A variety of depreciation methods are used to allocate the cost of an asset to all of the accounting periods benefited by the use of the asset.  Your client has just purchased a piece of equipment for $100,000.  Explain the concept of depreciation.  Which of the following depreciation methods would you recommend: straight-line depreciation, double declining balance method, or an alternative method? All text from the attached chapter 6 must be cited using the below referenceReferenceK Wainwright, S. (Ed.). (2012). Principles of Accounting: Volume I . San Diego, CA: Bridgepoint Education, Inc.06ch_accounting_volumei.pdfchapter 6
Plant Assets
Copyright Barbara Chase/Corbis/AP Images
Learning Goals
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Apply the principles of ordinary and necessary cost, along with other special rules
related to capitalization of expenditures.

Understand conceptual and applied issues pertaining to alternative depreciation
methods.

Know the principles that govern the accounting for asset-related expenditures subsequent to acquisition.

Record transactions related to the disposal of assets.

Understand the basic elements of accounting for natural resources and related
depletion.

Understand the basic elements of accounting for intangibles and related amortization.
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CHAPTER 6
Chapter Outline
Chapter Outline
6.1 Ordinary and Necessary Costs
Special Rules
Materiality Issues
Depreciation
6.2 Depreciation Methods
The Straight-Line Method of Depreciation
The Double-Declining-Balance Method of Depreciation
The Units-of-Output Method of Depreciation
Revisions in Depreciation
Two Sets of Books?
6.3 Asset-Related Costs Subsequent to Acquisition
Sale or Abandonment of Property, Plant, and Equipment
Impairment
Taking a “Big Bath”
Natural Resources
Intangible Assets
Research and Development Costs
Goodwill
R
emember that a classified balance sheet includes a separate category entitled Property,
Plant, and Equipment. This section typically follows the Long-Term Investments section. Property, Plant, and Equipment (PP&E) should reflect only the physical assets that
are used in the business’s production activities. This would include land, buildings, and
equipment. Idle facilities or assets acquired for speculative purposes should be shown in
long-term investments. Within the PP&E section, assets are usually listed according to
their useful lives. Land is listed first because it has a permanent life and is followed by
buildings, then equipment. Table 6.1 shows a typical balance sheet disclosure.
Table 6.1: A typical balance sheet disclosure
Land
Buildings
$ 250,000
$ 600,000
Less: Accumulated depreciation
(150,000)
Equipment
$850,000
Less: Accumulated depreciation
(550,000)
450,000
300,000
$1,000,000
This balance sheet section would appear within a company’s balance sheet, similar to
Exhibit 6.1.
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waL80144_06_c06_135-154.indd 3
(150,000)
$ 850,000
(550,000)
Less: Accumulated depreciation
Equipment
Less: Accumulated depreciation
Total Assets
Receivable from employee
Other Assets
Goodwill
Intangible Assets
$ 600,000
Building and equipment
Land
Property, Plant, & Equip.
Cash value of insurance
Stock investments
Long-term Investments
300,000
450,000
$ 250,000
40,000
$100,000
10,000
140,000
Inventories
Prepaid insurance
250,000
Accounts receivable
$ 100,000
10,000
350,000
1,000,000
140,000
500,000
$ 2,000,000
$
Total Liabilities and Equity
Total stockholder’s Equity
Retained earnings
Capital stock
Stockholder’s equity
Total Liabilites
Mortgage liabity
Note payable
Long-term Liabilities
Current portion of note
Taxes payable
Interest payable
Accounts payable
Current Liabilities
Current Assets
Cash
Liabilities
Assets
Mega Company
Balance Sheet
December 31, 20XX
980,000
$ 400,000
135,000
$ 235,000
119,000
12,000
5,000
$ 114,000
2,000,000
1,380,000
$ 620,000
370,000
$ 250,000
Section 6.1 Ordinary and Necessary Costs
CHAPTER 6
Exhibit 6.1: Mega Company balance sheet
6.1 Ordinary and Necessary Costs
T
he amount of cost reported for an item of PP&E is the ordinary and necessary cost to
get the item in place and in condition for its intended use. These costs are referred
to as capital expenditures. Capital expenditures include the direct purchase price and
the cost of permits, sales tax, freight, installation, and other usual costs to prepare the
item for use. Costs that are not ordinary and necessary, such as repairing damage caused
by an accident during installation of equipment, would be expensed. Sometimes, new
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Section 6.1 Ordinary and Necessary Costs
machinery requires employee training on its use. Although there are a few exceptions,
such costs are normally expensed as incurred.
Equipment often has a list price, but the actual negotiated purchase price may be reduced
by discounts and rebates. Perhaps you have purchased a car at less than the amount listed
on the window sticker. Accountants use the negotiated price as the basis for accounting
measurement, as will be apparent in the following example.
