The allocation of a plant asset's cost to expense over its useful life is called ________.

396

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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397

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.

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

Cost $13,000 Expected salvage value $ 1,000 Estimated useful life in years 5 Estimated useful life in miles 100,000

Illustration 9-7 Delivery truck data

Illustration 9-8 (in the margin) shows the use of the primary depreciation methods in 600 of the largest companies in the United States.

STRAIGHT-LINE Under the straight-line method, companies expense the same amount of depreci- ation for each year of the asset’s useful life. It is measured solely by the passage of time.

In order to compute depreciation expense under the straight-line method, companies need to determine depreciable cost. Depreciable cost is the cost of the asset less its salvage value. It represents the total amount subject to depre- ciation. Under the straight-line method, to determine annual depreciation ex- pense, we divide depreciable cost by the asset’s useful life. Illustration 9-9 shows the computation of the first year’s depreciation expense for Barb’s Florists.

2% Declining-balance 3% Units-of-activity

7% Other

88% Straight-line

Illustration 9-8 Use of depreciation methods in 600 large U.S. companies

Cost � Salvage � Depreciable Value Cost

$13,000 � $1,000 � $12,000

Annual Depreciable � Useful Life � Depreciation

Cost (in years) Expense $12,000 � 5 � $2,400

Alternatively, we also can compute an annual rate of depreciation. In this case, the rate is 20% (100% � 5 years). When a company uses an annual straight-line rate, it applies the percentage rate to the depreciable cost of the asset.

Illustration 9-10 (page 405) shows a depreciation schedule using an annual rate. This illustration indicates that the depreciation expense of $2,400 is the same each year. The book value (computed as cost minus accumulated depreciation) at the end of the useful life is equal to the expected $1,000 salvage value.

Illustration 9-9 Formula for straight-line method

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What happens to these computations for an asset purchased during the year, rather than on January 1? In that case, it is necessary to prorate the annual depre- ciation on a time basis. If Barb’s Florists had purchased the delivery truck on April 1, 2011, the company would own the truck for nine months of the first year (April–December).Thus, depreciation for 2011 would be $1,800 ($12,000 � 20% � 9/12 of a year).

The straight-line method predominates in practice. Such large companies as Campbell Soup, Marriott, and General Mills use the straight-line method. It is simple to apply, and it matches expenses with revenues when the use of the asset is reasonably uniform throughout the service life. For simplicity, Rent-A-Wreck is probably using the straight-line method of depreciation for its vehicles.

UNITS-OF-ACTIVITY Under the units-of-activity method, useful life is expressed in terms of the total units of production or use expected from the asset, rather than as a time period. The units-of-activity method is ideally suited to factory machinery. Manufacturing companies can measure production in units of output or in machine hours. This method can also be used for such assets as delivery equipment (miles driven) and airplanes (hours in use). The units-of-activity method is generally not suitable for buildings or furniture, because depreciation for these assets is more a function of time than of use.

To use this method, companies estimate the total units of activity for the entire useful life,and then divide these units into depreciable cost.The resulting number rep- resents the depreciation cost per unit.The depreciation cost per unit is then applied to the units of activity during the year to determine the annual depreciation expense.

To illustrate, assume that Barb’s Florists drives its delivery truck 15,000 miles in the first year. Illustration 9-11 shows the units-of-activity formula and the com- putation of the first year’s depreciation expense.

Depreciation 405

BARB’S FLORISTS

Computation End of YearAnnual Depreciable

� Depreciation

� Depreciation Accumulated Book

Year Cost Rate Expense Depreciation Value

2011 $12,000 20% $2,400 $ 2,400 $10,600* 2012 12,000 20 2,400 4,800 8,200 2013 12,000 20 2,400 7,200 5,800 2014 12,000 20 2,400 9,600 3,400 2015 12,000 20 2,400 12,000 1,000 *Book value � Cost � Accumulated depreciation � ($13,000 � $2,400).

