Financial Accounting Fifth Edition

Long-Term Assets

7
CHAPTER BUSF-SHU250
Jing Dai

7-1
Long-Term Assets

Tangible assets Intangible assets

• Land • Patents
• Land improvements • Trademarks
• Buildings • Copyrights
• Equipment • Franchises
• Natural resources • Goodwill

- Physical substance - Lack of physical substance

- Existence often based on
legal contract
7-2
Illustration 7–1
Balance Sheet for Darden Restaurants
DARDEN RESTAURANTS
Balance Sheet (partial)
($ in thousands)

Cash $ 233,100
Receivables 75,900
Inventory 178,900
Other current assets 311,900
Total current assets 799,800
Property, plant, and equipment 2,272,300
Intangible assets 2,151,900
Other long-term assets and investments 280,200
Total assets $5,504,200

7-3
Part A
ACQUISITIONS

7-4
Learning Objective 1

LO7–1 Identify the major types of property, plant, and

equipment.

7-5
Property, Plant, and Equipment
Recorded at:

The original cost of the asset

+
All expenditures necessary
to get the asset ready for use

7-6
Land
• Land includes the cost of the land and all
expenditures necessary to get the land ready
for its intended use
• Costs to get the land ready for use include
items such as:
q Real estate commissions and fees
q Back property taxes or other obligations
q Clearing, filling, and leveling the land
q Cash received from selling salvaged building
materials, which reduces the cost of land

7-7
Illustration 7–2
Computation of the Cost of Land
Purchase price of land (and existing building) $500,000
Commissions 30,000
Back property taxes 6,000
Title insurance 3,000
Cost of removing existing building 50,000
Less: Salvaged materials from existing building (5,000)
Cost of leveling the land 6,000
Total cost of land $590,000

Land includes the initial purchase price plus all

expenditures (net of salvaged materials) necessary to get
the land ready for use.
7-8
Land Improvements
• Land improvements are amounts spent to
improve the land
• Examples:
q Parking lots, sidewalks, driveways, landscaping,
lighting systems, fences, and sprinklers
• Land improvements have limited useful lives
and are recorded separately from the Land
account.

7-9
Buildings
• Buildings: administrative offices, retail stores,
manufacturing facilities, and storage
warehouses
• Costs of getting a building ready for use
include items such as:
q Realtor commissions and legal fees
q Remodeling costs

7-10
Buildings
• What if a firm constructs a building rather
than purchasing it?
• The cost of construction includes:
q Architect fees
q Material costs
q Construction labor
q Manager supervision
q Overhead
q Interest costs
q Etc.

7-11
Equipment
• Equipment: machinery used in manufacturing,
computers and other office equipment, vehicles,
furniture, and fixtures
• The cost of equipment is the actual purchase price plus
all other costs necessary to prepare the asset for use.
q Sales tax
q Shipping
q Delivery insurance
q Assembly
q Installation
q Testing
q Legal fees incurred to establish title
• Recurring costs such as annual property insurance and
annual property taxes on vehicles are expensed as
incurred
7-12
Illustration 7–3
Computation of the Cost of
Equipment
Purchase price $82,000
Sales tax 6,500
Transportation 800
Shipping insurance 200
Installation 1,500
Total cost of equipment $91,000

Total cost of equipment includes the initial purchase

price plus all expenditures necessary to get the
equipment ready for use.
7-13
Basket Purchases
• Purchase of more than one asset at the same
time for one purchase price
q Example: purchase land, building, and equipment
together for $900,000

• Because we need to record land, building, and

equipment in separate accounts we must
allocate the total purchase price based on the
relative fair values of the individual assets

7-14
Illustration 7–4
Allocation of Cost in a Basket Purchase
Purchase of land, building, and equipment = $900,000
Estimated fair value of: Land $ 200,000
Building $ 700,000
Equipment $ 100,000
$1,000,000
Determine amount to record for each asset.
Estimated Allocation Amount of Recorded
Fair Value Percentage Basket Purchase Amount
Land $ 200,000 $200,000/$1,000,000 = 20% × $900,000 $180,000
Building 700,000 $700,000/$1,000,000 = 70% × $900,000 630,000
Equipment 100,000 $100,000/$1,000,000 = 10% × $900,000 90,000
Total $1,000,000 100% $900,000

