UNIT 6: ACCOUNTING FOR PLANT ASSETS AND DEPRECIATION

Contents
6.0 Aims and Objectives
6.1 Introduction
6.2 Nature and Meaning of Long – Term Assets
6.3 Acquisition Cost of Plant and Equipment
6.4 Depreciation of Plant Assets
6.5 Factors That Affect the Computation of Depreciation
6.6 Methods of Computing Depreciation
6.6.1 Straight – Line Method
6.6.2 Units – of Production Method
6.6.3 Double – Declining Balance Method
6.6.4 Sum –of – the – years – Digits Method
6.7 Comparison of Depreciation Methods
6.8 Recording Depreciation
6.9 Revision of Depreciation Rates
6.10 Capital and Revenue Expenditures
6.11 Disposal of plant Assets.
6.11.1 Recording Discarding or Plant Asset
6.11.2 Recording the Sale of Plant Asset for Cash
6.11.3 Recording Exchanges of Plant Assets
6.12 Accounting For Intangible Assets and Natural Resources.
6.13 Summary
6.14 Answers to Check Your Progress Exercise
6.15 Glossary
6.16 Model Examination Questions
6.17 Reference Books

6.0 AIMS AND OBJECTIVES

The main objective of this unit is to acquaint the student with the basic concepts and
accounting aspects of plant assets and intangible long-term assets. The accounting for cost

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allocation of long – term assets such as depreciation, amortization, and depletion are also
discussed. Also the accounting fundamentals of disposal of depreciable assets such as
discarding, selling, and exchanging are explained to the students.

Having studied and worked through this unit the learners would be able to:
 measure the acquisition cost of plant assets such as land, buildings and equipment
 compute periodic depreciation of plant assets using different methods.
 Record depreciation expense in the accounting books.
 Distinguish expenses from expenditures that should be capitalized.
 Compute gains and losses on disposal of plant assets,
 Understand the concepts of intangible assets and natural resources.

6.1 INTRODUCTION

Assets are economic resources owned and held by a business enterprise that are expected to
benefit future operations. Certain kinds of assets – for example, cash, receivables,
merchandise inventory, supplies and other assets that can be reasonably be converted into
cash or sold or used up within one year or one accounting period in the normal operation of
business – are current assets. These assets are part of the operating activities of a business.
Remember, the accounting for current assets have been explained in earlier chapters. Other
groups of assets – Plant and equipments and the right granted by patent, trade marks or
copyright are long-term assets.

Most business enterprises hold such major assets as land, buildings, equipment, furniture,
tools, and intangible assets. These assets help produce revenues over many periods by
facilitating the production and sale of goods or services to customers. Because these assets
are necessary in a company’s day – to – day operations, companies do not sell them in the
ordinary course of business. Keep in mind, though, that one company’s long – term asset
might be another company’s short – term asset. For example, a truck dealer would regard a
delivery truck as a current asset merchandise inventory. Long – term assets differ from
current assets in that they support the operating cycle instead of being a part of it. They are
also expected to benefit the business for a long period than do current assets. Current assets
are expected to be realized within one year or during the operating cycle, whichever is longer.

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Long – term assets are expected to last beyond that period. In this chapter you will learn
about the accounting for plant assets and intangible assets.

In the chapter that follow the meaning and nature of plant assets, the techniques used to
compute the acquisition cost of plant assets, and the methods of computing depreciation are
discussed in detail. Finally, the accounting for intangible assets will be discussed.

6.2 NATURE AND MEANING OF LONG – TERM ASSETS

Long – term assets are assets that (1) have a useful life of more than one year, (2) are acquired
for use in the operation of the business, and (3) are not intended for resale to customers.

Although there is no strict minimum useful life for an asset to be classified as long – term, the
most common criterion is that the asset must be capable of repeated use for a period at least a
year. Assets not used in the normal course of business should not be included in this
category. Thus, land held for speculative reasons or buildings that are no longer used in the
ordinary business operations should not be included in the proper, plant, and equipment
category. Instead, they should be classified as long – term investments.

If an item is held for resale to customers, it should be classified as inventory – not plant and
equipment – no matter how durable it is. For example, a printing press held for sale by a
printing press manufactures would be considered inventory. Whereas the same printing press
would be plant and equipment for a printing company that buys the press to use in its
operations. Long – term assets are divided into tangible (plant assets) and intangible
categories.

Tangible assets (also called plant assets or fixed assets) are assets with physical substance that
can be used in the operations of a business relatively for a longer period of time (usually
more than one year or one operating cycle whichever is longer. Examples of plant (or fixed)
assets include land, buildings, machineries, tools, furniture, etc.

Intangible assets are assets without a physical feature that can be charged in the operations of
business for long period of time. They generally consist of rights or advantages held such as
patents, copyrights, goodwill, franchise, trademarks, organization costs, etc.

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The allocation of the cost of intangible assets to the periods they benefit is called
amortization. Although the current asset accounts receivable and prepaid expenses do not
have physical substance, they are not intangible assets because they are not long – term.

6.3 ACQUISITION COST OF PROPERTY, PLANT, AND EQUPMENT

The acquisition cost of property, plant, and equipment includes all expenditures reasonable
and necessary to get it in place and ready for use. For example, the cost of installing and
testing a machine is a legitimate cost of the machine. However, if the machine is an operating
expense and not an acquisition cost.

Cost is easiest to determine when a transaction is made for cash. In this case, the cost of the
asset is equal to the cash paid for the asset plus expenditures for freight, insurance while in
transit, installation costs, and other necessary related costs. If a debt (or a liability) is incurred
in the purchase of the asset, the interest charges are not a cost of the asset but a cost of
borrowing the money to buy the asset. They are, therefore, an operating expense. An
exception to this principle is that interest costs during the construction of an asset are properly
included as a cost of the asset.

NB. For practical purposes many companies establish policies defining when expenditure should be
recorded an expense or an asset. For example, small expenditures for items that normally
would be treated as assets may be treated as expenses because the amounts involved are not
material in relation to net income thus, a wastebasket, which might last for years, would be
recorded as a supplies expense rather than as a depreciable asset.

For reasons of clarification some of the problems of determining the cost of plant asset are
demonstrated in the illustrations for land, buildings, equipment, and land improvements
presented below.

Land:- The acquisition cost of land includes the purchase price (the negotiated cash price)
plus other expenditures incurred in connection with the purchase of land such as cost of land
surveys, legal fees, brokers commissions, transfer taxes, cost of preparing the land to build on,
and even the demolition costs of old structures that might be torn down to get the land ready
for its intended use. Under historical – cost assumption, land is reported in the balance sheet
at its original cost.

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Land Improvements: - Improvements to real estate (land) such as driveways, parking lots,
and fences, have a limited life and thus are subject to depreciation. They should be recorded
in an account called Land Improvements rather than in the Land account.

Buildings:- When an existing building is acquired, its cost includes the purchase price plus
all repairs and other expenses necessary to put it in a usable condition. On the other hand,
when a business constructs its own building, the cost includes all reasonable and necessary
expenditures such as those for materials, labor, part of the overhead and other indirect costs,
engineers and architects’ fees, insurance during construction, interest incurred on construction
loans during the period of construction, lawyers’ fees, and building permits. If outside
contractors are used in the construction, the net contract price plus other expenditures
necessary to put the building in usable condition are included. Buildings are subjected to
depreciation because they have a limited useful life.

Equipment: - The cost of equipment includes all expenditures associated with purchasing the
equipment and preparing it for use. These expenditures include invoice price less cash
discounts (if any); freight or transportation, including insurance, excise taxes and tariffs;
buying expenses, installation costs, and test runs to ready the equipment for operation.
Equipment is subject to depreciation.

Check Your Progress Exercise - 1

1. What are the characteristics of long –term assets?

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2. Which of the following items would be classified as plant assets on the balance sheet?
a) A truck held for sale by a truck dealer,
b) An office building that was once the company headquarters but is now to be
sold.

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 c) A typewriter used by the secretary of the company.
d) A machine that is used in manufacturing operations.
e) Land held by the business for speculative purpose.

3. Haron Auto, Inc. Purchased a neighboring lot for a new building and parking lot.
Indicate whether each of the following expenditures is properly charged to a) Land, b)
Land Improvements, or c) Buildings.
1. Paving costs
2. Architects’ fee for building design.
3. Cost of clearing the property.
4. Structure construction costs
5. Lights around the property
6. Building permit.
7. Interest on the construction.
8. The cost of leveling or permanently changing the contour.

