Erin danielle company purchased equipment and incurred the following costs:

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Chapter

Plant Assets, Natural Resources, and Intangible Assets After studying this chapter, you should be able to: 1 Describe how the cost principle applies

to plant assets. 2 Explain the concept of depreciation. 3 Compute periodic depreciation using

different methods. 4 Describe the procedure for revising

periodic depreciation. 5 Distinguish between revenue and

capital expenditures, and explain the entries for each.

6 Explain how to account for the disposal of a plant asset.

7 Compute periodic depletion of natural resources.

8 Explain the basic issues related to accounting for intangible assets.

9 Indicate how plant assets, natural resources, and intangible assets are reported.

S T U D Y O B J E C T I V E S

Feature Story

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9

HOW MUCH FOR A RIDE TO THE BEACH?

It’s spring break. Your plane has landed, you’ve finally found your bags, and you’re dying to hit the beach—but first you need a “vehicular unit” to get

Scan Study Objectives ■

Read Feature Story ■

Read Preview ■

Read text and answer p. 402 ■ p. 409 ■ p. 412 ■ p. 417 ■

Work Comprehensive p. 421 ■ p. 422 ■

Review Summary of Study Objectives ■

Answer Self-Study Questions ■

Complete Assignments ■

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Do it!

Do it!

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you there. As you turn away from baggage claim you see a long row of rental agency booths. Many are names you are familiar with—Hertz, Avis, and Budget. But a booth at the far end catches your eye—Rent-A-Wreck (www.rent-a-wreck.com). Now there’s a company making a clear statement!

Any company that relies on equipment to generate revenues must make decisions about what kind of equipment to buy, how long to keep it, and how vigorously to maintain it. Rent-A-Wreck has decided to rent used rather than new cars and trucks. It rents these vehicles across the United States, Europe, and Asia. While the big-name agencies push vehicles with that “new car smell,” Rent-A-Wreck competes on price. The message is simple: Rent a used car and save some cash. It’s not a message that appeals to everyone. If you’re a marketing executive wanting to impress a big client, you probably don’t want to pull up in a Rent-A-Wreck car. But if you want to get from point A to point B for the minimum cash per mile, then they are playing your tune. The company’s message seems to be getting across to the right clientele. Revenues have increased significantly.

When you rent a car from Rent-A-Wreck, you are renting from an independ- ent business person who has paid a “franchise fee” for the right to use the Rent-A-Wreck name. In order to gain a franchise, he or she must meet finan- cial and other criteria, and must agree to run the rental agency according to rules prescribed by Rent-A-Wreck. Some of these rules require that each fran- chise maintain its cars in a reasonable fashion. This ensures that, though you won’t be cruising down Daytona Beach’s Atlantic Avenue in a Mercedes con- vertible, you can be reasonably assured that you won’t be calling a towtruck.

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Inside Chapter 9…

• Many U.S. Firms Use Leases (p. 401)

• ESPN Wins Monday Night Football Franchise (p. 416)

• All About You: Buying a Wreck of Your Own (p. 420)

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Preview of Chapter 9

The accounting for long-term assets has important implications for a company’s reported results. In this chapter, we explain the application of the cost principle of accounting to property, plant, and equipment, such as Rent-A-Wreck vehicles, as well as to natural resources and intangible assets such as the “Rent-A-Wreck” trademark. We also describe the methods that companies may use to allocate an asset’s cost over its useful life. In addition, we discuss the accounting for expenditures incurred during the useful life of assets, such as the cost of replacing tires and brake pads on rental cars.

The content and organization of Chapter 9 are as follows.

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398

Plant Assets, Natural Resources, and Intangible Assets

SECTION 1 Plant Assets

Plant assets are resources that have three characteristics: they have a physical sub- stance (a definite size and shape), are used in the operations of a business, and are not intended for sale to customers. They are also called property, plant, and equip- ment; plant and equipment; and fixed assets. These assets are expected to provide services to the company for a number of years. Except for land, plant assets decline in service potential over their useful lives.

Because plant assets play a key role in ongoing operations, companies keep plant assets in good operating condition. They also replace worn-out or outdated plant assets, and expand productive resources as needed. Many companies have substantial investments in plant assets. Illustration 9-1 shows the percentages of plant assets in relation to total assets of companies in a number of industries.

Plant Assets

• Determining the cost of plant assets

• Depreciation • Expenditures during

useful life • Plant asset disposals

Natural Resources

• Accounting for natural resources

• Financial statement presentation

Intangible Assets

• Accounting for intangibles • Types of intangibles • Research and

development costs

Statement Presentation and Analysis

• Presentation • Analysis

Wendy's 70%

10 20 30 40 50 Plant assets as a percentage of total assets

60 70 80 90

36%

18%

7%

56%

Nordstrom

Wal-Mart

Caterpillar

75%Southwest Airlines

Microsoft Corporation

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

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Determining the Cost of Plant Assets 399

The cost principle requires that companies record plant assets at cost.Thus Rent-A-Wreck records its vehicles at cost. Cost consists of all expendi- tures necessary to acquire the asset and make it ready for its intended use. For example, the cost of factory machinery includes the purchase price, freight costs paid by the purchaser, and installation costs. Once cost is established, the company uses that amount as the basis of accounting for the plant asset over its useful life.

