Plant assets are assets that are held for more than one year and are uses in business operations. Land, buildings, equipment, furniture, and machinery are examples of plant assets. When a plant asset is initially acquired, all costs incurred for acquisition and installation are debited to the plant asset account. Expenditures that are related to land can be debited to either Land, Land Improvements, or Buildings depending upon how permanent they are and how long they are expected to last.
Depreciation
All plant assets, except land, depreciate. Factors that contribute to depreciation are physical and functional. Physical depreciation arises from the actual use of a plant asset. Functional depreciation is due to obsolescence factors such as technological advances and less demand for a product. The purpose of recording depreciation is to show the decline of usefulness of an asset, not a decline in its market value. Depreciation merely reduces the value of plant asset accounts, it does not reduce the cash account or affect cash flows.
Determining Depreciation
Factors that determine depreciation expense are the initial cost, the residual value and the useful life. Depreciation can only be estimated because it depends on several potentially changing elements. Residual value is any value that remains after an asset has been retired. The calculation of depreciation is based on the initial cost minus residual value. Several methods used to calculate depreciation. The straight-line method is the most popular. Different depreciation methods can be used for financial statement information and tax purposes.
Straight-Line Method
The straight-line method of depreciation charges equal amounts of depreciation to each period over the useful life of the asset. It is determined by subtracting the residual value from the initial cost and dividing it by the number of the years of estimated life. Due to its simplicity, it is the most widely used method.
Units-Of-Production Method
The units-of-production method determines depreciation expense based on the amount the asset is used. The length of life of an asset is expressed in a form of productive capacity. The initial cost less any residual value is divided by productive capacity to determine a rate of unit-of-production depreciation per units of usage. Units of usage c can be expressed in quantity of goods produced, hours used, number of cuttings, miles driven or tons hauled, for instance. The depreciation expense of a period is determined by multiplying usage by a fixed unit-of-production rate of usage. This depreciation method is commonly used when asset usage varies from year-to-year.
Declining-Balance Method
The declining-balance (also known as double-declining-balance) method is a popular form of accelerated depreciating. The rate used is usually twice the rate employed by the straight-line method. This method does not consider the estimated salvage value in determining the depreciation rate or in computing the periodic depreciation. However, an asset cannot be depreciated beyond the estimated salvage value. Depreciation expense is highest in the first year, and becomes smaller each subsequent year.
Sum-of-The-Years-Digits Method
The sum-of-the-years-digits method is an another form of accelerated depreciation. The annual depreciation is calculated by subtracting salvage value from original cost, and multiplying this figure by a fractional rate of depreciation. The denominator of the fraction is the sum of the years of useful life; for a life of 5 years, the denominator is = 1 + 2 + 3 + 4 + 5 = 15. The numerator is the year in reverse order. For the first year, the numerator is 5 and the fraction is 5/15.
Comparing Depreciation Methods
Different depreciation methods produce different results, and in some circumstances the use of a particular depreciation method is recommended. When the use of an asset fluctuates from period to period, the units-of-production method is recommended. For assets that decline in usefulness early, and are subject to high maintenance costs as they age, a form of accelerated depreciation should be used, i.e. declining-balance and the sum-of-the-years- digits methods.
Depreciation & Income Taxes
For tax purposes, the straight-line, declining-balance, sum-of-the-years-digits, and units-of-production methods of depreciation were allowed prior to 1981. Between 1980 and 1987, either the straight-line method or the Accelerated Cost Recovery System (ACRS) could be used. The Tax Reform Act of 1986 revised the ACRS by providing a depreciation rate schedule for eight classes of plant assets. The use of an accelerated depreciation method reduces tax liabilities and increases cash flows.
Revising Depreciation Estimates
Because depreciation is estimated, it often needs to be revised periodically over the life of the asset. An error in estimating the salvage value, the years of useful life, or both can require a revision. Previously recorded depreciation is not affected by a revision. The revision of depreciation is only affects future depreciation expenses.
