HU, Plant assets and depreciation accounting

CHAPTER 2
PLANT ASSETS AND INTANGIBLE ASSETS
Long-lived is a general term that may be applied to assets of a permanent or
relatively fixed nature owned by a business enterprise.
Long-lived assets consist of:
1) Intangible assets and
2) Tangible assets
I. Intangible Assets
 Have no physical characteristics that we can see and touch but represent
exclusive privileges and rights to their owners.
 Are long-lived assets that are without physical characteristics, are not held
for sale, but are useful in the operations of an enterprise.
Intangibility denotes lack of physical substance. Intangible assets often include
patents, copyrights, trademarks, organization costs and goodwill. The cost of acquired
intangible assets is amortized over their estimated economic lives, but not in excess of
40 years. Research and development costs incurred in the creation of internally
developed intangible assets are recognized currently as expenses.
II. Tangible Assets
 Have physical characteristics that we can see and touch. Tangibility is the
characteristic of bodily substance, as exemplified by a tract of timber, a bridge
or a machine.
These tangible assets include:
a) Plant assets
b) Natural resources
A) Plant Assets
 Are long-lived tangible assets that are of a permanent nature, used in
the operations of the business.
 Other descriptive titles are frequently used are property, plant, and
equipment, used either alone or in various combinations.
To be classified as a plant asset, an asset must
b. be tangible, that is, capable of being seen and touched;
c. have a useful service life of more than one year; and
d. be used in business operations rather than held for resale.
The properties most frequently included in plant assets may be described in more
specific terms as equipment, furniture, tools, machinery, buildings, and land. On the
balance sheet, you will find these assets included under the heading “property, plant
and equipment”.

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I. Land
Unlike the other kinds of tangible property, land has an indefinite economic life. In
general, land does not deteriorate with the passage of time and is not physically
exhausted through use. There may be exceptional cases. Agricultural land may suffer
a loss of usefulness through erosion or failure to maintain fertility. Building sites may
be damaged or destroyed by slides, floods, or earthquakes. Generally, land is
accounted for as a non-depreciable plant asset.
II. Property having a limited economic life
With the exception of land, all other plant assets have limited economic lives. The
cost of such assets is allocated through the process of depreciation to the cost of the
goods and services produced.
Characteristics of Plant Assets
Plants assets are generally are acquired for use rather than for sale.
1) In yielding services for many accounting periods, a plant asset does not
change in physical characteristic; that is, it does not become physically
incorporated in the finished goods of a business enterprise. For example, a
building or machine wears out and eventually loses its ability to perform
efficiently, but its physical components remain relatively unchanged. In
contrast, material is incorporated in finished goods.
2) They yield services over many years.
Plant assets include all long-lived tangible assets that are used to generate the
principal revenues of the business. Inventory is a tangible asset but not a plant asset
because inventory is usually not long-lived and it is held for sale rather than for use.
What represents a plant asset to one company may be inventory to another. For
example, a business such as a retail appliance store may classify a delivery truck as a
plant asset because a truck is used to deliver merchandise, but a business such as a
truck dealership would classify the same delivery truck as inventory because the
truck is held for sale.
Although there is no standard criterion as to the minimum length of life
necessary for classification as plant assets or intangible assets, such assets must be
capable of repeated use or benefit and are ordinarily expected to last more than a year.
However, the asset need not actually be used continuously or even often. For
example, items of stand by equipment held for use in the event of a breakdown of
regular equipment or for use only during peak or emergency periods of activity are
included in plant assets because the equipment is used in the operations of the
business.

