CHAPTER ONE

1. Property, Plant, and Equipment (PPE) and Intangible Assets

 Assets of a company having physical existence and expected to be used for a period exceeding one
year or operating cycle form a part of property, plant and equipment (PPE). Other terms commonly
used are tangible assets, fixed assets, and plant assets.
 PPE include:
1. Land and land improvements
2. Building structure (offices, factories, warehouses)

3. Plant and machinery

4. Vehicles

5. Equipments (furniture, tools), etc.

1.1 Characteristics of PPE

 The major characteristics of PPE are:
1. Acquired for use in operations and not for resale. An asset must be used in the normal business
operations to be classified as a fixed asset. They do not become part of a product held for
resale.
2. Long-term in nature and usually subject to depreciation, with the exception of land. These
assets last for a number of years and their costs must be allocated to the periods, which benefit
from their use. The process of allocation of fixed asset cost over several periods is called
depreciation. However; certain assets have unlimited useful life such as land and they are not
depreciated.
3. Have physical substance.

1.2 Acquisition cost of PPE

Property, plant and equipment are valued in the accounts at their historical cost. Historical cost is
measured by the cash or cash equivalent price of obtaining the asset and bringing it to the location and
condition necessary for its intended use.

i. Cost of land: If purchased to construct a building, then all net costs up to excavation for
building. Special assessments (streets, drainage) for relatively permanent improvements are included
in the land account. Improvements (parking lots, fences) are recorded in Land Improvements
account and depreciated over estimated lives.
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 Cost of land typically includes (a) purchase price; (b) closing costs such as title, attorney, and recording
fees; (c) cost of grading, filling, draining, and clearing the property; (d) assumption of any
encumbrances on the property; and (e) any land improvements that have an indefinite life. The cost of
removing an old building from land purchased for the purpose of constructing a new building is properly
charged to the land account. Also, when improvements that have a limited life (fences, driveways, etc)
are made to the land they should be set up in a separate Land Improvements account so they can be
depreciated over their estimated useful life.

Any proceeds from getting the land ready for its intended use, such as salvage receipts on the demolition
of an old building or the sale of cleared timber, are treated as reductions in the price of the land.

Land held for speculative purpose should be recorded in an investment account. In such a case direct
costs such as taxes, insurance, etc incurred while holding the land should be capitalized. Companies use
this approach except when the asset is currently producing revenue (such as rental property).

Land held by a real estate company for resale should be classified as inventory.

ii. Buildings: Cost of building should include all expenditures related directly to acquisition or
construction. These costs include (1) materials, labor, and overhead costs incurred during construction
and (2) professional fees and building permits. Also, any fees such as those incurred for building
permits or the services of an attorney or architect are included in acquisition cost. In general, all costs
incurred from excavation of the site to completion of the building are considered part of the building
costs.
iii. Equipment: The term Equipment in accounting includes delivery equipment, office equipment,
machinery, furniture and fixture, furnishings, factory equipment, and similar fixed assets. Cost of such
assets includes purchase price plus all expenditures related to the purchase that occur subsequent to
acquisition but prior to actual use. These related costs would include such items as freight charges,
insurance charges on the asset while in transit, assembly and installation, special preparation of
facilities, and asset testing costs.

iv. Self-Constructed Assets: Companies can construct their own assets. Determining cost of such asset
can be a problem. Direct costs such as material and direct labor used create no problem. However;
assignment of indirect costs (overhead costs) create a problem. These costs may be handled in one of
two ways:
(a) Assign no fixed overhead to the cost of the constructed asset, or

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 (b) Assign a portion of all overhead to the construction process,
The second method appears preferable because of its consistency with the historical cost principle. It
should be noted that the cost recorded for a constructed asset could never exceed the price charged by an
outside producer. If the allocated overhead results in recording construction costs in excess of the costs
that independent producer would charge, the company should record the excess overhead as period loss
than capitalizing it. This avoids capitalizing the asset at more than its probable fair value.