The following journal entry illustrates the recording of a purchase of a new item of
equipment. The equipment had a list price of $500,000 but a negotiated purchase price
of $425,000. Sales tax was $3,000. Freight and normal installation costs totaled $25,000.
The item was dropped during installation, and an additional $10,000 was spent to
repair damage.
05-14-X3
Equipment
453,000.00
Repair Expense
10,000.00
Cash
463,000.00
Purchased equipment
Special Rules
If the preceding transaction was financed with debt rather than cash (i.e., credit Notes
Payable), none of the interest cost would be added to the asset. Instead, interest is usually charged to Interest Expense as incurred. There is an exception for interest costs
associated with debt that is used to finance construction of a particular asset; interest
incurred during the active period of construction is added to the cost of the account
(it is deemed to be an ordinary and necessary cost associated with the asset’s acquisition). The interest capitalization rules can be quite complex and are usually covered in
advanced accounting courses.
Certain costs normally accompany the acquisition of land, like title fees, legal fees, and
surveys. Additional costs may be needed to ready the land for its intended use. Examples
include zoning costs, drainage, and grading. Because these costs are ordinary and necessary, they may be added to the Land account.
To illustrate, assume that Quantum Realty acquired a tract of land that it intended to
develop into land for commercial use. A creek that meandered across the property
adversely impacted the land. Quantum paid $1,000,000 for the land and incurred surveying costs of $40,000. It was necessary to obtain a floodplain permit costing $10,000, and
an additional $150,000 was spent rerouting the creek into a channel. All these costs are
considered to be ordinary and necessary to get the land in condition for its intended use,
and the land should be recorded into the Land account as follows:
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Section 6.2 Depreciation Methods
04-15-X5
Land
1,200,000.00
Cash
1,200,000.00
To record cost of land, including costs associated with surveys, permits, and grading
Materiality Issues
Look around your room and consider how many expenditures were for long-lived assets
that were relatively minor in value—perhaps a trashcan, a telephone, a picture on the
wall, and so forth. If your room were a business, would you capitalize those expenditures and depreciate them over their useful life? Or would you decide that the cost of
record keeping exceeded the benefit? If so, you might choose to simply expense the cost
as incurred (as many businesses do). The reason is materiality; no matter which way that
you account for the cost, it is not apt to bear on anyone’s process about the company.
Depreciation
Once an asset’s cost has been appropriately determined, recorded, and appropriately
posted to the ledger, it becomes necessary to depreciate the asset. As you may recall from
Chapter 3, depreciation is not intended to value or revalue the asset. Instead, depreciation
is the process of allocating an asset’s cost to all accounting periods benefited by the asset’s
use (i.e., spread the cost over the asset’s service life). The number of periods benefited is
known as the service life of the asset.
Your determination of the service life of an asset will depend on professional judgment,
taking into account facets such as the rate of the asset’s physical deterioration and the
possibility of obsolescence. You should observe that service life might be completely different from physical life. For example, how many computers have you owned, and why
did you replace an old one? In all likelihood, its service life to you had been exhausted,
even though it was still physically functional. Some assets like land have a permanent life
and are rarely depreciated.
6.2 Depreciation Methods
R
ecall from Chapter 5 that companies can use different inventory methods. This is also
true for depreciation. The cost of an asset and its service life are important factors
that will drive the depreciation amount, but you must also select a specific depreciation
method. The method reflects the pattern by which the cost is allocated to specific periods.
We will look at three specific techniques: (1) straight line, (2) double-declining balance,
and (3) units of output.
Before looking at the unique features of these methods, it is first necessary to learn a few
more terms. You have already been made familiar with the concepts of cost and service
life. You also need to know about salvage value. Salvage value is also called residual value
and is the amount one expects to receive when selling or trading at the end of an asset’s
service life. Salvage value is excluded from the amount to be depreciated. As such, the
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Section 6.2 Depreciation Methods
depreciable base is equal to cost minus the salvage value. At any point in time, an asset’s
total cost minus accumulated depreciation to date can be referred to as the remaining
net book value.
The Straight-Line Method of Depreciation
The straight-line method spreads the depreciable base over the service life, with an
equal amount of depreciation assigned to each period. Each accounting period should
bear an appropriate amount of depreciation. If the business produces monthly financial
statements, this means that 1/12th of the annual amount should be allocated to each
month for purposes of calculating business income. The following examples illustrate calculations of the annual depreciation expense, assuming the asset is acquired on the first
day of the year. For assets not acquired on the first day of a year (i.e., most assets), a convention
must be adopted. Thus, some business treat all assets acquired in the first half of the year as
being acquired on the first day of the year (and assets acquired in the last half of the year
as not being acquired until the last moment of the year). Other businesses are far more
precise and allocate depreciation down to the number of days in use in a particular period.
