Accounting for Plant Assets and Depreciation

Unit 4:  Accounting For Plant Assets And Depreciation

4.1 Introduction

In the previous chapter you have learnt about the accounting for current assets (i.e. accounting for cash, receivables and inventories). In this chapter you will learn about the issues of plant assets and its related depreciation.

Most business enterprise holds such major assets as land, buildings, equipments, furnitures, tools, and etc. These assets help produce revenue over many periods by facilitating the production and sale of goods or services to customers. Because these assets are necessary in a company’s day-to-day operations, companies do not sell them in the ordinary course of business. Keep in mind, though; one company’s long-term asset might be another company’s short-term asset. For example, a delivery truck is a long-term asset for most companies, but a truck dealer would regard a delivery truck as a current asset merchandise inventory.

 

4.2 Nature and Meaning of Long-term Assets

Assets that can be used by a business enterprise for relatively long period (usually more than one year) are called Long-Term Assets.

Long-term assets are divided into tangible and intangible categories.

Tangible assets (also called plant assets or fixed assets) are assets with physical substance that can be charged in the operations of business for a relatively longer period of time, usually more than one year or one operating cycle whichever is longer. Examples are land, buildings, equipments and machineries, trucks, etc.

In contrast, intangible assets are assets without a physical feature that can be charged in the operations of business for long period of time. They generally consist of rights or advantages held such as goodwill, patents, copyrights, franchise, trade marks, organization costs, etc.

 

4.3 Determination of the Acquisition Cost of Plant Assets

The acquisition cost of plant (fixed) assets is the cash or cash-equivalent purchase price, including incidental costs required to complete the purchase, to transport the asset, and to prepare it for use.

For example, expenditures related to the acquisition of a plant asset such as freight, insurance while in transit, and installation are included in the cost of the asset because they are necessary if the asset is to function. According to the matching principle, therefore, such costs are allocated to the economic life of the asset rather than charged as expenses in the current period.

Land

The acquisition cost of land includes the negotiated cash price plus other costs such as the cost of land surveys, legal fees, title fees, broker’s commissions, co9st of preparing the land to build on, and even the demolition costs of old structures that might be torn down to get the land ready for its intended use.

Under the historical cost assumption, land is reported in the balance sheet at its original cost. Land is not subjected to depreciation because land does not have a limited useful life.

The following illustration will help us how to determine the cost of land.

Illustration-1

A business enterprise acquires a piece of land for future site. It pays a cash price of Br. 210,000, pays brokerage fees of Br. 7500 and title fees of Br. 3000, pays Br. 5000 to have unwanted building removed, and pays, Br. 1500 to have the site graded. The business receives

Br. 2000 salvage from the old building. The cost of the land is determined as follows:

Cash prices (negotiated price)…………………………………………Br. 210,000.00

Title Fees……………………………………………………………………..3,000.00

Brokerage Fees………………………………………………………………...7,500.00

Cost of Grading……………………………………………………………..…1,500.00

Cost of removing (demolition) unwanted building  Br. 5000

Less: Salvage received……………………………….(2000)…………………3,000.00

Total cost of land…………………………………………………… .….Br. 225,000.00

Generally, land is part of property, plant and equipment. If the major purpose of acquiring and holding land is speculative, it is more appropriately classified as an investment. If the land is held on a real estate concern for resale, it should be classified as inventory. When the land has been purchased for the purpose of constructing a building, all costs incurred up to the excavation for the new building are considered land costs. Removal of old buildings clearing, grading and filling are considered land costs because these costs are necessary to get the land in condition for its intended purpose. Any proceeds obtained in the process of getting the land ready for its intended use, such as salvage receipts on the demolition of an old building are treated as reductions in the price of the land.

Cost of buildings

When an existing building is purchased its cost includes, the purchase price plus all repairs and other expenses required to put it in a usable conditions. On the other hand, when a business constructs a new building, the cost includes all reasonable and necessary expenditures, such as those for materials, labor, part of the overhead and other indirect costs, engineers and architects’ fees, insurance during construction, interest incurred on construction loans during the period of construction, lawyers' fees, and building permits. If outside contractors are used in the construction, the net contract price plus other expenditures necessary to put the building in usable condition are included.

