Chapter 1: Property, Plant and Equipment

Property, Plant and Equipment

Businesses must have some long-lived assets (property, plant and equipment) in order to carry out their operations. For example, the business needs managerial building, factory building, lands, equipment, furniture, machineries, vehicles, etc. You may think that the business can operate without acquiring a building, it can be rented for example. Well, in this case it is important to remember the properties of the assets1. First of all, for an economic resource to be recognized as an asset, it must have a capacity of providing future benefit. Secondly, it must be controlled by the business and lastly the transaction that caused future benefit and control must occur in the past. The control property here indicates that an economic resource must be fully under control of a business but other parties don’t have a right of providing benefit from it.

When the business rents a building to use in the operations, it cannot be recognized as an asset because the business doesn’t have full control on building. For example, the business cannot sell the building to anyone. But there is one exception at this point. Leasing transactions provides companies use the property, plant and equipment assets within a rental agreement. At the end of the agreement the user company called as “lessee” takes over the property of the asset from the owner (lessor) company. During the rental period, lessee makes the rental payments. Though a leasing transaction seems as if it is a rental transaction, because the ownership of the asset is handed over to the user company, according to the substance over legal form concept of accounting. The legal form of this transaction is a rental transaction but as the asset is going to be taken over from the owner at the end of the rental agreement, economic substance of the transaction steps forward and the economic resource acquired by a leasing transaction recognized as an asset.

Property, Plant, and Equipment assets are long-lived and tangible assets used in the operations of a business. Property, Plant, and Equipment assets are called in various names such as Plant Assets or Fixed Assets. By whatever name, these assets are expected to provide benefit to the company for a long term. Property, Plant, and Equipment assets are critical to a company’s success because they play a key role in ongoing operations and determine the company’s capacity and therefore its ability to satisfy customers.

Property, plant and equipment assets have the following major characteristics:

• They are acquired for use in operations and not for resale.
• They are in long-term in nature and usually depreciated.
• They possess physical substance.

Acquisition of Property, Plant and Equipment

The decision to acquire a long-term asset is a complex process. The historical cost principle requires that companies record property, plant and equipment assets at their actual cost. So, what is cost? Cost consists of all expenditures necessary to acquire the asset and make it ready for its intended use.4 According to the historical cost principle, cost is the cash or cash equivalent price of obtaining the asset and bringing it to the location and condition necessary for its intended use5. So, pay attention to the expression “bringing it to the location and condition necessary for its intended use”. This means that the cost of the property, plant, and equipment assets does not only consist of the purchase price of the asset. Added to the purchase price cash or cash equivalent prices for transferring, installment, assembling, insurance during transfer, permits, etc. must be included.

All expenditures made to acquire land and ready it for intended use are considered as the part of the land cost6. The cost of the land includes the following items;

• purchase price
• brokerage commission
• survey and legal fees
• property taxes in arrears
• taxes assessed to transfer the ownership on the land
• cost of clearing the land and removing unwanted buildings.

All necessary costs incurred in making land ready for its intended use increase (debit) the Land account. The cost of land improvements includes all expenditures necessary to make the improvements ready for their intended use.

Buildings are facilities used in operations, such as stores, offices, factories, warehouses, and so forth. Cost of the building may vary according to its acquisition method. The company may purchase a ready-made building or construct one. In either case, the cost of the building should include all the expenditures related to their acquisition or construction. When a building is purchased, the costs will be the purchase price and plus the costs to renovate the building to ready it for use8. When a new building is constructed, its cost consists of the contract price plus payments made by the owner for architects’ fees, building permits, excavation costs, payments for material, labor and overhead costs incurred during construction.

There are also some regular maintenance operations during the life of property, plants and equipment. As for the building, it may be the inside paintwork, some repairs, etc. These expenditures will not be added to the cost of the building, because they do not extend the useful life or increase the capacity of the asset. These kinds of expenditures will be recognized as a period expense and are debited to Repairs and Maintenance Expense account.

There are also some expenditures made for building and these expenditures yielded as extending the useful life of the asset and/or increasing the capacity of the asset. These kinds of expenditures must be capitalized. Capitalization means recording as an asset. In this context, if an expenditure extends the useful life and/or increases the capacity of an asset, it must be added to the cost of the related asset.

Sometimes companies sign construction contracts with construction companies in order to construct a building. During the construction, company makes payments as progress payments to contractor for the construction process. These payments are recorded to Construction-inProgress account until the construction is finished. Construction-in- Progress account is also a long-lived asset account. When the construction is finished and the contractor hands over the building, the balance of the Construction-in-Progress account is transferred to Building account.

Like the other long-lived assets, the cost of machinery and equipment includes all the necessary expenditures for the machines and equipment to become available for their intended use. In addition to purchase price, transportation charges, insurance while in transit, installation costs and the cost of testing before using are included in the cost of machinery and equipment. Assume that the test results are perfect. When the test product sold, the earned revenue will decrease the cost of the machine. These costs incur only at the initial recognition of machinery and equipment. In other words, for the first recognition of these assets, expenditures made for bringing them to their initial use are capitalized. Assume that the machinery has been installed and the company is using them. After three years of using, the company needs to move and settle to a new location. In this case, the expenditure for disassembling and reassembling the machinery, transportation charges, insurance during transportation, etc. will not be capitalized. They will be recorded as period expenses.

Desks, chairs, sofas, file cabinets, shelving and so forth are all examples for furniture and fixtures. They are the assets that utilize the company by easing the operations. Like all other long-lived assets, their costs consist of purchase price and other necessary expenditures made to bring them to their intended use.