6.4 DEPRECIATION OF PLANT ASSETS

Depreciation accounting is described by the American Institute of Certified Public

Accountants (AICPA) as follows:

The cost of a productive facility is one of the costs of the services it renders during its
useful economic life. Generally accepted accounting principles requires that this cost
be spread over the expected useful life of the facility in such a way as to allocate it as
equitable as possible to the periods during which services are obtained from the use of
the facility. This procedure is known as depreciation accounting,
accounting, a system of
accounting which aims to distribute the cost or other basic value of tangible capital
assets, less salvage (if any), over the estimated useful life of the unit… in a systematic
and rational manner. It is a process of allocation, not of valuation.

The above description contains several important points. First, all plant assets except land
have a limited economic life. Because of this limited useful life, the costs of these assets must
be distributed as depreciation expense over the years they benefit. Accordingly, the cost of
such assets should be transferred to the related expense accounts in an orderly manner during

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their estimated economic life. This periodic cost allocation (or expiration) is called
depreciation.

Factors contributing to a decrease in usefulness may be divided into two categories: Physical
depreciation,
depreciation, which includes wear from use and deterioration from the action of the
elements, and functional depreciation,
depreciation, which includes inadequacy and obsolescence. A
plant asset becomes inadequate if its capacity is not sufficient to meet the demands of
increased production. A Plant asset is obsolete if the commodity that it produces is no more
needed or if a new machine can produce a commodity of better quality or at a minimum cost.
Now a days, the tremendous growth of technological progress has made obsolescence an
important part of depreciation.

Second,
Second, the term depreciation, as used in accounting, does not refer to the physical
deterioration of an asset or the decrease in market value of asset overtime. Depreciation
means the allocation of the cost of a plant asset to the periods that benefit from the services of
the asset. The term is used to describe the gradual conversion of the cost of the asset into an
expense.

Third, depreciation is not a process of valuation. Accounting records are kept in accordance
with the cost principle; they are not indicators of changing price levels. It is possible that,
through an advantageous buy and specific market conditions, the market value of an asset
may rise. Nevertheless, depreciation must continue to be recorded because it is the result of
an allocation, not a valuation, process.

Check Your Progress Exercise – 2

1. Is the purpose of depreciation to determine the value of plant assets?
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2. GMT Manufacturing Co. acquired land next to its factory to be used as a parking lot.
Expenditures incurred by the company were as follows: Purchase price, Birr. 150,000.00;
demolition of a shack on the property, birr 4000, general grading of property, birr 2100,
parking lot, birr 20,000.00; lighting for parking lot, birr 16,000.00; and signs for parking

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 lot, birr 3200.00. Determine the amount that should be debited to the land account and to
the land Improvements account.
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6.5 FACTORS THAT AFFECT THE COMPUTATION OF PRECIATION

Four factors affect the computation of depreciation. They are

1) cost,
2) estimated salvage (residual) value,
3) depreciable cost (cost less salvage value, if any), and
4) estimated economic (useful) life.

Cost – As explained earlier in the unit, cost is the net purchase price plus all reasonable and
necessary expenditures to get the asset in place and ready for use.

Salvage Value - also known as scrap value represent the estimated market value of the asset
at the time of its retirement from service.

Depreciable cost - the depreciable cost of a plant asset is the difference between the asset cost
and its estimated salvage value. For example, a delivery truck that costs birr 150,000.00 and
has a salvage value of birr 10,000.00 would have a depreciable cost of birr 140,000.00, (birr
150,000.00 – birr 10,000.00). Depreciable cost must be allocated over the estimated
economic life of the asset.

Estimated Useful life - the estimated useful life (economic life) of an asset is the total number
of service units expected from the asset. Service units may be measured in terms of years the
asset is expected to be used, units expected to be produced, miles or kilometers expected to be
driven, or similar measures. In determining the estimated useful life of an asset, the
accountant should consider all relevant information, including

1) past experience with similar assets,

2) the asset’s present condition,
3) the company’s repair and maintenance policy,

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 4) current technological and industry trends, and
5) local conditions such as whether.

NB. Neither the period of usefulness of a plant asset nor its residual value at the end of that
period can be accurately determined until the asset is retired. However, in determining the
amount of the periodic depreciation, these two related factors must be estimated at the time
the asset is placed in service.

6.6 METHODS OF COMPUTING DEPRECIATION

Businesses used different methods to allocate the cost of plant assets to the accounting periods
they benefit through depreciation. Each of them is proper for certain circumstance.

The most common methods of depreciation for plant asset are 1) the straight – line method, 2)
the units – of – production method, 3) the declining – balance method; and 4) the sum –of –
the – years – digits’ method.

6.6.1 Straight – Line Depreciation

When the straight – line method is used to allocate depreciation, the depreciable cost of the
asset is spread evenly over the economic life of the asset. The straight – line method is based
on the assumption that depreciation depends only on the passage of time. The depreciation
expense for each period is computed by dividing the depreciable cost (cost of the depreciating
asset less its estimated residual value) by the estimated economic life of the asset.

Under this method, the depreciation expense to be reported is the same each year.

To illustrate this method, suppose that a store equipment costs birr 30,000.00 at the end of its
estimated useful life of four years. The annual depreciation would be birr 6750.00 under the
straight –line method, computed as follows:

= Cost – Salvage value

Estimated years of Economic life

= Birr 30,000.00 – birr 3000.00

4 Years

= Birr 6750.00

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The same periodic depreciation expense is to be reported throughout the economic life of the
asset presented below.

Cost of the depreciable asset……………………………………..Birr 30,000.00

Less: Estimated salvage value………………. ………………………..3,000.00
………………………..3,000.00
Total amount to be depreciated (or total
depreciable cost of the asset)……………………………………… 27,000.00
Estimated Economic years of life……………………………………… 4 years.
Annual depreciation (yearly depreciation expense to be reported
on the income statement birr 27,000.00÷4 years) -----------------Br. 6750.00
……………………………… Birr 6750.00

The following schedule summarizes the accumulation of depreciation over the useful life of
the asset. Total cost subject to depreciation (depreciable cost) is birr 27,000.00 (cost of birr
30,000.00 – estimated salvage value of Birr 3000.00).

Depreciation Schedule, Straight – Line Method.

Method.

Yearly Accumulated Book Value

year Cost depreciation Depreciation (or carrying value
Date of purchase Birr 30,000.00 - - Birr 30,000.00
End of first year 30,000.00 Birr 6,750.00 Birr 6,750.00 23,450.00
End of second year 30,000.00 6,750.00 13,500.00 16,500.00
End of Third year 30,000.00 6,750.00 20,250.00 9,750.00
End of Fourth 30,000.00 6,750.00 27,000.00 3,000.00

*Estimated salvage value of the asset at the time of retirement from service

NB The annual straight – line depreciation may be converted to a percentage rate, determined
on the basis of cost and the estimated life of the asset without regard to residual value. The
conversion to an annual percentage rate is accomplished by dividing 100 by the number of
years of life. Thus a life of 40 years is equivalent to a 2 1/2 % depreciation rate, 25 years is
equivalent to a 4% rate, 10 years is equivalent to 10%, and so on.

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What would be the depreciation expense on store equipment if it was place in service after
four months in the first year had been elapsed?

In such circumstances only apportion of the yearly (or annual) depreciation is allocated as
depreciation expense ( i.e., birr. 6750 X 8/12 or Birr 4500).

Based on the data given earlier, assuming the fiscal period ending on December 31 and the
first use of the asset on July 15, the depreciation for the fiscal year would be birr 3375 (for 6
months). If usage had begun on July 16, the depreciation for the period would be birr 3937.50
(for 7 months including July).

Check Your Progress Exercise - 3

1. Cybersys information communications Co. purchased a word processor for birr 4200.
It has an estimated useful life of five years and an estimated residual value of birr 500.
Compute the depreciation expense for each of the five years using the straight - line
method.
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2. Convert each of the following estimates of useful life to a straight line depreciation
rate stated as a percent, assuming that the selvage value of the asset is to be ignored:
a) 8 years
b) 12 years
c) 50 years
d) 20 years
e) 25 years.

6.6.2 Units - of Production Method

The production method of depreciation is based on the assumption that depreciation is mainly
the result of use and that the passage of time plays no role in the depreciation process. If we
assume that the store equipment form the previous example has an estimated economic life of
30,000.00 hours, the depreciation cost per hour would be determined as follows:

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 Cost – Salvage value = depreciation per hour (or
(or per units)
Estimated units of useful life (hours,miles, no of units)
units)

= Birr 30,000.00 – Birr 3000.00

30,000.00

=Birr 0.90 Per hour.

The depreciation for each accounting period is then computed by multiplying hourly
depreciation (or depreciation rate) by the total hours used during the period.

