CHAPTER 9 Long-Lived Assets

SYNOPSIS

In this chapter, the author discusses (1) accounting for the acquisition, use, and disposal of
long-lived assets, and (2) management's incentives for selecting accounting procedures
associated with long-lived assets. The specific issues discussed in accounting for long-lived
assets include the costs to capitalize when the asset is acquired, the treatment of
postacquisition costs, cost allocation, and the disposal of long-lived assets. The discussion of
cost allocation focuses on the alternative depreciation methods for fixed assets and the activity
method for natural resources. The author also discusses intangible assets, deferred costs, and
international financial reporting standards as they relate to property, plant and equipment. The
ethics vignette considers a case where management's methods of accounting for long-lived
assets may be within the guidelines of GAAP but still leave the statement reader with vague and
insufficient information.

The ethics vignette looks at the variations of accounting principles allowed under GAAP and if
companies disclose enough information for users of financial statements related to depreciation
and long-lived assets.

The Internet research exercise examines the FASB's recent financial accounting standard for
asset impairments.

The following key points are emphasized in Chapter 9:

1. How the matching principle underlies the methods used to account for long-lived assets.

2. Major questions that are addressed when accounting for long-lived assets and how the
financial statements are affected.

3. Major economic consequences associated with the methods used to account for long-lived
assets.

4. Costs that should be included in the capitalized cost of a long-lived asset.

5. Accounting treatment of postacquisition expenditures.

6. How the cost of a long-lived asset is allocated over its useful life and the alternative
allocation methods.

7. Disposition of long-lived assets.

8. The increasing importance of fair market value and issues that must be addressed when
using fair market value as a basis for long-lived assets.

TEXT/LECTURE OUTLINE

Long-lived assets.
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I. Assets used in the operations of a business (not for resale) that provide benefits to the
company extending beyond the current operating period. Long-lived assets include the
following:

A. Land.

B. Fixed assets (i.e., buildings, machinery, and equipment).

C. Natural resource costs.

D. Intangible assets.

E. Deferred costs.

II. The relative size of long-lived assets.

III. Long-lived asset accounting: general issues and financial statement effects.

A. Three basic questions when accounting for long-lived assets.

1. What dollar amount should be included in the capitalized cost of the long-lived
asset?

2. Over what time period should the cost be amortized?

3. At what rate should the cost be amortized?

B. An overview of long-lived asset accounting—acquisition, use, and disposal.

IV. Acquisition: what costs to capitalize?

A. As a general rule, all costs necessary to get the asset in a serviceable and usable
condition and location should be capitalized. The allowable costs of capitalization vary
across long-lived assets.

B. The capitalized cost of land should include:

1. Purchase price of the land, including closing costs (such as title, legal, and
recording fees).

2. Costs incurred to prepare the land for its intended use such as razing old
buildings, grading, filling, and so forth. Any proceeds received from preparing
the land for its intended use (such as the sale of scrap from a demolished old
building) reduce the capitalized cost of land.

3. Permanent land improvements such as landscaping, sewers, drainage

systems, and so forth.

C. Lump sum purchases.

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1. As a general rule, allocate the purchase price to the assets based on their
relative fair market values. This method requires that the fair market value of
each asset acquired be known.
2. Because fair market values are somewhat subjective, using fair market values
to allocate the purchase price among the individual assets acquired gives
management discretion about how much to report for each asset. This
discretion, in turn, can affect the timing of expense recognition and certain key
ratios.
D. Construction of long-lived assets.

V. Post-acquisition expenditures: betterments or maintenance?

A. Betterments—costs incurred to improve an asset.

1. To be considered a betterment, an expenditure must provide one of the

following:

a) An increase in the asset's useful life.

b) An improvement in the quality of the asset's output.
c) An increase in the quantity of the asset's output.
d) A reduction in the costs associated with operating the asset.
2. Betterments should be capitalized as part of the long-lived asset and
amortized over the asset's remaining useful life.

B. Maintenance expenditures—costs incurred to repair or maintain an asset's current

level of productivity. Maintenance expenditures are considered period expenses.

VI. Cost allocation: amortizing capitalized costs.

A. The purpose of cost allocation is to match the costs of long-lived assets against the
benefits the assets helped generate.

