Disposal of Plant Assets

Unit 5: Disposal of Plant Assets

5.1  Introduction

So far we have seen how to account for property, plant, and equipment assets, from calculating acquisitions cost to depreciating this cost up to the end of the asset’s useful life. Plant assets, such as equipment, delivery trucks, or machineries cannot be used forever. The assets may wear out or the business may replace them with newer model. When a plant asset is no longer useful to a business the asset may be disposed of either through discarding, sale, or traded-in with similar) or dissimilar) assets. This chapter therefore, is presented this concept in detail.

 

5.2 disposals of plant assets

A plant asset rarely lasts exactly as long as its estimated life. If it lasts longer than its estimated life, it is not depreciated past the point at which its carrying value equals its residual value. The purpose of depreciation is to spread the depreciable cost of the asset over the economic life of the asset. Thus, the total accumulated depreciation should never exceed the total depreciable cost. If the asset is still used in the business beyond the end of its estimated life, its cost and accumulated depreciation remain in the ledger accounts. Proper records will thus be available for maintaining control over plant assets. If the residual value is zero, the book value of a fully depreciated asset is zero until the asset is disposed off. If such an asset is discarded, no gain or loss results. A plant asset may be disposed by:

(1) Discarding it as worthless; (2) Selling it; or (3) Trading it in on a new asset

 

   5.2.1  Recording Discarding of a Plant Asset

If a plant asset is of no further use to the business and cannot be sold or traded, then the plant asset is discarded. If the asset has no book value. (i.e., if it is fully depreciated), the plant asset account is credited for the amount of the original cost of the item being discarded. At the same time, the accumulated depreciation account is debited for the amount of the total accumulated depreciation of the item being discarded. In this case neither gain nor loss is realized. On the other hand, if a plant asset has a book value (if not fully depreciated) at the time it is discarded, the business incurs a loss.

Illustration - 1

Suppose for example, on July 5, year 5, equipment that was acquired On Jan 10, year 1, at a cost of Br. 11,000, is discarded as worthless. The discarded equipment has a carrying value of Br. 2000 at the time of disposal. The carrying value is computed as the difference between the cost of asset Br. 11,000 and accumulated deprecation, Br. 9000. A loss equal to the carrying value should be recorded when the equipment is discarded.

Solution:

The journal entry required to discard the plant asset as of July 5, year 5, is:

         Year 5

         July 5. Accumulated Deprecation, Equipment …………9000.00

                   Loss on disposal of plant Asset…………………2000.00

                                       Equipment ……………………………….11000.00

              Discarding Equipment no longer used in the business.

 

   5.2.2 Recording the Sale of Plant Asset

The entry to record the sale of an asset for cash is similar to the one illustrated above except that the receipt of cash should also be recorded. The following entries show how to record the sale of equipment under three assumptions about the selling price. In the first case, the Br. 2000 cash received is exactly equal to the book value of the equipment (which is equal to Br. 2000).

Case 1. Sold at an amount equal to Book value, Br. 2000, no gain or loss results.

                        Year 5

July 5. Cash ……………………………………2000.00

          Accumulated Depreciation, Equip……...9000.00

                             Equipment ………………………………..11000.00         

       Sale of equipment at an amount equal to book value 

Case 2. Sold at Br. 1500 cash; Loss of Br. 500, (BV = Br. 2000)

                Year 5

   July 5. Loss on sale of equipment………………….500.00

              Accumulated Depreciation……………   9000.00

               Cash …………………………………….1500.00

                             Equipment…………………………………11000.00

        Sale of equipment at less than the book value. Loss of Br. 500

Case 3. Sold at Br. 3000 cash; gain of Br. 1000, cash received through

            Sale less book value of the asset (Br. 3000 – Br. 2000)

            Year 5

July 5.

         Cash ……………………………………….3000.00

         Accumulated Depr, Equipment……………9000.00

                       Equipment…………………………………..11000.00

                       Gain on sale of plant asset………………...1000.00

Sale of equipment at more than the book value; gain of Br. 1000,

 (Br. 3000 – Br.2000) recorded

 

   5.2.3 Recording Exchange of Plant Assets

Businesses also dispose of plant assets by trading them in on the purchase of other plant assets. Exchanges may involve similar assets, such as an old machine traded-in on a newer model, or dissimilar assets, such as a machine traded-in on a truck. In either case, the purchase price is reduced by the amount of the trade-in allowance.

The basic accounting for exchanges of plant assets is similar to accounting for sales of plant assets for cash. If the trade-in allowance received is greater than the carrying value of the assets surrendered, there has been a gain. If the trade-in allowance is less than the carrying value, there has been a loss.

