Chapter 2: Accounting for Plant Assets
Chapter Two
Accounting for Plant Assets
2.1 Nature of Plant Assets
Plant assets:
Are Long lived assets usually more than a year
Are Acquired for use in business operations i.e. must be capable of providing repeated
use or benefit
Are not acquired for resale. Any asset that is acquired for resale purpose is not a plant
asset regardless of their durability, nature of the assets, and the length of time they are
held. Example land held for speculation purpose.
Are subject to depreciation i.e. decline in usefulness through passage of time
2.2 Acquisition Cost of Plant Assets
The cost of a plant asset includes all expenditures that are reasonable and necessary for
getting the asset to the desired location and ready for use. They are:
Purchase Price
Sales Tax
Insurance
Transportation Cost
Maintenance cost
Cost of replacing parts
Repairs and Painting costs
Fees paid to architects or designers
For engineers for plans and supervision
Other costs like labor, materials and overhead costs
2.3 Nature and Accounting for Depreciation
Plant asset is expected to have a lower value or no value when it is retired from the service.
This is because plant assets decline in usefulness through the time which we call it
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Chapter 2: Accounting for Plant Assets
depreciation. The difference between the initial cost and the value remaining when it is
retired (Residual Value or Scrape Value or Salvage Value or Trade in Value) is called
depreciable cost that is the cost that should be allocated over the useful life the assets as a
depreciation expense.
Depreciation is also the systematic allocation of the cost of a plant asset over its estimated
life. The causes of depreciation are divided into two broad classes:
1. Physical Usage – physical depreciation results from the wear and tear of plant assets due
to operating use and forces of nature such as earth quake, land slide, storm, etc
2. Functional or economic depreciation – results from obsolescence and inadequacy
Obsolescence – is the process of becoming out of date because of technological
innovation. Example type writing equipment
Inadequacy – refers to the effect of growth and change in the scale of a business
operation. Inability to meet the demand of customers. Example small machines held
by large business
Accounting for Depreciation
Factors that affects periodic depreciation expense are the
Initial cost or acquisition cost
Residual value
Useful life or estimated economic life and method of depreciation
Methods of Depreciation
Usually the following 4 methods are used to allocate the depreciate cost. These are:
1. Straight line method
2. Declining balance method
3. Sum of the year’s digit method and
4. Units of production method
1. Straight Line Method (SLM)
This method allocates depreciable cost to each period of the Estimated Economic Life of the
assets equally. Depreciation per year is computed as follows:
Depreciation per Year = (Acquisition Cost – Residua Value) / Estimated Economic Lif
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Chapter 2: Accounting for Plant Assets
Illustration 2.1: assume that a machine is acquired at the beginning of 1991 for Br 100,000
and the residual value of the machine at the end of 10 years of economic life is estimated at
Br 10,000. Instruction: compute the amount of depreciation allocable to each year and
present the necessary adjustment at the end of each year.
Depreciation per Year = (Br 100,000– 10,000) / 10 Years = Br 90,000 / 10 = Br 9,000
Depreciation Expense 9,000
Accumulated Depreciation 9,000
2. Declining Balance Method
This method yields a decline in periodic depreciation charges over the estimated life of the
assets. The most common techniques are to double the straight line depreciation and multiply
the resulting rate to the cost of the asset less its accumulated depreciation.
Depreciation per year = (2 / EEL) * (Acquisition Cost – Accumulated Depreciation)
Illustration 2.2: CC Corporation purchased equipment on January 1, 2000 for Br 20000
which has an expected life of 5 years and salvage value of Br 1,000. Instruction: calculate the
declining balance rate and the amount of depreciation for its useful life.
Cost = Br 20,000
EEL = 5 years
Residual Value = Br 1,000
Year 2000 = 2/ 5 * (Br 20,000 – 0) = 40% * Br 20,000 = Br 8,000
Year 2001 = 40% * (Br 20,000 – 8,000) = 40% * Br 12,000 = Br 4,800
Year 2002 = 40% * (Br 20,000 – 12,800) = Br 2,880
Year 2003 = 40% * (Br 20,000 – 15,680) = Br 1,728
Year 2004 = 40% * (Br 20,000 – 17,408) = Br 1,037
In the year 2004 the calculated amount of depreciation is Br 1037 but the actual depreciation
expense is Br 1,592 (Br 2,592 – 1000). The 2,592 is the difference between Br 20,000 (cost)
and 17,408 (accumulated depreciation). The estimated residual value does not enter into the
computation of depreciation expense until the very end. This is because this method provides
an automatic residual value. If an asset has a Residual Value, this depreciation method should
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Chapter 2: Accounting for Plant Assets
consider the stated residual value. Thus, in the above example the depreciation expense for
year 2004 is Br 1,592 rather than Br 1,037
3. The Sum Of Years Digits(SOYD) Method
Under this method the periodic charge for depreciation declines steadily or continuously over
the estimated life of the asset because successive small action is applied each year to the
original cost less estimated residual value. The following steps are followed to determine the
depreciation charge under this method:
Estimate the useful life of the asset in the years
Assign consecutive numbers for each year starting from 1
Find the sum of these numbers using the following formula: SOYD = [N (N + 1)] / 2.