v. Interest Cost during Construction: Three approaches have been suggested to account for the
interest incurred in financing the construction of PPE.
1) Capitalize no interest charges during construction.
2) Charge construction with all costs of funds employed, whether identifiable or not. Interest
whether actual or impute should be considered. Cost of construction, in this method, includes
cost of financing whether by cash, debt or stock.
3) Capitalize only the actual interest costs incurred during construction. This approach capitalizes
only interest costs incurred through debt financing, i.e. it excludes cost of equity financing.
Under this approach a company that uses debt financing will have higher cost than a company
that uses stock financing.
FASB Statement No. 34, "Capitalization of Interest Costs." requires capitalizing only the actual
interest costs incurred during construction. To implement this approach, companies consider the
three items:
a. Qualifying assets
b. Capitalization period.
c. Amount of capitalize.
a. Qualifying assets: To qualify for interest capitalization, assets must require a period of time to
get them ready for their intended use. Assets that qualify for interest cost capitalization include
assets under construction for an enterprise's own use (such as buildings, plants, and machinery)
and assets intended for sale or lease that are constructed or otherwise produced as discrete
projects (like ships or real estate developments).
b.Capitalization period: The period during which interest must be capitalized begins when all three
conditions are present: (a) expenditures for the asset have been made; (b) activities that are
necessary to get the asset ready for its intended use are in progress; and (c) interest cost is being
incurred.
c.Amount of capitalize: The amount of interest that may be capitalized is limited to the lower of (a)
actual interest cost incurred during the period or (b) the amount of interest cost incurred during

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 the period that theoretically could have been avoided if the expenditure for the asset had not been
made (avoidable interest). The amount of interest that may be capitalized during an accounting
period is determined by multiplying interest rate(s) by the weighted-average amount of
accumulated expenditures for qualifying assets during the period.

Weighted-average accumulated expenditures (WAAE): In computing WAAE, a company

weights the construction expenditure by the amount of time (fraction of accounting period) that it
can incur interest cost on the expenditure.
Illustration 1
Assume a 17 month bridge construction, current year payments to the contractor of birr 240,000 on march1,
birr 480,000 on July 1, and birr 360,000 on November 1. The company computes the weighted average
accumulated expenditures for the year ended December 31 as follows.
Expenditure Capitalization
Date Amount
X period = WAAE
March 1 Birr 240,000 10/12 Birr 200,000
July 1 480,000 6/12 240,000
Nov. 1 360,000 2/12 60,000
Birr 1,080,000 Birr 500,000

Interest rates
Companies follow the below principles in selecting the appropriate interest rates to be applied to the
weighted average accumulated expenditures:
1. For the portion of weighted-average accumulated expenditures that is less than or equal to any
amounts borrowed specifically to finance construction of the assets, use the interest rate incurred on the
specific borrowings.
2. For the portion of weighted average accumulated expenditures that is greater than any debt incurred
specifically to finance construction of the assets, use a weighted average of interest rates incurred on all
other outstanding debt during the period.
Illustration 2
The table below show computation of weighted average interest rates for debt greater than the amount
incurred specifically to finance construction of an asset.
Principal Interest
12%, 2-year note Birr 600,000 72,000
9%, 10-year bonds 2,000,000 180,000
7.5%, 20- year bonds 5,000,000 375,000
7,600,000 627,000
Weighted average interest rate = 8.25
=

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Illustration 3
To illustrate application of interest capitalization, assume that on Nov. 1 2013 Guna Trading entered into
contract with Zumra Construction PLC to construct a building for birr 1,400,000 on land costing birr
100,000 (purchased from Zumra construction PLC and is included in the first payment). Guna Trading
made the following payments to the construction company during 2014.
January 1 March 1 May 1 December 1 Total
Birr 210,000 300,000 540,000 450,000 1,500,000

Zamra Construction PLC completed the building, ready for use, on December 31, 2014. Guna Trading
had the following de.bt outstanding at December 31, 2014.

