Chapter Ten: Property, Plant, & Equipment

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Industrial Plant pictureProperty, Plant, & Equipment is a separate category on a classified balance sheet. It typically follows Long-term Investments and is oftentimes referred to as “PP&E.” Items appropriately included in this section are the physical assets deployed in the productive operation of the business, like land, buildings, and equipment. Note that idle facilities and land held for speculation are more appropriately listed in some other category on the balance sheet, like Long-term Investments.

Within the PP&E section, items are customarily listed according to expected life. Land comes first, followed by buildings, then equipment. For some businesses the amount of Property, Plant, & Equipment can be substantial. This is the case for firms that have large investments in manufacturing operations or significant real estate holdings. Other service or intellectual-based businesses may actually have very little to show within this balance sheet category.

Below is an example of a typical PP&E section on the balance sheet:

PP&E on the Balance Sheet

In the alternative, many companies relegate the preceding level of detail into a note accompanying the financial statements, and instead just report a single number for "property, plant, and equipment, net of accumulated depreciation" on the face of the balance sheet.

cost assignment

The correct amount of cost to allocate to a productive asset is based on those expenditures that are ordinary and necessary to get the item in place and in condition for its intended use. Such amounts include the purchase price (less any negotiated discounts), permits, freight, ordinary installation, initial setup/calibration/programming, and other normal costs associated with getting the item ready to use. These costs are termed capital expenditures and are assigned to an asset account. In contrast, other expenditures may arise that are not “ordinary and necessary,” or benefit only the immediate period. These costs should be expensed as incurred. An example is repair of abnormal damage caused during installation of equipment.

Assume that Pechlat purchased a new lathe. The lathe had a list price of $90,000, but Pechlat negotiated a 10% discount. In addition, Pechlat agreed to pay freight and installation of $5,000. During installation the lathe’s spindle was bent and had to be replaced for $2,000. The journal entry to record this transaction is:

Cost Assignment Journal Entry

interest and training cost

Interest paid to finance the purchase of property, plant, and equipment is expensed. An exception is interest incurred on funds borrowed to finance construction of plant and equipment. Such interest related to the period of time during which active construction is ongoing is capitalized. Interest capitalization rules are quite complex, and are typically covered in intermediate accounting courses.

The acquisition of new machinery is oftentimes accompanied by employee training regarding correct operating procedures. The normal rule is that training costs are expensed. The logic is that the training attaches to the employee not the machine, and the employee is not owned by the company. On rare occasion, justification for capitalization of very specialized training costs (where the training is company specific and benefits many periods) is made, but this is the exception rather than the rule.

land

When acquiring land, certain costs are ordinary and necessary and should be assigned to Land. These costs include the cost of the land, title fees, legal fees, survey costs, and zoning fees. Also included are site preparation costs like grading and draining, or the cost to raze an old structure. All of these costs may be considered ordinary and necessary to get the land ready for its intended use. Some costs are land improvements. This asset category includes the cost of parking lots, sidewalks, landscaping, irrigation systems, and similar expenditures. Why separate land and land improvement costs? The answer to this question will become clear when depreciation is considered. Land is considered to have an indefinite life and is not depreciated. Alternatively, parking lots, irrigation systems, and so forth do wear out and must be depreciated.

lump-sum acquisition

A company may buy an existing facility consisting of land, buildings, and equipment. The negotiated price is usually a “turnkey” deal for all the components. While the lump-sum purchase price for the package of assets is readily determinable, assigning costs to the individual components can become problematic. Yet, for accounting purposes, it is necessary to allocate the total purchase price to the individual assets acquired. This may require a proportional allocation of the purchase price to the individual components.