Illustration 9-10 Straight-line depreciation schedule

$2,400

20 11

20 12

20 13

20 14

20 15

Year

D ep

re ci

at io

n Ex

pe ns

e

Depreciation Depreciable

� Total Units

� Cost per Cost of Activity

Unit

$12,000 � 100,000 miles � $0.12

Depreciable Units of Annual Cost per � Activity during � Depreciation

Unit the Year Expense

$0.12 � 15,000 miles � $1,800

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

Another term often used is the units-of-production method.

H E L P F U L H I N T Under any method, depreciation stops when the asset’s book value equals expected salvage value.

Illustration 9-11 Formula for units-of-activity method

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The units-of-activity depreciation schedule, using assumed mileage, is as follows.

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

BARB’S FLORISTS

Computation End of YearAnnual Units of

� Depreciation Depreciation Accumulated Book

Year Activity Cost/Unit � Expense Depreciation Value

2011 15,000 $0.12 $1,800 $ 1,800 $11,200* 2012 30,000 0.12 3,600 5,400 7,600 2013 20,000 0.12 2,400 7,800 5,200 2014 25,000 0.12 3,000 10,800 2,200 2015 10,000 0.12 1,200 12,000 1,000

*($13,000 � $1,800).

$5,000 $4,000 $3,000 $2,000 $1,000

0

Year

D ep

re ci

at io

n Ex

pe ns

e

20 11

20 12

20 13

20 14

20 15

Illustration 9-12 Units-of-activity depreciation schedule

This method is easy to apply for assets purchased mid-year. In such a case, the company computes the depreciation using the productivity of the asset for the par- tial year.

The units-of-activity method is not nearly as popular as the straight-line method (see Illustration 9-8, page 404), primarily because it is often difficult for companies to reasonably estimate total activity. However, some very large companies, such as Chevron and Boise Cascade (a forestry company), do use this method. When the productivity of an asset varies significantly from one period to another, the units-of-activity method results in the best matching of expenses with revenues.

DECLINING-BALANCE The declining-balance method produces a decreasing annual depreciation expense over the asset’s useful life. The method is so named because the periodic deprecia- tion is based on a declining book value (cost less accumulated depreciation) of the asset. With this method, companies compute annual depreciation expense by mul- tiplying the book value at the beginning of the year by the declining-balance depre- ciation rate. The depreciation rate remains constant from year to year, but the book value to which the rate is applied declines each year.

At the beginning of the first year, book value is the cost of the asset. This is so because the balance in accumulated depreciation at the beginning of the asset’s useful life is zero. In subsequent years, book value is the difference between cost and accumulated depreciation to date. Unlike the other depreciation methods, the declining-balance method does not use depreciable cost. That is, it ignores salvage value in determining the amount to which the declining-balance rate is applied. Salvage value, however, does limit the total depreciation that can be taken. Depreciation stops when the asset’s book value equals expected salvage value.

A common declining-balance rate is double the straight-line rate. The method is often called the double-declining-balance method. If Barb’s Florists uses the double-declining-balance method, it uses a depreciation rate of 40% (2 � the straight-line rate of 20%). Illustration 9-13 shows the declining-balance formula and the computation of the first year’s depreciation on the delivery truck.

Book Value Declining- Annual at Beginning � Balance � Depreciation

of Year Rate Expense

$13,000 � 40% � $5,200

Illustration 9-13 Formula for declining- balance method

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The delivery equipment is 69% depreciated ($8,320 � $12,000) at the end of the second year. Under the straight-line method, the truck would be depreciated 40% ($4,800 � $12,000) at that time. Because the declining-balance method pro- duces higher depreciation expense in the early years than in the later years, it is considered an accelerated-depreciation method. The declining-balance method is compatible with the expense recognition principle. It matches the higher deprecia- tion expense in early years with the higher benefits received in these years. It also recognizes lower depreciation expense in later years, when the asset’s contribution to revenue is less. Some assets lose usefulness rapidly because of obsolescence. In these cases, the declining-balance method provides the most appropriate deprecia- tion amount.

