-CHAPTER TWO

ACCOUNTING FOR PLANT AND INTANGIBLE ASSETS

In the previous chapter you have learnt about the accounting for current assets (i.e. accounting
for cash, receivables and inventories). In this chapter you will learn about the issues of plant
assets and its related depreciation.
Most business enterprise holds such major assets as land, buildings, equipments, furnitures,
tools, and etc. These assets help produce revenue over many periods by facilitating the
production and sale of goods or services to customers. Because these assets are necessary in a
company’s day-to-day operations, companies do not sell them in the ordinary course of business.
Keep in mind, though; one company’s long-term asset might be another company’s short-term
asset. For example, a delivery truck is a long-term asset for most companies, but a truck dealer
would regard a delivery truck as a current asset merchandise inventory.
2.1. NATURE AND MEANING OF LONG-TERM ASSETS
Assets that can be used by a business enterprise for relatively long period (usually more than one
year) are called Long-Term Assets.
Assets.
Long-term assets are divided into tangible and intangible categories.
Tangible assets (also called plant assets or fixed assets) are assets with physical substance that
can be charged in the operations of business for a relatively longer period of time, usually more
than one year or one operating cycle whichever is longer. Examples are land, buildings,
equipments and machineries, trucks, etc.
In contrast, intangible assets are assets without a physical feature that can be charged in the
operations of business for long period of time. They generally consist of rights or advantages
held such as goodwill, patents, copyrights, franchise, trade marks, organization costs, etc.
2.2. DETERMINATION OF THE ACQUISITION COST OF PLANT ASSETS
The acquisition cost of plant (fixed) assets is the cash or cash-equivalent purchase price,
including incidental costs required to complete the purchase, to transport the asset, and to prepare
it for use.
For example, expenditures related to the acquisition of a plant asset such as freight, insurance
while in transit, and installation are included in the cost of the asset because they are necessary if
the asset is to function. According to the matching principle, therefore, such costs are allocated to
the economic life of the asset rather than charged as expenses in the current period.
Land
The acquisition cost of land includes the negotiated cash price plus other costs such as the cost of
land surveys, legal fees, title fees, broker’s commissions, cost of preparing the land to build on,
and even the demolition costs of old structures that might be torn down to get the land ready for
its intended use.
Under the historical cost assumption, land is reported in the balance sheet at its original cost.
Land is not subjected to depreciation because land does not have a limited useful life.
The following illustration will help us how to determine the cost of land.

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Illustration-1
A business enterprise acquires a piece of land for future site. It pays a cash price of Br. 210,000,
pays brokerage fees of Br. 7500 and title fees of Br. 3000, pays Br. 5000 to have unwanted
building removed, and pays, Br. 1500 to have the site graded. The business receives

Br. 2000 salvage from the old building. The cost of the land is determined as follows:
Cash prices (negotiated price)…………………………………………Br. 210,000.00
Title Fees……………………………………………………………………..3,000.00
Brokerage Fees………………………………………………………………...7,500.00
Cost of Grading……………………………………………………………..…1,500.00
Cost of removing (demolition) unwanted building Br. 5000
Less: Salvage received………………………………. (2000)……………...…3,000.00
Total cost of land………………………………………………….….….Br.
land………………………………………………….….….Br. 2
25,000.00
Generally, land is part of property, plant and equipment. If the major purpose of acquiring and
holding land is speculative, it is more appropriately classified as an investment. If the land is held
on a real estate concern for resale, it should be classified as inventory. When the land has been
purchased for the purpose of constructing a building, all costs incurred up to the excavation for
the new building are considered land costs. Removal of old buildings clearing, grading and
filling are considered land costs because these costs are necessary to get the land in condition for
its intended purpose. Any proceeds obtained in the process of getting the land ready for its
intended use, such as salvage receipts on the demolition of an old building are treated as
reductions in the price of the land.
Cost of buildings
When an existing building is purchased its cost includes, the purchase price plus all repairs and
other expenses required to put it in a usable conditions. On the other hand, when a business
constructs a new building, the cost includes all reasonable and necessary expenditures, such as
those for materials, labor, part of the overhead and other indirect costs, engineers and architects’
fees, insurance during construction, interest incurred on construction loans during the period of
construction, lawyers' fees, and building permits. If outside contractors are used in the
construction, the net contract price plus other expenditures necessary to put the building in
usable condition are included.
Cost of equipment
The term “equipment” in accounting includes office equipment, store equipment, factory
equipment, delivery equipment, machinery, furniture’s and fixtures, and similar fixed assets. The
cost of such assets includes the invoice (purchase) price, transportation and handling charges,
insurance on the equipment while in transit, assembling and installation costs, and costs of
conducting trail runs. As indicated earlier, all costs of getting an asset ready for its intended use
are costs of that asset.
2.3. NATURE AND MEANING OF DEPRECIATION

