Tangible resources that have physical substance, are used in the operations of the business, and are not intended for sale to customers.
> Plant assets are critical to a company’s success because they determine the company’s capacity and therefore its ability to satisfy customers.
> It is important for a company to (1) keep assets in good operating condition, (2) replace worn-out or outdated assets, and (3) expand its productive assets as needed.
1. Describe how the cost principle applies to plant assets.
> The cost principle requires that companies record plant assets at cost. Cost consists of all expenditures necessary to acquire an asset and make it ready for its intended use
Revenue expenditures (p. 449)
Expenditures that are immediately charged against revenues as an expense.
Capital expenditures (p. 449)
Expenditures that increase the company’s investment in plant assets.
> Cost is measured by the cash paid in a cash transaction or by the cash equivalent price paid when companies use noncash assets in payment. The cash equivalent price is equal to the fair value of the asset given up or the fair value of the asset received, whichever is more clearly determinable. Once cost is established, it becomes the basis of accounting for the plant asset over its useful life.
> Current fair value is not used to increase the recorded cost after acquisition.
Cash equivalent price (p. 449)
An amount equal to the fair value of the asset given up or the fair value of the asset received, whichever is more clearly determinable.
> IFRS is flexible regarding asset valuation. Companies revalue to fair value when they believe this information is more relevant.
> 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 on the land assumed by the purchaser.
> Land improvements are structural additions made to land, such as 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.
> Because of their limited useful life, 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.
> When a building is purchased, such costs include the purchase price, closing costs (attorney’s fees, title insurance, etc.), and real estate broker’s commission. Costs to make the building ready for its intended use consist of expenditures for remodeling rooms and offices 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 made by the owner for architects’ fees, building permits, and excavation costs.
> 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, subsequent interest payments on funds borrowed to finance the construction are recorded as increases (debits) to Interest Expense.
> The cost of equipment 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.
> Two criteria apply in determining the cost of equipment: (1) the frequency of the cost—one time or recurring, and (2) the benefit period—the life of the asset or one year.
Lessor (p. 452)
A party that has agreed contractually to let another party use its asset for a period at an agreed price.
Lessee (p. 452)
A party that has made contractual arrangements to use another party’s asset for a period at an agreed price.
> Some advantages of leasing an asset versus purchasing it are:
1.Reduced risk of obsolescence. Frequently, lease terms allow the party using the asset (the lessee) to exchange the asset for a more modern one if it becomes outdated. This is much easier than trying to sell an obsolete asset. 2.Little or no down payment. To purchase an asset, most companies must borrow money, which usually requires a down payment of at least 20%. Leasing an asset requires little or no down payment. 3.Shared tax advantages. Startup companies typically earn little or no profit in their early years, and so they have little need for the tax deductions available from owning an asset.
In a lease, the lessor gets the tax advantage because it owns the asset. It often will pass these tax savings on to the lessee in the form of lower lease payments. 4.Assets and liabilities not reported. Many companies prefer to keep assets and especially liabilities off their books. Reporting lower assets improves the return on assets ratio (discussed later in this chapter). Reporting fewer liabilities makes the company look less risky. Certain types of leases, called operating leases, allow the lessee to account for the transaction as a rental, with neither an asset nor a liability recorded.
> Under another type of lease, a capital lease, lessees show both the asset and the liability on the balance sheet. The lessee accounts for capital lease agreements in a way that is very similar to purchases: The lessee shows the leased item as an asset on its balance sheet, and the obligation owed to the lessor as a liability. The lessee depreciates the leased asset in a manner similar to purchased assets.
2. Explain the concept of depreciation.
Depreciation (p. 453)
The process of allocating to expense the cost of a plant asset over its useful life in a rational and systematic manner.
> Depreciation affects the balance sheet through accumulated depreciation, which companies report as a deduction from plant assets. It affects the income statement through depreciation expense.
> Depreciation is a cost allocation process, not an asset valuation process.
> The book value—cost less accumulated depreciation—of a plant asset may differ significantly from its fair value. In fact, if an asset is fully depreciated, it can have zero book value but still have a significant fair value.
> Depreciation applies to three classes of plant assets: land improvements, buildings, and equipment. Each of these classes is considered to be a depreciable asset because the usefulness to the company and the revenue-producing ability of each class decline over the asset’s useful life.
> Depreciation does not apply to land because its usefulness and revenue-producing ability generally remain intact as long as the land is owned. In fact, in many cases, the usefulness of land increases over time because of the scarcity of good sites. Thus, land is not a depreciable asset.
