Accounting in a Nutshell 3
Property, Plant, and Equipment
Joel Shapiro has been an
accounting instructor at Ryerson
University in Toronto, Canada for
20 years. Previously, he developed
an accounting and inventory
management software system for
small businesses. In his spare time,
he enjoys working on Kakuro and
cryptic crossword puzzles and travels
throughout Ontario as a bridge
tournament director.
Joel Shapiro, MBA
Accounting Instructor, Ryerson University, Toronto
Abstract: This short article explains the generally ac-
cepted methods of accounting for tangible long-lived as-
sets and the related depreciation expense. Four methods
of calculating depreciation are illustrated, with sample
problems and solutions. As well, the issues of impair-
ment and disposals are discussed. In addition, guidance
is provided with respect to the analysis and interpreta-
tion of key financial ratios related to tangible long-lived
assets.
Keywords: depreciation, disposals, impairment, long-lived
assets
Definitions
Long-lived assets are those that the company has pur-
chased, or has the exclusive right to use, and intends
to use for more than one year. The major category of
long-lived assets is property, plant, and equipment (PP&E),
which includes tangible assets such as land, buildings,
equipment, machinery, computers, vehicles (including
ships and space satellites!), furniture, and fixtures.
PP&E, like all assets, eventually become either cash
(when they are sold) or an expense (as they are used
in everyday operations over their lives). This expense
is called depreciation. In addition, if an assets value in
use declines below the amount at which it is carried on
the companys books, a loss due to impairment must be
recorded.
Introduction
This article will concentrate mostly on the accounting
for PP&E, from acquisition through use to eventual dis-
posal. Other types of long-lived assets, such as natural
resources (e.g., oil and gas, ore, timber) and intangible
assets (e.g., trademarks and copyrights), are not dis-
cussed in this article.
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 Accounting in a Nutshell 3
What Costs Are Included in PP&E?
The general rule for PP&E (and all other as-
sets as well) is that all costs that have been
laid out in order to get the item to the loca-
tion and condition in which it can be used
are included. Simply put, if an expenditure
was made in order to purchase the item, if
it is a one-time expense for that item rather
than a cost that will recur over time, and
if it was necessary in order to make the
item ready for use, then that cost is part
of PP&E. We say that such a cost is capital-
ized. Anything else would be expensed in
the period.
Here are some examples. The actual
invoice price of an item would obviously
be included, as well as any nonrefundable
taxes paid. If the item is imported, any cus-
toms duties, excise taxes, and the like would
be part of its cost as well. Insurance while
the item is in transit from the supplier, and
the shipping cost, would also be included
ONLY if the goods are the property of the
purchaser while in transit. If any one-time
installation and testing costs are needed
in order to begin to use the asset, that too
is included in the cost of the asset. Ongo-
ing costs not attributable to specific items,
such as insurance on assets during their
useful lives, or training expenses for em-
ployees using the asset, or additional costs
for extended warranties, are not included.
Any discounts taken after the fact, such as
for prompt payment to the supplier, would
be deducted from the cost of the asset, as
the asset now costs less than originally
expected.
What Is Depreciation?
Most non-accountants think of deprecia-
tion as the reduction over time in the mar-
ket value of an asset. It is often said that
a brand-new car depreciates in value by
one-third the minute the buyer drives it
off the dealers lot! In accounting, however,
depreciation has nothing whatsoever to
do with valuation. We can all think of as-
sets whose market values increase, or ap-
preciate, over timereal estate being an
2 Expert Insights
obvious example. Even cars can appreciate
in value, if they are kept long enough to
become antiquesHenry Ford sold his first
Model Ts for a few hundred dollars. You
will never be able to buy a roadworthy one
today for that price!
For accounting, depreciation is simply
a process of allocation, not valuation. The
historic cost principle states that in most
circumstances, an asset must be recorded
and carried at the amount originally paid
for it (with adjustments as described in the
preceding section). The matching prin-
ciple, however, states that the revenues
earned in a particular accounting period
must be matched with the expenses in-
curred in that period to earn that revenue.