Cost of equipment

The term “ equipment” in accounting includes office equipment, store equipment, factory equipment, delivery equipment, machinery, furnitures and fixtures, and similar fixed assets. The cost of such assets includes the invoice (purchase) price, transportation and handling charges, insurance on the equipment while in transit, assembling and installation costs, and costs of conducting trail runs. As indicated earlier, all costs of getting an asset ready for its intended use are costs of that asset.

 

4.4  NATURE and Meaning of Depreciation

As plant assets are used in the operations of a business, their value to provide service decreases through usage and the passage of time.

This cost allocation of plant asset, called depreciation, is recorded in the accounting books periodically.

Depreciation is frequently misunderstood. The term depreciation, as used in accounting, does not refer to the physical deterioration of an asset or the decrease in market value of an asset overtime.  

Depreciation means the allocation of the cost of a plant asset to the periods that benefit from the services of the asset.

The term depreciation is used to describe the gradual conversion of the cost of the asset into an expense.

Depreciation is not a process of valuation. Ac counting records are kept in accordance with the cost principle; they are not indicators of changing price levels. It is possible that, through an advantageous buy and specific market conditions the market value of a building may rise. Nevertheless, depreciation must continue too be recorded because it is the result of an allocation, not a valuation process.

 

4.5 Factors that affect the computation of depreciation

Four factors affect the computation of depreciation. They are:

  1. Cost
  2. Residual value
  3. Depreciable cost, and
  4. Estimated economic (useful) life.

Cost- is the net purchase price plus all reasonable and necessary expenditures to get the asset in place and ready for use.

Residual value- also known as salvage value, disposal value, scrape value, or trade-in value represents the estimated market value of the asset at the time of its retirement.

Depreciable cost - represents the difference between the asset cost and its estimated residual value. For example, an item of equipment that costs Br. 5000 and has a residual value of Br. 500 would have a depreciable cost of Br. 4500, (Br. 5000 - Br. 500). The depreciable costs must be allocated over the estimated economic life of the asset.

Estimated economic (useful) life- the estimated economic life of an asset is the total number of service units expected from the asset. Service units may be measured in terms of years the asset is expected to be used, units expected to be produced, miles or kilometers expected to be driven, or similar measures. In determining the estimated useful life of an asset, the accountant should consider all relevant information, including (1) past experience with similar repair assets, (2) the asset’s present condition, (3) the company’s repairs and maintenance policy, (4) current technological and industry trends, and (5) local conditions such as whether.

 

4.6 methods of computing depreciation

Depreciation methods differ primarily in the amount of cost allocated to each period. A list of depreciation amounts for each year of an asset’s useful life is called depreciation schedule.

The most common methods of computing depreciation for plant assets are:

  1. The straight line method
  2. The units of production method
  3. The double-declining balance method, and
  4. The sum-of- the years-digits method.

 

   4.6.1  Straight-Line Depreciation

When this method is used to allocate depreciation, the depreciable cost of the asset is spread evenly (uniformly) over the useful life of an asset. The straight-line method is based on the assumption that depreciation depends only on the passage of time. The depreciation expense for each period is computed by dividing the depreciable cost by the number of accounting periods in the asset’s estimated useful life. The depreciation expense to be reported is the same in each year. The following illustration will help us to understand the Straight-Line method of computing depreciation.