Specific Construction Debt

1.15%, 3-year note to finance purchase of land and construction of the building, dated
. December 31, 2013, with interest payable annually on December 31. . . . . . . . . . . . . . . . Birr 750,000
Other Debt
. 2. 10%, 5-year note payable, dated December 31, 2010, with interest payable annually on
December 31. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Birr 550,000
. 3. 12%, 10-year bonds issued December 31, 2009, with interest payable annually on
December 31. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Birr 600,000

Solution
 Computation of WAAE for the year 2014:
Expenditure Capitalization
Date Amount
X period = WAAE
January 1 Birr 210,000 12/12 Birr 210,000
March 1 300,000 10/12 250,000
May 1 540,000 8/12 360,000
Dec. 31 450,000 0 0
Birr Birr 820,000
1,500,000

 Computation of avoidable interest

Weighted Average interest rate (WAIR) computation:
Principal Interest
10%, 5-year note Birr 550,000 55,000
12%, 10-year bonds 600,000 72,000
1,150,000 127,000
Weighted average interest rate 11.04%
=

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 Computation of avoidable interest
WAAE X Interest rate = Avoidable interest
Birr 750,000 .15(construction note) 112,500
70,000 .1104(WAIR) 7,728
820,000 120,228

Actual Interest cost

Construction note Birr 750,000*.15 = 112,500
5- year note 550,000*.10 = 55,000
10-year bonds 600,000*.12 = 72,000
Actual interest 239,500

Actual interest 239,500

avoidable interest (capitalized) 120,228
Interest expense 119,272

Guna Trading records the following journal entries during 2014:

Date Description debit credit

2014 1 Land 100,000
January
Building( construction in progress) 110,000
Cash 210,000
March 1 Building( construction in progress) 300,000
Cash 300,00
May 1 Building( construction in progress) 540,000
Cash 540,000
December 31 Building( construction in progress) 450,000
Cash 450,000
Building( construction in progress) 120,000
Interest Expense 119,272
Cash 239,500

Disclosure of capitalized interest

Amount of capitalized interest can be disclosed either in the body of income statement as part of non
operating section or in the notes accompanying the financial statement.

Income from operations xxxx

Other expenses and loses
Interest expense 239,500
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 Less: capitalized interest 120,228 (119,272)
Income before income taxes xxxx
Income taxes xxxx
Net income xxxx

Note 1: Accounting policies-capitalized interest, during 2014, total interest cost was birr
239,500, of which birr 120,228 was capitalized and birr 119,272 was charged to expense.

Special Issues Related to Interest Capitalization

1. Expenditures for land – Interest costs are only capitalized if the land is being purchased with the
intent of developing it for future use. If buy land with the intent to put something on it, the interest
cannot be capitalized as part of the land account - instead it's part of the other fixed asset.
2. Interest Revenue – Any interest revenue you earn, cannot be offset against interest costs.

1.3 Valuation of PPE

PPEs should be recorded at fair value of what they give up or at fair value of the asset received
whichever is more clearly evident. The section below show, valuation of PPE when fair value is
obscured by the form of the transaction.
1. Cash Discounts: GAAP allows either
i. Reduce the price of the fixed asset only if the discount is taken or
ii. Always reduce the price of the asset, whether the discount is taken or not.
2. Deferred Payment Contracts: Assets purchased on long-term credit contracts should be
accounted for at the present value of the consideration exchanged. When no interest rate is
stated, or if the specified rate is unreasonable, an appropriate rate should be imputed.
To illustrate, assume MAA Garment issues a birr 100,000, 5 year, zero interest bearing note to
Mesfin Industrial Engineering PLC for the new equipment. The prevailing market rate of interest
for obligation of this nature is 10%. The note is to be settled in five birr 20,000 installments,
made at the end of each year. Entries for 1st and 2nd year are as follows:

