Ch. 3 Assets and Liabilities
3.4 Long-Term Tangible and Intangible Assets
Learning Objectives
After finishing this section, students will be able to:
- Determine the difference between a tangible and an intangible asset.
- Record the initial purchase and depreciation expense using the straight-line method.
Assets are items a business owns. For accounting purposes, assets are categorized as current versus long term, and tangible versus intangible. Assets that are expected to be used by the business for more than one year are considered long-term assets. They are not intended for resale and are anticipated to help generate revenue for the business in the future. Some common long-term assets are computers and other office machines, buildings, vehicles, software, computer code, and copyrights. Although these are all considered long-term assets, some are tangible and some are intangible.
Assets are recorded on the balance sheet at cost. If the value of the asset goes up, the balance sheet amount will not change.
Tangible Assets
An asset is considered a tangible asset when it is an economic resource that has physical substance—it can be seen and touched. Tangible assets can be either short term, such as inventory and supplies, or long term, such as land, buildings, and equipment. To be considered a long-term tangible asset, the item needs to be used in the normal operation of the business for more than one year, not be near the end of its useful life, and the company must have no plan to sell the item in the near future. The useful life is the time period over which an asset cost is allocated. Long-term tangible assets are known as fixed assets.
Inventory (Short Term)
Inventory is a current asset and was discussed in 3.1 Inventory and Cost of Goods Sold.
Property, Plant, and Equipment (Long Term)
Many businesses invest a lot of money in production facilities and operations. Some production processes are more automated than others, and they require a greater investment in property, plant, and equipment than production facilities that may be more labor intensive. Such acquisitions might include new machinery, buildings, warehouses, or even land in order to expand operations or make the work process more efficient.
Long-term assets that are not used in daily operations are typically classified as an investment. For example, if a business owns land on which it operates a store, warehouse, factory, or offices, the cost of that land would be included in property, plant, and equipment. However, if a business owns a vacant piece of land on which the business conducts no operations (and assuming no current or intermediate-term plans for development), the land would be considered an investment.
Intangible Assets
Companies may have other long-term assets used in the operations of the business that they do not intend to sell, but that do not have physical substance; these assets still provide specific rights to the owner and are called intangible assets. These assets typically appear on the balance sheet following long-term tangible assets. Examples of intangible assets are patents, copyrights, franchises, licenses, goodwill, sometimes software, and trademarks. Because the value of intangible assets is very subjective, it is usually not shown on the balance sheet until there is an event that indicates value objectively, such as the purchase of an intangible asset.
Patent
A patent is a contract that provides a company exclusive rights to produce and sell a unique product. The rights are granted to the inventor by the federal government and provide exclusivity from competition for twenty years. Patents are common within the pharmaceutical industry as they provide an opportunity for drug companies to recoup the significant financial investment on research and development of a new drug. Once the new drug is produced, the company can sell it for twenty years with no direct competition.
Trademarks and Copyrights
A company’s trademark is the exclusive right to the name, term, or symbol it uses to identify itself or its products. Federal law allows companies to register their trademarks to protect them from use by others. Trademark registration lasts for ten years with optional 10-year renewable periods. This protection helps prevent impersonators from selling a product similar to another or using its name. For example, a burger joint could not start selling the “Big Mac.” Although it has no physical substance, the exclusive right to a term or logo has value to a company and is therefore recorded as an asset.
A copyright provides the exclusive right to reproduce and sell artistic, literary, or musical compositions. Anyone who owns the copyright to a specific piece of work has exclusive rights to that work. Copyrights in the United States last seventy years beyond the death of the original author. While you might not be overly interested in what seems to be an obscure law, it actually directly affects you and your fellow students. It is one of the primary reasons that your copy of the Collected Works of William Shakespeare costs about $40 in your bookstore or online, while a textbook, such as Principles of Biology or Principles of Accounting, can run in the hundreds of dollars.
