Chapter Eleven: Advanced PP&E Issues/Natural Resources/Intangibles
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Most items of PP&E require substantial ongoing costs to keep them in good order. The accounting rules for such costs treat them as “capital expenditures” if future economic benefits result from the expenditure. Future economic benefits occur if the service life of an asset is prolonged, the quantity of services expected from an asset is increased, or the quality of services expected from an asset is improved. Expenditures not meeting at least one of these criteria should be accounted for as a revenue expenditure and be expensed as incurred. Judgment is required in applying these rules. A literal reading might lead one to believe that routine maintenance would be capitalized. After all, fueling a car does extend its service life. But, that interpretation would miss the intent of the rule. It is implied that routine costs to maintain normal operating condition be expensed as incurred. The capitalization criteria are instead focused on nonrecurring costs.
A truck may have an engine that is in need of replacement. The replacement of the engine represents a “restoration” of some of the original condition (akin to “undepreciating”). Restoration and improvement type costs are considered to meet the conditions for capitalization because of the enhancement to service life/quality. This entry records the restoration:
Notice that the preceding debit is to Accumulated Depreciation. The effect is to increase the net book value of the asset by reducing its accumulated depreciation on the balance sheet. This approach is perfectly fine for “restoration” expenditures. However, if one is “improving” the asset beyond its original condition (sometimes termed a betterment), the costs would instead be capitalized by debiting the asset account directly.
Over time the productive assets in use by a company may no longer be needed and a decision is made to dispose of those assets. Disposal may occur by abandonment, sale, or exchange. In any case, it is necessary to update depreciation calculations through the date of disposal. Then, and only then, would the asset disposal be recorded.
If the asset is being scrapped (abandoned), the journal entry entails the elimination of the cost of the asset from the books, removal of the related accumulated depreciation, and potentially recording a loss to balance. This loss reflects the net book value that was not previously depreciated:
On the other hand, an asset may be disposed of by sale, in which case the journal entry would need to be modified to include the proceeds of the sale. Assume the above asset was sold for $10,000. The entry would be as follows:
While the journal entry alone might be sufficient to demonstrate the loss calculation, one might also consider that an asset with a $25,000 net book value is being sold for $10,000. This gives rise to the loss of $15,000.
Conversely, what if this asset were sold for $30,000? In that case, the asset having a $25,000 net book value is converted to $30,000 cash. This triggers a $5,000 gain. Simply stated a $30,000 asset replaces an asset that was reported at $25,000. Following is the entry for that scenario:
Sometimes a new car purchase is accompanied by a “trade in” of an old car. This would be a classic exchange transaction. In business, equipment is often exchanged (e.g., an old copy machine for a new one). Sometimes land is exchanged. Exchanges can be motivated by tax rules because neither company may be required to recognize a taxable event on the exchange. The result could be quite different if the asset was sold for cash. Whatever the motivation behind the transaction, the accountant is pressed to measure and report the event.
Exchanges that have commercial substance (future cash flows are expected to change) should be accounted for at fair value. Various scenarios are illustrated in the following examples. Recognize that some exchanges may lack commercial substance. For example, two companies may swap inventory and neither expects a significant change in cash flows because of the trade. Gains are not recorded on exchanges lacking commercial substance and are typically illustrated in more advanced courses.
The fair value approach for exchanges having commercial substance will ordinarily result in recognition of a gain or loss because the fair value will typically differ from the recorded book value of a swapped asset. There is deemed to be a culmination of the earnings process when assets are exchanged. In other words, one productive component is liquidated and another is put in its place. The following examples illustrate exchange transactions for scenarios involving both losses and gains.
Example A: Loss Implied
Company A gives an old truck ($1,000,000 cost, $750,000 accumulated depreciation) for a boat. The fair value of the old truck is $150,000 (which is also deemed to be the fair value of the boat).
The boat should be recorded at fair value. Because this amount is less than the net book value of the old truck, a loss is recorded for the difference:
Example B: Gain Implied
Company A gives an old truck ($1,000,000 cost, $750,000 accumulated depreciation) for a boat. The fair value of the old truck is $350,000 (which is also deemed to be the fair value of the boat).
The boat should be recorded at fair value. Because this amount is more than the net book value of the old truck, a gain is recorded for the difference:
Exchange transactions are oftentimes accompanied by giving or receiving boot. Boot is the term used to describe additional monetary consideration that may accompany an exchange transaction. Its presence only slightly modifies the preceding accounting by adding one more account (typically Cash) to the journal entry.
Example C: Boot given
Company A gives an old truck ($1,000,000 cost, $750,000 accumulated depreciation) and $50,000 cash for a boat. The fair value of the old truck is $100,000. The fair value of the boat is $150,000.
Notice that the following entry has an added credit to Cash reflecting the additional consideration. The loss is $150,000. The loss is the balancing amount, and reflects that $300,000 of consideration (cash ($50,000) and an old item of equipment ($1,000,000 - $750,000 = $250,000)) was swapped for an item worth only $150,000. Had boot been received, Cash would have instead been debited (and a smaller loss, or possibly a gain, would be recorded to balance the entry).
When the carrying amount of a long-lived asset (or group of assets) is not recoverable from expected future cash flows, an impairment has occurred. The owner of the asset no longer expects to be able to generate returns of cash from the asset sufficient to recapture its recorded net book value. A loss is recognized for the amount needed to reduce the asset to its fair value (i.e., debit loss and credit the asset). The downward revised carrying value will be depreciated over its remaining estimated life.
