Chapter 9: Accounting for

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Chapter 9:Accounting

forProperty, Plant, and Equipment

Fundamentals of Intermediate AccountingWeygandt, Kieso and Warfield

Prepared byBonnie Harrison, College of Southern Maryland

LaPlata, Maryland

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Chapter 9Accounting for Property, Plant

and EquipmentAfter studying this chapter, you should be able to:Describe property, plant and equipment and costs

included in its initial valuation,Describe the accounting problems associated with

self-constructed assets.Understand accounting issues related to acquiring

and valuing plant assets.Describe the accounting treatment for costs

subsequent to acquisition.

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Chapter 9Accounting for Property Plant and

EquipmentAfter studying this chapter, you should be able to :Explain the concept of depreciation.Identify the factors involved in the depreciation

process.Compare activity, straight line, and decreasing charge

methods of depreciation.Describe the accounting treatment for the disposal of

property, plant and equipment.Explain how property, plant and equipment are

reported and analyzed.

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Property, Plant, and Equipment (PP&E)

Includes land, building, structures and equipment

They are not held for resale They are long term and are subject to

depreciation (except land) They are tangible

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Acquisition Cost Historical cost is the basis for determining cost. Historical cost includes:

the asset’s cash or cash equivalent price, and the cost of readying the asset for use

Costs incurred after acquisition are: added to asset’s cost, if they provide future

service potential, - or -

expensed, if they do not add to service potential

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Cost of Land, Building, and Equipment

Land costs include: purchase price closing costs, attorney fees, and recording fees costs of getting land ready for use (clearing etc) special assessments for local improvements assumption of liens or encumbrances, and additional improvements with an indefinite life

Sale of salvaged materials reduces cost

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Land Improvements, Building, and Plant

Improvements with limited lives are recorded as Land Improvements (and not as Land)

Building cost includes: costs of materials and labor, and overhead professional fees and building permits

Cost of equipment includes: purchase price freight and handling charges insurance on equipment while in transit costs of special foundation, and trial runs assembling, installation, and trial run costs

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Self-Constructed Assets These are assets constructed by the business for

use in operations The cost of self-constructed assets includes:

cost of direct materials,cost of direct labor,variable manufacturing overhead, a pro rata portion of the fixed overhead,

- and -actual interest costs incurred during

construction (with modification)

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Interest Capitalization: Rationale

• When under construction: – asset does not produce revenue, so

capitalize interest cost• When construction is complete:

– asset produces revenue, so expense interest cost

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Valuation Issues

• A cash discount, whether taken or not, reduces purchase price of asset. (This is the preferred approach)

• Cost of assets, acquired in a basket purchase, are allocated on the basis of their relative fair market values

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Issuance of Stock for Assets

If stock is traded:

basis for recording is the market value of the stock issued.

If the market value of stock is not determinable:

basis for recording is market value of asset.

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Contributions

Contributions received: Recognized in period received as revenue Recorded at fair value of assets received

Contributions given: Recognized as expense in period donated Recorded at fair value of asset donated Difference between fair value and book value

recorded as gain or loss.

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Costs subsequent to Acquisition

• If costs incurred increase future benefits, capitalize costs

• If costs maintain a given level of services, expense costs

• Costs incurred after acquisition can be: additions improvements and replacements rearrangements and reinstallation repairs

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Improvements and ReplacementsCapitalize costs, if

Improvements Replacementsor

They increase future service potential

Substitution ofa better assetfor present

asset

Substitution ofa similar asset

for present asset

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Capitalization Approaches

• Carrying value of asset is known

• Carrying value of the asset is unknown

• Substitution approach

• Capitalize the new asset (without removing the old asset from the pool), OR

• Debit accumulated depreciation (when expenditures extend useful life of asset)

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Depreciation - Concept

* Depreciation is a means of cost allocation.* It is not a method of valuation.* Depreciation involves:

allocating the cost of tangible assets to an expense in a systematic and rational manner to periods expected to benefit from use of assets

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Factors in the Depreciation Process

Questions to be answered:

What is the depreciable base of the asset?

What is the asset’s useful life?

What method of cost apportionment is best for the asset in question?

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Depreciable Base

Depreciable base is the amount subject to depreciation.