When a company purchases an asset during the year, it must prorate the first year’s declining-balance depreciation on a time basis. For example, if Barb’s Florists had purchased the truck on April 1, 2011, depreciation for 2011 would be- come $3,900 ($13,000 � 40% � 9/12). The book value at the beginning of 2012 is then $9,100 ($13,000 � $3,900), and the 2012 depreciation is $3,640 ($9,100 � 40%). Subsequent computations would follow from those amounts.

COMPARISON OF METHODS Illustration 9-15 compares annual and total depreciation expense under each of the three methods for Barb’s Florists.

Depreciation 407

H E L P F U L H I N T The method recom- mended for an asset that is expected to be signi- ficantly more productive in the first half of its useful life is the declining- balance method.

BARB’S FLORISTS

Computation End of YearAnnual Book Value

� Depreciation

� Depreciation Accumulated Book

Year Beginning of Year Rate Expense Depreciation Value

2011 $13,000 40% $5,200 $ 5,200 $7,800 2012 7,800 40 3,120 8,320 4,680 2013 4,680 40 1,872 10,192 2,808 2014 2,808 40 1,123 11,315 1,685 2015 1,685 40 685* 12,000 1,000

*Computation of $674 ($1,685 � 40%) is adjusted to $685 in order for book value to equal salvage value.

$5,000 $4,000 $3,000 $2,000 $1,000

0

Year

D ep

re ci

at io

n Ex

pe ns

e

20 11

20 12

20 13

20 14

20 15

Illustration 9-14 Double-declining-balance depreciation schedule

Straight- Units-of- Declining- Year Line Activity Balance 2011 $ 2,400 $ 1,800 $ 5,200 2012 2,400 3,600 3,120 2013 2,400 2,400 1,872 2014 2,400 3,000 1,123 2015 2,400 1,200 685

$12,000 $12,000 $12,000

Illustration 9-15 Comparison of depreciation methods

Annual depreciation varies considerably among the methods, but total depre- ciation is the same for the five-year period under all three methods. Each method is acceptable in accounting, because each recognizes in a rational and systematic manner the decline in service potential of the asset. Illustration 9-16 (page 408) graphs the depreciation expense pattern under each method.

The depreciation schedule under this method is as follows.

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Depreciation and Income Taxes The Internal Revenue Service (IRS) allows corporate taxpayers to deduct depreci- ation expense when they compute taxable income. However, the IRS does not re- quire the taxpayer to use the same depreciation method on the tax return that is used in preparing financial statements.

Many corporations use straight-line in their financial statements to maximize net income. At the same time, they use a special accelerated-depreciation method on their tax returns to minimize their income taxes.Taxpayers must use on their tax returns either the straight-line method or a special accelerated-depreciation method called the Modified Accelerated Cost Recovery System (MACRS).

Revising Periodic Depreciation Depreciation is one example of the use of estimation in the accounting process. Management should periodically review annual depreciation expense. If wear and tear or obsolescence indicate that annual deprecia- tion estimates are inadequate or excessive, the company should change

the amount of depreciation expense. When a change in an estimate is required, the company makes the change in

current and future years. It does not change depreciation in prior periods. The rationale is that continual restatement of prior periods would adversely affect con- fidence in financial statements.

To determine the new annual depreciation expense, the company first com- putes the asset’s depreciable cost at the time of the revision. It then allocates the re- vised depreciable cost to the remaining useful life.

To illustrate, assume that Barb’s Florists decides on January 1, 2014, to extend the useful life of the truck one year because of its excellent condition. The company has used the straight-line method to depreciate the asset to date, and book value is $5,800 ($13,000 � $7,200).The new annual depreciation is $1,600, computed as follows.

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

Straight-line Declining-balance Units-of-activity

Key: $5,000

$4,000

$3,000

$2,000

$1,000

0 2011 2012 2013 2014 2015

Year

D ep

re ci

at io

n Ex

pe ns

e

Illustration 9-16 Patterns of depreciation

Describe the procedure for revising periodic depreciation.

S T U D Y O B J E C T I V E 4

H E L P F U L H I N T Use a step-by-step approach: (1) determine new depreciable cost; (2) divide by remaining useful life.

