CHAPTER TWO: PPE, INTANGIBLE ASSETS & NATURAL RESOURCES

CHAPTER 2
PROPERTY, PLANT & EQUIPMENT (PPE), INTANGIBLE ASSETS &
NATURAL RESOURCES
OBJECTIVES
After studying this chapter, you should be able to:
 Define plant assets and describe the accounting for their cost.
 Compute depreciation, using the following methods: straight-line method, units-of-production
method, and declining-balance method.
 Classify fixed asset costs as either capital expenditures or revenue expenditures.
 Journalize entries for the disposal of fixed assets.
 Describe internal controls over fixed assets.
 Compute depletion and journalize the entry for depletion.
 Describe the accounting for intangible assets, such as patents, copyrights, and goodwill.
 Describe how depreciation expense is reported in an income statement, and prepare a balance sheet
that includes fixed assets and intangible assets.

2. INTRODUCTION
Assume that you are a certified flight instructor and you would like to earn a little extra money by
teaching people how to fly. Since you don’t own an airplane, one of the pilots at the local airport is willing
to let you use her airplane for a fixed fee per year. You will also have to pay your share of the annual
operating costs, based on hours flown. In addition, the owner will consider your request for upgrading the
plane’s equipment. At the end of the year, the owner has the right to cancel the agreement.
One of your friends is an airplane mechanic. He is familiar with the plane and has indicated that it needs
its annual inspection. There is some structural damage on the right aileron. In addition to this repair, you
would like to equip the plane with another radio and a better navigation system.
Since you will not have any ownership in the airplane, it is important for you to distinguish between
normal operating costs and costs that add future value or worth to the airplane. These latter costs should be
the responsibility of the owner. In this case, you should be willing to pay for part of the cost of the annual
inspection. The cost of repairing the structural damage and upgrading the navigation system should be the
responsibility of the owner.
Businesses also distinguish between the cost of a fixed asset and the cost of operating the asset. In this
chapter, we discuss how to determine the portion of a fixed asset’s cost that becomes an expense over a
period of time. We also discuss accounting for the disposal of fixed assets and accounting for intangible
assets, such as patents and copyrights.

Before taking up depreciation, it should be understood that the costs relating to the use of long-term
assets should be properly calculated and matched against the revenue earned so that periodic net income
can be determined. These use costs or expense or periodic write off are known by different names for
different category of assets given as under:
Types of Long-Term Assets (Plant Assets) Term of expenses or write off or use costs
1. Tangible Assets:
(i) Land None
(ii) Plant, Building, Equipment, Tools,
Furniture, Fixtures, and Vehicles Depreciation
(iii) Natural Resources such as Oil, Timber,
Coal, Minerals Deposits Depletion
2. Intangible Assets such as Patents, Copyrights,

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Trademarks, Goodwill Amortization

2.2. NATURE OF FIXED ASSETS

Businesses use a variety of fixed assets, such as equipment, furniture, tools, machinery, buildings, and
land. Fixed assets are long-term or relatively permanent assets. They are tangible assets because they
exist physically. They are owned and used by the business and are not offered for sale as part of normal
operations. Other descriptive titles for these assets are plant assets or property, plant, and equipment.
Classifying Costs
The following diagram displays questions that help classify costs. If the purchased item is long-lived, then
it should be capitalized, which means it should appear on the balance sheet as an asset. Otherwise, the cost
should be reported as an expense on the income statement. Capitalized costs are normally expected to last
more than a year. If the asset is also used for a productive purpose, which involves a repeated use or
benefit, then it should be classified as a fixed asset, such as land, buildings, or equipment. An asset need
not actually be used on an ongoing basis or even often. For example, standby equipment for use in the
event of a breakdown of regular equipment or for use only during peak periods is included in fixed assets.
Fixed assets that have been abandoned or are no longer used should not be classified as a fixed asset.

Fixed assets are owned and used by the business and are not offered for resale. Long-lived assets held for
resale are not classified as fixed assets, but should be listed on the balance sheet in a section entitled
investments. For example, undeveloped land acquired as an investment for resale would be classified as an
investment, not land.

i) The Cost of Fixed Assets

The costs of acquiring fixed assets include all amounts spent to get the asset in place and ready for use.
For example, freight costs and the costs of installing equipment are included as part of the asset’s total
cost. The direct costs associated with new construction, such as labor and materials, should be debited to a
“construction in progress” asset account. When the construction is complete, the costs should be
reclassified by crediting the construction in progress account and debiting the appropriate fixed asset
account. For growing companies, construction in progress can be significant. For example, Intel
Corporation disclosed $2.7 billion of construction in progress, which was over 15 percent of its total
fixed assets.
Exhibit 1 summarizes some of the common costs of acquiring fixed assets. These costs should be recorded
by debiting the related fixed asset account, such as Land, Building, Land Improvements, or Machinery and
Equipment. Only costs necessary for preparing a long-lived asset for use should be included as a cost of
the asset. Unnecessary costs that do not increase the asset’s usefulness are recorded as an expense. For
example, the following costs are included as an expense:
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• Vandalism
• Mistakes in installation
• Uninsured theft
• Damage during unpacking and installing
• Fines for not obtaining proper permits from governmental agencies