Hourly rate X Total Number of hours = Depreciation expense of

During the period the period
If we assume that the use of the equipment was 7000.00 hours for the first year, 6500.00
hours for the second, 6400.00 hours for the third, 5900 hours for the fourth, and 4200.00
hours for the fifth, the depreciation schedule for the store equipment would appear as follows:
Depreciation Schedule – Production Method
Year Cost Hour Depreciation Yearly Accum. Book
per hour depc Depc. Value
Date of purchase 30,000.00 - - - - Birr 30000
End of first year 30,000.00 7000.00 Birr 0.90 Birr.6300 Birr 6300 23700
End of second year 30,000.00 6500.00 0.90 5850 12150 17850
End of Third Year 30,000.00 6400.00 0.90 5760 17910 12090
End of fourth year 30,000.00 5900.00 0.90 5310 23220 6780
End of Fifth Year 30,000.00 4200.00 0.90 3780 27000 3000

Under the production method, there is a direct relation between the amount of depreciation
each year and the units of out put or use. Also, the accumulated depreciation increases each
year indirect relation to units of out put or use. Finally, the carrying value decreases each year
in direct relation to units of output or use. Finally, the carrying value decreases each year in
direct relation to units of out put or use until it reaches the estimated residues value.

Under the production method, the units of out put or use that is used to measure estimated
useful life for each asset should be appropriate for that asset, For example, for one machine
number of units produced may be an appropriate measure, for another number of hours may

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be a better measure. The production method should be used only when the out put an asset
over its useful life can be estimated with reasonable accuracy.

NB. The units of production method is more logical than the straight – line method when the
amount of usage of a plant asset varies from year to year considerably

Check Your Progress Exercise - 4

1. XY Furniture company purchased a new machine for birr 25,000.00. the machine has
a useful life of 50,000.00 operating hours with no salvage value. Assuming that during
the first year of operation the machine was places in service for 6200.00 hours.
Determine: a) the depreciation per hour.
b) the depreciation expense to be reported during the first
year of the asset’s Life.

6.6.3 Double - Declining – Balance Method

This method of depreciation results in relatively large amounts of depreciation in the early
years of an asset’s life and smaller amounts in later years

This method is based on the assumption of the passage of time, assumes that many kinds of
plant assets are most efficient when new, and so they provide more and better service in the
early years of useful life. It is consistent with the matching rule to allocate more depreciation
to the early years than to later years if the benefits or service received in the early years are
greater.

The declining – balance method is the most common accelerated method of depreciation.
Under this method, depreciation is computed by applying a fixed rate to the carrying value
(the declining balance of a long – lived asset) resulting in higher depreciation changes during
the early years of the asset’s life. Though any fixed rate might be used under the method, the
most common rate is a percentage equal to twice the straight – line percentage. When twice
the straight – line rate is used, the method is usually called the double – declining – balance
method. In out earlier example, the store equipment had an estimated economic life of four
years. Consequently, under the straight – line method, the depreciation rate for each year was
25 percent (100 ÷4years).

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Therefore, under the double – declining – balance method, the fixed rate is 50 percent (25
percent X 2 ). This fixed rate of to percent is a applied to the remaining carrying value at the
end of each year.

NB When computing depreciation using the declining – balance method estimated residual
value is not taken into account except in the last year of an asset’s useful life, when
depreciation is limited to the amount necessary to bring the carrying value down to the
estimated salvage value.

The depreciation schedule for the double declining – balance method is illustrated below:
Depreciation Schedule, Double – Declining – Balance Method.

Yearly Accumulated Book

Cost Depreciation Depreciation Value
Date of purchase Birr 30,000 - - -
End of first year 30,000 ( 50% X br. 30,000 Br. 15,000 Br. 15,000
End of second year 30,000 ( 50% X br. 15000 22,500 7,500
End of Third year 30,000 ( 50% X br. 7,500 26,250 3,750
End of Fourth year 30,000 27,000 3,000

* Depreciation limited to amount necessary to reduce book value to residual (salvage) value:
Birr 750= birr 3750 (previous book value)

Note that the fixed rate of 50 percent is always applied to the book value at the end of the
previous year.

The depreciation is greatest in the first year and declines each year after that. Finally the
depreciation in the last year is limited to the amount necessary to reduce book value to
salvage (residual) value.

Check Your Progress Exercise – 5

1. What is the principal argument supporting an accelerated depreciation method?

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 2. HAB’HAB company purchase a new computer (office equipment) for birr 9000. The
computer is expected to last five years and have a residual value of birr 1000, how much
would depreciation expense be in each year if the double-declining balance method is
used?
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6.6.4 Sum – of – the – Years – Digits’ Method

The sum- of – the – years – digits method yields results like those obtained by use of the
declining balance method. The period depreciation expense declines steadily over the
estimated life of the asset because a successively smaller fraction is applied each year to the
original cost of the asset loss the estimated salvage (residual) value.

 The denominator of the fraction, which remains the same, is the sum of the digits
representing the years of life.

 The numerator of the fraction, which changes each year, is the number of years of life
remaining at the beginning of the year for which depreciation is being computed.

 For example, for an asset with an estimated life of 10 years, the denominator of the
fraction is 10+9+8+7+6+5+4+3+2+1=55 for the first year; the numerator is 10, for the
second years 9, and so on.

 What is the denominator of the fraction for an asset with an estimated economic life of
6 years? The depreciation schedule for this method is a follows:

Depreciation schedule, sum – of – the- digits’ method

Accumulated Book Value

Depreciable cost Rate Yearly Depreciation Depreciation (Carrying Value)
Date of Purchasing 1/10 - - Br. 30,000.00
Fist Year 27,000 4/10 (4/10 X 7000)=br.10800 Birr 10800.00 19,200.00
Second year 27,000 3/10 (3/10 X 7000)= 8100 18900.00 11,100.00
Third year 27,000 2/10 (2/10 X 7000)= 5400 24300.00 5,000.00
Fourth year 27,000 1/10 (1/10 X 7000)= 2700 27000.00 3,000.00

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NB. When the first use of the asset does not coincide with the beginning of a fiscal year, it is
necessary to allocate each full year’s depreciation between the two fiscal years benefited.
Assuming that the asset in the example was placed in service after three months of the fiscal
year had been elapsed, the depreciation for that fiscal year would be birr 8100, computed as
follows:

9/12 X 4/10 X (Birr 30,000 – Birr 3000)……………………………Birr 8,100.00

And the depreciation for the second your would be birr
3/12 X 4/10 ( birr 30,000.00 – Birr 3000.0)………………………....Birr 2,700.00
Plus, 9/12 X 3/10 (Birr 30,000.00 – birr 3000.00)…………………………….. 6,075.00
Total, Second fiscal year depreciation……………………………………..Birr
depreciation……………………………………..Birr 8,775.00

 What will be the total depreciation expense for the third year?
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Check Your Progress Exercise - 6

1. An asset with a cost of birr 46,000.00 an estimated residual value of birr 4000, and an
estimated economic life of 6 years is to be depreciated by the sum – of – the – years –
digits method.

Determine:
a) The denominator of the fraction.
b) The amount of depreciation to be reported in the first full year of use of the
asset’s life.
c) The amount of depreciation to be reported in the second year, assume that the
asset was placed in service after four – months of the first year had been
elapsed.

2. YADOT Engineering Company purchased a supercomputer that will assist it in

designing factory layouts. The cost of the computer was birr 235,000.00. Its expected
economic life is 7 years Assuming that the computer has no residual value, and the

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 company uses the sum – of – the – years – digits’ method to allocate depreciation.
Determine:-

a) The denominator of the fraction.

b) The amount of depreciation calculated for the first year assuming that the
computer was placed in service after six – months in the first year had been elapsed.
c) The depreciation charge for the second and third years respectively.

6.7 COMPARISON OF DEPRECIATION METHODS

The straight-line depreciation provides uniform or equal depreciation charges to expense

throughout the life of the asset.

The production method of depreciation provides for periodic changes to depreciation expense
that may vary considerably, depending upon the amount of usage of the asset. The production
method does not generate a regular patter because of the random fluctuation of the
depreciation from year to year.

Both the double – decaling balance and the sum – of – the – years – digits methods are
accelerated depreciation methods because they provides (report) a relatively higher
depreciation expense in the early uses of the life of the asset and a gradually declining
periodic expense thereafter.

Accelerated depreciation methods also recognize that changing technologies make some
equipment lose their capacity to yield services rapidly. Thus, it is realistic to allocate more to
depreciation in the early years than in later years. New inventions and products result in
obsolesce of equipment bought earlier making it necessary to replace equipment sooner than
if technology changed more slowly. Another argument in favor of an accelerated method is
that repair (maintenance) expense is likely to be greater in later years than in early years.
Thus, the reduced amounts of depreciation reported in later years of the asset’s life are offset
to some extent by increased repair (maintenance) expense. This result naturally assumes that
the services received from the asset are roughly equal from year to year.