Date of purchase
Equipment 75,816
Discount on N/P 24,184
N/P 100,000

PV of the note= 20,000( = 75,816

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 End of first year
Interest Expense (10% of 75,816) 7,582
N/P 20,000
Cash 20,000
Discount on N/P 7,582

End of Second Year

Interest Expense (75,816-(20,000-7,582) 6,340
N/P 20,000
Cash 20,000
Discount on N/P 6,340

3. Lump Sum Purchases: Total cost should be allocated on the basis of relative market values.
Insurance appraisals, property tax assessments, or independent appraisals may be used as
indicators of relative market values.
To illustrate, assume Sheba University College decide to purchase several assets of a small
private school for birr 80,000. The private school is in process of liquidation. Its assets sold are:

Book Fair
value value
Inventory 30,000 25,000
Land 20,000 25,000
Building 35,000 50,000
85,000 100,000
The purchase price birr 80,000 can be allocated based on fair value of the assets in the following
manner:

inventory = 20,000

Land = 20,000

Building = 40,000

4. Issuance of Stock: Market value of stock issued is used as an indication of the cost of the
property acquired. If the stock's market value is not determinable, use the fair market value of
the property acquired.

5. Donated assets (nonreciprocal transfers): The fair value of the asset should be used to record the
asset on the company's books. The corresponding credit which the company will record is
revenue in the amount of the asset's fair value.
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 6. Exchanges of property, plant and equipment (this will be discussed when we deal with
disposition of plant assets)
Some exceptions to historical cost valuation:

i. Fair value is used for Donated assets.

ii. Prudent cost can be used if self-constructed assets cost exceed fair value or if you were
ignorant about price and paid too much for an asset originally.
iii. Non-monetary exchanges assets considered non-commercial and gain indicated—asset is
recorded at amount that balances the entry.

1.4 Treatment of Costs incurred subsequent to acquisition

Costs related to plant assets that are incurred after the asset is placed in use are either added to the asset
account (capitalized) or charged against operations (expensed) when incurred.
In general, costs incurred to achieve greater future benefits from the asset should be capitalized. For the
costs to be capitalized, one of three conditions must be present:

i. The useful life of the asset must be increased,

ii. The quantity of service produced from the asset must be increased, or
iii. The quality of the units produced must be enhanced.

a.Additions result in the creation of new assets, they should be capitalized.

b.Improvements and replacements are substitutions of one asset for another. Improvements
substitute a better asset for the one currently used, whereas a replacement substitutes a similar
asset. The major problem in accounting for improvements and replacements concerns
differentiating these expenditures from normal repairs. It should be capitalized only if an
improvement or replacement increases the future service potential of the asset. Capitalization
may be accomplished by: (a) substituting the cost of the new asset for the cost of the asset
replaced, (b) capitalizing the new cost without eliminating the cost of the asset replaced, or (c)
debiting the expenditure to accumulated depreciation. The specific facts related to the situation
will aid in determining the most appropriate method to use.

c. Rearrangement and reinstallation costs are generally carried forward as a separate asset and
amortized against future income.

d.Expenditures that simply maintain a given level of service such as normal repairs should be
expensed.

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In many instances, a considerable amount of judgment is required in deciding whether to capitalize or
expense an item. However, consistent application of a capital/expense policy is normally more
important than attempting to provide theoretical guidelines.
Major question regarding this is: Do we capitalize (capital expenditure) or expense these costs (revenue
expenditure)?
General Rule: Expenditures that allow the fixed asset to achieve greater future benefits should be
capitalized. Expenditures that maintain a given level of service/benefit should be expensed.

