5

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Describe property, plant, and 5. Understand accounting issues related

equipment. to acquiring and valuing plant assets.

2. Identify the costs to include in initial 6. Describe the accounting treatment for
valuation of property, plant, and costs subsequent to acquisition.
equipment. 7. Describe the accounting treatment for
3. Describe the accounting problems the disposal of property, plant, and
associated with self-constructed assets. equipment.

4. Describe the accounting problems

associated with interest capitalization.
5-1
 PROPERTY, PLANT, AND EQUIPMENT

Property, plant, and equipment are assets of a durable

nature. Other terms commonly used are plant assets and
fixed assets.
Includes:
► “Used in operations” and not
§ Land,
for resale.
§ Land improvement
► Long-term in nature and § Building structures
(offices, factories,
usually depreciated.
warehouses), and
► Possess physical substance. § Equipment
(machinery, furniture,
tools).

5-2 LO 1
 ACQUISITION OF PROPERTY, PLANT,
AND EQUIPMENT (PP&E)

Historical cost measures the cash or cash equivalent price of

obtaining the asset and bringing it to the location and condition
necessary for its intended use.

In general, costs include:

1. Purchase price, including import duties and non-refundable

purchase taxes, less trade discounts and rebates.

2. Costs attributable to bringing the asset to the location and

condition necessary for it to be used in a manner intended
by the company.

5-3 LO 2
 ACQUISITION OF PROPERTY, PLANT,
AND EQUIPMENT (PP&E)

Companies value property, plant, and equipment in

subsequent periods using either the
u cost method or

u fair value (revaluation) method.

5-4 LO 2
 ACQUISITION OF PP&E

Cost of Land
All expenditures made to acquire land and ready it for use.
Costs typically include:
(1) purchase price;
(2) closing costs, such as title to the land, attorney’s fees, and
recording fees;
(3) costs of grading, filling, draining, and clearing;
(4) assumption of any liens, mortgages, or encumbrances on
the property; and
(5) additional land improvements that have an indefinite life.

5-5 LO 2
 ACQUISITION OF PP&E

Cost of Land
u Improvements with limited lives, such as private
driveways, walks, fences, and parking lots, are recorded
as Land Improvements and depreciated.

u Land acquired and held for speculation is classified as

an investment.

u Land held by a real estate concern for resale should be

classified as inventory.

5-6 LO 2
 ACQUISITION OF PP&E

Cost of Buildings
Includes all expenditures related directly to acquisition or
construction. Costs include:

u materials, labor, and overhead costs incurred during

construction and

u professional fees and building permits.

Companies consider all costs incurred, from excavation to

completion, as part of the building costs.

5-7 LO 2
 ACQUISITION OF PP&E

Cost of Equipment
Include all expenditures incurred in acquiring the equipment
and preparing it for use. Costs include:
u purchase price,

u freight and handling charges,

u insurance on the equipment while in transit,

u cost of special foundations if required,

u assembling and installation costs, and

u costs of conducting trial runs.

5-8 LO 2
 ACQUISITION OF PP&E

Self-Constructed Assets
Costs include:
u Materials and direct labor

u Overhead can be handled in two ways:

1. Assign no fixed overhead.

2. Assign a portion of all overhead to the construction

process.

Companies use the second method extensively.

5-9 LO 3
 ACQUISITION OF PP&E

Interest Costs During Construction

Three approaches have been suggested to account for the
interest incurred in financing the construction.

$0
Increase to Cost of Asset $?

Capitalize no Capitalize
interest during Capitalize actual all costs of
construction costs incurred during funds
construction

IFRS

5-10 LO 4
 ACQUISITION OF PP&E

Interest Costs During Construction

u IFRS requires capitalizing actual interest during
construction. The rationale is that during construction, the
asset is not generating revenues. Therefore, a company
should defer (capitalize) borrowing costs.

u Capitalization is consistent with historical cost.

u Capitalization considers three items:

1. Qualifying assets.

2. Capitalization period.

3. Amount to capitalize.
5-11 LO 4
 Interest Costs During Construction
1. Qualifying Assets
Require a substantial period of time to get them ready for
their intended use or sale.
Two types of assets:
(1) Assets under construction for a company’s own use
(including buildings, plants, and large machinery)

(2) Assets intended for sale or lease that require a substantial

period of time to produce (e.g., ships or real estate
developments).