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As plant assets are used in the operations of a business, their value to provide service decreases
through usage and the passage of time.
This cost allocation of plant asset, called depreciation,
depreciation, is recorded in the accounting books
periodically.
Depreciation is frequently misunderstood. The term depreciation, as used in accounting, does not
refer to the physical deterioration of an asset or the decrease in market value of asset overtime.
Depreciation means the allocation of the cost of a plant asset to the periods that benefit from the
services of the asset.
The term depreciation is used to describe the gradual conversion of the cost of the asset into an
expense.

Depreciation is not a process of valuation.

valuation. Ac counting records are kept in accordance with the
cost principle; they are not indicators of changing price levels. It is possible that, through an
advantageous buy and specific market conditions the market value of a building may rise.
Nevertheless, depreciation must continue too be recorded because it is the result of an allocation,
not a valuation process.
2.4. FACTORS THAT AFFECT THE COMPUTATION OF DEPRECIATION
Four factors affect the computation of depreciation. They are:
(1) Cost
(2) Residual value
(3) Depreciable cost, and
(4) Estimated economic (useful) life.
Cost- is the net purchase price plus all reasonable and necessary expenditures to get the asset in
place and ready for use.
Residual value- also known as salvage value,value, disposal value, scrape value, or trade-in value
represents the estimated market value of the asset at the time of its retirement.
Depreciable cost - represents the difference between the asset cost and its estimated residual
value. For example, an item of equipment that costs Br. 5000 and has a residual value of Br. 500
would have a depreciable cost of Br. 4500, (Br. 5000 - Br. 500). The depreciable costs must be
allocated over the estimated economic life of the asset.
Estimated economic (useful) life- the estimated economic life of an asset is the total number of
service units expected from the asset. Service units may be measured in terms of years the asset
is expected to be used, units expected to be produced, miles or kilometers expected to be driven,
or similar measures. In determining the estimated useful life of an asset, the accountant should
consider all relevant information, including (1) past experience with similar repair assets, (2) the
asset’s present condition, (3) the company’s repairs and maintenance policy, (4) current
technological and industry trends, and (5) local conditions such as whether.
2.5. METHODS OF COMPUTING DEPRECIATION
Depreciation methods differ primarily in the amount of cost allocated to each period. A list of
depreciation amounts for each year of an asset’s useful life is called depreciation schedule.
schedule.

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 The most common methods of computing depreciation for plant assets are:
(1) The straight line method
(2) The units of production method
(3) The double-declining balance method, and
(4) The sum-of- the years-digits method.
2.5.1 Straight-Line Depreciation
When this method is used to allocate depreciation, the depreciable cost of the asset is spread
evenly (uniformly) over the useful life of an asset. The straight-line method is based on the
assumption that depreciation depends only on the passage of time. The depreciation expense for
each period is computed by dividing the depreciable cost by the number of accounting periods in
the asset’s estimated useful life. The depreciation expense to be reported is the same in each
year. The following illustration will help us to understand the Straight-Line method of computing
depreciation.
Illustration - 2
Suppose, for example a business enterprise acquires a new computer (office equipment) at a cost
of Birr 6000. It is estimated that the computer has an estimated residual value of Birr 1000 at the
end of its estimated useful life of 4 years. The yearly (annual) depreciation would be Birr 1250m
computed as follows:
Annual depreciation = Cost - Salvage value
Estimated useful life

= Birr 6000 – Birr 1000 = Birr 1250

4 years

The depreciation to be reported for each of the four years would be as follows:
Depreciation Method- Straight-Line Method
Year Cost Yearly Accumulated Carrying value
Depreciation Depreciation (Book Value)
Beginning of first year Br. 6000 - - Br. 6000.00
End of first year 6000 Br. 1250.00 Br. 1250.00 4750.00
End of second year 6000 1250.00 1250.00 3500.00
End of third year 6000 1250.00 3750.00 2250.00
End of fourth year 6000 1250.00 5000.00 1000.00