In the following sections, we explain the application of the cost principle to each of the major classes of plant assets.

Land Companies acquire land for use as a site upon which to build a manufacturing plant or office.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 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.

Companies record as debits (increases) to the Land account all necessary costs incurred to make land ready for its intended use.When a company acquires vacant land, these costs include expenditures for clearing, draining, filling, and grading. Sometimes the land has a building on it that must be removed before construction of a new building. In this case, the company debits to the Land account all demoli- tion and removal costs, less any proceeds from salvaged materials.

To illustrate, assume that Hayes Manufacturing Company acquires real es- tate at a cash cost of $100,000. The property contains an old warehouse that is razed at a net cost of $6,000 ($7,500 in costs less $1,500 proceeds from salvaged materials).Additional expenditures are the attorney’s fee, $1,000, and the real es- tate broker’s commission, $8,000. The cost of the land is $115,000, computed as follows.

DETERMINING THE COST OF PLANT ASSETS

Describe how the cost principle applies to plant assets.

S T U D Y O B J E C T I V E 1

H E L P F U L H I N T Management’s intended use is important in applying the cost principle.

Land

Cash price of property $100,000 Net removal cost of warehouse 6,000 Attorney’s fee 1,000 Real estate broker’s commission 8,000

Cost of land $115,000

Illustration 9-2 Computation of cost of land

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

Land Improvements Land improvements are structural additions made to land. Examples are drive- ways, 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 parking lot for Home Depot

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includes the amount paid for paving, fencing, and lighting. Thus Home Depot debits to Land Improvements the total of all of these costs.

Land improvements have limited useful lives, and their maintenance and replacement are the responsibility of the company. Because of their limited useful life, companies expense (depreciate) the cost of land improvements over their use- ful lives.

Buildings Buildings are facilities used in operations, such as stores, offices, factories, ware- houses, and airplane hangars. Companies debit to the Buildings account all neces- sary expenditures related to the purchase or construction of a building. When a building is purchased, such costs include the purchase price, closing costs (attor- ney’s fees, title insurance, etc.) and real estate broker’s commission. Costs to make the building ready for its intended use include expenditures for remodeling and replacing or repairing the roof, floors, electrical wiring, and plumbing. When a new building is constructed, cost consists of the contract price plus payments for architects’ fees, building permits, and excavation costs.

In addition, companies charge certain interest costs to the Buildings account: Interest costs incurred to finance the project are included in the cost of the building when a significant period of time is required to get the building 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 the construction period. When construction has been completed, the company records subsequent interest payments on funds borrowed to finance the construction as debits (increases) to Interest Expense.

Equipment Equipment includes assets used in operations, such as store check-out counters, office furniture, factory machinery, delivery trucks, and airplanes.The cost of equip- ment, such as Rent-A-Wreck vehicles, 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, Rent-A-Wreck does not include motor vehicle licenses and accident insurance on company vehicles in the cost of equipment. These costs represent annual recurring expenditures and do not benefit future periods. Thus, they are treated as expenses as they are incurred.

To illustrate, assume Merten Company purchases factory machinery at a cash price of $50,000. Related expenditures are for 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 follows.

400 Chapter 9 Plant Assets, Natural Resources, and Intangible Assets

Factory Machinery

Cash price $50,000 Sales taxes 3,000 Insurance during shipping 500 Installation and testing 1,000

Cost of factory machinery $54,500

Illustration 9-3 Computation of cost of factory machinery

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Merten makes the following summary entry to record the purchase and related expenditures:

Factory Machinery 54,500 Cash 54,500

(To record purchase of factory machine)

For another example, assume that Lenard Company purchases a delivery truck at a cash price of $22,000. Related expenditures consist of 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, com- puted as follows.

Determining the Cost of Plant Assets 401

Delivery Truck

Cash price $22,000 Sales taxes 1,320 Painting and lettering 500

Cost of delivery truck $23,820

Lenard treats the cost of the motor vehicle license as an expense, and the cost of the insurance policy as a prepaid asset. Thus, Lenard makes the following entry to record the purchase of the truck and related expenditures:

Delivery Truck 23,820 License Expense 80 Prepaid Insurance 1,600

Cash 25,500 (To record purchase of delivery truck and related expenditures)

Cash Flows

�54,500

A SEL� �

�54,500 �54,500

Illustration 9-4 Computation of cost of delivery truck

Many U.S. Firms Use Leases

Leasing is big business for U.S. companies. For example, business investment in equipment in a recent year totaled $709 billion. Leasing accounted for about

31% of all business investment ($218 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 com- panies have established separate leasing companies, such as Boeing Capital Corporation, Dell Financial Services, and John Deere Capital Corporation. And, as an excellent example of the magnitude of leasing, leased planes account for nearly 40% of the U.S. fleet of commer- cial airlines. In addition, leasing is 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?

