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9

Reporting and Analyzing Long-Lived Assets

 CHAPTER PREVIEW 

For airlines and many other companies, making the right decisions regarding long-lived assets is critical because these assets represent huge investments. The discussion in this chapter is in two parts: plant assets and intangible assets. Plant assets are the property, plant, and equipment (physical assets) that commonly come to mind when we think of what a company owns. intangible assets. These assets, such as copyrights and patents, lack physical substance but can be extremely valuable and vital to a company's success.

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A Tale of Two Airlines

So, you're interested in starting a new business. Have you thought about the airline industry? Today, the most pro�itable airlines in the industry are not well-known majors like American Airlines and United. In fact, most giant, older airlines seem to be either bankrupt or on the verge of bankruptcy. In a recent year, �ive major airlines representing 24% of total U.S. capacity were operating under bankruptcy protection.

Not all airlines are hurting. The growth and pro�itability in the airline industry today is found at relative newcomers like Southwest Airlines and JetBlue Airways. These and other new airlines compete primarily on ticket prices. During a recent �ive-year period, the low-fare airline market share increased by 47%, reaching 22% of U.S. airline capacity.

Southwest was the �irst upstart to make it big. It did so by taking a different approach. It bought small, new, fuel-ef�icient planes. Also, instead of the “hub-and-spoke” approach used by the majors, it opted for direct, short hop, no frills �lights. It was all about controlling costs—getting the most out of its ef�icient new planes.

JetBlue, founded by former employees of Southwest, was recently ranked as the number 1 airline in the United States by the airline rating company SkyTrax. Management initially attempted to differentiate JetBlue by offering amenities not found on other airlines, such as seatback entertainment systems, while adopting Southwest's low-fare model. This approach was successful during JetBlue's early years, as it enjoyed both pro�itability and rapid growth. However, more recently the company has had to take aggressive steps to rein in costs in order to return to pro�itability.

In the past, upstarts such as Valujet chose a different approach. The company bought planes that were 20 to 30 years old (known in the industry as zombies), which allowed it to quickly add planes to its �leet. Valujet started with a $3.4 million investment and grew to be worth $630 million in its �irst three years.

But with high fuel costs, airlines are no longer in the market for old planes which generally can't be operated ef�iciently. Today, success in the airline business comes from owning the newest and most ef�icient equipment, and knowing how to get the most out of it.

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LEARNING OBJECTIVE 1

Explain the accounting for plant asset expenditures. 

Plant assets are resources that have physical substance (a de�inite size and shape), are used in the operations of a business, and are not intended for sale to customers. They are called various names— property, plant, and equipment; plant and equipment; and �ixed assets. By whatever name, these assets are expected to be of provide service to the company for a number of years. Except for land, plant assets decline in service potential (ability to produce revenue) over their useful lives.

Plant assets are critical to a company's success because they determine the company's capacity and therefore its ability to satisfy customers. With too few planes, for example, JetBlue Airways and Southwest Airlines would lose customers to their competitors. But with too many planes, they would be �lying with empty seats. Management must constantly monitor its needs and acquire assets accordingly. Failure to do so results in lost business opportunities or inef�icient use of existing assets and poor �inancial results.

It is important for a company to (1) keep assets in good operating condition, (2) replace worn-out or outdated assets, and (3) expand its productive assets as needed. The decline of rail travel in the United States can be traced in part to the failure of railroad companies to maintain and update their assets. Conversely, the growth of air travel in this country can be attributed in part to the general willingness of airline companies to follow these essential guidelines.

For many companies, investments in plant assets are substantial. Illustration 9-1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch09lo1#c09-�ig-0001) shows the percentages of plant assets in relation to total assets in various companies in a recent year.

ILLUSTRATION 9-1 Percentages of plant assets in relation to total assets

DETERMINING THE COST OF PLANT ASSETS The historical cost principle requires that companies record plant assets at cost. Thus, JetBlue Airways and Southwest Airlines record their planes at cost. Cost consists of all expenditures necessary to acquire an asset and make it ready for its intended use. For example, when Boeing buys equipment,

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the purchase price, freight costs paid by Boeing, and installation costs are all part of the cost of the equipment.

Determining which costs to include in a plant asset account and which costs not to include is very important. If a cost is not included in a plant asset account, then it must be expensed immediately. Such costs are referred to as revenue expenditures. On the other hand, costs that are not expensed immediately but are instead included in a plant asset account are referred to as capital expenditures. JetBlue reported capital expenditures of $730 million during 2014.

