Chapter 9
Plant Assets
Plant Assets are also called fixed assets; property, plant and equipment; plant
and equipment; long-term assets; operational assets; and long-lived assets.
They are characterized by:
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have a useful life of more than one year;
used in the operation of the business; and
are not intended for resale to customers (not inventory).
Plant assets are tangible assets. "Tangible assets" are assets that you can
touch. Plant assets include land, buildings, equipment, and natural resources.
Determining the Cost of Plant Assets
Plant assets are recorded at cost (historical cost principle). The cost of plant
assets include the purchase cost, freight charges ("freight in"), insurance while in
transit, taxes, tariffs, buying expenses, installation costs, test runs, and other
costs involved in the acquisition of the asset. These are costs necessary to get
the asset ready for use. If a cost is not necessary, then it is an expense (e.g.,
vandalism, mistakes in installation, uninsured theft, damage during unpacking
and installing, and fines for not obtaining proper permits from government
agencies).
When a cost incurred is added to the cost of an asset, it is referred to as a capital
expenditure. When a cost (an expense) is not capitalized as a cost of an asset,
but is instead expensed, it is referred to as a revenue expenditure.
When one asset is traded for another asset, then the fair market value of the
property given for the new asset is treated as the historical cost of the new asset.
Your book refers to this as the cash equivalent price. This is an
oversimplification of the actual treatment.
When a group of long-term assets is purchased for a lump sum (a basket
purchase), the cost should be allocated to the assets acquired in proportion to
their appraised values. For example, if you purchase an existing building, the
acquisition cost must be allocated between the land, building and other assets
acquired.
The cost of an asset constructed includes materials, labor and overhead.
Examples of the Treatment of Acquisition Costs of Assets.
Land
When land is purchased, the "Land" account is debited for:
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the price paid for the land;
real estate commissions;
lawyers' fees;
back taxes assumed (these are taxes accrued while the property was
owned by the seller, but the taxes are paid by the buyer);
draining, clearing, landscaping, and grading costs;
assessments for local improvements; and
the cost (less salvage value) of razing structures situated on the property.
Land Improvements
Land improvements, such as driveways, parking lots, fences and signs, are
subject to depreciation and require a separate Land Improvements account.
Buildings
The cost of buildings purchased includes the applicable items described above
and the cost of any repairs made in order to make the building usable. If a
building is construction, the construction costs are added to the cost of the
building.
Interest incurred during the construction of a building or other plant asset is
included in the cost of the asset (capitalized interest). This is true even if the
loan was not directly used to construct the asset. Interest incurred for the
purchase of a plant asset is expensed when incurred.
Equipment
The cost of equipment includes the price paid, sales taxes, freight charges, and
insurance during transit paid by the purchaser. It also includes expenditures
required in assembling, installing, and testing the unit.
Journal Entries For Acquiring Fixed Assets (Not in Book)
The acquisition of plant assets is often financed by issuing stock, notes, or bonds
or through operations.
When an asset is purchased for cash, the general journal entry is as follows:
D. Equipment
Cr. Cash
$5,000
$5,000
When an asset is purchased for debt, the general journal entry is as follows:
D. Equipment (cost)
Cr. Cash (down payment)
Notes Payable (amount borrowed)
$5,000
$1,000
4,000
When an asset is acquired for equity, the general journal entry is as follows:
D. Equipment (cost)
Cr. Common Stock (par value)
APIC (cost in excess of par)
$5,000
$1,000
4,000
To Buy or Lease?
A lease is a contract that allows a business or an individual to use an asset for a
specific length of time in return for periodic payments. There are two types of
leases: (i) operating leases; and (ii) capital leases. Capital leases are financing
transactions. The lessee (renter) is treated as having acquired the leased
property through the use of financing (the Capital Lease). An operating lease is
a lease that does not meet the criteria for “Capital Leases”.
There are advantages for leasing plant assets:
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Reduced Risk of Obsolescence. The lease may allow the lessee to
exchange the leased asset for a more modern one if it becomes outdated.
Little or No Down Payment. In order to purchase an asset, the purchaser
must usually pay a material portion of the purchase price in cash (e.g.,
20%). Leases require little or no down payment.
Shared Tax Advantages. With some leases (e.g., operating leases), the
lessor (rather than the lessee) receives the depreciation tax deduction.
The lessee may not need the tax deduction, and the lessor is willing to
accept lower rental payments in exchange for receiving the tax deduction.
Assets and Liabilities Not Reported. In the case of operating leases, the
lessee is not treated as the owner of the asset, and therefore does not
report the assets and the associated liabilities on their balance sheet.