Assets that do not qualify for interest capitalization are

(1) assets that are in use or ready for their intended use

5-12 (2) inventories that are produced over a short period of time. LO 4
 Interest Costs During Construction

2. Capitalization Period
Begins when:
1. Expenditures for the assets are being incurred.

2. Activities for readying the asset for use or sale are

in progress .

3. Interest costs are being incurred.

Ends when:
The asset is substantially complete and ready for use.

5-13 LO 4
 Interest Costs During Construction

3. Amount to Capitalize
The amount of borrowing cost to be capitalized varies
depending on whether the project is being funded from
specific debt or from general debt.

A. Project funded by specific debt

Capitalize the actual borrowing costs incurred during the
capitalization period offset by any investment income from
the borrowings.

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 Interest Costs During Construction

Comprehensive Illustration: On November 1, 2021, Shalla

Company contracted Pfeifer Construction Co. to construct a building
for $1,400,000 on land costing $100,000 (purchased from the
contractor and included in the first payment). Shalla made the
following payments to the construction company during 2022.

5-15 LO 4
 Interest Costs During Construction

Pfeifer Construction completed the building, ready for occupancy, on

December 31, 2022. Shalla had a 15 percent, three-year, $1,500,000,
note to finance purchase of land and construction of the building,
dated December 31, 2021, with interest payable annually on
December 31. During 2021, a portion of the proceeds from the
borrowing that had not yet been expended in the project were
invested and earned $60,000 in interest income.

The amount of borrowing costs to be capitalized for 2022 would be

computed as
Borrowing cost – 1,500,000 x 0.15 = 225,000
Less – investment income (60,000)
Borrowing cost to be capitalized 165,000
5-16 LO 4
 Interest Costs During Construction

Shalla records the following journal entries during 2015:

January 1 Land 100,000

Buildings (or CIP) 110,000
Cash 210,000
March 1 Buildings 300,000
Cash 300,000
May 1 Buildings 540,000
Cash 540,000
December 31 Buildings 450,000
Cash 450,000

Buildings (Capitalized Interest) 165,000

Cash 165,000

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 Interest Costs During Construction

B. Project funded by general debt

When a project is funded by general debt, the company will
need to determine
1. Average carrying amount of the project during the period.

2. Weighted average borrowing cost (capitalization rate)

3. Multiply the average carrying amount by the capitalization rate

Note- The amount capitalized will be lower of actual, or the

amount computed by multiplying the average carrying
amount by the capitalization rate.

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 Interest Costs During Construction

Comprehensive Illustration: On November 1, 2021, Shalla

Company contracted Pfeifer Construction Co. to construct a building
for $1,400,000 on land costing $100,000 (purchased from the
contractor and included in the first payment). Shalla made the
following payments to the construction company during 2022.

5-19 LO 4
 Interest Costs During Construction

Pfeifer Construction completed the building, ready for occupancy, on

December 31, 2022. Shalla had the following two debt obligations
outstanding during 2022:

1. 10 percent, $1,000,000, 5-year note payable, dated December 31,

2018, with interest payable annually on December 31.

2. 12 percent, $1,500,000, 10-year bonds issued December 31, 2017,

with interest payable annually on December 31.

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 Interest Costs During Construction

Step 1. Compute average carrying amount of the project during

the period.

The capitalization period on computation of average carrying amount is the number of

months between the expenditure is made and the end of the year or the end of the project,
whichever occur first.

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 Interest Costs During Construction
Step 2. Compute weighted average borrowing cost
(capitalization rate)

(0.1 x 1,000,000) + (0.12 x 1,500,000)

= 11.2%
1,000,000+1,500,000

Step 3. Multiply the average carrying amount by the

capitalization rate

• $820,000 x 11.2% = $91,840

• In 2022, the actual borrowing costs were $280,000 [($1,000,000 ×

.10) + ($1,500,000 × .12)]. Shalla will capitalize $91,840 since it is
lower than the actual borrowing cost.

