Chapter 6 Property, Plant, and Equipment

Introduction
All of the firms assets can be classified as either current assets or long-lived assets. Current Assets are assets that will be used up in a firms operations or are soon to be converted into cash within one year or operating cycle. Where as, long-lived assets provide benefits for more than one year or operating cycle. Long-lived assets consist of tangible and intangible assets.

A) Tangible assets have physical characteristics that we can see and touch. These tangible assets include B)
1) Plant assets such as buildings, machinery, vehicle, and furnitures. 2) Natural resources such as gas and oil. Intangible Assets have no physical characteristics that we can see and touch but represent exclusive privilege and rights to their owners. Example includes patent and goodwill.

Property, Plant, And Equipment: To be classified as a plant asset, an asset must 1) be tangible, that is capable of being seen and touched; 2) have a useful service life of more than one year; 3) be used in business operations rather than held for resale. Plant assets are also called Property, Plant and Equipment or Fixed assets. E.g Inventory is a tangible asset but not a plant asset because inventory is usually not long-lived and it is held for sale rather than for use. Plant assets are often sub divided in to four classes 1) 2) 3) 4) Land such as a building site. Land improvement such as fencing, drive ways, parking lots etc. Building such as stores, offices, factories and warehouses. Equipments such as office furniture, factory machinery and delivery equipment and etc.

There are three accounting problems associated with plant assets: 1) Determining the cost of plant assets. 2) Allocating the cost of plant assets over the useful life of the assets. 3) Accounting for disposal of plant assets.

6.1 Determining the cost of plant assets (property, plant and equipment)
The correct amount of cost to allocate to PP&E is based on a fairly straight-forward rule to identify those expenditures which are ordinary and necessary to get the item in place and in condition for its intended use. meaning that cost consists of all expenditure necessary to acquire the asset and make it ready for its use. Such amounts include the purchase price (less any negotiated discounts), permits, freight, ordinary installation, initial setup/calibration/programming, and other normal costs associated with getting the item ready to use. These costs are termed "capital expenditures." In contrast, other expenditures may arise which were not "ordinary

and necessary," or benefit only the immediate period. These costs should be expensed as incurred. An example is repair of abnormal damage caused during installation of equipment. To magnify the point ordinary and necessary cost let us see the following illustration Assume that Mnu Company purchased new equipment. The equipment had a list price of $90,000, but Mnu negotiated a 10% discount. In addition, Mnu Company agreed to pay freight and installation of $5,000. During installation, the equipments spindle was bent and had to be replaced for $2,000. The journal entry to record this transaction is: 22/01/2005 Equipment Repair Expense Cash Paid for equipment (($90,000 X .90) + $5,000), and repair cost 86,000 2,000 88,000

Land Vs Land Improvement

Illustration, when acquiring land, certain costs are ordinary and necessary and should be assigned to Land. These costs obviously will include the cost of the land, plus title fees, survey costs, real estates brokers commission and zoning fees. But other more exotic (unusual) costs come into play and should be added to the Land account; the list can grow long. For example, costs to grade and drain land to get it ready for construction can be construed as part of the land cost. Likewise, the cost to demolish an old structure from the land may be added to the land account (net of any salvage value that may be extracted from the likes of old bricks or steel, etc.). All of these costs may be considered to be ordinary and necessary costs to get the land ready for its intended use. However, at some point, the costs shift to another category -- "land improvements." Land Improvements is another item of PP&E and includes the cost of parking lots, sidewalks, landscaping, irrigation systems, and similar expenditures. Why do you suppose it is important to separate land and land improvement costs? The answer to this question will become clear when we consider deprecation issues. As you will soon see, land is considered to have an indefinite life and is not depreciated. Alternatively, you know that parking lots, irrigation systems, etc. do wear out and must therefore be depreciated. To Illustration, Assume that Mnu Company purchased an old farm on the outskirts of San Diego, California, as a factory site. The company paid $225,000 for the land. In addition, the company agreed to pay unpaid property taxes from previous periods (called back taxes) of $12,000. Attorneys fees and other legal costs relating to the purchase of the farm totaled $1,800. The farm buildings were demolished at a cost of $18,000. The purpose of the demolition was to construct a new building at the site. Some of the structural pieces of the building were salvageable and were sold for $3,000. Then the cost of the land is computed as follows: Cost of factory site Back taxes Attorneys fees & other legal costs Demolition Sales of Salvaged parts $225,000 12,000 1,800 18,000 (3,000) $253,800