7-15
Concept Check 7–1
A company makes a basket purchase of land,
buildings, and equipment with estimated fair values
of $70,000, $150,000, and $30,000, respectively.
The purchase price is $210,000. How much should
be recorded to the Land account?
a. $ 126,000
b. $ 70,000
c. $ 58,800
d. $ 25,200

7-16
Natural Resources
• Natural resources: oil, natural gas, timber, and
salt
• Distinguished from other assets by the fact
that they are physically used up, or depleted
• Recorded at cost plus all other costs necessary
to get the natural resource ready for its
intended use

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Key Point
Tangible assets such as land, land
improvements, buildings, equipment, and
natural resources are recorded at cost plus all
costs necessary to get the asset ready for its
intended use.

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Learning Objective 2

LO7–2 Identify the major types of intangible assets.

7-19
Intangible Assets
• Intangible assets: patents, copyrights,
trademarks, franchises, and goodwill
• Lack physical substance but can be very
valuable
• Existence often based on legal contract
• Acquired in two ways:
q Purchased
q Developed internally

7-20
Illustration 7–5
World’s Top 10 Brands
Brand Value ($ in billions)
#1 Apple 181.2
#2 Google 141.7
#3 Microsoft 80
#4 Coca-Cola 69.7
#5 Amazon 64.8
#6 Samsung 56.2
#7 Toyota 50.3
#8 Facebook 48.2
#9 Mercedes-Benz 47.8
#10 IBM 46.8

0 20 40 60 80 100 120 140 160 180 200

Source: “Best Gobal Brands 2017 Rankings,” [Link], 2017,

[Link].

7-21
Recording and Reporting
Intangible Assets
• Purchased intangibles: record at their original
cost plus all other costs necessary to get the
asset ready for use.
q Similar to reporting purchased property, plant,
and equipment.
• Intangible assets developed internally:
expense in the income statement most of the
costs for internally developed intangible
assets in the period we incur those costs.
q Difficult to determine portion of the expense that
benefits future periods.
7-22
Patents
• Exclusive right to manufacture a product or to
use a process
• Granted for a period of 20 years
• When purchased:
q Capitalize the purchase price plus legal and filing
fees
• When developed internally:
q Capitalize legal and filing fees only (Research and
Development costs are expensed as incurred)

7-23
Copyrights
• Exclusive right of protection given to the
creator of a published work
• Granted for the life of the creator plus 70
years
• Allows holder to pursue legal action against
anyone who attempts to infringe the copyright
• Accounting is virtually identical to that of
patents

7-24
Trademarks
• Word, slogan, or symbol that distinctively
identifies a company, product, or service
• Renewable for an indefinite number of 10-year
periods
• Firms often acquire trademarks through
acquisition.
q Capitalize purchase price, legal, registration, and
design fees
• When a firm develops a trademark internally
through advertising, it records the advertising
costs as expense when incurred.

7-25
Franchises
• Local outlets that pay for the exclusive right to
use the franchisor’s name and to sell its products
within a specified geographical area
• The franchisee records the initial fee as an
intangible asset
• Additional periodic payments by the franchisee
usually are for services the franchisor provides on
a continuing basis. These are expensed by the
franchisee as incurred.

7-26
Buying Goodwill
• Recorded only when one company acquires another
company.

• When you buy a company, you buy a BASKET of

ASSETS and LIABILITIES.
What you pay = What you Get?

7-27
Buying Goodwill
• What you pay > What you Get
• Goodwill = Amount paid- Basket got
• Goodwill is the portion of the purchase price that
exceeds the fair value of identifiable net assets
q Net assets = assets acquired less liabilities assumed

7-28
Illustration 7–6
Business Acquisition with Goodwill
Allied Foods acquires Ritz Produce for $36 million.
The following information is known for Ritz Produce:
Fair value of the identifiable assets = $50 million
Fair value of the identifiable liabilities = $24 million
For how much will Allied record goodwill?
($ in millions)
Purchase price $ 36
Less:
Fair value of assets acquired $ 50
Less: Fair value of liabilities assumed (24)
Fair value of identifiable net assets (26)
Goodwill $ 10
7-29
Goodwill
• Most companies also create goodwill to some extent
through advertising, employee training, and other
efforts. However, as it does for other internally
generated intangibles, a company must
expense costs incurred in the internal generation of
goodwill.

