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Accounting I | © John Petroff, Nancy Paz, veronika wu, Tibebe Mengistu Source: PEOI |
INTRODUCTION TO PLANT ASSETS
Plant assets are assets that are held for more than one year and
are uses in business operations. Land, buildings, equipment,
furniture, and machinery are examples of plant assets. When a
plant
asset is initially acquired, all costs incurred for acquisition
and
installation are debited to the plant asset account. Expenditures
that are related to land can be debited to either Land, Land
Improvements, or Buildings depending upon how permanent they are
and how long they are expected to last.
DEPRECIATION
All plant assets, except land, depreciate. Factors that contribute
to depreciation are physical and functional. Physical depreciation
arises from the actual use of a plant asset. Functional
depreciation is due to obsolescence factors such as technological
advances and less demand for a product. The purpose of recording
depreciation is to show the decline of usefulness of an asset,
not
a decline in its market value. Depreciation merely reduces the
value of plant asset accounts, it does not reduce the cash account
or affect cash flows.
DETERMINING DEPRECIATION
Factors that determine depreciation expense are the initial cost,
the residual value and the useful life. Depreciation can only
be
estimated because it depends on several potentially changing
elements. Residual value is any value that remains after an asset
has been retired. The calculation of depreciation is based on
the
initial cost minus residual value. Several methods used to
calculate depreciation. The straight-line method is the most
popular. Different depreciation methods can be used for financial
statement information and tax purposes.
STRAIGHT-LINE METHOD
The straight-line method of depreciation charges equal amounts
of
depreciation to each period over the useful life of the asset.
It
is determined by subtracting the residual value from the initial
cost and dividing it by the number of the years of estimated life.
Due to its simplicity, it is the most widely used method.
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Example:
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UNITS-OF-PRODUCTION METHOD
The units-of-production method determines depreciation expense
based
on the amount the asset is used. The length of life of an asset
is
expressed in a form of productive capacity. The initial cost less
any
residual value is divided by productive capacity to determine
a rate
of unit-of-production depreciation per units of usage. Units of
usage c
can be expressed in quantity of goods produced, hours used, number
of
cuttings, miles driven or tons hauled, for instance. The depreciation
expense of a period is determined by multiplying usage by a fixed
unit-of-production rate of usage. This depreciation method is
commonly used when asset usage varies from year-to-year.
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Example: A truck was purchased for $27,000 with a residual value of $2,000 based on a life of 200,000 miles. For the month of February, the truck registered 400 miles of use. The depreciation expense is computed as:
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DECLINING-BALANCE METHOD
The declining-balance (also known as double-declining-balance)
method is a popular form of accelerated depreciating. The rate
used is usually twice the rate employed by the straight-line method.
This method does not consider the estimated salvage value in
determining the depreciation rate or in computing the periodic
depreciation. However, an asset cannot be depreciated beyond the
estimated salvage value. Depreciation expense is highest in the
first year, and becomes smaller each subsequent year.
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Example:
v DDB % is computed as 100%, or 1 divided by life of the asset:
Thus, depreciation expense schedule for the above example is
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SUM-OF-THE-YEARS-DIGITS METHOD
The sum-of-the-years-digits method is an another form of accelerated
depreciation. The annual depreciation is calculated by subtracting
salvage value from original cost, and multiplying this figure
by a
fractional rate of depreciation. The denominator of the fraction
is the sum of the years of useful life; for a life of 5 years,
the
denominator is = 1 + 2 + 3 + 4 + 5 = 15. The numerator is the
year
in reverse order. For the first year, the numerator is 5 and the
fraction is 5/15.
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Example:
The formula to solve the SYD depreciation is
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COMPARING DEPRECIATION METHODS
Different depreciation methods produce different results, and
in
some circumstances the use of a particular depreciation method
is
recommended. When the use of an asset fluctuates from period to
period, the units-of-production method is recommended. For assets
that decline in usefulness early, and are subject to high
maintenance costs as they age, a form of accelerated depreciation
should be used, i.e. declining-balance and the sum-of-the-years-
digits methods.
DEPRECIATION & INCOME TAXES
For tax purposes, the straight-line, declining-balance,
sum-of-the-years-digits, and units-of-production methods of
depreciation were allowed prior to 1981. Between 1980 and 1987,
either the straight-line method or the Accelerated Cost Recovery
System (ACRS) could be used. The Tax Reform Act of 1986 revised
the
ACRS by providing a depreciation rate schedule for eight classes
of
plant assets. The use of an accelerated depreciation method reduces
tax liabilities and increases cash flows.