NB.
NB. There are three important points to note from the depreciation schedule for the straight-line
depreciation method. First, the depreciation is the same each year. Second, the accumulated
depreciation increases uniformly. Third, the carrying (Book) value decreases uniformly until it
reaches the estimated residual value.
2.5.2. Units of Production Method

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 The production method of depreciation is based on the assumption that depreciation is mainly the
result of use and that the passage of time plays no role in the depreciation process. If we assume
that the office equipment from the previous illustration has an estimated useful life of 10,000
hours, the depreciation cost per hour would be determined as follows:
Hourly depreciation = Cost – Salvage value = Br. 6000.00 – 1000 = Br. 0.50
Rate Estimated units of useful life 10,000 operating hrs.
If we assume that the use of the equipment was 2800 hours for the first year, 3600 hours for the
second, 2400 hours for the third, and 1200 hours for the fourth, the depreciation schedule for the
office equipment would appear as follows:
Depreciation Schedule – Production Method

Year Cost Hours Depreciation Yearly Accum. Carrying value

Per Hour Depr. Depr. (Book value)
Beginning of the Br. 6,000 - Br. 0.50 - - Br. 6,000.00
First year
End of first year 6,000 2,800 0.50 Br. 1,400.00 Br. 1,400.00 4,600.00
End of second 6,000 3,600 0.50 1,800.00 3,200.00 2,800.00
year
End of third year 6,000 2,400 0.50 1,200.00 4,400.00 1,600.00
End of fourth year 6,000 1,200 0.50 600.00 5,000.00 1,000.00

Under the production method, there is a direct relation between the amounts of depreciation each
year and the units of output or use. Also, the accumulated depreciation increases each year
indirect relation to units of output or use. Finally, the carrying amount decreases each year in
direct relation to units of output or use until it reaches the estimated residual value.
Under the production method, the units of output or use that is used to measure estimated useful
fife for each asset should be appropriate for that asset. For example, for one machine number of
units produced may be an appropriate measure, for another number of hours may be a better
measure. The production method should be used only when the output of an asset over its useful
life can be estimated with reasonable accuracy.
2.5.3 Declining Balance Method
This method of depreciation results in relatively large amount of depreciation in the early years
of an assets life and smaller amounts in later years. This method is based on the assumption of
the passage of time. Since most kinds of plant assets are most efficient when new, and so they
provide more and better service in the early years of useful life. It is consistent with the matching
rule to allocate more depreciation to the early years than to later years if the benefits or services
received in the early years are greater.
The declining-balance method is the most common accelerated method of depreciation. Under
this method depreciation is computed by applying a fixed rate to the book value of the asset,
resulting in higher depreciation charges during the early years of the asset’s life. Though any

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 fixed rate might be used under the method, the most common rate is a percentage equal to twice
the straight-line percentage. When twice the straight-line rate is used, the method is usually
called the double-declining balance method.
method.
Referring to the previous example, the equipment had an estimated useful life of four years.
Consequently, under the straight-line method, the depreciation rate for each year was 25 percent,
(100/ estimated useful life of the asset for 100/ 4 years).
Therefore, under the double-declining balance method, the fixed rate is 50 percent (2X 25
percent). This fixed rate of 50 percent is applied to the remaining carrying value at the end of
each year. Estimated residual value is not taken into account in computing depreciation except in
the last year of an asset’s useful life, when depreciation is limited to the amount necessary to
bring the carrying value down to the estimated residual value. The depreciation schedule for this
method is as follows:
Depreciation Schedule, Double-Declining Balance Method

Year Cost Fixed Depr. Yearly Accumulated Carrying Value

Rate Depreciation Depreciation (BV)
Date of purchase Br. 6000 50% - - Br. 6000
End of first year 6000 50% Br. 3000 Br. 3000 3000
End of Second year 6000 50% 1500 4500 1500
End of third year 6000 50% 750 5250 750
End of fourth year 6000 50% 250 550 500

NB.
NB. The fixed rate of 50% is always applied to the Book value at the end of the previous year.
The depreciation is greatest in the first year and declines each year after that. Finally, the
depreciation in the last year is limited to the amount necessary to reduce book value to residual
value, Br. 250 = Br. 750 – Br. 500 (i.e. Previous book value minus residual value).