Exhibit 1: Costs of Acquiring Fixed Assets

LAND: BUILDING:
Purchase price Architects’ fees
Sales tax Engineers’ fees
Permits for government agencies Insurance costs incurred during construction
Brokers’ commissions Interest on money borrowed to finance
construction
Title fees Walkways to and around the building
Surveying fees Sales taxes
Delinquent real estate taxes Repairs(purchase of existing building)
Raising or removing unwanted buildings, less Reconditioning(purchase of existing building)
any savage+
Grading and leveling Modifying for use
Paving a public street bordering the land Permits from government agencies
MACHINERY AND EQUIPMENT: LAND IMPROVEMENTS:
Sales taxes Trees and shrubs
Freights Fences
Installation Outdoor lighting
Repairs (purchase of used equipment) Paved parking areas
Reconditioning(purchase of used equipment)
Insurance while in transit
Assembly
Modifying for use
Testing for use
Permits from government agencies

ii) Nature of Depreciation

As we have discussed in earlier chapters, land has an unlimited life and therefore can provide unlimited
services. On the other hand, other fixed assets such as equipment, buildings, and land improvements lose
their ability, over time, to provide services. As a result, the costs of equipment, buildings, and land
improvements should be transferred to expense accounts in a systematic manner during their expected
useful lives. This periodic transfer of cost to expense is called depreciation.
The adjusting entry to record depreciation is usually made at the end of each month or at the end of the
year. This entry debits Depreciation Expense and credits a contra asset account entitled Accumulated
Depreciation or Allowance for Depreciation. The use of a contra asset account allows the original cost to
remain unchanged in the fixed asset account. Factors that cause a decline in the ability of a fixed asset to
provide services may be identified as physical depreciation or functional depreciation. Physical
depreciation occurs from wear and tear while in use and from the action of the weather. Functional
depreciation occurs when a fixed asset is no longer able to provide services at the level for which it was
intended. For example, a personal computer made in the 1980s would not be able to provide an Internet

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connection. Such advances in technology during this century have made functional depreciation an
increasingly important cause of depreciation.
The term depreciation as used in accounting is often misunderstood because the same term is also used in
business to mean a decline in the market value of an asset. However, the amount of a fixed asset’s
unexpired cost reported in the balance sheet usually does not agree with the amount that could be realized
from its sale. Fixed assets are held for use in a business rather than for sale. It is assumed that the business
will continue as a going concern. Thus, a decision to dispose of a fixed asset is based mainly on the
usefulness of the asset to the business and not on its market value.
Another common misunderstanding is that accounting for depreciation provides cash needed to replace
fixed assets as they wear out. This misunderstanding probably occurs because depreciation, unlike most
expenses, does not require an outlay of cash in the period in which it is recorded. The cash account is
neither increased nor decreased by the periodic entries that transfer the cost of fixed assets to depreciation
expense accounts.

2.3. ACCOUNTING FOR DEPRECIATION

Three factors are considered in determining the amount of depreciation expense to be recognized each
period. These three factors are (a) the fixed asset’s initial cost, (b) its expected useful life, and (c) its
estimated value at the end of its useful life. This third factor is called the residual value, scrap value,
salvage value, or trade in value.

a) Cost- is the net purchase price plus all reasonable and necessary expenditures to get the asset in
place and ready for use.
b) Residual value- also known as salvage value, disposal value, scrape value, or trade-in value
represents the estimated market value of the asset at the time of its retirement. Depreciable cost -
represents the difference between the asset cost and its estimated residual value. For example, an
item of equipment that costs Br. 5000 and has a residual value of Br. 500 would have a depreciable
cost of Br. 4500, (Br. 5000 - Br. 500). The depreciable costs must be allocated over the estimated
economic life of the asset.
c) Estimated economic (useful) life- the estimated economic life of an asset is the total number of
service units expected from the asset. Service units may be measured in terms of years the asset is
expected to be used, units expected to be produced, miles or kilometers expected to be driven, or
similar measures. In determining the estimated useful life of an asset, the accountant should
consider all relevant information, including (1) past experience with similar repair assets, (2) the
asset’s present condition, (3) the company’s repairs and maintenance policy, (4) current
technological and industry trends, and (5) local conditions such as weather.

It is not necessarily that an enterprise uses a single method of computing depreciation for all classes of its
depreciable assets. The methods used in the accounts and financial statements may also differ from the
methods used in determining income and property taxes. The four method used most often are straight
line, units of production, double-declining balance, and sum-of- the years-digits method.