The cost of the vehicles include the purchase price and other necessary expenditures made to bring them to their intended uses. If the expenditure made for vehicles extends the useful life of the vehicle and/ or increases the capacity, like modification or engine renewal, then these expenditures will be capitalized. But the regular maintenance expenditures such as oil change or minor engine repairs will be recorded as period expenses.

Depreciation

Depreciation is the allocation of long-term asset’s cost to expense over its useful life. All assets, except land, lose their ability to provide services and wear out as they are used. Thus, the costs of long-lived assets should be recorded as an expense over their useful lives. This periodic recording of the cost of long-lived assets as an expense is called depreciation.

Depreciation also acts as a hidden fund source for a company. At the end of the long-lived asset’s useful life, the accumulated depreciation will be equal to the cost or the depreciable cost of the long-lived asset. This means that the depreciation expenses recorded throughout the asset’s useful life will reduce the profit of the company and this will lead less tax expense and this will result as a hidden fund at the end of asset’s useful life. This is sort of legal encouragement for the companies to make new investments.

The cost of the long-lived asset is a known issue for the company. The capitalized cost of the asset is the main factor here. As you know that the cost of the asset is not just only the purchase price paid for acquiring it, it a very important issue to calculate the actual cost of the asset. As you know, actual cost of the long lived asset includes all items paid for the asset to perform its intended function.

The residual value (also called salvage value) and the useful life of the asset are estimations. The company should estimate the cash value of the asset at the end of its useful life. In other words, residual value is the amount that the company will receive when it is sold at the end of its useful life. By considering together, the company will find out the depreciable cost of the asset. Depreciable cost is the cost when residual value is subtracted from capitalized cost of the asset.

The useful life of an asset is an estimation, too. The company will estimate for how long the company will get benefit by using that asset. A company’s useful life estimation might be shorter than the economic life or physical life of the asset. Economic life is the life of the asset that its manufacturer indicated. But the useful life of the asset is related to the time that the company will benefit for. For example, the company purchases a truck for transportation. The company estimates to use the truck (benefit from it) for five years (useful life) but the manufacturer company of the truck indicates that it has a life span of 15 years (economic life).

There are various depreciation methods for the companies to apply but three are used most commonly:

• Straight-line Depreciation Method
• Double Declining Balance Depreciation Method
• Units-of-production Depreciation Method
• Partial Year Depreciation Method

Each method is appropriate in certain circumstances. These methods work differently on how they achieve the annual depreciation amount, but they all result in the same total depreciation over the total life of the asset.

Disposing of Property, Plant and Equipment Assets

Property, Plant and Equipment assets remain on the business’s accounting books until they are disposed of. Companies dispose of property, plant and equipment assets which are no longer useful for the company. Eventually, a long-lived asset wears out or becomes obsolete. When plant assets are no longer useful because they have physically deteriorated or become obsolete, a company can dispose them by discarding, selling them for cash, or exchanging them for a new long-lived asset. The disposal of property, plant and equipment assets can take one of three forms:

• Discard (retire) the long-lived asset.
• Sell the long-lived asset for cash.
• Exchange the long-lived asset for another longlived asset.

Regardless of the type of disposal, the company must determine the book value of the long-lived asset at the disposal date to determine the gain or loss on disposal. As you remember, the book value is the difference between the cost of the long-lived asset and the accumulated depreciation to date. If the long-lived asset is no longer useful, it is disposed. In such a case, the company will remove the asset and associated accumulated depreciation from the accounts.

Discarding (retiring) of property, plant and equipment assets involve disposing of the asset for no cash. If an asset is disposed of when it is fully depreciated and has no residual value, then the original cost and accumulated depreciation of the long-lived asset are simply written off the accounting books. There is no need to bring the depreciation up to date because the asset is already fully depreciated. In addition, no gain or loss is recognized because no cash was received or paid. A loss is recognized if a company retires a long-lived asset before it is fully depreciated and no cash is received for residual or salvage value.

Accounting for the sale of a long-lived asset is essentially the same as accounting for its discarding except that cash is received in the exchange. In a disposal by sale for cash, the company compares the book value of the asset with the cash received from the sale. If the cash received from the sale exceed the book value of the long-lived asset, a gain on disposal occurs. If the cash received from the sale is less than the book value of the long-lived asset sold, a loss on disposal occurs. Machinery& Equipment account is credited when it is sold. When the machinery is sold, its accumulated depreciation must be removed from accounting books. Hence there is no more machinery so there shouldn’t be any accumulated depreciation related to it. Thus, accumulated depreciation account is debited in order to remove from the accounting books.

Accounting for the sale of a long-lived asset is essentially the same as accounting for its discarding except that cash is received in the exchange. In a disposal by sale for cash, the company compares the book value of the asset with the cash received from the sale. If the cash received from the sale exceed the book value of the long-lived asset, a gain on disposal occurs. If the cash received from the sale is less than the book value of the long-lived asset sold, a loss on disposal occurs. Machinery& Equipment account is credited when it is sold. When the machinery is sold, its accumulated depreciation must be removed from accounting books. Hence there is no more machinery so there shouldn’t be any accumulated depreciation related to it. Thus, accumulated depreciation account is debited in order to remove from the accounting books.

If exchanges have commercial substance (which is when there is a change in cash flow resulting from the transaction), the parties should recognize a gain or loss on the exchange. The old asset will be removed from the accounting books, and the new asset will be recorded at its market value. Most of the exchanges have commercial substance (even when similar assets are exchanged). If exchanges do not have commercial substance, ignore any gain or loss on the transaction (there are a few exceptional situations) and record the acquired asset at the book value of the asset given up in the exchange plus cash paid and minus cash received instead of at market value.