset more productive (by increasing either the quantity or the quality of the asset’s output) but may or may not increase the useful life. These costs are added to the asset account. (example - putting a special radio communication system in your company truck)
(2) Expensed if they do not provide future benefits
Ordinary repairs - these keep the asset in good working condition but do not add to the useful life or productivity of the asset (Example - putting gas and oil in the car or repairing the brakes) Typically, these expenses are debited to Repairs and Maintenance expense.
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Assets can be sold, given away, scrapped (thrown out), stolen or destroyed.
In each case, the asset (at its total historical cost) and the related accumulated depreciation must be removed from the books. The proceeds from the sale (or the proceeds from the insurance company if any) are recorded and the difference becomes the gain or loss on disposition.
Before the disposition is recorded, the accumulated depreciation and the current year’s depreciation expense must be brought up to date and recorded.
Hints:
If the proceeds on the disposition are greater than the NBV, there will be a gain (gains are always credits).
If the proceeds on the disposition are less than the NBV, there will be a loss (losses are always debits)
(Net book value (NBV) = asset cost - accumulated depreciation)
When the company gives the asset away as a donation, "Contribution Expense" is debited for the fair market value of the asset and a gain or a loss may be recorded as usual.
Example 1
HCT Company sold a machine on June 30 for AED 28,000. The original cost of the machine was AED 40,000, the accumulated depreciation was AED 14,000. Depreciation of AED 4,000 is recorded at the end of each year.
Solution:
| Debit | Credit | |
| Depreciation expense | 2,000 | |
| Accumulated Depreciation-machine | 2,000 | |
| Accumulated depreciation - machine | 16,000 | |
| Cash | 28,000 | |
| Machine | 40,000 | |
| Gain on sale of machine | 4,000 |
Example 2
HCT Company donated the machine to a charity on Dec 31. The original cost of the machine was AED 40,000, the accumulated depreciation (including this year's depreciation) was AED 16,000. The fair market value of the machine was AED 22,000.
Solution:
| Accumulated depreciation - machine | 16,000 | |
| Contribution expense | 22,000 | |
| Loss on disposition of machine | 2,000 | |
| Machine | 40,000 |
Why depreciate assets?
Depreciation is a way to allocate the cost of assets to expense as we use the asset to earn revenue. This follows the matching principle. The going concern principle is also involved because we assume that the asset will be used in the business for a long period of time.
The net book value of the asset may or may not be close to the fair market value.
There are many ways to depreciate assets. Companies can choose different methods for different types of assets, but they should not change from one method to another one for the same asset due to the consistency principle.
We will study three methods of depreciation:
(1) Straight-line depreciation
(2) Declining-balance method
(3) Units of activity method
(1) Straight-line depreciation
With this method, depreciation is calculated based on time, not usage of the asset.
The depreciation expense will be the same each period over the life of the asset.
If the asset is not purchased at the beginning of the period, the calculation must be prorated.
Depreciation = (cost price - salvage value)/ estimated useful life
Journal Entry
Depreciation Expense - equipment
Accumulated Depreciation - equipment
Example:
Ajman Company purchased a truck on March 1, 1996 for AED 46,000. The freight and taxes on the truck were AED 2,000. The truck is expected to last for 4 years with a salvage value of AED 6,000.
Calculate the straight-line depreciation for 1996, 1997, 1998 and 1999, and 2000.
1996
1997
1998
1999
2000
(2) Declining-balance method
With this method, depreciation is again calculated based on time, not usage of the asset.
However, the depreciation expense will be the higher in the early periods and will reduce as the asset grows older. This reflects the idea that a newer asset is more productive. (a car is a good example). The salvage value is not considered in the calculation of depreciation, however, when the net book value reaches the salvage value, no more depreciation expense will be recorded.
Again, if the asset is not purchased at the beginning of the period, the calculation must be prorated.
Depreciation = Net Book Value (NBV) * rate
The rate can be given to you as a % or you may need to calculate it using the useful life.
If the double-declining method is used, the rate would be twice the straight line rate and would be calculated as follows:
Rate = (100/ useful life) * 2 (the answer will be a %)
The rate will be same for the asset’s useful life, but since the NBV will decrease, the depreciation expense will decrease as the asset grows older.
