Chapter 16

Accounting for Plant Assets and Depreciation

Assets
Assets are classified into the following groups. Current Assets Plant Assets Intangible Assets Natural Resources

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Current Assets
Includes cash, assets that will be turned into cash, and assets that will be used up within one year.

In addition to cash, includes accounts receivable, merchandise inventory, supplies, and prepaid insurance.
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Plant Assets
Have a useful life of more than one year. Acquired for use in the operations of the firm. Not intended for resale to customers in the normal course of business. They are tangiblecapable of being touched.
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Plant Assets
Examples: land, buildings, trucks, automobiles, machinery, equipment, furniture Plant assets are also known as fixed assets, capital assets, and property, plant, and equipment.

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Determining the Cost of a Plant Asset

The cost of a plant asset consists of all normal amounts spent to acquire the asset and make it ready for use. In addition to the purchase price, the cost of a plant asset might include sales tax, delivery charges, insurance charges while in transit, installation charges, and testing charges.

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Recording the Purchase of a Plant Asset

Example: The Simon Company bought a factory machine for $25,000. In addition; it paid $1,500 for sales tax, $900 for a delivery charge, $300 for insurance, and $800 for an installation charge. Thus, the total cost was $28,500.
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Recording the Purchase of a Plant Asset

A purchase of a plant asset is recorded by

debiting the asset account and crediting either Accounts Payable or Cash.

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Recording the Purchase of a Plant Asset

20X1 Jan. 2

Machinery Accounts Payable

Purchased factory machine on account.

28,500

28,500

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Determining the Cost of Land and Buildings

Land and buildings must be recorded in separate accounts even if they are purchased together for one price.

If a single price is paid for land and a building, the appropriate cost for each is usually determined by an appraisal.
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Depreciation

Definition: The process of allocating the cost of a plant asset to operations during its estimated useful life.

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Depreciation
By making periodic adjustments for depreciation, a business matches the cost of a plant asset against the revenue that asset helps to earn during its estimated useful life.

Depreciation is not intended to determine the current value of plant assets. It is a process of cost allocation, not valuation.

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Recording Depreciation
Depreciation of plant assets is recorded by means of adjusting entries at the end of each accounting period. The depreciation for each class of plant assets is debited to a Depreciation Expense account and credited to an Accumulated Depreciation account.

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Recording Depreciation
Adjusting Entries
20X1 Dec. 31 Depr. Expense Accum. Depr.Machinery $$$$ $$$$

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Depreciation on the Financial Statements

Depreciation Expense is an operating expense and appears on the income statement. Accumulated Depreciation is a contra asset and appears on the balance sheet as a deduction from the related plant asset. The cost of a plant asset less its accumulated depreciation is the book value of the asset.
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Calculating Depreciation
Three factors must be known in order to calculate depreciation for a plant asset. Cost Estimated Salvage Value Estimated Useful Life

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Calculating Depreciation
The cost of a plant asset is the purchase price plus any amounts that must be spent to prepare the asset for use. The estimated salvage value is the amount the firm expects to receive when the plant asset is sold or discarded.

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Calculating Depreciation
The estimated useful life is the number of years the plant asset is expected to be useful to the firm or the amount of output the asset is expected to produce.

Example: The estimated useful life of a machine might be five years or 200,000 production units. Or can be operated for 150,000 hours.
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Methods of Calculating Depreciation

The most common methods are as follows.

Straight-line Method Units-of-production Method Declining-balance Method Double Declining-balance Method

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Straight-line Method
This method allocates an equal amount of depreciation to each full year of a plant assets useful life. Yearly depreciation = Cost Salvage value Years of useful life

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Straight-line Method
Example: The Simon Company bought a machine for $28,500 on January 2, 20X1. It expects the machine to have a useful life of five years. The Salvage Value is $3,000.

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Straight-line Method
Cost Salvage value = Yearly depreciation Years of useful life $28,500 $3,000 = $25,500 = $5,100 5 (years) 5

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Recording Depreciation
Adjusting Entries
20X1 Dec. 31 Depr. Expense Accum. Depr.Machinery 5,100

5,100

To record depreciation Expense for the period

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Straight-line Depreciation for Less Than a Year

Depreciation can only be taken for the number of months in a year that a plant asset is owned. If a firm buys a plant asset on or before the 15th of a month, the month is counted for depreciation.

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Straight-line Depreciation for Less Than a Year

If a firm buys a plant asset after the 15th of a month, the month is not counted for depreciation.