The annual charge for depreciation is determined by dividing the depreciable base by
the service life. If an asset has a $550,000 cost, $50,000 salvage value, and a 5-year life,
then annual depreciation would be equal to $100,000 [($550,000 2 $50,000)/5 years 5
$100,000]. Table 6.2 lists the amounts reported for each of the 5 years.
Table 6.2: Annual depreciation expense and accumulated depreciation for 5 years
Annual Depreciation Expense
Accumulated Depreciation
Year 1
$100,000
$100,000
Year 2
100,000
200,000
Year 3
100,000
300,000
Year 4
100,000
400,000
Year 5
100,000
500,000
The appropriate journal entry for each year would be as follows:
12-31-XX
Depreciation Expense
100,000.00
Accumulated Depreciation
100,000.00
To record annual depreciation expense
As a general rule, the annual depreciation would be included in each period’s income
determination. Remember that Depreciation Expense is a temporary account that is closed
each year. In contrast, Accumulated Depreciation is a real account appearing on the balance sheet. Its value builds over time (because the account is not closed), and the appropriate balance sheet presentation would be as follows at the end of year 4:
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Section 6.2 Depreciation Methods
Equipment
$550,000
Less: Accumulated depreciation
400,000
$150,000
The Double-Declining-Balance Method of Depreciation
The double-declining-balance (DDB) method “front loads” depreciation to the early
periods of an asset’s service life. It is sometimes used when the service quality produced
by an asset declines over time or if repair and maintenance costs tend to rise as an asset
ages (i.e., the reducing depreciation charge is offset with a rising maintenance charge).
Annual depreciation under the DDB method is determined by multiplying the beginningof-year net book value of an asset by twice the straight-line rate. Because net book value
is decreasing, so is the annual depreciation charge. The mechanics of the DDB method
is best shown with a simple example. Let’s return to our $550,000 asset with a 5-year
life. First, the straight-line rate is 20% per year (one fifth each year), and twice that rate
is 40%. Thus, the first year’s double-declining depreciation is 40% of $550,000 (we
initially ignore salvage value with the DDB method), or $220,000. This leaves a
remaining net book value of $330,000 ($550,000 2 $220,000), and the second year’s
depreciation expense is only $132,000 ($330,000 3 40%). Table 6.3 lists the entire
pattern of depreciation.
Table 6.3: Entire pattern of depreciation
Annual Depreciation
Expense
Accumulated
Depreciation
Illustrative Calculation
Year 1
$220,000
$220,000
Year 2
132,000
352,000
($550,000 2 $220,000) 3 40%
Year 3
79,200
431,200
($550,000 2 $352,000) 3 40%
Year 4
47,520
478,720
($550,000 2 $431,200) 3 40%
Year 5
21,280
500,000
See text.
$550,000 3 40%
You probably noted how salvage was not reduced against the balance each year in the
fundamental calculation of the DDB method. However, it is not ignored completely. In the
year when calculated accumulated depreciation begins to exceed the depreciable base,
depreciation is discontinued. In our example, this did not occur until the final year 5.
Only $21,280 of depreciation was recorded in the final year (despite the fact that the DDB
calculations return a higher value). The suspension of the recording of depreciation would
occur anytime the accumulated amount of depreciation equals the depreciable base. This
could occur well before the last year of use.
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Section 6.2 Depreciation Methods
The Units-of-Output Method of Depreciation
In a limited number of circumstances, an asset’s consumption may be associated with a
specific measure of use or output. Such would the case for an aircraft engine that might
deliver a fixed number of flight hours before a mandatory replacement schedule. When this
type of situation is encountered, accountants may resort to the units-of-output method
of depreciation. To illustrate, assume that Sky Air uses a jet engine with a 50,000-hour
life and $5,000,000 cost (and no salvage value). Sky Air’s hourly engine cost is $100
($5,000,000450,000 hours). Table 6.4 shows the amount of depreciation to be
recorded over the life of the engine (hours flown are assumed).
Table 6.4: Depreciation over the life of an engine
Hours Flown
Hourly Rate
Total Depreciation
Year 1
10,000
$100
$1,000,000
Year 2
5,000
$100
500,000
Year 3
8,000
$100
800,000
Year 4
12,000
$100
1,200,000
Year 5
5,000
$100
500,000
Year 6
5,000
$100
500,000
Year 7
5,000
$100
500,000
50,000
$100
$5,000,000
During a month in which the engine is flown for 200 hours, the depreciation would be
reported at $20,000 (200 hours 3 $100 per hour). The units-of-output method is like the
straight-line method, but the unit of allocation is units of use rather than units of time. A
simple method, it seems to produce a very systematic and rational cost allocation. Unfortunately, the cases in which it can be used are limited. Few assets have such a readily fixed
and determinable life.