REVISING DEPRECIATION ESTIMATES
Because depreciation is estimated, it often needs to be revised
periodically over the life of the asset. An error in estimating
the
salvage value, the years of useful life, or both can require a
revision. Previously recorded depreciation is not affected by
a
revision. The revision of depreciation is only affects future
depreciation expenses.
RECORDING DEPRECIATION EXPENSES
When depreciation is to be recorded, a Depreciation Expense
account is debited, and Accumulated Depreciation is credited.
Accumulated Depreciation is a contra-asset account that decreases
the value of plant assets. The use of a contra-asset account
allows assets to be shown at cost, and thus allows easier
computations if a revision is necessary or different depreciation
methods are used. When an asset is sold, all accounts related
to
the depreciation of that asset are adjusted.
CAPITAL AND REVENUE EXPENDITURES
Expenditures on plant assets fall into two categories:
1)- capital expenditures: these increase the productive capacity,
efficiency or useful life of the asset, and
2)- revenue expenditures: these include maintenance and repairs.
If an expenditure increases the efficiency or capacity of a plant
asset, that Plant Asset account is debited. If an expenditure
increases the useful life of a plant asset, the Accumulated
Depreciation account is debited. Revenue expenditures are
expensed in the year incurred.
DISPOSING PLANT ASSETS
Plant assets can be disposed of by discarding, selling, or trading
in
for other assets. No matter how plant assets are disposed of,
the
book value of the asset must be removed from the account. When
an
asset becomes completely useless, it is taken of the books by
debiting the Accumulated Depreciation account and crediting the
Equipment account. In the event an asset is discarded before its
estimated useful life, the loss must be debited to the Loss on
Disposal of Plant Assets account.
DISPOSING PLANT ASSETS
When a plant asset is sold, the Cash and Accumulated Depreciation
accounts are always debited, and the Equipment account is credited.
In the event there is a loss or gain from the sale, either the
Loss
on Disposal of Plant Assets or the Gain on Disposal of Plant Assets
accounts will have an entry. When old plant assets are exchanged
for
new plant assets, it is generally accepted that any gains from
a
trade need not be recognized. The amount that is owed after credit
for the trade-in is known as the boot, which is also the required
cash payment. The entry is this situation is
Debit Accumulated Depreciation (old equipment)
Debit Plant Assets (new equipment)
Credit Plant Assets (old equipment)
Credit Cash.
SUBSIDIARY LEDGERS FOR PLANT ASSETS
When a business has a large number of plant assets to keep track
of,
the use of a subsidiary ledger is recommended. Detailed information
on each plant asset is maintained in the subsidiary ledger. All
plant assets can be specifically identified by an assigned number.
The first part of the number corresponds to the general ledger
account, while the second part of the number represents the
identification assigned to the asset. Periodically, it is advisable
to compare balances of the subsidiary ledger with the controlling
accounts in the general ledger. Subsidiary ledgers are very useful
in determining depreciation expenses, filing tax and insurance
forms, as well as recording the disposal of plant assets.
COMPOSITE-RATE DEPRECIATION METHOD
The composite-rate depreciation method determines depreciation
of
a group of similar plant assets by using a single rate. This rate
is determined by dividing annual depreciation by the total original
cost of assets. Although specific equipment in the group may be
added and retired, this method assumes that the mix will remain
unchanged. Gains and losses from the retirement or disposal of
assets are not realized.
LEASING PLANT ASSETS
A business can rent a property for a specified period of time
under
a contract known as a lease. The lessor is the owner of the property,
and the lessee is the party that has the right to use the property.
Leases which extent over most of the asset life, and which transfer
ownership to the lessee at the end of the lease, are called capital
leases. Assets held under capital lease must be shown on the balance
sheet, and therefore, the Plant Assets is debited and a lease
liability account is credited.
Operating leases tend to be more short-term, and the lessee does
not
acquire the leased property at the end of the lease.
INTANGIBLE ASSETS
Intangible assets do not have physical substance. They are not
held for sale, and they are usually highly valuable to the
business. They include patents, copyrights, trademarks, goodwill,
and franchises. Except for goodwill, most intangible assets
receive legal protection of exclusive use. The cost of obtaining
legal protection for the intangible asset should be debited to
the
intangible asset account. The periodic loss of value of the
intangible asset is called amortization, and is expensed annually.
Research and development costs are treated as expense in the year
incurred, and are not treated as intangible assets because it
is
their future success is uncertain.
DEPLETION
The periodic allocation of the use of natural resources is a called
depletion. Mineral deposits, coal, timber, natural gas, and
petroleum are all subject to depletion. Depletion Expense
is debited and Accumulated Depletion is credited for the amount
of
usage during the period. The usage is based on current year
production as a fraction of total capacity, and the determination
is essentially identical to the unit-of-production depreciation
method.
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