The above calculations form the basis for the following entry:

23/01/2006

Land Cash To record Purchase of Land

253,800 253,800

Lump-Sum Acquisitions (Group Purchase of Assets)

A company may buy an existing manufacturing facility, complete with land, buildings, and equipment. The negotiated price is usually a "turnkey" deal for all the components. While the lump-sum purchase price for the package of assets is readily determinable, assigning costs to the individual components can become problematic. Yet, for accounting purposes, it is necessary to allocate the total purchase price to the individual assets acquired. This requires a pro-rata allocation of the purchase price to the individual components. This concept is best illustrated with an example: Suppose Mnu Company acquired a manufacturing facility from Sam Company for the grand total of $2,000,000. To keep it simple, we will assume that the facility consisted of land, building, and equipment. If Mnu had acquired the land separately, it is estimated that its fair value would be $500,000. The fair value of the building, by itself, is estimated to be $750,000. Finally, the equipment would cost $1,250,000 if purchased independent of the "package" deal. The accounting task is to allocate the cost of $2,000,000 to the three separate pieces. If you sum the perceived value of the components, you will note that it comes to $2,500,000 ($500,000 + $750,000 + $1,250,000). Yet, the actual purchase price was only 80% of this amount: Purchase Price Allocation Fair Value Land Building Equipment $500,000 750,000 1,250,000 $2,500,000 Percentage applicable Unit Cost of an item $400,000 ..600,000 ....1,000,000 $2,000,000

80% 80%.................................. 80%..............................

The above calculations form the basis for the following entry: 01/01/2005 Land Building Equipment Cash Purchased land, building, and equipment Interest Cost: Amounts paid to finance the purchase of property, plant, and equipment is expensed. An exception is interest incurred on funds borrowed to finance construction of plant and equipment. Such interest related to the period of time during which active construction is ongoing is capitalized. Interest capitalization rules are quite complex, and are typically covered in detail in intermediate accounting courses. Training Costs: The acquisition of new machinery is oftentimes accompanied by employee training regarding the correct operating procedures for the device. The normal rule is that training costs are expensed. The logic here is that the training attaches to the employee not the machine, and the employee is not owned by the 400,000 600,000 1,000,000 2,000,000

company. On rare occasion, justification for capitalization of very specialized training costs (where the training is company specific and benefits many periods) is made, but this is the exception rather than the rule

6.2) Allocating the cost of plant assets over the useful life of the assets
Casually (carelessly), people will speak of deprecation as a decline in value. However, in accounting language (jargon), the term is meant to refer to the allocation of an asset's cost to the accounting periods benefited -not an attempt to value the asset. Thus, it is often said that depreciation is a process of "allocation" not "valuation." We have already addressed how an asset's cost is determined. Next, we must consider how to allocate costs to accounting period benefited The depreciation method is simply the pattern by which the cost is allocated to each of the periods involved in the service life. You may be surprised to learn that there are many methods from which to choose. Four popular depreciation methods are: (1) Straight-line, (2) units-of-output, (3) double-declining-balance, and (4) sum-of-the-years'-digits. A) THE STRAIGHT-LINE METHOD Under this simple and popular approach, the annual depreciation is calculated by dividing the depreciable base by the service life. In mathematical formula Depreciation per period = Asset Cost

Estimated salvage value

Estimated Useful life An asset that has a $100,000 cost, $10,000 salvage value, and a four-year life would produce the following amounts:

For each of the above years, the journal entry to record depreciation is as follows: 12-31-XX Depreciation Expense Accumulated Depreciation To record annual depreciation expense The appropriate balance sheet presentation would appear as follows (end of year 3 in this case): 22,500 22,500

