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D. Purchase of Groups of Fixed Assets (Basket Purchase)
Module 11: Fixed Assets
Purchase of Asset 1 with a FMV of $60,000, Asset 2 with a FMV of $120,000, and Asset 3 with a FMV of $20,000
all for $150,000 cash.
E. Capital vs. Revenue Expenditures
1. Capital expenditures and revenue expenditures are charges that are incurred after the acquisition cost has been
determined and the related fixed asset is in operation.
Capital expenditures are not normal, recurring expenses; they benefit the operations of more than
one period. The cost of major rearrangements of assets to increase efficiency is an example of a capital
Revenue expenditures are normal recurring expenditures. However, some expenditures that meet the test
for capital expenditures are expensed because they are immaterial (e.g., less than $50).
2. Expenditures to improve the efficiency or extend the asset life should be capitalized and charged to future
a. A subtle distinction is sometimes made between an improvement in efficiency and an extension of the
asset life. Some accountants feel improvements in efficiency should be charged to the asset account, and
improvements extending the asset life should be charged to the accumulated depreciation account. The
rationale is that improvements extending the asset life will need to be depreciated over an extended period
of time, requiring revision of depreciation schedules.
3. The chart on the following page summarizes the appropriate treatment of expenditures related to fixed assets.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 20 THROUGH 24
Depreciation is the annual charge to income for asset use during the period. Since depreciation is a noncash
expense, it does not provide resources for the replacement of assets. It is simply a means of spreading asset
costs to periods in which the assets produce revenue.
a. Essentially, the “depreciation base” is allocated over the asset’s useful life in a rational and systematic
manner. The meaning of the key terms is as follows:
COSTS SUBSEQUENT TO ACQUISITION OF PROPERTY, PLANT, AND EQUIPMENT
Normal accounting treatment
Type of expenditure
Extensions, enlargements, or expansions made to an
Recurring, relatively small expenditures
Debit (credit) to
Debit (credit) to
2. Repairs and maintenance
b. Extraordinary (major)
1. Maintain normal operating condition
2. Do not add materially to use value
3. Do not extend useful life
Not recurring, relatively large expenditures
1. Primarily increase the quality and/or output of
2. Primarily extend the useful life
3. Replacements and
a. Book value of old
component is known
Major component of asset is removed and replaced
with the same type of component with comparable
performance capabilities (replacement) or a different
type of component having superior performance
Old component amounts
New component outlay
4. Reinstallations and
b. Book value of old
component is not known
Primarily increases the use value
Primarily extends the useful life
proceeds and loss (or
gain) on old asset
Provide greater efficiency in production or reduce
1. Material costs, benefits extend into future accounting
2. No measurable future benefit
Module 11: Fixed Assets
Systematic—Formula or plan
Rational—Representational faithfulness (fits with reality)
Allocation—Not a process of valuation
2. The objective is to match asset cost with revenue produced. The depreciation base is cost less salvage value
(except for the declining balance method which ignores salvage value). The cost of an asset will include any
reasonable cost incurred in bringing an asset to an enterprise and getting it ready for its intended use. The
useful life can be limited by
a. Technological change
b. Normal deterioration
c. Physical usage
(1) The first two indicate depreciation is a function of time whereas the third indicates depreciation is a
function of the level of activity. Other depreciation methods include inventory, retirement, replacement,
group, composite, etc.
3. Depreciation methods based on time are
a. Straight-line (SL)
(1) Declining balance (DB)
(a) Most common is double-declining balance (DDB)
(2) Sum-of-the-years’ digits (SYD)
Straight-line and accelerated depreciation are illustrated by the following example:
$10,000 asset, four-year life, $2,000 salvage value.
$10,000 – $2,000
Twice the straight-line rate (2 × 25%) times the net book value at beginning of each year, but not
below salvage value (salvage value is not deducted for depreciation base).
4/10**, 3/10, 2/10, 1/10 of ($10,000 – $2,000).
* $10,000 – ($5,000 + 2,500) = $2,500 Book value at beginning of year three. $2,500 – 2,000 salvage value = $500.
** n(n + 1)
a. Straight-line and accelerated depreciation methods are illustrated by the following graphs:
Module 11: Fixed Assets
b. Accelerated depreciation is justified by
(1) Increased productivity when asset is new
(2) Increasing maintenance charges with age
(3) Risk of obsolescence
c. Accelerated depreciation methods result in a better matching of costs and revenues when one or more of
these factors are present.
Physical usage depreciation is based on activity (e.g., machine hours) or output (e.g., finished widgets).
Annual depreciation =
Current activity or output
Total expected activity or output
× Depreciation base
A machine costs $60,000. The machine’s total output is expected to be 500,000 units. If 100,000 units are produced in the first year, $12,000 of depreciation would be incurred (100/500 × $60,000).
NOTE: Physical usage depreciation results in a varying charge (i.e., not constant). Also physical usage
depreciation is based on asset activity rather than expiration of time.