Summary of Costs Subsequent to Acquisition

Type of Expenditure Normal Accounting Treatment
Additions Capitalize it to asset account
improvement/replacement a. If carrying value known:
Remove cost of and accumulated depreciation on asset
Recognize any gain or loss
Capitalize cost of improvement/replacement
b. If carrying value is unknown:
1. If useful life of the asset is increased, debit accumulated
depreciation for cost of improvements/replacement.
2. If quality or quantity of units produced enhanced, capitalize
cost of improvement/replacement to asset account.
Rearrangement and a) If original installation cost is known:
installation Account for cost of rearrangement /installation as a
replacement.
b) If original installation cost is unknown:
i. And rearrangement/reinstallation cost is material in
amount and benefits future periods, capitalize as an
asset.
ii. And rearrangement/reinstallation cost is not material in
or future benefits is questionable, expense the cost
when incurred.
Repairs i. Major: As appropriate, treat as an addition, improvements,
or replacement.
ii. Minor: Expense cost of repairs when incurred.
1.5 Depreciation and Depletion

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 Depreciation is the accounting process of allocating cost of tangible assets to expense in a systematic
and rational manner to those periods expected to benefit from the use of asset. When companies write
off cost of long-lived assets over their estimated life, they use the term depreciation. Reduction in the
cost of natural resource is described as depletion and in the cost of intangible assets is described as
amortization.

Factors in the estimation of periodic depreciation

The estimation of periodic depreciation is dependent on the following three variables:
1. Economic life
2. Depreciation base
3. Method of cost allocation

Economic life
Economic life of an asset is the total units of service expected to be derived from that asset. Business
managers usually measure economic life of a plant asset in terms of time units such as month, year.
Companies retire assets for two reasons: physical factors and economic factors. Physical factors are the
wear, tear, decay, and casualties that make it difficult for the asset to perform indefinitely. These
economic and physical factors can be categorized into three:
i. Inadequacy
ii. Supersession
iii. Obsolescence
Depreciable base
Depreciable base (depreciable cost) is portions of cost of plant asset that should be allocated to revenue
during its economic life. Depreciable cost is the difference between original cost and salvage value. For
example if an asset with original cost of birr 10,000 has a salvage value of birr 1,000 , its depreciable
base will be birr 9,000 = 10,000 – 1,000.

Method of cost allocation

The depreciation method used should be systematic and rational. There are various depreciation
methods, these are:
i. Activity method (units of production or use method)
ii. Straight-line method
iii. Decreasing balance method (accelerated method)
a. Sum-of-the- years digits method
b. Declining balance method

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iv. Special depreciation methods
a. Group and composite method
b. Hybrid or combination method

Illustration
To illustrate application of the depreciation methods, assume that Medrok Mines company purchased a
for excavation purposes. Information about the crane is as follows:
Cost of crane……………………..birr 500,000
Estimated useful life…..………………. 5 year
Estimated salvage value…..………birr 50,000
Production life in hours ………….30,000 hours

Activity method, units of production method

If Medrok use the crane for 4,000 hours for the first year, the depreciation charge is:

Depreciation per hour = = = 15

Depreciation charge =

Straight line method

Depreciation charge =

Depreciation charge =

Decreasing charge methods

a. Sum-of-the- years digits method
Under this method, periodic depreciation is determined based on decreasing fraction of depreciable cost.
Numerator of the fraction is a number of years of estimated life remaining as of the beginning of the
year, and the denominator is sum of the years.

Denominator = sum of the years=

year Remaing Depr. Depr. Depr. BV end of

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 life Fraction base Expense year
1 5 5/15 450,000 150,000 350,000
2 4 4/15 450,000 120,000 230,000
3 3 3/15 450,000 90,000 140,000
4 2 2/15 450,000 60,000 80,000
5 1 1/15 450,000 30,000 50,000
Total 15 15/15 450,000

b. Declining balance method

Unlike other methods, declining balance method does not deduct the salvage value in computing
deprecation base. The declining balance rate (double of straight line method rate) is multiplied by the
book value of the asset at the beginning of each period to determine periodic deprectiation until book
value of the asset equals its estimated salvage value.
Straight line depreciation rate of an asset with 5 years useful life is 100/5 = 20%