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6.8 RECORDING DEPRECIATION

The amount by which a fixed asset depreciates is an expense of the business. The amount of
depreciation expense should be recorded at the end of each accounting (fiscal) period.

If depreciation expense is not recorded, the income statement will not contain all the business.
This will cause the net income to be reported higher than it should be.

Income tax laws allow a business to deduct depreciation as an expense in determining net
income. If depreciation expenses are not included on the income tax reports, the business will
pay more income taxes than it should.

Illustration
A delivery truck is purchased for Birr 55,000.00 and that it has an estimated useful life of 10
years and an estimated residual value of birr 8,000.00. Assume that the first use of the asset
was on April 5, 19 X 1 and that the yearly accounting period runs January 1 through
December 31. Assume that the company uses the straight – line depreciation:

a) Determine the depreciation expense to be reported in 19 X 1.

b) Record the depreciation expense as of Dec. 31, 19 X 1.

Solution:
a) Depreciation expense for 19 X 1
Annual depreciation = original – salvage Value
Estimated useful life

=birr 55,000 – birr 8000 =birr 4700

10 years

However, the asset was placed in service after 3 – months for the first year had been elapsed,
therefore only depreciation for none months must be allocated in 19 X 1. ( ie, April – Dec. 31)

Thus, birr 4700 X 9/12 = birr 3525.00.

b) Entry to record depreciation expense for 19 X 1.

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 19 X 1
Dec. 31. Depreciation expense………………3525.00
Accumulated Depreciation – delivery Truck………3525.00
To record depreciation expense for the year.

The Accumulated Depreciation Account:

The balance of a plant asset account should always show the original cost of the asset owned
and held by the business. Therefore, the amount of depreciation should not directly be credits
to a plant (fixed) asset account. The asset accounts are credited only when the assets are
disposed of.

The account to which the estimated amount of depreciation is credited is called Accumulated
depreciation (or allowance for depreciation) or Reserve for Depreciation), followed by the
name of the fixed asset account.

The balance in the accumulated depreciation account is always a credit balance because it is a
deduction (or a contra) from the balance of the related asset account.

The credit balance in the accumulated Depreciation Account shows the estimated decrease in
the value of the asset because of usage depreciation). The difference between the balance of
the fixed asset account and its related accumulated depreciation account is the book value or
the carrying value of the asset.

Delivery Truck Accumulated Dept. – Delivery truck

Cost 55,000 Depreciation
Year 1 …3525
Depreciation
19x2……4700

Based on the information presented in the T- accounts, the asset account delivery truck,
remains at cost, birr 55,000.00 until the asset is retired from service and the related
accumulated depreciation increase each year on the periodic depreciation expense. The book
(carrying) valve with is the difference between cost and the related accumulated depreciation
is computed as follow:

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 Book (carrying) value = Cost – accumulated Depreciation
=Birr 55,000.00 – Birr 8,225.00
=birr 46,775

Depreciation of Plant Assets of Low Unit Cost

Subsidiary ledgers are not usually maintained for classes of plant assets that are made up of
individual items of low unit cost, such as hand tools and other small portable equipment.
Because of hard usage, breakage, and pilferage, such assets may be relatively short lived and
may require constant replacement. In such cases, the usual depreciation methods are not
practical. One common method of determining cost expiration is to take a periodic inventory
of the items on hand, estimate their fair value based on original cost, and transfer the
remaining amount from the asset account to an appropriately titled account, such as tools
Expense. Other categories to which the same method is often applied are dies, molds,
patterns, and spare parts.

Composite – Rate Depreciation Method

Under this method, depreciation is computed for the entire groups of assets by use of a single
rate, the basis for grouping may be similarity in life estimates or other common traits, or it
may be broad end to include all assets within a functional class, such as office equipment or
factory equipment.

When depreciations computed on the basis of a composite group of assets of differing life
spans, a rate based on averages must be developed. This may be done by (1) computing the
annual depreciation for each asset (2) determining the total annul depreciation, and (3)
dividing the sum thus determined by the total cost of the assets. This procedure is illustrated
as follows.

Asset Cost Estimated Estimated Annual

No Residual value life Depreciation
0101 Birr 50,000.00 Birr 5,000.00 15 years Birr 3000.00
0102 25,000.00 1,000.00 12 years 2000.00

0109 15,000.00 1,000.00 10 years 1350.00

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 Total Birr 560.000.00 Birr 76,350.00

Composite rate = Ann. depreciation (total) = $76350

Cost (total) 560,000

Although new assets of differing life spans and residual values will be added to the group and
old assets will be retired, the “mix” is assumed to remain relatively unchanged. Accordingly,
a deprecation rate based on averages ( ) also remains unchanged for an indefinite time in the
future.

When a composite rate is used, it may be applied against total asset cost on a monthly basis,
or some reasonable assumption may be made regarding the timing of increases and decreases
in the group. A common practice is to assume that all additions and retirements have occurred
uniformly throughout the year. The composite rate is there applied to the average of the
beginning and ending balances of the account. Another acceptable averaging technique is to
assume that all additions and retirements during the first half of the year occurred as if the
first day of the year, and that all additions and retirements during the second half of the year
occurred on the first day of the following year.

NB. When assets with in the composite group are retired, no gain or no loss should be
recognized. Instead, the asset account is credited for the cost of the asset and the
accumulated depreciation account is for the excess of the cost over the amount
realized from the disposal. Any depicted in the amount of depreciation recorded on the
shorter-lived assets is presumed to be balanced by excessive depreciation on the
longer-lived assets.

Group Depreciation
To say shat the estimated useful life of an asset, such as a piece of equipment is five years
means that the average piece of equipment of that type is expected to last five years. In reality,
some equipment may last only two or three years, and other equipment may last eight or mine
years, or longer. For this reason, and for reasons of convenience, large companies will group
similar items, such as trucks, power lines, office equipment, or transformers, for purposes of
calculating depreciation. This method is called group depreciation.G roup depreciation
is used widely in all fields of industry and business.

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6.9 REVISION OF DEPRECIATION RATES

Because a depreciation rate is based on an estimate of an asset’s useful life, the periodic
depreciation charge is seldom precisely accurate. Sometimes it is very inadequate or
excessive. This situation may result from an underestimate or overestimate of the asset’s
useful life or from a wrong estimate of the residual value. What action should be taken when
it is fond, after several years of use, that a piece of equipment will not last as long as – or will
last longer than originally thought? Sometimes it is necessary to revise the estimate of useful
life, so that the periodic depreciation expense increases or decreases. Then, to correct the
situation, the remaining depreciable cost of the asset is spread over the remaining years of
useful life.

To illustrate, assume that a delivery truck was purchased for a price of Birr 75,000.00, with a
residual value of Birr 5000.00. At the time of the purchase, the truck was expected to last 4
years, and it was deprecated on the straight line basis. However, after 8 years of intensive
use, it is determined that the delivery truck will last only 4 more years, but that the estimated
residual value of the end of the two years will still be Birr 5000.00. At that time, the asset o/c
and its related accumulated depreciation account would appear as follows:

Delivery Truck Accum- Depr – Deliver truck

Cost 75,000.00 40,000.00 Bal. at the
End of 8th year

The remaining depreciable cost is computed as follows:

Cost – Depreciation already taken minus residual value
Birr 75,000 – birr 40,000 – Birr 5000 = Birr 30,000
The new annual periodic depreciation charge is computed by dividing the remaining
depreciable cost of Birr 3000 by the remaining useful life of 4 years. Therefore, the new

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periodic depreciation charge is Birr 7500.00. The annual adjusting entry for depreciation for
the nest two years would be as follows:

Dec. 31. Depr. Expense – Deliver………………………..7,500.00

Accum. Depr, Delivery……………………………………..7,500.00
To record depr. Expense for the year.

Depreciation Partial Years:

So far, the illustrations of the depreciation methods have assumed that the plant assets were
purchased at the beginning or end of the accounting period. In most cases, they buy the assets
when they are needed and sell or discard them when they are no longer useful or needed. The
time of year is normally not a factor in the decision. Consequently, it is often necessary to
calculate depreciation for partial years.