Illustration - 2

Suppose, for example a business enterprise acquires a new computer (office equipment) at a cost of Birr 6000. It is estimated that the computer has an estimated residual value of Birr 1000 at the end of its estimated useful life of 4 years. The yearly (annual) depreciation would be Birr 1250m computed as follows:

            Annual depreciation = Cost - Salvage value

                                            Estimated useful life

                                         = Birr 6000 – Birr 1000    = Birr 1250  

                                                    4 years

The depreciation to be reported for each of the four years would be as follows:          

                        Depreciation Method- Straight-Line Method

Year

Cost

Yearly Depreciation

Accumulated Depreciation

Carrying value (Book Value)

Beginning of first year

Br. 6000

-

-

Br.  6000.00

End of first year

6000

Br. 1250.00

Br. 1250.00

4750.00

End of second year

6000

1250.00

1250.00

3500.00

End of third year

6000

1250.00

3750.00

2250.00

End of fourth year

6000

1250.00

5000.00

1000.00

                                              

NB. There are three important points to note from the depreciation schedule for the straight-line depreciation method. First, the depreciation is the same each year. Second, the accumulated depreciation increases uniformly. Third, the carrying (Book) value decreases uniformly until it reaches the estimated residual value.

 

   4.6.2 Units of Production Method

The production method of depreciation is based on the assumption that depreciation is mainly the result of use and that the passage of time plays no role in the depreciation process. If we assume that the office equipment from the previous illustration has an estimated useful life of 10,000 hours, the depreciation cost per hour would be determined as follows:

      Hourly depreciation  = Cost – Salvage value               = Br. 6000.00 – 1000 = Br. 0.50

            Rate                    Estimated units of useful life             10,000 operating hrs.

If we assume that the use of the equipment was 2800 hours for the first year, 3600 hours for the second, 2400 hours for the third, and 1200 hours for the fourth, the depreciation schedule for the office equipment would appear as follows:

Depreciation Schedule – Production Method

Year

Cost

Hours

Depreciation Per Hour

Yearly Depr.

Accum.

Depr.

Carrying value (Book value)

Beginning of the

First year

Br. 6,000

-

Br. 0.50

-

-

Br. 6,000.00

End of first year

6,000

2,800

0.50

Br. 1,400.00

Br. 1,400.00

4,600.00

End of second year

6,000

3,600

0.50

1,800.00

3,200.00

2,800.00

End of third year

6,000

2,400

0.50

1,200.00

4,400.00

1,600.00

End of fourth year

6,000

1,200

0.50

600.00

5,000.00

1,000.00

Under the production method, there is a direct relation between the amounts of depreciation each year and the units of output or use. Also, the accumulated depreciation increases each year indirect relation to units of output or use. Finally, the carrying amount decreases each year in direct relation to units of output or use until it reaches the estimated residual value.

Under the production method, the units of output or use that is used to measure estimated useful fife for each asset should be appropriate for that asset. For example, for one machine number of units produced may be an appropriate measure, for another number of hours may be a better measure. The production method should be used only when the output of an asset over its useful life can be estimated with reasonable accuracy.

 

4.6.3 Declining Balance Method

This method of depreciation results in relatively large amount of depreciation in the early years of an assets life and smaller amounts in later years. This method is based on the assumption of the passage of time. Since most kinds of plant assets are most efficient when new, and so they provide more and better service in the early years of useful life. It is consistent with the matching rule to allocate more depreciation to the early years than to later years if the benefits or services received in the early years are greater.

The declining-balance method is the most common accelerated method of depreciation. Under this method depreciation is computed by applying a fixed rate to the book value of the asset, resulting in higher depreciation charges during the early years of the asset’s life. Though any fixed rate might be used under the method, the most common rate is a percentage equal to twice the straight-line percentage. When twice the straight-line rate is used, the method is usually called the double-declining balance method.

Referring to the previous example, the equipment had an estimated useful life of four years. Consequently, under the straight-line method, the depreciation rate for each year was 25 percent, (100/ estimated useful life of the asset for 100/ 4 years).