Journal Entries Relating To Leases (Not In Book)
Rental payments under an operating lease are treated as a rent expense for
each period the asset is leased:
D. Rent Expense
Cr. Cash
$5,000
$5,000
Capital leases are not really leases. They are financing transactions. You are
really buying an asset; not leasing it. Many car leases are, in fact, financing
transactions. A capital lease (as determined by certain criteria) is in substance a
sale and should be recorded as an asset (to be depreciated) and a related
liability by the lessee.
When the capital lease is signed, the lessee makes journal entries that record the
acquisition of an asset and liability. The purchase price and the amount of the
liability is the present value of all of the payments under the lease:
D. Equipment Under Capital Lease (present value of lease
payments)
Cr. Obligations Under Capital Lease (present value of
lease payments)
$5,000
$5,000
At the end of each year, the lessee depreciates the leased asset:
D. Depreciation Expense
Cr. Accumulated Depreciation, Equipment Under Capital
Lease
$1,000
$1,000
Each payment under the lease is treated as a payment on the debt. A portion is
treated as interest and a portion is treated as principal:
D. Interest Expense (amount paid over present value)
Obligations Under Capital Lease (amount related to present
value)
Cr. Cash
$200
800
$1,000
Depreciation
In dealing with long-term assets, the major accounting problem is to determine
how much of the asset has benefited the current period (e.g., expenses) and how
much should be carried forward as an asset to benefit future periods (e.g.,
assets).
This allocation of costs to different accounting periods is called:
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depreciation in the case of plant and equipment (property, plant and
equipment);
depletion in the case of natural resources, and
amortization in the case of intangible assets.
Because land has an unlimited useful life, its cost is never converted into an
expense.
The unexpired cost of an asset is called the carrying value (also book value), and
is equal to the cost less accumulated depreciation.
Equipment (cost of asset)
Less: Acc. Depr. (All Depr to date)
Book Value or Carrying Value
$10,000
-4,000
$6,000
Depreciation, as used in accounting, refers to the allocation of the cost (less the
residual value) of a plant asset to the periods benefited by the asset. It does not
refer to the physical deterioration or the decrease in market value of the asset; it
is a process of allocation, not valuation. Your book notes that the useful life of an
asset is limited by physical depreciation (e.g., as you drive your car, it
deteriorates and breaks down) and functional depreciation (e.g., as your
computer gets older it can't handle newer computer programs).
A plant asset should be depreciated over its estimated useful life in a systematic,
rational manner. Depreciation can be computed once the cost, salvage value,
and estimated useful life have been determined.
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Cost is the cost of the asset calculated in the manner described above.
Salvage Value is the estimated value at the disposal date; it is often
referred to as "residual value" or "disposal value".
Estimated useful life is the period in which the company will use the plant
asset. It is measured in time or in units.
Depreciable cost equals the cost less the salvage value. It represents the net
cost of the asset’s use by the. For example, if a company buys a computer for
$1,000 and intends to sell it for $100 after it is finished using the computer, the
company’s use of computer costs the company $900. The depreciation expense
may not exceed the depreciable cost of the asset.
The following journal entry is used in connection with depreciation.
D. Depreciation Expense, Asset Name
Cr. Accumulated Depreciation, Asset Name
$1,000
$1,000
The most common methods of depreciation are:
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The straight-line method (based on the passage of time)
The declining-balance method (an accelerated method), and
The units-of-activity method (based on units produced, miles driven, and
the like)
Straight-Line Method
Under the straight-line method, the depreciable cost is spread uniformly over the
estimated useful life of the asset. Depreciation for each year is computed as
follows:
Cost - Salvage Value
-------------------------------------Estimated useful life in years
For example, if you had an asset with a cost of $10,000, a salvage value of
$1,000, and a useful life of 10 years, each year you would take $900 of
depreciation ($10,000 - $1,000)/10.
Declining-Balance Method
Accelerated methods of depreciation result in larger depreciation in the early
years of an asset's life. Under the declining-balance method, depreciation is
computed by multiplying the existing carrying value of the asset by a fixed
percentage. The double-declining-balance method is a form of the decliningbalance method; it uses a fixed percentage that is twice the straight-line
percentage.
Under the double-declining-balance method, the fixed percentage is double the
percentage used in the straight line calculation. For example, if the useful life is
10 years, then the straight-line depreciation would be 1/10 (10%) of the
depreciable cost. With the double declining balance method, you would use
twice the straight-line rate (20%). This percentage is then multiplied against the
existing book value of the asset for the year in question.