For example, assume that a piece of equipment is purchased for Birr 5000 and that it has an
estimated useful life of five years, and an estimated residual value of Birr 500.00 assume also
that it is purchased on October 2 and that the yearly accounting period ends on Dec.37
depreciation must be recorded for three months, October through December, or three –
twelfths of the year. This factor is applied to the calculated depreciation for the entire year.
The three months’ depreciation under the straight line method is calculated as follows:

If the company used the double – declining – balance method on the above equipment, the
depreciation on the asset would be computed as follows:

Birr 5000 X 40/100 X 3/12 =Birr 500

If the company used the sum – 0f - the – years – digits method the depreciation on the asset
would be computed:

Birr (5000 – 500) X 5/15 X 3/12 = birr 375, and the

depreciation for the 2nd year would be :

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 (5000 -500) X 5/15 X 9/12 = Birr 1125
(5000 -500) X 4/15 X 3/12 = 300
Total ,2nd year depreciation = Birr 1425

Typically, the depreciation calculation is rounded off to the nearest whole month because a
partial month’s depreciation is not usually material and the calculation is easier. In this case,
depreciation was recorded form the beginning of October. If the equipment had been
purchased on October 16 or there after, depreciation would be charged beginning November
1, as if the equipment were purchased on that date.

NB, for all methods, the remainder (nine – twelfths) of the first year’s depreciation is recorded
in the next annual accounting period together with three twelfths of the second year’s
depreciation.

6.10 CAPITAL AND REVENUE EXPENDITURES

In addition to the acquisition of plant assets, capital expenditures include additions and
betterments.

An addition is an enlargement to the physical layout of plant asset. Suppose for example, if a
new wing is added to a building, the benefits from the expenditures will be received over
several years, and the amount paid for it should be debited to the asset account.

Betterment is an improvement that does not add to the physical layout of the asset.
Installation of an air – conditioning system is an example of betterment that will offer benefits
aver a period of years, so its cost should be charged to an asset account.

Another capital expenditures include extraordinary repairs. Extraordinary repairs are repairs
of a more significant nature they affect at estimated residual value or estimated useful life of
an asset. For example, boiler for heating a building may be given a complete overhaul, at a
cost of , that will extend its useful life by 5 years.

Typically extraordinary repairs are recorded by debiting the Accumulates depreciation

account, under the assumption, that some of the depreciation previously recorded has now
been eliminated. The effect of this reduction in the accumulated depreciation a/c is to

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increase the carrying value of the asset by the cost of the extraordinary repair. Consequently,
the new carrying value of the asset should be depreciated over the new estimated useful life.

Suppose for example, a machine costing Birr 25,000 had no estimated residual value and an
original estimated useful life of then years, has been depreciated for 7 years. The
accumulated depreciation under the straight line method was Birr 17,500.00, and the carrying
value was Birr 7500 (Birr 25,000 – Birr 17500). At the very beginning of the 8 th year, the
machine was given a major overhaul costing Birr 2500.00 This expenditure extended the
useful life of the machine 3years beyond the original estimate. The entry for the
extraordinary repair would be as follows:

Jan. 4 Accumulated Depr, Machinery…………2500.00

Cash………………………………………………..2500.00
Extraordinary Repair to Machinery

The annual periodic depreciation for each of the five years remaining in the machine’s useful
life would be calculated as follows:

Cost of Asset…………………………………………………..Birr 25,000.00

Accum – Depreciation before extraord. Rep. Birr 17, 500.00
Extraordinary repair, Jan 4,………………………. 2,500.00 15,000.00
Book value (carrying value) after exfrarrd………………………....10,000.00
Annual perivdic depreciation= Birr 10,000.00 = 2, 000.00
5years
Revenue Expenditures:

Among the more usual kinds of revenue expenditures for plant asset are the repairs,
maintenance, lubrication, cleaning, and inspection necessary to keep the asset in good
working condition.

Ordinary repairs are expenditures that are necessary to maintain an asset in good operation
conditions. Trucks must have tune –ups, their tires and batteries must be replaced regularly,
and other routine repairs must be made. Offices and halls must be painted regularly, and

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broken tiles or woodwork must be replaced. Such repairs are current expense, and must be
charged against the revenue in the current fiscal period.

Check Your Progress Exercise -7

1. What is the distinction between revenue expenditures and capital expenditures, and
what in general is included in the cost of a long – term asset?
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2. Moon Company purchased a used tractor for Birr 35,000.00. Before the tractor could
be used, it required an overhaul, which cost Birr 3000.00. Its first tank of fuel cost Birr
150, and painting, Birr 750. The tractors are expected to last five years and have a
residual value of Birr 2000.

Required:
Required:
(a) Determine the cost and depreciable cost of the tractor.
(b) Calculate the depreciation for the first year under the straight – line method.
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6.11 DISPOSAL OF PLANT ASSETS

Plant assets, such as equipments, delivery trucks or machineries, cannot be used forever. The
assets many wear out or the business may replace them with newer model.

When a plant (fixed) asset is no longer useful to a business the asset may be disposed of by:
1) discarding it as worthless;
2) selling it; or
3) trading it in on a new asset.

6.11.1 Recording Discarding of Plant Asset

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If a plant asset is of no further use to the business and cannot be sold or traded, then the plant
asset is discarded.

If the asset has no book value (i.e. if it is fully depreciated),

 the plant asset account is credited for t he amount of the original cost of the item
being discarded. At the same time, the accumulated depreciation account is debited for
the amount of the total accumulated depreciation of the item being discarded In this case
no gain or loss is realized.
 If a plant asset has a book value (if not fully depreciated) at the time it is
discarded, the business incurs a loss.

For example, on March 10, year 4 an office machine that was acquired on Jan 2, Year 1 at a
cost of birr 7000.00, is discarded as worthless. The book value is computed as the difference
between the cost of the asset birr 7000.00 and accumulated Depreciation, Birr 5500.00. A
loss equal to the carrying value (book value) should be recorded when the machine is
discarded. When the machine is discarded. Therefore, the entry to record the disposal of the
disposal of the asset would be:

19 X 4
March 10. Accumulated depreciation, Machinery…………5500.00
Loss on disposal of plant Asset……………………..1500.00
Office Machine……………………………………….7000
Discarding machinery no longer used in the business.

6.11.2 Recording the Sale of Plant Assets for Cash

The entry to record the sale of an asset for cash is similar to the one illustrated above except
that the receipt of cash should also be recorded. The following entries show how to record the
sale of a machine under three assumptions about the selling price. In the first cash, the Birr
1500.00 cash received is exactly equal to the book value of the machine (Birr 500); therefore,
no gain or loss results.

Case 1 March 10. cash……………………………1500.00

Accumulated Depr- equipment …………..5500.00

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 Equipment……………………………………7000.00
Sale of equipment at an amount equal to Birr; no gain or loss.

Case 2.
2. Sold at Birr. 1000.00 cash; Loss of Birr 500, (BV= Birr 500)
July 5…………………………….1000.00
Loss on sale of equip……...500.00
Accumulated Depr……….5500.00
Equipment………………….7000.00
Sale of Equipment at less than the BV. Loss of Birr 500.00

Case 3.
3. Sold at Birr 3000 cash; gain of Birr 1500, cash received through sale
(Book Value of the asset (Birr 3000- Birr 1500).

July 5 Cash …………………………………..3000.00

Accumulated Depreciation Equip……...5500.00
Equipment………………………………..7000.00
Gain on sale of Plant Asset ………………1500.00
Sale of Equipment at more than the BV; gain
of Birr 1000, (3000 – 1500) recorded.

6.11.3 Recording Exchanges of Plant Assets

Businesses also dispose of plant assets by trading them in on the purchase of other plant
assets. Exchanges may involve similar assets, such as an old machine traded in on a newer
model, or dissimilar assets, such as a machine traded in on a truck. In either case, the
purchase price is reduced by the amount of the trade – in allowance.

The basic accounting for exchanges of plant assets is similar to accounting for sales of plant
assets for cash. If the trade in allowance received is greater than the carrying value of the
asset surrendered, there has been a gain. If the trade – in allowance is less than the carrying
value, there has been a loss.

There are special rules for recognizing these gains and losses, depending on the nature of the
assets exchanged.

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 Losses Gains
Exchange Recognized Recognized
For financial reporting purposes
Of dissimilar assets Yes Yes
Of similar assets Yes Yes
For Income Tax Purposes
Of dissimilar assets Yes Yes
Of similar assets No No

Both gains and losses are recognized when a company exchanges dissimilar assets. Assets are
dissimilar when they perform different functions, assets are similar when they perform the
same function.

For financial reporting purposes, gains on exchanges of similar assets are not recognized
because the earning lives of the assets surrendered are not considered to be completed. When
a company trades- in an older machine on a newer machine of the same type, the economic
substance of the transaction is the same as that of a major renovation and upgrading of the old
machine. You could think of the trade – in as an extension of the life and usefulness of the
original machine. Instead of recognizing a gain at the time of the exchange, the company
records the new machine at the sum of the book value of the older machine plus any cash paid
(or boot involved).