There are special rules for recognizing these gains and losses, depending on the nature of the assets exchanged.

Both Gains and Losses are recognized when a company exchanges dissimilar assets. Assets are dissimilar when they perform different functions; assets are similar when they perform the same function.

For financials reporting purposes, gains on exchanges of similar assets are not recognized because the earning lives of the asset surrendered are not considered to be completed.

When a company trades-in an older machine on a newer machine of the same type, the economic substance of the transaction is the same as that of a major renovation and upgrading of the older machine.

Accounting for exchange of similar assets is complicated by the fact that neither gains nor losses are recognized for income tax purposes.

Loss Recognized on the Exchange

A loss is recognized for financial reporting purposes on all exchange in which a material loss occurs.

Illustration-2

To illustrate the recognition of a loss, assume that the business exchange a machine with a cost of Br. 11,000, and accumulated depreciation of Br. 9000 for a newer more modern machine on the following terms:           

Cost of new machine ………………………Birr 12000.

            Trade-in Allowance for old machine……………(1500)

            Cash payment required (Boot)……………..Birr 10500.

Solution

In the illustration above, the trade-in allowance (1500) is less than the carrying value (Br. 2000) of the old machine. The loss on the exchange is Br. 500, (Br. 2000 – Br. 1500). Therefore, the journal entry required to record the exchange of assets would be as follows:       

         Year 5.

         July 5. Equipment (New)……………………..120,00.00

         Accum. Depreciation-Equip…………………...9,000.00

         Loss on Exchange of plant assets………………. 500.00

                          Equipment (old)……………………………………11,000.00

                          Cash…………………………….…………………. 10,500.00

 

Loss Not Recognized on the Exchange

In the previous illustration, in which a loss was recognized, the new asset was recorded at the purchase price of Br. 12000 and a loss of Br. 500 was recognized. If the transaction is for similar assets and is to be recorded for income tax purpose, the loss should not be recognized. In this case, the cost basis of the new asset will reflect the effect of the unrecorded loss. The cost basis for the new asset, therefore, is computed by adding the cash payment to the carrying value of the old asset:

                 Carrying (Book) value of old Equipment……………………..Birr 2,000.00

                 Cash paid (Boot given)…………………………………………    10,500.00

                  Cost-basis of new Equipment ……………………………… Birr 12,500.00

Note that no loss is recognized in the entry to record this transaction.

       Year 5.

       July 5. Equipment (New)……………………………….12,500.00

                  Accumulated Depreciation………………………  9,000.00

                                     Equipment (old)……………………………11,000.00

                                    Cash………………………………………..  10,500.00

To record exchange of Equipments - cost of old Equipments

 and its related Accumulated Depreciation removed from the

 accounts; new equipment recorded at amount equal to book

value of old equipment plus boot given.

NB. The new equipment is recorded (reported) at a purchase price of Br. 12000 plus the unrecognized loss of Br. 500. the post postponement of the loss. Since depreciation of the new equipment will be computed based on a cost of Br. 12500 instead of Br. 12000, the “unrecognized” loss results in more depreciation each year on a new equipment than the loss had been recognized.

 

Gain Recognized on the Exchange

Gains on exchanges are recognized for financial reporting purposes when dissimilar assets are exchanged. To illustrate the recognition of a gain, assume the following terms in which the machines being exchanged serve different functions:         

Price of new machine………………………………Birr 12,000.00

           Trade-in Allowance for old machine………………….(3000)

           Cash payment required (Boot given)……………….Birr 9,000.00

Here the trade-in allowance (Br. 3000) exceeds the carrying value (Br. 2000) of the old machine by Br. 1000. thus, there is a gain on the exchange, if the trade-in allowance represents the fair mark value of the old machine. Assuming that this condition is true, the entry to record the transaction is as follows:

             Years 5

         July 5. Equipment (New)……………………………12,000

                    Accumulated Depreciation…………………….9,000

                                           Equipment (old)………………………….11,000

                                           Cash ……………………………………… 9,000

                                           Gain on exchange of Equip………………..1,000

To record the exchange of Equipments to remove

 cost of old equipment and the related accumulated

 depreciation, new equipment recorded at cost price;

 gain recognized.