Therefore, under the double-declining balance method, the fixed rate is 50 percent (2X 25 percent). This fixed rate of 50 percent is applied to the remaining carrying value at the end of each year. Estimated residual value is not taken into account in computing depreciation except in the last year of an asset’s useful life, when depreciation is limited to the amount necessary to bring the carrying value down to the estimated residual value. The depreciation schedule for this method is as follows:

Depreciation Schedule, Double-Declining Balance Method

Year

Cost

Fixed Depr. Rate

Yearly Depreciation

Accumulated Depreciation

Carrying Value (BV)

Date of purchase

Br. 6000

50%

-

-

Br. 6000

End of first year

6000

50%

Br. 3000

Br. 3000

3000

End of Second year

6000

50%

1500

4500

1500

End of third year

6000

50%

750

5250

750

End of fourth year

6000

50%

250

550

500

NB. The fixed rate of 50% is always applied to the Book value at the end of the previous year. The depreciation is greatest in the first year and declines each year after that. Finally, the depreciation in the last year is limited to the amount necessary to reduce book value to residual value, Br. 250 = Br. 750 – Br. 500 (i.e. Previous book value minus residual value).

 

   4.6.4 The Sum of The Years Digits Method                                                          

Like the declining balance method, the sum of the years digits method provides a higher amount of periodic depreciation expense in the earlier use of the asset's life and a decline depreciation expense thereafter because a successively smaller fraction is applied each year to the depreciable cost of the asset. Under this method, first we must determine the denominator of the fraction, which is the sum of the digits representing the years of life. While computing depreciation, the denominator of the fraction is unchanged and would remain the same. On the other hand the numerator of the fraction, decreases year by year (4/10,3/10/2/10/1/10). At the end of the asset’s useful life, the balance remaining should be equal to the salvage value. For example, for a plant asset with an estimated life of 4 years, the denominator of the fraction is 4+3+2+1 = 10. The depreciation schedule for this method is as follows:

Depreciation Schedule- Sum-of-the-Years-Digits Method                              

Year

Depreciable Cost

Rate

Yearly Depreciation

Accumulated Depreciation

Book Value

Date of purchase

Br6000

-

-

-

Br. 6000

End of first year

6000

4/10

Br.  2200

Br. 2200

3800

End of second year

6000

3/10

1650

3850

2150

End of third year

6000

2/10

1100

4950

1050

End of fourth year

6000

1/10

550

5500

500

     
NB. The above illustration for the sum of year’s digit method is based on the assumption that the first use of the asset concide with the beginning of the fiscal period. When the first use of the asset does not concide with the beginning of a fiscal year, it is necessary to allocate each full year’s depreciation b/n the two fiscal years benefited. Assuming that the asset in the example was placed in service after four months of the fiscal year had been elapsed, the depreciation for that fiscal year would be Br. 1466.67 computed as follows:

First year depreciation = 4/10 X (6000 – 500) X 8/12…………………. Br. 1466.67

Therefore, the depreciation for the second year would be                   ….Br. 1833.33

Computed as follows:

                                        = 4/10 X (6000 – 500) X 4/12………………..  Br.      733.33

                                        = 3/10 X (6000 – 500) X 8/12…………………….    1100.00

              Total, second fiscal year depreciation……………………………  Br. 1833.33

 

4.7 Comparison of depreciation methods

The straight-line depreciation provides a uniform or equal depreciation charges to expense throughout the service life of the asset. 

The production method of depreciation provides for periodic charges to depreciation expense that may vary considerably, depending upon the amount of usage of the asset. The production method does not generate a regular pattern because of the random fluctuation of the deprecation from year to year.

The major limitation of the production method is that it is not appropriate in situation in which depreciation is a function of time instead of activity. Another problem in using the production method is that an estimate of units of output or service hours received is often difficult to determine.

Both the declining balance and the sum of the years digits methods are referred to as accelerated depreciation methods, because they provides (report) relatively higher depreciation expense in the earlier uses of the life of the asset and a gradually declining periodic expense thereafter.

The main justification for this approach is that more depreciation should be charged in earlier years because the asset suffers its greatest loss of services in those years.

Accelerated depreciation method also recognizes that changing technologies make some equipment lose their capacity to yield services rapidly. Thus, it is appropriate to allocate more to depreciation in the early years, than in later years.

Another argument in favor of an accelerated method is that repair (maintenance) expense is likely to be greater in later years than in early years. Thus, the reduced amounts of depreciation reported in later years of the asset’s life are offset to some extent by increased repair (maintenance) expense.