Revisions in Depreciation
The initial assumptions about useful life and residual value are subject to change. When
this happens, accountants have to decide if the effects are sufficiently material to justify a
revision in periodic depreciation. Perhaps after completing 5 years of use of an asset with
an estimated life of 10 years, someone concludes that the asset will continue in use for
7 more years (bringing the total life to 12 years). This suggests that the annual expense for
depreciation is less than originally thought. You may be thinking that you need to restate
prior and future years’ depreciation. However, accounting rules take a simpler approach
and deal with changes in estimates prospectively. This means that the accountant will
revise accounting to adjust only current and future periods. In the case of depreciation,
this occurs rather simply as shown in the following example.
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Section 6.3 Asset-Related Costs Subsequent to Acquisition
CHAPTER 6
Assume that an asset costing $200,000 and having no salvage value was initially depreciated over 10 years. The annual charge for the first 5 years was $20,000 per year ($200,000/
10 years), and totaled $100,000 ($20,000 per year 3 5 years). Early in the sixth year, the
total life of the asset was concluded to be 12 years (in other words, 7 remaining years).
Further, it was additionally concluded that the asset would now have a $30,000 salvage
value. The revised annual depreciation would be $10,000 per year for the last 7 years of
useful life. This amount is calculated by taking the remaining depreciable base of $70,000
($200,000 cost minus accumulated depreciation of $100,000 and salvage value of $30,000)
and spreading it evenly over the last 7 years of useful life.
Two Sets of Books?
You may have heard something about “keeping two sets of books.” Generally, this has a
pejorative connotation and implies some form of deception. However, tax laws tend to
be rather “friendly” by allowing companies to depreciate assets quickly—much faster
than under generally accepted accounting principles (GAAP). The depreciation under
the tax rules reduces taxable income and taxes due. Governments are usually pleased to
grant this accelerated benefit in efforts to stimulate asset purchases and economic activity.
Thus, it is not uncommon for a company’s tax depreciation to initially exceed the amounts
allowed under GAAP. This necessarily entails a company keeping two sets of books—one
for tax and one for accounting. This is not only not wrong but also absolutely necessary. If
you continue to study accounting, you will discover that there are significant complexities
associated with measuring and reporting assets and liabilities that have different tax and
accounting treatments. For now, you just need to know that accounting and tax rules are
not always the same.
6.3 Asset-Related Costs Subsequent to Acquisition
Y
ou probably know that the purchase price of an asset is not the only cost of ownership.
In some cases, it is only the beginning. Consider your car. It must be fueled, insured,
and maintained. Maintenance can include a variety of services like lubrication, tune-ups,
shock absorbers, body work, and engine overhaul. Many business assets require such
support, and that support can be very costly. Accountants need to account for such costs,
and it becomes important to know whether such costs are capital expenditures or not.
Remember that a capital expenditure would be recorded as an asset (i.e., debit the asset
and credit Cash); if the cost is not a viewed as a capital expenditure, then it is recorded as
an expense (i.e., debit the expense and credit Cash). Thus, assessing the nature of an assetrelated expenditure (capital in nature or not) becomes highly significant.
Accountants have developed principles that should form the foundation for deciding if
an asset-related expenditure is capital in nature. Simply stated, if an expenditure results
in the extension of the service life of an asset or the quantity/quality of services expected
from an asset are increased, then the cost is viewed as capital in nature. By default, if one
or more of these criteria are not met, then the cost would be expensed as incurred. You
must be careful not to conclude that routine operating costs meet these conditions. If an
expenditure is intended to merely maintain normal operating condition (e.g., lubrication),
it is not a capital expenditure; it is instead termed a revenue expenditure.
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Section 6.3 Asset-Related Costs Subsequent to Acquisition
CHAPTER 6
The reason for the different treatment relates primarily to the number of periods benefited
by an expenditure. The former (capital expenditure) generally describes costs that are
regarded as attributable to multiple accounting periods, and the latter (revenue expenditure) is usually for benefits that are quickly consumed during the period in which the cost is
incurred. Generalizing about all costs and all businesses is very difficult. For instance, new
tires on a farmer’s tractor might last 20 years, but new tires on the farmer’s truck might last
only 1 year. Thus, it is impossible to develop a uniform capitalization/expensing protocol.
Judgment is always required, but Table 6.5 helps frame the concept with specific examples.