Declining balance rate of the same asset = 20% * 2 = 40%

year Beg. BV Declining Depreciation Bal of Ending BV

balance rate Expense Accumulated
dep.
1 500,000 40% 200,000 200,000 300,000
2 300,000 40% 120,000 320,000 180,000
3 180,000 40% 72,000 392,000 108,000
4 108,000 40% 43,200 435,200 64,800
5 64,800 40% 14,800 450,000 50,000

v. Special depreciation methods

a. Group and composite method
Companies often depreciate multiple-asset accounts using one rate. The choice between group
method and composite depends on the nature of the asset involved. Companies frequently use the
group method when the assets are similar in nature and have approximately the same useful
lives. They use the composite approach when the assets are dissimilar and have different lives.
The group method more closely approximates a single-unit cost procedure because the dispersion
form the average is not as great.
Composite depreciation rate is computed by dividing depreciation per year by total cost of the assets. To
illustrate assume that Mastewal construction company establishes composite depreciation rate for its
cars, trucks and crane as shown below:

Asset Original Salvage Depreciation Estimated Dpereciation

cost value cost life per year
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 (SLM)
Cars 145,000 25,000 120,000 3 40,000
Truck 44,000 4,000 40,000 4 10,000
crane 35,000 5,000 30,000 5 6,000
224,000 34,000 190,000 56,000

Composite depreciation rate=

Composite life =

b. Hybrid or combination method

Companies are free to develop their own special or tailor-made depreciation methods. GAAP requires
only that the method result in the allocation of an asset’s cost over the asset’s life in a systematic and
rational manner. Hybrid method is a combination of depreciation methods, example a combination of
straight line methods and activity method.
Special Depreciation issues
1. How should companies compute depreciation for partial periods?
2. Does depreciation provide for the replacement of assets?
3. How should companies handle revisions in depreciation rates?

1.6 Disposition of PPE

Plant assets (except land) eventually become inadequate or obsolete and must be sold, retired (junked) or
exchanged for new assets.
General Procedure to dispose of PPE
1. Record the asset depreciation up to date of sale
2. Record the disposal by
 Writing off asset cost (credit)
 Writing off Accumulated Depreciation (debit)
 Record any cash received (debit)
 Record gain (credit) or loss (debit)

I. Sale of PPE
Steps in Sale of Plant Assets:
1. Update depreciation to the date of sale
2. Determine the current book value (BV) of the asset being sold

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 3. Determine if there is a gain or loss by comparing cash received for the asset with the asset’s
book value
If Cash > BV, record a gain (credit)
If Cash < BV, record a loss (debit)
If Cash = BV, no gain or loss
4. Prepare journal entry to record the sale
 Debit Cash received
 Debit Accumulated Depreciation
 Credit Asset for original cost
 Record gain (credit) or loss (debit)
Example:
On September 30, 1999, Tena Company sold a machine that originally cost birr100,000 for birr 60,000
cash. Accumulated depreciation taken on the machine was birr 46,000.
BV = cost - accumulated depreciation
BV = 100,000 - 46,000
BV = 54,000
Gain = excess of cash received over book value of asset sold
Gain = 60,000 - 54,000 = 6,000
Prepare the journal entry to record sale of the machine on September 30, 1999 assuming that
depreciation has already been recorded to that date.

II. Retirement/ Discarding/junked of PPE

Use same procedure as for a sale
 Update depreciation to date of sale
 Determine current book value
 Determine loss, if any
 Prepare journal entry

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Now assume the Tena Company retired the machine on September 30, 1998. All information is the
same except the asset is retired with no cash received.
Loss = Cash Received - Book Value
Loss = 0 - $54,000
Loss = $54,000

III. Exchange of PPE

Accounting depends on whether assets are similar or dissimilar (whether the exchange has commercial
substance). A nonmonetary exchange has commercial substance if the entity's future cash flows are
expected to significantly change as a result of the exchange.