Book value, 1/1/14 $5,800 Less: Salvage value 1,000

Depreciable cost $4,800

Remaining useful life 3 years (2014–2016)

Revised annual depreciation ($4,800 � 3) $1,600

Illustration 9-17 Revised depreciation computation

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before you go on...

Barb’s Florists makes no entry for the change in estimate. On December 31, 2014, during the preparation of adjusting entries, it records depreciation expense of $1,600. Companies must describe in the financial statements significant changes in estimates.

Expenditures During Useful Life 409

Related exercise material: BE9-3, BE9-4, BE9-5, BE9-6, BE9-7, E9-5, E9-6, E9-7, E9-8, and 9-2.Do it!

Action Plan

• Calculate depreciable cost (Cost�Salvage value).

• Divide the depreciable cost by the estimated useful life.

Depreciation expense � Cost � Salvage value

� $50,000 � $2,000

� $4,800 Useful life 10

The entry to record the first year’s depreciation would be:

Dec. 31 Depreciation Expense 4,800 Accumulated Depreciation 4,800

(To record annual depreciation on snow- grooming machine)

The Navigator✓

Do it! On January 1, 2011, Iron Mountain Ski Corporation purchased a new snow-

grooming machine for $50,000. The machine is estimated to have a 10-year life with a $2,000 salvage value. What journal entry would Iron Mountain Ski Corporation make at December 31, 2011, if it uses the straight-line method of depreciation?

Solution

Straight-Line Depreciation

During the useful life of a plant asset, a company may incur costs for ordi- nary repairs, additions, or improvements. Ordinary repairs are expendi- tures to maintain the operating efficiency and productive life of the unit. They usually are fairly small amounts that occur frequently. Examples are motor tune-ups and oil changes, the painting of buildings, and the replac- ing of worn-out gears on machinery. Companies record such repairs as debits to Repair (or Maintenance) Expense as they are incurred. Because they are immedi- ately charged as an expense against revenues, these costs are often referred to as revenue expenditures.

Additions and improvements are costs incurred to increase the oper- ating efficiency, productive capacity, or useful life of a plant asset.They are usually material in amount and occur infrequently. Additions and im- provements increase the company’s investment in productive facilities. Companies generally debit these amounts to the plant asset affected.They are often referred to as capital expenditures. Most major U.S. corporations disclose annual capital expenditures.

Companies must use good judgment in deciding between a revenue ex- penditure and capital expenditure. For example, assume that Rodriguez Co. purchases a number of wastepaper baskets.Although the proper accounting would appear to be to capitalize and then depreciate these wastepaper bas- kets over their useful life, it would be more usual for Rodriguez to expense them immediately. This practice is justified on the basis of materiality. Materiality refers to the impact of an item’s size on a company’s financial

EXPENDITURES DURING USEFUL LIFE

Distinguish between revenue and capital expenditures, and explain the entries for each.

S T U D Y O B J E C T I V E 5

E T H I C S N O T E

WorldCom perpetrated the largest accounting fraud in history by treating $7 billion of “line costs” as capital expenditures. Line costs are rental payments to access other companies’ networks. Like any other rental payment, they should have been expensed as incurred. Instead, capitalization delayed expense recognition to future periods and thus boosted current-period profits.

JWCL165_c09_396-443.qxd 8/4/09 9:39 PM Page 409

operations.The materiality principle states that if an item would not make a differ- ence in decision making, the company does not have to follow GAAP in reporting that item.

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

PLANT ASSET DISPOSALS

Companies dispose of plant assets in three ways—retirement, sale, or exchange—as Illustration 9-18 shows.Whatever the method, at the time of disposal the company must determine the book value of the plant asset. As noted earlier, book value is the difference between the cost of a plant

asset and the accumulated depreciation to date.

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

S T U D Y O B J E C T I V E 6

Equipment is scrapped or discarded.

Equipment is sold to another party.

Piper Co.

Lowy Co.

Lowy Co.

Retirement Sale Existing equipment is traded for new equipment.

Exchange

Piper Co.

