My video lectures about depreciation methods and how to compute depreciation expense such cost of plant assets, factors in computing depreciation, depreciation methods such as straight line, declining balanced, units of activity and disposal of plant assets are covered in intermediate accounting course and CPA lessons. Or browse from the menu above.
Plant assets are resources that have three characteristics. They have a physical substance (a definite size and shape), are used in the operations of a business, and are not intended for sale to customers. They are also called property, plant, and equipment; plant and equipment; and fixed assets. These assets are expected to be of use to the company for a number of years. Except for land, plant assets decline in service potential over their useful lives.
Because plant assets play a key role in ongoing operations, companies keep plant assets in good operating condition. They also replace worn-out or outdated plant assets, and expand productive resources as needed. Many companies have substantial investments in plant assets.
Determining the Cost of Plant Assets
The historical cost principle requires that companies record plant assets at cost. Thus, Rent-A-Wreck records its vehicles at cost. Cost consists of all expenditures necessary to acquire the asset and make it ready for its intended use. For example, the cost of factory machinery includes the purchase price, freight costs paid by the purchaser, and installation costs. Once cost is established, the company uses that amount as the basis of accounting for the plant asset over its useful life.
In the following sections, we explain the application of the historical cost principle to each of the major classes of plant assets.
Companies often use land as a building site for a manufacturing plant or office building. The cost of land includes (1) the cash purchase price, (2) closing costs such as title and attorney’s fees, (3) real estate brokers’ commissions, and (4) accrued property taxes and other liens assumed by the purchaser. For example, if the cash price is $50,000 and the purchaser agrees to pay accrued taxes of $5,000, the cost of the land is $55,000.
Companies record as debits (increases) to the Land account all necessary costs incurred to make land ready for its intended use. When a company acquires vacant land, these costs include expenditures for clearing, draining, filling, and grading. Sometimes the land has a building on it that must be removed before construction of a new building. In this case, the company debits to the Land account all demolition and removal costs, less any proceeds from salvaged materials.
Land improvements are structural additions with limited lives that are made to land. Examples are driveways, parking lots, fences, landscaping, and underground sprinklers. The cost of land improvements includes all expenditures necessary to make the improvements ready for their intended use. For example, the cost of a new parking lot for Home Depot includes the amount paid for paving, fencing, and lighting. Thus, Home Depot debits to Land Improvements the total of all of these costs.
Land improvements have limited useful lives. Even when well-maintained, they will eventually need to be replaced. As a result, companies expense (depreciate) the cost of land improvements over their useful lives.
Buildings are facilities used in operations, such as stores, offices, factories, warehouses, and airplane hangars. Companies debit to the Buildings account all necessary expenditures related to the purchase or construction of a building. When a building is purchased, such costs include the purchase price, closing costs (attorney’s fee, title insurance, etc.), and the real estate broker’s commission. Costs to make the building ready for its intended use include expenditures for remodeling and replacing or repairing the roof, floors, electrical wiring, and plumbing. When a new building is constructed, its cost consists of the contract price plus payments for architects’ fees, building permits, and excavation costs.
In addition, companies charge certain interest costs to the Buildings account. Interest costs incurred to finance the project are included in the cost of the building when a significant period of time is required to get the building ready for use. In these circumstances, interest costs are considered as necessary as materials and labor. However, the inclusion of interest costs in the cost of a constructed building is limited to interest costs incurred during the construction period. When construction has been completed, the company records subsequent interest payments on funds borrowed to finance the construction as debits (increases) to Interest Expense.
Equipment includes assets used in operations, such as store check-out counters, office furniture, factory machinery, delivery trucks, and airplanes. The cost of equipment, such as Rent-A-Wreck vehicles, consists of the cash purchase price, sales taxes, freight charges, and insurance during transit paid by the purchaser. It also includes expenditures required in assembling, installing, and testing the unit. However, Rent-A-Wreck does not include motor vehicle licenses and accident insurance on company vehicles in the cost of equipment. These costs represent annual recurring expenditures and do not benefit future periods. Thus, they are treated as expenses as they are incurred.