Fractional Period Depreciation: Assets may be acquired at other than the beginning of an accounting
period, and depreciation must be calculated for a partial period. With the straight-line method the amount is simply a fraction of the annual amount. For example, an asset acquired on the first day of April would be used for only nine months during the first calendar year. Therefore, year one depreciation would be 9/12 of the annual amount. Following is the depreciation table for the above asset, this time assuming an April 1 acquisition date:

When does this method appropriate? Use of this method is appropriate for assets where (1) time rather than obsolescence is the major factor limiting the assets life and (2) relatively constant amounts of periodic services (benefits) are received from the asset. Assets that posses these features include pipelines, fencing, and storage tanks. B) The Units-Of-Output (Activity) Method This technique involves calculations that are quite similar to the straight-line method, but it allocates the depreciable base over the units of output (e.g., machine hours) rather than years of use. Under this method, first the depreciation charge per unit of output is calculated; then this figure is multiplied by the numbers of units of goods or service produced during the accounting period to find depreciation expense for a given period. In mathematical formula Depreciation per unit = Asset cost Estimated Salvage value Estimated total units of pxn during useful life of the asset Depreciation per unit X number of units of output produced For given period

Depreciation per period =

To illustrate, assume Sam Painting Company purchased an air filtration system that has a life of 8,000 hours. The filter costs $100,000 and has a $10,000 salvage value. Sam anticipates that the filter will be used 1,000 hours during the first year, 3,000 hours during the second, 2,000 during the third, and 2,000 during the fourth. Accordingly, the depreciation schedule would appear as follows:

The form of journal entry and balance sheet account presentation are just as were illustrated for the straight-line method, but with the revised amounts from the above table. When does this method appropriate? It is logical to use this approach in those situations where the life is best measured by identifiable units of machine "consumption." For example, perhaps the engine of a corporate jet has an estimated 50,000 hour life. Or a printing machine may be expected to produce 4,000,000 copies. In cases like these, the accountant may opt for the units of output method C) The Double-Declining Balance Method The Double-Declining Balance Method (DDB) produces a declining annual depreciation expense over the useful life of the asset. This method results in relatively large amounts of depreciation in early years of asset life and smaller amounts in later years. With this method, a fixed percentage of the straight-line rate (i.e., 200% or "double") is multiplied by the remaining book value of an asset (as of the beginning of a particular year) to determine depreciation for a particular year. As time passes, book value and annual depreciation decrease. In mathematical formula: Depreciation Per period = ( 2 X Straight-Line rate*) X (Asset Cost Accumulated Depreciation) Straight-Line Rate is calculated by dividing 100% by the number of years of useful life of the asset To illustrate, let's again utilize our example of the $100,000 asset, with a four-year life, and $10,000 salvage value. Depreciation for each of the four years would appear as follows:

The amounts in the above table deserve additional commentary. Year one is hopefully clear -- expense equals the cost times twice the straight line rate (4 year life = 25% straight-line rate; 25% X 2 = 50% rate). Year two is the 50% rate applied to the remaining balance of the asset as of the beginning of the year; the remaining balance would be the cost minus the accumulated depreciation ($100,000 - $50,000). Year three is just like year two -50% times the beginning book value ($100,000 - $75,000).

Note that salvage was simply ignored in the beginning years' calculations. For year four, however, the
calculated amount (($100,000 - $87,500) X 50% = $6,250)) would cause the lifetime depreciation to exceed the $90,000 depreciable base. Thus, in year four, only $2,500 is taken as expense even though the calculated amount is higher. This gives rise to an important general rule for DDB -- salvage value is initially ignored, but once accumulated depreciation reaches the amount of the depreciable base, then depreciation ceases. In our example, only $2,500 was needed in year four to bring the aggregate depreciation up to the $90,000 level. It is possible that an asset will have no salvage value. If you are very perceptive, you will note that the mathematics of DDB will never fully depreciate such assets (since you are always taking only a percentage of the

remaining balance, you can never bring the remaining balance to zero). In these cases, accountants typically change to the straight-line method near the end of an asset's useful life to "finish off" the accounting for an asset which is to be taken to a final zero net book value. The mechanics of this shift in method are sometimes covered in intermediate accounting. Fractional Period Depreciation: Under DDB, fractional years involve a very simple adaptation to the approach presented above. The first partial year will be a fraction of the annual amount, and all subsequent years will be the normal calculation (twice the straight-line rate times the beginning of year book value). If our example asset were purchased on April 1, 20X1, the following calculations result:

When does this method appropriate? This method can be justified if the quality of service produced by an asset declines over time, or if repair and maintenance costs will rise over time to offset the declining depreciation amount. D) The Sum-Of-The-Years'-Digits Method Under the technique, depreciation for any given year is determined by multiplying the depreciable base by a fraction; the numerator is the number of years of useful life remaining at beginning of accounting period (e.g., the digit for an asset with a ten-year life would be 10 for the first year of use, 9 for the second, and so on) and the denominator is the sum-of-the-years' digits (e.g., 10 + 9 + 8 + . . . + 2 + 1 = 55). In mathematical formula Depreciation per period = Number of years of useful life Remaining at beginning of accounting period X (Asset cost estimated SV) SOYD SOYD = n (n + 1) 2

Fractional Period Depreciation: With the sum-of-the-years'-digits method, fractional years require fairly intensive layering for every year (e.g., if a ten-year asset is acquired on July 1, 20X1, depreciation for 20X1 is the depreciable base times 10/55 times 6/12 (relating to six months of use); depreciation for 20X2 is the depreciable base times 10/55 times 6/12 (reflecting the last six months of the first layer), plus the depreciable base times 9/55 times 6/12 (reflecting the first six months of the next layer)). Returning to our $100,000, four-year lived asset; if the asset was acquired on April 1, Year 1, the resulting depreciation amounts are calculated as:

Admittedly, the above table is a bit "busy," but if you take time to trace each of the amounts, it will be a good key to your understanding. Before moving away from the sum-of-the-years'-digits methods, you may find it tedious to be adding numbers like 10 + 9 + 8 + . . . + 1 = 55. But, mathematicians long ago figured out a short cut for this calculation: (n(n + 1))/2, where n is the number of items in the sequence. Thus, for an asset with a ten year life: (10 (10 + 1)/2 = 10(11)/2 = 110/2 = 55 . Try this on your own for the 4 year life, and make sure you result is "10." Try again for a 15 year life asset, and make sure you get "120." Do you see that the sum-of-the-years' digits fraction for the 4th year of use would be 12/120? Remember, you count backwards -- Year one is 15/120, Year two is 14/120, Year 3 is 13/120, and Year 4 would be 12/120. Changes in Estimates: Obviously, the initial assumption about useful life and residual value is only an estimate. Time and new information may suggest that the initial assumptions need to be revised, especially if the initial estimates prove to be materially off course. It is well accepted that changes in estimates do not require redoing the prior period financial statements; after all an estimate is just that, and the financial statements of prior periods were presumably based on the best information available at the time. Therefore, rather than correcting prior periods' financial statements, such revisions are made prospectively (over the future) so that the remaining depreciable base is spread over the remaining life. To illustrate, let's return to the straight-line method. Assume that two years have passed for our $100,000 asset that was initially believed to have a four-year life and $10,000 salvage value; as of the beginning of Year 3, new information suggests that the asset will have a total life of seven years (three more than originally thought), and have a $5,000 salvage value. As a result, the revised remaining depreciable base (as of January 1, 20X3) will be spread over the remaining five years, as follows:

The depreciation amounts for Years 3 through 7 are based on spreading the "revised" depreciable base over the last five years of remaining life. The "revised" depreciable base is $50,000, and is calculated as the original cost ($100,000) minus the depreciation already taken ($45,000), and minus the revised salvage value ($5,000).

6.3 Disposal of Plant Assets

Plant asset may be disposed by sales, exchange, retirement or destruction. Whenever an asset is disposed 1) the assets depreciation must be brought up to date. 2) The book value of the asset must be compute and compared with the selling price. If the book value is lower than the selling price, then the company report loss and if the book value of the asset is lower than the selling price, a gain is reported. 3) At the date of disposal the asset cost and accumulated depreciation must be written off.