7-30
Concept Check 7–2
Which of the following is an exclusive right to
manufacture a product or to use a process?
a. Trademark
b. Patent
c. Copyright
d. Goodwill
A patent is an exclusive right to manufacture a product or
to use a process. The U.S. Patent and Trademark Office
grants this right for a period of 20 years.

7-31
Learning Objective 3

LO7–3 Describe the accounting treatment of

expenditures after acquisition.

7-32
Expenditures After Acquisition
• Repairs and maintenance
• Additions
• Improvements
• Litigation costs
For all expenditures after acquisition:
If they benefit only
Expense
the current period
or
If they benefit
Capitalize
future periods as well
Capitalize = record an asset
7-33
Repairs and Maintenance

Expensed if repairs Capitalize as assets more

maintain a given level of extensive repairs that
benefits in the period increase future benefits
incurred

For a delivery truck

EXPENSE CAPITALIZE
Cost of an engine tune-up or the Cost of a new transmission or an
repair of an engine part engine overhaul
Additions

Occurs when we add a new major component to an existing

asset

CAPITALIZE
the cost of additions because
they increase, rather than
maintain, the future benefits from
the expenditure

Adding a refrigeration unit to a

delivery truck increases the
capability of the truck, thus
increasing its future benefits.
Improvements

Occurs when we replace a major component

CAPITALIZE
the cost of improvements
because they increase, rather
than maintain, the future benefits
from the expenditure

Replacing an existing
refrigeration unit in a delivery
truck with a new but similar unit
or with a new and improved
refrigeration unit.
 Legal Defense of Intangible assets

The cost of legally defending the right that gives the asset its
value

If the defense of an intangible right is

Successful Unsuccessful

CAPITALIZE EXPENSE
Litigation costs and amortize The litigation costs as incurred
them over the remaining useful because they provide no future
life of the related intangible benefit
Illustration 7–7
Expenditures after Acquisition
Type of Period Usual Accounting
Expenditure Definition Benefited Treatment

Repairs and Maintaining a given level of Current Expense

maintenance benefits

Repairs and Making major repairs that Future Capitalize

maintenance increase future benefits

Additions Adding a new major Future Capitalize

component

Improvements Replacing a major component Future Capitalize

Legal defense Incurring litigation costs to

of intangible defend the legal right to the Future Capitalize
assets asset (Expense if defense
is unsuccessful)

7-38
Materiality
• An item is said to be material if it is large enough
to influence a decision.
• When an expenditure is not material, the item is
typically recorded as an expense regardless of its
expected period of benefit.
• Companies generally have policies regarding
amounts that are not material. They will expense
all costs under a certain dollar amount, say
$1,000, regardless of whether future benefits are
increased.

7-39
Key Point
We capitalize (record as an asset) expenditures
that benefit future periods. We expense items
that benefit only the current period.

7-40
Concept Check 7–3
Which of the following costs would be expensed?
a. Adding a refrigeration unit to a delivery truck
b. Adding a new suspension system to a delivery
truck that will allow for heavier loads
c. Adding a new transmission to a delivery truck,
which will increase its life and future benefits
d. Performing a tune-up on a delivery truck

7-41
Part B
COST ALLOCATION

7-42
Learning Objective 4

LO7–4 Calculate depreciation of property, plant, and

equipment.

7-43
Depreciation
• Dictionary definition
q Decrease in value of an asset
• Accounting definition
q Allocation of an asset’s cost to expense over time

• Why Depreciation？
q Matching the benefit of the asset that was consumed with the
revenue it helps to generate

7-44
 Recording Depreciation
A local Starbucks pays $1,200 for equipment—say, an
espresso machine, with a useful life of four years.
Record depreciation expense for the first year.
December 31 Debit Credit
Depreciation Expense………………………… 300
Accumulated Depreciation ………….. 300
(Depreciate equipment; $300 = $1,200 ÷ 4 years)

Balance Sheet Presentation Asset account

Equipment (cost) $1,200
Less: Accumulated depreciation ($300 × 1 year) (300)
= Book value $ 900

Contra asset account

7-45
Factors Used in Calculating
Depreciation
•Service life (or useful life)—The estimated use the company expects to
receive from the asset before disposing of it.
•Residual value (or salvage value)—The amount the company expects
to receive from selling the asset at the end of its service life.
•Depreciation method—The pattern in which the asset’s benefit is
consumed over the service life. In determining how much of an asset’s
cost to allocate to each year, a company should choose a depreciation
method that corresponds to the pattern of benefits received from using
the asset.