Table 6.5: Examples of expenditures
Capital Expenditure
Revenue Expenditure
Buying a new motor
Tuning up a vehicle
Replacing a parking lot
Painting stripes in a parking lot
Installing fire sprinkler system
Test checking valves on a sprinkler system
Buying new windows
Cleaning windows
Changing out faucets
Replacing washers
Installing new duct work for air conditioning
Cleaning air filters
Replacing carpet
Cleaning carpet
The manner in which capital expenditures are actually recorded in the journal can vary
based on the nature of the outlay. Sometimes, a cost is designed to restore an asset to its
original condition—for example, replacing a motor in a vehicle. In some ways, this can be
seen as partially returning the asset to its new condition. These replacement outlays are
usually “capitalized” by debiting Accumulated Depreciation (and crediting Cash), which
has the effect of increasing the asset’s net book value.
At other times, the capital expenditures may actually improve the asset beyond its original condition. For instance, adding a satellite navigation system to a ship that was previously only piloted by a human is actually a betterment beyond the original condition. Accordingly, the expenditure is normally added to the gross cost of the asset directly
(debit Ship and credit Cash). Under some accounting systems, asset accounts are unitized.
In other words, the cost of a building can be split between the building’s shell and the
many improvements within (e.g., ventilation systems). For those systems, any betterment
expenditures would likely be recorded into a separate account (e.g., Satellite Navigation
System, rather than Ship).
Sale or Abandonment of Property, Plant, and Equipment
An item of property, plant, and equipment may be sold or abandoned. If the asset is abandoned for no consideration (e.g., taking it to the junk yard), the accounting process would
be to record any unrecognized depreciation up to the date of abandonment and then
remove the asset and accumulated depreciation from the accounts. For instance, assume
that an asset costing $90,000, with a 90-month life, straight-line depreciation, and no salvage value is abandoned on April 30, 20X4. Further assume the asset is 80 months old and
depreciation was last recorded on December 31, 20X3:
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4-30-X4
Depreciation Expense
4,000.00
Accumulated Depreciation
4,000.00
To record depreciation for first 4 months of the year
04-30-X4
Accumulated Depreciation
80,000.00
Loss
10,000.00
Equipment
90,000.00
Abandoned equipment costing $90,000 and having accumulated depreciation of
$80,000
Alternatively, if the same asset were instead sold for $25,000 cash, then a $15,000 gain
would result. The following journal entries reveal how this occurs:
4-30-X4
Depreciation Expense
4,000.00
Accumulated Depreciation
4,000.00
To record depreciation for first 4 months of the year
04-30-X4
Accumulated Depreciation
80,000.00
Cash
25,000.00
Gain
15,000.00
Equipment
90,000.00
Sold equipment costing $90,000 and having accumulated depreciation of $80,000 for
$25,000.
It bears repeating that the preceding entries to dispose of an asset would only be
recorded subsequent to a separate entry to update the depreciation accounting through
the April 30 disposal date.
Impairment
An asset’s value may be diminished but not to the point of triggering an abandonment.
In other words, the owner does not expect to generate cash flows from the asset sufficient
to recover the recorded net book value. Very simply, the fair value of the asset is below its
reported value. Accountants tend toward conservatism and try to avoid reporting assets
at more than they are worth. Specific accounting rules provide a framework for measuring the amount of impairment. The amount of impairment is recorded as a loss (debit
the loss and credit the asset). This approach results in reducing the asset’s reported value
down to an amount that bears closer proximity to its value/recoverable amount.
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Section 6.3 Asset-Related Costs Subsequent to Acquisition
Taking a “Big Bath”
This terminology is sometimes used to characterize significant one-time impairment
losses. You may see this occur when a business has gone through a significant down
period and is struggling to regain its footing. Coincident with such efforts, a business may
evaluate all assets in use and conclude that some assets are impaired. This requires that
the carrying value (i.e., the amount reported on the balance sheet) be reduced. Management has some degree of incentive to engage in this “bath.”
Why? Given that this reduction in carrying value will produce an offsetting loss, isn’t this
something that management might wish to avoid? The logic goes like this: Things are
already bad, so where is the harm? And, more to the point, future periods’ income will
be buoyed by this action because the reduction in carrying value will leave fewer assets
that will need to be depreciated in the future. The reduction in future expenses increases
the odds of an eventual return to profitability. Memories are short and management may
hope that the “bath” will be forgotten once profitability is restored.
Natural Resources
So far, you may have envisioned productive assets as consisting primarily of buildings
and machinery, but there are other categories to consider. An energy company may have
a significant investment in oil and gas reserves, for example. Such natural resources can
pertain to mineral deposits, timber, and countless other assets. There are many industryspecific accounting rules for unique natural resources, making it difficult to generalize
about the accounting treatment. However, you should know that natural resources tend
to be established in the accounting records at their acquisition cost, plus selected exploration and development costs. This recorded cost pool is then allocated to future accounting
periods via periodic depletion charges.