Journal Entry
Depreciation Expense - equipment
Accumulated Depreciation - equipment
Example 1:
Ajman Company purchased a truck on March 1, 1996 for AED 46,000. The freight and taxes on the truck were AED 2,000. The truck is expected to last for 4 years with a salvage value of AED 6,000.
Calculate the double-declining depreciation for 1996, 1997, 1998 and 1999, and 2000.
1996
1997
1998
1999
2000
Example 2:
Sharjah Company purchased a machine on Oct 1, 1996 for AED 95,000. The freight and taxes on the machine were AED 5,000. The machine is expected to last for 5 years with a salvage value of AED 13,000.
Calculate the double-declining depreciation for 1996, 1997, 1998 and 1999, and 2000.
Solution:
1996
1997
1998
1999
2000
(3) Units of Activity Method
With this method, depreciation is based on usage of the asset, not time.
The depreciation expense will increase when the asset is used more.
If the asset is not purchased at the beginning of the period, the calculation does NOT need to be prorated because the calculation is based on usage, not time.
Depreciation = (cost price - salvage value)/ estimated useful life in units * current units of activity
Sometimes the units of activity will be the number of products produced by a machine, or the number of hours that a machine has worked or the number of kilometers that a car has driven. In all cases, the calculation is the same.
Journal Entry
Depreciation Expense - equipment
Accumulated Depreciation - equipment
Example 1:
Ajman Company purchased a truck on March 1, 1996 for AED 46,000. The freight and taxes on the truck were AED 2,000. The truck is expected to last for 4 years or 420,000 kms with a salvage value of AED 6,000.
Calculate the units of activity depreciation for the following years assuming the following usage:1996 - 70,000 kms , 1997 - 110,000 kms , 1998 - 100,000 kms, 1999 - 80,000 kms, and 2000 - 60,000 kms.
Solution:
1996
1997
1998
1999
2000
Example 2:
Sharjah Company purchased a machine on Nov 1, 1996 for AED 95,000. The costs to install the machine were AED 5,000. The machine is expected to produce 600,000 products and then have a salvage value of AED 10,000.
Calculate the units of activity depreciation for the following years assuming the following production:1996 - 110,000 products, 1997 - 140,000 products, 1998 - 180,000 products, 1999 - 80,000 products, and 2000 - 90,000 products.
Solution:
1996
1997
1998
1999
2000
Calculating depreciation usually involves two estimates - useful lives and salvage values of assets. These estimates sometimes change as new information is received.
Also when additions, betterments or extraordinary repairs are made to assets, the asset’s book value is increased and the depreciation must be recalculated.
To recalculate depreciation, use the following formulas:
1. Straight-line depreciation
=( Net book value of asset - new salvage value) / remaining useful life
2. Double declining
= Net book value of asset * new rate
3. Units of activity
= (Net book value of asset – new salvage value)/ remaining life in units * units for the current year
Most US GAAP and IAS rules are the same for Property, Plant and Equipment. However, the "write up" or revaluation of assets is one rule that is allowed under IAS rules that is not allowed under US GAAP and has caused a lot of debate.
Under both US GAAP and IAS, the cost of an asset should be reduced (written down) if its value has permanently decreased more than its book value. This is called an impairment in value and follows the conservatism principle.
For example:
A piece of land was purchased for AED 300,000 in 1990 when land prices were high. The value of this land has now been estimated to be AED 210,000.
The entry to record this would be:
Impairment loss (an income statement account) 90,000
Land 90,000
Under US GAAP, assets are not allowed to be written up. This means that if an asset has increased in value, it must still be recorded at its original cost. This follows the historical cost and the conservatism principle.
Under IAS, assets that have permanently increased in value may be written up to this new value. It is felt that this treatment offers more realistic values for the balance sheet, but it is still somewhat controversial.
For example, if a piece of land was originally purchased for AED 300,000 and is now worth AED 420,000, the following journal entry would be made:
Land 120,000
Revaluation surplus (this is an equity account on the balance sheet) 120,000
If the asset was a depreciable asset, the depreciation would be recalculated using the new higher asset value. This would cause future net incomes to be lower.
Natural resources are assets from nature like timber (trees), mineral deposits and oil reserves. They are also called "wasting assets" because they get used up. In their natural state, they are really inventories of raw materials to be used later and are shown as long term assets.
Natural resources are recorded at cost.
Development Costs
Costs that are needed to get the natural resource ready for use are added to the cost.