To illustrate, assume Dibitanzl acquired a manufacturing facility from Malloy for $2,000,000. Assume that the facility consisted of land, building, and equipment. If Dibitanzl had acquired the land separately, its estimated value would be $500,000. The estimated value of the building is $750,000. Finally, the equipment would cost $1,250,000 if purchased independent of the “package.” The sum of the values of the components comes to $2,500,000 ($500,000 + $750,000 + $1,250,000). Yet, the actual purchase price was only 80% of this amount ($2,500,000 X 80% = $2,000,000). The accounting task is to allocate the actual cost of $2,000,000 to the three separate pieces, as shown by the following:

Pruchase Price Allocation example

The preceding allocation process proportionately assigns cost based on value, as shown by this illustration:

Lump Sum pie chart

The above calculations form the basis for the following entry:

Lump-Sum Acquisition Journal entry

It is important to note that the preceding allocation approach would not be used if the asset package constituted a “business.” Those procedures were briefly addressed in the previous chapter.

judgment

Accounting may seem to be mechanical. However, there is a need for the exercise of judgment. Professional judgment was required to estimate the value of the components for purposes of making the preceding entry. Such judgments are oftentimes an inescapable part of the accounting process. Note that different estimates of value would have caused a different proportion of the $2,000,000 to be assigned to each item.

Does the allocation really matter? It is actually very important because the amount assigned to land will not be depreciated. Amounts assigned to building and equipment will be depreciated at different rates. Thus, the future pattern of depreciation expense (and therefore income) will be altered by this initial allocation. Investors pay close attention to income and proper judgment becomes an important element of the accounting process.

materiality

Many expenditures are for long-lived assets of relatively minor value. Examples include trash cans, telephones, and so forth. Should those expenditures be capitalized and depreciated over their useful life? Or, does the cost of record keeping exceed the benefit? Many businesses simply choose to expense small costs as incurred. The reason is materiality; no matter which way one accounts for the cost, it is not apt to bear on anyone’s decision-making process about the company. This again highlights the degree to which professional judgment comes into play in the accounting process.

 

Service Life and Cost Allocation

Casually, people will speak of depreciation as a decline in value or “using-up” of an asset. However, in accounting jargon, the term is meant to refer to the allocation of an asset’s cost to the accounting periods benefited. It is not an attempt to value the asset. Thus, it is often said that depreciation is a process of “allocation” not “valuation.” Once an asset’s cost is determined, it next becomes necessary to determine the accounting periods benefited (i.e., service life).

Determining the service life of an asset is an essential first step in calculating the amount of depreciation attributable to a specific period. Several factors must be considered:

Physical deterioration -- “Wear and tear” will eventually cause most assets to simply wear out and become useless. Thus, physical deterioration serves to establish an outer limit on the service life of an asset.

Obsolescence -- The shortening of service life due to technological advances that cause an asset to become out of date and less desirable.

Inadequacy -- An economic determinant of service life which is relevant when an asset is no longer fast enough or large enough to fill the competitive and productive needs of a company.

Factors such as these must be considered in determining the service life of a particular asset. In some cases, all three factors come into play. In other cases, one factor alone may control the determination of service life. Importantly, service life can be completely different from physical life. For example, computers are often replaced even though still physically functional.

Recognize that some assets have an indefinite (or permanent) life. One prominent example is land. Accordingly, it is not considered to be a depreciable asset.

 

Depreciation Concepts

Once the cost and service life of an asset are determined, it is time to move on to the choice of depreciation method. The depreciation method is simply the pattern by which the cost is allocated to each of the periods involved in the service life. There are many methods from which to choose. Three popular methods are:

  • straight-line
  • units-of-output, and
  • double-declining balance

Why so many choices? To explain, begin by assuming that a $100 asset is to be depreciated over four years. Under the straight-line approach, depreciation expense is simply $25 per year (shown in burgundy below). This may seem very logical if the asset is used uniformly over the four-year period. But, what if maintenance costs (shown in green) are also considered? As an asset ages, it is not uncommon for maintenance costs to expand. Assume the first-year maintenance is $0 and rises each year as shown. Combining the two costs together reveals an increase in total cost, even though the usage is deemed to be constant.

With accelerated depreciation (shown below), the combined amount of depreciation and maintenance provides a level measure of total cost. This may achieve a better matching of total costs and benefits in this particular scenario. Does this mean that accelerated depreciation is better? Not necessarily. Facts can vary, and the point is to show why multiple methods exist and can be justified.

