Unit 11

Fixed Assets

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.

Example:

Purchased a building for $400,000 with a life of 30 years and residual

value of $40,000.

Cost of equipment Residual

= $400,000 $40,000/ 30 years
amount/ Life
= $ 12,000 depreciation expense
per year
Cost of equipment Residual = $400,000 $40,000/ 360 months
amount/ Life
= $ 1,000 depreciation expense
 per month

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.

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:

Cost Residual/ Life in units = Depreciation expense per unit

Depreciation expense per unit X
= Depreciation expense
Units used

$27,000 2,000/ 200,000 = $0.125 per mile

$0.125 per mile x 400 = $ 50 Depreciation expense

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.

Example:

Assume equipment that had a five-year life and a residual value of

$ 1,500 was acquired for $36,000. The DDB equation is

DDB% x Book value = Depreciation expense

v DDB % is computed as 100%, or 1 divided by life of the

asset:
 100%/5 = 20% x 2 = 40% , or 1/5 = 20% x 2 = 40%

Thus, depreciation expense schedule for the above example is

Depreciation Net Book

Year DDB% X Book Value =
Expense Value
0 $ 36,000
1 40% X $ 36,000 = $ 14,400 21,600
2 40% X 21,600 = 8,640 12,960
3 40% X 12,960 = 5,184 7,776
4 40% X 7,776 = 3,110 4,666
5 40% X 4,666 = 1,867 2,799
Accumulated
$ 33,201
depreciation
Book value $ 2,799

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.

Example:

Bought equipment worth $ 12,000 with a residual value of $2,000. Its life
is estimated at five years.

The denominator is determined as follows:

Yr. 1 + Yr. 2 = 3 + Yr. 3 = 6 + Yr. 4 = 10 + Yr. 5 = 15

The formula to solve the SYD depreciation is

SYD fraction x Cost Residual = Depreciation expense

SYD Cost
Year X X Depreciation
Fraction Residual
1 5/15 X $ 10,000 X $ 3,333
2 4/15 X $ 10,000 X $ 2,667
3 3/15 X $ 10,000 X $ 2,000
 4 2/15 X $ 10,000 X $ 1,333
5 1/15 X $ 10,000 X $ 667
15/15 Total depreciation $10,000

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.