7-46
 Straight-Line
Depreciation
Allocates an equal amount of the depreciable
cost to each year of the asset’s service life

Depreciation Asset cost - Estimated residual value

expense =
Asset’s service life

Cost of the new truck $40,000

Estimated residual value $5,000
Estimated service life 5 years or 100,000 miles

Depreciation expense = $40,000 − $5,000 = $7,000

per year 5 years

7-47
Straight-Line Depreciation
Schedule Same amount
each year
Original
cost
LITTLE KING SANDWICHES
Depreciation Schedule—Straight-Line

Calculation End-of-Year Amounts

Depreciable Depreciation Depreciation Accumulated Book
Year Cost × Rate = Expense Depreciation Value*
1/5 = $40,000
1 $35,000 0.20 $ 7,000 $ 7,000 33,000
2 35,000 0.20 7,000 14,000 26,000
3 35,000 0.20 7,000 21,000 19,000
4 35,000 0.20 7,000 28,000 12,000
5 35,000 0.20 7,000 35,000 5,000
Total $35,000

*Book value is the original cost of the asset ($40,000) minus accumulated depreciation. Book value of $33,000 at the end of
year 1, for example, is $40,000 minus $7,000 in accumulated depreciation.
Residual value

7-48
Partial-Year Depreciation
What if the delivery truck was purchased during
the year, say on March 1, and then used for five
years? (Recall annual depreciation = $7,000)
• Depreciate for portion of the year held
• Year 1: $7,000 × 10/12 = $ 5,833
• Years 2–5: $7,000 per year = $28,000
• Year 6: $7,000 x 2/12 = $ 1,167
• Total depreciation over life = $35,000

7-49
Concept Check 7–4
How much depreciation should be recorded in the
first year for a delivery truck purchased on April 1
with a cost of $30,000, an expected life of five years,
and an estimated residual value of $5,000? Assume
the straight-line method is used.
a. $ 5,000
b. $ 3,750
c. $ 4,500
d. $ 6,000

7-50
Change in Depreciation Estimate
Assume that after three years Little King Sandwiches
estimates the remaining service life of the delivery truck
to be four more years, for a total service life of seven years
rather than the original five. Little King also changes the
estimated residual value to $3,000 from the original
estimate of $5,000.
How much is depreciation in years 4 to 7?

Book value, end of year 3 $19,000

− New residual value (3,000)
New depreciable cost 16,000
÷ New remaining service life 4
Annual depreciation in years 4 to 7 $ 4,000
7-51
Double Declining-Balance
Depreciation
• In some situations it might be more reasonable to assume that
the asset will provide greater benefits in the earlier years of its
life than in the later years.
• Will be higher than straight-line depreciation in earlier years, but
lower in later years
• Both declining-balance and straight-line will result in the same
total depreciation over the asset’s service life
• The most common declining-balance rate is 200% of the straight-
line rate, which we refer to as the double-declining-balance
method since the rate is double the straight-line rate

7-52
Illustration 7–13
Double-Declining-Balance
Depreciation Schedule Declining
each year
amount

LITTLE KING SANDWICHES

Depreciation Schedule—Double-Declining-Balance

Calculation End-of-Year Amounts

Beginning Depreciation Depreciation Accumulated Book
Year Book Value × Rate = Expense Depreciation Value*
$ 40,000
1 $40,000 0.40 $16,000 $16,000 24,000
2 24,000 0.40 9,600 25,600 14,400
3 14,400 0.40 5,760 31,360 8,640
4 8,640 0.40 3,456 34,816 5,184
5 5,184 Double 184** 35,000 5,000
Total straight-line $35,000
rate
*Book value is the original cost of the asset minus accumulated depreciation. Book value at the end of year 1 is $24,000, equal to the cost of
$40,000 minus accumulated depreciation of $16,000. Book value at the end of year 1 in the last column is equal to book value at the beginning
of year 2 in the second column of the schedule.
**Amount necessary to reduce book value to residual value. Remaining Residual value
depreciation
7-53
Common Mistake
When using the declining-balance method, mistakes are
commonly made in the first and last year of the calculation.
In the first year, students sometimes calculate depreciation
incorrectly as cost minus residual value times the depreciation
rate. The correct way in the first year is to simply multiply cost
times the depreciation rate.
In the final year, some students incorrectly calculate depreciation
expense in the same manner as in earlier years, multiplying book
value by the depreciation rate. However, under the declining-
balance method, depreciation expense in the final year is the
amount necessary to reduce book value down to residual value.