Example: A firm buys an equipment on July 12, 20X1. At the end of 20X1, it will take six months of depreciation.
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Units-of-Production Method
Allocates the cost of a plant asset based on the number of units it is expected to produce. There are two steps to calculating depreciation with this method. Step 1: Find the depreciation per unit of production. Step 2: Multiply the units produced each year by the depreciation per unit.
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Units-of-Production Method
Remember the Simon Company bought a machine for $28,500. The machine has an estimated salvage value of $3,000. The firm expects the machine will operate for 150,000 hours during its life. The amount of depreciation per unit (hour) is found as follows.

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Units-of-Production Method
Cost Salvage value = Depreciation per unit Units of production $28,500 $3,000 = $25,500 = $0.17 150,000 (hours) 150,000

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Units-of-Production Method
During 20X1, the Simon Company used its machine for 31,000 hours. The depreciation for that year is $5,270. $0.17 (depr. per hour) 31,000 (hours) = $5,270 The units-of-production method is a logical choice for a plant asset whose use varies from year to year.
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Revenue and Capital Expenditures

Businesses sometimes spend money on the plant assets they already own. These amounts are classified as; revenue expenditures or capital expenditures.

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Revenue and Capital Expenditures

Revenue expenditures: A revenue expenditure benefits only the current accounting period and is debited to an expense account. Example: tune-up or oil change for a truck

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Revenue and Capital Expenditures

Capital expenditures. A capital expenditure benefits more than the current accounting period. Capital expenditures include additions, betterments, and extraordinary repairs.

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Revenue and Capital Expenditures

Additions and betterments add value to a plant asset and are debited to the asset account. Example: constructing a new wing on a building and installing an energy-saving furnace

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Revenue and Capital Expenditures

Extraordinary repairs prolong the life of a plant asset and are debited to its Accumulated Depreciation account.

Example: installing a new engine in a truck

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Selling Plant Assets

When a plant asset is sold, it may be sold for its book value, above its book value (at a gain), or below its book value (at a loss). Example: The Mead Company sells a machine for $1,000 after five years of use. The machine cost $10,000 and has accumulated depreciation of $9,000. The book value is $1,000.
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Selling Plant Assets

20X6 Jan. 2

Cash 1,000 Accum. Depr.Machinery 9,000 Machinery 10,000

Sold machine for book value.

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Selling Plant Assets

Example: The Mead Company sells its machine for $1,200 and therefore has a gain of $200.

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Selling Plant Assets

20X6 Jan. 2

Cash 1,200 Accum. Depr.Machinery 9,000 Machinery 10,000 Gain on Disposal 200
Sold machine at a gain.

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Selling Plant Assets

Example: The Mead Company sells its machine for $700 and therefore has a loss of $300.

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Selling Plant Assets

20X6 Jan. 2

Cash 700 Accum. Depr.Machinery 9,000 Loss on Disposal 300 Machinery 10,000
Sold machine at a loss.

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Trading in Plant Assets

Trading in old assets for new ones is a common practice. A trade-in allowance is received for the old asset. The difference between the price of the new asset and the trade-in allowance for the old one is the amount the buyer must pay, called the boot.

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Trading in Plant Assets

The trade-in allowance for an old asset may be equal to the book value, or it may be more or less than the book value. Generally accepted accounting principles require the gain on a trade for a similar asset not be recorded. However, a loss should be recorded. For federal income tax purposes, gains and losses on trades of similar assets cannot be recognized.
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Trading in Plant Assets

Example: Assume the Mead Company trades in an old machine with a cost of $18,000, accumulated depreciation of $14,000, and a book value of $4,000 for a new machine with a list price of $24,000.

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Trading in Plant Assets

Example
Mead receives a trade-in allowance of $6,000 and must pay $18,000 (the boot). List price of new machine Trade-in allowance for old machine Difference to be paid (boot) $24,000 6,000 $18,000

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Trading in Plant Assets

Example
The Mead Company will record the new machine at a cost of $22,000. Book value of old machine Difference to be paid (boot) Cost of new machine $ 4,000 18,000 $22,000

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Trading in Plant Assets

Example

20X6 Jan. 2 Machinery (new) 22,000 Accum. Depr.Machinery 14,000 Machinery (old) 18,000 Cash 18,000 Traded in old machine for new one.
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Discarding Plant Assets

If a plant asset cannot be sold or traded in when it is no longer useful, it will be discarded. If a fully depreciated plant asset is discarded, no gain or loss occurs. However, if there is still a book value, a loss occurs.

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Discarding Plant Assets

20X1 Jan. 2 Accum. Depr.Office Furniture Office Furniture

Discarded fully depreciated desks.

12,000 12,000

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Discarding Plant Assets

20X1 Jan. 2 Accum. Depr.Office Equipment Loss on Disposal Office Equipment

7,000 1,000

8,000

Discarded computers at a loss.

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