A) Sales of plant assets

Companies frequently dispose of plant assets by selling them. By comparing an assets book value with its selling price, a company may show either a gain or loss. To illustrate, assume that mnu company sold equipment costing $45,000 with accumulated depreciation of $14,000 for $$35,000. Equipment cost Acc. Depreciation Less selling price Gain realized $45,000 14,000

$31,000 35,000 4,000

The journal entry to record the sale is; Cash 35,000 Acc. Depreciation-equipment 14,000 Equipment 45,000 Gain on disposal of plant asset 4,000 If on other hand, the equipment is sold for $28,000, a loss of $3,000 ($31,000- 28,000) is realized.

Cash Acc. Depreciation-equipment Loss on disposal of PA Equipment

28,000 14,000 3,000 45,000

If the equipment is sold for $31,000, no gain or loss occurs. The journal entry to record the sale is Cash Acc. Depreciation-equipment Equipment 31,000 14,000 45,000

Accounting for depreciation to date of disposal When a plant asset is disposed it is important to record the depreciation up to the date of sale or disposal. For example, if an asset is sold on May 1, 2005 and depreciation was last recorded on Dec 31,2004, the depreciation for 4 months should be recorded. To illustrate, assume that on August 1, 2005 mnu company sold a machine for $1,500. When the machine was purchased on Jan 1997, it cost $12,000 and was being depreciated at the SLM rate of 10% per year. As of December 31,2004, after closing entries were made, the machines accumulated depreciation account had a balance of $9,600. Before a gain or loss can be determined and before an entry can be made to record the sale, the following entry must be made to record depreciation for the seven months. July 31 Depreciation expense Acc. Depreciation-equipment 700 700

( To record depreciation for 7 months $12,000 X .10 X 7/12) Gain or loss form disposal of a machine can be computed as Machine cost Acc. Depreciation Less selling price loss realized The required entry would be August 1,2005 Cash Acc. Depreciation-equipment Loss on disposal of PA Machine 1,500 10,300 200 12,000 $12,000 10,300 $1,700 1,500 200

b) Retirement of plant assets without sale

When a plant asset is retired from service, the assets cost and accumulated depreciation must be removed from the plant asset accounts.

Option 1: Retiring fully depreciated plant asset and had no salvage value To illustrate assume that Mnu company retired a fully depreciated machine that cost $15,000 and had no salvage value. To record this transaction the required entry would be Acc. Depreciation 15,000 Machinery 15,000 (To record the retirement of a fully depreciated machine) Option 2. Retiring a plant asset before fully depreciated and had no salvage value

Consider the previous example and assume that at the date of disposal the machine has accumulated depreciation only $13,000 and had no salvage value. To record this transaction the required entry would be Acc. Depreciation 13,000 Loss on disposal 2,000 Machinery 15,000 (To record the retirement of a machine before fully depreciated) Option 3. Retiring a plant asset before fully depreciated and had salvage value

Consider the previous example and assume that at the date of disposal the machine has accumulated depreciation only $13,000 and estimated salvage value $1,200. To record this transaction the required entry would be Salvaged Materials 1,200 Acc. Depreciation 13,000 Loss on disposal 800 Machinery 15,000 (To record the retirement of a machine before fully depreciated and had salvage value)

C) Destruction of plant assets

Plant assets are sometimes destroyed by fire, storm and other causes. Losses are normally incurred in such situations. Option 1: Uninsured plant asset For example, assume that an uninsured building costing $40,000 with accumulated depreciation of $12,000 was completely destroyed by a fire. The journal entry is Acc. Depreciation Fire Loss building (To record loss) Option 2: insured plant asset 12,000 28,000 40,000

If the building was insured, only the amount of the fire loss exceeding the amount to be recovered form the insurance company would be debited to the fire loss account.