At the time of disposal, the company records depreciation for the fraction of the year to the date of disposal. The book value is then eliminated by (1) debiting (decreasing) Accumulated Depreciation for the total depreciation to date, and (2) crediting (decreasing) the asset account for the cost of the asset. In this chapter we examine the accounting for the retirement and sale of plant assets. In the appendix to the chapter we discuss and illustrate the accounting for exchanges of plant assets.

Retirement of Plant Assets To illustrate the retirement of plant assets, assume that Hobart Enterprises retires its computer printers, which cost $32,000. The accumulated depreciation on these printers is $32,000. The equipment, therefore, is fully depreciated (zero book value). The entry to record this retirement is as follows.

Accumulated Depreciation—Printing Equipment 32,000 Printing Equipment 32,000

(To record retirement of fully depreciated equipment)

What happens if a fully depreciated plant asset is still useful to the company? In this case, the asset and its accumulated depreciation continue to be reported on the balance sheet, without further depreciation adjustment, until the company re- tires the asset. Reporting the asset and related accumulated depreciation on the balance sheet informs the financial statement reader that the asset is still in use. Once fully depreciated, no additional depreciation should be taken, even if an as- set is still being used. In no situation can the accumulated depreciation on a plant asset exceed its cost.

If a company retires a plant asset before it is fully depreciated, and no cash is received for scrap or salvage value, a loss on disposal occurs. For example, assume

H E L P F U L H I N T When a company disposes of a plant asset, the company must remove from the accounts all amounts related to the asset. This includes the original cost in the asset account and the total depreciation to date in the accumulated depreciation account.

Cash Flows no effect

A SEL� �

�32,000 �32,000

Illustration 9-18 Methods of plant asset disposal

JWCL165_c09_396-443.qxd 7/31/09 4:20 PM Page 410

July 1 Depreciation Expense 8,000 Accumulated Depreciation—Office Furniture 8,000

(To record depreciation expense for the first 6 months of 2011)

Accumulated Depreciation—Delivery Equipment 14,000 Loss on Disposal 4,000

Delivery Equipment 18,000 (To record retirement of delivery equipment at a loss)

that Sunset Company discards delivery equipment that cost $18,000 and has accu- mulated depreciation of $14,000. The entry is as follows.

Plant Asset Disposals 411

Companies report a loss on disposal in the “Other expenses and losses” section of the income statement.

Sale of Plant Assets In a disposal by sale, the company compares the book value of the asset with the proceeds received from the sale. If the proceeds of the sale exceed the book value of the plant asset, a gain on disposal occurs. If the proceeds of the sale are less than the book value of the plant asset sold, a loss on disposal occurs.

Only by coincidence will the book value and the fair market value of the as- set be the same when the asset is sold. Gains and losses on sales of plant assets are therefore quite common. For example, Delta Airlines reported a $94,343,000 gain on the sale of five Boeing B727-200 aircraft and five Lockheed L-1011-1 aircraft.

GAIN ON DISPOSAL To illustrate a gain, assume that on July 1, 2011, Wright Company sells office furni- ture for $16,000 cash. The office furniture originally cost $60,000. As of January 1, 2011, it had accumulated depreciation of $41,000. Depreciation for the first six months of 2011 is $8,000. Wright records depreciation expense and updates accu- mulated depreciation to July 1 with the following entry.

After the accumulated depreciation balance is updated, the company com- putes the gain or loss. Illustration 9-19 shows this computation for Wright Company, which has a gain on disposal of $5,000.

Cost of office furniture $60,000 Less: Accumulated depreciation ($41,000 � $8,000) 49,000

Book value at date of disposal 11,000 Proceeds from sale 16,000

Gain on disposal $ 5,000

Illustration 9-19 Computation of gain on disposal

Cash Flows no effect

A SEL� �

�14,000 �4,000 Exp

�18,000

Cash Flows no effect

A SEL� �

�8,000 Exp �8,000

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before you go on...

Companies report a gain on disposal in the “Other revenues and gains” section of the income statement.