2.5.4 The Sum of The Years Digits Method

Like the declining balance method, the sum of the years digits method provides a higher amount
of periodic depreciation expense in the earlier use of the asset's life and a decline depreciation
expense thereafter because a successively smaller fraction is applied each year to the depreciable
cost of the asset. Under this method, first we must determine the denominator of the fraction,
which is the sum of the digits representing the years of life. While computing depreciation, the
denominator of the fraction is unchanged and would remain the same. On the other hand the
numerator of the fraction, decreases year by year (4/10,3/10/2/10/1/10). At the end of the asset’s
useful life, the balance remaining should be equal to the salvage value. For example, for a plant
asset with an estimated life of 4 years, the denominator of the fraction is 4+3+2+1 = 10. The
depreciation schedule for this method is as follows:
Depreciation Schedule- Sum - of - the - Years - Digits Method

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 Year Depreciable Rate Yearly Accumulated Book Value
Cost Depreciation Depreciation
Date of purchase Br6000 - - - Br. 6000
End of first year 6000 4/10 Br. 2200 Br. 2200 3800
End of second year 6000 3/10 1650 3850 2150
End of third year 6000 2/10 1100 4950 1050
End of fourth year 6000 1/10 550 5500 500
NB.
NB. The above illustration for the sum of year’s digit method is based on the assumption that the
first use of the asset concide with the beginning of the fiscal period. When the first use of the
asset does not concide with the beginning of a fiscal year, it is necessary to allocate each full
year’s depreciation b/n the two fiscal years benefited. Assuming that the asset in the example
was placed in service after four months of the fiscal year had been elapsed, the depreciation for
that fiscal year would be Br. 1466.67 computed as follows:
First year depreciation = 4/10 X (6000 – 500) X 8/12…………………. Br. 1466.67
Therefore, the depreciation for the second year would be ….Br. 1833.33
Computed as follows:

= 4/10 X (6000 – 500) X 4/12……………….. Br. 733.33

= 3/10 X (6000 – 500) X 8/12……………………. 1100.00

Total, second fiscal year depreciation…………………………… Br. 1833.33

2.6. COMPARISON OF DEPRECIATION METHODS

The straight-line depreciation provides a uniform or equal depreciation charges to expense
throughout the service life of the asset.
The production method of depreciation provides for periodic charges to depreciation expense
that may vary considerably, depending upon the amount of usage of the asset. The production
method does not generate a regular pattern because of the random fluctuation of the deprecation
from year to year.
The major limitation of the production method is that it is not appropriate in situation in which
depreciation is a function of time instead of activity. Another problem in using the production
method is that an estimate of units of output or service hours received is often difficult to
determine.
Both the declining balance and the sum of the years digits methods are referred to as accelerated
depreciation methods, because they provides (report) relatively higher depreciation expense in
the earlier uses of the life of the asset and a gradually declining periodic expense thereafter.
The main justification for this approach is that more depreciation should be charged in earlier
years because the asset suffers its greatest loss of services in those years.

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Accelerated depreciation method also recognizes that changing technologies make some
equipment lose their capacity to yield services rapidly. Thus, it is appropriate to allocate more to
depreciation in the early years, than in later years.
Another argument in favor of an accelerated method is that repair (maintenance) expense is
likely to be greater in later years than in early years. Thus, the reduced amounts of depreciation
reported in later years of the asset’s life are offset to some extent by increased repair
(maintenance) expense.
A visual comparison may provide a better understanding of the three-depreciation methods disc
ribe above. Figure 4-1 compares the yearly depreciation under the four methods.