Goodwill
Goodwill is a unique intangible asset. Goodwill refers to the value of certain favorable factors that a business possesses that allows it to generate a greater rate of return or profit. Such factors include superior management, a skilled workforce, quality products or service, great geographic location, and overall reputation. Companies typically record goodwill when they acquire another business in which the purchase price is in excess of the fair value of the identifiable net assets. The difference is recorded as goodwill on the purchaser’s balance sheet.
Capitalization
When a business purchases a long-term asset (used for more than one year) via cash, accounts payable, or a loan, it classifies the asset based on whether the asset is used in the business’s operations. If a long-term asset is used in the business operations, it will belong in property, plant, and equipment or intangible assets. In this situation the asset is typically capitalized. Capitalization is the process by which a long-term asset is recorded on the balance sheet and its allocated costs are expensed on the income statement over the asset’s economic life.
The amount to capitalize includes the expense of items that are needed to put the asset to use. These items may include purchase price, sales tax, transportation, or installation. A simple way to determine what cost to put into the asset, think about the date of the expense. If the expense was before the asset was put into use, it should be capitalized on the balance sheet. If the expense occurred after the asset was put into use, it would be expensed on the income statement
When purchasing or acquiring a long-term asset, it must be recorded at the historical (initial) cost, which includes all costs to acquire the asset and put it into use. The initial recording of an asset has two steps:
- Record the initial purchase on the date of purchase, which places the asset on the balance sheet (as property, plant, and equipment) at cost, and record the amount as notes payable, accounts payable, or an outflow of cash.
- At the end of the period, make an adjusting entry to recognize the depreciation expense. Companies may record depreciation expense incurred annually, quarterly, or monthly.
Companies will often set a monetary threshold for capitalizing assets. For instance, companies do NOT want to depreciate and track a $20 hammer over five years but they would want to track a $500 air compressor. Before you start capitalizing assets, determine what your company’s momentary threshold should be.
Depreciation Expense
Depreciation is the process of allocating the cost of a tangible asset over its useful life, or the period of time that the business believes it will use the asset to help generate revenue. The cost of the asset appears on the balance sheet. Recording depreciation allows the company to bring the expense to the income statement to reduce the company’s net income.
Three of the most popular financial depreciation methods are the straight-line method, the units-of-production method, and the double-declining-balance method. In this textbook, we will only learn the straight-line method.
The expense recognition principle that requires that the cost of the asset be allocated over the asset’s useful life is the process of depreciation. For example, if we buy a delivery truck to use for the next five years, we would allocate the cost and record depreciation expense across the entire five-year period. The calculation of the depreciation expense for a period is not based on anticipated changes in the fair market value of the asset; instead, the depreciation is based on the allocation of the cost of owning the asset over the period of its useful life.
The following items are important in determining and recording depreciation:
- Book value is the asset’s original cost less accumulated depreciation.
- Useful life is the length of time the asset will be productively used within operations.
- Salvage (residual) value is the price the asset will sell for or be worth as a trade-in when its useful life expires. The determination of salvage value can be an inexact science, since it requires anticipating what will occur in the future. Often, the salvage value is estimated based on past experiences with similar assets.
- Depreciable base is the depreciation expense over the asset’s useful life. For example, if we paid $50,000 for an asset and anticipate a salvage value of $10,000, the depreciable base is $40,000. We expect $40,000 in depreciation over the time period in which the asset was used, and then it would be sold for $10,000.
Accumulated depreciation is a contra account, meaning it is attached to another account and is used to offset the main account balance that records the total depreciation expense for a fixed asset over its life. In this case, the asset account stays recorded at the historical value but is offset on the balance sheet by accumulated depreciation. Accumulated depreciation is subtracted from the historical cost of the asset on the balance sheet to show the asset at book value. Book value is the amount of the asset that has not been allocated to expense through depreciation.