Inventory depreciation is a method typically used in situations where there are many low-cost tangible assets,
such as hand tools for a manufacturer or utensils for a restaurant.
a. Using this method, an inventory of the assets is taken at the beginning and the end of the year. Valuation of
these assets is based on appraisal value. Depreciation is calculated as follows:
= Beginning inventory + Cost of acquisitions – Ending inventory
b. The inventory method is advantageous in situations involving such small assets because it is not practical
to maintain separate depreciation schedules for them. On the other hand, this method is often criticized
because it is not systematic and rational.
Composite (group) depreciation averages the service life of a number of property units and depreciates the
group as if it were a single unit.
a. The term “group” is used when the assets are similar; “composite” when they are dissimilar.
b. The depreciation rate is the following ratio:
Sum of annual SL depreciation of individual assets
Total asset cost
c. Thus, composite depreciation is a weighted-average of a group of assets—usually of a similar nature,
expected life, etc.
Three types of assets (A, B, and C) are depreciated under the composite method.
Module 11: Fixed Assets
Depreciation or composite rate =
Composite life = 3.39 years ($190,000 ÷ $56,000)
NOTE: The composite life is the depreciation base divided by the annual depreciation.
(1) Depreciation is recorded until the book value of the composite group is depreciated to the salvage value
of the then remaining assets. As assets are retired the composite group salvage value is reduced.
NOTE: Gains and losses are not recognized on disposal (i.e., gains and losses are netted into accumulated
depreciation). This latter practice also affects the length of time required to reduce the book value (cost less
accumulated depreciation) to the group salvage value.
The entry to record a retirement is
Cash, other consideration
Changes in depreciation. A change in depreciation method is a change in accounting estimate effected by a change
in accounting principle. Therefore, a change in depreciation method is treated as a change in accounting estimate.
a. Changes in depreciation estimates also include changes in the expected useful life or salvage value. Changes
in accounting estimates are accounted for on a prospective basis in the current and future periods. Make the
change prospectively from the beginning of the year in which the change in estimate occurs. The procedure
for straight-line depreciation is
(1) Divide the periods remaining (from the beginning of the year of change) into
(2) The remaining depreciation base (i.e., undepreciated cost to date less revised salvage value)
Fractional year depreciation. Many conventions exist for accounting for depreciation for midyear asset
acquisitions. They include
a. A whole year’s depreciation in year of acquisition and none in year of disposal
b. One-half year’s depreciation in year of acquisition and year of disposal
c. Depreciation to nearest whole month in both year of acquisition and year of disposal
NOTE: CPA exam questions generally specify the convention to be followed.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 25 THROUGH 37
G. Disposals and Impairment of Value
1. The entry to record the disposal (sale) of an asset is
Module 11: Fixed Assets
Gain or loss
a. Remember to record depreciation for disposed assets up to the point of disposal.
Jimco, a manufacturer of sports equipment, purchased a machine for $6,000 on 1/1/Y1. The machine had an
eight-year life, a $600 salvage value, and was depreciated using the straight-line method. Thus, depreciation was
charged at a rate of $56.25 per month [($6,000 cost $600 salvage) ữ (8 yrs ì 12 mos/yr)]. If Jimco sells the asset
on 9/1/Y6 for $3,000, the following entries must be made to record year 6 depreciation and to record the sale:
Accumulated depreciation ($56.25 × 8 mos)
Accumulated depreciation ($56.25 × 68 mos)
Gain on sale of equip. [$3,000 cash – ($6,000 – $3,825)CV]
2. In some cases, assets are intended to be disposed of in a future reporting period rather than held for use. If
management has adopted such a plan for disposal, a loss is recognized if the fair value minus selling costs
(NRV) is less than the recorded carrying value.
Assume that the asset in the above example has not been sold yet. However, management intends to dispose of it
in the next year at NRV of $1,500. The entry to record management’s intents would be as follows:
Loss on planned disposition*
Equipment to be disposed of
* 1,500 – (6,000 – 3,825)
a. Fixed assets intended for disposal are not subsequently depreciated. The equipment to be disposed of would
be classified as other assets on the balance sheet.
Losses on fixed assets to be disposed of can be recovered due to changes in the fair value or selling costs
associated with the asset. This write-up, however, cannot exceed the carrying amount prior to recognition of
impairment. If the NRV for this asset increases in the next period, the maximum recovery (gain) that could
be recognized is $675.
Assets that are intended to be held and used should be tested for impairment. Impairment occurs when the
carrying amount of a long-lived asset or asset group exceeds its fair value. However, an impairment loss is
recognized only if the carrying amount of the asset is not recoverable. The carrying value is considered not
recoverable if it exceeds the sum of the expected value of the undiscounted cash flows.
a. The loss on impairment recognized is the difference between the asset’s fair value and its carrying value. In
determining the fair value, the principal or most advantageous market for the asset should be used consistent
with the asset’s highest and best use. The in-use valuation premise assumes the highest value of the asset
is achieved by using it in the business with other assets. An in-exchange premise assumes that the highest
value of the asset is the amount received to sell the asset stand-alone.