For income tax purposes, neither gains nor losses are recognized from the exchange of similar
assets.
Loss Recognized on The Exchange:
A loss is recognized for financial reporting purposes on all exchanges in which a material loss
occurs.

To illustrate the recognition of a loss, let us assume that the firm in our comprehensive
example exchanges the office machine for a newer, more modern machine on the following
terms:

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 Price of new machine……………………………….birr 8000.00
Trade –in allowance for old machine…………………..(1000.00)
Cash payment required (Boot given)…………….Birr 7,000.00

In this case the trade – in allowance (birr 1000) is less than the book value (Birr 1500) of the
old machine. The loss on the exchange is birr 500 (birr 1500 – Birr 1000). The following
Journal entry records this transaction under the assumption that the loss is to be recognized.

19X4
March 10 Office Machine (new)………………….8000.00
Accumulated Depr –Machinery…………..5500.00
Loss on exchange of Machinery……………500.00
Off. Machinery(old)………………………..7000.00
Cash………………………………………...7000.00
To record exchange of machines – cost of old machine and
its accumulated depreciation removed from the records;
new machine recorded at list price; loss recognized.

Attempt the following questions:

1. If a plant asset is discarded before the end of its useful life, how is the amount of loss
measured?-------------------------------------------------------------------------------------------
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2. When similar assets are exchanged, at what amount’s the new asset recorded for
federal income tax purposes?
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Loss not recognized on the Exchange:

In the above example, in which a loss was recognized, the new asset was recorded at the
purchase price of Birr 8000.00 and a loss of Birr 500 was recognized. If the transaction is for
similar assets and is to be recorded for income tax purposes, the loss should not be
recognized.

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In this case, the cost basis of the new asset will reflect the effect of the unrecorded loss. The
cost basis for the new asset is computed by adding the cash payment to the carrying value of
the old asset:

Carrying value of old equipment……………………….Birr 1500.00

Cash paid (Boot given)……………………………………….7000.00
given)……………………………………….7000.00
Cost basis of new equipment…………………………………8500.00
equipment…………………………………8500.00

Note that no loss is recognized in the entry to record this transaction

Mar.10. Office Machine (New)…………………….8500.00

Accumulated Depreciation Machinery………………...5500.00
Office Machine (old)……………………………7000.00
Cash……………………………………………..7000.00
To record Exchange of equipments –cost of old
Equipments and its related accumulated depreciation
removed from the accounts; new equipment recorded at
amount equal to BV of old equipment plus boot given.

NB. The new machinery is reported at a purchase price of Birr 8000.00 plus the unrecognized
loss of Birr 500. the non recognition of the loss on the exchange is, in effect, a postponement
of the loss. Since depreciation of the new machine will be computed based on a cost of Birr
8500.00 instead of Birr 8000.00, the “unrecognized”

Loss results in more depreciation each year on a new equipment than the loss had been
recognized.

Gain Recognized on The Exchange

Gain on exchanges are recognized for accounting purposes when dissimilar assets are
exchanged.

To illustrate the recognition of a gain, we continue with our previous example, assuming the
following terms in which the machine being exchanged serve different functions:

Price of new machine………………………… Birr 8000.00

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 Trade – in allowance for old machine……………...(2500.00)
machine……………...(2500.00)
Cash payment required (Boot)…………………Birr 5500.00

Here the trade – in allowance (Birr 2500) exceeds the book value (Birr 1500.00) of the office
Machine by Birr 1000.00. Thus, there is a gain on the exchange, assuming that the price of the
new machine has not been inflated to allow for an excessive trade – in value . In other words,
a gain exists if the trade in allowance represents the fair market value of the old machine.
Assuming that this condition is true, the entry to record the transaction is as follows:

19X4
March 10 office Machine (new)…………………………. 8000.00
Accumulated Depr- Machinery…………………..5500.00
Office Machine (old)………………………………7000.00
Cash………………………………………………..5500.00
Gain on exchange of plant asset…………………..1000.00

Gain Not Recognized on The Exchange

A gain on an exchange should not be recognized in the accounting records if the machines
perform similar functions.

The cost basis of the new machine must indicate the effect of the unrecorded gain. This cost
basis is computed by adding the boot (the cash payment ) to the carrying value of the old
asset.

Carrying (book) value of old machine…………………Birr 1500.00

Cash paid (boot given)………………………………………5500.00
given)………………………………………5500.00
Cost basis of new office machine……………………………7000.00
machine……………………………7000.00

Thus, the entry to record the transaction is as follows:

19X4
March 10. Office Machine (new)…………………………Birr 7000.00
Accumulated Depr – Off. Machine…………………..5500.00
Office Machine (old)……………………………………7000.00
Cash……………………………………………………..5500.00

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NB. As with the non-recognition of losses, the non recognition of the gain on exchange is, in
effect, a postponement of the gain.

Check Your Progress Exercise -8

1. HABESHA Trading had a piece of equipment that cost Birr 8100 and on which Birr
4500 of accumulated depreciation had been recorded. The equipment was disposed of on
Jan 4, the first day of business of the current year.

Give the journal entries to record the disposal under each of the following assumption:

a) It was discarded as having no value

b) It was sold for Birr 1500 cash
b) It was sold for birr 4000 cash.

2. Give the Journal entries to record the disposal referred to in Question No 1 under the
following assumptions:
a) The equipment was traded in on dissimilar equipment having a list price of
birr 12000.00 a Birr 3800.00 trade-in was allowed, and the balance was paid in
cash. Gains and losses are to be recognized.
b) The equipment was traded – in on dissimilar equipment having a list price
of birr 12000.00. A birr 1750.00 trade – in was allowed, and the balance was
paid in cash. Gains and losses are to be recognized.
c) Same as a, except that the items are similar and gains and losses are not to
be recognized.

6.12 ACCOUNTING FOR INTANGIBLE ASSETS AND NATURAL RESOURCES

An intangible asset is long –term, but it has no physical substance. Its value comes from the
long – term rights or advantage that it offers to the owner. Among the most common
examples are patents, copyrights, leaseholds, leasehold improvements, trademarks, and brand
names, franchises, licenses, formulas, and goodwill.

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Some current assets, such as accounts receivable and certain prepaid expenses, have no
physical nature, but they are not classified as intangible assets because they are short term.
Intangible assets are both long term and nonphysical.

Intangible assets are accounted for at acquisition cost, that is , the amount paid for them.
Some intangible assets, such as goodwill and trademarks, may be acquired of little or no cost.
Even though they may have great value and be needed for profitable operations, they should
not appear on the balance sheet unless they have been purchased from another party at a price
established in the market place.

Patents:
Manufacturers may acquire exclusive rights to produce and sell commodities with one or
more unique features. Such rights are evidenced by patents, which are granted to inventors.

Patents continue in effect for seventeen years. Thus, the maximum amortization period for
patent is 17 years. An enterprise may obtain patents on new products developed in its own
research laboratories or it may purchase patent rights from others. The initial cost of
purchased patents should be debited to an asset account and then written off or amortized over
the years of its expected usefulness. This period of time may be less than the remaining legal
life of the patent, and the expectations are also subject to change in the future.

Goodwill:
The term goodwill is widely used by business people to mean the good reputation of a
company.

From an accounting standpoint, goodwill exists when a purchaser pays more for a business
than the fair market value of the net assets if purchased separately. Because the purchaser has
paid more than the fair market value of the physical assets, there must be intangible assets.

Goodwill exists because most businesses are worth more as going concerns than as collections
of assets.

Goodwill reflects all the factors that allow a company to earn a higher than market rate of
return on its investments, including customer satisfaction, good management, manufacturing

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efficiency, the advantage of holding a monopoly, good locations, and good employee
relations. The payment above and beyond the fair market value of the intangible asset and
other specific intangible assets is therefore properly recorded in the goodwill account.

Accountants are in general agreement that goodwill should be recognized in the accounts only
if it can be objectively determined by a transaction, such as the purchase or sale of a business.
The value of goodwill also decreases through time and that the recorded costs should be
amortized over the years during the goodwill is expected to be of value.

NB:
NB: The maximum period of amortization for goodwill is forty (40) years.

Copyrights
The exclusive right to publish and sell a literacy, artistic, or musical composition is obtained
by a copyright.

The costs assigned to a copyright include all costs of creating the work plus the cost of
obtaining a copyright. A copyright that is purchased from another should be recorded at the
price paid for it. The maximum period of amortization for a copyright is 50 years beyond the
author’s death.

Accounting for Natural Resources

Natural resources are also known as wasting assets.
assets. Examples of natural resources are
standing timber, oil and gas fields, and mineral deposits.

The distinguishing characteristic of these natural resources is that they are converted into
inventory by cutting, pumping or mining. For example, an oil field is a reservoir of
unplumbed oil, and a coalmine is a deposit of unmanned coal.

