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College Accounting, 5th Edition : Lecture Hall : Chapter Summaries : Chapter 16 Accounting for Plant Assets and Depreciation

Chapter 16 Accounting for Plant Assets and Depreciation

Current assets are assets that will be sold, used up, or turned into cash within one accounting cycle. Plant assets are assets that (1) have a useful life of more than one year, (2) are acquired for use in the operation of the business, (3) are not intended for resale to customers in the normal course of business, and (4) are tangible (you can touch them). Examples of plant assets include buildings, land, furniture, equipment, and machinery. Other terms used to describe plant assets include long-term assets, fixed assets, capital assets, and property, plant, and equipment.

Intangible assets and natural resources are also long-term assets. An intangible asset[close]
intangible asset
lacks physical substance but does benefit a business because it provides legal rights. Examples of intangible assets include patents, copyrights, trademarks, and franchises. A natural resource[close]
natural resource
, also referred to as a wasting asset, is an asset acquired for the purpose of removing or extracting natural resources, such as timber, coal, gold, gas, and oil.

When a plant asset is purchased, an asset account is debited for the cost of the asset and either Accounts Payable, Notes Payable, or Cash is credited, depending on whether the purchase was on account, in exchange for a promissory note, or for cash.

The cost of a plant asset includes all expenditures necessary to actually acquire the asset and get it into operation. For example, the cost of a new computer would include not only the purchase price but also sales taxes (if any), freight charges, installation charges, and fees paid to train employees how to use the computer. However, the cost of a plant asset does not include expenditures for repairs when the asset is damaged by vandalism or careless handling before it goes into use. Such expenditures are debited to expense accounts. The Land Improvements account[close]
Land Improvements account
is a specific type of plant asset.

Plant assets are purchased for the use they provide in operating a business and earning revenue. However, all plant assets--with the exception of land--either wear out with the passage of time, become obsolete with new technology, or become inadequate to meet expanded needs. Since plant assets lose their usefulness, a part of their cost should be allocated to each accounting period in which the assets are used. The process of allocating the cost of a plant asset over its expected useful life is referred to as depreciation, and the amount allocated is called depreciation expense[close]
depreciation expense
. The process of allocating the cost of an intangible asset over its expected useful life is called amortization[close]
amortization
. And the process of allocating the cost of a natural resource over its expected useful life is called depletion[close]
depletion
.

Depreciation is recorded by debiting a depreciation expense account and crediting an accumulated depreciation account. Accumulated depreciation[close]
Accumulated depreciation
is the total depreciation from the start of the life of a plant asset to any point in time. A depreciation expense account is temporary and is thus closed to the Income Summary account. An accumulated depreciation account, on the other hand, is a permanent account and will remain open to accumulate depreciation charges over the life of the related plant asset.

Three factors are needed to compute depreciation: (1) the original cost of the asset, (2) the estimated salvage value of the asset, and (3) the estimated useful life of the asset. The original cost of a plant asset is the recorded cost, which includes the purchase price plus any additional expenditures necessary to acquire the asset and get it into operation. The estimated salvage value[close]
salvage value
of a plant asset is the expected value of the asset at the end of its productive life. The estimated useful life (EUL)[close]
estimated useful life (EUL)
of a plant asset is the estimated length of its usefulness to the business that acquired it. The length of usefulness can be measured in terms of time, such as years, or in terms of units of output, such as miles driven.

There are various methods of figuring depreciation. The principle of consistency--keeping one method--applies. Three common methods are (1) the straight-line method, (2) the units-of-production method, and (3) the double declining-balance method. The straight-line method is simple to use and results in an equal amount of depreciation expense over each year in the life of a plant asset. Straight-line depreciation is computed using the following formula:

C – S / L

where C = cost of the asset, S = estimated salvage value of the asset, and L = estimated useful life of the asset. The straight-line rate[close]
straight-line rate
is the percent of annual depreciation. Depreciation is summarized in a depreciation schedule[close]
depreciation schedule
.

The units-of-production method[close]
units-of-production method
uses an estimate of the output of an asset. With the units-of-production method, the life of the asset is usually stated in terms of miles driven, hours of operation, or units produced. A rate is obtained by dividing the estimated life into the cost of the asset minus its salvage value. The result is a constant rate that is applied to actual usage in the current and later accounting periods.

The double declining-balance method[close]
double declining-balance method
results in greater depreciation being charged during the earlier years of a plant asset's life and less depreciation as the asset ages. The accelerated method of depreciation[close]
accelerated method of depreciation
is appropriate for assets whose productivity is greater during the earlier years or in cases where technology will probably make an asset inadequate before its physical life is over.

A revenue expenditure[close]
revenue expenditure
is an expenditure that benefits only the current period. A capital expenditure[close]
capital expenditure
adds value to an asset or extends its life. Two types of capital expenditures that add value are the addition[close]
addition
and the betterment[close]
betterment
. A capital expenditure that prolongs life is an extraordinary repair[close]
extraordinary repair
.

When an asset is no longer useful, it should be sold, traded, or discarded. The first step in recording the disposal of a plant asset is to update depreciation. Updating depreciation involves recording the depreciation expense for the time between the date on which depreciation was last recorded and the disposal date.

If an asset is sold for more than its book value, there is a gain; if an asset is sold for less than its book value, there is a loss; and if an asset is sold for exactly book value, there is no gain or loss.

Often, plant assets are traded in for other plant assets. If an asset is traded in for a similar asset and a difference (boot[close]
boot
) is paid, special rules come into play. For financial reporting purposes, a gain cannot be recognized if the amount received in a trade is more than book value, but a loss can be recognized if the amount received in a trade is less than book value. For federal income tax purposes, neither gains nor losses can be recognized when an asset is traded for a similar asset and a difference is paid. When a gain or loss is not recognized, the cost of the asset acquired is determined as follows:

Book value of asset being traded + Difference paid (boot) = Cost of new asset

An intangible asset should be amortized (written off) over its expected useful life. A business must decide how long an intangible asset will be of benefit. A patent, for example, has a maximum legal life of 20 years. However, the cost may be written off over a shorter period (but not a longer period) if it is believed that the patent will not benefit the business for its full legal life. According to accounting pronouncements, intangible assets should be written off over a reasonable period of time, not to exceed 40 years.

As we have noted already, the expense that results from the consumption or exhaustion of natural resources is called depletion. The calculation of depletion is similar to the calculation of depreciation under the units-of-production method. The cost of the asset is divided by the estimated output. The rate obtained is applied to the actual output from the asset.


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