LOSS ON DISPOSAL Assume that instead of selling the office furniture for $16,000, Wright sells it for $9,000. In this case, Wright computes a loss of $2,000 as follows.

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

Wright records the sale and the gain on disposal as follows.

July 1 Cash 16,000 Accumulated Depreciation—Office Furniture 49,000

Office Furniture 60,000 Gain on Disposal 5,000

(To record sale of office furniture at a gain) Cash Flows

�16,000

A SEL� �

�16,000 �49,000 �60,000

�5,000 Rev

July 1 Cash 9,000 Accumulated Depreciation—Office Furniture 49,000 Loss on Disposal 2,000

Office Furniture 60,000 (To record sale of office furniture at a loss)

Cash Flows

�9,000

A SEL� �

�9,000 �49,000

�2,000 Exp �60,000

Wright records the sale and the loss on disposal as follows.

Cost of office furniture $60,000 Less: Accumulated depreciation 49,000

Book value at date of disposal 11,000 Proceeds from sale 9,000

Loss on disposal $ 2,000

Companies report a loss on disposal in the “Other expenses and losses” section of the income statement.

Illustration 9-20 Computation of loss on disposal

Do it! Overland Trucking has an old truck that cost $30,000, and it has accumulated

depreciation of $16,000 on this truck. Overland has decided to sell the truck. (a) What entry would Overland Trucking make to record the sale of the truck for $17,000 cash? (b) What entry would Overland Trucking make to record the sale of the truck for $10,000 cash?

Solution

Plant Asset Disposal

Action Plan

• At the time of disposal, determine the book value of the asset.

• Compare the asset’s book value with the proceeds received to determine whether a gain or loss has occurred.

(a) Sale of truck for cash at a gain: Cash 17,000 Accumulated Depreciation—Truck 16,000

Truck 30,000 Gain on Disposal [$17,000 � ($30,000 � $16,000)] 3,000

(To record sale of truck at a gain)

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SECTION 2 Natural ResourcesH E L P F U L H I N T Natural resources consist of standing timber and underground deposits of oil, gas, and minerals.These long-lived productive assets have two distinguishing character- istics: (1) They are physically extracted in operations (such as mining, cutting, or pumping). (2) They are replaceable only by an act of nature.

Accounting for Natural Resources 413

(b) Sale of truck for cash at a loss: Cash 10,000 Loss on Disposal [$10,000 � ($30,000 � $16,000)] 4,000 Accumulated Depreciation—Truck 16,000

Truck 30,000 (To record sale of truck at a loss)

Related exercise material: BE9-9, BE9-10, E9-9, E9-10, and 9-3.Do it!

The Navigator✓

H E L P F U L H I N T On a balance sheet, natural resources may be described more specifically as timberlands, mineral deposits, oil reserves, and so on.

ACCOUNTING FOR NATURAL RESOURCES

The acquisition cost of a natural resource is the price needed to acquire the resource and prepare it for its intended use. For an already-discovered resource, such as an existing coal mine, cost is the price paid for the property.

The allocation of the cost of natural resources to expense in a rational and systematic manner over the resource’s useful life is called depletion. (That is, depletion is to natural resources as depreciation is to plant assets.) Companies generally use the units-of-activity method (learned earlier in the chapter) to com- pute depletion. The reason is that depletion generally is a function of the units ex- tracted during the year.

Under the units-of-activity method, companies divide the total cost of the natural resource minus salvage value by the number of units estimated to be in the resource. The result is a depletion cost per unit of product.They then multiply the depletion cost per unit by the number of units extracted and sold.The result is the annual depletion expense. Illustration 9-21 shows the formula to compute depletion expense.

Compute periodic depletion of natural resources.