Recording Depreciation Expenses
When depreciation is to be recorded, a Depreciation Expense account is debited, and Accumulated Depreciation is credited. Accumulated Depreciation is a contra-asset account that decreases the value of plant assets. The use of a contra-asset account allows assets to be shown at cost, and thus allows easier computations if a revision is necessary or different depreciation methods are used. When an asset is sold, all accounts related to the depreciation of that asset are adjusted.
Capital And Revenue Expenditures
Expenditures on plant assets fall into two categories:
- capital expenditures: these increase the productive capacity, efficiency or useful life of the asset, and
- revenue expenditures: these include maintenance and repairs.
Disposing Plant Assets
Plant assets can be disposed of by discarding, selling, or trading in for other assets. No matter how plant assets are disposed of, the book value of the asset must be removed from the account. When an asset becomes completely useless, it is taken of the books by debiting the Accumulated Depreciation account and crediting the Equipment account. In the event an asset is discarded before its estimated useful life, the loss must be debited to the Loss on Disposal of Plant Assets account.
Disposing Plant Assets
When a plant asset is sold, the Cash and Accumulated Depreciation accounts are always debited, and the Equipment account is credited. In the event there is a loss or gain from the sale, either the Loss on Disposal of Plant Assets or the Gain on Disposal of Plant Assets accounts will have an entry. When old plant assets are exchanged for new plant assets, it is generally accepted that any gains from a trade need not be recognized. The amount that is owed after credit for the trade-in is known as the boot, which is also the required cash payment. The entry is this situation is Debit Accumulated Depreciation (old equipment) Debit Plant Assets (new equipment) Credit Plant Assets (old equipment) Credit Cash.
Subsidiary Ledgers for Plant Assets
When a business has a large number of plant assets to keep track of, the use of a subsidiary ledger is recommended. Detailed information on each plant asset is maintained in the subsidiary ledger. All plant assets can be specifically identified by an assigned number. The first part of the number corresponds to the general ledger account, while the second part of the number represents the identification assigned to the asset. Periodically, it is advisable to compare balances of the subsidiary ledger with the controlling accounts in the general ledger. Subsidiary ledgers are very useful in determining depreciation expenses, filing tax and insurance forms, as well as recording the disposal of plant assets.
Composite-Rate Depreciation Method
The composite-rate depreciation method determines depreciation of a group of similar plant assets by using a single rate. This rate is determined by dividing annual depreciation by the total original cost of assets. Although specific equipment in the group may be added and retired, this method assumes that the mix will remain unchanged. Gains and losses from the retirement or disposal of assets are not realized.
Leasing Plant Assets
A business can rent a property for a specified period of time under a contract known as a lease. The lessor is the owner of the property, and the lessee is the party that has the right to use the property. Leases which extent over most of the asset life, and which transfer ownership to the lessee at the end of the lease, are called capital leases. Assets held under capital lease must be shown on the balance sheet, and therefore, the Plant Assets is debited and a lease liability account is credited. Operating leases tend to be more short-term, and the lessee does not acquire the leased property at the end of the lease.
Intangible Assets
Intangible assets do not have physical substance. They are not held for sale, and they are usually highly valuable to the business. They include patents, copyrights, trademarks, goodwill, and franchises. Except for goodwill, most intangible assets receive legal protection of exclusive use. The cost of obtaining legal protection for the intangible asset should be debited to the intangible asset account. The periodic loss of value of the intangible asset is called amortization, and is expensed annually. Research and development costs are treated as expense in the year incurred, and are not treated as intangible assets because it is their future success is uncertain.
Depletion
The periodic allocation of the use of natural resources is a called depletion. Mineral deposits, coal, timber, natural gas, and petroleum are all subject to depletion. Depletion Expense is debited and Accumulated Depletion is credited for the amount of usage during the period. The usage is based on current year production as a fraction of total capacity, and the determination is essentially identical to the unit-of-production depreciation method.
by John Petroff
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