Chapter 6: Property, Plant & Equipment, and Intangible Assets
Property, Plant & Equipment; Depreciation; Long-Lived Tangible Assets; Intangible Assets
What are Tangible Long-Lived Assets?
Tangible long-lived assets, also called property, plant & equipment, do not last forever & must be expensed over their useful lives (depreciation).
Land is a unique asset, as it’s not expensed over time because its usefulness never decreases!
What are Intangible Assets?
Intangible assets are useful because of the special rights they carry. They have no physical form. This includes patents, copyrights, & trademarks. The related expense account for these is amortization.
Intangible assets also includes goodwill, whose related expense account is impairment losses.
Measure & Account for the Cost of tangible Assets
What is the Basic Working Rule for Determining Cost of an Asset?
Cost of an asset is the sum of all the costs incurred to bring the asset to its location & intended use. The cost of property, plant & equipment includes its purchase price plus taxes, commissions, & other amounts paid to make the asset ready for use.
The cost of land includes its purchase price, real estate commission, survey fees, legal fees & back property taxes. Land cost also includes expenditures for grading & clearing the land, and demolishing unwanted buildings.
Cost of land does NOT include fencing, paving, sprinkler systems, driveways, signs & lighting. These are recorded in a separate account called land improvements & are subject to depreciation.
Buildings, Machinery & Equipment
- Constructing a Building: Cost includes architectural fees, building permits, contractors’ charges, payments for material, labour, overhead. The company may also include as cost the interest on money borrowed.
- Purchasing Existing Building: Cost includes purchase price, brokerage commission, sales & other taxes paid, repairs/renovations.
- Purchasing Machinery/Equipment: Cost includes purchase price, transportation, insurance while in transit, non-refundable sales & other taxes, purchase commission, installation costs, expenditures to test the asset before use, & cost of any special platforms used to support the equipment.
- After asset is up & running, insurance, taxes, & maintenance are recorded as expenses, not the asset’s cost.
When the company paints their logo on the side of a building, even if they don’t own the building, painting the logo is a cost. This logo depreciates & is considered a leasehold improvement.
Lump-Sum (or Basket) Purchases of Assets
Businesses often purchase several assets as a group, or in a “basket”, for a single lump-sum amount. Companies must identify the cost of each. Total cost is divided among assets according to their relative fair values.
Example: A company purchases a building & land for $2.8 million. An appraisal says the land’s fair value is $300k & the building’s fair value is $2.7 million. The company would add these 2 costs (and get $3 million). Then they would calculate the ratio of each asset to this fair aggregate value. In this case, the land is 10% of the fair aggregate value. That means the cost of land is 10% of $2.8 million.
Capital Expenditure vs. Immediate Expense
Expenditures that increase the asset’s productivity or extend its useful life are called capital expenditures (also called betterments). Capital expenditures are said to be capitalized, which means the cost is added to an asset account & not expensed immediately.
Costs that merely maintain the asset or restore it to working order are considered repairs & are expenses. Small costs are usually expensed.
Measure & Record Depreciation on tangible Assets
What is the Carrying Amount of Property, Plant & Equipment?
This is what shown on the balance sheet. Depreciation expense is shown on the income statement. In the private enterprise sector, depreciation expense is referred to as amortization.
What is Depreciation Caused By?
- Physical Wear & Tear: Physical deterioration takes its toll on the usefulness of vehicles, buildings, etc.
- Obsolescence: Computers & other electronics may be obsolete before they deteriorate. An asset is obsolete when another asset can do the job more efficiently. An asset’s useful life may be shorter than its physical life.
How to Measure Depreciation?
To measure depreciation for property, plant & equipment, we must know its:
- Estimated Useful Life: The length of service expected from using the asset. Useful life of building may be stated in years. Useful life of airplanes may be stated in kilometres travelled. Companies base such estimates on experience & information from industry and government publications.
- Estimated Residual Value (Scrap Value or Salvage Value): The expected cash value of an asset at the end of its useful life. For example, after using a machine till its useful life, a company may sell it as scrap metal. Estimated residual value is not depreciated.
Formula for Depreciable Cost
3 Depreciation Methods
All these methods result in the same total amount of depreciation, which is the asset’s depreciable cost.
In this method, an equal amount of depreciation is assigned to each year (or period) of asset use.
In this method, a fixed amount of depreciation is assigned to each unit of output, or service, produced by the asset.