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 Interest Costs During Construction

Shalla records the following journal entries during 2022:

January 1 Land 100,000

Buildings (or CIP) 110,000
Cash 210,000
March 1 Buildings 300,000
Cash 300,000
May 1 Buildings 540,000
Cash 540,000
December 31 Buildings 450,000
Cash 450,000
Buildings (Capitalized Interest) 91,840
Interest Expense (280,000 – 91,840) 188,160
Cash 280,000

5-23 LO 4
 Interest Costs During Construction

Special Issues Related to Interest Capitalization

1. Expenditures for Land
u If land is purchased as a site for a structure, interest
costs capitalized during the period of construction are
part of the cost of the plant, not the land.

u Conversely, if the company develops land for lot sales,

it includes any capitalized interest cost as part of the
acquisition cost of the developed land.

2. Interest Revenue
u In general, companies should not offset interest revenue
against interest cost unless earned on specific borrowings.
5-24 LO 4
 VALUATION OF PP&E
Cash Discounts — When a company purchases plant
assets subject to cash discounts, consider the discount as a
reduction in the purchase price of the asset whether the discount
is taken or not.

Deferred-Payment Contracts — Assets purchased on

long-term credit contracts are valued at the present value of the
consideration exchanged.

For example, Greathouse Company purchases Equipment in

exchange for a $10,000 zero-interest-bearing note payable four
years from now for $7,084.30.
Equipment 7,084.30
Notes payable 7,084.30
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 VALUATION OF PP&E
Lump-Sum Purchases — Allocate the total cost among
the various assets on the basis of their relative fair market
values.

A company purchases land, building, and equipment for a lump

sum of $90,000. The fair market values of these items, as
determined by appraisal or reference to state property tax
assessments, are $40,000, $50,000, and $10,000, respectively.
Land 36,000
Building 45,000
Equipment 9,000

Cash 90,000
5-26 LO 5
 VALUATION OF PP&E

Issuance of Shares — The market price of the shares

issued is a fair indication of the cost of the property acquired.

A company issues 100 shares of its $ 100-par ordinary shares

for equipment whose fair value is unclear. The Fair market value
of the share on the date of issuance is $ 120 per share. The
entry is:
Equipment 12,000
Share capital – ordinary 10,000
Share premium – ordinary 2,000

5-27 LO 5
 VALUATION OF PP&E

Exchanges of Non-Monetary Assets

Ordinarily accounted for on the basis of:
u the fair value of the asset given up or

u the fair value of the asset received,

whichever is clearly more evident.

5-28
 VALUATION OF PP&E
Exchanges of Non-Monetary Assets
Recognizing gains or losses on the exchange depends on
whether the transaction has commercial substance or no.

5-29
 VALUATION OF PP&E
Exchanges of Non-Monetary Assets

1. Exchange has commercial substance

An exchange has commercial substance if the two parties’

economic positions change as a result of change in future cash
flows.

companies should recognize immediately any gains or losses on

the exchange.

5-30
 VALUATION OF PP&E
Exchanges of Non-Monetary Assets

2. Exchange has no commercial substance

An exchange lacks commercial substance if the two parties are in

the same economic position as before the exchange. It is mainly
due to exchanging similar assets but not have a significant
difference in cash flows.

If the exchange lacks commercial substance, company should

defer any gain or loss. It will recognizes gain or loss when it later
sells the asset.

5-31
 VALUATION OF PP&E
Exchanges of Non-Monetary Assets
• In exchange, Trade-in allowance is the amount that a property
owner is willing to reduce the selling price of its property in
exchange for another old property.

• Most of the time trade in allowance and fair value of old asset
are similar. But, in some situations trade in allowance of old
asset may be different from its fair value.

• Cash to be paid (boot) = list price [fair value] of new asset –

trade in allowance of old asset

• Cost of new asset = fair value of old asset + cash paid (boot)

5-32
 Exchanges of Non-Monetary Assets

Illustration: Information Processing, Inc. trades its used machine for a

new model at Jerrod Business Solutions Inc. The exchange has
commercial substance. The used machine has a book value of €8,000
(original cost €12,000 less €4,000 accumulated depreciation) and a fair
value of €6,000. The new model lists for €16,000. Jerrod gives
Information Processing a trade-in allowance of €9,000 for the used
machine. Information Processing computes the cost of the new asset
as follows.