B. Amortization terms.

1. Depreciation—the amortization of fixed assets.

2. Depletion—the amortization of natural resource costs.

3. Amortization—the allocation of intangible assets and deferred costs.

C. Steps in the allocation process.

1. Determine over what period of time the long-lived asset will help generate
benefits. This step requires the company to estimate the asset's useful life.
Estimating an asset's useful life is very subjective and is complicated by
technological advances.
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2. Determine the dollar amount of the asset's capitalized cost that the company
expects to consume over the asset's estimated useful life.

a) This step requires the company to estimate the asset's salvage value.
Estimating an asset's salvage value is extremely difficult. In practice,
many managers simply assign a salvage value of zero to assets because
of the difficulty in estimating a reasonable salvage value.
b) The dollar amount of the asset's capitalized cost that the company
expects to consume over the asset's estimated useful life is called the
asset's depreciation base (for fixed assets). The depreciation base
equals the capitalized cost of the asset less its estimated salvage value.
3. Select a cost allocation method.

a) The choice of cost allocation methods does not affect the dollar amount
amortized over a long-lived asset's estimated useful life. The dollar
amount that is amortized over the asset's life is always its depreciation
base.
b) A cost allocation method determines the rate at which an asset's
capitalized cost will be amortized to future periods. That is, the total
amount amortized over an asset's life is the same across allocation
methods, but the timing of the allocations will differ.
D. Cost allocation (depreciation) methods.

1. Straight-line method.

a) Allocates an equal amount of the depreciation base to each period.

b) Depreciation expense equals:
(Capitalized cost minus Salvage value) ÷ Estimated life in years.
2. Double-declining-balance method.

a) Allocates larger amounts of an asset's depreciation base to the earlier

periods of the asset's life than to the later periods.
b) Salvage value is not used to calculate depreciation expense, but the
asset's book value cannot be reduced below its salvage value.
c) Depreciation expense = (Book value x 2) ÷ N, where N = the entire
estimated useful life.

3. Activity method (units-of-production).

a) Allocates an equal amount of the cost to each unit of output. This method
is most commonly used to deplete natural resource costs.
b) Expense = [(Capitalized cost – Salvage value) ÷ Estimated life in units of
production] x Number of units produced.
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E. Economic effects of cost allocation methods.

1. Cost allocation methods and the matching principle.

2. How does management choose an acceptable cost allocation method?

3. Depreciation methods for income tax purposes.

VII. Disposal: retirements, sales, and trade-ins.

A. General rules for accounting for the disposal of fixed assets.

1. Depreciate the asset up to the date of disposal.

2. Remove the cost and related accumulated depreciation (for fixed assets) from
the books.

3. Record the receipt or payment of cash (or other assets) involved in the
disposal.

4. Recognize any gains or losses on the disposal. Gains and losses are
computed as the difference between the disposed asset's book value and the
net value of assets received.

B. Methods to dispose of fixed assets.

1. Retirement; discontinue using the long-lived asset.

2. Sale; exchange a long-lived asset for cash or a receivable.

3. Trade-in; an exchange for dissimilar assets.

a) Exchanging a long-lived asset (and often cash) for a different type of

long-lived asset.

b) It is often difficult to determine the value of the new asset, which, in turn,
affects the magnitude of any gains or losses on the transaction.
(1) As a general rule, value the new asset at the fair market value of the
assets given up or at the fair market value of the assets received,
whichever is clearly more evident and objectively determined.

(2) Accounting for trade-ins is governed by APB No. 29, "Accounting for
Nonmonetary Transactions."

VIII. Intangible assets.

A. Assets characterized by rights, privileges, and benefits of possession rather than

by physical existence.
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B. Intangible assets and deferred costs should be amortized, in certain instances,

over the shorter of the asset's legal life or the asset's useful life.

C. The preferred method to amortize intangible assets is the straight-line method.

D. Types of intangible assets.

1. Copyrights—exclusive rights over musical or artistic works. The legal life is

the life of the creator plus an additional 50 years.

2. Patents—provide the holder exclusive rights to use, manufacture, or sell a

product or process. The legal life is 10 years.

3. Trademarks (or trade name)—a word, phrase, or symbol that identifies an

enterprise or product. The legal life is 20 years but the exclusive right can be
renewed indefinitely.

4. Computer software development costs.

5. Goodwill – The nature of goodwill and the methods used to account for it are
discussed in Chapter 8.

E. Organizational costs - costs incurred prior to the start of a company's operations

that are necessary to allow the company to begin operations. Such costs typically
include legal and accounting services, licenses, underwriting fees, titles, and so
forth.

F. Research and development costs.

1. Governed by SFAS No. 2, "Accounting for Research and Development

Costs."

2. Conceptually, some R&D costs provide future benefits and would be

capitalized as an asset and amortized as the R&D provides benefits.
However, given the difficulty of matching specific expenditures with associated
benefits, the FASB mandated that all R&D costs should be treated as period
costs.