This per-unit depreciation expense is then multiplied by the number of units produced each period to compute depreciation.
Double-Diminishing-Balance (DDB) Method
This method is the main accelerated depreciation method, where a larger amount of the asset’s cost is written off near the start of its useful life. It computes annual depreciation by multiplying the asset’s declining carrying amount by a constant percentage, which is 2x the straight-line depreciation rate. Double-diminishing-balance amounts are computed as follows:
- Compute straight-line depreciation rate per year.
- A 5-year asset has a straight-line depreciation rate of 1/5 (20%) each year.
2. Multiple the straight-line rate by 2 to compute the double-diminishing rate.
- A 5-year asset has a DDB rate of 40%.
3. Multiple the DDB rate by the period’s beginning asset carrying amount (cost less accumulated depreciation).
- Residual value is ignored except during the final year.
4. Determine the final year’s depreciation amount by adjusting the depreciation expense so that the remaining carrying amount of the asset is equal to the residual value.
The DDB method differs from other methods in 2 ways:
- Residual value is ignored when calculating depreciation expense; depreciation is computed on the asset’s full cost.
- Depreciation expense in final year is the amount needed to reduce the asset’s carrying amount to its residual value.
Comparing Depreciation Methods
For an asset that generates revenue evenly over time, the straight-line method best meets this criterion. The units-of-production method best fits those assets that wear out because of physical use rather than obsolescence. The accelerated method (DDB) applies best to assets that generate greater amounts of revenue earlier in their useful lives and less in later years.
Recent surveys of companies in Canada & the U.S. indicate straight-line depreciation is used by 80%+. ~10% use some form of accelerated depreciation, & the rest use units of production & other methods. Many companies use more than one method.
Additional Topics for Long-Lived Tangible Assets
Depreciation for Partial Years
Companies purchase property, plant & equipment in the middle of their fiscal years. So how would companies depreciate the asset for the end of their fiscal year?
- Compute depreciation for a full year.
- Multiply the full year’s depreciation by the fraction of the year that the company held the asset.
Changing the Useful Life of a Depreciable Asset
Managers might decide to change, based on new information, an asset useful life. This is called a change in accounting estimate.
For example, an $40,000 asset was believed to have a useful life of 8 years. 2 years in, management believes the asset will remain useful for an additional four years. The company would spread the remaining depreciable carrying amount (cost less accumulated depreciation less residual value; $30,000) over the asset’s remaining life (10 years) as follows:
Fully Depreciated Assets
A fully depreciated asset is an asset that has reached the end of its estimated useful life. The equipment’s carrying amount is zero, but that doesn’t mean the equipment is worthless. The company may continue using the equipment for a few more years but will not take any more depreciation.
When disposing equipment, companies remove asset’s cost & accumulated depreciation from books.
Derecognition of Property, Plant & Equipment
Derecognition is a term IFRS uses to refer to property, plant, and equipment that is either no longer useful or has been sold. When this occurs, the related accounts are removed from the company’s books and a gain or loss is recorded.
Before accounting for the disposal of the asset, the business should bring depreciation up to date to:
- Record the expense up to the date of sale.
- Measure the asset’s final carrying amount.
To account for disposal, the asset & its related accumulated depreciation are removed from the books.
If a company decides to dispose of an asset before its fully depreciated, they must record a loss.
The Loss on Disposal of Store Fixtures is reported as Other Income (Expense) on income statement.
Selling Property, Plant & Equipment
Let’s say that a company sells an asset that has depreciated for a few years. They have update the depreciation up to the point of sale & then record any gain from the sale.
Depreciation for Tax Purposes
The Income Tax Act requires taxpayers to use accelerated and sometimes straight-line depreciation (up to specified capital cost allowance [CCA] maximums) for tax purposes. In other words, a taxpayer may use one method of depreciation for accounting purposes and another method for tax purposes.
Depreciating Significant Components
IFRS require that significant components of an item of property, plant, and equipment be depreciated separately. Under ASPE, depreciating separate components is done only when practicable.
For example, if a company owns a plane with a useful life of 20 years, the aircraft would be depreciated separately from the interior equipment (chairs) which have a useful life of 5 years.
At each reporting date, a company should review its property, plant & equipment to see if an asset is impaired. Impairment occurs when the carrying amount exceeds its recoverable amount. Recoverable amount is determined to be the higher of an asset’s fair value (less costs to sell) & its value in use. Value in use is the present value of estimated future cash flows expected to be earned from the continuing use of an asset and from its disposal at the end of its useful life. For example:
Impairment may be caused by factors like obsolescence, physical damage & loss in market value.