Exchanges of Nonmonetary Assets

Ordinarily accounted for on the basis of:
 the fair value of the asset given up or
 the fair value of the asset received,
Whichever is clearly more evident.
Companies should recognize immediately any gains or losses on the exchange when the transaction has
commercial substance (future cash flows change as a result of the transaction).

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 If cash is 25% or more of the fair value of the exchange, recognize entire gain because earnings process
is complete.

1. Exchanges - Loss Situation

Companies recognize a loss immediately whether the exchange has commercial substance or not.
Rationale: Companies should not value assets at more than their cash equivalent price; if the loss were
deferred, assets would be overstated.

2. Exchange – Gain Situation Illustration:

Carlos Arruza Company exchanged equipment used in its manufacturing operations plus $3,000 in cash
for similar equipment used in the operations of Tony LoBianco Company. The following information
pertains to the exchange.

Arruza LoBianco
Equipment (cost) $28,000 $28,000
Accumulated Depreciation 19,000 10,000
.
Fair value of equipment 15,500 12,500
Cash given up 3,000

Instructions: prepare the journal entries to record the exchange on the books of both companies:

Arruza LoBianco
Fair value of equipment received $12,500 $15,500
Cash received / paid 3,000 (3,000)
Less: Bookvalue of equipment
($28,000-19,000) (9,000)
($28,000-10,000) (18,000)
Gain or (Loss) on Exchange $6,500 ($5,500)

Calculation of Gain or Loss

When a company receives cash (sometimes referred to as “boot”) in an exchange that lacks commercial
substance, it may immediately recognize a portion of the gain.

Has Commercial Substance

Arruza: LoBianco:

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Lacks Commercial Substance
Arruza:

Deferred gain = birr 6,500 – 1,258 = 5,242

Lacks Commercial Substance

LoBianco (no change):

Companies recognize a loss immediately whether the exchange has commercial substance or not.

Summary of Gain and Loss Recognition on Exchanges of Nonmonetary Assets Lacks Commercial
Substance

Non monetary
No exchange result in yes
loss
Always recognize
losses
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CBE, MU February 2018 Page 18
substance?
 yes no

Recognize gain Cash receive?

yes no

Recognize gain as % of Defer gain

transaction received in cash

Gain available (FV>NBV)

1.7 . Intangible Assets

 Non-current assets without physical substance
 Often provide exclusive rights or privileges to use the asset
 Useful life is often difficult to determine

Intangible assets should be record at cost that is current cash equivalent, including purchase price, legal
fees, and filing fees. The Cost is allocated over the period the asset is expected to produce revenue using
a process called “amortization”. Amortize the cost over:
 economic life
 legal life or
 40 years...
Whichever is shorter and use straight-line method to amortize the cost.

Intangible Assets Examples

 Patents

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  Copyrights
 Franchises
 Trademarks
 Leaseholds
 Leasehold improvements
 goodwill

Patents
It is exclusive right granted by federal government to sell or manufacture invention.
Its cost is purchase price plus any legal cost to defend.
Legal life is 17 years.
Research and Development costs to develop a patent are expensed as cost is incurred.

Copyrights
Exclusive right granted by the federal government to protect artistic or intellectual properties
Legal life is life of creator plus 50 years

Franchises
Right to sell products or provide services purchased by franchisee from franchisor.
Purchase price is intangible asset which is amortized over shorter of legal life, economic life, or
40 years

Trademarks
A symbol, design, or logo associated with a business.
If internally developed, trademarks have no recorded asset cost and If purchased, trademarks are
recorded at cost, and amortized over shorter of legal or economic life, or 40 years.

