Chapter 10

Property, Plant & Equipment

Property, Plant & Equipment

• Property, plant, and equipment includes land, buildings, and equipment (machinery, furniture, tools).

• Major characteristics include:

“Used in operations” and not for resale.

Long-term in nature and usually depreciated.

Possess physical substance.

PP&E Historical Cost

• Valued at Historical Cost, reasons include:

At acquisition, cost reflects fair value.

Historical cost is reliable.

Companies should not anticipate gains and losses but should recognize gains and losses only when the asset is sold.

Cost of Land

• Includes all costs to acquire land and ready it for use. Costs typically include:

(1)the purchase price;

(2)closing costs, such as title to the land, attorney’s fees, and recording fees;

(3)costs of grading, filling, draining, and clearing;

(4)assumption of any liens, mortgages, or encumbrances on the property; and

(5)Additional land improvements that have an indefinite life.

Cost of Buildings

• Includes all costs related directly to acquisition or construction.

• Costs typically include:

(1)materials, labor, and overhead costs incurred during construction and

(2)professional fees and building permits.

Cost of Equipment

• Include all costs incurred in acquiring the equipment and preparing it for use.

• Costs typically include:

(1)purchase price,

(2)freight and handling charges

(3)insurance on the equipment while in transit,

(4)cost of special foundations if required,

(5)assembling and installation costs, and

(6)costs of conducting trial runs.

Acquisition Costs

(a) Money borrowed to pay building contractor : Notes Payable

(b) Payment for construction from note proceeds: Buildings

(c) Cost of land fill and clearing: Land

(d) Delinquent real estate taxes on property assumed: Land

(e) Premium on insurance policy during construction: Buildings

(f) Refund of 1-month insurance premium because construction completed early: (Buildings)

Acquisition Costs

• (g) Architect’s fee on building: Buildings

• (h) Cost of real estate purchased as a plant site (land $200,000 and building $50,000): Land

• (i) Commission fee paid to real estate agency: Land

• (j) Installation of fences around property: Land Improvements

• (k) Cost of razing and removing building: Land

(l) Proceeds from salvage of demolished building: (Land)

(m) Cost of parking lots and driveways: Land Improvements

(n) Cost of trees and shrubbery (permanent): Land

Self-constructed Assets

• Costs typically include:(1) Materials and direct labor

(2) Overhead can be handled in two ways:

1. Assign no fixed overhead

2. Assign a portion of all overhead to the construction process.

– Companies use the second method extensively.

Interest Costs During Construction

• Three approaches have been suggested to account for the interest incurred in financing the construction.

1. Capitalize no interest during construction 2. Capitalize actual costs incurred during construction (GAAP) 3. Capitalize all cost of funds

GAAP requires — capitalizing actual interest (with modification).

Consistent with historical cost — all costs incurred to bring the asset to the condition for its intended use.

Interest Costs During Construction

• Richard Company begins construction on a building early in 2008 and completes construction by the end of the year. Richard incurred total interest costs on borrowing during 2008 in the amount of $325,000. It determines that $165,000 of these interest costs is attributable to expenditures on the new building.

Buildings 165,000Interest Expense160,000Cash 325,000

Other Valuation Issues

• Companies should record property, plant, and equipment:

at the fair value of what they give up or

at the fair value of the asset received,

• whichever is more clearly evident.• Cash Discounts — whether taken or not —

generally considered a reduction in the cost of the asset.

Acquiring PP&E

• Lump-Sum Purchases

Allocate the total cost among the various assets on the basis of their fair market values.

• Issuance of Stock

The market value of the stock issued is a fair indication of the cost of the property acquired.

Contributions of PP&E

• Companies should use:

the fair value of the asset to establish its value on the books and

should recognize contributions received as revenues in the period received.

Costs Subsequent to Acquisition

• In general, costs incurred to achieve greater future benefits should be capitalized, whereas expenditures that simply maintain a given level of services should be expensed.

• To capitalize costs, one of three conditions must be present:

Useful life of the asset must be increased.

Quantity of units produced from asset must be increased.

Quality of units produced must be enhanced.

Costs Subsequent to Acquisition

• Major Types of Expenditures

Additions

Improvements and replacements

Rearrangement and reinstallation

Repairs

[See Illustration 10-6, in the text, for summary of normal accounting treatment for these expenditures.]

Depreciation

• Depreciation is the accounting process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset.

• Allocating costs of long-term assets:

Fixed assets = Depreciation expense

Intangibles = Amortization expense

Natural resources = Depletion expense

Depreciation

• Factors Involved in the Depreciation Process

(1)What depreciable base is to be used?

(2)What is the asset’s useful life?

(3)What method of cost allocation is best?

Depreciation Methods

• The profession requires the method employed be “systematic and rational.” Examples include:

(1)Activity method (units of use or production).

(2)Straight-line method.

(3)Sum-of-the-years’-digits.

(4)Declining-balance method.

Calculating Depreciation

• Robert Parish Corporation purchased a new machine for its assembly process on September 30, 2007. The cost of this machine was $117,900. The company estimated that the machine would have a salvage value of $12,900 at the end of its service life. Its life is estimated at 5 years and its working hours are estimated at 1,000 hours. Year-end is December 31.

• (a) Straight-line depreciation.• (b) Activity method.• (c) Sum-of-the-years’-digits.• (d) Double-declining balance.

Straight-line Depreciation

CurrentDepreciable Annual Partial Year Accum.

Year Base Years Expense Year Expense Deprec.