2.3.1. Straight-Line Depreciation

When this method is used to allocate depreciation, the depreciable cost of the asset is spread evenly
(uniformly) over the useful life of an asset. The straight-line method is based on the assumption that
depreciation depends only on the passage of time. The depreciation expense for each period is computed
by dividing the depreciable cost by the number of accounting periods in the asset’s estimated useful life.
The depreciation expense to be reported is the same in each year. The following illustration will help us to
understand the Straight-Line method of computing depreciation.
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Illustration - 2
Suppose, for example, a business enterprise acquires a new computer (office equipment) at a cost of Birr
6,000. It is estimated that the computer has an estimated residual value of Birr 1000 at the end of its
estimated useful life of 4 years. The yearly (annual) depreciation would be Birr 1250 computed as follows:
Annual depreciation = Cost - Salvage value
Estimated useful life
Birr 6,000 – Birr 1,000
= = Birr 1,250
4 𝑦𝑒𝑎𝑟𝑠
The depreciation to be reported for each of the four years would be as follows:
Year Cost Yearly Accumulated Carrying value
Depreciation Depreciation (Book Value)
Beg. of first year Br. 6000 - -` Br. 6,000.00
End of 1 year 6000 Br. 1250.00 Br. 1250.00 4750.00
End of 2 year 6000 1250.00 2500.00 3500.00
End of 3 year 6000 1250.00 3750.00 2250.00
End of 4 year 6000 1250.00 5000.00 1000.00
NB. There are three important points to note from the depreciation schedule for the straight-line
depreciation method. First, the depreciation is the same each year. Second, the accumulated depreciation
increases uniformly. Third, the carrying (Book) value decrease uniformly until it reaches the estimated
residual value.

2.3.2. Declining Balance Method (DBM)

This method of depreciation results in relatively large amount of depreciation in the early years of an
assets life and smaller amounts in later years. This method is based on the assumption of the passage of
time. Since most kinds of plant assets are most efficient when new, and so they provide more and better
service in the early years of useful life. It is consistent with the matching rule to allocate more depreciation
to the early years than to later years if the benefits or services received in the early years are greater.

The declining-balance method is the most common accelerated method of depreciation. Under this method
depreciation is computed by applying a fixed rate to the book value of the asset, resulting in higher
depreciation charges during the early years of the asset’s life. Though any fixed rate might be used under
the method, the most common rate is a percentage equal to twice the straight-line percentage. When twice
the straight-line rate is used, the method is usually called the double-declining balance method (DDBM).

The declining-balance method provides for a declining periodic expense over the estimated useful life of
the asset. To apply this method, the annual straight-line depreciation rate is doubled. For example, the
declining-balance rate for an asset with an estimated life of 5 years is 40%, which is double the straight-
line rate of 20% (100%/5). For the first year of use, the cost of the asset is multiplied by the declining
balance rate. After the first year, the declining book value (cost minus accumulated depreciation) of the
asset is multiplied by this rate. To illustrate, the annual declining balance depreciation for an asset with an
estimated 5-year life and a cost of $24,000 is shown below.

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You should note that when the declining-balance method is used, the estimated residual value is not
considered in determining the depreciation rate. It is also ignored in computing the periodic depreciation.
However, the asset should not be depreciated below its estimated residual value. In the above example, the
estimated residual value was $2,000. Therefore, the depreciation for the fifth year is $1,110.40 ($3,110.40
- $2,000.00) instead of $1,244.16 (40% * $3,110.40).
In the example above, we assumed that the first use of the asset occurred at the beginning of the fiscal
year. This is normally not the case in practice, however, and depreciation for the first partial year of use
must be computed. For example, assume that the asset above was in service at the end of the third month
of the fiscal year. In this case, only a portion (9/12) of the first full year’s depreciation of $9,600 is
allocated to the first fiscal year. Thus, depreciation of $7,200 (9/12 * $9,600) is allocated to the first
partial year of use. The depreciation for the second fiscal year would then be $6,720 [40% * ($24,000 -
$7,200)].

2.3.3. Units of Production/Activity Method

How would you depreciate a fixed asset when its service is related to use rather than time? When the
amount of use of a fixed asset varies from year to year, the units-of-production method is more
appropriate than the straight-line method. In such cases, the units-of-production method better matches the
depreciation expense with the related revenue.
The units-of-production method provides for the same amount of depreciation expense for each unit
produced or each unit of capacity used by the asset. To apply this method, the useful life of the asset is
expressed in terms of units of productive capacity such as hours or miles. The total depreciation expense
for each accounting period is then determined by multiplying the unit depreciation by the number of units
produced or used during the period. If we assume that the office equipment from the previous illustration
has an estimated useful life of 10,000 hours, the depreciation cost per hour would be determined as
follows:
𝑐𝑜𝑠𝑡 − 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 6,000 − 1,000
Hourly depreciation = = = 0.50 𝐵𝑖𝑟𝑟
Estimated units of useful life 10,000 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 ℎ𝑜𝑢𝑟𝑠
If we assume that the use of the equipment was 2,800 hours for the first year, 3,600 hours for the second,
2,400 hours for the third, and 1,200 hours for the fourth, the depreciation schedule for the office
equipment would appear as follows:
Cost Hours Depr. Per Yearly Accum. Carrying value
Year Hour Depr. Depr. (Book value)
Beg. of theFirst year Br. 6,000 - Br. 0.50 - - Br. 6,000
End of 1 year 6,000 2,800 0.50 Br. 1,400 Br. 1,400 4,600
End of 2 year 6,000 3,600 0.50 1,800 3,200 2,800
End of 3 year 6,000 2,400 0.50 1,200 4,400 1,600
End of 4 year 6,000 1,200 0.50 600 5,000 1,000