Neither revenues nor expenses need be ac-
companied by the receipt or payment of
cashthats what receivables and payables
are for. The use of an item of PP&E is also
an expense of the period because it helps
to generate revenue even though this use is
not an actual outflow of cash. The expense
represented by the use of an asset is called
depreciation. Depreciation is merely the
way accountants allocate the cost of an as-
set over the periods during which its use
helps to generate revenue. Depreciation,
then, is a straightforward application of
the matching principle and has nothing to
do with what the asset may or may not be
worth on the open market.
Note on terminology: In the past, de-
preciation has at times been referred to as
amortization. Today, the term amortization
is used for intangible assets, not PP&E.
Two Important Estimates That Must
Be Made
Since depreciation is the process of allocat-
ing an assets cost over all the periods for
which it is expected to generate revenue,
an estimate must be made at the start of
just how many periods that will be. This
is a matter of judgment. Companies are
free to choose any number that is reason-
able and may even change this estimate
later if circumstances warrant. Computers
 Accounting in a Nutshell 3
frequently are given very short lives, a few
years at most. Cars would typically last a
bit longerfurniture, fixtures, and equip-
ment longer stillbuildings even longer,
perhaps as long as 50 years or more. An
exception is landland is assumed to last
indefinitely and is therefore not depreci-
ated at all. Land improvements, however
(such as parking lots, drainage systems,
and lighting), do have definite useful lives
and are depreciated. Companies are re-
quired to disclose, in the notes to their fi-
nancial statements, what their estimates of
useful lives are for each separate category
of PP&E that they own.
Note that an assets estimated useful life
may very well be shorter than its actual
physical life. A company that purchases
new trucks for its fleet every five years
would choose that number for the useful
life of its trucks, even though the trucks
may be sold to another company at that
time and may remain on the road longer.
A second estimate that must be made
when an asset is purchased, before its de-
preciation can be calculated, is the assets
residual or salvage value. This is what the
company thinks the asset can be sold for
(or its trade-in value) at the end of its useful
life. In many case, this will be zero, but if it
isnt, then that portion of the assets cost will
not be depreciated, as it will be recovered
upon the assets disposal. The amount that
will be depreciated, assuming that the asset
is held for its entire life, is its cost less its re-
sidual value. This is known as the deprecia-
tion base or depreciable amount. An assets
carrying value (or carrying amount) is the
amount actually on its booksthe assets
cost less its accumulated depreciation.
Once the assets cost is known and its
useful life and residual value have been
estimated, then depreciation can be calcu-
lated. As depreciation is a rational method
of allocating the assets depreciable amount
over its estimated useful life, once a depre-
ciation method is chosen the depreciation
for each year of the assets life can be cal-
culated ahead of time. There are several
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depreciation methods that are acceptable
to accountants and that can give very dif-
ferent depreciation figures. Note, however,
that over the entire life of an asset, the to-
tal depreciation expense will be its depre-
ciable amountdifferent methods only
allocate that amount differently to differ-
ent periods. The result is the same in the
long run. A company should use the same
method for all assets of the same type, but
may choose different methods for different
categories of assets.
Four of the most popular methods are
described below.
The Straight-Line Method
This is the simplest and most commonly
used method. Annual depreciation is cal-
culated as the depreciation base divided
by the useful life in years. Thats all there
is to it. So, if a truck costing $35,000 is
purchased and is expected to have a re-
sidual value of $5,000 and last five years
before it is sold or traded in, then it
would be depreciated by $6,000 each year
[($35,000$5,000) 5]. Most companies
calculate depreciation monthly, so this
would be $500 per month, starting with
the month in which the truck began to be
used. Assets whose usefulness is constant
over their lives would be good candidates
for this methodfor example, buildings,
furniture, and land improvements.
The Units-of-Output Method
(Also Called Units-of-Production
Method)
This variation on the straight-line method
can be used for assets whose usage is me-
tered or can be counted in some way. In-
stead of estimating the assets life in years,
it is estimated in units of output. Examples
might be miles driven for a car or truck,
or copies made for a photocopier, or hours
flown for an airplane. So, if a truck costing
$35,000 is purchased and is expected to have
a residual value of $5,000 and last 60,000
miles before it is sold or traded in, then it
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