7-54
Concept Check 7–5
How much depreciation should be recorded for the
first year for a delivery truck with a cost of $30,000,
an expected life of six years, and an estimated
residual value of $6,000? Assume the double-
declining-balance method is used.
a. $ 12,000
b. $ 10,000
c. $ 8,000
d. $ 5,000

7-55
Activity-Based
Depreciation
Allocate an asset’s cost based on use rather than time

Step 1

Compute the average depreciation rate per unit

Depreciable Cost

Total units expected to be produced

Step 2

Multiply the average depreciation rate per unit by the

number of units each period

7-56
Activity-Based Depreciation

Cost of the new truck $40,000

Estimated residual value $5,000
Estimated service life 5 years or 100,000 miles

Depreciation rate Depreciable cost

=
per unit Total units expected to be produced
$40,000 – $5,000
Depreciation rate = = $0.35 per mile
100,000 expected miles

7-57
Activity-Based Depreciation
Schedule
LITTLE KING SANDWICHES
Depreciation Schedule—Activity-Based

Calculation End-of-Year Amounts

Miles Depreciation Depreciation Accumulated Book
Year Driven x Rate = Expense Depreciation Value*
$40,000
1 30,000 $0.35 $10,500 $10,500 29,500
2 22,000 0.35 7,700 18,200 21,800
3 15,000 0.35 5,250 23,450 16,550
4 20,000 0.35 7,000 30,450 9,550
5 13,000 0.35 4,550 35,000 5,000
Total $35,000

*Book value is the original cost of the asset ($40,000) minus accumulated depreciation. Book value of $29,500 in year 1 is $40,000 minus
$10,500 in accumulated depreciation.
Cost allocated Residual value
Actual miles per mile
7-58
Comparison of Depreciation
Methods
Double-Declining-
Year Straight-Line Balance Activity-Based
1 $ 7,000 $16,000 $10,500
2 7,000 9,600 7,700
3 7,000 5,760 5,250
4 7,000 3,456 7,000
5 7,000 184 4,550
Total $35,000 $35,000 $35,000

Total depreciation is the same

under each method

7-59
Depreciation Expense Over Time
for Three Depreciation Methods
16,000 –
14,000 –
Depreciation expense

12,000 –
10,000 –
8,000 –
6,000 –
4,000 –
2,000 –
0– | | | | |
Year 1 Year 2 Year 3 Year 4 Year 5
Time

Straight-line Activity-based Double-declining balance

7-60
Use of Various Depreciation Methods
Other (1%)
Activity-Based (3%)

Declining-Balance (4%)

Straight-Line (92%)

7-61
 Tax Depreciation
• An accelerated method that reduces taxable income more
in the earlier years of an asset’s life than straight-line.
• Most companies use the straight-line method for financial
reporting and an accelerated method called MACRS
(Modified Accelerated Cost Recovery System) for tax
reporting.
• MACRS combines declining-balance methods in earlier
years with straight-line in later years to allow for a
more advantageous tax depreciation deduction.
• Thus, companies record higher net income using straight-
line depreciation and lower taxable income using MACRS
depreciation.

7-62
Common Mistake
Some students mistakenly depreciate land
because it's part of property, plant, and
equipment. Land is property, but it is not
depreciated because its service life never ends.

7-63
Learning Objective 5

LO7–5 Calculate amortization of intangible assets.

7-64
Amortization of Intangible Assets
• Allocating the cost of most tangible assets to expense
is called
q Depreciation
• Allocating the cost of intangible assets to expense is
called
q Amortization
• Most intangible assets have a finite useful life that can
be estimated.
• Most companies use straight-line amortization for
intangibles.
• Many companies credit amortization to the intangible
asset account itself rather than to accumulated
amortization.

7-65
Amortization of a Franchise
In early January, Little King Sandwiches acquires franchise rights from
University Hero for $800,000. The franchise agreement is for a period of
20 years. Record amortization for the first year.