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Under the production method, there is a direct relation between the amounts of depreciation each year and
the units of output or use. Also, the accumulated depreciation increases each year indirect relation to units
of output or use. Finally, the carrying amount decreases each year in direct relation to units of output or
use until it reaches the estimated residual value.

Under the production method, the units of output or use that is used to measure estimated useful life for
each asset should be appropriate for that asset. For example, for one machine number of units produced
may be an appropriate measure, for another number of hours may be a better measure. The production
method should be used only when the output of an asset over its useful life can be estimated with
reasonable accuracy.

2.3.4. The Sum of the Years Digits Method (SYDM)

Like the declining balance method, the sum of the years’ digits method provides a higher amount of
periodic depreciation expense in the earlier use of the asset's life and decline depreciation expense
thereafter because a successively smaller fraction is applied each year to the depreciable cost of the asset.
Under this method, first we must determine the denominator of the fraction, which is the sum of the digits
representing the years of life. While computing depreciation, the denominator of the fraction is unchanged
and would remain the same. On the other hand the numerator of the fraction, decreases year by year (4/10,
3/10/2/10/1/10). At the end of the asset’s useful life, the balance remaining should be equal to the salvage
value. For example, for a plant asset with an estimated life of 4 years, the denominator of the fraction is
4+3+2+1 = 10. The method is illustrated by the following depreciation schedule for an asset with an
assumed cost of Br.16, 000, residual value of Br.1, 000 and life of 5 years:
Year Cost less Rate Depreciation Accumulated Book Value – end of
residual value for the year Depreciation-end of year year
1 Br 15,000 5/15 5,000 Br. 5,000 Br. 11,000
2 15,000 4/15 4,000 9,000 7,000
3 15,000 3/15 3,000 12,000 4,000
4 15,000 2/15 2,000 14,000 2,000
5 15,000 1/15 1,000 15,000 1,000

NB. The above illustration for the sum of year’s digit method is based on the assumption that the first use
of the asset coincides with the beginning of the fiscal period. When the first use of the asset does not
coincide with the beginning of a fiscal year, it is necessary to allocate each full year’s depreciation b/n the
two fiscal years benefited. Assuming that the asset in the example was placed in service after three months
of the fiscal year had been elapsed, the depreciation for that fiscal year would be Br. 3,750 (9/12 * 5/15 *
Br. 15,000). The depreciation for the second year would be Br. 4,250, computed as follows:
3/12 * 5/15 * Br. 15,000 ……………………….. Br. 1,250
9/12 * 4/15 * Br. 15,000 ……………………….. Br. 3.000
Total, second fiscal year ……………………………... Br. 4,250

2.4. Comparing Depreciation Methods

The straight-line depreciation provides a uniform or equal depreciation charges to expense throughout the
service life of the asset. The production method of depreciation provides for periodic charges to
depreciation expense that may vary considerably, depending upon the amount of usage of the asset. The
production method does not generate a regular pattern because of the random fluctuation of the
deprecation from year to year.

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The major limitation of the production method is that it is not appropriate in situation in which
depreciation is a function of time instead of activity. Another problem in using the production method is
that an estimate of units of output or service hours received is often difficult to determine.
Both the declining balance and the sum of the years digits methods are referred to as accelerated
depreciation methods, because they provides (report) relatively higher depreciation expense in the earlier
uses of the life of the asset and a gradually declining periodic expense thereafter. The main justification
for this approach is that more depreciation should be charged in earlier years because the asset suffers its
greatest loss of services in those years.Accelerated depreciation method also recognizes that changing
technologies make some equipment lose their capacity to yield services rapidly. Thus, it is appropriate to
allocate more to depreciation in the early years, than in later years.
Another argument in favor of an accelerated method is that repair (maintenance) expense is likely to be
greater in later years than in early years. Thus, the reduced amounts of depreciation reported in later years
of the asset’s life are offset to some extent by increased repair (maintenance) expense.