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Assets acquired for resale in the normal course of business cannot be characterized
as plant assets, regardless of their durability or the length of time they are held. For
example, land held for speculative or as a prospective building site or not yet put in to
service is a long-term investment rather than a plant asset because the land is no
being used by the business. When a building is constructed on the land and is placed
in service, the land is reported in the balance sheet under plant assets.
b) Natural resources
This term includes wasting assets that are subject to exhaustion through extraction.
The principal types of wasting assets are mineral deposits, oil and gas deposits, and
standing timber. In essence, natural resources are long-term inventories acquired for
sale or use in production over a number of years. The cost of acquiring and
developing wasting assets is allocated to expense in the form of depletion charges.
Acquisition cost of plant assets
The cost of acquiring a plant asset includes all expenditures necessary to get it in
place and ready for use. The acquisition cost of a plant asset is the amount of cash /or
cash equivalents given up to acquire that asset and place it in operating condition at
its proper location.
Thus, Cost includes all normal, reasonable, and necessary expenditures to obtain
the asset and get it ready for use. Acquisition cost also includes the repair and
reconditioning cost for used or damaged assets.
Expenditures resulting from carelessness or errors in installing the asset, from
vandalism, or from other unusual occurrences do not increase the usefulness of the
asset and should be treated as an expense. Unnecessary costs (such as traffic tickets or
fines) that must be paid as a result of hauling machinery to a new plant are not part of
the acquisition cost of the asset.
1. Land
Land is non-depreciable. The cost of land includes:
 The acquisition (purchase) (negotiated) price.
 All costs of closing the transaction and obtaining title, such as broker’s
commission, real-estate commission, attorney’s fees, existing mortgage note
assumed, legal fees, escrow fees (amount paid to agents), title investigations,
and title insurance premiums.
 All costs of surveying (surveying fees), clearing, draining, grading or filling to
make the land suitable for the desired use, including the cost of demolishing
existing unwanted (unneeded) structures-that is- when land purchased as a
building site contains an unusable building that must be removed, the entire
purchase price should be debited to land, including the cost of removing the
building less any cash received from the sale of salvaged items, such as crops or
fruit on the land; that occurs while the land is being readied for use.
 Cost of landscaping and local assessments for side walks, streets, sewers and
water mines.

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 Delinquent real estate taxes (unpaid taxes) (back taxes) (accrued property
taxes and other liens on land) assumed by purchaser or buyer.
 The costs incurred to make the land suitable for its intended purposes such as
cost of clearing trees, or of leveling hills or filling low spots, are included in
the cost of land. Any salvage material recovered in the process of clearing
land represents a cost offset.
Land held as a potential building site or for investment purposes is not currently
used in operations and should be reported under investments in the balance sheet
rather than as a part of the plant assets category. The carrying costs, such as property
taxes and weed control incurred prior to the time that the land is placed in use, are
capitalized (added to the cost of the land). When the site is placed in use, the land is
reclassified from the investment category to the plant assets category, and future
carrying costs are recognized as expenses.
Illustration 2.1
Best Luck Company purchased a six-acre tract of land and an existing building for
$500,000. The company plans to raze the old building and construct a new office
building on the site. In addition to the purchase price, the company made the
following expenditures at closing of the purchase:
 Title insurance ------------------------- $3,000
 Escrow fees------------------------------- 1,000
 Property taxes----------------------------6,000
Shortly after closing, the company paid a contractor $10,000 to tear down the old
building and remove it from the site. An additional $5,000 was paid to grade the land.
Property taxes include $4,000 of delinquent taxes paid by the buyer on the behalf of
the seller and $2,000 attributable to the portion of the current fiscal year after the
purchase date.
Required:
What is the capitalized cost of land?
2. Building
All necessary expenditures relating to the purchase or construction of a building
are charged to the Building account.
When an existing building is purchased, its cost includes:
Purchase price
Closing costs (attorney’s fees, title insurance, etc)
Cost of remodeling rooms and offices and replacing or repairing the roof,
floors, electrical wiring, and plumbing (or repair and remodeling costs)
Unpaid taxes assumed by the purchaser, legal costs and real estate commissions
paid.

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When a new building is constructed, its cost consists of:

Contract price (payments to contractors)
Fees paid for architects and engineers for plans and supervision (Architect’s
fees)
Building permits
Cost of digging the foundation (Excavation cost)
Labor and materials to build the building
Salaries f officers supervising the construction
Insurance and taxes incurred during the construction
Cost of temporary structures used for offices or for storing tools and materials
during construction of a new building
Interest incurred during construction period on money borrowed to finance
the construction
Any miscellaneous amounts earned from the building during construction reduce
the cost of the building. For example, if a small completed portion of the building is
rented out during construction of the remainder of the building, the rental proceeds
are credited to the Building account.
3. Land Improvements
The cost of land improvements includes all expenditures necessary to make the
improvements ready for their intended use. It is important to distinguish between
the cost of land and the land improvements because land has an indefinite life and
land improvements usually do not. Land improvement costs are capital expenditures
and are either recorded as land cost or recorded in a separate land improvements
ledger account.
Examples of land improvements include: temporary landscaping (such as bushes,
gardens, and trees), parking lots (costs of paving and lighting), drive ways and private
roads, the cost of fences, lawn and garden sprinkler systems
Some of the land improvements (such as landscaping and drainage) are as
indefinite economic lives as that of land, so included (added) to land cost. However,
the cost of land improvements such as side walks, streets and sewers may or may not
have indefinite economic lives. In many localities, the cost of streets, sewers, and
similar improvements are paid by the owners of the benefited property, but the local
governmental unit agrees to maintain and replace them if they are built to standard
specifications. In such cases the special assessments expenditure is a part of land cost,
because it is permanent in nature. However, if the property owner is responsible for
eventual replacement of land improvements, they have limited economic lives and
are recorded in a separate Land Improvements ledger account to facilitate
depreciation accounting.

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Illustration 2.2
The costs incurred by XYZ Company to acquire land and construct a building were
as follows:
Land (including miscellaneous acquisition costs) ----------------$150,000
Construction insurance-------------------------------------------- 3,500
Building construction contract (excluding excavation) ---------220,000
Architects fees---------------------------------------------------- 2,000
Street and sidewalk installation (maintenance by the city) -------4,000
Costs of excavation for foundation--------------------------------- 3,100
Property taxes on land (prior to construction) ----------------------1,600
Advertising costs to attract tenants---------------------------------1,250
Interest cost during acquisition period on loan to pay contractor—2,600
Required:
Determine the cost of XYZ Company’s (a) land, and (b) building for financial
accounting.
4. Machinery and Equipment
The cost of machinery or equipment consists of sellers net invoice price (whether
the discount is taken or not), sales and other taxes, legal fees, broker’s fees,
transportation (freight) charges, insurance during transit paid by the purchaser, cost
of installation, testing and break-in costs, costs of accessories, other costs needed to
put the machine or equipment in operating condition in its intended location for use
It also includes expenditures required in assembling, installing, and testing the
unit. However, Motor vehicle licenses and accident insurance on company trucks and
cars are expensed as incurred, because they represent annual recurring expenditures
and do not benefit future periods.
The cost of machinery does not include costs of removing and disposing of a
replaced, old machine that has been used in operations. Such costs are part of the gain
or loss on disposal of the old machine.
NB: The cost of machinery or equipment includes any cost incurred to get the
machinery and equipment ready for its intended use.
Illustration 2.3
Assume that the Lenard Company purchases a delivery truck at a cash price of
$22,000. Related expenditures consist of sales taxes $1,320, painting and lettering
$500, motor vehicle license $80, and a 3-year accident insurance policy $1,600.
Required:
Determine the cost of delivery truck.

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Nature of Depreciation
As time passes, all plant assets with the exception of land lose their capacity to yield
services. Accordingly, the cost of such assets should be transferred to the related
expense accounts in an ordinary manner during their expected useful life. This
periodic cost expiration is called “depreciation”.
Depreciation is the amount of plant asset cost allocated to each accounting period
benefiting from the plant asset’s use and is a process of allocation, not asset valuation.
All plant assets are subject to depreciation except land.
Purpose of calculating depreciation of plant assets
 To properly measure net income through matching principle. Depreciation
expense is often a significant factor in determining net income. For this
reason, most financial statement users interested in the amount of, and
methods used to compute, a company’s depreciation expense.
 To recognize the decline in the usefulness of plant assets.
Major Causes of Depreciation
Factors contributing to a decline in usefulness may be divided into two categories:
1) Physical Depreciation, which includes wear from use and deterioration from the
action of the elements, and
2) Functional (Economic) Depreciation, which includes inadequacy and obsolescence.