> During a depreciable asset’s useful life, its revenue-producing ability declines because of wear and tear.
> A decline in revenue-producing ability may also occur because of obsolescence.
> Obsolescence is the process by which an asset becomes out of date before it physically wears out.
> When a business is acquired, proper allocation of the purchase price to various asset classes is important, since different depreciation treatment can materially affect income. For example, buildings are depreciated, but land is not.
> Recognizing depreciation for an asset does not result in the accumulation of cash for replacement of the asset. The balance in Accumulated Depreciation represents the total amount of the asset’s cost that the company has charged to expense to date; it is not a cash fund.
> Three factors in computing depreciation
1.Cost. Earlier in the chapter, we explained the considerations that affect the cost of a depreciable asset. Remember that companies record plant assets at cost, in accordance with the 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, repair and maintenance policies, and vulnerability of the asset to obsolescence.
The company’s past experience with similar assets is often helpful in deciding on expected useful life. 3.Salvage value. Salvage value is an estimate of the asset’s value at the end of its useful life for its owner. Companies may base the value 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 expense is reported on the income statement. > Accumulated depreciation is reported on the balance sheet as a deduction from plant assets.
3. Compute periodic depreciation using the straight-line method, and contrast its expense pattern with those of other methods.
Although a number of methods exist, depreciation is generally computed using one of three methods:
> Once a company chooses a method, it should apply that method consistently over the useful life of the asset. Consistency enhances the ability to analyze financial statements over multiple years.
> Straight-line depreciation is used for some or all of the depreciation taken by more than 95% of U.S. companies.
Straight-line method (p. 455)
A method in which companies expense an equal amount of depreciation for each year of the asset’s useful life.
> To compute the annual depreciation expense, we divide depreciable cost by the estimated useful life. Depreciable cost represents the total amount subject to depreciation; it is calculated as the cost of the plant asset less its salvage value.
> What happens when an asset is purchased during the year, rather than on January 1 as in our example? In that case, it is necessary to prorate the annual depreciation for the portion of a year used.
Depreciable cost (p. 455)
The cost of a plant asset less its salvage value.
Declining-balance method (pp. 456, 476)
A depreciation method that applies a constant rate to the declining book value of the asset and produces a decreasing annual depreciation expense over the asset’s useful life.
Accelerated-depreciation method (p. 456)
A depreciation method that produces higher depreciation expense in the early years than the straight-line approach.
> A common declining-balance rate is double the straight-line rate. Using that rate, the method is referred to as the double-declining-balance method.
> Useful life can be expressed in ways other than a time period. Under the units-of-activity method, useful life is expressed in terms of the total units of production or the use expected from the asset.
> The units-of-activity method is ideally suited to factory machinery: Companies can measure production in terms of units of output or in terms of machine hours used in operating the machinery. It is also possible to use the method for such items as delivery equipment (miles driven) and airplanes (hours in use).
> The units-of-activity method is generally not suitable for such assets as buildings or furniture because activity levels are difficult to measure for these assets.
> As the name implies, under units-of-activity depreciation, the amount of depreciation is proportional to the activity that took place during that period.
> Periodic depreciation varies considerably among the methods, but total depreciation is the same for the five-year period. Each method is acceptable in accounting because each recognizes the decline in service potential of the asset in a rational and systematic manner.
> Depreciation and Income Taxes
The Internal Revenue Service (IRS) allows corporate taxpayers to deduct depreciation expense when computing taxable income. However, the tax regulations of the IRS do not require the taxpayer to use the same depreciation method on the tax return that it uses in preparing financial statements.
> Depreciation per financial statements is usually different from depreciation per tax returns.
> Companies must disclose the choice of depreciation method in their financial statements or in related notes that accompany the statements.
4. Describe the procedure for revising periodic depreciation.
When making the change, the company (1) does not correct previously recorded depreciation expense, but (2) revises depreciation expense for current and future years. The rationale for this treatment is that continual restatement of prior periods would adversely affect users’ confidence in financial statements.
To determine the new annual depreciation expense, the company first computes the asset’s depreciable cost at the time of the revision. It then allocates the revised depreciable cost to the remaining useful life.
Use a step-by-step approach: (1) determine new depreciable cost; (2) divide by remaining useful life.
> Management should periodically review annual depreciation expense. If wear and tear or obsolescence indicates that annual depreciation is either inadequate or excessive, the company should change the depreciation expense amount.
> When a change in an estimate is required, the company makes the change in current to future years but not to prior years.
> Extending an asset’s estimated life reduces depreciation expense and increases current period income.