A visual comparison may provide a better understanding of the three-depreciation methods disc ribe above. Figure 4-1 compares the yearly depreciation under the four methods.

three method of determinign depreciation

In the above graph that shows yearly depreciation, straight-line depreciation is uniform at Birr 1375 per year over the four years period. However, the declining balance method begins at an amount greater than straight line (Br.3000) and decreases each year to amounts that are less than straight line (ultimately, Br. 250). The production method does not generate a regular pattern because of the random fluctuation of the depreciation from year to year. In general companies use different methods of deprecation for goods reason. The straight-line method can be advantageous for financial reporting because it can produce the highest net income, and the accelerated depreciation method can be beneficial for tax purposes because it can result in lower income taxes.

 

4.8 Recording Depreciation

The amount by which a fixed asset decreases is an expense of the business. The amount of depreciation expense should be recorded each fiscal period. If depreciation expense is not recorded, the income statement will not contain all the expenses of the business. This will cause the net income to be reported higher than it should be. Income tax laws allow a business to deduct depreciation as an expense in determining net income. If depreciation expenses are not included on the income tax reports, the business will pay more income taxes than it should be.

Depreciation may be recorded by an entry a t the end of each month, or the adjustment may be delayed until the end of the year.

To record the periodic cost expiration (allocation) of plant asset, the expense account, depreciation expense is debited and the part of the entry that records the decrease in the plant asset is credited to a contra asset account entitled Accumulated Depreciation or Allowance for Depreciation. The use of this contra asset account permits the original cost to remain unchanged in the plant asset account. This facilitates the computation of periodic depreciation, the listing of both cost and accumulated depreciation on the balance sheet, and reporting required for property and income tax purposes.

NB. An exception to the general procedure of recording depreciation monthly or annually is often made when a plant asset is sold, traded-in, or discarded.

 

4.9 special depreciation methods

Some times each of the four depreciation methods discussed so far may not b e suitable because the assets involved have unique characteristics, or the nature of the industry requires that a special depreciation method be use of these methods, the group and composite methods are discussed below:

 

   4.9.1 Group And Composite Methods

Depreciation methods are usually applied to a single asset. Under some circumstances, however, a number (group) of asset accounts are depreciated using one rate. For example, an enterprise such as Ethiopian Telecommunication Corp. might depreciate telephone poles, microwave systems, or switchboards by groups.

Group depreciation - the term “group” refers to a collection of assets that are similar in nature. The group method is frequently used when the assets are fairly homogeneous and have approximately the same useful lives. The group method more closely approximates a single-unit cost procedure because the dispersion from the average is not as great.

Composite-rate depreciation - the term “composite” refers to  collection of assets that are not similar (or dissimilar) in nature.

The composite method is used when the assets are heterogeneous and have different lives.

When depreciation is computed on the basis of a composite group of assets of differing life spans, a rate based on averages must be developed. This is done by (1) computing the annual depreciation for each asset, (2) determining the annual depreciation, and (3) dividing the sum thus determined by the total cost of the assets.      

Illustration - 3

Tana Transport share Co. depreciates its group of cars, buses, and trucks on the basis of composite-depreciation method. The composite-rate depreciation is computed in the following manner:

                        Original           Residual           Depreciable         Estimated        Annual Dep.

Asset                  Cost                 Value                  Cost                     Life     (straight line method)        

Cars                Br.400,000         Br. 80,000         Br. 320,000          8 years                Br. 40,000

Buses                2,400,000             240,000            2,160,000        10 years                    216,000

Trucks              1,500,000             150,000            1,350,000          9 years                    150,000

                   Br. 4,300,000       Br. 470,000     Br. 3,830,000                                   Br. 406,000

 

Composite depreciation rate  =   Br. 406,000      =  9.44%

                                                   Br. 4,300,000                      

If no change exists in the asset account, the group of assets will be depreciated to the residual or salvage value at the rate of Br. 406,000 (Br. 4,300,000 x 9.44%) a year.