Natural resources are shown on the balance sheet as long-term assets with such descriptive
titles as Timber (Lumber) Lands, Oil and Gas Reserves, and Mineral Deposits. When the
timber is cut, the oil is pumped, or the coal is mined, it becomes an inventory of the product to
be sold.

Natural resources are recorded at acquisition cost, which may also include some costs of
development.

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As the resources are converted through the process of cutting, pumping, or mining, the asset
account must be proportionally reduced. As a result, the original cost of the natural resource
reserves is gradually reduced , and depletion is recognized by the amount of the decrease.

Depletion
The term depletion is used to describe not only the exhaustion of a natural resource but also
the proportional allocation of the cost of natural resources to the units extracted. The costs are
allocated in a way that is much like the production method used to calculate depreciation.

For example, for a mine having an estimated 1,500,000.00 tons of coal a cost of Birr
1,800,000.00 and an estimated residual value of Birr 300,000.00 of coal are mined and sold
during the first year, the depletion expense for the year is Birr 115,000. This expense is
recorded as follows:

Dec.31 Depletion Expense, Coal Deposits………………….115,000.00

Accumulated Depletion, Coal Deposit……………………115,000.00
To record depletion of coal mine.

On the balance sheet, the mine would be presented as follows:

Coal Deposits……………………………..Birr 1,800,00.00
Less: Accumulated Depletion…………………...115,000.00
Depletion…………………...115,000.00 1,685,000.00

6.13 SUMMARY

 Most business enterprise hold such major assets as land, buildings, equipment,
furniture, tools, and intangible assets. These assets help produce revenues over many
periods by facilitating the production and sale of goods or services. Because these assets
are necessary in a company’s day-to-day operations, companies do not sell them in the
ordinary course of business.
 Long-term assets are assets that (1) have a useful life of more than one year, (2)
are acquired for use in the operation of the business, and (3) are not intended for resale to
customers.
 Long-term assets are divided into tangible (plant assets) and intangible categories.
Tangible (plant) assets are assets with physical substance that can be used in the

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 operations of a business relatively for a long period of time usually more than one year or
one operating cycle whichever is longer. Intangible assets are assets without a physical
feature that can be charged in the operations of business for long period of time.
 The cost of long-term assets includes all expenditures reasonable and necessary to
get it in place and ready for use.
 The cost of a productive asset is one of the services it renders during its useful
economic life. Generally accepted accounting principles requires that this cost be spread
over the expected useful life of the asset in such a way to allocate it as equitable as
possible to the periods during which services are obtained from the use of the asset. This
procedure is known as depreciation accounting, a system of accounting which aims to
distribute the cost or other estimated useful life of the unit in a systematic and rational
manner.

6.14 ANSWERS TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress Exercise – 1

1. Long-term assets are assets that:
(a) Have a useful life of more than one year,
(b) Are acquired for use in the operation of the business, and
(c) Are not intended for resale to customers

2. Items c and d would be classified as plant assets on the balance sheet. Items a, b,
b, and c
would not be reported as plant assets

3. (a) Land : - 8
(b) Land Improvements: - 1,
(c) Buildings: - 2, 3, 4, 5, 6, 7,

Check Your Progress Exercise – 2

1. No! Depreciation is the process of allocating the cost of plant asset on rational manner over
the estimated economic (or service) life of the plant asset.

2. Debited to the Land account:

 Purchase price---------------------------------br. 150,000.00

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  Demolition of shack --------------4,000.00
 General Grading of property------------2,100.00

Amounts Debited to Land Improvements

 Packing lot,-------------------br. 20,000.00
 Lighting for parking lot---------16,000.00
 Signs for parking lot -------------3,200.00
-------------3,200.00
Total -----------------br. 39,200.00

Check Your Progress Exercise – 3

1. Annual Depreciation by the straight-line method is:
Annual Depreciation = OC – Estimated Salvage value
Estimated useful life
= br. 4200 – br. 500
5 years
= br. 740
Therefore, the depreciation expense for each year is equal, ie, br. 740.

2. (a) 8 years = = 12.5 % straight line depreciation rate.

(b) 12 years =

(c) 50 years = = 2 % straight line rate

(d) 20 years = = 5% straight line rate

(e) 25 years = = 4 % straight line rate

Check Your Progress Exercise – 4

1. (a) the depreciation per hour (or hourly depreciation) is :

Hourly

Depreciation =

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 =

Hourly Depr. = br. 50

(b) Since the asset was placed in service for 6200 hours in the first year, the deprecation
expense to be reported in the first year is br. 3100.00, computed as follows:
br. 0.50 X 6200 = br. 3100

Check Your Progress Exercise – 5

1. It is based on the assumption that many kinds of plant assets are most efficient when new,
and so they provided more and better service in the early years of useful life.

2.
Year Cost Yearly Accumulated Book
Depreciation Depreciation Value
1 Br. 9000 Br. 9000 x 40/100 = 3600 Br. 3600.00 Br. 5400.00
2 9000 9400 x 40/100 = 2160 5760.00 3240.00
3 9000 3240 x 40/100 = 1296 6056.00 2944.00
4 9000 2944 x 40/100 = 1177.60 7233.60 1766.40
5 9000 1766 x 40/100 = 706.56 7940.16 1059.84

Check Your Progress Exercise – 6

1. Cost of asset ----------br. 46,000.00
Estimated residual value---------4,000.00
Estimated Economic Life --------6 years
Depreciation Method ---------sum of the years’ digits

(a) The denominator

of the fraction = = 21

(b) Depreciation = (br. 46,000 – br. 4000) x = br. 12,000

(first Year)
(c) Second year

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 depreciation = br. 42,000 x = b.r 10,000.00

 Since the asset was placed in service after four months of the first year
had been elapsed, the depreciation expense to be reported in the second
year would be:

42,000 x ---------br, 4000.00

Plus, 42,000 X ----------6666.67

----------6666.67

Total, Second year depreciation br. 10,666.67

2. Cost ----------------------------------------------------br. 235,000.00

Economic (useful) life-------------------------------------7 years
Residual value--------------------------------------------------0-
(a) The denominator

of the fraction = = 28

(b) Depreciation for

first year = br. 235,000 x = br. 29,375

(c) Second year

depreciating = br. 235,000 x = br. 29375

Plus, 235,000 x = 25178.40

Total, second year deprecation = br.

br. 54,553.40

Check Your Progress Exercise – 7

1. Careful distinction between revenue and capital expenditures is important to the proper
application of the matching rule.

 Revenue expenditures – are expenditures related to the maintenance and

operations of long-term assets. Among the more visual kinds of revenue
expenditures for plant asset are the repairs, maintenance, lubrication, cleaning,
and inspection necessary to keep the asset in good working condition. Revenue

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 expenditures are recorded in the expense accounts because the benefit only the
current period operation.

 Capital expenditures – are expenditures for the acquisition or expansion

(addition) of a long-term asset. In addition to the acquisition of plant assets,
capital expenditures include additions, betterments, and extraordinary repairs. An
addition is an enlargement to the physical layout of plant asset, such as adding a
wing to a building. Betterment is an improvement that does not add to the
physical layout of the asset. A betterment increases the productive capacity or
efficiency of a plant asset for the remaining useful life. Therefore, it must be
charged (debited) to the plant asset account. Another capital expenditures include
extraordinary repairs. Extraordinary repairs are repairs of a more significant
nature; they affect the estimated residual value or estimated useful life of an asset.
For example, major structural repairs made to a building that will extend its useful
life beyond its original estimate, is regarded as extraordinary repairs.
Extraordinary repairs are recorded by debiting the Accumulated Depreciation
account to make better off the depreciation accumulated in earlier years.

In general, the acquisition cost of long-term asset includes all expenditures reasonable and
necessary to get it in place and ready for use.

2. (a) Cost of tractor :

br. 35,000 + br. 3000 = birr 38,000.00
depreciable cost = br. 38,000 – br. 2000 = birr 36,000.00
(b) Depreciation for the first year using straight-line method:

Annual depr = br.

= br.

= br. 7200.00
NB. Costs fro fuel; br. 150 and painting, br. 750 are not taken into account in the determination

of the cost of the tractor. Instead, they are treated as current period expenses .

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Check Your Progress Exercise – 8
1. Equipment traded-old
Cost-------------------------------------------------------------Birr 8100.00
Accumulated depreciation ----------------------------------------4500.00
Book value (carrying value)---------------------------------Birr 3600.00

(a) The asset was discarded as having no value:

Jan.4. Accumulated depreciation ------------------4500
Loss on disposal of equipment ------------3600
Equipment -----------------------------------8100
Entry to record the disposal of plant asset and the recognition of
loss on disposal of plant asset.