S T U D Y O B J E C T I V E 7

Total Cost Total Depletion minus Salvage � Estimated � Cost per

Value Units Unit

Depletion Number of Annual Cost per � Units Extracted � Depletion

Unit and Sold Expense

To illustrate, assume that Lane Coal Company invests $5 million in a mine estimated to have 10 million tons of coal and no salvage value. In the first year, Lane extracts and sells 800,000 tons of coal. Using the formulas above, Lane computes the depletion expense as follows:

$5,000,000 � 10,000,000 � $0.50 depletion cost per ton

$0.50 � 800,000 � $400,000 annual depletion expense

E T H I C S N O T E

Investors were stunned at news that Royal Dutch/Shell Group had significantly overstated its reported oil reserves—and perhaps had done so intentionally.

Illustration 9-21 Formula to compute depletion expense

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Lane records depletion expense for the first year of operation as follows.

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

Dec. 31 Depletion Expense 400,000 Accumulated Depletion 400,000

(To record depletion expense on coal deposits)Cash Flows

no effect

A SEL� �

�400,000 Exp �400,000

The company reports the account Depletion Expense as a part of the cost of pro- ducing the product.Accumulated Depletion is a contra-asset account, similar to ac- cumulated depreciation. It is deducted from the cost of the natural resource in the balance sheet, as Illustration 9-22 shows.

FINANCIAL STATEMENT PRESENTATION

LANE COAL COMPANY Balance Sheet (partial)

Coal mine $5,000,000 Less: Accumulated depletion 400,000 $4,600,000

Many companies do not use an Accumulated Depletion account. In such cases, the company credits the amount of depletion directly to the natural resources account.

Sometimes, a company will extract natural resources in one accounting period but not sell them until a later period. In this case, the company does not expense the depletion until it sells the resource. It reports the amount not sold as inventory in the current assets section.

SECTION 3 Intangible Assets

Intangible assets are rights, privileges, and competitive advantages that result from the ownership of long-lived assets that do not possess physical substance. Evidence of intangibles may exist in the form of contracts or licenses. Intangibles may arise from the following sources:

1. Government grants, such as patents, copyrights, and trademarks. 2. Acquisition of another business, in which the purchase price includes a pay-

ment for the company’s favorable attributes (called goodwill). 3. Private monopolistic arrangements arising from contractual agreements, such

as franchises and leases.

Some widely known intangibles are Microsoft’s patents, McDonald’s franchises, Apple’s trade name iPod, J.K. Rowlings’ copyrights on the Harry Potter books, and the trademark Rent-A-Wreck in the Feature Story.

Illustration 9-22 Statement presentation of accumulated depletion

ACCOUNTING FOR INTANGIBLE ASSETS

Companies record intangible assets at cost. Intangibles are categorized as having either a limited life or an indefinite life. If an intangible has a limited life, the company allocates its cost over the asset’s useful life using a process similar to depreciation. The process of allocating the cost of in-

tangibles is referred to as amortization.The cost of intangible assets with indefinite lives should not be amortized.

Explain the basic issues related to accounting for intangible assets.

S T U D Y O B J E C T I V E 8

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To record amortization of an intangible asset, a company increases (debits) Amortization Expense, and decreases (credits) the specific intangible asset. (Unlike depreciation, no contra account, such as Accumulated Amortization, is usually used.)

Intangible assets are typically amortized on a straight-line basis. For example, the legal life of a patent is 20 years. Companies amortize the cost of a patent over its 20-year life or its useful life, whichever is shorter. To illustrate the computation of patent amortization, assume that National Labs purchases a patent at a cost of $60,000. If National estimates the useful life of the patent to be eight years, the annual amortization expense is $7,500 ($60,000 � 8). National records the annual amortization as follows.

Types of Intangible Assets 415

H E L P F U L H I N T Amortization is to intangibles what depreciation is to plant assets and depletion is to natural resources.

Dec. 31 Amortization Expense—Patent 7,500 Patent 7,500

(To record patent amortization)

Companies classify Amortization Expense—Patents as an operating expense in the income statement.

There is a difference between intangible assets and plant assets in determining cost. For plant assets, cost includes both the purchase price of the asset and the costs incurred in designing and constructing the asset. In contrast, cost for an intan- gible asset includes only the purchase price. Companies expense any costs incurred in developing an intangible asset.