Note that the declining-balance method does not use residual value in figuring
the rate. Despite this, you are not allowed to depreciate the asset below the
residual vale. In other words, depreciation is limited to the amount necessary to
bring the carrying value down to the estimated residual value.
Units-of-Activity Method
This is often referred to as the units-of-production method or the production
method. This method is similar to the straight-line method. Under the straightline method, the cost of the asset is spread out evenly over the period in which
the asset is used. Under the units-of-production method, the cost is spread
evenly over the units produced by the asset.
Depreciation for each year is computed as follows:
Cost - Salvage Value
------------------------------------Estimated units of useful life
Units of production method is a good application of the matching principle but
can only be used if output over useful life can be estimated with reasonable
accuracy.
Depreciation and Income Taxes
The Internal Revenue Code uses the Modified Accelerated Cost Recovery
System (MACRS), which computes depreciation in a manner that is different than
the depreciation methods used in financial accounting. For example, under
MACRS, set recovery periods are used instead of the actual useful lives of given
assets.
A company is not required to use the same depreciation methods for tax
purposes and financial statement purposes. Because a company may wish to
maximize its profits, it will choose to minimize its depreciation expense by using
the straight-line method. On the other hand, the same company may wish to
minimize its income taxes, and therefore will minimize its income by using an
accelerated depreciation method.
Depreciation Disclosure in the Notes
A company must disclose the depreciation methods that it employs. This
disclosure is made in the notes to the financial statements.
Revising Periodic Depreciation
When a company changes an estimate which was used in calculated
depreciation expense (e.g., extending the useful life of an asset or changing the
residual value of the asset), then the company, using the remaining book value of
the asset, recalculates the depreciation expense of the asset, leaving previous
depreciation unchanged.
Other Comments on Depreciation (Not In Book)
Besides calculating depreciation on an asset by asset basis, assets may be
depreciated by grouping them together with other assets with similar traits.
Depreciation is calculated on the group as a whole.
When an asset is purchased after the beginning of the year or is discarded
before the end of the year, depreciation is recorded for only part of the year. This
is done by computing the year's depreciation and multiplying this figure by the
fraction of the year that the asset was in use.
Expenditures During Useful Life
Expenditures relating to plant assets (payments or obligations to make future
payments) are of two types:
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Capital expenditures, such as the purchase or expansion of a building,
benefit several periods and are recorded as the acquisition of assets
("capitalized").
Revenue expenditures, such as operation and maintenance costs, benefit
only the current period and are recorded as expenses ("expensed").
Ordinary repairs are expenditures necessary to maintain an asset in good
operating condition; they are charged as an expense in the period incurred.
Your book refers to capital expenditures as additions and improvements. They
are described as costs that increase the operating efficiency, productive capacity
or expected useful life of existing plant assets.
Capital Expenditures (Not In Book)
Capital expenditures on an asset that you already own are usually described as
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Additions;
Betterments; or
Extraordinary Repairs
An addition adds a new feature to an existing building. An example of an addition
would be adding a new room to a building. The cost is capitalized and then
depreciated (expensed) over the useful life of the room or the building, whichever
is shorter. A new asset is created by the expenditure
A betterment improves a fixed asset's operating efficiency or capacity for its
remaining useful life. It is added to the cost of the original asset. An example
would be exchanging the hard drive of a computer for a newer one with more
capacity. The cost of the new drive is added to the computer’s cost, and the cost
and any accumulated depreciation related to the old hard drive should be
removed from the computer’s cost.
Extraordinary repairs are expenditures that either increase an asset's residual
value or lengthen its useful life (e.g., a major overhaul of a car engine).
Extraordinary repairs are recorded by debiting Accumulated Depreciation and
crediting Cash. This has the effect of increasing the book value of the asset, but
makes it appear less depreciated. The thought is that by making the
extraordinary repair, you have undone the previous depreciation.
D. Accumulated Depreciation, Asset Name
Cr. Depreciation Expense, Asset Name
$2,000
$2,000
If a capital expenditure is recorded mistakenly as a revenue expenditure, current
period expense is overstated and net income is understated. In future periods,
net income will be overstated since it was all expensed in the first period. The
opposite effects would be true for a revenue expenditure recorded mistakenly as
a capital expenditure.
Impairments
As noted above, the historical cost of a plant asset is used in a company’s
balance sheet. The balance sheet is also governed by the principle of
conservatism. When the market value of an asset falls below the book value of
the asset, the asset is impaired. A company is required to write down the book
value of the impaired asset to its fair market value in the year that the decline in
value occurs.
