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Accounting in a Nutshell 3

Property, Plant, and Equipment

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.
Joel Shapiro has been an PP&E, like all assets, eventually become either cash
accounting instructor at Ryerson
University in Toronto, Canada for
(when they are sold) or an expense (as they are used
20 years. Previously, he developed in everyday operations over their lives). This expense
an accounting and inventory is called depreciation. In addition, if an assets value in
management software system for use declines below the amount at which it is carried on
small businesses. In his spare time,
the companys books, a loss due to impairment must be
he enjoys working on Kakuro and
cryptic crossword puzzles and travels recorded.
throughout Ontario as a bridge
tournament director. 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? obvious example. Even cars can appreciate
The general rule for PP&E (and all other as- in value, if they are kept long enough to
sets as well) is that all costs that have been become antiquesHenry Ford sold his first
laid out in order to get the item to the loca- Model Ts for a few hundred dollars. You
tion and condition in which it can be used will never be able to buy a roadworthy one
are included. Simply put, if an expenditure today for that price!
was made in order to purchase the item, if For accounting, depreciation is simply
it is a one-time expense for that item rather a process of allocation, not valuation. The
than a cost that will recur over time, and historic cost principle states that in most
if it was necessary in order to make the circumstances, an asset must be recorded
item ready for use, then that cost is part and carried at the amount originally paid
of PP&E. We say that such a cost is capital- for it (with adjustments as described in the
ized. Anything else would be expensed in preceding section). The matching prin-
the period. ciple, however, states that the revenues
Here are some examples. The actual earned in a particular accounting period
invoice price of an item would obviously must be matched with the expenses in-
be included, as well as any nonrefundable curred in that period to earn that revenue.
taxes paid. If the item is imported, any cus- Neither revenues nor expenses need be ac-
toms duties, excise taxes, and the like would companied by the receipt or payment of
be part of its cost as well. Insurance while cashthats what receivables and payables
the item is in transit from the supplier, and are for. The use of an item of PP&E is also
the shipping cost, would also be included an expense of the period because it helps
ONLY if the goods are the property of the to generate revenue even though this use is
purchaser while in transit. If any one-time not an actual outflow of cash. The expense
installation and testing costs are needed represented by the use of an asset is called
in order to begin to use the asset, that too depreciation. Depreciation is merely the
is included in the cost of the asset. Ongo- way accountants allocate the cost of an as-
ing costs not attributable to specific items, set over the periods during which its use
such as insurance on assets during their helps to generate revenue. Depreciation,
useful lives, or training expenses for em- then, is a straightforward application of
ployees using the asset, or additional costs the matching principle and has nothing to
for extended warranties, are not included. do with what the asset may or may not be
Any discounts taken after the fact, such as worth on the open market.
for prompt payment to the supplier, would Note on terminology: In the past, de-
be deducted from the cost of the asset, as preciation has at times been referred to as
the asset now costs less than originally amortization. Today, the term amortization
expected. is used for intangible assets, not PP&E.

What Is Depreciation? Two Important Estimates That Must


Most non-accountants think of deprecia- Be Made
tion as the reduction over time in the mar- Since depreciation is the process of allocat-
ket value of an asset. It is often said that ing an assets cost over all the periods for
a brand-new car depreciates in value by which it is expected to generate revenue,
one-third the minute the buyer drives it an estimate must be made at the start of
off the dealers lot! In accounting, however, just how many periods that will be. This
depreciation has nothing whatsoever to is a matter of judgment. Companies are
do with valuation. We can all think of as- free to choose any number that is reason-
sets whose market values increase, or ap- able and may even change this estimate
preciate, over timereal estate being an later if circumstances warrant. Computers

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Accounting in a Nutshell 3

frequently are given very short lives, a few depreciation methods that are acceptable
years at most. Cars would typically last a to accountants and that can give very dif-
bit longerfurniture, fixtures, and equip- ferent depreciation figures. Note, however,
ment longer stillbuildings even longer, that over the entire life of an asset, the to-
perhaps as long as 50 years or more. An tal depreciation expense will be its depre-
exception is landland is assumed to last ciable amountdifferent methods only
indefinitely and is therefore not depreci- allocate that amount differently to differ-
ated at all. Land improvements, however ent periods. The result is the same in the
(such as parking lots, drainage systems, long run. A company should use the same
and lighting), do have definite useful lives method for all assets of the same type, but
and are depreciated. Companies are re- may choose different methods for different
quired to disclose, in the notes to their fi- categories of assets.
nancial statements, what their estimates of Four of the most popular methods are
useful lives are for each separate category described below.
of PP&E that they own.
Note that an assets estimated useful life The Straight-Line Method
may very well be shorter than its actual This is the simplest and most commonly
physical life. A company that purchases used method. Annual depreciation is cal-
new trucks for its fleet every five years culated as the depreciation base divided
would choose that number for the useful by the useful life in years. Thats all there
life of its trucks, even though the trucks is to it. So, if a truck costing $35,000 is
may be sold to another company at that purchased and is expected to have a re-
time and may remain on the road longer. sidual value of $5,000 and last five years
A second estimate that must be made before it is sold or traded in, then it
when an asset is purchased, before its de- would be depreciated by $6,000 each year
preciation can be calculated, is the assets [($35,000$5,000) 5]. Most companies
residual or salvage value. This is what the calculate depreciation monthly, so this
company thinks the asset can be sold for would be $500 per month, starting with
(or its trade-in value) at the end of its useful the month in which the truck began to be
life. In many case, this will be zero, but if it used. Assets whose usefulness is constant
isnt, then that portion of the assets cost will over their lives would be good candidates
not be depreciated, as it will be recovered for this methodfor example, buildings,
upon the assets disposal. The amount that furniture, and land improvements.
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- The Units-of-Output Method
tion base or depreciable amount. An assets (Also Called Units-of-Production
carrying value (or carrying amount) is the Method)
amount actually on its booksthe assets This variation on the straight-line method
cost less its accumulated depreciation. can be used for assets whose usage is me-
Once the assets cost is known and its tered or can be counted in some way. In-
useful life and residual value have been stead of estimating the assets life in years,
estimated, then depreciation can be calcu- it is estimated in units of output. Examples
lated. As depreciation is a rational method might be miles driven for a car or truck,
of allocating the assets depreciable amount or copies made for a photocopier, or hours
over its estimated useful life, once a depre- flown for an airplane. So, if a truck costing
ciation method is chosen the depreciation $35,000 is purchased and is expected to have
for each year of the assets life can be cal- a residual value of $5,000 and last 60,000
culated ahead of time. There are several miles before it is sold or traded in, then it

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