It is determined by taking: Original cost of the asset less Estimated salvage or disposal value

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Estimated Service Lives An asset’s service life and physical life are not the

same. Assets are retired (from productive life) due to:

physical factors (such as casualty), or economic factors (such as obsolescence)

Economic factors in turn include Inadequacy (asset can not meet current demand) Supercession (by a better asset) Obsolescence (other factors)

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Depreciation Methods

Depreciation methods can be classified as follows: Tax depreciation methods Financial accounting depreciation methods

Financial accounting methods are: activity method straight-line method accelerated method

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Depreciation Methods: OverviewDepreciation

Methods

Financial AccountingDepreciation Methods

TaxDepreciation

Activitymethod

Straight-linemethod

Acceleratedmethods

1. Declining Balance2. Sum-of-the-years’ digits

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Depreciation Methods: Example

Amber Corporation buys a truck on January 1, 2003. Information relating to the truck is as follows:

Cost, $34,000 Estimated service life, 5 years (or 60,000 miles) Salvage value end of five years or use, $4,000 Actual miles driven:

20,000 miles (in 2003); 15,000 miles (in 2004)

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Straight-line method1. Depreciable base = $34,000 less $4,000 = $30,000

2. Annual depreciation = $30,000 / 5 years = $6,000

3. Depreciation Schedule: (years 1 and 2)Year Book Depreciation Accumulated Book value**

(beg) Depreciation end of year1 $34,000 $6,000 $6,000 $28,0002 $28,000 $6,000 $12,000 $22,000

** Book Value = Cost - Accumulated Depreciation

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Activity method (unit = mile)1. Depreciable base = $34,000 less $4,000 = $30,000

2. Depreciation per mile = $30,000 / 60,000 = $0.50

4. Depreciation Schedule: (years 1 and 2)Year Book Depreciation Accumulated Book value

(beg) Depreciation end of year1 $34,000 $10,000 $10,000 $24,0002 $24,000 $ 7,500 $17,500 $16,500

3. Depreciation (2003) = $0.50 * 20,000 miles = $10,000 Depreciation (2004) = $0.50 * 15,000 miles = $ 7,500

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Sum-of-the-years’-digits (SYD) method

1. Depreciable base = $34,000 less $4,000 = $30,000

2. SYD fraction = (1+2+3+4+5) = 15

3. Depreciation (2003) = $30,000 * (5/15) = $10,000 Depreciation (2004) = $30,000 * (4/15) = $ 8,000 Depreciation (2005) = $30,000 * (3/15) = $ 6,000 Depreciation (2006) = $30,000 * (2/15) = $ 4,000 Depreciation (2007) = $30,000 * (1/15) = $ 2,000

Decreasing Fractions

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Sum-of-the-years’-digits (SYD) method

4. Depreciation Schedule

Year Book Depreciation Accumulated Book value(beg) Depreciation end of year

1 $34,000 $10,000 $10,000 $24,0002 $24,000 $ 8,000 $18,000 $16,0003 $16,000 $ 6,000 $ 24,000 $10,0004 $10,000 $ 4,000 $ 28,000 $ 6,0005 $ 6,000 $ 2,000 $ 30,000 $ 4,000

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Double Declining balance method

1. Rate of depreciation = 2 * (1/5) = 0.40

2. Depreciation (2003) = $34,000 * 0.40 = $ 13,600 Depreciation (2004) = $20,400 * 0.40 = $ 8,160 Depreciation (2005) = $12,240 * 0.40 = $ 4,896 Depreciation (2006) = $ 7,344 * 0.40 = $ 2,938 Depreciation (2007) = ($34,000–$4000) – 29,594 = $406

Total depreciation taken = $ 30,000

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Double declining balance method

3. Depreciation Schedule

Year Book Depreciation Accumulated Book value(beg) Depreciation end of year

1 $34,000 $13,600 $13,600 $20,4002 $20,400 $ 8,160 $21,760 $12,2403 $12,240 $ 4,896 $ 26,656 $ 7,3444 $ 7,344 $ 2938 $ 30,000 $ 4,4065 $ 4,000 $ 406 $ 30,000 $ 4,000

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Partial year depreciation

When an asset is bought sometime during the year, a partial depreciation charge

is required. The procedure is:

Determine depreciation for a full year, and allocate the amount between the two

periods affected (see example ==> )

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Partial year depreciation: Example

Amber Corporation buys a truck on July 1, 2003. Information relating to the truck is as follows:

Cost, $10,000 Estimated service life, 5 years Salvage value end of five years, none.

Determine depreciation expense under the double declining balance method.

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Partial year depreciation: Example

Determine depreciation as follows: First year (2003) ==>

$10,000 X 40% = $4,000 X 6/12 = $2,000

Second full year (2004) ==> ($10,000 - $2,000) X 40% = $3,200

And so on for the remaining years

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Revision of Depreciation Estimates

Determination of depreciation involves initial estimates (life, salvage value.)

When these estimates are revised, we re-compute depreciation.

These revised depreciation expenses apply prospectively to the remaining life of asset.

These changes do not affect prior periods.

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Revision of Depreciation Estimates: Example

Amber Corporation buys a depreciable asset on January 1, 2003 for $95,000.

Estimated life was 20 years. Estimated salvage value was $5,000.On January 1, 2009, estimates were revised as

follows: salvage value, $2,000 estimated life : 24 years (years 2003 through 2032)

Determine depreciation for 2009 based on straight line method of depreciation.