2.5. CAPITAL AND REVENUE EXPENDITURES

The costs of acquiring fixed assets, adding to a fixed asset, improving a fixed asset, or extending a fixed
asset’s useful life are called capital expenditures. Such expenditures are recorded by either debiting the
asset account or its related accumulated depreciation account. Costs that benefit only the current period or
costs incurred for normal maintenance and repairs are called revenue expenditures. Such expenditures are
debited to expense accounts. For example, the cost of replacing spark plugs in an automobile or the cost of
repainting a building should be debited to an expense account.
To properly match revenues and expenses, it is important to distinguish between capital and revenue
expenditures. Capital expenditures will affect the depreciation expense of more than one period, while
revenue expenditures will affect the expenses of only the current period.

1) Capital Expenditure
(a) Addition to Plant Assets
Expenditures for additions to existing plant assets would be debited to plant asset accounts. The costs of
additions would be depreciated over the estimated useful life of the additions. As for example, the costs of
adding an air conditioning system to a building or of addition of a wing to a building would be treated as
capital expenditures.
(b) Betterments
Expenditures that increase operating efficiency or capacity for the remaining useful life of a plant asset are
called betterments. Such expenditures would be added to the plant asset account. As for example, if the
power unit attached to a machine is replaced by one of the greater capacity, the cost would be debited to
the plant asset account. Also, the cost and the accumulated depreciation related to the old power unit
would be removed from the accounts. The cost of the new power unit would be depreciated over its
estimated useful life.
(c) Extra Ordinary Repairs
Expenditures that increase the useful life of an asset beyond the original estimate are called extraordinary
repairs. They should be debited to the appropriate accumulated depreciation account, however, rather than
to asset account.
In such circumstances, the extra ordinary repairs may be said to restore or “make good” a portion of the
depreciation accumulated in prior years. In addition, the periodic depreciation for future periods would be
re-determined on the basis of the revised book value of the asset and the revised estimate of the remaining
useful life.

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2) Revenue Expenditures
Expenditures for ordinary maintenance and repairs of a recurring nature should be classified as revenue
expenditures and debited to expenses accounts. For example, the costs of replacing spark plugs in the
automobile or the cost of repainting a building should be debited to proper expenses accounts.
Small expenditures are usually treated as repair expense, even though they may have the characteristics of
capital expenditure

Stages of Acquiring Fixed Assets

The costs incurred for fixed assets can be classified into four stages: preliminary, pre-acquisition,
acquisition or construction, and in-service. These stages are illustrated below.

The preliminary stage occurs before management believes acquiring a fixed asset is probable. During this
stage, a company may conduct feasibility studies, marketing studies, and financial analyses to determine
the viability of a fixed asset acquisition. These costs are not associated with a particular fixed asset, so
must be treated as revenue expenditures.At the pre-acquisition stage, acquiring the fixed asset has become
probable, but has not yet occurred. Costs that are incurred during this stage, such as surveys, zoning, and
engineering studies, can be associated with a specific fixed asset and should be treated as a capital
expenditure. As we stated previously, capital expenditures are the costs of acquiring, constructing, adding,
or replacing fixed assets.
During the acquisition or construction stage, the acquisition has occurred or construction has begun, but
the fixed asset is not yet ready for use. Costs directly identified with the fixed asset during this stage
should be capitalized in the fixed asset account or in a construction in progress account. General and
administrative costs should not be allocated to fixed asset acquisition or construction for capitalization.
These costs are debited to the appropriate general and administrative expense account. When the fixed
asset is ready for use, the capitalized costs should be transferred from construction in progress to the
related fixed asset account. During the in-service stage, the fixed asset is complete and ready for use.
During this stage, the fixed asset should be depreciated as described in the previous section. In addition,
normal, recurring, or periodic repairs and maintenance activities related to fixed assets during this stage
should be charged to maintenance expense for the period. Costs incurred to either acquire additional
components of fixed assets or replace existing components of fixed assets should be capitalized, as
described in the next section. Exhibit 2 summarizes the accounting for capital and revenue expenditures
for the four stages of acquiring fixed assets.

Exhibit 2 Capital and Revenue Expenditures

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2.6. DISPOSAL OF FIXED ASSETS
Fixed assets that are no longer useful may be discarded, sold, or traded for other fixed assets. The details
of the entry to record a disposal will vary. In all cases, however, the book value of the asset must be
removed from the accounts. The entry for this purpose debits the asset’s accumulated depreciation account
for its balance on the date of disposal and credits the asset account for the cost of the asset.
A fixed asset should not be removed from the accounts only because it has been fully depreciated. If the
asset is still used by the business, the cost and accumulated depreciation should remain in the ledger. This
maintains accountability for the asset in the ledger. If the book value of the asset was removed from the
ledger, the accounts would contain no evidence of the continued existence of the asset. In addition, the
cost and the accumulated depreciation data on such assets are often needed for property tax and income
tax reports.

