Lecture: Long-Lived Assets
Lecture script · about 15–20 minutes spoken · Week 11
Opening
Think about a laptop you plan to use for all 4 years of your studies. Say it cost $1,200. Would you say it cost you $1,200 in your first year and nothing after that? Most people wouldn't. It feels fairer to say it cost about $300 a year, because you use it every year. Hold on to that feeling. It's the whole idea behind this lecture.
Now picture our bicycle shop. It has bought a delivery van to bring repaired bicycles back to customers, and it plans to drive that van for 5 years. A coffee roaster buying a roasting machine faces the same question. So does a software firm buying a patent. What did the asset cost, and how much of that cost belongs to each year?
Let me remind you where we are. In Week 4 you recorded the shop's first depreciation: $200 a month on its $12,000 of equipment, with a credit to Accumulated Depreciation. In Week 5 you placed property, plant, and equipment on the classified balance sheet. In Week 7 you compared inventory methods by their effects, never by which was better. And in Week 10 you measured what customers owe.
Here's the plan. We'll name the kinds of long-lived assets and measure the van's cost. We'll treat depreciation as what it really is. Then we'll depreciate the van three ways, compare the three, sell the van, and finish with patents, goodwill, and quarries. Next week, in Current Liabilities and Payroll, we cross to the debts the shop owes within a year.
1. What counts as a long-lived asset
Walk through the shop in your mind. The cash in the safe will be spent this month. The supplies on the shelf will be used up soon. But the work stands and the van will serve the shop for years.
That's the idea. Long-lived assets are the assets a business uses in its operations for more than one year and does not hold for sale. They come in three groups. Property, plant, and equipment is the physical group: the van, the work stands, a building. Intangible assets have no physical form but give the business rights or advantages, like a patent. And natural resources are taken from the earth or grown on it, like timber or a mineral deposit.
The words "does not hold for sale" do real work. The bicycles in the shop's stockroom are expensive too, but the shop bought them to resell. They're inventory. A bicycle shop's van is equipment. A van dealer's vans are inventory.
Pause and try this. The shop owns a delivery van and a stock of bicycles for sale. Which one is a long-lived asset?
Picture each one a year from now, and decide.
Here's the answer. The van is the long-lived asset. The shop uses it in its work for years, while it sells the bicycles to customers, so they're inventory.
So price doesn't decide it. Use does.
2. What an asset costs
Imagine you buy a used couch from across town and rent a truck to bring it home. Did the couch cost you only the seller's price? I'd say it cost the price plus the truck, because without the truck there's no couch in your living room.
Accounting thinks the same way. The cost of a long-lived asset is everything needed to acquire it and get it ready for use, such as the price, freight, and setup. Putting a cost into an asset account like this is called capitalizing it.
Here's the van, from Dataset H, which is illustrative. The price was $28,000. Freight to deliver it was $1,500. Setup so it could carry bicycles was $500. Add them: 28,000 plus 1,500 plus 500 is $30,000. The shop paid cash, so the entry debits Delivery Van for 30,000 and credits Cash for 30,000. One asset went up and another went down by the same amount, so total assets didn't move.
The coffee roaster works the same way. The price of its roasting machine, the shipping, and the installation all go into the machine's cost, because it can't roast a single bean until all three are done.
Pause and try this. Should the shop record the $1,500 delivery charge as an expense of the month the van arrived?
Think about whether the van could work without it.
Here's the answer. No. The $1,500 is part of the van's $30,000 cost, because the van couldn't do any work until it arrived.
That charge will be spread over the van's 5 years, right along with the price.
3. Depreciation is allocation
Back to your laptop. After a year, you could sell it for something, maybe more than you'd guess, maybe less. That resale price is interesting, but it isn't what you used up. You used up one year of a laptop you planned to keep for 4.
Depreciation follows that second idea. Depreciation is the allocation of a long-lived asset's cost to the periods that use it. It is not a measure of the asset's market value, and it is not a cash payment.