5-33
 Exchanges of Non-Monetary Assets

Illustration: Information Processing records this transaction as

follows:

Equipment 13,000
Accumulated Depreciation—Equipment 4,000
Loss on Disposal of Equipment 2,000
Equipment 12,000
Cash 7,000

Loss on
Disposal

5-34
 Exchanges of Non-Monetary Assets
Illustration: assume the same information as in the previous example
except the transaction lacks commercial substance.
Information Processing records this transaction as follows:

Equipment 15,000
Accumulated Depreciation—Equipment 4,000
Equipment 12,000
Cash 7,000

Deferred
Loss on
Disposal

5-35
 Exchanges of Non-Monetary Assets

Exchanges—Gain Situation
Has Commercial Substance. Company usually records the
cost of a non-monetary asset acquired in exchange for
another non-monetary asset at the fair value of the asset
given up, and immediately recognizes a gain.

5-36
 Exchanges of Non-Monetary Assets

Illustration: Interstate Transportation Company exchanged a

number of used trucks plus cash for a semi-truck. The used trucks
have a combined book value of $42,000 (cost $64,000 less $22,000
accumulated depreciation). Interstate’s purchasing agent,
experienced in the secondhand market, indicates that the used
trucks have a fair market value of $49,000. In addition to the trucks,
Interstate must pay $11,000 cash for the semi-truck. Interstate
computes the cost of the semi-truck as follows.

5-37
 Exchanges of Non-Monetary Assets

Illustration: Interstate records the exchange transaction as follows:

Truck (semi) 60,000

Accumulated Depreciation—Trucks 22,000
Trucks (used) 64,000
Gain on Disposal of Trucks 7,000
Cash 11,000

Gain on
Disposal

5-38
 Exchanges of Non-Monetary Assets

Exchanges—Gain Situation
Lacks Commercial Substance. Now assume that
Interstate Transportation Company exchange lacks
commercial substance.

Interstate defers the gain of $7,000 and reduces the basis of

the semi-truck.

5-39
 Exchanges of Non-Monetary Assets

Illustration: Interstate records the exchange transaction as

follows:

Trucks (semi) 53,000

Accumulated Depreciation—Trucks 22,000
Trucks (used) 64,000
Cash 11,000

5-40
 VALUATION OF PP&E

Government Grants
Government Grants are assistance received from a
government in the form of transfers of resources to a
company in return for past or future compliance with certain
conditions relating to the operating activities of the
company.

IFRS requires grants to be recognized in income (income

approach) on a systematic basis that matches them with
the related costs that they are intended to compensate.

5-41 LO 5
 Government Grants

Example 1: Grant for Lab Equipment. AG Company received a

€500,000 subsidy from the government to purchase lab
equipment on January 2, 2015. The lab equipment cost is
€2,000,000, has a useful life of five years, and is depreciated on
the straight-line basis.

IFRS allows AG to record this grant in one of two ways:

1. Credit Deferred Grant Revenue for the subsidy and amortize

the deferred grant revenue over the five-year period.

2. Credit the lab equipment for the subsidy and depreciate this
amount over the five-year period.

5-42 LO 5
 Government Grants

Example 1: Grant for Lab Equipment. If AG chooses to record

deferred revenue of €500,000, it amortizes this amount over the
five-year period to income (€100,000 per year). The effects on the
financial statements at December 31, 2015, are:

5-43 LO 5
 Government Grants

Example 1: Grant for Lab Equipment. If AG chooses to reduce

the cost of the lab equipment, AG reports the equipment at
€1,500,000 (€2,000,000 - €500,000) and depreciates this amount
over the five-year period. The effects on the financial statements
at December 31, 2015, are:

5-44 LO 5
 COSTS SUBSEQUENT TO ACQUISITION

Recognize costs subsequent to acquisition as an asset

when the costs can be measured reliably and it is probable that
the company will obtain future economic benefits.
Evidence of future economic benefit would include increases in
1. useful life,

2. quantity of product produced, and

3. quality of product produced.