[A] Discarding Fixed Assets

When fixed assets are no longer useful to the business and have no residual or market value, they are
discarded. To illustrate, assume that an item of equipment acquired at a cost of $25,000 is fully
depreciated at December 31, the end of the preceding fiscal year. On February 14, the equipment is
discarded. The entry to record this is as follows:

If an asset has not been fully depreciated, depreciation should be recorded prior to removing it from
service and from the accounting records. To illustrate, assume that equipment costing $6,000 is
depreciated at an annual straight-line rate of 10%. In addition, assume that on December 31 of the
preceding fiscal year, the accumulated depreciation balance, after adjusting entries, is $4,750. Finally,
assume that the asset is removed from service on the following March 24. The entry to record the
depreciation for the three months of the current period prior to the asset’s removal from service is as
follows:

The discarding of the equipment is then recorded by the following entry:

The loss of $1,100 is recorded because the balance of the accumulated depreciation account ($4,900) is
less than the balance in the equipment account ($6,000). Losses on the discarding of fixed assets are non-
operating items and are normally reported in the Other Expense section of the income statement.

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[B] Selling Fixed Assets
The entry to record the sale of a fixed asset is similar to the entries illustrated above, except that the cash
or other asset received must also be recorded. If the selling price is more than the book value of the asset,
the transaction results in a gain. If the selling price is less than the book value, there is a loss.
To illustrate, assume that equipment is acquired at a cost of $10,000 and is depreciated at an annual
straight-line rate of 10%. The equipment is sold for cash on October 12 of the eighth year of its use. The
balance of the accumulated depreciation account as of the preceding December 31 is $7,000. The entry to
update the depreciation for the nine months of the current year is as follows:

After the current depreciation is recorded, the book value of the asset is $2,250 ($10,000 - $7,750). The
entries to record the sale, assuming three different selling prices, are as follows:
Sold at book value, for $2,250. No gain or loss.

Sold below book value, for $1,000. Loss of $1,250.

Sold above book value, for $2,800. Gain of $550.

[C] Exchanging Similar Fixed Assets

Old equipment is often traded in for new equipment having a similar use. In such cases, the seller allows
the buyer an amount for the old equipment traded in. This amount, called the trade-in allowance, may be
either greater or less than the book value of the old equipment. The remaining balance—the amount
owed—is either paid in cash or recorded as a liability. It is normally called boot, which is its tax name.
The basic accounting for exchanges of plant assets is similar to accounting for sales of plant assets for
cash. If the trade-in allowance received is greater than the carrying value of the assets surrendered, there
has been a gain. If the trade-in allowance is less than the carrying value, there has been a loss.

There are special rules for recognizing these gains and losses, depending on the nature of the assets
exchanged.
Exchange Losses Recognized Gains Recognized
For Financial Reporting Purposes:
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 Of Similar Assets Yes No
 Of Dissimilar Assets Yes Yes
For Income Tax Purposes:
 Of Similar Assets No No
 Of Dissimilar Assets Yes Yes

Both Gains and Losses are recognized when a company exchanges dissimilar assets. Assets are dissimilar
when they perform different functions; assets are similar when they perform the same function.

For financial reporting purposes, gains on exchanges of similar assets are not recognized because the
earning lives of the asset surrendered are not considered to be completed.

When a company trades-in an older machine on a newer machine of the same type, the economic
substance of the transaction is the same as that of a major renovation and upgrading of the older machine.

Accounting for exchange of similar assets is complicated by the fact that neither gains nor losses are
recognized for income tax purposes.

i. Gains on Exchanges
Gains on exchanges of similar fixed assets are not recognized for financial reporting purposes. This is
based on the theory that revenue occurs from the production and sale of goods produced by fixed assets
and not from the exchange of similar fixed assets. When the trade-in allowance exceeds the book value of
an asset traded in and no gain is recognized, the cost recorded for the new asset can be determined in
either of two ways:

Cost of new asset = List price of new asset - Unrecognized gain

or
Cost of new asset = Cash given (or liability assumed) - Book value of old asset

To illustrate, assume the following exchange:

Similar equipment acquired (new):
List price of new equipment . . . . . . . . . . . . . . . . . . . . . . $5,000
Trade-in allowance on old equipment . . . . . . . . . . . . . . . 1,100
Cash paid at June 19, date of exchange . . . . . . . . . . . . . . $3,900

Equipment traded in (old):

Cost of old equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000
Accumulated depreciation at date of exchange . . . . . . . . 3,200
Book value at June 19, date of exchange . . . . . . . . . . . . . $ 800

Recorded cost of new equipment:

Method One:
List price of new equipment . . . . . . . . . . . . . . . . . . . . . . $5,000
Trade-in allowance . . . . . . . . . . . . . . . . . . . . . $1,100
Book value of old equipment . . . . . . . . . . . . . (800)
Unrecognized gain on exchange . . . . . . . . . . . . . . . . . . . (300)
Cost of new equipment . . . . . . . . . . . . . . . . . . . . . . . . . . $4,700
Method Two:

