allocating purchase price to assets
Long-terms assets are assets which a company plans to hold for more than one year. Typically, when we think of long-term assets, we think of buildings, land and equipment. Long-term assets also include intangible assets, like patents, trademarks and copyrights.
Assets are typically assigned to accounts based on the type of asset. Vehicles are separated from buildings. Land is separated both of these. It is important to note that buildings and land do not go in the same account, which means when a building is purchased on a piece of land, the costs of these items must be individually allocated into their separate accounts.
When a business acquires an asset, that asset must be recorded at cost. All costs associated with acquiring the asset and getting it ready to use should be considered as part of the cost of an asset. Remember that an asset is something the company owns or has the right to, which can be used to generate revenue. If the company purchases a piece of machinery but in order to use it, the company must have it delivered and installed, those costs should be included in the cost of the asset. Other costs that might be considered part of the asset include legal and closing costs, appraisal fees, transportation, upgrades and even repairs in cases where the machine isn’t working at the time of purchase.
To record assets, debit the asset account (Buildings, Land, Equipment, Vehicles, etc.) and credit the methods of payment, which are generally Cash, Notes Payable or a combination of the two. Note that these entries are regular journal entries and should be recorded at the time of purchase.
Allocating the Purchase Price Among Several Assets
When a business purchases a building, the company is not just acquiring a building. Many times we forget that the purchase includes land, improvements to the land (driveways, sidewalks, etc.), light fixtures and climate control systems inside the building. There might also be equipment or furniture included in the deal. Why is this important?
As assets are used up, they must be depreciated. This also allows the company to recover the cost of those assets. The matching principle states that expenses must be matched with the revenue they help generate. Companies use assets to generate revenue, therefore, a portion of the cost must be expensed.
Not all assets are used up at the same rate. The useful life of a building is much longer than the useful life of the carpets in the building. Land has an indefinite life, but land improvements have a definite life that is probably shorter than the building on that land. Because all these items have different lives and will be replaced at different times, the costs associated with those pieces of the purchase need to be split up and properly categorized.
On February 24, the business purchases a building and land for $450,000, paying $250,000 in cash and signing a note for the difference. An appraisal company hired by the business assesses the purchase for asset allocation purposes and comes up with the following appraisal:
You might be asking yourself how it is possible that the value is $510,000 when the purchase price was $450,000. One reason this happens is because the individual components are worth more than the bundle. There are also market forces, like a large number of similar buildings or few buyers, that can depress prices. Regardless of the reason, the company needs to find a way to allocate the cost.
The best way to allocate the purchase price is to use ratios. We can easily determine the ratios by using the assessed value of each component to the total assessed value. For example, the building is 49% of the total assessed value. Calculate that by dividing the assessed value of the building by the assessed value of the total purchase.
$250,000 / $510,000 = .49 or 49%
Repeat this for all of the components:
|Land Improvements||$ 90,000||18%|
|Building Fixtures||$ 40,000||8%|
Now that we know the ratio of each component to the total, we can use the ratios to allocate the purchase price of $450,000.
49% X $450,000 = $220,500
25% X $450,000 = $112,500
18% X $450,000 = $ 81,000
8% X $450,000 = $ 36,000
100% X $450,000 =$450,000
Using ratios allows us to allocate the assessment to the purchase price. Using the allocated amounts, we can now write a journal entry for the transaction.
Depreciation of Assets
We previously discussed the expensing or using up of assets. In accounting, the formal term for this is “depreciation”. You have probably heard the term deprecation used when referring to the decline in value of an asset, like a vehicle. In non-accounting terms, depreciation means fall in market value; however, in accounting, we very rarely use market value. In accounting, there is no connection between market value and depreciation.
Depreciation generates an expense, which we call Depreciation Expense (pretty complicated, huh?). If we were writing a journal entry to record depreciation, we would debit Depreciation Expense. What would the credit be? Remember that the cost principle states that assets must be recorded at cost. When we depreciate an asset, did the cost decrease? No. Therefore, we cannot decrease the asset account directly. Instead, we will pair an account with the asset to hold all the depreciation that has accumulated over the years. Do you know what we call that account? Ready for this one? It’s very complicated. We call the account Accumulated Depreciation. See, told you it was complicated. Since Accumulated Depreciation has a normal credit balance, the account is considered a contra-asset. Entries involving depreciation are considered adjusting entries.
Annual depreciation on the company’s equipment is $4,230.
Depreciation entries are one of the easiest types of entries because once you know the dollar value of the transaction, the entry is always the same. The accounts are Depreciation Expense and Accumulated Depreciation. Some companies have one Depreciation Expense and one Accumulated Depreciation account, while others have those accounts for each type of asset (buildings, equipment, computers, furniture and fixtures, etc). We will assume that the company has depreciation accounts for each type of asset.
Disposing of Assets
When a company gets rid of an asset, whether it is sold or just scrapped, the company must record a journal entry to remove the asset and the accumulated depreciation associated with it. The company must also determine if there is a gain or loss on the disposal.
In order to see if there is a gain or loss on an asset, the company must first determine the book value of the asset. Book value is the value of the asset on the company’s books or accounting records. Book value is asset cost less accumulated depreciation. If the company has a vehicle with a cost of $20,000 and accumulated depreciation of $17,000, the book value is $3,000. What if the company sold that vehicle for $5,000 cash on June 10? If the asset is worth $3,000 and is sold for $5,000, the company has a $2,000 gain.
To record the entry for the sale of the vehicle, we must remove $20,000 from Vehicles and $17,000 from Accumulated Depreciation – Vehicles. We must also record the $5,000 cash received for the vehicle and record the gain. A gain is like revenue and the normal balance in the account is a credit.
What if the asset was instead sold for $2,500? If the book value is $3,000, there is now a $500 loss on disposal. A loss behaves like an expense and the normal balance is a debit.
What if the company scraps the car, meaning the company just disposes of it? No cash is received. If the book value is $3,000 and the company receives nothing, there is now a $3,000 loss.
When disposing of assets, remember to remove the entire cost of the asset and all of the accumulated depreciation for that asset. Do not just remove the book value. Disposing of an asset means disposing of all traces of it!