Straight-Line Effects

Straight-line Effects illustration

Accelerated Effects

Accelerated Effects illustration

SOME IMPORTANT TERMINOLOGY

In any discipline, precision is enhanced by adopting terminology that has very specific meaning. Accounting for Property, Plant, & Equipment is no exception. An exact understanding of the following terms is paramount:

  • Cost: The dollar amount assigned to a particular asset, usually the ordinary and necessary amount expended to get an asset in place and in condition for its intended use.
  • Service life: The useful life of an asset to an enterprise, usually relating to the anticipated period of productive use of the item.
  • Salvage value: Also called residual value. This is the amount expected to be realized at the end of an asset’s service life; for example, the anticipated future sales proceeds for used equipment.
  • Depreciable base: The cost minus the salvage value. Depreciable base is the amount of cost that will be allocated to the service life.
  • Book value: Also called net book value. This refers to the balance sheet amount at a point in time that reveals the cost minus the amount of accumulated depreciation (book value has other meanings when used in other contexts, so this definition is limited to its use in the context of PP&E).

Below is an illustration relating these terms to the financial statement presentation for a building:

Building Depreciation example

Building Depreciation example terms

In the preceding illustration, assuming straight-line depreciation, what is the asset’s age? The $2,000,0000 depreciable base ($2,300,000 - $300,000) is evenly spread over 20 years. This produces annual depreciation of $100,000. As a result, the accumulated depreciation of $1,500,000 suggests an age of 15 years (15 X $100,000).

 

Depreciation Methods

Video LectureThere are many possible depreciation methods, but straight-line and double-declining balance are the most popular. In addition, the units-of-output method is uniquely suited to certain types of assets. The following discussion covers each of these methods. Intermediate accounting courses typically introduce additional techniques that are sometimes appropriate.

THE STRAIGHT-LINE METHOD

Under the straight-line approach the annual depreciation is calculated by dividing the depreciable base by the service life. To illustrate assume that an asset has a $100,000 cost, $10,000 salvage value, and a four-year life. The following schedule reveals the annual depreciation expense, the resulting accumulated depreciation at the end of each year, and the related calculations.

Straight-line Method example

For each of the above years, the journal entry to record depreciation is as follows:

Straight-line Method Journal entry

The applicable depreciation expense would be included in each year’s income statement (except in a manufacturing environment where some depreciation may be assigned to the manufactured inventory, as explained in managerial accounting courses). The appropriate balance sheet presentation would appear as follows (end of year 3 in this case):

Straight-line Balance Sheet example

FRACTIONAL PERIOD DEPRECIATION (SL)

Assets may be acquired at other than the beginning of an accounting period. Some companies simply assume that these assets are acquired at the beginning or end of the period. Other companies will calculate depreciation for partial periods. With the straight-line method the partial-period depreciation is simply a fraction of the annual amount. For example, an asset acquired on the first day of April would be used for only nine months during the first calendar year. Therefore, Year 1 depreciation would be 9/12 of the annual amount. Following is the depreciation table for the asset, this time assuming an April 1st acquisition date:

Fractional Period example

SPREADSHEET SOFTWARE (SL)

Computer-based spreadsheets usually include built-in depreciation functions. Below is a screen shot showing the straight-line method. Data are entered in the query form, and the routine returns the formula and annual depreciation value to the selected cell of the worksheet.

Fractional Period Spreadsheet illustation

THE UNITS-OF-OUTPUT METHOD

The units-of-output method involves calculations that are quite similar to the straight-line method, but it allocates the depreciable base over the units of output rather than years of use. It is logical to use this approach in those situations where the life is best measured by identifiable units of machine “consumption.” For example, perhaps the engine of a corporate jet has an estimated life of 50,000 hours. Or, a printing machine may produce an expected 4,000,000 copies. In cases like these, the accountant may opt for the units-of-output method.