Every method needs three estimates. Residual value is the amount the business expects to receive for the asset when it stops using it; for the van, that's $3,000. Useful life is how long the business expects to use the asset; for the van, 5 years or 90,000 miles. And depreciable cost is cost minus residual value, the part that gets used up. For the van, 30,000 minus 3,000 is $27,000.
I want to be honest about one thing. These are estimates. Nobody knows on day one exactly how long a van will last or what it'll sell for.
Pause and try this. When the shop records a year of the van's depreciation, does any cash leave the bank?
Picture the entry's two accounts before you decide.
Here's the answer. No cash moves. The entry debits Depreciation Expense and credits Accumulated Depreciation, and Cash isn't in it at all.
A used van's price can rise or fall in a month, and the depreciation stays the same, because it tracks cost, not price.
4. The straight-line method
Think about splitting a streaming plan evenly with a roommate. Every month looks like every other month. The first method treats an asset's years the same way.
The straight-line method records the same depreciation in each full year: cost minus residual value, divided by useful life. For the van, that's 30,000 minus 3,000, which is 27,000, divided by 5, which is $5,400 a year. That's a rate of 20 percent a year. Each year-end adjusting entry debits Depreciation Expense 5,400 and credits Accumulated Depreciation 5,400. Like every Week 4 adjustment, it touches one income statement account and one balance sheet account, and never Cash.
Now let's walk the depreciation schedule, a table of each year's depreciation, the Accumulated Depreciation so far, and the book value left. Book value starts at $30,000. After Year 1 it's $24,600. Then $19,200, then $13,800, then $8,400, and after Year 5 it's $3,000, the residual value. Five years at $5,400 is $27,000, the whole depreciable cost.
Pause and try this. At the end of Year 1, the van's book value is $24,600. Is that what a buyer would pay for the van?
Think about what book value measures.
Here's the answer. Not necessarily. The $24,600 is the part of the cost the shop hasn't moved into expense yet, and a buyer might pay more or less.
5. The units-of-production method
Picture someone who rents out a pressure washer by the hour. A busy month wears it out faster than a slow one. It'd be fair to charge more of its cost to the busy month.
The units-of-production method ties depreciation to use: cost minus residual value, divided by total expected units, times the units used. The van's units are miles. Its depreciable cost of $27,000, spread over 90,000 miles, gives $0.30 a mile. In its first year the van drives 20,000 miles, so depreciation is 20,000 times $0.30, which is $6,000. Book value at the end of Year 1 is $24,000.
A year with more miles gets more depreciation, and a year with fewer gets less. Over all 90,000 miles, the method still moves $27,000 into expense.
Pause and try this. Why is the rate $0.30 a mile, and not the full $30,000 cost divided by 90,000 miles?
Remember the part of the cost that never gets used up.
Here's the answer. Because the $3,000 residual value comes back when the shop sells the van. Only the $27,000 depreciable cost is spread over the miles.
6. The double-declining-balance method
A new phone loses a lot of its usefulness in its first year, as newer models come out, and less after that. Some assets give more of their service early. An accelerated method records more depreciation early and less later.
The double-declining-balance method multiplies the asset's book value at the start of each year by twice the straight-line rate, and stops when book value reaches residual value. The van's straight-line rate is 20 percent, so this rate is 40 percent.
Two things trip people up, so let me name them. First, you don't subtract the residual value at the start; the 40 percent goes on the full book value. Year 1 is 30,000 times 0.40, which is $12,000, leaving $18,000. Year 2 is $7,200, Year 3 is $4,320, and Year 4 is $2,592, leaving a book value of $3,888. Second, the residual value is a floor. In Year 5, 40 percent of $3,888 would be $1,555.20. That would push book value below $3,000. So Year 5 takes only the $888 that brings book value down to $3,000.
Pause and try this. In Year 5, should the shop record $1,555.20 of depreciation or $888?
Check where each one leaves the book value.
Here's the answer. It records $888. The method never takes book value below the $3,000 residual value.
Add the five years and you get $27,000, the same total as straight-line.
