What are Long-Term Assets?

what-are-long-term-assetsThere 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.

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).

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.


Long Term Asset Purchase 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


Change in Estimates of Long-Term Assets

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.


Long-Term Asset Valuation 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.


Long-Term Asset Sale 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

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