This distinction is important; it has immediate, and often material, implications for the income statement. Some companies, in order to boost current income, have improperly capitalized expenditures that they should have expensed. For example, suppose that a company improperly capitalizes to a building account $1,000 of maintenance costs incurred at the end of the year. (That is, the costs are included in the asset account Buildings rather than being expensed immediately as Maintenance and Repairs Expense.) If the company is allocating the cost of the building as an expense (depreciating it) over a 40-year life, then the maintenance cost of $1,000 will be incorrectly spread across 40 years instead of being expensed in the current year. As a result, the company will understate current-year expenses by approximately $1,000 and will overstate current-year income by approximately $1,000. Thus, determining which costs to capitalize and which to expense is very important.

Cost is measured by the cash paid in a cash transaction or by the cash equivalent price paid when companies use noncash assets in payment. The cash equivalent price is equal to the fair value of the asset given up or the fair value of the asset received, whichever is more clearly determinable. Once cost is established, it becomes the basis of accounting for the plant asset over its useful life. Current fair value is not used to increase the recorded cost after acquisition. We explain the application of the historical cost principle to each of the major classes of plant assets in the following sections.

INTERNATIONAL NOTE IFRS is more �lexible regarding asset valuation. Companies revalue to fair value when they believe this information is more relevant.

Land

Companies often use land as a building site for a manufacturing plant or of�ice site. The cost of land includes (1) the cash purchase price, (2) closing costs such as title and attorney's fees, (3) real estate brokers' commissions, and (4) accrued property taxes and other liens on the land assumed by the purchaser. For example, if the cash price is $50,000 and the purchaser agrees to pay accrued taxes of $5,000, the cost of the land is $55,000.

All necessary costs incurred in making land ready for its intended use increase (debit) the Land account. When a company acquires vacant land, its cost includes expenditures for clearing, draining, �illing, and grading. If the land has a building on it that must be removed to make the site suitable for construction of a new building, the company includes all demolition and removal costs, less any proceeds from salvaged materials, in the Land account.

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To illustrate, assume that Hayes Company acquires real estate at a cash cost of $100,000. The property contains an old warehouse that is removed at a net cost of $6,000 ($7,500 in costs less $1,500 proceeds from salvaged materials). Additional expenditures are for the attorney's fee $1,000 and the real estate broker's commission $8,000. Given these factors, the cost of the land is $115,000, computed as shown in Illustration 9-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch09lo1#c09-�ig-0002) .

ILLUSTRATION 9-2 Computation of cost of land

When Hayes records the acquisition, it debits Land and credits Cash for $115,000.

Land Improvements

Land improvements are structural additions with limited lives that are made to land, such as driveways, parking lots, fences, landscaping, and underground sprinklers. The cost of land improvements includes all expenditures necessary to make the improvements ready for their intended use. For example, the cost of a new company parking lot includes the amount paid for paving, fencing, and lighting. Thus, the company would debit the total of all of these costs to Land Improvements.

Land improvements have limited useful lives. Even when well-maintained, they will eventually need to be replaced. As a result, companies expense (depreciate) the cost of land improvements over their useful lives.

Buildings

Buildings are facilities used in operations, such as stores, of�ices, factories, warehouses, and airplane hangars. Companies charge to the Buildings account all necessary expenditures relating to the purchase or construction of a building. When a building is purchased, such costs include the purchase price, closing costs (attorney's fees, title insurance, etc.), and real estate broker's commission. Costs to make the building ready for its intended use consist of expenditures for remodeling rooms and of�ices and replacing or repairing the roof, �loors, electrical wiring, and plumbing. When a new building is constructed, its cost consists of the contract price plus payments made by the owner for architects' fees, building permits, and excavation costs.

In addition, companies add certain interest costs to the cost of a building. Interest costs incurred to �inance a construction project are included in the cost of the asset when a signi�icant period of time is required to get the asset ready for use. In these circumstances, interest costs are considered as necessary as materials and labor. However, the inclusion of interest costs in the cost of a constructed building is limited to interest costs incurred during the construction period. When construction has been completed, subsequent interest payments on funds borrowed to �inance the construction are recorded as increases (debits) to Interest Expense.

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Equipment

Equipment includes assets used in operations, such as store check-out counters, of�ice furniture, factory machinery, and delivery trucks. JetBlue Airways' equipment includes aircraft, in-�light entertainment systems, and trucks for ground operations. The cost of equipment consists of the cash purchase price, sales taxes, freight charges, and insurance during transit paid by the purchaser. It also includes expenditures required in assembling, installing, and testing the unit. However, companies treat as expenses the costs of motor vehicle licenses and accident insurance on company trucks and cars. Such items are annual recurring expenditures and do not bene�it future periods. Two criteria apply in determining the cost of equipment: (1) the frequency of the cost—one time or recurring, and (2) the bene�it period—the life of the asset or one year.