2007 105,000$ / 5 = 21,000$ x 3/12 = 5,250$ 5,250$

2008 105,000 / 5 = 21,000 21,000 26,250

2009 105,000 / 5 = 21,000 21,000 47,250

2010 105,000 / 5 = 21,000 21,000 68,250

2011 105,000 / 5 = 21,000 21,000 89,250

2012 105,000 / 5 = 21,000 x 9/12 = 15,750 105,000

105,000$

J ournal entry:

2007 Depreciation expense 5,250

Accumultated depreciation 5,250

Activity Method

($105,000 / 1,000 hours = $105 per hour)(Given) CurrentHours Rate per Annual Partial Year Accum.

Year Used Hours Expense Year Expense Deprec.

2007 200 x $105 = 21,000$ 21,000$ 21,000$

2008 150 x 105 = 15,750 15,750 36,750

2009 250 x 105 = 26,250 26,250 63,000

2010 300 x 105 = 31,500 31,500 94,500

2011 100 x 105 = 10,500 10,500 105,000

1,000 105,000$

J ournal entry:

2007 Depreciation expense 21,000

Accumultated depreciation 21,000

Sum of the Years’ Digits

CurrentDepreciable Annual Partial Year Accum.

Year Base Years Expense Year Expense Deprec.

2007 105,000$ x 5/15 = 35,000$ x 3/12 8,750$ 8,750$

2008 105,000 x 4.75/15 = 33,250 33,250 42,000

2009 105,000 x 3.75/15 = 26,250 26,250 68,250

2010 105,000 x 2.75/15 = 19,250 19,250 87,500

2011 105,000 x 1.75/15 = 12,250 12,250 99,750

2012 105,000 x .75/15 = 5,250 5,250 105,000

105,000$

J ournal entry:

2007 Depreciation expense 8,750

Accumultated depreciation 8,750

Double Declining Balance(note: calculations are incorrect)

CurrentDepreciable Rate Annual Partial Year Accum.

Year Base per Year Expense Year Expense Deprec.

2007 117,900$ x 40% = 47,160$ x 3/12 = 11,790$ 11,790$

2008 106,110 x 40% = 42,444 42,444 54,234

2009 63,666 x 40% = 25,466 25,466 79,700

2010 38,200 x 40% = 15,280 15,280 94,980

2011 22,920 x 40% = 9,168 9,168 104,148

2012 13,752 x 40% = 5,501 Plug 852 105,000

105,000$

J ournal entry:

2007 Depreciation expense 11,790

Accumultated depreciation 11,790

Depreciation Issues

(1) How should depreciation be computed for partial periods?Companies normally compute depreciation on the basis of the nearest full month.

(2) How are revisions in depreciation rates handled?

• Changes in Depreciation Rate

Accounted for in the period of change and future periods (Change in Estimate)

Not handled retrospectively

Not considered errors or extraordinary items

Sale of Plant Assets• Sim City Corporation owns machinery that cost $20,000 when

purchased on January 1, 2005. Depreciation has been recorded at a rate of $3,000 per year, resulting in a balance in accumulated depreciation of $9,000 at December 31, 2007. The machinery is sold on September 1, 2008, for $10,500. Prepare journal entries to (a) update depreciation for 2008 and (b) record the sale.

(a) Depreciation Expense ($3,000 x 8/12) 2,000

Accumulated Depreciation 2,000

(b) Cash 10,500

Accumulated Depreciation 11,000

Machinery 20,000

Gain on Sale 1,500

Involuntary Conversion

• Sometimes an asset’s service is terminated through some type of involuntary conversion such as fire, flood, theft, or condemnation.

• Companies report the difference between the amount recovered (e.g., from a condemnation award or insurance recovery), if any, and the asset’s book value as a gain or loss.

• They treat these gains or losses like any other type of disposition.

Exchanges

• Ordinarily accounted for on the basis of:

the fair value of the asset given up or

the fair value of the asset received,

• whichever is clearly more evident. • Companies should recognize immediately any

gains or losses on the exchange when the transaction has commercial substance (future cash flows change as a result of the transaction).

Accounting for Exchanges

• * If cash is 25% or more of the fair value of the exchange, recognize entire gain because earnings process is complete.

Exchanges—Calculating Gain or Loss

• Companies recognize a loss immediately whether the exchange has commercial substance or not.

• Rationale: Companies should not value assets at more than their cash equivalent price; if the loss were deferred, assets would be overstated.

Arruza LoBianco

Fair value of equipment received $12,500 $15,500

Cash received / paid 3,000 (3,000)

Less: Bookvalue of equipment

($28,000-19,000) (9,000)

($28,000-10,000) (18,000)

Gain or (Loss) on Exchange $6,500 ($5,500)

Summary of Gain and Loss Recognition on Exchanges of Nonmonetary Assets Lacks Commercial Substance

PP&E Disclosures

• Depreciating assets, use Accumulated Depreciation.• Depleting assets may include use of Accumulated

Depletion account, or the direct reduction of asset.

Basis of valuation (cost)Pledges, liens, and other commitmentsDepreciation expense for the period.Balances of major classes of depreciable assets.Accumulated depreciation.A description of the depreciation methods used.

Ratio Analysis

Return on Sales:Net Income

SalesAsset Turnover:

Sales Average Total AssetsReturn on Assets: Net income Average Total Assets

PP&E Disclosure Issues

• Magnitude depends on industry & business strategy.

• Age of fixed assets can be important; use average age & other ratios

• Various acquisition, disposal & write-off issues• Occasionally related to fraud, such as Waste

Management

Average Age Calculations

• Average age = (accumulated depreciation / depreciation expense)

• Average depreciable life = (ending gross investment / depreciation expense)

• Average age % = (accumulated depreciation / ending gross investment)

• Older plants are typically less efficient & subject to breakdowns