The journal entry to reflect the impairment loss is reflected below:
D. Impairment Loss
Cr. Asset Name
$10,000
$10,000
Plant Asset Disposals
Disposal occurs when the asset is discarded, sold, or traded in. When a business
disposes of an asset, depreciation is recorded for the period preceding disposal.
This brings the asset's Accumulated Depreciation account up to the date of
disposal.
When a machine is discarded, Accumulated Depreciation, Machinery is debited
and Machinery is credited for their present balances.
If the machine is fully depreciated:
D. Accumulated Depreciation, Machinery
Cr. Machinery
$10,000
$10,000
If the machine has not been fully depreciated, then Loss on Disposal of
Machinery must be debited for the carrying value to balance the entry.
D. Accumulated Depreciation, Machinery
Loss on Disposal of Machinery
Cr. Machinery
$7,000
3,000
$10,000
When a machine is sold for cash, Accumulated Depreciation, Machinery is
debited, Cash is debited, and Machinery is credited.
If a machine is sold for its book value:
D. Cash
Accumulated Depreciation, Machinery
Cr. Machinery
$3,000
7,000
$10,000
If the cash received is less than the carrying value of the machine, then Loss on
Sale of Machinery would also be debited. On the other hand, if the cash received
is greater than the carrying value, then Gain on Sale of Machinery would be
credited to balance the entry.
$2,000
D. Cash
Accumulated Depreciation, Machinery
7,000
Loss on Sale Machinery
1,000
Cr. Machinery
(Sale of machine at less than carrying value; loss recorded)
D. Cash
Accumulated Depreciation, Machinery
Cr. Machinery
Gain on Sale of Machinery
(Sale of machine at more than carrying value)
$4,000
7,000
$10,000
$10,000
1,000
Trade Ins (Not In Book)
When an asset is traded in (exchanged) for a similar one, the gain or loss should
first be computed, as follows:
Trade-in allowance
- Carrying value of asset traded in
--------------------------------------------Gain (loss) on trade-in
For financial reporting purposes, both gains and losses should be recognized
(recorded) on the exchange of dissimilar assets. Gains should not be recognized
on the exchange of similar assets. Losses are recognized.
For income tax purposes, neither gains nor losses should be recognized on the
exchange of similar assets, but both should be recognized on the exchange of
dissimilar assets. When a gain or loss is to be recognized, the asset acquired
should be debited for its list price (cash paid plus trade-in allowance); a realistic
trade-in value is assumed. The old asset is removed from the books, as
explained above.
When a gain or loss is not to be recognized, the asset acquired should be
debited for the carrying value of the asset traded in plus cash paid (this will result
in non-recognition of the gain or loss).
If you received a new machine worth $15,000 in exchange for cash of $9,000
and an old machine with a book value of $3,000, you would record the new
machine at $12,000 ($3,000 book value + cash of $9,000):
D. Machinery (New)
Accumulated Depreciation, Machinery (Old)
Cr. Machinery (Old)
Cash
$12,000
7,000
$10,000
9,000
If a gain was recognized on the above transaction, then the new machine would
be recorded at its fair market value and a gain of $3,000 would be recognized on
the receipt of a credit of $6,000 for the old machine with the book value of
$3,000.
D. Machinery (New)
Accumulated Depreciation, Machinery (Old)
Cr. Machinery (Old)
Cash
Gain on Exchange of Machine
$15,000
7,000
$10,000
9,000
3,000
Natural Resources (Not in Book)
Natural resources are tangible non-monetary assets containing valuable
substances that may be extracted and sold. They are sometimes referred to as
"wasting assets", and include standing timber, oil and gas fields, and mineral
deposits. Depletion refers to the allocation of a natural resource's cost to
accounting periods based on the amount extracted each period. Depletion for
each year is computed as follows:
Cost - residual value
--------------------------------------------- x actual units extracted during period
Estimated units to be extracted
Units extracted but not sold during the year are recorded as inventory, to be
charged as an expense in the year sold. Tangible assets used with natural
resources should be depreciated over the shorter of the life of the tangible asset
or the life of the natural resource.
There are two acceptable methods of accounting for exploration and
development of oil and gas reserves.
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Under successful efforts accounting, the cost of producing wells is
capitalized and depleted, while the cost of dry wells is expensed
immediately.
Under the full-costing method, the cost of all wells is capitalized and
depleted.