Restoration Costs
In addition, any costs needed to restore the property to its natural state are also added to the cost of the natural resource after they have been incurred. Future depletion would be calculated using this higher cost.
If the costs for restoration can be accurately estimated in advance, they would be added to the cost of the asset when calculating depletion (see formula below) but they would NOT be added to the cost of the asset on the balance sheet until they were actually paid.
Regular maintenance costs
Costs to keep the asset in working condition are expensed as incurred.
Exploration costs
Cost incurred to find new resources are normally expensed except in special circumstances.
The cost of the asset is allocated to expense as the asset is consumed. This is called depletion. The total of each year’s depletion is called Accumulated Depletion and is deducted from the Natural Resource account on the balance sheet.
The depletion is allocated to depletion expense (and becomes a part of the cost of goods sold) when the resource is sold. If some of the resource has been produced (eg. mined) but not sold, the related depletion is shown as inventory and included in the current asset section.
Depletion is calculated in the same way as the units of activity method.
Formula:
Depletion per unit = (total cost - salvage value + restoration costs if known)/total estimated units
Depletion = depletion per unit * number of units produced
If all of the units produced are NOT sold, then this depletion must be divided into two parts:
Depletion expense = depletion per unit * number of units sold
(depletion expense would be a part of cost of goods sold on the income statement)
Inventory = depletion per unit * number of units left on hand
(inventory would be found in the current asset section of the balance sheet)
Example:
Assume that a company bought land with 20,000 trees for AED 400,000. The company plans to sell the trees for a profit and then sell the land for AED 40,000 after they have cut all the trees. In 1996, the company cut down 6000 trees and sold 5950 of them.
Depletion per unit = (400,000 - 40,000)/20,000 = AED 18 per tree
The journal entry to record depletion would be:
Depletion expense (based on units sold) 107,100
Inventory (based on units left) 900
Accumulated depletion (based on units produced) 108,000
On the balance sheet, you would see:
Current Assets:
Inventory 900
Natural Resources:
Timberland 400,000
Less accumulated depletion (108,000) 292,000
The inventory represents the trees that have been cut but not sold. The AED 292,000 represents the value of the land and the remaining trees. The accumulated depletion will increase each year as the trees are cut.
If equipment is used to produce the natural resource, it should be depreciated using the units of activity method for better matching. (although the straight-line method can also be used) It will be shown in the fixed asset section of the balance sheet.
References Keiso text chapter 12
, Larson Text chapter 11 pages 409 - 413Intangibles are long term assets that have no physical existence but help to produce products or provide services. They are usually listed on the balance sheet as "Other Assets".
When an intangible asset is purchased, it is recorded at cost. The cost is then allocated to expense over time. This is called amortization and is usually done using the straight-line method with no salvage value. The total of the amortization over the years is called accumulated amortization. This is deducted from the intangible asset to determine its net book value.
Many companies prefer to reduce the intangible asset account itself instead of using the accumulated amortization account - this is also acceptable. The asset is then recorded on the balance sheet at its net book value. We will use this method.
1. Patents
Is the exclusive right to produce and sell a particular product or process. It lasts for 17 years. When a patent is purchased, the cost should be capitalized. Also, when legal fees are incurred to protect an existing patent, these should also be capitalized.
Costs to develop your own patent are expensed as research and development costs.
Patents should be amortized over the lesser of their useful life or 17 years.
Example:
Dubai Research labs spent AED 500,000 in Jan 1998 to develop a patent for a new medicine. They also bought a patent from an inventor for AED 120,000 on June 30 , 1998. On Jan 1, 1999, the company spent AED 60,000 on legal fees to protect their patent from a competitor. The company expects that the patent will be commercially valuable for 10 years, after that it is expected that new and improved products will be available.
Required:
Prepare entries to record the above and the adjusting entries for 1998 and 1999.
2. Copyrights
Is the exclusive right to publish and sell a literary, musical, or artistic work. It lasts for the life of the artist plus 50 years.
Copyrights should be amortized over the lesser of their useful life or 40 years.
(note: 40 years is the maximum length of time for any amortization or depreciation in the United States and Canada, however, the IAS rules specify that the maximum length should be 20 years. We will follow the U.S. rule.)
3. Trademarks and Trade Names
Is the exclusive right to use a particular name or symbol. It can last indefinitely.
Trademarks should be amortized over the lesser of their useful life or 40 years.