IX. IFRS vs. US GAAP: revaluations to fair market value.

X. ROE exercise

XI. Review problem

XII. Ethics in the real world.

XIII. Internet research exercise.

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LECTURE TIPS

1. Students often have difficulty in deciding which costs should be capitalized as part of a
long-lived asset (such as the cost of demolishing an old building on land just acquired) and
which costs should be expensed. It should be stressed that for some costs, a great deal of
judgment is involved. However, if the cost is necessary to get the asset into a useable
condition, the cost should be capitalized. End-of-chapter exercise 9–3 and problem 9–1 are
helpful in addressing which costs to capitalize.

2. The straight-line method is usually easily understood. However, the double-declining-

balance (DDB) method often poses more problems to students. The primary problems are
(1) computing the appropriate multiplication factor to multiply against the asset's book
value, and (2) depreciating the asset below its salvage value. End-of-chapter exercises 9–9
and 9–10 can be used to illustrate the computations for each method.

3. Distinguishing between betterment and maintenance expenditures is also a difficult area. It

should be pointed out that even practicing accountants face this problem because a great
deal of judgment is involved in classifying postacquisition costs. End-of-chapter exercise 9–
4 provides several situations to illustrate the concepts involved.

4. Distinguishing between depreciation expense and accumulated depreciation sometimes

poses difficulty. It should be stressed that depreciation expense represents the cost of the
fixed asset allocated to expenses for a particular accounting period; accumulated
depreciation represents the total depreciation expense taken on a fixed asset since that
fixed asset was acquired. Recording the entries in end-of-chapter exercise 9–10 in T-
accounts will help the student distinguish between the two.

OUTSIDE ASSIGNMENT OPPORTUNITIES

Group study of long-lived assets both across time and within and across industries (continuing
assignment for Chapters 6–14)

1. Using the most recent annual report of a major public company in one of the four general
industry groupings, identify or compute the items listed below for the two most recent years.
Compare the items across time. Relate your findings to the economic characteristics and
current conditions in the industry and the company’s strategy for competing. Prepare a
written summary of your findings. Report findings in a class discussion session in which
comparisons will be made both across time and within and across industries.
Summary of the accounting policies for long-lived assets, including
depreciation, depletion, and amortization methods and rates
Property, plant, and equipment (net) as a percentage of total assets
Identifiable intangibles as a percentage of total assets
Goodwill as a percentage of total assets
R&D expense as a percentage of total revenues
Depreciation, depletion, and amortization expenses as a percentage
of total revenues
Summary of any impairment losses recognized
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Article search: application of accounting standards for impairment of long-lived assets

2. Search the financial press (The Wall Street Journal, Barrons, Fortune, Forbes, etc.) for an
article reporting on a company that applied the accounting standards for impairment of
long-lived assets. Consider the impact on its current and future financial statements, both
from a user orientation and an economic consequences perspective, and present your
findings in writing and/or orally to the class.

ANSWERS TO IN-TEXT DISCUSSION QUESTIONS

358. The importance of fixed asset accounting to the financial statements of the companies
mentioned would be ranked in the order the companies were named: Chevron, Yahoo,
and the Goldman Sachs. A natural resources company such as Chevron is highly capital
intensive, with large investments in property, plant, and equipment. An Internet
company such as Yahoo has electronic equipment, as opposed to extensive properties
or heavy equipment. Banks such as the Goldman Sachs have large financial assets on
their balance sheets which far outweigh fixed assets.

360. By choosing to depreciate their aircraft over a longer useful life, United spreads the cost
of the aircraft over a greater number of reporting periods. This would serve to decrease
depreciation expense and increase reported income compared to Delta, which is using a
shorter useful life for its aircraft. Delta’s net PPE assets would be greater on the balance
sheet as there would be less accumulated depreciation on their equipment. There would
be no effect on the statement of cash flows because depreciation is a non-cash
expense.

361. By extending the depreciation lives of its aircraft, American Airlines chose to spread the
cost of the aircraft over a greater number of reporting periods. This would serve to
decrease depreciation expense and increase reported income. There would be no effect
on the statement of cash flows because depreciation is a non-cash expense.

362. Zimmer’s investments in property, plant and equipment would be reflected as negative
cash flows in the investing section of the statement of cash flows. These assets are
accounted for as long term assets on the balance sheet and will be subject to
depreciation over their useful lives.