Expenditures During Useful Life
During the useful life of a plant asset, a company may incur costs for ordinary repairs, additions, or improvements. Ordinary repairs are expenditures to maintain the operating efficiency and productive life of the unit. They usually are small amounts that occur frequently. Examples are motor tune-ups and oil changes, the painting of buildings, and the replacing of worn-out gears on machinery. Companies record such repairs as debits to Maintenance and Repairs Expense as they are incurred. Because they are immediately charged as an expense against revenues, these costs are often referred to as revenue expenditures.
In contrast, additions and improvements are costs incurred to increase the operating efficiency, productive capacity, or useful life of a plant asset. They are usually material in amount and occur infrequently. Additions and improvements increase the company’s investment in productive facilities. Companies generally debit these amounts to the plant asset affected. They are often referred to as capital expenditures.
Companies must use good judgment in deciding between a revenue expenditure and capital expenditure. For example, assume that Rodriguez Co. purchases a number of wastepaper baskets. The proper accounting would appear to be to capitalize and then depreciate these wastepaper baskets over their useful lives. However, Rodriguez will generally expense these wastepaper baskets immediately. This practice is justified on the basis of materiality. Materiality refers to the impact of an item’s size on a company’s financial operations. The materiality concept states that if an item would not make a difference in decision-making, the company does not have to follow GAAP in reporting that item.
Factors in Computing Depreciation
1.Cost. Earlier, we explained the issues affecting the cost of a depreciable asset. Recall that companies record plant assets at cost, in accordance with the historical cost principle.
2.Useful life. Useful life is an estimate of the expected productive life, also called service life, of the asset for its owner. Useful life may be expressed in terms of time, units of activity (such as machine hours), or units of output. Useful life is an estimate. In making the estimate, management considers such factors as the intended use of the asset, its expected repair and maintenance, and its vulnerability to obsolescence. Past experience with similar assets is often helpful in deciding on expected useful life. We might reasonably expect Rent-A-Wreck and Avis to use different estimated useful lives for their vehicles.
3.Salvage value. Salvage value is an estimate of the asset’s value at the end of its useful life. This value may be based on the asset’s worth as scrap or on its expected trade-in value. Like useful life, salvage value is an estimate. In making the estimate, management considers how it plans to dispose of the asset and its experience with similar assets.
Depreciation is generally computed using one of the following methods:
Each method is acceptable under generally accepted accounting principles. Management selects the method(s) it believes to be appropriate. The objective is to select the method that best measures an asset’s contribution to revenue over its useful life. Once a company chooses a method, it should apply it consistently over the useful life of the asset. Consistency enhances the comparability of financial statements. Depreciation affects the balance sheet through accumulated depreciation and the income statement through depreciation expense.
Under the straight-line method, companies expense the same amount of depreciation for each year of the asset’s useful life. It is measured solely by the passage of time.
Under the units-of-activity method, useful life is expressed in terms of the total units of production or use expected from the asset, rather than as a time period. The units-of-activity method is ideally suited to factory machinery. Manufacturing companies can measure production in units of output or in machine hours. This method can also be used for such assets as delivery equipment (miles driven) and airplanes (hours in use). The units-of-activity method is generally not suitable for buildings or furniture because depreciation for these assets is more a function of time than of use.
The declining-balance method produces a decreasing annual depreciation expense over the asset’s useful life. The method is so named because the periodic depreciation is based on a declining book value (cost less accumulated depreciation) of the asset. With this method, companies compute annual depreciation expense by multiplying the book value at the beginning of the year by the declining-balance depreciation rate.
Sale of Plant Assets
In a disposal by sale, the company compares the book value of the asset with the proceeds received from the sale. If the proceeds of the sale exceed the book value of the plant asset, a gain on disposal occurs. If the proceeds of the sale are less than the book value of the plant asset sold, a loss on disposal occurs.
Natural resources consist of standing timber and underground deposits of oil, gas, and minerals. These long-lived productive assets have two distinguishing characteristics: (1) they are physically extracted in operations (such as mining, cutting, or pumping), and (2) they are replaceable only by an act of nature.
The acquisition cost of a natural resource is the price needed to acquire the resource and prepare it for its intended use. For an already-discovered resource, such as an existing coal mine, cost is the price paid for the property.
The allocation of the cost of natural resources in a rational and systematic manner over the resource’s useful life is called depletion. (That is, depletion is to natural resources as depreciation is to plant assets.) Companies generally use the units-of-activity method (learned earlier in the chapter) to compute depletion. The reason is that depletion generally is a function of the units extracted during the year.