To illustrate: assume that in the previous example, the building was partially insured and that $22,000 is recoverable from the insurance company. The journal entry is Receivable from Insurance company 22,000 Acc. Depreciation 12,000 Fire Loss 6,000 Building 40,000 (To record fire loss and amount recovered from insurance company) D) Exchange of a plant asset Plant asset may also be disposed through exchange. Exchanges can be for either similar or dissimilar assets. If a gain or loss results from the exchange, the loss is always recognized; the gain may or may not be recognized, depending on whether the asset exchanged is similar or dissimilar to the asset received In general losses on plant assets are recognized, regardless of whether the assets are similar or dissimilar in nature. Gains are recognized if the assets are dissimilar in nature because the earnings process related to those assets is considered to be completed. With one exception, gains are deferred on the exchange of similar plant assets. A gain on exchange of similar assets occurs when monetary consideration is received in addition to the similar asset. In this case, a partial gain may be recognized when cash is received along with an asset a) Similar Assets: are those of the same general type, that perform the same function, or that are employed in the same line of business. Examples of the exchange of similar assets include exchanging a building for another building, a delivery truck for a delivery truck and so on. When similar assets are exchanged, the general rule that new assets are recorded at 1) the cash price of the asset received or 2) the book value of the old asset plus the cash paid, which ever is lower. When this rule is applied to exchanges of similar assets, you will notice that losses are recognized, but gains are not. To illustrate the accounting for exchange of similar plant assets, assume that $50,000 cash and delivery truck No.1 which costs 45,000, had $38,000 accumulated depreciation, and had a $5,000 fair market value- were exchanged for delivery truck No.2. The new truck has a cash price (fair market value) of $55,000. A loss of $2,000 is realized on the exchange. Cost of Delivery truck No.1 Acc. Depreciation Less fair market value of old asset loss on exchange of plant asset $45,000 $38,000

$7,000 5000 2000

The journal entry to record the exchange is Cost of truck No. 2 Acc. Depreciation-equipment 55,000 38,000

Loss on disposal of PA 2000 Truck No.1 45,000 Cash 50,000 (To record loss on exchange of similar plant assets) Please note that accounting for any gain resulting from exchanges of similar plant assets is handled differently than a gain resulting form exchange of dissimilar plant assets To illustrate, consider the previous example and assume that the fair market value of the delivery truck no 1 was $9,000, and $46,000 cash was given in exchange for delivery truck No.2. A gain of $2,000 is indicated on the exchange: Cost of Delivery truck No.1 Acc. Depreciation Less fair market value of old asset Gain on exchange of plant asset The journal entry to record the exchange is Cost of truck No. 2 Acc. Depreciation-equipment 53,000 38,000 $45,000 $38,000

$7,000 9000 2000

Truck No.1 45,000 Cash 50,000 (To record gain on exchange of similar plant assets) Note: When similar assets are exchanged, a gain is not recognized. The new asset is recorded at book value of the old asset plus cash paid. The gain is deducted from the cost of the new asset. Thus, the cost basis of the new delivery truck is equal to $53,000. this amount is used in recording depreciation on the truck and determining any gain or loss on its disposal. Why gains on exchange of similar assets dont recognize? The justification given by accounting theories is that revenue should not be recognized merely because one productive asset is substituted for a similar productive asset but rather should be considered to flow from the production and sale of the goods or service to which the substituted productive asset is committed. In effect, the gain on an exchange of similar plant assets is realized in future accounting periods in the form of increased net income resulting form smaller depreciation charges on newly acquired asset. b) Dissimilar Assets; In contrary to the above, examples of the exchange of dissimilar assets include exchanging a building for land, and equipment for inventory. In accounting for the exchange of a plant asset, the asset received would normally be recorded at either (1) the stated cash price of the new asset or (2) a known fair value of the asset given up plus any cash paid. If the amount at which the new asset is recorded exceeds the book value of the old asset plus any cash paid, a gain is recorded to balance the journal entry. If the situation is in the contrary, a loss is recorded to balance the journal entry. To illustrate such an example, assume that an old factory machine is exchanged for a new delivery truck. The machine cost $45,000 and had an accumulated depreciation balance of $38,000. The truck had a $55,000 cash price and was acquired by trading in a machine with a fair value of $3,000 and paying $52,000 cash. The journal entry to record the exchange is