Cash Flows

�25,500

A SEL� �

�23,820 �80 Exp

�1,600 �25,500

ACCOUNTING ACROSS THE ORGANIZATION

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before you go on...

It is important to understand that depreciation is a process of cost allocation. It is not a process of asset valuation. No attempt is made to measure the change in an asset’s market value during ownership. So, the book value (cost less accumu- lated depreciation) of a plant asset may be quite different from its market value.

Depreciation applies to three classes of plant assets: land improvements, build- ings, and equipment. Each asset in these classes is considered to be a depreciable asset. Why? Because the usefulness to the company and revenue-producing ability of each asset will decline over the asset’s useful life. Depreciation does not apply

to land because its usefulness and revenue-producing ability generally remain intact over time. In fact, in many cases, the usefulness of land is greater over time because of the scarcity of good land 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.

Revenue-producing ability may also decline because of obsolescence. Obsolescence is the process of becoming out of date before the asset phys- ically wears out. For example, major airlines moved from Chicago’s

402 Chapter 9 Plant Assets, Natural Resources, and Intangible Assets

Do it! Cost of Plant Assets

The first four payments ($15,000, $900, $500, and $200) 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 costs and therefore are expensed.

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Action Plan

• Identify expenditures made in order to get delivery equipment ready for its intended use.

• Treat operating costs as expenses.

Related exercise material: BE9-1, BE9-2, E9-1, E9-2, E9-3, and 9-1.Do it!

Assume that Drummond Heating and Cooling Co. 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 each of these costs would be accounted for.

Solution

DEPRECIATION

As explained in Chapter 3, 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. Cost allocation enables companies to properly match expenses with revenues in accordance with the expense recognition principle (see Illustration 9-5).

Explain the concept of depreciation.

S T U D Y O B J E C T I V E 2

Depreciation allocation

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Illustration 9-5 Depreciation as a cost allocation concept

E T H I C S N O T E

When a business is acquired, proper allocation of the purchase price to various asset classes is important, since different depreciation treatment can materially affect income. For example, buildings are depreciated, but land is not.

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Midway Airport to Chicago-O’Hare International Airport because Midway’s runways were too short for jumbo jets. Similarly, many companies replace their computers long before they originally planned to do so because improvements in new computing technology make the old computers obsolete.

Recognizing depreciation on an asset does not result in an accumulation of cash for replacement of the asset. The balance in Accumulated Depreciation rep- resents the total amount of the asset’s cost that the company has charged to expense. It is not a cash fund.

Note that the concept of depreciation is consistent with the going-concern as- sumption. The going-concern assumption states that the company will continue in operation for the foreseeable future. If a company does not use a going-concern assumption, then plant assets should be stated at their market value. In that case, depreciation of these assets is not needed.

Factors in Computing Depreciation Three factors affect the computation of depreciation:

1. Cost. Earlier, we explained the issues affecting the cost of a depreciable asset. Recall that companies record plant assets at cost, in accordance with the cost principle.

2. Useful life. Useful life is an estimate of the expected productive life, also called service life, of the asset. Useful life may be expressed in terms of time, units of activity (such as machine hours), or units of output. Useful life is an estimate. In making the estimate, management considers such factors as the intended use of the asset, its expected repair and maintenance, and its vulnerability to obso- lescence. Past experience with similar assets is often helpful in deciding on ex- pected useful life. We might reasonably expect Rent-A-Wreck and Avis to use different estimated useful lives for their vehicles.

3. Salvage value. Salvage value is an estimate of the asset’s value at the end of its useful life. This value may be based on the asset’s worth as scrap or on its expected trade-in value. Like useful life, salvage value is an estimate. In making the estimate, management considers how it plans to dispose of the asset and its experience with similar assets.

Illustration 9-6 summarizes the three factors used in computing depreciation.

Depreciation 403

Cost: all expenditures necessary to acquire the asset and make it ready for intended use Useful life: estimate of the

expected life based on need for repair, service life, and vulnerability to obsolescence

Salvage value: estimate of the asset s value at the end of its useful life

,

Illustration 9-6 Three factors in computing depreciation

A L T E R N A T I V E T E R M I N O L O G Y

Another term sometimes used for salvage value is residual value.

H E L P F U L H I N T Depreciation expense is reported on the income statement. Accumulated depreciation is reported on the balance sheet as a deduction from plant assets.

Depreciation Methods Depreciation is generally computed using one of the following methods:

1. Straight-line 2. Units-of-activity 3. Declining-balance

Compute periodic depreciation using different methods.

S T U D Y O B J E C T I V E 3

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Each method is acceptable under generally accepted accounting principles. Management selects the method(s) it believes to be appropriate. The objective is to select the method that best measures an asset’s contribution to revenue over its useful life. Once a company chooses a method, it should apply it consistently over the useful life of the asset. Consistency enhances the compara- bility of financial statements. Depreciation affects the balance sheet through accumulated depreciation and the income statement through depreciation expense.

We will compare the three depreciation methods using the following data for a small delivery truck purchased by Barb’s Florists on January 1, 2011.