Leases
A contract to rent property. Right to use is granted by lessor to lessee.
Two types of leases
i. Capital leases
ii. Operating leases

i. Capital Leases
A means of financing acquisition of property. Lessor transfers ownership to lessee at end of lease.
However, lessee records leased property from the beginning as if it were purchased, ignoring the legal
reality.
ii. Operating Leases
If a lease does not qualify as capital lease, it is an operating lease. Common rental agreements are
normally operating leases.
 Rent expense is normally recorded as incurred.
 However, if there is a prepayment at the start of the lease, it is accounted for as long-term
prepaid rent in an intangible asset account called “leasehold”.

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Leasehold Improvements
Long-lived alterations made by lessee to leased property. Leasehold improvements are amortized over
the shorter of the life of the improvement or the life of the lease.

Goodwill
Occurs when one company buys the assets and assumes the liabilities of another company. Only
purchased goodwill is recorded as an asset. Goodwill is the amount by which cost exceeds
the fair market value of net assets acquired
• Goodwill = Cost - (FMV of net assets acquired)
• Net assets = assets - liabilities

Goodwill Example
Eddy Company paid $1,000,000 to purchase all of James Company’s assets and assumed James
Company liabilities of $200,000. James Company’s assets were appraised at a fair value of $900,000

1.8 Impairment of Intangible assets

All definite intangible assets are amortized through their useful life. However, Intangible assets with
indefinite lives are not amortized. Instead, these assets are to be tested at least annually for possible
impairment, and the asset’s book value is written down (decreased) to its fair value if impaired.
Goodwill is recorded only by an acquiring company when it purchases another company and pays more
for that company than the value of the assets acquired. According to IFRS and GAAP, goodwill is not
amortized. Instead, the acquiring company measures the current value of its goodwill each year. If the
goodwill has increased in value, there is nothing to record. But if goodwill’s value has decreased, then
the company records a loss and writes the goodwill down.
 For example, suppose Walmart has goodwill of $2,000,000 and is worth only $1,500,000 on
December 31, 2011. In that case, Walmart would make the following entry:
Loss on impairment of goodwill ………………500,000
Goodwill ($2,000,000 - $1,500,000) …………. 500,000
Identifiable Intangible Assets
Intangibles may be classified by a company according to whether they are purchased from others
(externally acquired) or internally developed. In addition, they may be classified according to whether
they are identifiable or unidentifiable.
Identifiable intangible assets are those intangible that can be purchased or sold separately from the other
assets of the company. An asset meets the identifiability criterion in the definition of an intangible asset
when it:
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a) is separable, i.e. is capable of being separated or divided from the entity and sold, transferred,
licensed, rented or exchanged, either individually or together with a related contract, asset or
liability; or
b) arises from contractual or other legal rights, regardless of whether those rights are transferable or
separable from the entity or from other rights and obligations. Patents, copyrights, trademarks and
trade names, franchises, and computer software costs are examples of identifiable intangible assets.
Unidentifiable Intangible Assets
The definition of an intangible asset requires an intangible asset to be identifiable to distinguish it from
goodwill. Goodwill acquired in a business combination represents a payment made by the acquirer in
anticipation of future economic benefits from assets that are not capable of being individually identified
and separately recognized. However, purchased goodwill is recognized as unidentifiable intangible asset
even it is not separately identified. Internally developed goodwill is expensed as occurred or it is not
recorded as intangible asset.
1.9 Accounting for Research and Development costs (R&D)
While all research and development costs must be reported as an expense under U.S. GAAP,
International Financial Reporting Standards (IFRS) require that research expenditures be reported as an
expense, but development costs be capitalized as an asset after technical and commercial feasibility of
the resulting product or service have been established.
To illustrate, assume that Abbott Laboratories (a manufacturer of pharmaceutical and nutritional
products) spent more than $2 million on research to discover new products. The entry required to record
the research and development cost is;
Research and Development 2,000,000
Cash 2,000,000
End of Chapter Notes!

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