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In Interemediate Financial Accounting I, we introduced the concept of capitalization of costs. For costs related to acquiring or building property, plant, and equipment, and intangible assets, we place the initial costs on the balance sheet as an asset.
Do these costs stay on the balance sheet forever?
Do these costs stay on the balance sheet forever?
In most cases, no! Instead, the value is reduced each period as the asset is used up and the reduction is recorded as an expense - called either depreciation, amortization, or depletion, depending on asset type - in the income statement.
Three terms
Three terms
In Intermediate Financial Accounting I, we spoke about two different types of long-lived assets: (1) Property, Plant, and Equipment and (2) Intangible Assets. Recall that Property, Plant, and Equipment included Natural Resources, and Intangible Assets included Goodwill.
Costs related to these assets are initially capitalized and then expensed as the assets are used up. This expensing process has three different names, depending on the type of asset.
Depreciation: Cost allocation for Property, Plant, and Equipment excluding natural resources.
Depletion: Cost allocation for natural resources.
Amortization: Cost allocation for intangibles.
Are there major differences between these three cost allocation terms?
Are there major differences between these three cost allocation terms?
No! No major differences. They all refer to the process of expensing previously capitalized assets.
Accountants just like to give names to everything.
What about goodwill? Do we ever expense capitalized goodwill costs?
What about goodwill? Do we ever expense capitalized goodwill costs?
No! Believe it or not, we do not record expense for previously capitalized goodwill costs. Instead, GAAP requires companies to test goodwill for something called impairment (on an annual basis) and we will this discuss later.
PP&E and intangible costs included in inventory?
PP&E and intangible costs included in inventory?
If an asset is used in the manufacture of a product, depreciation, depletion, or amortization of that asset is included in the cost of inventory. Otherwise, these costs are included in operating expenses (e.g., Selling, General, and Administrative expenses) in the income statement.
Time based methods
Time based methods
In time based methods, the goal is allocate cost based on the passage of time.
For example, an asset worth $10,000 that is expected to last 5 years would generate $2,000 of depreciation expense per year ($10,000 ÷ 5 years).
Activity based methods
Activity based methods
In activity based methods, the goal is to allocate cost based on some measure of use or activity.
For example, a machine on an automobile assembly line that costs $1,000,000 and is expected to be used in the production of 100,000 cars would generate $10 of depreciation per car produced ($1,000,000 ÷ 100,000 cars).
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