CHAPTER 9

Property, Plant and Equipment

Answers to Questions

1. To be included in the category of property, plant, and equipment, an asset must:

(1) be held for use in the normal course of business; (2) have an expected useful
life of more than one year; and (3) be tangible property – that is, the asset must
have physical substance.
2. Generally, the expenditures incurred to obtain the benefits to be derived from the
asset are capitalized and included as a cost of property, plant, and equipment.
They include the costs incurred in the acquisition of an asset and in putting the
asset into operating condition. Costs of maintaining the benefits at the levels
originally expected are expensed.
3. When securities are exchanged for an asset, the acquisition cost of that asset
should be either the fair value of the securities given up or the fair value of the
asset acquired. The choice should be made on the basis of the market that is more
active and results in a more verifiable valuation. If neither of these amounts is
known, an appraisal of the asset may be used, or, as a final solution, the company’s
board of directors may place a value on the transaction.
4. In a lump-sum purchase, the total purchase price should be allocated to the
individual assets on the basis of their relative fair market values. This allocation
is necessary because some of the assets may have different economic lives, may
not be depreciable, or may be depreciated by different methods.
5. When similar productive assets are exchanged a gain is recognized to the extent
that “boot” is received along with the asset. A loss is always recognized, in
accordance with the conservatism convention of accounting.
When dissimilar productive assets are exchanged, the earning process is
considered completed and both gains and losses are recognized.
6. Under PAS 16, no gain may be recognized on the self-construction of an asset.
The revenue recognition principle allows recognition of profit on asset use and
disposal, not on the acquisition or construction of an asset. If construction costs
are materially greater than the fair market value of the asset, then the convention
of conservatism requires the write-down of capitalized costs and a recognition of
the loss.
7. The historical cost principle is applicable in recording the acquisition of
operational assets. Therefore, operational assets (other than those acquired in
exchanges of similar assets) are recorded at their cash equivalent cost at
acquisition date. Subsequent to initial acquisition, operational assets which
decrease in use value as they are used to generate revenue are depreciated over
their economic useful life in conformity with the matching principle. This
requires that costs be associated with the corresponding revenues generated.
8. The basic principle is that the asset acquired should be recorded at the market
value of the asset given up. However, when the assets are similar, the asset
acquired is recorded at the book value of the asset surrendered plus any cash
given; if cash is received, the transaction is treated as a part sale / part exchange.
Regardless of whether cash is paid or received, however, if the market value of
the asset acquired is less than the book value of the assets given up, the asset
acquired is recorded at its market value.
9. It may be argued that general overhead should be allocated to a self-constructed
asset when the construction process displaces other activities which benefit from
the general overhead. In these cases, the self-constructed asset receives some of
those benefits and therefore should bear some of the cost of those benefits.
10. Interest capitalization must begin when (1) qualifying expenditures are first made,
(2) activities that are necessary to get the asset ready for its intended use are in
progress, and (3) interest cost is being incurred. Interest capitalization must cease
when (a) the asset is substantially completed and ready for its intended use, or (b)
interest costs are not being incurred, or (c) there are no qualifying expenditures.
11. Post-acquisition costs are capitalized when either the useful life is increased by
one year or more, or the utility of the operational asset is enhanced such that the
asset will provide greater benefits beyond the current year.
12. Upon disposal of an operational asset, the following accounting steps should be
taken in the order given:
a. The asset should be depreciated up to the date of disposal.
b. Accruals of taxes, insurance premiums, etc., should be recorded up to date of
disposal.
c. The sale of the asset should be recorded by removing from the accounts the
balances in the asset account and the related accumulated depreciation
account. The difference between the carrying or book value of the asset
disposed of and any net proceeds from its sale should be reported as a loss or
gain on disposal.
13. All three terms – depreciation, depletion, and amortization – refer to the process
of allocating the cost of an asset to the periods in which the benefits are recognized
as revenues. It is the nature of the asset that distinguishes the three terms.
Depreciation is used in reference to tangible assets; depletion refers to natural
resources such as oil or gas; and amortization is the allocation of the cost of
intangible assets such as goodwill or leased property. Amortization is sometimes
used as the general term to describe the periodic allocation of costs.
14. The objective of accounting for depreciation is to match the cost of an asset with
the revenues, or benefits, derived from the asset in a systematic and rational
manner. Since the cost of an asset less any expected residual value is the total
lifetime expense, it is recognized systematically against the revenues, or benefits,
received.
15. Note: Part c involves an understanding of cash flow concepts discussed briefly in
Chapter 5. The recording of depreciation affects a company’s financial statements
as follows:
Income statement – the company expenses depreciation directly or through cost
of goods sold (for manufacturing assets). In either case, it decreases income
before income taxes, income tax expense, and net income.
Statement of financial position – the Accumulated Depreciation account offsets
the related asset account. Thus, recording depreciation reduces the book value of
a company’s assets. Depreciation included in manufacturing costs on unsold
inventory affects the cost of the inventory on the statement of financial position.
Since net income is reduced, retained earnings are also reduced.
Statement of cash flows – depreciation is an expense that does not require an
outlay of cash. Consequently, it is added back to net income to show net cash
provided by operating activities under the indirect method. Under the direct
method, it is omitted from the statement.
16. Depreciation results primarily from physical causes and functional causes. Wear
and tear, which is due to operational usage, suggests the use of an activity method
of depreciation. Deterioration and decay are more dependent upon time and thus
a time method of depreciation, such as the straight-line, declining-balance, or
sum-of-the-years’-digits method, is more appropriate. The functional causes of
depreciation – obsolescence or inadequacy – seem to relate more to time methods
of depreciation. However, each situation must be evaluated separately because
there are no steadfast rules for a depreciation method – only that it be “systematic
and rational.”
The requirement that all companies use the same method of depreciation is not
desirable because different patterns of benefits do exist for different types of
assets. If the purpose of such a requirement is to reduce the differences in
financial statements, this would not accomplish it. Even if two companies are
using the same method of depreciation, by assuming different useful lives or
salvage values, the depreciation amount can be markedly different. Such a
requirement would be an example of form over economic substance.
17. Obsolescence of an operational asset refers to circumstances in which the asset is
unable to provide increased service requested by the business, due perhaps to
expansion, or inefficiency relative to newer assets available.
18. Refer to page 252.
19. Refer to page 252.
20. Refer to page 252.
Answers to Multiple Choice Questions

1. A 11. D 21. A 31. D

2. D 12. D 22. D 32. B
3. A 13. B 23. A 33. B
4. D 14. B 24. D 34. C
5. D 15. D 25. A 35. C
6. D 16. B 26. C
7. C 17. B 27. D
8. C 18. D 28. B
9. D 19. D 29. B
10. B 20. A 30. C