 

Gain Not Recognized on the Exchange:

A gain on an exchange should not be recognized in the accounting records if the assets perform similar functions. The cost basis for the new equipment must indicate the effect of the unrecorded gain. This cost basis is computed by adding the cash payment to the carrying value of the old asset:

Carrying value of old equipment …………………………..Birr 2,000.00

Cash paid (Boot Given)………………………………………… 9,000.00

Cost basis of new Equipment…………………………….  Birr 11,000.00

The entry to record the transaction is as follows:

           Year 5

July 5. Equipment (New)……………………………..11,000.00

                    Accumulated Depreciation……………………   9,000.00

                                 Equipment (old)…………………………………..11,000.00

                                Cash…………………………………………………9,000.00

To record exchange of Equipment to remove the cost of old

equipment and the related accum. depr. of old assets; new

equipment recorded at a cost equal to BV of old asset plus cash paid.

As with the no recognition of losses, the no recognition of the gain on exchanges is, in effect, a postponement of the gain. Since depreciation will be computed on the cost basis of Br. 11,000, the “unrecognized” gain is reflected in less deprecation each year on new equipment than if the gain had been recognized.

 

5.3 Accounting For Intangible assets and natural resources

Intangible Assets: are long-term assets that do not have physical substance and in most cases relate to legal rights or advantages held.

Intangible assets include patents, copyrights, trademarks, franchises, organization costs, leaseholds, leasehold improvements, and goodwill. The allocation of intangible assets to the periods they benefits is called amortization.

Intangible assets are accounted for at acquisition cost, that is, the amount paid for them. Some intangible assets such as goodwill and trademarks may be acquired at little or no cost. Even though they may have great value and be needed for profitable operations they should not appear on the balance sheet unless they have been purchased from another party at a price established in the market place.

The, Accounting Principles Board (APB) has decided that a company should record as assets the costs of Intangible assets acquired from others. However, the company should record as expenses the cost of developing intangible assets. Also, intangible assets that have a determinable useful life such as patents, copyrights, and leaseholds, should be written off through periodic amortization over that useful life in much the same way that plant assets are depreciated.

Even though some intangible assets, such as goodwill and trademarks, have no measurable limit on their lives, they should also be amortized over a reasonable length of time (not to exceed forty years).

Illustration - 3

Assume that on Jan 2,2002 MOHA Soft Drink Bottling company purchased a patent on a unique bottle cap for Br. 54,000.

The entry to record the patent would be as follows:     

       2002

       Jan 2. Patent……………………………..54,000

                      Cash……………………………………..54,000

                            To record the purchase of Bottle cap patent

Assume that MOHA’s management determines that, although the patent for the bottle cap will last for seventeen years, the product using the cap will be sold only for the next six years. The entry to record the annual amortization would be as follows:                

Amortization Expense………………………..9,000.00

              Patent……………………………………………9,000.00

To record annual amortization of patent (Br. 54000/ 6 years)

Note that the patent account is reduced directly by the amount of the amortization expense. This is in contrast to other long-term asset accounts in which depreciation or depletion is accumulated in a separate contra account.

If the patent becomes worthless before it is fully amortized, the remaining carrying value is written off as a loss. For instance, assume that after the first two years MOHA soft Drink Bottling Company’s chief competitor’s offers a bottle with a new type of cap that makes MOHA’s cap obsolete. The entry to record the loss is:

        Loss on patent……………………………36,000.00

                    Patent……………………………………36,000.00

  To record the loss resulting from patents becoming worthless.

 

Depletion of Natural Resources

We now turn our attention to another group of long-lived assets natural resources, such as minerals, oil, and timber or lumber. These natural resources are extracted from the earth.

Depletion is the accounting measure used to allocate the acquisition cost of natural resources. Depletion differs from depreciation because depletion focuses specifically on the physical use and exhaustion of the natural resources, while depreciation focuses more broadly on any reduction of the economic value of a plant or fixed asset. The costs of natural resources are usually classified as long-terms assets.

Depletion expense is the measure of that portion of long-term assets that is used up in a particular period.

Illustration - 4

Suppose for example, MIDROC Construction has acquired the right to use 10,000 acres of land in Kibre-Mengist territory to mine for gold at a total cost of, Br. 10,000.000. The Company estimated that the mine will; provide approximately 500,000 grams of gold. The depletion rate established is computed in the following manner.

             Total cost – Salvage value         = Depletion cost per unit.

             Total estimated units available

                 Br. 10,000,000    = Br. 20 per gram

                    500,000 units

If 100,000 grams are extracted in the first year, then the depletion for the year is 2000.000 (1000,000 x Br. 20.00). The entry to record the depletion is therefore:

Depletion Expense…………………..2,000,000

Accumulated Depletion……………………….2,000,000

 

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