To illustrate, assume that Lenard Company purchases a delivery truck on January 1 at a cash price of $22,000. Related expenditures are sales taxes $1,320, painting and lettering $500, motor vehicle license $80, and a three-year accident insurance policy $1,600. The cost of the delivery truck is $23,820, computed as shown in Illustration 9-3 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch09lo1#c09-�ig-0003) .

ILLUSTRATION 9-3 Computation of cost of delivery truck

Lenard treats the cost of a motor vehicle license as an expense and the cost of an insurance policy as a prepaid asset. Thus, the company records the purchase of the truck and related expenditures as follows.

For another example, assume Merten Company purchases factory machinery at a cash price of $50,000. Related expenditures are sales taxes $3,000, insurance during shipping $500, and installation and testing $1,000. The cost of the factory machinery is $54,500, computed as shown in Illustration 9-4 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch09lo1#c09-�ig-0004) .

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ILLUSTRATION 9-4 Computation of cost of factory machinery

Thus, Merten records the purchase and related expenditures as follows.

EXPENDITURES DURING USEFUL LIFE During the useful life of a plant asset, a company may incur costs for ordinary repairs, additions, and improvements. Ordinary repairs are expenditures to maintain the operating ef�iciency and expected productive life of the unit. They usually are fairly small amounts that occur frequently throughout the service life. Examples are motor tune-ups and oil changes, the painting of buildings, and the replacing of worn-out gears on factory machinery. Ordinary repairs are debited to Maintenance and Repairs Expense as incurred.

In contrast, additions and improvements are costs incurred to increase the operating ef�iciency, productive capacity, or expected useful life of the plant asset. These expenditures are usually material in amount and occur infrequently during the period of ownership. Expenditures for additions and improvements increase the company's investment in productive facilities and are generally debited to the plant asset affected. Thus, they are capital expenditures. The accounting for capital expenditures varies depending on the nature of the expenditure.

Northwest Airlines at one time spent $120 million to spruce up 40 jets. The improvements were designed to extend the lives of the planes, meet stricter government noise limits, and save money. The capital expenditure was expected to extend the life of the jets by 10 to 15 years and save about $560 million compared to the cost of buying new planes. The jets were, on average, 24 years old.

ANATOMY OF A FRAUD

Bernie Ebbers was the founder and CEO of the phone company WorldCom. The company engaged in a series of increasingly large, debt-�inanced acquisitions of other companies. These acquisitions made the company grow quickly, which made the stock price increase dramatically. However, because the acquired companies all had different accounting systems, WorldCom's �inancial records were a mess. When WorldCom's performance started to �latten out, Bernie coerced WorldCom's accountants to engage in a number of fraudulent activities to make net income look better than it really was and thus prop up the stock price. One of these frauds involved treating $7 billion of line costs as capital expenditures. The line costs, which were rental fees paid to other phone companies to use their phone lines, had always been properly expensed in previous years. Capitalization delayed expense recognition to future periods and thus boosted current-period pro�its.

Total take: $7 billion

THE MISSING CONTROLS

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Documentation procedures. The company's accounting system was a disorganized collection of non- integrated systems, which resulted from a series of corporate acquisitions. Top management took advantage of this disorganization to conceal its fraudulent activities.

Independent internal veri�ication. A fraud of this size should have been detected by a routine comparison of the actual physical assets with the list of physical assets shown in the accounting records.

TO BUY OR LEASE? In this chapter, we focus on purchased assets, but we want to expose you brie�ly to an alternative—leasing. A lease is a contractual agreement in which the owner of an asset (the lessor) allows another party (the lessee) to use the asset for a period of time at an agreed price. In many industries, leasing is quite common. For example, one-third of heavy-duty commercial trucks are leased.

Some advantages of leasing an asset versus purchasing it are:

1. Reduced risk of obsolescence. Frequently, lease terms allow the party using the asset (the lessee) to exchange the asset for a more modern one if it becomes outdated. This is much easier than trying to sell an obsolete asset.

2. Little or no down payment. To purchase an asset, most companies must borrow money, which usually requires a down payment of at least 20%. Leasing an asset requires little or no down payment.

3. Shared tax advantages. Startup companies typically earn little or no pro�it in their early years, and so they have little need for the tax deductions available from owning an asset. In a lease, the lessor gets the tax advantage because it owns the asset. It often will pass these tax savings on to the lessee in the form of lower lease payments.

4. Assets and liabilities not reported. Many companies prefer to keep assets and especially liabilities off their books. Reporting lower assets improves the return on assets (discussed later in this chapter). Reporting fewer liabilities makes the company look less risky. Certain types of leases, called operating leases, allow the lessee to account for the transaction as a rental, with neither an asset nor a liability recorded.