5-45 LO 6
 COSTS SUBSEQUENT TO ACQUISITION
1. Additions
• Involve adding a new major component to an existing asset
and should be capitalized. For example, adding a
refrigeration unit to a delivery truck
• The capitalized cost of additions is depreciated over the
remaining useful life of the original asset or its own useful
life, whichever is shorter.
• Illustration – to improve the service value of a delivery truck,
a company added hydraulic lift at cost of $5,500 to allow for
easier and quicker loading of cargo.
Delivery truck 5,500
Cash 5,500
5-46 LO 6
 COSTS SUBSEQUENT TO ACQUISITION
2. Improvements and replacements
• involve the substitution of a major component of an asset for
a new component.
• Improvement (betterment) is the substitution of a better
asset
• Replacement, on the other hand, is the substitution of a
similar asset

2. For example, an existing refrigeration unit in a delivery truck

could be replaced with a new but similar unit or with a new
and improved refrigeration unit.
3. The improvement can be recorded as (a) a disposition of
the old component and (b) the acquisition of the new
5-47 LO 6
component.
 COSTS SUBSEQUENT TO ACQUISITION

2. Improvements and replacements

• Illustration - Palmer Corporation replaced the air conditioning
system in one of its office buildings. The cost of the old air
conditioning system, $200,000, is included in the cost of the
building. However, the company has separately depreciated
the air conditioning system. Depreciation recorded up to the
date of replacement totaled $160,000. The old system was
removed and the new system installed at a cost of $230,000,
which was paid in cash. Parts from the old system were sold
for $12,000.

5-48 LO 6
 COSTS SUBSEQUENT TO ACQUISITION

2. Improvements and replacements

(i) Cash 12,000
Acc depn (building old) 160,000
Loss on disposal 28,000
Building (old) 200,000

(ii) Building (new) 230,000

Cash 230,000

5-49 LO 6
 COSTS SUBSEQUENT TO ACQUISITION

3. Repairs

a) Ordinary Repairs (maintenance) –Such expenditures are

revenue expenditures and are recorded as increases to
Repairs and Maintenance Expense.
b) Extraordinary Repairs – costs incurred to extend the
asset’s useful life. Such costs are capital expenditures and
are recorded as a decrease in an accumulated
depreciation.
For example, the engine of a forklift that is near the end of its
useful life may be overhauled at a cost of $4,500, extending its
useful life by eight years.
Accumulated depreciation – forklift 4,500
5-50 LO 6
Cash 4,500
 COSTS SUBSEQUENT TO ACQUISITION

5-51 LO 6
 DISPOSITION OF PROPERTY, PLANT,
AND EQUIPMENT

A company may retire plant assets voluntarily or dispose of

them by
u Sale,

u Exchange,

u Involuntary conversion, or

u Abandonment.

Depreciation must be taken up to the date of disposition.

5-52 LO 7
 DISPOSITION OF PP&E

Sale of Plant Assets

Illustration: Barret Company recorded depreciation on a machine
costing €18,000 for nine years at the rate of €1,200 per year. If it
sells the machine in the middle of the tenth year for €7,000, Barret
records depreciation to the date of sale as:

Depreciation Expense (€1,200 x ½) 600

Accumulated Depreciation—Machinery 600

5-53 LO 7
 DISPOSITION OF PP&E

Illustration: Barret Company recorded depreciation on a machine

costing $18,000 for 9 years at the rate of $1,200 per year. If it sells
the machine in the middle of the tenth year for $7,000, Barret
records depreciation to the date of sale. Record the entry to record
the sale of the asset:

Cash 7,000
Accumulated Depreciation—Machinery 11,400
Machinery 18,000
Gain on Disposal of Machinery 400

5-54 LO 7
 DISPOSITION OF PP&E

Involuntary Conversion
Sometimes an asset’s service is terminated through some type of
involuntary conversion such as fire, flood, theft, or
condemnation.

Companies report the difference between the amount recovered

(e.g., from a condemnation award or insurance recovery), if any,
and the asset’s book value as a gain or loss.

They treat these gains or losses like any other type of disposition.