To illustrate, assume Dat Nguyen Painting Corporation purchased an air filtration system that has a life of 8,000 hours. The filter cost $100,000 and has a $10,000 salvage value. Nguyen anticipates that the filter will be used 1,000 hours during the first year, 3,000 hours during the second, 2,000 during the third, and 2,000 during the fourth. Accordingly, the anticipated depreciation schedule would appear as follows (if actual usage varies, the schedule would be adjusted for the changing estimates using principles that are discussed later in this chapter):

Units-of-Output example

The form of journal entry and balance sheet account presentation are just like the straight-line illustration, but with the revised amounts from this table.

THE DOUBLE-DECLINING BALANCE METHOD

Video LectureAs one of several accelerated depreciation methods, double-declining balance (DDB) results in relatively large amounts of depreciation in early years of asset life and smaller amounts in later years. This method can be justified if the quality of service produced by an asset declines over time, or if repair and maintenance costs will rise over time to offset the declining depreciation amount.

With this method, 200% of the straight-line rate is multiplied times the remaining book value of an asset (as of the beginning of a particular year) to determine depreciation for a particular year. As time passes, book value and annual depreciation decrease. To illustrate, again utilize the example of the $100,000 asset, with a four-year life, and $10,000 salvage value. Depreciation for each of the four years would appear as follows:

Double-Declining Balance example

The amounts in the above table deserve additional commentary. Year 1 expense equals the cost times twice the straight-line rate (four-year life = 25% straight-line rate; 25% X 2 = 50% rate). Year 2 is the 50% rate applied to the beginning of year book value. Year 3 is calculated in a similar fashion.

Note that salvage value was ignored in the preliminary years’ calculations. For Year 4, however, the calculated amount (($100,000 - $87,500) X 50% = $6,250) would cause the lifetime depreciation to exceed the $90,000 depreciable base. Thus, in Year 4, only $2,500 is taken as expense. This gives rise to an important general rule for DDB: salvage value is initially ignored, but once accumulated depreciation reaches the amount of the depreciable base, then depreciation ceases. In the example, only $2,500 was needed in Year 4 to bring the aggregate depreciation up to the $90,000 level.

An asset may have no salvage value. The mathematics of DDB will never fully depreciate such assets (since one is only depreciating a percentage of the remaining balance, the remaining balance would never go to zero). In these cases, accountants typically change to the straight-line method near the end of an asset’s useful life to “finish off” the depreciation of the asset’s cost.

SPREADSHEET SOFTWARE (DDB)

DDB is also calculable from spreadsheet depreciation functions. Below is a routine that returns the $12,500 annual depreciation value for Year 3.

Double-Declining Balance Spreadsheet illustration

FRACTIONAL PERIOD DEPRECIATION (DDB)

Under DDB, fractional years involve a very simple adaptation. The first partial year will be a fraction of the annual amount, and all subsequent years will be the normal calculation (twice the straight-line rate times the beginning of year book value). If the example asset was purchased on April 1st of Year 1, the following calculations result:

Fractional Period DDB example

ALTERNATIVES TO DDB

150% and 125% declining balance methods are quite similar to DDB, but the rate is 150% or 125% of the straight-line rate (instead of 200% as with DDB).

Changes in estimates

Obviously, the initial assumption about useful life and residual value is only an estimate. Time and new information may suggest that the initial assumptions need to be revised, especially if the initial estimates prove to be materially off course. It is well accepted that changes in estimates do not require restating the prior period financial statements; after all, an estimate is just that, and the financial statements of prior periods were presumably based on the best information available at the time. Therefore, such revisions are made prospectively (over the future) so that the remaining depreciable base is spread over the remaining life.

To illustrate, reconsider the straight-line method. Assume that two years have passed for the $100,000 asset that was initially believed to have a four-year life and $10,000 salvage value. As of the beginning of Year 3, new information suggests that the asset will have a total life of seven years (three more than originally thought), and a $5,000 salvage value. As a result, the revised remaining depreciable base (as of the beginning of Year 3) will be spread over the remaining five years, as follows:

Change in Estimates example

Depreciation for Years 3 through 7 is based on spreading the “revised” depreciable base over the last five years of remaining life. The “revised” depreciable base is $50,000. It is computed as the original cost, minus the previous depreciation ($45,000), and minus the revised salvage value ($5,000).