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Revision of Depreciation Estimates: Example

Accumulated depreciation to date of revision of estimates:

($95,000 - $5,000) / 20 years = $4,500 dep $4,500 * 6 years = $27,000 accumulated depr.

Amount to be depreciated (years 2009 through 2032 = 18 years) ($95,000 - $27,000 - $2,000) / 18 years = $3,667 (rounded) annual depreciation

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Dispositions of PP&E

• Plant assets may be:– retired voluntarily, or– disposed of by sale, exchange, involuntary

conversion

• Depreciation is recorded up to the date of disposal before determining gain or loss

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Accounting for ExchangesTypes of Accounting Rationale Exchange Guidance

Dissimilar Recognize gain Earnings processassets and losses is complete

Similar Recognize loss; Earnings processassets (cash Gain up to boot is partiallyreceived) (partial gain) complete

Similar Recognize loss; Earnings processassets (No Defer gain is not completecash received)

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Dissimilar Assets

• Amber Company exchanges a number of trucks for land from Becktel Company.

• Fair value of trucks: $ 49,000.• Book value of trucks: $ 42,000

(Cost, $64,000; Accu. Depr, $ 22,000) • Cash paid to Becktel: $ 17,000• Record the purchase in Amber’s books.

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Dissimilar Assets

Amber BecktelLand, FMV= $66,000

Cash, $17,000plus

Trucks,FMV= $49,000

Amber recognizes gain= FMV less Book value = $7,000

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Dissimilar Assets

Land Dr. $ 66,000 Accu. Dep (Trucks) Dr. $ 22,000 Trucks $ 64,000 Cash $

17,000 Gain on disposal $

7,000

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Similar Assets (loss)

• Amber Company exchanges a used machine for a similar machine from Becktel Company.

• Fair value of used machine: $ 6,000.• Book value of used machine: $ 8,000

(Cost, $12,000; Accu. Depr, $ 4,000)

• Cash paid to Becktel: $ 7,000• Record the purchase in Amber’s books.

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Similar Assets (Loss)

Cash, $ 7,000plus

used machine,FMV= $ 6,000

Amber recognizes loss ==> Book value less FMV = $2,000

Amber BecktelNew machine, FMV= $13,000

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Similar Assets (Loss)

New Machine Dr. $ 13,000 Accu. Dep (Old) Dr. $ 4,000 Loss on disposalDr. $ 2,000 Machine (old) $ 12,000 Cash $ 7,000

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Similar Assets (Deferred gain)

• Davis Company exchanges Ford cars for GM cars from Nertz Company.

• Fair value of Ford cars: $ 160,000.• Book value of Ford cars: $ 135,000 (Cost,

$150,000; Accu. Depr, $ 15,000) • Cash paid to Nertz: $ 10,000• Fair value of GM cars: ($160,000 + $ 10,000)

$ 170,000• Record the purchase in Davis’ books.

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Similar Assets (Deferred Gain)

Cash, $ 10,000plus

Ford cars,FMV= $ 160,000

Davis defers gain ==> FMV less book value = $25,000

Davis NertzGM cars, FMV= $170,000

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Similar Assets (Deferred Gain) GM cars Dr. $ 145,000 (see below)

Accu. Dep (Ford) Dr. $ 15,000 Ford cars (old) $ 150,000 Cash $ 10,000

Fair value of GM cars $170,000 Gain deferred ($ 25,000)

GM cars (basis) $145,000

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Similar Assets (Partial gain)

• Davis Company exchanges Ford cars for GM cars from Nertz Company.

• Fair value of Ford cars: $ 160,000.• Cash paid to Nertz: $ 10,000• Fair value of GM cars: ($160,000 + $ 10,000)

$ 170,000• Book value of GM cars: $ 136,000 (Cost,

$200,000; Accu. Depr, $ 64,000) • Record the purchase in Nertz’s books.

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Similar Assets (Partial Gain)

Cash, $ 10,000plus

Ford cars,FMV= $ 160,000

Nertz: Gain realized: FMV less book value = $34,000

Davis NertzGM cars, FMV= $170,000

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Similar Assets (Partial gain)

• Since Nertz receives cash (boot) as part of the exchange, Nertz recognizes partial gain as follows:

FMV less Book value = Realized gain $170,000 less $136,000 = $ 34,000

• Recognized gain: (next slide)

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Similar Assets (Partial gain)

• Nertz recognizes partial gain as follows: (boot / total consideration) * Realized gain ($10,000 / $ 170,000) * $34,000 = $ 2,000. Total gain less gain recognized = deferred gain

$34,000 less $2,000 = $32,000

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Nertz Company (Partial Gain) Ford cars Dr. $ 128,000 (see below)

Accu. Dep (GM) Dr. $ 64,000 Cash Dr. $ 10,000 GM cars (old) $ 200,000

Gain on disposal $ 2,000

Fair value of Ford cars $160,000 Gain deferred ($ 32,000) Ford cars (basis) $128,000

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