Accounting for Depreciation

If a plant asset is expected to have no value at the time that it is retired from
service, its entire initial cost should be spread over the expected useful life of the asset
as depreciation expense. Also, if a plant asset’s value at the time of retirement is
expected to be very small in comparison with the cost of the asset, this value may be
ignored and the entire cost speared over the asset’s expected useful life. If a plant asset
is expected to have a significant value at the time that it is retire from service, the
different between its initial cost and this value is the cost( depreciation cost) that
should be speared over the useful life of the asset as depreciation expense.
Factors to be considered in computing depreciation
In determining the amount of depreciable cost (depreciation base) (cost minus
estimated salvage value) that is to be recognized as periodic depreciation expense,
three factors needed to be considered: the plant asset’
(a) Initial cost: all expenditures necessary to acquire the asset and make it ready for
intended use.
(b) Residual value/Salvage value / scrap value: is the plant asset’s estimated value at the
time that it is to be retired from service. In other words, salvage value (or scrap value)
is the amount of money the company expects to recover, less disposal costs, on the
date a plant asset is scrapped, sold, or trade in. In making the estimate, management

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should consider how it plans to dispose of the asset and its exchange with similar
assets.
(c) Useful life: refers to the length of time the company owning the assets intended to
use it; useful life is not necessarily the same time period as either economic life or
physical life. The economic life of a car may be 7 years and its physical life may be 10
years, but if a company has a policy of trading cars every 3 years, useful life may be
expressed in years, months, working hours, or units of production. Obsolescence may
also affect useful life. For example, a machine may be capable of producing units for
20 years, but it is expected to be obsolete in 6 years. Thus, its estimated useful life is 6
years – not 20.

Depreciation methods
Depreciation generally computed using one of the following methods.
1. Straight-line method
2. Units- of- production method
3. Accelerate depreciation methods (such as double declining
balance method and sum- of- the -years- digits method).
It is not necessary that an enterprise use a single method of computing depreciation
for all classes of its depreciable assets. The method used in the accounts and financial
statements may also differ from the methods used in determining income taxes and
property taxes.
As it is true for inventory methods, a company is normally free to adopt the
method(s) of depreciation it believes most appropriate for its business operations.
The theoretical guideline is to use a depreciation method that reflects most closely
the underlying economic circumstances. Thus, companies should adopt the
depreciation method that allocates plant asset cost to accounting period according to
the benefits received from the use of the asset.
In practice, the measurement of benefits from the use of a plant asset is impractical
and often not possible. As a result, a depreciation method must meet only on
standard: The depreciation method must allocate plant asset cost to accounting
periods in a systematic and rational manner.
Regardless of the method or methods chosen, the company must disclose its
depreciation method (s) in the footnotes to its financial statement.
“Note: Companies may use different depreciation methods for different plant
assets.”

1. Straight line method

The straight-line method of determining depreciation provides for equal periodic
charges to expense over the estimated life of the asset.

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Under the straight-line method, depreciation is the same for each year of the asset’s
useful life. It is measure solely by the passage of time. To apply the straight-line
method, an equal amount of plant asset cost is charged to each accounting period.
In order to compute depreciation expense, it is necessary to determine depreciable
cost. Depreciable cost is the cost of the assets less its salvage value. It is the total
amount subject to depreciation. Depreciable costs then, divided by the asset’s useful
life to determine depreciation expense.
The formula for calculating depreciation under the straight line method is:

Depreciation expense = Asset cost – Estimated salvage value

Per year Number of accounting periods in estimated
Useful life
Depreciable cost (depreciation Base) = Asset - Estimated
Cost Salvage Value
The distinguishing characteristic of the straight-line method of depreciation is that
each full year of service absorbs an equal portion of cost. Use of the straight line
method is appropriate for assets where Time rather than obsolescence is the major
factor limiting the asset’s life and relatively constant amount of periodic services are
received from the asset. Assets that possess these features include pipelines, fencing,
and storage tanks. The straight-line method is widely used because of its simplicity.
In addition, it provides a reasonable allocation of costs to periodic revenue when
usage is relatively the same from period to period.