363. The fair market value of each identifiable current and noncurrent asset, and of each
liability, would first be determined. Monetary assets (cash, securities, receivables) would
be valued at face value, net realizable value, present value, or quoted market prices.
Liabilities would be valued at face value or present value. The value of nonmonetary
assets (inventories, land, buildings, equipment, and identifiable intangible assets) would
be determined using replacement costs, comparable sales values, or the present value
of estimated future cash flows.
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The fair market value of identifiable net assets as determined in the preceding paragraph
would be deducted from the purchase price. The excess of the purchase price over net
assets would be assigned to goodwill. In the case of Kellogg’s purchase of Worthington
Foods, goodwill of $194 was arrived at by subtracting net assets of $156 million (assets
valued at $218 million, minus liabilities valued at $62 million), from the purchase price of
$350 million.

The valuations required in this process are inherently subjective and offer opportunities
to either maximize or minimize future income. For instance, valuations which give lower
values to identifiable net assets, result in a higher value assigned to goodwill, which is
not amortized against future income. Within identifiable net assets, a higher value
assigned to assets such as land result in greater future income because land is not
depreciated. Conversely, a higher value assigned to inventory results in a larger cost of
goods sold in the next period, thus reducing income.

364. The interest costs of the funds borrowed by AT&T that related to the period of time
during which the facilities were under construction would have been capitalized as part
of the cost of those facilities. This is because these costs were incurred in the process of
getting the facilities into operating condition. The interest expense that applied to the
post construction period would have been treated as an operating expense in the year
incurred.

364. By capitalizing costs that should have been expensed, WorldCom understated its
expenses and overstated net income for the period during which this fraud took place.
Net income in future periods would have been reduced through depreciation, had the
fraud not been discovered.

365. Renewals and improvements are betterments and are capitalized because they improve
the asset by extending its useful life, improve the quantity or quality of its output, or
reduce the cost of operating the asset. Repairs are considered part of maintenance and
are expensed as incurred, because they do not improve the asset or extend its useful
life.

366. The accounting expert is referring to estimates of salvage value, the dollar amount that
can be recovered when a long-lived asset is sold, traded, or scrapped. Salvage value
reduces the depreciable cost of an asset, thus reducing the amount of depreciation
expense recognized in each period subsequent to acquisition of the asset. The expert is
warning financial statement users interested in reported income that income may be
overstated to the extent that salvage values are overstated and depreciation
understated. The warning recognizes management’s discretion and incentive to make
optimistic assumptions of salvage values.

366. The ranges of useful lives vary for these two broad categories of assets because
buildings generally last a lot longer than machinery or equipment. The broad ranges of
lives used by management gives them a certain amount of flexibility in managing
earnings by choosing useful lives that extend or compress the time period during which
newly acquired assets are to be depreciated. The extent to which the choice of useful life
will impact current year net income is usually minor unless there was a relatively large
dollar amount of new asset acquisitions.
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367. An analyst comparing PepsiCo to Coca-Cola would want to factor in the differences in
the useful lives assigned to assets being depreciated. The change in depreciation
schedules is a way to make earnings look better when they have not improved at all.
The depreciation is not relevant to cash flow, and PepsiCo’s response to any comments
about the change in their depreciation schedule could be deflected by focusing on cash
flow. PepsiCo might also state that the adjustment to the depreciation schedules was
necessary to reflect the reality that their assets are being used for longer periods of time.

368. If they had $5.4 billion in fixtures and equipment, none of which were fully depreciated,
and they used an average life of 9 years, the annual depreciation expense (straight line
method) for these fixtures would be approximately $5.4 billion divided by 9, or $600
million. This, of course, is a very rough estimate because it assumes an average life of 9
years which could be significantly different than the true weighted average life of the
assets being depreciated.

370. Conforming to industry practice makes it easier to compare HP’s financial statements to
those of their competitors. Straight-line would do a better job of matching costs with
revenues than accelerated methods if assets being depreciated made equal
contributions to revenues during each year of their useful lives.

371. If everything about each company was exactly the same except for the method each
used for depreciation, reported income would differ, as would related balance sheet
amounts. Accordingly, financial statement ratios used as performance measures for
each company would differ. Analysts must consider these differences when making
comparisons within the industry, either qualitatively, or by attempting to make
computational adjustments to make each company comparable. When such differences
exist, analysts may wish to focus more on performance measures not dependent on the
amount of depreciation, such as cash flow from operations, or earnings before interest,
taxes, depreciation and amortization (EBITDA).

372. The activity (units-of-production) method would be used for oil and gas producing
assets, which has the effect of assigning more costs to expense in proportion to the
asset’s level of activity. This method achieves the best application of the matching
principle, because the more active an asset is, the more revenue it should produce. This
is particularly true in the case of natural resources like oil and gas. The straight-line
method would be used for other property, plant, and equipment. The benefits from those
assets are less directly related to activity, and more likely constant across time, so an
even amount of expense each year is appropriate. The 25 and 45 year lives assigned to
refining and pipeline assets probably reflect with some degree of accuracy the actual
useful lives of these types of assets.