4. Franchises
Is a contractual agreement giving the franchisee the right to sell certain products or services and use a certain trade name, usually in a specific geographical area.
Often the franchisee must pay a large fee to the franchiser "up front" and then must pay a percentage of their sales each year. The up front amount is capitalized but the yearly percentage (called a royalty) is expensed. Some franchises have a limited life while others have an indefinite life.
Franchise rights should be amortized over the lesser of their useful life and 40 years.
5. Leaseholds
Sometimes a company must pay rent in advance. If the rent in advance is for a time period less than 1 year, it is classified as prepaid rent. If the time period is longer than 1 year, the rent is classified as a leasehold. It is NOT amortized. Instead, the full amount is debited to rent expense in the period that it relates to.
Example:
Dubai Trading Co. signed an 8 year lease that specifies that the annual rent will be AED 120,000 for their office building. As indicated in the contract, they made a deposit of the first two months and the last two months rent.
Prepare the journal entry to record the deposit.
6. Leasehold Improvements
These are assets that the lessee adds to the leased property such as partitions, store fronts, or permanent shelving or flooring. These become a part of the leased property and belong to the lessor when the lease is over.
Leasehold improvements are amortized over the lesser ot the life of the asset or the remaining life of the lease.
Example:
On Jan 1, 1996, Emirates Trading Co. leased some store space from the Deira City Centre. The lease is for 10 years. Emirates Trading spent AED 3200 to build some partitions in the store and spent AED 1400 to install permanent lighting in the ceiling. The partitions and lighting are expected to last for 20 years.
Required:
Prepare the journal entry to record the above and the adjusting entry needed on Dec 31, 1996.
7. Organization Costs
Are costs incurred to set up a corporation. These include fees paid to lawyers, accountants, and investment brokers to set up the company.
Organization costs are usually amortized over 40 years.
8. Goodwill
Exists when a company has the potential to earn higher than usual profits.
Some examples are:
| - Good location |
| - Superior personnel |
| - Good reputation |
| - Strong customer base |
Although a company may have created its own goodwill, it is not recorded on the books unless it is purchased. Goodwill is purchased when a company purchases another company and pays a higher fee than the total of the identifiable assets.
Goodwill is amortized over the lesser of its useful life or 40 years.
Example:
On June 30, 1999 Sharjah Retail Co. purchased another existing retail business in Fujairah for AED 300,000. The business was in a very good location and had a strong loyal customer base. Fair market values for the assets of the Fujairah business were as follows:
Building 100,000
Land 90,000
Furniture 20,000
Inventory 30,000
Required:
Prepare the journal entry to record the purchase and the adjusting entry need on Dec 31, 1999 assuming that the maximum amortization period is used.
Research and Development costs
Are costs that are incurred to find and develop new products. These are NOT intangible
assets and should be expensed when incurred because their future benefits are uncertain. Costs to develop products that can be patented or trademarked are included here and are, therefore, expensed when incurred.Small payments
made to register patents, copyrights, or trademarks should be expensed. This is due to the materiality concept,
Loss in value
If an intangible asset losses its value, it should be written down immediately by debiting a loss account and crediting the intangible asset for its net book value.
Example:
Falcon Investments Inc. bought a franchise for a Crispy Chicken Restaurant for AED 180,000 on April 1, 1997. They thought that the franchise would be commercially successful for 20 years. However, on June 30, 1999 , the restaurant had to be closed down permanently due to the its bad reputation. Apparently the methods used to cook the chicken resulted in the death of several customers!
Required: Record all the entries needed for this franchise.
| Long term Assets | AED | AED |
| Property, Plant and Equipment | ||
| Land | 500,000 | |
| Building | 300,000 | |
| Less: accumulated depreciation | (100,000) | 400,000 |
| Equipment | 75,000 | |
| Less: accumulated depreciation | (25,000) | 50,000 |
| Total Property, plant and equipment | 950,000 | |
| Natural Resources | ||
| Oil deposit | 600,000 | |
| Less: accumulated depletion | (100,000) | 500,000 |
| Timberland | 430,000 | |
| Less: accumulated depletion | (70,000) | 360,000 |
| Total Natural resources | 860,000 | |
| Other assets | ||
| Goodwill (net) | 60,000 | |
| Trademark (net) | 90,000 | |
| Total other assets | 150,000 | |
| Total Long term assets | 1,960,000 |