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Book value of old equipment . . . . . . . . . . . . . . . . . . . . . . $ 800
Cash paid at date of exchange . . . . . . . . . . . . . . . . . . . . . 3,900
Cost of new equipment . . . . . . . . . . . . . . . . . . . . . . . . . . $4,700
The entry to record this exchange and the payment of cash is as follows:

Not recognizing the $300 gain ($1,100 trade-in allowance minus $800 book value) at the time of the
exchange reduces future depreciation expense. That is, the depreciation expense for the new asset is based
on a cost of $4,700 rather than on the list price of $5,000. In effect, the unrecognized gain of $300 reduces
the total amount of depreciation taken during the life of the equipment by $300.
ii. Losses on Exchanges
For financial reporting purposes, losses are recognized on exchanges of similar fixed assets if the trade-in
allowance is less than the book value of the old equipment. When there is a loss, the cost recorded for the
new asset should be the market (list) price. To illustrate, assume the following exchange:
Similar equipment acquired (new):
List price of new equipment . . . . . . . . . . . . . . . . . . . . . . $10,000
Trade-in allowance on old equipment . . . . . . . . . . . . . . . 2,000
Cash paid at September 7, date of exchange . . . . . . . . . . $ 8,000
Equipment traded in (old):
Cost of old equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,000
Accumulated depreciation at date of exchange . . . . . . . . 4,600
Book value at September 7, date of exchange . . . . . . . . . $ 2,400
Trade-in allowance on old equipment . . . . . . . . . . . . . . . 2,000
Loss on exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 400
The entry to record the exchange is as follows:

2.7. INTERNAL CONTROL OF FIXED ASSETS

Because of their dollar value and long-term nature, it is important to design and apply effective internal
controls over fixed assets. Such controls should begin with authorization and approval procedures for the
purchase of fixed assets. Controls should also exist to ensure that fixed assets are acquired at the lowest
possible costs. One procedure to achieve this objective is to require competitive bids from preapproved
vendors.
As soon as a fixed asset is received, it should be inspected and tagged for control purposes and recorded in
a subsidiary ledger. This establishes the initial accountability for the asset. Subsidiary ledgers for fixed
assets are also useful in determining depreciation expense and recording disposals. Operating data that
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may be recorded in the subsidiary ledger, such as number of breakdowns, length of time out of service,
and cost of repairs, are useful in deciding whether to replace the asset. A company that maintains a
computerized subsidiary ledger may use bar-coded tags, similar to the one on the back of this textbook, so
that fixed asset data can be directly scanned into computer records.
Fixed assets should be insured against theft, fire, flooding, or other disasters. They should also be
safeguarded from theft, misuse, or other damage. For example, fixed assets that are highly open to theft,
such as computers, should be locked or otherwise protected when not in use. For computers, safeguarding
also includes climate controls and special fire-extinguishing equipment. Procedures should also exist for
training employees to properly operate fixed assets such as equipment and machinery.
A physical inventory of fixed assets should be taken periodically in order to verify the accuracy of the
accounting records. Such an inventory would detect missing, obsolete, or idle fixed assets. In addition,
fixed assets should be inspected periodically in order to determine their condition.
Careful control should also be exercised over the disposal of fixed assets. All disposals should be properly
authorized and approved. Fully depreciated assets should be retained in the accounting records until
disposal has been authorized and they are removed from service.

2.8. NATURAL RESOURCES

The fixed assets of some businesses include timber, metal ores, minerals, or other natural resources. As
these businesses harvest or mine and then sell these resources, a portion of the cost of acquiring them must
be debited to an expense account. This process of transferring the cost of natural resources to an expense
account is called depletion. The amount of depletion is determined by multiplying the quantity extracted
during the period by the depletion rate. This rate is computed by dividing the cost of the mineral deposit
by its estimated size.
Computing depletion is similar to computing units-of-production depreciation. To illustrate, assume that a
business paid $400,000 for the mining rights to a mineral deposit estimated at 1,000,000 tons of ore. The
depletion rate is $0.40 per ton ($400,000/1,000,000 tons). If 90,000 tons are mined during the year, the
periodic depletion is $36,000 (90,000 tons * $0.40). The entry to record the depletion is shown below.

Like the accumulated depreciation account, Accumulated Depletion is a contra asset account. It is
reported on the balance sheet as a deduction from the cost of the mineral deposit.

2.9. INTANGIBLE ASSETS

a) Patents
Manufacturers may acquire exclusive rights to produce and sell goods with one or more unique features. Such
rights are granted by patents, which the federal government issues to inventors. These rights continue in
effect for specified years, depending on the low of the land. A business may purchase patent rights from
others, or it may obtain patents developed by its own research and development efforts.
The initial cost of a purchased patent, including any related legal fees, is debited to an asset account. This cost
is written off, or amortized, over the years of the patent’s expected usefulness. This period of time may be less
than the remaining legal life of the patent. The estimated useful life of the patent may also change as
technology or consumer tastes change.

