Plant Assets and Depreciation

Plant Assets and Depreciation

Depreciation expense spreads the cost of major equipment and assets over a period of time that spans a number of years. Amortization is used to allocate the cost of intangible assets, such as patents, copyrights, trademarks, and franchises. Depletion is used to record the cost of natural resources extracted from the earth.

There are three main events in the life of any asset:

1. acquisition
2. useful life
3. disposal or retirement

Fixed asset acquisition

Depreciable cost

Some costs are incidental to buying new equipment. A specialist might be hired to install a large printing press, or other specialized, complex piece of manufacturing equipment. This type of cost is included in the depreciable cost of the asset. 

Sometimes employees have to be trained. The cost of training may be considered part of the depreciable cost, it the amount is material to the purchase of the asset. A brief training session for one or two machine operators will probably be an immaterial amount. 

The cost of  training the entire company's personnel when a new computer system is installed would probably be a material amount, especially in a large company. Every employee might require a day's training or more in the new system. The loss of productivity would be a material amount, and should be classified as part of the depreciable cost of the asset.

Recording Asset Acquisitions

Land is a non-depreciable asset. It falls into its own category in the books and on the Balance Sheet. Don't include land costs with other fixed asset costs, such as buildings. They must always be entered separately. Buildings will be depreciated; land will not be depreciated. 

The Useful Life of an asset, is the period of time the company expects to use the asset in the business. It is also important that the asset be used as it is intended, and for the production of income. For instance, a computer that is being used as a doorstop is not contributing to the production of income, and it is also not being used as it was intended. 

[Of course, at this point some very clever student will say something like, "What if the computer is used as part of an art project displayed in the foyer of an office building? It's not being used as intended nor in the production of income." Well, young Einstein, objects d'art are Investments, not depreciable plant assets. Nice try, but no banana for the monkey.]

Why do assets depreciate?

For Federal Income Tax purposes, depreciation is referred to as cost recovery. The government allows you to use the cost of plant assets to offset income. You recover your cost a little bit at a time, over a number of years. Each year you reduce your income tax expense, by an amount relative to the cost recovery amount for that year. It's a slightly strange concept if you're not involved in preparing income taxes. But it does make sense if you think about it a bit.

For financial statement purposes, depreciation reflects a number of different influences that each affect an asset over its useful life.

• recognize physical deterioration
• recognize obsolescence
• recognize a reduction in market value
• recognize benefits derived from using the asset
• apply a logical, systematic cost allocation over a relevant period of time
• apply the matching principle

Usually, at this point, students are a showing a slight glaze over their eyes. I then reiterate that depreciation expense reduces income, which in turn cuts income taxes. Cutting our taxes, that's something most of us can relate to. So depreciation is a good thing, an important thing, a joyous and wonderful thing. 

[you may now take a few moments to celebrate the joys of depreciation ...ahhhhh.]

Depreciation Methods

We will study a couple of depreciation methods. There are other methods. If you study international accounting, you will find that other countries deal with these issues in a very different way than we do in the US. But we're #1, so we must be right (hee, hee).
 

OK, let's try this again.

[It is a little known fact that the US congress is responsible for the rapid growth of the computer industry during the 1980s and 1990s. The MACRS depreciation rules were so complex everyone had to buy computers just to do the calculations each year. Millions of computers were sold, just to calculate MACRS depreciation  ........ OK, I'm just kidding. You didn't really think I was serious, did you?. Hey, this is week 8, we're almost done.]

Selling or disposing of Fixed Assets
After selling or disposing of fixed assets, the company no longer has the asset. This requires a journal entry to remove everything in the accounting records relating to the asset. 

The depreciable cost and accumulated depreciation relating to the asset must both be removed, or reversed. There might be a gain or loss when disposing of assets. There might also be incidental costs relating to disposing of the asset. All these things should be included in the journal entry recording the disposal.

Let's assume on September 1, the ledger shows these balances for a piece of equipment.

Removing these amounts from the books with a journal entry
When assets disposed of there might be a gain, loss or a wash (no gain or loss). In either case all such journal entries will start from the same place, removing the related asset cost and accumulated depreciation. This journal entry does not balance; is the beginnings of a journal entry, and must be completed when all the information is available.

Notice the exact opposite of the account balances is entered for each account. This causes the account balances to go to zero after this journal entry is posted.

The asset and related accumulated depreciation have both been removed from the books.
 

Calculating Book Value

Book Value is the difference between the asset cost and accumulated depreciation:
 

Gains and losses are calculated using the Book Value.
 

Equipment sold for a Gain

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

The journal entry is now in balance. Did you notice what I did? I started the journal entry with what I already knew - the cost and accumulated depreciation. I left 2 lines blank in the middle of the journal entry, so the sales price and gain or loss could be recorded. 
 

Equipment sold for a Loss

 
If the equipment is sold for less than its book value there will be a loss. Losses are similar to expenses, and will be recorded with a debit entry. Let's say the equipment is sold on September 15 for $1,000. The loss will be:
 

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

Equipment sold for a Wash

If the equipment is sold equal to its book value there will be a wash. Let's say the equipment is sold on September 15 for $1,400. 
 

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places. In this case there is a wash, so no gain or loss is recorded. The equipment is simply removed from the books.

Equipment Junked

If the equipment is junked there will be a loss equal to its book value. We call this abandonment. The item is usually just thrown in the trash, or hauled to the dump. Sometimes a company will have to pay to have the item hauled away. Incidental costs are revenue expenditures, and are not included in calculating the capital gain or loss.
 

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places. 

Intangible Assets

Intangibles are assets that have no physical existence. They are legal assets or accounting assets, such as copyrights, patents, trademarks or goodwill. We use a simple form of amortization, usually straight-line, to allocate the cost of these items to expenses.