Straight-Line Method
Straight-line depreciation is a method of depreciation that evenly splits the depreciable amount across the useful life of the asset. If the total value of a new piece of office equipment purchased with cash is $45,000. We must determine the yearly depreciation expense for Office Equipment by dividing the depreciable base of $45,000 minus the salvage value of $10,000 by the economic life of five years, giving an annual depreciation expense of $7,000. Example: (45,000-10,000) / 5 years
Formula: Depreciable Base / Useful Life
| Year | Depreciation Expense | Accumulated Depreciation | Book Value |
|---|---|---|---|
| Year 1 | $7,000 | $7,000 | $38,000 |
| Year 2 | 7,000 | 14,000 | 31,000 |
| Year 3 | 7,000 | 21,000 | 24,000 |
| Year 4 | 7,000 | 28,000 | 17,000 |
| Year 5 | 7,000 | 35,000 | 10,000 |
Depreciation will be recorded each year so the expense of the asset will be on the income statement and the book value of the asset will decrease on the balance sheet. Accumulated Depreciation and Depreciation Expense increase by $7,000.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||
| Cash | + | Equipment | + | Accum. Depr. | = | Liabilities | + | Retained Earnings | Revenue | – | Depreciation Expense | = | Net Income | Cash | OA,IA,FA |
| -45,000 | 45,000 | = | -45,000 | FA | |||||||||||
| -7,000 | -7,000 | – | 7,000 | = | -7,000 | – | – | ||||||||
| Partial Balance Sheet | ||
| [Company Name] | ||
| For Year Ended [Date] | ||
| Property, Plant, and Equipment | ||
|---|---|---|
| Equipment | $45,000 | |
| Accumulated Depreciation-Equipment | 7,000 | |
| Total Property, Plant, and Equipment | $38,000 | |
Depreciation Expense vs Inventory
3.4a Example
Montello Inc. purchases on account a delivery truck for $25,000. The truck has a salvage value of $6,000 and is expected to be driven for ten years.
Instructions:
- Using a horizontal model, record the initial purchase.
- Create a depreciation schedule using the straight-line method.
- Record the depreciation expense.
Key Takeaways
A company purchases a piece of machinery for $50,000. The following additional costs are incurred:
- Shipping and handling: $3,000
- Installation costs: $2,000
- Initial training for staff: $1,500
- First-year maintenance contract: $2,500
- Labor cost of staff to make product, $7,000
Check Figures:
- Machinery Cost to Capitalize, $56,500
- Solution
3.4a Homework
Ronson recently purchased a new boat on account to help ship product overseas. The following information is related to that purchase:
- purchase price $4,500,000
- cost to bring boat to shipping facility $15,000
- yearly insurance cost $12,000
- pays annual maintenance cost of $22,000
- received a 10% discount on sales price
Instructions:
- Determine the amount for the boat that will be depreciated. In a horizontal model, record the initial purchase.
- Create a depreciation schedule using the straight-line method with a useful life of ten years and a salvage value of $200,000. Record the first year of depreciation in the horizontal model.
- Create a partial Balance Sheet showing the asset and accumulated depreciation.
Licensing and Attribution
Content in this chapter is remixed from the following openly licensed resource(s):
Principles of Accounting, Volume 1: Financial Accounting by Mitchell Franklin, Patty Graybeal, and Dixon Cooper licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License
is a contract that provides a company exclusive rights to produce and sell a unique product.
is the exclusive right to the name, term, or symbol it uses to identify itself or its products.
provides the exclusive right to reproduce and sell artistic, literary, or musical compositions.
refers to the value of certain favorable factors that a business possesses that allows it to generate a greater rate of return or profit.
is the process by which a long-term asset is recorded on the balance sheet and its allocated costs are expensed on the income statement over the asset’s economic life.
is the process of allocating the cost of a tangible asset over its useful life, or the period of time that the business believes it will use the asset to help generate revenue.
is the asset’s original cost less accumulated depreciation.
is the length of time the asset will be productively used within operations.
is the price the asset will sell for or be worth as a trade-in when its useful life expires.
is the depreciation expense over the asset’s useful life.
is a contra account, meaning it is attached to another account and is used to offset the main account balance that records the total depreciation expense for a fixed asset over its life.