2, Units of Production Method

The units-of-production depreciation method assigns an equal amount of depreciation
to each unit of product manufactured or service rendered by an asset. Since this
method of depreciation is based on physical output, it is applied in situations where
usage rather than obsolescence is the main factor leading to the demise of the asset.
The units of production method yields a depreciation charges that varies with the
amount of asset usage. To apply this method, the length of the life of the asset is
expressed in terms of productive capacity, such as hours, miles or number of units.
Under this method, depreciation is first computed for the
appropriate unit of production, and the depreciation for each accounting
period is then determined by multiplying the unit depreciation by the
number of units used.
The unit of activity method is ideally suited to factory machinery; production
can measure in terms of units of out put or in terms of machine hours used in
operating the machine. It is also possible to use this method for such items as delivery
equipment (miles driven) and air plane (hours in use). The units of activity method is
generally not suitable for such assets as building or furniture because depreciation for
these assets in more a function of time than of use.

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The units-of-production depreciation formulas are:

Depreciation per unit = Asset Cost– Estimated salvage value
(Depreciation rate) Estimated total units of production (or service)
during useful life of asset

Depreciation per period = Depreciation per unit x Number of units of goods or

Services produced.
Note: when production of the asset varies significantly from one period to another,
the unit of activity (units –of-production) method results in the best matching of
expected costs with revenues.

Illustration 2.4
A diesel powered generator with a cost of $170,000 and estimated salvage value of
$10,000 is expected to have a useful operating life of 40,000 hours. During May, the
generator was operated 320 hours.
Required
Determine the depreciation for the month.

3. Accelerated Depreciation Method

Accelerated depreciation method records higher amounts of depreciation during
the early years of an asset’s life and lower amounts in the asset’s later years. A
business might choose an accelerated depreciation for the following reasons:
1) The value of the benefits received from the asset decline with age (for example,
office buildings).
2) The asset is a high-technology asset subject to rapid obsolescence (for example,
computers)
3)Repairs increase substantially in the asset’s later years, and under this method the
depreciation and repairs remain fairly constant over the assets life (for example,
automobiles).
The two most common accelerated methods of depreciation are:
 The double declining balance (DDB) method.
 The sum – of – the – year’s – digits (SOYD) method.
A. Double-Declining Balance Method

The double-declining-balance (DDB) yields a declining periodic depreciation

charge over estimated life of the asset.

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The DDB method of computing periodic depreciation charges is applied by first

calculating the straight-line rate depreciation rate. The straight-line rate is calculated
by dividing 100% by the number of years of useful life of the asset. Then, multiply
this rate by 2. The resulting double-declining rate is applied to the declining book
value (cost minus accumulated depreciation) of the asset.
Salvage value is ignored in making the calculations. However, at the point where
book value is equal to the salvage value, no more depreciation is taken.

The formula for DDB depreciation is:

Depreciation = (2 X Straight line rate) X (Asset – Accumulated
Per period Cost Depreciation)

Straight-line rate = 100%/Number of years of useful life of the asset

Note that estimated residual value is not considered in determining the depreciation
rate. It is also ignored in computing periodic depreciation, except that the asset should
not be depreciated below the estimated residual value.

B. Sum-of-the-Year’s-Digits method.

The sum-of-the-years –digits method yield result like those obtained by the use
of the double declining balance method.
This method is similar to the double declining balance method because it also
assumes that an asset is used more extensively during the first-years of operation.
Under this method, an important consideration is give to the number of years in the
asset’s useful life.
The periodic charge for depreciation declines steadily over the estimated life of
the asset because a successively smaller fraction is applied each year to the original
cost of the asset less the estimated residual value.
The denominator of the fraction, which remains the same, is the sum of the digits
representing the years of life. The numerator is the fraction, which changes each year,
is the number of years of life remaining at the beginning of the year for which
depreciation is being computed.
The sum-of-the-years –digits (SOYD) method is so called because the consecutive
digits for each year of an asset’s estimated life are added together and used as the
denominator of a fraction. The numerator is the number of years of useful life
remaining at the beginning of the accounting period.
To compute that period’s depreciation expense, this fraction is then multiplied by
the acquisition cost of the asset less estimated salvage value.