If situation changes, IFRS do permit a company to reverse impairment loss by writing the asset up to its carrying amount. Accounting standards for private enterprises require a them to review its property, plant & equipment only when impairment is suspected. Reversal of the write-off isn’t allowed.
IFRS’ Cost Model
Cost less accumulated depreciation less accumulated impairment loss.
In this method, an asset is recorded at cost when purchased but subsequently measured at its fair value less accumulated depreciation less accumulated impairment losses. It may be revalued at year-end or when the company believes a change in the asset value has taken place. With every new change in the asset account, depreciation must be revised accordingly based on the new carrying amount.
Example: A company bought a building for $1.8 million, depreciated over 25 years with no residual value. Subsequently, if appraised value is determined to be $2 million, the increase of $200,000 will be recognized through equity by the following journal entry:
Revaluation Surplus is an equity account that is reported as other comprehensive income. Only the cost model is used under ASPE.
T-Accounts for Analyzing Property, Plant & Equipment Transactions
Decision Guidelines for Capitalizing/Expensing, & Depreciation Method
Account for Intagible Assets
Quick Information about Intangible Assets
- Like tangible assets, an intangible asset is recorded at its acquisition cost.
- The residual value of most intangibles is zero.
What are the 2 Categories of Intangible Assets?
- Intangibles with Finite Lives: These can be measured. We record amortization for these. Amortization works like depreciation & is usually computed on a straight-line basis, but other methods could be used.
- Intangibles with Indefinite Lives: No amortization for these intangibles is recorded. Instead, check them annually for any loss in value (impairment), & record a loss when it occurs. Goodwill is the most prominent example of an indefinite intangible asset.
Summary of Categories
*Not required unless there are signs to suggest that impairment has occurred.
Accounting for Specific Intangibles
Patents are federal government grants giving the holder the exclusive right for 20 years to produce & sell an invention. Patents can be purchased & amortized, like any other asset.
Copyrights are exclusive rights to reproduce and sell a book, musical composition, film, software, or other work of art. Copyrights extend 50 years beyond the author’s death. Copyrights can be purchased & amortized, like any other asset.
Trademarks & Trade Names
Trademarks & trade names (or brand names) are distinctive identifications of products/services. It includes logos & slogans. The cost of a trademark or trade name may be amortized over its useful life, but if the trademark is expected to generate cash flow for the indefinite future, the business should not amortize the trademark’s cost.
Franchises & Licences
Franchises and licences are privileges granted by a private business or a government to sell a product or service in accordance with specified conditions. The useful lives of many franchises and licences are indefinite and, therefore, are not amortized.
Goodwill is defined as the excess of the cost of purchasing another company over the sum of the market values of its net assets (assets minus liabilities). A purchaser is willing to pay for goodwill when it buys another company with abnormal earning power. Special Features of Goodwill:
- Goodwill is recorded only when it is purchased in the acquisition of another company. A purchase transaction provides objective evidence of the value of goodwill.
- Goodwill isn’t amortized since it has an indefinite life. If the value of goodwill is impaired, it must be written down.
Accounting for the Impairment of an Intangible Asset
Some intangibles—like goodwill, licences & some trademarks—have indefinite lives and, therefore, are not subject to amortization. But all intangibles are subject to a write-down when the carrying amount exceeds its recoverable amount.
Under ASPE, impairment of intangible assets is tested only when there’s an indication of impairment.
Accounting for Research & Development Costs
Both IFRS and ASPE require development costs meeting certain criteria to be capitalized & then expensed over the life of the product, while research costs are to be expensed as incurred.
Analyze a Company’s Return on Assets
What is Return on Assets (ROA)?
ROA, also known as rate of return on assets, measures how much the entity earned for each dollar of assets invested by both shareholders and creditors. The higher, the better.
*Average Total Assets = (Beginning Total Assets + Ending Total Assets)/2
Decision Guidelines for Return on Assets (ROA)
Cash Flow Impact of Long-Lived Asset Transactions
3 main types of long-lived asset transactions appear on the statement of cash flows:
- Acquisitions: Acquisitions are investing activities.
- Sales: Sales of long-lived assets are investing activities. Gains & loss are not reported as investing activity.
- Depreciation & Amortization: Shows up in the operating activities (adjustment to reconcile net income).