Patents A patent is an exclusive right issued by the U.S. Patent Office that enables the recipient to manufacture, sell, or otherwise control an invention for a period of 20 years from the date of the grant. A patent is nonrenewable. But companies can extend the legal life of a patent by obtaining new patents for improvements or other changes in the basic design. The initial cost of a patent is the cash or cash equivalent price paid to acquire the patent.

The saying, “A patent is only as good as the money you’re prepared to spend defending it” is very true. Many patents are subject to litigation. Any legal costs an owner incurs in successfully defending a patent in an infringement suit are consid- ered necessary to establish the patent’s validity. The owner adds those costs to the Patent account and amortizes them over the remaining life of the patent.

The patent holder amortizes the cost of a patent over its 20-year legal life or its useful life, whichever is shorter. Companies consider obsolescence and inadequacy in determining useful life. These factors may cause a patent to become economi- cally ineffective before the end of its legal life.

Copyrights The federal government grants copyrights which give the owner the exclusive right to reproduce and sell an artistic or published work. Copyrights extend for the life of the creator plus 70 years. The cost of a copyright is the cost of acquiring and defending it.The cost may be only the $10 fee paid to the U.S. Copyright Office. Or it may amount to much more if an infringement suit is involved.

The useful life of a copyright generally is significantly shorter than its legal life. Therefore, copyrights usually are amortized over a relatively short period of time.

TYPES OF INTANGIBLE ASSETS

Cash Flows no effect

A SEL� �

�7,500 Exp �7,500

JWCL165_c09_396-443.qxd 7/31/09 4:20 PM Page 415

Trademarks and Trade Names A trademark or trade name is a word, phrase, jingle, or symbol that identifies a par- ticular enterprise or product. Trade names like Wheaties, Game Boy, Frappuccino, Kleenex, Windows, Coca-Cola, and Jeep create immediate product identification. They also generally enhance the sale of the product.The creator or original user may obtain exclusive legal right to the trademark or trade name by registering it with the U.S. Patent Office. Such registration provides 20 years of protection.The registration may be renewed indefinitely as long as the trademark or trade name is in use.

If a company purchases the trademark or trade name, its cost is the purchase price. If a company develops and maintains the trademark or trade name, any costs related to these activities are expensed as incurred. Because trademarks and trade names have indefinite lives, they are not amortized.

Franchises and Licenses When you fill up your tank at the corner Shell station, eat lunch at Taco Bell, or rent a car from Rent-A-Wreck, you are dealing with franchises.A franchise is a contrac- tual arrangement between a franchisor and a franchisee. The franchisor grants the franchisee the right to sell certain products, provide specific services, or use certain trademarks or trade names, usually within a designated geographical area.

Another type of franchise is that entered into between a governmental body (commonly municipalities) and a company.This franchise permits the company to use public property in performing its services.Examples are the use of city streets for a bus line or taxi service,use of public land for telephone and electric lines,and the use of air- waves for radio or TV broadcasting. Such operating rights are referred to as licenses.

When a company can identify costs with the purchase of a franchise or license, it should recognize an intangible asset. Companies should amortize the cost of a limited-life franchise (or license) over its useful life. If the life is indefinite, the cost is not amortized. Annual payments made under a franchise agreement are recorded as operating expenses in the period in which they are incurred.

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

ESPN Wins Monday Night Football Franchise

What is a well-known franchise worth? Recently ESPN outbid its rivals for the right to broadcast Monday Night Football. At a price of $1.1 billion per year—

nearly twice what rival ABC paid in previous years—it isn’t clear who won and who lost. When bidding for a unique franchise like Monday Night Football, management must con-

sider many factors to determine a price. As part of the deal, ESPN also got wireless rights and Spanish-language telecasts. By its estimation, ESPN will generate a profit of $200 million per year from Monday Night Football. ABC was losing $150 million per year.

Another factor in the decision was ESPN management’s concern that if ESPN didn’t win the bid, a buyer would emerge that would use Monday Night Football as a launching pad for a new sports network. ESPN doesn’t want any more competitors than it already has. It is hard to put a price tag on the value of keeping the competition to a minimum.