7. Comparing the methods
Imagine three friends who each owe the same share of a trip. One pays the same amount every month. One pays more at the start. One pays by the miles driven each month. In the end, each friend pays the same total. Only the timing differs.
That's the honest way to compare depreciation methods: by their effects, never as a ranking. In Year 1 the van's depreciation is $5,400 under straight-line, $6,000 under units-of-production in a 20,000-mile year, and $12,000 under double-declining-balance. That's $6,600 more than straight-line. But straight-line and double-declining-balance both total $27,000 over the 5 years.
So a method that records more depreciation early shows lower net income and a lower book value in the early years, and higher net income later. GAAP allows each method. A business picks the one that fits how it expects to use the asset, and then it applies that method consistently, as you saw with inventory methods in Week 7.
Pause and try this. Does the shop that uses double-declining-balance own a cheaper van than the shop that uses straight-line?
Think about what the van cost each of them.
Here's the answer. No. Both vans cost $30,000. The methods only decide which years carry more of the $27,000 of depreciation.
8. Selling the van
Suppose you sell your old bike for $150. Did you make $150? Not really. You gave up a bike to get it.
A business looks at it the same way. The gain or loss on disposal is the cash received minus the asset's book value on the date of sale. More cash than book value is a gain. Less is a loss.
The shop uses straight-line and sells the van at the end of Year 3 for $12,500. After 3 years, Accumulated Depreciation is 3 times 5,400, or $16,200. Book value is 30,000 minus 16,200, which is $13,800. The shop received $12,500 for something carried at $13,800, so it has a loss of $1,300. The entry debits Cash 12,500, Accumulated Depreciation 16,200, and Loss on Sale of Delivery Van 1,300, and credits Delivery Van 30,000. Both sides come to $30,000.
Here's something worth seeing. Under double-declining-balance, book value after 3 years would be $6,480, and the same sale would show a gain of $6,020. Yet over the 3 years, the total cost to the shop is $17,500 either way.
Pause and try this. Under straight-line, is the shop's gain on this sale $12,500?
Compare the cash with the book value.
Here's the answer. No. The $12,500 is the cash. The shop gave up a van carried at $13,800, so it records a $1,300 loss.
9. Patents, goodwill, and quarries
Some assets you can't touch. A patent on an invention is one. Others, like stone in a quarry, are very physical and get used up as they're dug out. We'll take these in words.
Amortization of an intangible asset is the allocation of the cost of an intangible asset with a finite life, such as a patent, to the periods of its useful life. It plays the part for a patent that depreciation plays for a van. So if a small software firm buys a patent, it spreads that cost over the years the patent helps it.
Goodwill is the amount a buyer pays for a whole business beyond the value of that business's identifiable assets minus its liabilities. Under the general GAAP rule, goodwill is not amortized. Private companies and not-for-profit entities may elect to amortize it.
Depletion is the allocation of a natural resource's cost to the periods in which its units are taken out. A quarry spreads its cost over the tons of stone it removes.
Pause and try this. Under the general GAAP rule, which is amortized: a patent with a finite life, or goodwill?
Recall the rule's exception before you decide.
Here's the answer. The patent. Goodwill is not amortized under the general rule, though private companies and not-for-profit entities may elect to.
Closing
Let me pull it together. Long-lived assets serve a business for more than a year and aren't held for sale. Their cost includes everything needed to get them ready, so the van cost $30,000, freight and setup included. Depreciation allocates that cost; it doesn't measure price, and it doesn't move cash. Straight-line gives $5,400 a year. Units-of-production gives $0.30 a mile. Double-declining-balance starts at $12,000 and stops at the residual value. Every method moves the same $27,000 into expense, only in different years. Selling the van for $12,500 at a $13,800 book value is a $1,300 loss, not a gain. Patents are amortized, goodwill isn't under the general rule, and natural resources are depleted.
Next in this module come the Readings & Resources page, the lecture tutorial, the practice set, the quiz, the discussion, and the assignment. Next week, in Current Liabilities and Payroll, we turn to what the shop owes, starting with its mechanic's paycheck.
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