Depletion is like depreciation but relates to natural resources instead of buildings
and equipment. The process of measuring depletion generally consists of dividing the
resource’s total cost, less residual value, by the total expected units of output. This results
in a per-unit depletion charge that is either assigned to depletion expense or inventory (if
the extracted resource has not been delivered to an end customer). You can think of the
depletion as a “first cousin” of units-of-output depreciation.
To illustrate, assume that Copper River Mines invested a total of $1,000,000 in a mineral
deposit and that amount is initially recorded into a Copper Ore account on its balance
sheet. The deposit contained 500,000 tons of ore. Thus, the ore has a per-unit depletion
cost of $2 ($1,000,0004500,000 tons). During 20X5, 100,000 tons of ore were extracted. Of
this amount, 75,000 tons were sold, and 25,000 tons were loaded on a barge, awaiting sale
to a customer. The total depletion amounts to $200,000 (100,000 tons  $2 per ton). Of
the depletion, $150,000 would be expensed (75,000 tons  $2) and $50,000 (25,000  $2)
would be carried as inventory. The following entry shows this allocation:
12-31-X5
Depletion Expense
150,000.00
Copper Inventory
50,000.00
Copper Ore
200,000.00
To reduce Copper Ore and allocate depletion to expense and inventory
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Section 6.3 Asset-Related Costs Subsequent to Acquisition
Intangible Assets
Remember that a classified balance sheet also contains an area for reporting intangible
assets. Recall that intangibles are resources that do not physically exist. Examples include
patents, copyrights, trademarks, brands, franchises, and similar items. Some intangibles
are internally developed, and some are purchased from others.
As you would imagine, some of a company’s most important intangibles are ones that
are not directly purchased from another party. Brands, trademarks, internally discovered
concepts that result in patents, trade secrets, and so forth are significant assets that may
take years to build up and often have very little specifically identified cost. Despite their
tremendous value, these intangibles may not appear on a balance sheet. The cost principle
generally requires that a recorded amount on a balance sheet be tied to the asset’s cost.
Because the cost is negligible or hard to pinpoint, the result is that much of this value
remains invisible.
On the other hand, a company may acquire intangible rights from others. For example,
one company may buy a copyright to an artist’s song. Such purchased intangibles are
recorded at their cost. This cost is to be expensed over the shorter of its legal life or useful
life. For instance, a patent has a 20-year legal life. But, in many cases, the economic value
of a patent may benefit a shorter amount of time. The accountant must exercise considerable judgment to reach a conclusion on the accounting life of such assets. The process
of expensing an intangible over time is called amortization. Amortization is not much
different than depreciation or depletion; it is just the process of allocating cost to the benefited time periods. If an intangible has an indefinite life, the cost is not amortized at all,
but the recorded cost will be periodically evaluated for impairment.
To illustrate the accounting for intangibles, assume that Tremonton Medical purchased a
patent for $100,000 and estimated the useful life to equal the 20-year legal life. The appropriate entries are as follows:
01-1-X5
Patent
100,000.00
Cash
100,000.00
Paid $100,000 to purchase a patent
12-31-X5
Amortization Expense
5,000.00
Patent
5,000.00
To record annual amortization expense ($100,000/20 years)
Notice that the annual amortization entry credits the asset account directly. Intangibles are
usually reported net of their accumulated amortization. Unlike with buildings and equipment, no accumulated amortization account is necessary.
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Concept Check
Research and Development Costs
As noted, a company’s internally developed intangibles are not shown as assets. Under
GAAP applicable in the United States, this concept is carried far. All costs that are classified as research and development (R&D) are to be expensed as incurred. These costs
pertain to activities related to a planned search for new knowledge, product, or processes.
You are probably aware, for instance, that pharmaceutical companies spend heavily in
pursuit of new drugs. Many of these costs are likely to generate substantial future benefits. Nevertheless, their R&D costs are expensed each year, regardless of the likelihood of
success of failure for a project. Thus, balance sheets are often void of some very significant
intangible assets. You might find it interesting to note that the global accounting approach
often varies from the U.S. approach, and some international companies do in fact report
an R&D asset!
Goodwill
One way in which intangible business values are realized is when a business is sold. Then
the purchaser will record the assets and liabilities of the acquired company at their fair
value. The purchaser may, however, pay far more for the business than just the identifiable pieces are worth. In such case, the excess purchase price is recorded as unique
intangible asset called goodwill. Simply, goodwill is the excess of the fair value of a company over the fair value of the identifiable elements. A buyer may be willing to pay the
goodwill premium because of the acquired business’s favorable operating results over
time, good reputation, location advantages, established customer base, and similar value
propositions. When you see goodwill on a corporate balance sheet, it means that the company has purchased one or more businesses in the past and willingly paid a premium.