The following journal entry relates to depletion:
D. Depletion Expense, Coal Deposits
Cr. Accumulated Depletion, Coal Deposits
$1,000
$1,000
Analyzing Plant Assets
Financial Analysts often use two ratios to evaluate a company’s use of its plant
assets:
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Return on Assets Ratio, and
Asset Turnover Ratio
Return on Assets Ratio
Financial Analysts often look at the profit earned on the company’s assets. The
Return on Assets Ratio is calculated as follows:
Net Income
-----------------------Average Total Assets
Asset Turnover Ratio
The Asset Turnover Ratio looks at the productivity of a company’s assets (rather
than their profitability). This ratio is calculated as follows:
Net Sales
---------------------------Average Total Assets
Profit Margin Ratio Revisited
The Profit Margin and the Asset Turnover Ratio are components of the Return on
Assets:
Profit Margin
X
Asset Turnover Ratio
=
Return On Assets
Net Income
Net Sales
X
Net Sales
Average Total Assets
=
Net Income
Average Total Assets
Net Sales in the Profit Margin and the Asset Turnover Ratio cancel out and leave
you with the Return on Assets. This relationship demonstrates the fact that if a
company wishes to increase its profitability, it can either:
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increase its profit margin (earn more income on its given revenue), or
increase its asset turnover ratio (make its assets more productive).
Intangible Assets
Intangible assets are long-term assets that have no physical substance; they
represent certain legal rights and advantages extended to their owner. Examples
of intangible assets are patents, copyrights, trademarks, goodwill, leaseholds,
leasehold improvements, franchises, licenses, brand names, formulas, and
processes.
An intangible asset should be written off over its useful life through a process
called amortization in accordance with the matching principle. Assets with an
indefinite useful life should not be amortized. These assets however still must be
written down as impaired assets if their fair market value declines below their
book value.
Rather than using a contra account to reduce the asset being amortized (as was
the case with Accumulated Depreciation and Accumulated Depletion), the
intangible asset is reduced by its Amortization expense. There is no contra
account.
The journal entry for amortization is as follows:
D. Amortization Expense, Patent
Cr. Patent
$1,000
$1,000
Patents
A patent is an exclusive legal right to use an invention for 20 years. The cost of a
patent should be amortized over the shorter of its useful life or its legal life. If a
company incurs legal costs in successfully defending its patent, these costs are
added to the cost of the patent and amortized over its remaining life.
Research and Development Costs
Research and development encompass the development of new products, the
testing of existing and proposed products, and pure research. According to
GAAP, research and development costs normally should be expensed in the
period incurred.
The cost of developing computer software should be treated as research and
development up to the point where a product is deemed technologically feasible.
From that point on, software production costs should be capitalized and
amortized over their useful lives using the straight-line method.
Copyrights
A copyright is an exclusive legal right to publish literary, musical, and other
artistic materials and software. For individuals, the copyright period is the
creator’s life plus 50 years. The cost of a copyright should be amortized over the
shorter of its useful life or its legal life. If a company incurs legal costs in
successfully defending its copyright, these costs are added to the cost of the
copyright and amortized over its remaining life.
Trademarks and Trade Names
Trademarks and trade names are the exclusive rights to use registered symbols
and names to identify a product or service. Trademarks and trade names are
registered with the U.S. Patent Office. Such registration provides 20 years’
protection and may be renewed indefinitely as long as the trademark or trade
name is in use. Because trademarks and trade names have an indefinite life,
they are not amortized.
Franchises and Licenses
A franchise grants the franchisee the exclusive right to operate a business in a
given territory (e.g., a Wendy’s). A license grants the licensee the right to use
property or a process (e.g., formula, technique, process, or design) of another
person, company or government. Annual payments on a franchise or license are
an operating expense. The cost of acquiring a franchise or license should be
amortized over its useful life. If the useful life is indefinite, then there should be
no amortization.
Goodwill
Goodwill, as the term is used in accounting, refers to a company's ability to earn
more than is normal for its particular industry or for the amount of its
capitalization (net assets). Goodwill is recorded only when a company is
purchased and equals the excess of the purchase cost over the fair market value
of the net assets. Goodwill is considered to have an indefinite useful life, and
therefore is not amortized. However, a company is required to examine whether
its Goodwill is impaired on an annual basis.
Leasehold (Not In Book)
A leasehold is the purchased right to rent property for a long period of time.
Leasehold improvements are improvements made to leased property that revert
to the lessor at the end of the lease. They are amortized over the shorter of: (i)
the useful life of the improvements or (ii) the remaining term of the lease.