The composite depreciation rate may be applied against total asset cost on a monthly basis, or some reasonable assumption may be made regarding the timing of increases and decreases in the group. A common practice is to assume that all additions and retirements have occurred uniformly throughout the year. The composite rate is then applied to the average of the beginning and ending balances of the account. Another acceptable averaging technique is to assume that all additions and retirements during the first-half of the year occurred as of the first day of the year, and that all additional and retirements during the second half of the year occurred on the first day of the following year.

NB. If an asset within the composite group is retired before, or after, the average service life of the group is reached, the resulting gain or loss should not be recognized. This practice is justified because some assets will be retired (disposed) before the average service life of the group and others after the average life. For this reason, the debit to Accumulated Depreciation is the difference between original costs and cash received.

Illustration - 4

Suppose that TANA Transport share Co. in the previous example, sold one of the trucks with the cost of Br. 75,000, at a selling price of Br. 40,000, at the end of the fourth year. Therefore, the entry to record the disposal would be:

Solution:

Original cost of the asset………………………………………..Birr 75,000

Less: cash receipts from sale of asset………………………………..40,000

Accumulated Depreciation of the asset…………………………Birr 35,000

Accumulated Depreciation……………35,000

Cash…………………………………...40,000

                 Cars, Buses, and Trucks……………….75,000

 

4.10 Revision of Depreciation Rates

When a plant asset is acquired, depreciation rates are carefully determined based on past experience with similar assets and other relevant information. The provisions for depreciation are only estimates, however, and it may be necessary to revise the estimated economic life and that of salvage value during the life of the asset. Unexpected physical deterioration or unforeseen obsolescence may make the useful life of the asset less than originally estimated. Good maintenance procedures, revision of operating procedures, or similar improvements may prolong the life of the asset beyond the original estimate.

Depreciation of partial years

So far, the illustrations of the depreciation methods have assumed that the plant assets were purchased at the beginning or end of the accounting period. However, business does not often buy assets exactly at the beginning or end of the accounting period. In most cases, they acquire the assets when they are needed and sell or discard them when they are no longer useful or needed. The time of year is normally not a factor in the decision. Thus, it is often necessary to calculate depreciation for partial years.

 

4.11 capital and revenue expenditures

Capital Expenditures- are expenditures that improve the operating efficiency (or capacity) or costs incurred to achieve greater future benefits.

In addition to the acquisition of plant assets, capital expenditures included additions and betterments.

An addition is an enlargement to the physical layout of a plant asset. Suppose for example, if a new wing is added to a building, the benefits from the expenditure will be received over several years, and the amount paid for it should be debited to the asset account.

A betterment, on the other hand, is an improvement that does not add to the physical layout of the asset. Installation of an air conditioning system is an example of betterment, Replacement of a concrete floor for a wooden floor is also betterment that will provide benefits over a number of years, so its cost should be charged (debited) to an asset account.

Another types of capital expenditures include extraordinary repairs. Extraordinary repairs are repairs of amore significant nature. They affect the estimated residual value or estimated useful life of an asset. For example, a boiler for heating a building may be given a complete overhaul, at a cost of Br. 3000 that will prolong its economic life by 5 years.

Extraordinary repairs are recorded by debiting the accumulated depreciation account, under the assumption that some of the depreciation previously recorded has now been eliminated. The effect of this reduction in the accumulated depreciation account is to increase the book value of the asset by the cost of the extraordinary repair. As a result, the new book value of the asset should be depreciated over the new estimated useful life.

Revenue expenditures

Revenue expenditures are expenditures incurred in order to maintain the normal operating efficiency of the asset.

Among the more usual kinds of revenue expenditures for plant asset are the repairs, maintenance, lubrication, Cleaning and inspection necessary to keep an asset in good working condition.

Ordinary repairs are expenditures that are necessary to keep an asset in good operating conditions. Trucks must have tune-ups, their tires and batteries must be replaced regularly, and other routine repairs must be made. Offices and halls must be painted regularly, and broken tiles or woodwork must be replaced. Such repairs benefits only the current period and therefore must be charged against the revenue in the current fiscal period.

 

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