Although goodwill is not amortized, accountants are required to evaluate it for impairment at least once each year. In other words, if the acquired business’s value has declined,
it can become necessary to remove the goodwill from the balance sheet.
Concept Check
The following questions relate to several issues raised in the chapter. Test your knowledge
of the issues by selecting the best answer. (The answers appear on p. 236.)
1. A
company financed a land purchase by paying $120,000 cash and assuming a
$100,000 mortgage payable. County fees to record the transfer of the land to the
buyer totaled $150. Costs to clear the land of rocks and trees amounted to $850.
What is the recorded cost of the land?
a. $120,000
b. $220,000
c. $220,850
d. $221,000
2. Depreciation is
a. a system of cost allocation, not valuation.
b. a system of valuation.
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CHAPTER 6
Key Terms
c. recorded in an effort to reduce assets to their fair market value.
d. based on an asset’s cost and residual value but not service life.
3. A
machine that was purchased 4 years ago for $45,000 has an accumulated depreciation balance of $8,000 and a residual value of $5,000. Assuming use of straight-line
depreciation, what is the machine’s estimated service life?
a. 4 years
b. 8 years
c. 20 years
d. Cannot be determined from the stated facts.
4. Tiger

Lines purchased and began depreciating a new truck on April 1, 20X4. The
truck, which cost $60,000, had a 5-year service life and a $12,000 residual value.
Assuming use of the double-declining-balance method, what is the 20X5 depreciation expense?
a. $13,440
b. $14,400
c. $16,800
d. $18,000
5. Revising a depreciation rate because of a change in a service life estimate
a. requires the correction of prior years’ financial statements.
b. involves allocating the remaining depreciable base over the future years of use.
c. requires that sufficient cash be available to replace the asset at the end of the new
service life.
d. is permitted only if the service life is shortened.
Key Terms
amortization The process of allocating
cost to the benefited time periods.
betterment A capital expenditure for an
improvement.
capital expenditures Ordinary and necessary costs such as direct purchase price
and the cost of permits, sales tax, freight,
installation, and other usual costs to prepare an item for use.
changes in estimates To revise the
accounting to adjust only current and
future periods.
DDB See double-declining-balance
method.
depletion Similar to depreciation but
relates to natural resources instead of
buildings and equipment.
depreciable base The cost of an item of
plant and equipment minus any residual
value.
double-declining-balance (DDB) method
A method of depreciation that “front loads”
depreciation to the early periods of an
asset’s service life.
goodwill The excess of the fair value of a
company over the fair value of the identifiable elements.
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CHAPTER 6
Critical Thinking Questions
materiality A concept dictating that an
accountant must judge the impact and
importance of a transaction to determine
its proper handling in the accounting
records.
natural resources Materials—such as mineral deposits and timber—that are assets.
net book value An asset’s total cost minus
accumulated depreciation to date.
R&D See research and development.
replacement An outlay expenditure
designed to restore an asset to its original
condition.
salvage value Also called residual value,
the amount a business expects to receive
when selling or trading at the end of an
asset’s service life.
service life The number of periods benefited in the life of an asset.
straight-line method A method of depreciation that spreads the depreciable base
over the service life, with an equal amount
of depreciation assigned to each period.
units-of-output method A method of
depreciation when an asset’s consumption
may be associated with a specific measure
of use or output.
research and development (R&D)
Internally developed intangibles that
are not assets.
Critical Thinking Questions
1. Do all items of property, plant, and equipment have a useful life? Explain.
2. How is the acquisition cost of a machine determined? Which of the following items
are included in the cost of an asset: purchase price, freight charges, cost of installation, medical costs of injured installer, special electrical wiring?
3. Explain the proper treatment of interest costs related to the purchase of a new
automobile.
5. Contrast the accounting treatments for land and land improvements.
6. What does the term depreciation mean in accounting? Is the term used differently by
others? Explain.
7. Define the term depreciable base.
8. Is
the units-of-output method of depreciation more appropriate to use for some
items of plant and equipment than for others? Why?
9. How

does a change in the estimated remaining service life of a piece of equipment
affect past and future depreciation amounts?
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CHAPTER 6
Exercises
Exercises
1. Determining

acquisition cost. Well-Made Fabricating Company recently purchased
a state-of-the-art metal-cutting tool. The invoice price was $300,000, which reflected
a 25% trade discount from the $400,000 list price. Other data related to the machine
were as follows:
Freight and installation costs
Cash discount for prompt payment of invoice
Materials used during setup and initial testing
Finger guards installed around cutting head
Property taxes paid for first year of ownership
Advertising brochure to inform customers of new cutting capabilities
$9,500
3,000
800
2,500
4,500
1,500
a. Determine the cost at which the machine should be recorded.
b. Briefly describe and justify the proper treatment of the items that you excluded in
part (a).