Measurements of impairment involve subjective components and judgment. These factors should be taken into consideration: significant decrease in market value, physical condition has declined unexpectedly, the asset is no longer used as intended, legal or regulatory issues have impeded the asset, the overall business seems threatened by unsuccessful performance, and so forth. In addition, the specific methods for determining if an impairment has occurred vary globally. While the U.S. approach focuses first on cash recovery, global standards look to a more restrictive fair value test.
Oil and gas reserves, mineral deposits, thermal energy sources, and standing timber are just a few examples of natural resource assets that a firm may own. There are many industry-specific accounting measurements attributable to such assets.
As a general rule, natural resources are initially entered in the accounting records at their direct cost plus logically related items like legal fees, surveying costs, and exploration and development costs. Once the cost basis is properly established, it must be allocated over the periods benefited through a process known as depletion. Think of it this way: depletion is to a natural resource as depreciation is to property, plant, and equipment.
The cost of a natural resource (less expected residual value) is divided by the estimated units in the resource deposit; the resulting amount is depletion per unit. If all of the resources extracted during a period are sold, then depletion expense equals depletion per unit times the number of units extracted and sold. If a portion of the extracted resources are unsold resources, then their cost (i.e., number of inventory units times depletion per unit) should be carried on the balance sheet as inventory.
Assume that a mine site is purchased for $9,000,000, and another $3,000,000 is spent on developing the site for production. Assume the site is estimated to contain 5,000,000 tons of the targeted ore. At completion of the operation, the site will be water flooded and sold as a recreational lake site for an estimated $2,000,000. The depletion rate is $2 per ton, as the following calculations show:
If 1,000,000 tons of ore are extracted in a particular year, the assigned cost would be $2,000,000. But where does that cost go? If 750,000 tons are sold and the other 250,000 tons are simply held in inventory of extracted material, then $1,500,000 would go to cost of goods sold and the other $500,000 would go to the balance sheet as inventory. A representative entry follows:
Property, plant, and equipment used to extract natural resources must be depreciated over its useful life. Sometimes the useful life of such PP&E is tied directly to the natural resource life, even though its actual physical life is much longer. For example, if a train track is built into a mine, the track is of no use once the mine closes (even though it could theoretically still carry a train for a much longer period). As a result, the track would be depreciated over the life of the mine. Conversely, the train that runs on the track can be relocated and used elsewhere; as such it would likely be depreciated over the life of the train rather than the life of the mine.
The defining characteristic of an intangible asset is the lack of physical existence. Nevertheless, such assets contribute to the earnings capability of a company. Examples include patents, copyrights, trademarks, brands, franchises, and similar items.
A company may develop such items via ongoing business processes. Globally, some internally developed intangibles are recognized where future benefits are clear and measurable. The U.S. is far more restrictive, and self-created intangibles seldom appear on a balance sheet.
On the other hand, intangibles may be purchased from another party. For example, one company may need to utilize technology embedded in a patent right belonging to someone else. When intangibles are purchased, the cost is recorded as an intangible asset. When a purchased intangible has an identifiable economic life, its cost is amortized over that useful life (amortization is the term to describe the allocation of the cost of an intangible, just as depreciation describes the allocation of the cost of PP&E).
Some intangibles have an indefinite life and those items are not amortized. Instead, they are periodically evaluated for impairment. If they are never found to be impaired, they will permanently remain on the balance sheet. The unamortized/unimpaired cost of intangible assets is positioned in a separate balance sheet section immediately following Property, Plant, and Equipment.
Assume that Mercury Pharmaceutical purchased a patent for $50,000, estimating its useful life to be five years. The appropriate entries are:
Unlike PP&E, notice that the preceding annual amortization entry credits the asset account directly. There is usually not a separate accumulated amortization account for intangible assets.
Patents give their owners exclusive rights to use or manufacture a particular product. The cost of obtaining a patent should be amortized over its useful life (not to exceed its legal life of 20 years). The amount included in the Patent account includes the cost of a purchased patent and/or incidental costs related to the registration and protection of a patent.
Copyrights provide their owners with the exclusive right to produce or sell an artistic or published work. A copyright has a legal life equal to the life of the creator plus 70 years; the economic life is usually shorter. The economic life is the period of time over which the cost of a copyright should be amortized.
Franchises give their owners the right to manufacture or sell certain products or perform certain services on an exclusive or semi-exclusive basis. The cost of a franchise is reported as an intangible asset, and should be amortized over the estimated useful life.
Trademarks/brands/internet domains are another important class of intangible assets. Although these items have fairly short legal lives, they can be renewed over and over. As such, they have indefinite lives.
Goodwill is a unique intangible asset that arises out of a business acquisition. It reflects the excess of the fair value of an acquired entity over the net of the amount assigned to identifiable assets acquired and liabilities assumed. Such excess may be paid because of the acquired company’s outstanding management, earnings record, or other similar features. Goodwill is deemed to have an indefinite life and not normally amortized, but should be evaluated for impairment at least annually.
Goodwill accounting for companies that do not have “public” shareholders is eligible for two simplifications: (1) amounts attributable to selected intangibles (certain customer related intangibles and the value of noncompetition agreements) can be combined with goodwill, and (2) the cost of goodwill may be amortized over a ten-year period.