Asset Revaluation

International accounting and reporting standards include provisions that permit companies to revalue items of PP&E to fair value. When applied, all assets in the same class must be revalued annually. Such balance sheet adjustments are offset with a corresponding change in the entity’s capital accounts. These revaluations pose additional complications because they result in continuous alterations of the amount of depreciation.

 

Tax Laws

Video LectureIt is important to note that tax methods and financial accounting methods are not always the same. This is certainly true when it comes to the subject of depreciation. For example, when the economy “slows down” governments will often try to stimulate economic investment activity by providing special incentives that are realized through rapid depreciation for tax purposes (even immediate write-off in some cases). The depreciation causes a decrease in taxable income and a company’s tax obligation. This feature can provide significant incentives for capital investment.

The history of tax laws is marked by many changes to the depreciation rates and methods. As a result, it is difficult to generalize. But, one depreciation technique is known as the Modified Accelerated Cost Recovery System (MACRS, pronounced “makers”). MACRS provides for a general depreciation system and an alternative system. Within those systems are generally provisions relating to the 200% declining balance, 150% declining balance, and straight-line techniques.

Further, tax systems will generally stipulate the useful life of an asset rather than leaving it to the imagination of the taxpayer. Tax codes tend to be very complete in identifying assets and their lives. Tax codes tend to be “favorable” to taxpayers, and generally result in depreciation occurring at a faster rate than under generally accepted accounting principles.

Is it bothersome that a company would use one accounting method for financial reporting and another for tax? Consider that accounting rules are about measuring economic activity of a business and require a proper scheme for assigning revenues and costs to time periods. Meanwhile, tax codes must be followed and often change to meet the revenue or social objectives of the government. As a result, temporary (and sometimes not so temporary) differences will arise between accounting and tax measurements. Records of these differences must be maintained, making the accounting task all the more challenging for a complex business organization.

 

Equipment Leases

Many businesses acquire needed assets via a lease arrangement. With a lease arrangement, the lessee pays money to the lessor for the right to use an asset for a stated period of time. In a strict legal context, the lessor remains the owner of the property. However, the accounting for such transactions looks through the legal form, and is instead based upon the economic substance of the agreement.

If a lease effectively transfers the “risks and rewards” of ownership to the lessee, then the applicable accounting rules dictate that the lessee account for the leased asset as though it has been purchased. The lessee records the leased asset as an item of property, plant, and equipment, which is then depreciated over its useful life to the lessee. The lessee must also record a liability reflecting the obligation to make continuing payments under the lease agreement, similar to the accounting for a note payable. Such transactions are termed capital leases. Note that the basic accounting outcome is as though the lease agreement represents the purchase of an asset, with a corresponding obligation to pay it off over time (the same basic approach as if the asset were purchased on credit).

Of course, not all leases effectively transfer the risks and rewards of ownership to the lessee. In the U.S., the determination of risk/reward transfer is based upon evaluation of very specific criteria: (1) ownership transfer of the asset by the end of the lease term, (2) minimum lease payments with a discounted present value that is 90% or more of the fair value of the asset, (3) a lease term that is at least 75% of the life of the asset, or (4) some bargain purchase element that kicks in before the end of the lease. If a lease does not include at least one of the preceding conditions, it is not a capital lease. Instead, it is an operating lease. Rent is simply recorded as rent expense as incurred and the underlying asset is not reported on the books of the lessee. Under international accounting standards, lease accounting rules are not as specific in guidance, but are substantively similar in intent and outcome.

Why all the trouble over lease accounting? Think about an industry that relies heavily on capital lease agreements, like the commercial airlines. One can see the importance of reporting the airplanes and the fixed commitment to pay for them. To exclude them would render the financial statements not representative of the true nature of the business operation.