Long term assets

Current assets versus long term assets

The difference between current and long term assets is that current assets are converted/used within a single operating cycle (inventory, work in progress, accounts receivable, etc), whereas long term assets are used for multiple operating cycles (machines, buildings, etc).

There are three types of long term assets: long term tangible assets, such as machines and buildings, long term intangible assets such as patents and trademarks and long term financial assets such as shares held in other companies. In this tutorial I focus on long term tangible assets. Many of the principles discussed here can be applied to intangible assets. Accounting for financial assets however, has some distinct features. I intend to discuss accounting for (long term) financial assets in a separate tutorial at a future point in time.

Key points:
- current assets are converted or used within a single operating cycle
- long term assets are used multiple operating cycles

Purchase (or development) of long term assets

First, it needs to be determined if accounting principles allow for the asset to be recognized. The accounting treatment under IFRS (and also under US GAAP) differs for tangible and intangible assets. The requirements for capitalizing self developed (as opposed to purchased) intangible assets are most restrictive. The rationale behind this is that the valuation for these assets is most uncertain. (If time permits, I hope to write several tutorials on IFRS.)

If accounting principles allow recognition of an asset, the next issue is which items can be included, and which items need to be expensed. The basic rule here is that – when recognizing the asset is allowed – all money that is spent to get the asset up and running is capitalized as part as the cost of the asset.

Example


The following items can be capitalized when the firm purchases a machine. The machine itself, transportation (getting the machine in place), fees paid for having the machine installed and tested, the cost of a trial run, and alike. If the firm’s own personnel is involved with installing the machine, their wages expenses can be allocated to the machine as well.
Examples that are excluded from the asset and consequently are expensed include training of personnel to learn how to use the machine, (unexpected) damages while installing the machine, or the drinks and snacks to celebrate the machine’s successful launch.

Key points:
- accounting principles determine which assets can be recognized, and which cannot; regulation is most restrictive on capitalizing intangible assets that are self developed (such as brand names)
- if an asset can be recognized, the items that are spent to get the asset ‘up and running’ are allowed to be capitalized

Depreciation methods

During the economic lifetime the value of the asset is reduced (expensed). This expense is called depletion for natural resources, depreciation for other tangible long term assets, and amortization for intangible long term assets.

Although other methods exist, I consider the two most common depreciation methods: the straight line method and the declining balance method.

straight line depreciation

As the name suggests, the straight line method results in a fixed amount for each period of the asset’s economic life time. The depreciable amount is the amount that needs to be expensed in total, which is the cost minus the residual value. The residual value is the amount that the firm expects to receive when the asset is disposed of at the end of the economic lifetime. Thus, the yearly depreciation expense is the depreciable amount divided by the economic lifetime.

Depreciation is the decline in value of the asset. Instead of deducting depreciation from the asset’s T-account, it is common practice to create an additional T-account (called contra T-account) where the depreciation is added to. Thus, every year the depreciation is credited to this T-account. Technically, a T-account with a credit balance can be included on the debit side of the balance sheet. In that case, the sign flips. Thus, accumulated depreciation is subtracted from the cost, resulting in the ‘carrying value’, which is also called ‘net value’ or ‘book value’. (Presenting accumulated depreciation on the credit side would of course result in a balanced balance sheet. However, it would imply that accumulated depreciation is a liability, which it is not.)

Example

At the beginning of the year, the firm buys new equipment for 10,000 cash with an estimated residual value of 1,000 and an economic lifetime of 4 years. The firm uses the straight line method.

Recording the purchase:

T-account Debit Credit  
Equipment 10,000    
Cash   10,000  

Alternative 1: recording depreciation expense without a contra T-account:

T-account Debit Credit  
Depreciation expense 2,250    
Equipment   2,250  

Alternative 2: recording depreciation expense with a contra T-account:

T-account Debit Credit  
Depreciation expense 2,250    
Accumulated depreciation, equipment   2,250  

The presentation on the balance sheet after 3 years is as follows:

Alternative 1 (without a contra T-account)    
Equipment, net 3,250  
     
Alternative 2 (with a contra T-account)    
Equipment, cost 10,000  
Accumulated depreciation, equipment -6,750  
  ______  
Equipment, net 3,250  

the declining balance method

An alternative method is the declining balance method. Where the straight line method is a percentage of the depreciable amount, with the declining balance method the depreciation expense is a percentage of the book value of the asset. As the book value declines over time, so does the depreciation expense. In the year that applying this rule would result in a book value below the residual value, the firm switches to straight line deprecation for the remaining year(s).