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The formula is:

Depreciation = Number of years of
Per period useful life remaining at (Asset - Estimated
beginning of accounting period X Cost salvage
Sum of Digits for value)
Years of life (SOYD)
The years are totaled to find SOYD. For an asset with a 10-year useful life, the
SOYD=10+9+8+7+6+5+4+3+2+1=55.
Alternatively, rather than adding the digits for all years together, the following
formula can be used to find the SOYD for any given number of periods:
SOYD = n (n+1)
2
Where n is the number of periods in the assets useful life. Thus, SOYD for an asset
with a 10-year useful life is:
SOYD= 10(10+1)/2 =15.
For the first year, the numerator is 5, for the second year 4 and so on. When the first
use of the asset does not coincide with the beginning of a fiscal year, it is necessary to
allocate each full year’s depreciation between the two fiscal years benefited.
Illustration 2.5
A piece of Machinery acquired at a cost of $40,000 has an estimated residual value
of the $4,000 and an estimated useful life of the 5 years. It was placed in service on
April 1 of the current fiscal year, which ends on December 31.
Required:
Determine the depreciation for the current fiscal year and for the following fiscal
year by:
a) The declining-balance method, at twice the straight-line rate.
b) The sum-of-the-years-digits method.
Illustration 2.6
Bonds Company purchased a new plant asset on April 1, 2007, at a cost of
$355,500. It was estimated to have a service life of 20 years and a salvage value of
$30,000. Bonds’s accounting period is the calendar year.
Instructions
(a) Compute the depreciation for this asset for 2007 and 2008 using the sum-of-the-
years’-digits method.
(b) Compute the depreciation for this asset for 2007 and 2008 using the double-
declining balance method.

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Illustration 2.7
Samson Company purchased equipment on January 2, 2005, for $80,000. The
equipment was expected to have a useful life of 4 years, or 14,800 operating hours and
a residual vale of $6,000. The equipment was used for 3,200 hours during 2005 and for
4,000, 3,800, and 3,800 hours for 2006, 2007, and 2008 respectively.

Instructions:
Determine the amount of the depreciation expense for the fiscal years ending
December 31, 2005, 2006, 2007, and 2008 by:
a) The straight-line method.
b) The declining-balance method, using twice the straight-line rate.
c) The sum-of-the-years-digits method.
d) The units-of-production method.

Illustration 2.8
ABC Company purchased equipment on July 1, 2000, for $90,000. The equipment
was expected to have a useful life of 3 years; or 7,000 operating hours, and a residual
value of $6,000. The equipment was used for 700 hours during 2000 and for 2,800,
2,400, and 1,100 hours for 2001, 2002, and 2003 respectively.
Required:
Determine the amount of depreciation expense for the years ended December 31,
2000, 2001, 2002 and 2003 by
a) The straight-line method.
b) The declining-balance method, using twice the straight-line rate.
c) The sum-of-the-years-digits method, and
d) The units-of-production method.
Illustration 2.9
Foster Corporation purchased a new machine for its assembly process on August
1, 2007. The cost of this machine was $235,800. The company estimated that the
machine would have a trade-in value of $25,800 at the end of its service life. Its life is
estimated at 10 years, and its working hours are estimated at 42,000 hours. Year-end
is December 31.
Instructions:
Compute the depreciation expense under the following methods. Each of the
following should be considered unrelated.
(a) Straight-line depreciation for 2007.
(b) Activity method for 2007, assuming that machine usage was 800 hours.
(c) Sum-of-the-years’-digits for 2008.
(d) Double-declining balance for 2008

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Comparison of Depreciation
All four depreciation methods will yield the same total depreciation over the life
of the asset. However, each method will yield periodic charges which may vary
significantly.
 The straight line-method (SLM): provides for equal (uniform) periodic charges
to depreciation expense over the estimated useful life of the asset.
 The units-of-production method: provides for periodic charges to depreciation
expense that may vary considerably, depending upon the amount of the asset
usage.
 Both the declining-balance and the sum-of –the-years digits methods provide
for a higher depreciation charge in the first year of use of the asset and a
gradually declining periodic charge there after. For this reason they are
frequently referred to as accelerated depreciation methods. These methods are
most appropriate for situations in which the decline in productivity or earning
power of the asset is proportionately greater in the early years of its use than
in later years. Further justification or their use is based on the tendency of
repairs to increase with the age of an asset. The reduced amounts of
depreciation in later years are therefore offset to some extent by increased
maintenance expenses.
Thus, each method is acceptable in accounting, because each recognizes the
decline in service potential of the asset in a rational and systematic manner.

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