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The straight-line method is normally used to determine the periodic amortization. When the amortization is
recorded, it is debited to an expense account and credited directly to the patents account. A separate contra
asset account is usually notused for intangible assets.
To illustrate, assume that at the beginning of its fiscal year, a business acquires patent rights for $100,000. The
patent had been granted 6 years earlier by the Federal Patent Office. Although the patent will not expire for
14 years, its remaining useful life is estimated as 5 years. The adjusting entry to amortize the patent at the end
of the fiscal year is as follows:

Rather than purchase patent rights, a business may incur significant costs in developingpatents through its
own research and development efforts. Such researchand development costs are usually accounted for as
current operating expenses in the period in which they are incurred. Expensing research and development
costs is justified because the future benefits from research and development efforts are highly uncertain.

b) Copyrights and Trademarks

The exclusive right to publish and sell a literary, artistic, or musical composition is granted by a copyright.
Copyrights are issued by the federal government and extend for 70 years beyond the author’s death. The
costs of a copyright include all costs of creating the work plus any administrative or legal costs of
obtaining the copyright. A copyright that is purchased from another should be recorded at the price paid
for it. Copyrights are amortized over their estimated useful lives. For example, Sony Corporation states
the following amortization policy with respect to its artistic and music intangible assets:

Intangibles, which mainly consist of artist contracts and music catalogs, are being amortized on a
straight-line basis principally over 16 years and 21 years, respectively.

A trademark is a name, term, or symbol used to identify a business and its products. For example, the
distinctive red-and-white Coca-Cola logo is an example of a trademark. Most businesses identify their
trademarks with ® in their advertisements and on their products. Under federal law, businesses can protect
against others usingtheir trademarks by registering them for 10 years and renewing the registration for 10-
year periods thereafter. Like a copyright, the legal costs of registering a trademark with the federal
government are recorded as an asset. Thus, even though the Coca-Cola trademarks are extremely valuable,
they are not shown on the balance sheet, because the legal costs for establishing these trademarks are
immaterial. If, however, a trademark is purchased from another business, the cost of its purchase is
recorded as an asset. The cost of a trademark is in most cases considered to have an indefinite useful life.
Thus, trademarks are not amortized over a useful life, as are the previously discussed intangible assets.
Rather, trademarks should be tested periodically for impaired value. When a trademark is impaired from
competitive threats or other circumstances, the trademark should be written down and a loss recognized.

c) Goodwill

In business, goodwill refers to an intangible asset of a business that is created from such favorable factors
as location, product quality, reputation, and managerial skill. Goodwill allows a business to earn a rate of
return on its investment that is often in excess of the normal rate for other firms in the same business.
Generally accepted accounting principles permit goodwill to be recorded in the accounts only if it is
objectively determined by a transaction. An example of such a transaction is the purchase of a business at
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a price in excess of the net assets (assets - liabilities) of the acquired business. The excess is recorded as
goodwill and reported as an intangible asset. Unlike patents and copyrights, goodwill is not amortized.
However, a loss should be recorded if the business prospects of the acquired firm become significantly
impaired. This loss would normally be disclosed in the Other Expense section of the income statement. To
illustrate, Time Warner recorded one of the largest losses in corporate history (nearly $54 billion) for the
write-down of goodwill associated with the AOL and Time Warner merger. The entry is recorded as:

2.10. FINANCIAL REPORTING FOR FIXED ASSETS AND INTANGIBLE ASSETS

How should fixed assets and intangible assets be reported in the financial statements?The amount of
depreciation and amortization expense of a period should be reported separately in the income statement
or disclosed in a note. A general description of the method or methods used in computing depreciation
should also be reported.
The amount of each major class of fixed assets should be disclosed in the balance sheet or in notes. The
related accumulated depreciation should also be disclosed, either by major class or in total. The fixed
assets may be shown at their book value (cost less accumulated depreciation), which can also be
described as their net amount. If there are too many classes of fixed assets, a single amount may be
presented in the balance sheet, supported by a separate detailed listing. Fixed assets are normally
presented under the more descriptive caption of property, plant,and equipment.
The cost of mineral rights or ore deposits is normally shown as part of the fixed assets section of the
balance sheet. The related accumulated depletion should also be disclosed. In some cases, the mineral
rights are shown net of depletion on the face of the balance sheet, accompanied by a note that discloses the
amount of the accumulated depletion.
Intangible assets are usually reported in the balance sheet in a separate section immediately following
fixed assets. The balance of each major class of intangible assets should be disclosed at an amount net of
amortization taken to date. Exhibit 3 is a partial balance sheet that shows the reporting of fixed assets and
intangible assets.

Exhibit 3: Fixed Assets and Intangible Assets in the Balance Sheet

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