Accounting for Long-term Assets
Before Mr. Serfy can buy a computer, he needs to make a capital contribution to his company. Let us assume that the owner contributes $25,000 cash. The later increases assets (Cash) and equity (Contributed Capital) which is an asset source transaction:
Illustration 8-2: Effect of a capital contribution of the horizontal model
| Assets |
= |
Equity |
Rev |
- |
Exp |
= |
Net Inc. |
Cash Flow |
|||||||
| Cash |
+ |
Comp. |
- |
A. Dep. |
= |
Cont. Cap. |
+ |
Ret. Earn. |
|||||||
| 25,000 |
+ |
n/a |
- |
n/a |
= |
25,000 |
+ |
n/a |
n/a |
- |
n/a |
= |
n/a |
25,000 |
FA |
After the capital contribution, Mr. Serfy can acquire a computer for $23,000. The effect of this investment on the accounting equation is as follows:
Illustration 8-3: Effect of a computer acquisition on the horizontal model
| Assets |
= |
Equity |
Rev |
- |
Exp |
= |
Net Inc. |
Cash Flow |
|||||||
| Cash |
+ |
Comp. |
- |
A. Dep. |
= |
Cont. Cap. |
+ |
Ret. Earn. |
|||||||
| (23,000) |
+ |
23,000 |
- |
n/a |
= |
n/a |
+ |
n/a |
n/a |
- |
n/a |
= |
n/a |
(23,000) |
IA |
As it was stated, the revenue is expected to be $9,000 per year. While helping to generate this revenue, the computer gets partially used. Recognizing depreciation expense reflects the process of recording the used computer part. The amount of depreciation expense in accordance with the straight-line method is determined by subtracting the salvage value from the historical cost and dividing the result by the number of years the computer will be in use. Taking our numbers, we get $5,000 ([($23,000 - $3,000] / 4 years) of depreciation expense per year. The revenue ($9,000) and expense ($5,000) recognition is repeated for 4 years as shown below via two entries. Note that depreciation is accumulated in a contra asset account called Accumulated Depreciation:
Illustration 8-4: Effect of revenue and depreciation on the horizontal model
| Assets |
= |
Equity |
Rev |
- |
Exp |
= |
Net Inc. |
Cash Flow |
|||||||
| Cash |
+ |
Comp. |
- |
A. Dep. |
= |
Cont. Cap. |
+ |
Ret. Earn. |
|||||||
| 9,000 |
+ |
n/a |
- |
n/a |
= |
n/a |
+ |
9,000 |
9,000 |
- |
n/a |
= |
9,000 |
9,000 |
OA |
| n/a |
+ |
n/a |
- |
5,000 |
= |
n/a |
+ |
(5,000) |
n/a |
- |
5,000 |
= |
(5,000) |
n/a |
|
Note that recognition of depreciation expense affects the balance sheet and income statement, but does not affect the statement of cash flows. The reason is because cash had already been paid when Mr. Serfy bought the computer. The invested amount is allocated to expense in equal parts over the computer useful life. The effects of depreciation occur throughout the life cycle of the asset (4 years). Indeed, the amount of depreciation expense each year remains at the $5,000 level; however, the amount of accumulated depreciation increases every year which in effect decreases the computer book value:
Illustration 8-5: Schedule of straight-line depreciation for Mr. Serfy's computer
Year |
Depreciable Cost |
- |
Depreciation Expense |
= |
Book Value |
20X7 |
20,000 |
- |
5,000 |
|
$15,000 |
20X8 |
20,000 |
- |
5,000 |
= |
$10,000 |
20X9 |
20,000 |
- |
5,000 |
= |
$5,000 |
20X0 |
20,000 |
- |
5,000 |
= |
$ 0 |
|
|
|
20,000 |
|
|
The final stage of the asset is its retirement and removal from the company's records. Suppose that the company sold the computer at the very end of 20X0 for $4,000. Because the carrying value of the computer was $3,000, the company recognized a gain of $1,000 ($4,000 - $3,000):
Illustration 8-6: Effect of Mr. Serfy's computer retirement on the horizontal model
| Assets |
= |
Equity |
Rev
/ |
- |
Exp
/ |
= |
Net |
Cash Flow |
|||||||
| Cash |
+ |
Comp. |
- |
A. Dep. |
= |
Cont. Cap. |
+ |
Ret. Earn. |
|||||||
| 4,000 |
+ |
(23,000) |
- |
(20,000) |
= |
n/a |
+ |
1,000 |
1,000 |
- |
n/a |
= |
1,000 |
4,000 |
IA |
The total cash inflow from the computer amounted to $40,000 ([$9,000 revenue x 4 years] + 4,000 salvage value). At the same time the acquisition cost was only $23,000. So, the computer not only recovered the investment, but also helped generate $17,000 ($40,000 - $23,000) of return on investment.
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