Truck 55,000 Acc. Depreciation-equipment 38,000 Loss on disposal of PA 4000 Machinery 45,000 Cash 52,000 (To record loss on exchange of similar plant assets) To illustrate the recognition of a gain from an exchange of dissimilar plant assets, assume that the fair market value of the above machine was $9,000 instead of $3,000, and that $46,000 was paid in cash. Truck cost Acc. Depreciation Less fair market value Gain realized The required journal entry would be Truck 55,000 Acc. Depreciation-equipment 38,000 Loss on disposal of PA 4000 Machinery 45,000 Cash 52,000 (To record loss on exchange of similar plant assets) $55,000 38,000

$7,000 9,000 2,000

Note: remember, both gains and losses are always recognized on exchanges of dissimilar plant assets

6.4 Intangible Assets

Intangible assets have no physical characteristics bur represent an exclusive privilege or rights to the owner of the business. Intagible assets usually arise from two sources: 1) exclusive privileges granted by governmental authority or by legal contract, such as patents, copyrights, franchises, trademarks and trade names; and 2) better management know how and customer loyalty, which is called goodwill. Accounting for intangible assets are similar to the accounting for plant assts in a sense that they are recorded at cost and the cost is allocated to the accounting periods benefited systematically and in a rational manner. However, there are certain differences between accounting for tangibles assets and accounting for plant assets.

1) Acquisition cost. Like most other assets, intangible assets are recorded initially at cost. However, only 2)
purchase costs (prices) are included in the acquisition cost. Other costs incurred in developing an intangible assets are expensed as incurred. Allocation of costs to accounting period benefited: All intangible assets are subject to amortization, which is similar to plant asset depreciation. Amortization refers to the allocation of an intangible assets cost to the accounting periods benefited. Intangible assets should be amortized over the shorter of a) their economic life or 40 years. Example, if the useful life of an intangible asset is 60 years, it must be written off over 40 years. If the useful life is less than 40 years, the useful life is used.

Generally, amortization is recorded by debiting amortization expense and crediting the intangible asset account.

Types of Intangible assets

A) Patents: A patent is a right granted by the government giving the owner the exclusive right to manufacture, sell or otherwise benefit from an invention for a limited period of time. Patents have a legal life of 17 years. Protection for the patent owner begins at the time of patent application and lasts for 17 years from the date the patent is granted. The acquisition cost of a patent is the cash or cash equivalent price paid to acquire the patent and the cost of the patent should be amortized over the shorter of 17 years or its estimated useful life. To illustrate assume that if a patent cost $40,000 and has a useful life of 10 years, the journal entries to record the patent and periodic amortization are: Patents Cash (to record purchases of patent) Amortization expense- Patent Patents ( To record patent amortization) 40,000 40,000 4,000 4,000

Note: If the patent becomes worthless before it is fully amortized, the unamortized balance in the patents account should be charged to expense and is classified as operating expense in the income statement. b) Goodwill In accounting, goodwill is an intangible value attached to a company resulting mainly from the companys management skill or know how and a favorable reputation with customers. A companys value may be greater than the total of the fair market value of its tangible and identifiable intangible assets. Goodwill cannot be purchased by itself; an entire business or a part of a business must be purchased to obtain the accompanying intangible assets, goodwill. To illustrate: assume that mnu company purchased all of Sam companys assets for $1,100, 000. The list of the items purchased along with their fair market value are as follows: Cash paid ----------------------------------------------------------1,100,000 Less: fair market values of individually identifiable assets Account receivables 95,000 M. Inventory 100,000 Land -----------------------------------------240,000 Buildings----------------------------------- 275,000 Equipment--------------------------------- 200,000 Patents 65,000

975,000 125,000

The $125,000 is the amount of goodwill to be recorded as an intangible asset on the book of Mnu company; all of the other assets will be recorded at their fair market value, and the liability will be recorded at the amount due. Account receivables 95,000 M. Inventory 100,000 Land -----------------------------------------240,000

Buildings----------------------------------- 275,000 Equipment--------------------------------- 200,000 Patents 65,000 Goodwill 125,000 Cash

1,100,000

Todays accounting practice require goodwill to be amortized over a period not to exceed 40 years. The entry to amortize the $125,000 goodwill over a 40 year period is Goodwill amortization expense Goodwill 3,125 3,125

Note: amortization expense for most intangible assets discussed in this chapter appears among the operating expense on the income statement. The account titles used are all of this type amortization of Goodwill (or patent)