December 31 Debit Credit

Amortization Expense………………………… 40,000
Franchises …………….......................... 40,000
(Amortize franchise; $40,000 = $800,000 / 20 years)

7-66
Amortization of a Patent
In addition, Little King purchases a patent for a meat-slicing process for
$72,000. The original legal life of the patent was 20 years, and there are
12 years remaining. However, due to expected technological
obsolescence, the company estimates that the useful life of the patent is
only 8 more years. Little King uses straight-line amortization for all
intangible assets. Record amortization for the first year.

December 31 Debit Credit

Amortization Expense………………………… 9,000
Patents ……………............................... 9,000
(Amortize patent; $9,000 = $72,000 / 8 years)

7-67
Illustration 7–19
Amortization Treatment of
Intangible Assets
Intangible Assets Intangible Assets
Subject to Amortization Not Subject to Amortization
(those with finite useful life) (those with indefinite useful life)
• Patents
• Copyrights • Goodwill
• Trademarks (with finite life) • Trademarks (with indefinite life)
• Franchises

7-68
Key Point
Amortization is a process, similar to
depreciation, in which we allocate the cost of
intangible assets over their estimated service
lives. Intangible assets with an indefinite useful
life (goodwill and most trademarks) are not
amortized.

7-69
Concept Check 7–6
Which of the following intangible assets would not
be subject to amortization?
a. Patents
b. Trademarks with an indefinite life
c. Copyrights
d. Franchises

7-70
Part C
ASSET DISPOSITION: SALE, RETIREMENT,
OR EXCHANGE

7-71
Learning Objective 6

LO7–6 Account for the disposal of long-term assets.

7-72
Three Methods of Asset Disposal

Disposal of Long-Term Assets

Most common Occurs when a long- Occurs when

method to term asset is no two companies
dispose of a longer useful but trade long-term
long-term asset cannot be sold assets
7-73
Data to Illustrate Long-Term Asset
Disposals
Original cost of the truck $40,000
Estimated residual value $5,000
Estimated service life 5 years
Assume straight-line depreciation $7,000

• What if the truck is:

q Sold after three years for $22,000
q Sold after three years for $17,000
q Retired after three years
q Exchanged for a new truck worth $45,000 and a $22,000
cash payment
7-74
 Gain on Sale
• Sell truck after three years for $22,000 (Depr. = $7,000/year)

Sale amount $22,000

Less:
Original cost of the truck $40,000
Less: Accumulated depreciation (3 years × $7,000/year) (21,000)
Book value at the end of year 3 19,000
Gain $ 3,000

t
Reduce accoun
balances to ze
ro Debit Credit
Cash ………………………………………………… 22,000
Accumulated Depreciation …………….. 21,000
Equipment ……………………………….. 40,000
Gain ………………………………………….. 3,000
(Sell equipment for a gain)
7-75
Common Mistake
Be careful not to combine the delivery truck
($40,000) and accumulated depreciation
($21,000) and credit the $19,000 difference to
the Equipment account. Instead, remove the
delivery truck and accumulated depreciation
from the accounting records separately.
Otherwise, the Equipment and the Accumulated
Depreciation accounts will incorrectly have a
remaining balance after the asset has been sold.

7-76
 Loss on Sale
• Sell truck after three years for $17,000 (Depr. = $7,000/year)

Sale amount $17,000

Less:
Original cost of the truck $40,000
Less: Accumulated depreciation (3 years × $7,000/year) (21,000)
Book value at the end of year 3 19,000
Loss $ (2,000)

t
Reduce accoun Debit Credit
ro
balances to ze
Cash ……………………………………………. 17,000
Accumulated Depreciation ………… 21,000
Loss …………………………………………….. 2,000
Equipment ……………………………… 40,000
(Sell equipment for a loss)
7-77
 Loss on Retirement
Sale amount $ 0
Less:
Original cost of the truck $40,000
Less: Accumulated depreciation (3 years × $7,000/year) (21,000)
Book value at the end of year 3 19,000
Loss $(19,000)

t
Reduce accoun
ro
balances to ze Debit Credit
Accumulated Depreciation ……………. 21,000
Loss ……………………………………………….. 19,000
Equipment ……………………………..... 40,000
(Retire equipment for a loss)

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Concept Check 7–7
If an asset is sold at the end of its first year of use,
which depreciation method would result in the
highest amount of gain (or lowest amount of loss)
assuming the asset is used fairly evenly over its life?
a. Straight-line
b. Double-declining-balance
c. Activity-based
d. Not enough information to determine