300
Graphical Comparison of three methods of
Yearly 2500 determining depreciation
Depreciation
2000

1500 SLD

1000
SYD
500
DDBD

1 2 3 4

In the above graph that shows yearly depreciation, straight-line depreciation is uniform at Birr
1375 per year over the four years period. However, the declining balance method begins at an
amount greater than straight line (Br.3000) and decreases each year to amounts that are less than
straight line (ultimately, Br. 250). The production method does not generate a regular pattern
because of the random fluctuation of the depreciation from year to year. In general companies
use different methods of deprecation for goods reason. The straight-line method can be
advantageous for financial reporting because it can produce the highest net income, and the
accelerated depreciation method can be beneficial for tax purposes because it can result in lower
income taxes.
2.7. RECORDING DEPRECIATION
The amount by which a fixed asset decreases is an expense of the business. The amount of
depreciation expense should be recorded each fiscal period. If depreciation expense is not
recorded, the income statement will not contain all the expenses of the business. This will cause
the net income to be reported higher than it should be. Income tax laws allow a business to

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deduct depreciation as an expense in determining net income. If depreciation expenses are not
included on the income tax reports, the business will pay more income taxes than it should be.

Depreciation may be recorded by an entry a t the end of each month, or the adjustment may be
delayed until the end of the year.
To record the periodic cost expiration (allocation) of plant asset, the expense account,
depreciation expense is debited and the part of the entry that records the decrease in the plant
asset is credited to a contra asset account entitled Accumulated Depreciation or Allowance for
Depreciation. The use of this contra asset account permits the original cost to remain unchanged
in the plant asset account. This facilitates the computation of periodic depreciation, the listing of
both cost and accumulated depreciation on the balance sheet, and reporting required for property
and income tax purposes.
NB. An exception to the general procedure of recording depreciation monthly or annually is
often made when a plant asset is sold, traded-in, or discarded.
Illustrative Problem
TORA-BORA Construction Company acquired a new crane for Birr 360,500 at the beginning of
year 1. The crane has an estimated residual value of Birr 35,000 and an estimated useful life of
five years. The crane is expected to last 10,000 operating hours. It was used 1800 hours in year 1,
2000 hours in year 2. and 2500 hours in year 3. Based on the information given above:
1) Compute the annual depreciation and the carrying value for the crane for each of the first
three years under each of the following methods:
a) Straight line method,
b) Units of production method,
c) Double-declining-balance method, and
d) Sum-of-the-years-digits method.
2) Prepare the adjusting entry that would be made each year to record the depreciation
calculated under the straight line method.
Solution:
1) a) Straight Line Method:
Annual depreciation = original cost – estimated salvage value
Estimated Economic life

= Br. 36,500 – Br. 35,000

5 years

= Br. 325,500 = Br. 65,100

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Therefore, deprecation for the first year, second year, and for the third year, is uniformly
Br. 65,100.
b) Units of Production Method:
Hourly Depreciation Rate = Original Cost – Salvage value

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 Estimated Operating Hours

= Br. 360,500 – 35,000

10,000 operating hours

= Br. 32.55

During the first year the crane has been in operation for 1800 hours. Therefore, the depreciation
for the first year is Br. 58,590, computed as follows:
Br. 32,55 X 1800 hours = Br. 58,590
Second year deprecation = Br. 32.55 X 2000 hours = Br. 65,100
Third year depreciation = Br. 32.55 X 2500 hours = Br. 81,375
c) Double-declining- balance Method:
To proceed with the double-declining-balance method, first we have to determine the rate. The
double-declining rate for the asset can be obtained by the following formula:

Rate = 100 X2
Estimated
Life

Rate = 100 2 = 40%

5 years

Unlike the other methods, in the declining-balance method the salvage value is not deducted in
computing the depreciation base. The declining balance rate is multiplied b y the book value of
the asset at the beginning of each period. Therefore,
First year depreciation = 40/100 X 36,500 = Br. 144,200

Second year deprecation = 40/100 X (360,500 – 144,200)

= 40/100 X 216,300 = Br.
Br. 86,520

Third year depreciation = 40/100 (360,500 – 230,720)

= 0.4 X 129,780 = Br. 51,912

d) Sum-of-the-years-digits Method
To work with this method, we must determine the denominator of the fraction,
The denominator or the fraction for an asset with an estimated economic life of 5 years is
5+4+3+2+1 = 15
 Depreciation for year 1 is therefore, 5/15 x (OC – Salvage value)

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 Which is 5/15x (325,500) = Br. 108,500
 Second year depreciation = 4/15 x (325,500) = Br. 86,800
 Third year depreciation= 3/15 x 325,500 = Br. 65,100

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