Where N = estimated useful life of the asset in years
Determine the numerator which is a number of the economic life of the asset remaining at
the beginning of each accounting period. Year 1= N, Year 2= N – 1, Year 2 = N – 2 , etc
Compute depreciation using the formula: Annual Depreciation = (AC – RV) * EEL/
SOYD
Illustration 2.3: JK Company purchased old building on January 1, 1995 for Br 105,000 and
its estimated life is 4 years with a salvage value of Br 5,000 and the physical period ends on
December 31, 1995. Instruction: determine the sum-of-years-digit and calculate the amount
of depreciation for its useful life.
SOYD = [N (N + 1)]/ 2 = [4 (4 + 1)] / 2 = 10
Depreciation Expense
1995 = 4/10 (105,000 – 5,000) = Br 40,000
1996 = 3/10 (105,000 – 5,000) = Br 30,000
1997 = 2/10 (105,000 – 5,000) = Br 20,000
1998 = 1/10 (105,000 – 5,000) = Br 10,000
4. Units Of Production Method
This method yields a depreciation charge that varies with the amount of usage. To apply this
method the life of the asset is expressed in terms of production capacity such as machine
hours, miles, kilo meters, or no of units, etc. Under this method depreciation is computed as
follows:
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Chapter 2: Accounting for Plant Assets
Depreciation Rate = (AC – RV) / Estimated Production Capacity
Depreciation Expense = Depreciation Rate * Actual Usage of the Asset
Illustration 2.4: XY Company purchased diesel powered generator on January 1, 2000 at Br
50000 and the generator has estimated economic life of 5 years or a production capacity of
500000 machine hours with no residual value. Instruction: calculate the depreciation expense
for the year 2000 and 2001 assuming that the generator was used for 100,000 and 120,000
machine hours, respectively.
Depreciation Rate = (Br 50,000 – 0) / 500,000 hours = Br 0.10 per hour
Year 2000 depreciation expense = depreciation rate * actual usage
Year 2000 depreciation expense = Br 0.10/ Hr. * 100000 hours
Year 2000 depreciation expense = Br 10,000
Year 2001 depreciation expense = depreciation rate * actual usage
Year 2001 depreciation expense = Br 0.10/ Hr. * 120000 hours
Year 2001 depreciation expense = Br 12,000
2.4 Disposal of Plant Assets
When an asset is no longer useful to the business, it is retired from the service. This is called
disposal. Disposal refers to discarding, selling, or exchanging plant assets. To journalize the
necessary entries on the date of disposal the following information are required:
The up-to-date balance of the accumulated depreciation account
The book value of the asset
The loss or gain on disposal
1. Discarding Plant Assets
When a plant asset are no longer useful to the business and has no market or sales value, they
are discarded.
2. Selling Old Plant Asset
The entry to record the sale of a plant asset is like the entry of discarding a plant asset except
that the cash or other asset to be received must be accounted for.
If the selling price > book value, there will be a gain on disposal
If the selling price < book value, there will be a loss on disposal
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Chapter 2: Accounting for Plant Assets
3. Exchanging or Trading in
Old plant assets are often traded in for new plant asset having similar use or dissimilar use.
Under this situation a trade-in allowance (TIA) is usually granted on old plant asset. The
trade-in allowance can be considered an agreed selling price for the old asset. This amount is
deducted from price of new asset as consideration for old plant asset. The balance paid to the
seller of the new asset after the trade-in allowance is deducted from the purchase price is
called Boots. The GAIN or LOSS on exchange is determined by comparing the TIA and the
Book Value of the old Asset:
If the TIA > book value, there will be a gain on disposal
If the TIA < book value, there will be a loss on disposal
According to international finance reporting standard (IFRS) on exchange of similar plant
assets, loss should be recognized and gain should be adjusted to the price the new asset. That
is, the new asset exchanged must be recorded at the book value of the old asset plus the cash
paid (Boots) or the purchase price whichever is lower.
2.5Accounting for Natural Resources and Depletion
Natural resources include forests, water, minerals, metal ores, oil, gas, etc. The costs of
natural resources include all the normal, necessary and reasonable expenditure incurred to
acquire these natural resources. The periodic cost allocation of the natural resources is called
depletion. To compute depletion the steps are as follows:
Depletion Rate = (Cost – the estimated RV) / Estimated Deposit
Depletion Expense= Depletion Rate * Extracted Deposit
Illustration 2.11: MIDROC Gold Mining Company pays Br 4,500,000 to acquire its mineral
site which is believed to contain 500,000 tons of Gold ores. The Residual Value is estimated
to be Br 500,000. If 12,000 tons are extracted during the year, compute the depletion rate and
depletion expense.
Depletion Rate = (4,500,000 – 500,000) / 500,000 tons = Br 8 per ton
Depletion Expense = Br 8 / ton * 12,000 tons = Br 96,000
The Accounting Entry would be:
Depletion Expense 96,000
Accumulated Depletion 96,000
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Chapter 2: Accounting for Plant Assets