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 Gain on Exchange
New truck $45,000
Less: cash paid 22,000
Less:
Original cost of the truck $40,000
Less: Accumulated depreciation (3 years × $7,000/year) (21,000)
Book value at the end of year 3 19,000
Gain $ 4,000

t
Reduce accoun Debit Credit
ro
balances to ze
Equipment (new) ............................. 45,000
Accumulated Depreciation …………… 21,000
Cash ……………………………………….. 22,000
Equipment (old) ……………………… 40,000
Gain ………………………………………… 4,000
(Exchange equipment for a gain)
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Key Point
If we dispose of an asset for more than its book
value, we record a gain. If we dispose of an asset
for less than its book value, we record a loss.

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Learning Objective 8

LO7–8 Identify impairment situations and describe

the two-step impairment process.

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Illustration 7–31
Two-Step Impairment Process

STEP 1: Are future cash flows less than book value?

Test for Impairment Yes No

Asset Asset Not

Impaired Impaired

STEP 2: Record Loss No Action

If Impaired, Record Loss (Loss equals book Needed
value of asset in
excess of fair
value of asset)

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 Example -- Asset Impairment
Impairment: Estimated future cash flows (future benefits)
generated for a long-term asset fall below its book value.
Example: Trademark has estimated future cash flows of
$20,000, a book value of $50,000, and fair value of $12,000
1. Impaired?
Yes.
- Estimated future cash flows ($20,000) < book value ($50,000)
2. Amount of loss?
$38,000 = book value ($50,000) − fair value ($12,000)

December 31 Debit Credit

Loss………………………….……………………… 38,000
Trademarks……………...................... 38,000
(Record impairment of trademark)
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Concept Check 7–9
An impairment loss is recorded when:
a. Fair value exceeds book value
c. Estimated future cash flows exceed fair value
d. Estimated future cash flows exceed book value
e. Book value exceeds estimated future cash flows

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Analysis

ASSET ANALYSIS

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Learning Objective 7

LO7–7 Describe the links among return on assets,

profit margin, and asset turnover.

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Illustration 7–26
Selected Financial Data

($ in millions)
Walmart
Net sales $481,317 Walmart is
Net income 14,293 larger.
Total assets, beginning 199,581 Is it also more
Total assets, ending 198,825 profitable?
Costco
Net sales $129,025
Net income 2,679
Total assets, beginning 33,163
Total assets 36,347

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Return on Assets
• Indicates the amount of net income generated
for each dollar invested in assets

Net income
Return on Assets =
Average total assets

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Illustration 7–27
Return on Assets for Walmart and
Costco

($ in millions) Net Income ÷ Average Total Assets = Return on Assets

Walmart $14,293 ÷ ($199,581 + $198,825)/2 = 7.2%
Costco $ 2,679 ÷ ($33,163 + $36,347)/2 = 7.7%

Costco is more profitable

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Illustration 7–28
Components of Return on Assets

Return on assets = Profit margin × Asset turnover

Net income = Net income × Net sales
Average total assets Net sales Average total assets

• Profit margin: indicates the earnings per

dollar of sales
• Asset turnover: measures the sales per
dollar of assets invested

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Illustration 7–29
Profit Margin
for Walmart and Costco
($ in millions) Net Income ÷ Net Sales = Profit Margin
Walmart $14,293 ÷ $481,317 = 3.0%
Costco $ 2,679 ÷ $129,025 = 2.1%

Walmart’s profit margin is higher than Costco’s

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Illustration 7–30
Asset Turnover
for Walmart and Costco

($ in millions) Net Sales ÷ Average Total Assets = Asset Turnover

Walmart $481,317 ÷ ($199,581 + $198,825)/2 = 2.4 times
Costco $129,025 ÷ ($33,163 + $36,347)/2 = 3.7 times

Costco’s asset turnover is higher than Walmart’s

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Concept Check 7–8
Papa’s Pizza has the following items for the past
year: Net sales are $24,128, net income is $2,223,
total assets at the beginning of year are $14,898,
and total assets at the end of year are $15,465.
What is the profit margin?
a. 9.2%
b. 61.7%
c. 14.6%
d. 14.9% The profit margin is computed by taking net
income and dividing by net sales. Net income
of $2,223 divided by net sales of $24,128
results in a profit margin of 9.2%.
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End of Chapter 7

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