(b) The asset was sold for Birr 1500.00 cash:

Jan.4. Cash--------------------------------1500
Accumulated depreciation ------4500
Loss on sale of plant asset-------2100
Equipment ---------------------------8100
Entry to record the sale of plant asset at loss book value exceeds
selling price.

(c) The asset was sold for Birr 4000.00

Jan.4. Cash -------------------------------------4000
Accumulated depreciation-------------4500
Equipment ------------------------8100
Gain on sale of plant asset--------400
Entry to record the sale of plant asset; and the recognition to
gains

2. (a) Jan 4. Equipment (new) --------------------------------12,000

Accumulated depreciation (old) ----------------4,500
Equipment (old) -------------------------------8,100
Cash----------------------------------------------8,200

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 Gain on disposal ----------------------------------200
Entry to record exchange of dissimilar assets, and the recognition of gain on the exchange.

(b) Jan 4. Equipment (new) --------------------------12,000

Accumulated deprecation (old) -----------4,500
Loss on disposal of plant asset ----------- 1,850
Equipment (old)-----------------------------------8,100
Cash------------------------------------------------10,250
Entry to record exchange of dissimilar assets; and the recognition of loss on
the exchange.

(c) Jan 4. Equipment (new) --------------------------------11,800

Accumulated depreciation (old) --------------- 4.500
Equipment (old) --------------------------8,100
Cash-----------------------------------------8,200
Entry to record exchange of similar assets; and the non-recognition of
gains.

6.15 GLOSSARY

1. Accumulated Depreciation:
Depreciation: The cumulative sum of all depreciation
recognized since the date of acquisition of the particular assets.
2. Amortization: When referring to long-lived assets, it is usually means the
allocation of the costs of intangible assets to the periods that benefit from these assets.
3. APB Opinions:
Opinions: A series of thirty-one opinions of the Accounting Principles
Board, many of which are still the “accounting law of the land”.
4. Book value:
value: The balance of an account shown on the books, net of any contra
accounts.
5. Contra account:
account: A separate but related account that offsets or is a deduction
from a companion account. An example is accumulated depreciation.
6. Franchises:
Franchises: Privileges granted by a government, manufacturer, or distributor
to sell a product or service in accordance with specified conditions.
7. Goodwill: The excess of the cost of an acquired company over the sum of the
fair market value of its identifiable individual assets less the liabilities.

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8. Leasehold:
Leasehold: The right to use a fixed asset for a specified period of time,
typically one year.
9. Leasehold Improvement:
Improvement: Investments by lessee in items that are permitted to
be removed from the premises when a lease expires, such as installation of new fixtures,
panels, walls, and air-conditioning equipment.
10. Trademarks:
Trademarks: Distance identification of a manufacture product or of a service
taking the form of a name, a sign, a slogan, a logo, or an emblem.

6.16 MODEL EXAMINATION QUESTIONS

Part I. Answer the following question.

1. Construct the assumptions underlying the straight – line depreciation method with the
assumptions underlying the production depreciation method.

2. What is the principal argument supporting the accelerated method.

3. Name the three factors that need to be considered in computing the amount of periodic
depreciation.

4. Which of the following qualities are characteristic of plant assets?

a) Intangible
b) Tangible
c) Capable of repented use in the normal operations of the business,
d) Held for sale in the normal course of business,
e) Used continuously in the normal operations of business,
f) Short – lived,
g) Long – lived

5. Why is it useful to think of a plant asset as a bundle of services?

Part II. Workout
BLUE – NILE construction company purchased a cement mixer on January 3, 29 X 1 for birr
145,000.00 the mixer is expected to have a useful life of 7 years and a residual value of birr
5000.00 The company engineers estimate that the mixer will have a useful life (Operating
capacity) of 28,000.00 operating hours. It was used 4400 hours in19 X 1, 4100 hours in 19 X

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2, 4150 hours in 19 X 3, 4050 hours in 19 X4, 3800 hours in 19 X 5, 3750 hours in 19 X 6,
and 3650 hours in 19 X 7. The company’s fiscal year end on December 31,

Required:
Compute the depreciation expense and the carrying (Book value) for 19 X1 to 19 X 1 to
19 X 7. Using the following four methods:

c) Straight – line,
d) Units production,
e) Double –declining balance, and
f) Sum – of – the – years – digits method

What conclusions can you draw from the patterns of yearly (annual) depreciation?
Part III
2. Define depreciation, state the factors that affect its computation, and show how to
record it?
3. Define long – term assets and identify the types of long – term assets?
4. Old stake mining co. computes the depletion rate of ore to be birr 3.00 per ton.
During year 1 the company mined 500,000 tons of ore and sold 400,000 tones. What is
the total depletion for year 1?
5. In what ways do an addition, betterment, and an extraordinary repair differ?
6. Tell whether each of the following transactions related to an office building is revenue
expenditure (RE) or a capital expenditure (CE). In addition, whether each transaction is
an ordinary repair (OR), an extraordinary repair (ER), and addition (A), a betterment (B),
or none of these (N).
a) The hallways and ceilings in the building are repainted at a cost of birr
7,400.00
b) The hallways, which have tile floors, are carpeted at a cost of Birr
25,000.00
c) A new wing is added to the building at a cost of birr 185,000.
d) Furniture is purchased for the entrance to the building at a cost of Birr
16,500.00

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The air – conditioning system is overhauled at a cost of birr 20,700.00. The over haul extends
the useful life of the air conditioning system by ten years

Part IV. Write, “True” if the statement is correct and write “false” if the statement is
incorrect.
1. If capital expenditure is incorrectly recorded as revenue expenditure,
the error will cause overstate the net income reported in that period.

2. Depreciation is an attempt to measure the decrease in market value of

an asset during a period of time.
3. An expenditure for repairs, maintenance, or other services made to
keep the operating capacity of the asset should be recorded as a debit
to an expense account.
4. The production method of depreciation is based on the assumption that
depreciation is mainly the result of use and that the passage of time
plays no role in the depreciation process.
5. Accumulated depreciation represents a fund being accumulated for the
replacement of plant assets.
1. Abay water construction purchased a drilling truck for Birr 750,000.00. The
company expected the truck to last 10 years or 400,000 miles, with an estimated residual
value of Birr 50,000.00 at the end of that time. During 19X5, the truck was driven 90,000
miles. The company’s year-end is December 31. compute the depreciation expense for
19X5 under each of the following deprecation method

a) Straight line
b) Production
c) Double – declining – balance, and
d) Sum of years digits.
2. A piece of equipment that cost Birr 32,400 and on which Birr 18000 of
accumulated depreciation had been recorded was disposed of on January 2, the first day of
business of the current year. Give general journal entries to record the disposal under
each of the following assumptions:
a) It was discarded as having no value.

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 b) It was sold for Birr 6000 cash
c) It was sold for Birr 16,000 cash
d) It was traded –in on dissimilar equipment having a list price of Birr 48,000.
A Birr 15,600 trade in was allowed, and the balance was period in cash. Gains and
losses are to be recognized.
3. A Commercial Vacuum cleaner costing Birr 2450, with accumulated depreciation
of Birr 1800, was traded in on a new model that had a list price of Birr 3050. a trade – in
allowance of Birr 500 was given.
a) Compute the carrying value of the old vacuum cleaner.
b) Determine the amount of cash required to purchase the new vacuum
cleaner
c) Compute the amount of loss on the exchange.
d) Determine the cost basis of the new vacuum cleaner assuming (1) loss is
recognized and (b) the loss is not recognized.
e) Compute the yearly depreciation on the new vacuum cleaner for both
assumptions in (d) assuming a useful life of five years, a residual value of Birr
800, and straight – line depreciation.

4. On August 27 of the current fiscal year ended Dec 31 ABB co acquired a patent
for Birr 91,000 and mineral rights for Birr 350,000. The patent, which expires in 10 years,
is expected to have value for 7 years. The mineral deposit is estimated at 700,000 tons of
are of uniform grade.

Required: Present entries to record the following for the current year: (a) amortization of the
patent, (b) depletions assuming that 100,000 tons were mined during the year.

6.17 REFERENCE

1. Belvered [Link], Jr.: Financial Accounting, 5th Edition.

Houghton Mifflin Company, 1995.

2. Fees and Warren: Principles of Accounting, 16th Edition.

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3. Horngren, Sundem, and Elliot: Introduction to Financial Accounting, 8 th
Edition.
Pearson Educational Inc. New Delhi, 2002.

4. Roger H. Hermanson, Jems [Link]

And R.F. Salmonson: Accounting Principles 4 th Edition. Houghton Mifflin Company,
1995.

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