Airlines often choose to lease many of their airplanes in long-term lease agreements. In recent �inancial statements, JetBlue Airways stated that it leased 60 of its 169 planes under operating leases. Because operating leases are accounted for as rentals, these 60 planes were not presented on its balance sheet.

Under another type of lease, a capital lease, lessees show both the asset and the liability on the balance sheet. The lessee accounts for capital lease agreements in a way that is very similar to debt-�inanced purchases: The lessee shows the leased item as an asset on its balance sheet, and the obligation owed to the lessor as a liability. The lessee depreciates the leased asset in a manner similar to purchased assets. Only four of JetBlue's aircraft were held under capital leases. We discuss leasing further in Chapter 10 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10#ch10) .1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch09ifrs#c09-note-0015)

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 ACCOUNTING ACROSS THE ORGANIZATION 

Many U.S. Firms Use Leases

Leasing is big business for U.S. companies. For example, in a recent year leasing accounted for about 33% of all business investment ($264 billion).

Who does the most leasing? Interestingly, major banks such as Continental Bank, J.P. Morgan Leasing, and US Bancorp Equipment Finance are the major lessors. Also, many companies have established separate leasing companies, such as Boeing Capital Corporation, Dell Financial Services, and John Deere Capital Corporation. As an example of the magnitude of leasing, leased planes account for nearly 40% of the U.S. �leet of commercial airlines. Lease Finance Corporation in Los Angeles owns more planes than any airline in the world.

Leasing is also becoming increasingly common in the hotel industry. Marriott, Hilton, and InterContinental are increasingly choosing to lease hotels that are owned by someone else.

Why might airline managers choose to lease rather than purchase their planes? (Go to WileyPLUS for this answer and additional questions.)

DO IT! 1

Cost of Plant Assets

Assume that Drummond Corp. purchases a delivery truck for $15,000 cash plus sales taxes of $900 and delivery costs of $500. The buyer also pays $200 for painting and lettering, $600 for an annual insurance policy, and $80 for a motor vehicle license. Explain how the company should account for each of these costs.

Action Plan ✓ Identify expenditures made in order to get delivery equipment

ready for its intended use.

✓ Expense operating costs incurred during the useful life of the equipment.

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SOLUTION

The �irst four payments ($15,000 purchase price, $900 sales taxes, $500 delivery, and $200 painting and lettering) are expenditures necessary to make the truck ready for its intended use. Thus, the cost of the truck is $16,600. The payments for insurance and the license are operating expenses incurred annually during the useful life of the asset.

Related exercise material: BE9-1, BE9-2, BE9-3, DO IT! 9-1, E9-1, E9-2, and E9-3.

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LEARNING OBJECTIVE 2

Apply depreciation methods to plant assets. 

As explained in Chapter 4 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch04#ch04) , depreciation is the process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systematic manner. Such cost allocation is designed to properly match expenses with revenues (see Illustration 9-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch09lo2#c09-�ig-0005) .)

ILLUSTRATION 9-5 Depreciation as a cost allocation concept

Depreciation affects the balance sheet through accumulated depreciation, which companies report as a deduction from plant assets. It affects the income statement through depreciation expense.

It is important to understand that depreciation is a cost allocation process, not an asset valuation process. No attempt is made to measure the change in an asset's fair value during ownership. Thus, the book value—cost less accumulated depreciation—of a plant asset may differ signi�icantly from its fair value. In fact, if an asset is fully depreciated, it can have zero book value but still have a signi�icant fair value.

Depreciation applies to three classes of plant assets: land improvements, buildings, and equipment. Each of these classes is considered to be a depreciable asset because the usefulness to the company and the revenue-producing ability of each class decline over the asset's useful life. Depreciation does not apply to land because its usefulness and revenue-producing ability generally remain intact as long as the land is owned. In fact, in many cases, the usefulness of land increases over time because of the scarcity of good sites. Thus, land is not a depreciable asset.

During a depreciable asset's useful life, its revenue-producing ability declines because of wear and tear. A delivery truck that has been driven 100,000 miles will be less useful to a company than one driven only 800 miles.

A decline in revenue-producing ability may also occur because of obsolescence. Obsolescence is the process by which an asset becomes out of date before it physically wears out. The rerouting of major airlines from Chicago's Midway Airport to Chicago-O'Hare International Airport because Midway's runways were too short for giant jets is an example. Similarly, many companies replace their computers

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long before they originally planned to do so because technological improvements make their old hardware obsolete.

Recognizing depreciation for an asset does not result in the accumulation of cash for replacement of the asset. The balance in Accumulated Depreciation represents the total amount of the asset's cost that the company has charged to expense to date; it is not a cash fund.

▼ HELPFUL HINT