Example


At the beginning of the year, the firm buys a new machine for 20,000 cash with an estimated residual value of 4,000 and an economic lifetime of 6 years. The firm uses the declining balance method using 40%.

The depreciation in year 1: 40% x 20,000 = 8,000
The depreciation in year 2: 40% x 12,000 = 4,800
The depreciation in year 3: 40% x 7,200 = 2,880
The depreciation in year 4: 40% x 4,320 = 1,728 106.66
The depreciation in year 5: 106.66
The depreciation in year 6: 106.67

In the fourth year the firm switches to straight line depreciation as an additional depreciation of 1,728 would result in a book value below the residual value of 4,000.

The double declining balance is a special case of the declining balance method, where the percentage used is 200% divided by the economic lifetime.

Example


The firm has purchased equipment with an economic lifetime of 10 years. The percentage that would be used with the double declining balance method would be 20% (=200% / 10 years).

Key points:
- the depreciable amount is the total depreciation over the economic lifetime and equals cost minus the residual value
- usually separate T-accounts are used to record historic cost and cumulative depreciation
- carrying value (book value, or ‘net’ value of assets) equals cost minus cumulative depreciation
- with the straight line method the yearly depreciation is constant: the depreciable amount divided by the number of years
- with the declining balance method the yearly depreciation equals a percentage of the book value
- the double declining balance method uses 200% divided by the economic lifetime as the percentage

Change in estimates

It is possible that changes occur during the economic lifetime of the asset. It’s value may change, the economic lifetime may change, or the estimate of the residual value could be revised. 

When historic cost is the basis for valuation (which usually is the cast) and the fair value of the asset increases in value, no change is made to the value of the asset, nor to the depreciation schedule. However, under IFRS it is possible to opt for fair value valuation for long term assets. I intend to write an separate tutorial on this issue. However, when the fair value of the asset decreases below the book value of the asset, the asset needs to be written down to the lower fair value. This is the application of the ‘lower of cost or market’-rule.

When the economic lifetime or estimates of the residual value change, no correction is made to ‘catch up’ or undo past years’ depreciation. Instead, the depreciation schedule is adapted to fit the new economic lifetime and residual value.

Example


Beginning of year 1, the firm has purchased a machine for 10,000, an economic lifetime of 10 years, and an estimated residual value of 1,000. Hence, the firm depreciates 900 a year.
After 5 years, when the book value is 5,500, management realizes the actual economic lifetime is only 8 years, with a residual value of 2,000. For the remaining 3 years, the firm will depreciate 1,166.66 per year (5,500 - 2,000 divided by 3 years).

Key points:
- when the firm uses historic cost as the basis for valuation, the firm will need to apply the ‘lower of cost or market’- rule
- the ‘lower of cost or market’- rule dictates that assets are not revalued upwards when the fair value of the asset increases, but need to be market down to the fair value if the fair value would drop below the book value of the asset
- if during the economic lifetime the estimated life time changes, or the estimated residual value changes, the depreciation schedule is adapted such that the remaining depreciable amount is depreciated over the remaining economic lifetime

Sale of long term assets

When the asset is disposed or sold, a gain or loss is realized.

Example


Beginning of year 1, the firm has purchased a machine for 10,000, an economic lifetime of 10 years, and an estimated residual value of 1,000. Hence, the firm depreciates 900 a year.

After 5 years, when the book value is 5,500, the firm sells the machine for 3,000 cash.

The journal entry of the transaction is:

T-account Debit Credit  
Cash 3,000    
Loss on sale machine 2,500    
Accumulated depreciation, machine 4,500    
Machine, cost   10,000  

Key points:
- When the asset is disposed or sold, a gain or loss is realized
- When a contra T-account is used for accumulated depreciation, the cost as well as the accumulated depreciation are removed from the books

Continue with reading the next tutorial: Liabilities



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