Current Assets Versus Long-Term Assets
The difference between current and a company’s 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 have a useful life or more than a year and are used for multiple operating cycles (machines, buildings, etc.).
There are three groups of long-term assets: long-term tangible assets, such as machines and buildings; long-term intangible assets such as long-term investments, patents, copyright, goodwill, and trademarks, and long-term financial assets such as shares held in other companies by shareholders. In this tutorial, I focus on the classification of long-term tangible assets. Many of the accounting principles discussed here can be applied to intangible assets. Accounting for financial assets, however, has some distinct features. I intend to discuss the accounting metrics for (long-term) financial assets in a separate tutorial at a future point in time.
- long term assets are used in 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 on 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 of the cost of the asset.
- if an asset can be recognized, the items that are spent to get the asset ‘up and running’ are allowed to be capitalized
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.
As the name suggests, the straight-line method results in a fixed amount for each period of the asset’s economic life. 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 the value of the asset. Instead of deducting depreciation of long-term assets 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 would fall under long-term liabilities, and it does not.)
Recording the purchase:
Alternative 1: recording depreciation expense without a contra T-account:
Alternative 2: recording depreciation expense with a contra T-account:
|Accumulated depreciation, equipment||2,250|
The presentation on the balance sheet after 3 years is as follows:
|Alternative 1 (without a contra T-account)|
|Alternative 2 (with a contra T-account)|
|Accumulated depreciation, equipment||-6,750|
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).
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.
- 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
Changes may occur during the economic life of the asset. Its value may change, the economic life 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 the depreciation schedule. However, under IFRS, it is possible to opt for fair value valuation for long-term assets. I intend to write a 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 life 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.
- 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.
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:
|Loss on sale machine||2,500|
|Accumulated depreciation, machine||4,500|
- When a contra T-account is used for accumulated depreciation, the cost as well as the accumulated depreciation are removed from the books