2. Depreciation

methods. Betsy Ross Enterprises purchased a delivery van for $30,000
in January 20X7. The van was estimated to have a service life of 5 years and a residual value of $6,000. The company is planning to drive the van 20,000 miles annually.
Compute depreciation expense for 20X8 by using each of the following methods:
a. Units-of-output, assuming 17,000 miles were driven during 20X8
b. Straight-line
c. Double-declining-balance
3. Depreciation

computations. Alpha Alpha Alpha, a college fraternity, purchased
a new heavy-duty washing machine on January 1, 20X3. The machine, which cost
$1,000, had an estimated residual value of $100 and an estimated service life of
4 years (1,800 washing cycles). Calculate the following:
a. The machine’s book value on December 31, 20X5, assuming use of the straightline depreciation method
b. Depreciation expense for 20X4, assuming use of the units-of-output depreciation
method. Actual washing cycles in 20X4 totaled 500.
c. Accumulated depreciation on December 31, 20X5, assuming use of the doubledeclining-balance depreciation method.
4. Depreciation

concepts. Evaluate the following comments as true or false. If the
comment is false, briefly explain why.
a. Depreciation is recorded over the years so that a company’s asset valuations are
reduced to reflect lower market values.
b. A depreciable asset’s cost, minus accumulated depreciation, equals book value.
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CHAPTER 6
Problems
c. An asset’s depreciable base and book value are identical at the end of the asset’s
service life.
d. Straight-line depreciation is probably the most popular accelerated depreciation
method used by businesses.
Problems
1. Cost treatment. Consider the following costs of Shamrock Company:
















Cost of grading land prior to construction
Cost of material used during trial runs of new machinery
Delinquent property taxes on newly acquired land
Damage to equipment, which occurred during installation
Fine for fire code violation in building
Freight charges on newly acquired equipment
Cost of parking lot constructed on property
Cost of three wastebaskets purchased for office use
Cost of clearing land prior to construction
Cost of purchasing used equipment
Interest incurred to purchase machinery on credit
Current property taxes on land and building
Attorney’s fees for land and building purchase
Construction costs of fence at company headquarters
Construction costs of new building
Cost of sprinkling system for landscaping
Instructions
a. Identify which of the preceding costs should be charged to asset accounts?
b. For the costs that you identified in part (a), indicate which asset account(s)
should be increased.
2. D
epreciation computations: change in estimate. Aussie Imports purchased a
specialized piece of machinery for $50,000 on January 1, 20X3. At the time of
acquisition, the machine was estimated to have a service life of 5 years (25,000
operating hours) and a residual value of $5,000. During the 5 years of operations
(20X3220X7), the machine was used for 5,100, 4,800, 3,200, 6,000, and 5,900 hours,
respectively.
Instructions
a. Compute depreciation for 20X3220X7 by using the following methods: straight
line, units of output, and double-declining-balance.
b. On January 1, 20X5, management shortened the remaining service life of the
machine to 20 months. Assuming use of the straight-line method, compute the
company’s depreciation expense for 20X5.
c. Briefly describe what you would have done differently in part (a) if Aussie Imports
had paid $47,800 for the machinery rather than $50,000 In addition, assume that
the company incurred $800 of freight charges $1,400 for machine setup and testing,
and $300 for insurance during the first year of use.
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CHAPTER 6
Problems
3. Depreciation

methods, changes in rates, and partial periods. Ridgemar Inc. purchased a bus for $200,000 on April 1, 20X1. The bus had a residual value of $50,000
and a 10-year (150,000-mile) service life. On January 1, 20X2, the service life was
decreased to recognize 8 years (or 120,000 miles) of remaining service from that
date. Miles driven during 20X1 and the first quarter of 20X2 totaled 16,400 and
4,700, respectively. Accumulated Depreciation accounts based on the straight-line,
units-of-output, and double-declining-balance depreciation methods follow.
a.
Accumulated Depreciation
12/31/X1:
?
3/31/X2: 4,336
b.
Accumulated Depreciation
12/31/X1:
?
3/31/X2: 5,233
c.
Accumulated Depreciation
12/31/X1:
?
3/31/X2: 10,625
Instructions
Determine which Accumulated Depreciation account corresponds to each of the
depreciation methods. Ridgemar rounds final depreciation computations to the
nearest dollar.
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