373. Delta could choose between straight-line or accelerated depreciation methods. Straight-
line depreciation, particularly in earlier years, would result in higher reported net income
and higher shareholders’ equity and total assets, compared to results using accelerated
methods. Therefore, performance measures based on net income, and liabilities to
equity or assets ratios, would appear more favorable using straight-line, and debt
covenants would less likely be violated.

374. By using accelerated depreciation methods for taxes, small businesses can decrease
their tax liabilities. When companies pay less tax they are able to keep more cash in the
near term. When small businesses have more cash, they will theoretically increase
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spending by investing in the business and potentially hiring more employees. This
increases over economic activities and aids in stimulating the economy.

375. The IRS took the position that the work on the jet engines should be treated as
betterments rather than as routine maintenance. If FedEx has a tax rate of 37.3%,
treating these costs as expenses increases FedEx’s cash flow (by way of reduced
income tax payments) by 37.3% of the amount of the expenditures in question.

378. There would have been a one time gain recorded on the sale of these assets. This
stream of income would not be expected to recur and, if material, would be reflected in
the income statement as a gain form the disposal of a segment of the business, rather
than as part of operating income.

379. The journal entry recorded by Honeywell would have been:

DR CR

Cash and investment securities (+A) $435

Loss on disposal of assets (+E, -SE) $124
Assets (-A) $559

379. “Customer relationships” is a sub-category of goodwill and is one of the biggest reasons
for paying more for the acquired company than the sum of the fair market value of its
tangible assets. Because the goodwill was developed internally by Holsum, rather than
purchased, it was not an asset on Holsum’s balance sheet. However, when Flowers
Foods acquires this goodwill in the acquisition and pays for it, Flowers has an asset to
reflect on its balance sheet.

CHARACTERISTICS OF END-OF-CHAPTER ASSIGNMENTS

Item Difficulty Description

Brief exercises:
BE9–1 E Change in depreciation method
BE9–2 M Depreciation and amortization
BE9–3 M Acquisition of fixed assets
BE9–4 M IFRS, long-lived assets, and the statement of cash flows

Exercises:
E9–1 E Determining the capitalized cost and depreciation base
E9–2 E Allocating cost on the basis of relative market value
E9–3 M Which costs are subject to depreciation?
E9–4 E Betterments or maintenance?
E9–5 M Matching principle and income recognition
E9–6 M Effect of estimated useful life on income and dividends
E9–7 M Revising the estimated life
E9–8 E Different amortization methods achieve different objectives
E9–9 M Computing depreciation and choosing a depreciation method
E9–10 M Depreciation calculations and journal entries
E9–11 M The activity method of depreciation
E9–12 M Depletion and matching
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E9–13 H An error in recording the acquisition of a fixed asset

E9–14 M Fixed asset sales
E9–15 M Retiring, selling, and trading in a fixed asset
E9–16 H Reverse T-account analysis
E9–17 H Inferring information from the financial statements
E9–18 H Reverse T-account analysis
E9–19 M Intangible assets: expense or capitalize and amortize?
E9–20 M The capitalized cost of a patent
E9–21 M Recognition of goodwill
E9–22 M GAAP versus IFRS regarding fair market values

Problems:
P9–1 E How much to capitalize?
P9–2 M Lump-sum purchases and cost allocations
P9–3 M Determining capitalized cost and depreciation
P9–4 H Expensing what should be capitalized can misstate net income
P9–5 M Accounting for betterments and maintenance costs
P9–6 M Accounting for betterments
P9–7 M Revising the estimated useful life
P9–8 M Effects of an accounting change
P9–9 H Why is double-declining-balance preferred for tax purposes?
P9–10 M The effect of depreciation on taxes, bonuses, and dividends
P9–11 M Different methods of cost allocation: natural resources
P9–12 M Selling and trading in fixed assets
P9–13 M Recognizing goodwill
P9–14 M Goodwill accounting

Issues for discussion:

ID9–1 M Lump-sum sales and purchase
ID9–2 M Capitalizing marketing costs
ID9–3 M Capital acquisitions
ID9–4 M GAAP versus IFRS
ID9–5 M Expense vs. capitalize
ID9–6 M Capital spending and profits
ID9–7 H Asset impairments
ID9–8 M Corporate restructuring
ID9–9 E Current values?
ID9–10E Subjective asset write-downs
ID9–11M Asset write-offs
ID9–12M GAAP versus IFRS
ID9–13M The annual report of Google