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D. Purchase of Groups of Fixed Assets (Basket Purchase)

D. Purchase of Groups of Fixed Assets (Basket Purchase)

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Module 11: Fixed Assets



278



EXAMPLE

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.

FMV



Relative FMV



Total cost



Allocated cost



Asset 1



$60,000



60/200



$150,000



$45,000



Asset 2



120,000



120/200



150,000



90,000



Asset 3



20,000



20/200



150,000



15,000



Total FMV



$200,000



Journalized:

Asset 1



$45,000



Asset 2



90,000



Asset 3



15,000

Cash









$150,000



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.



a.

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

expenditure.

b.

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

periods.







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







F.Depreciation



1.

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.





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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:



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COSTS SUBSEQUENT TO ACQUISITION OF PROPERTY, PLANT, AND EQUIPMENT





Normal accounting treatment

Capitalize



Type of expenditure

1.Additions



Expense

when

incurred



Characteristics





Extensions, enlargements, or expansions made to an

existing asset







Recurring, relatively small expenditures



Debit (credit) to

asset



Debit (credit) to

accum. deprec.



Other



x



2. Repairs and maintenance

a.Ordinary



b. Extraordinary (major)







1. Maintain normal operating condition



x



2. Do not add materially to use value



x



3. Do not extend useful life



x



Not recurring, relatively large expenditures

1. Primarily increase the quality and/or output of

services

2. Primarily extend the useful life



3. Replacements and

improvements



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

capabilities (betterment)







Old component amounts

New component outlay









4. Reinstallations and

rearrangements



x











b. Book value of old

component is not known



x







(x)

x



Primarily increases the use value

Primarily extends the useful life



x







Recognize any

proceeds and loss (or

gain) on old asset



x

x



Provide greater efficiency in production or reduce

production costs

1. Material costs, benefits extend into future accounting

periods

2. No measurable future benefit



x

x



279



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Module 11: Fixed Assets



280



(1)

Systematic—Formula or plan

(2)

Rational—Representational faithfulness (fits with reality)

(3)

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)

b.Accelerated

(1) Declining balance (DB)









(a) Most common is double-declining balance (DDB)

(2) Sum-of-the-years’ digits (SYD)



4.

Straight-line and accelerated depreciation are illustrated by the following example:



EXAMPLE

$10,000 asset, four-year life, $2,000 salvage value.

Year



Straight line



DDB



SYD



1



$2,000



$5,000



$3,200



2



$2,000



$2,500



$2,400



3



$2,000



$500*



$1,600



4



$2,000



--



$ 800



$10,000 – $2,000



Straight-line →



4

DDB

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).



SYD



* $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)

2







=



2



= 10



a. Straight-line and accelerated depreciation methods are illustrated by the following graphs:

$



SL



time



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4×5



$



SYD



time



$



DDB



time



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Module 11: Fixed Assets



281



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.



5.

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



EXAMPLE

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.



6.

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.



7.

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.



EXAMPLE

Three types of assets (A, B, and C) are depreciated under the composite method.



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Salvage value



Depreciation base



Useful life

(yrs.)



SL annual

depreciation



$30,000



5



$6,000



Asset type



Asset cost



A



$45,000



$15,000



B



90,000



50,000



40,000



4



10,000



C



145,000



25,000



120,000



3



40,000



$280,000



$90,000



$190,000



$56,000



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Module 11: Fixed Assets



282



Depreciation or composite rate =



$56,000

$280,000



= 20%



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



(amount received)



Accumulated depreciation



(plug)



Asset



(original cost)



8.

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)



9.

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









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G. Disposals and Impairment of Value

1. The entry to record the disposal (sale) of an asset is



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Module 11: Fixed Assets

Cash



(amount received)



Accumulated depreciation



(old asset)



Old asset

Gain or loss







283



(cost)

(loss)



(gain)



a. Remember to record depreciation for disposed assets up to the point of disposal.



EXAMPLE

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:

Depreciation expense



450



  Accumulated depreciation ($56.25 × 8 mos)



450



Cash



3,000



Accumulated depreciation ($56.25 × 68 mos)



3,825



 Equipment



6,000



  Gain on sale of equip. [$3,000 cash – ($6,000 – $3,825)CV]







825



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.



EXAMPLE

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*



675



Equipment to be disposed of



1,500



Accumulated depreciation



3,825



 Equipment



6,000



* 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.

b.

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.

3.

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.





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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.



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