5-55 LO 7
 DISPOSITION OF PP&E

Illustration: Camel Transport Corp. had to sell a plant located on

company property that stood directly in the path of an interstate
highway. Camel received $500,000, which substantially exceeded the
book value of the land of $150,000 and the book value of the building
of $100,000 (cost of $300,000 less accumulated depreciation of
$200,000). Camel made the following entry.

Cash 500,000
Accumulated Depreciation—Buildings 200,000
Buildings 300,000
Land 150,000
Gain on Disposal of Plant Assets 250,000

5-56 LO 7
 DEPRECIATION—METHOD OF COST
ALLOCATION

Depreciation is the accounting process of allocating the cost

of tangible assets to expense in a systematic and rational
manner to those periods expected to benefit from the use of
the asset.

Allocating costs of long-lived assets:

u Fixed assets = Depreciation expense

u Intangibles = Amortization expense

u Mineral resources = Depletion expense

5-57 LO 1
 DEPRECIATION—COST ALLOCATION

Factors Involved in the Depreciation Process

Three basic questions:
1. What depreciable base is to be used?
2. What is the asset’s useful life?
3. What method of cost apportionment is best?

5-58 LO 2
 Factors Involved in Depreciation Process

Depreciable Base for the Asset

5-59 LO 2
 Factors Involved in Depreciation Process

Estimation of Service Lives

u Service life often differs from physical life.
u Companies retire assets for two reasons:
1. Physical factors (casualty or expiration of
physical life).

2. Economic factors (inadequacy, supersession,

and obsolescence).

5-60 LO 2
 DEPRECIATION—COST ALLOCATION

Methods of Depreciation
The profession requires the method employed be “systematic
and rational.” Methods used include:

1. Activity method (units of use or production).

2. Straight-line method.

3. Diminishing (accelerated)-charge methods:

a) Sum-of-the-years’-digits.

b) Declining-balance method.

5-61 LO 3
 Methods of Depreciation

Activity Method

Data for
Stanley Coal
Mines

Illustration: If Stanley uses the crane for 4,000 hours the first
year, the depreciation charge is:

5-62 LO 3
 Methods of Depreciation

Straight-Line Method

Data for
Stanley Coal
Mines

Illustration: Stanley computes depreciation as follows:

5-63 LO 3
 Methods of Depreciation

Diminishing-Charge Methods ILLUSTRATION 11-2

Data Used to
IllustrateDepreciation
Methods

Data for
Stanley Coal
Mines

Sum-of-the-Years’-Digits. Each fraction uses the sum of the

years as a denominator (5 + 4 + 3 + 2 + 1 = 15). The numerator
is the number of years of estimated life remaining as of the
beginning of the year.

Alternate sum-of-the- n(n+1) 5(5+1)

15
years’ calculation 2 2
5-64 LO 3
 Methods of Depreciation

Sum-of-the-Years’-Digits

5-65 LO 3
 Methods of Depreciation

Diminishing-Charge Methods

Data for
Stanley Coal
Mines

Declining-Balance Method.
u Utilizes a depreciation rate (percentage) that is some multiple
of the straight-line method.

u Does not deduct the salvage value in computing the

depreciation base.

5-66 LO 3
 Methods of Depreciation

Declining-Balance Method

5-67 LO 3
 DEPRECIATION—COST ALLOCATION

Group and Composite Depreciation

• Companies with many plant assets often do not want to
bother recording depreciation for each one, but instead,
depreciate them as a group.

• If the assets are similar in nature, the collection is

referred to as a group; if the assets are dissimilar, the
collection is a composite.

• The depreciation for either a group or a composite uses

an average for the entire collection and depreciates on
that basis.
5-68 LO 4
 DEPRECIATION—COST ALLOCATION
Group and Composite Depreciation
• Example, A corporation has three types of plant assets.
Their costs, salvage values, useful lives, and straight-line
depreciation (by type) are as follows:
Type Cost Salvage Depreciable Useful Yearly
value base life depreciat
ion
1 40,000 1,000 39,000 10 3,900
2 50,000 2,000 48,000 20 2,400
3 20,000 3,000 17,000 5 3.400
Total 110,000 6,000 104,000 9,700

• Thus, these assets will be assigned yearly depreciation

of $9,700
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 DEPRECIATION—COST ALLOCATION

Component Depreciation
IFRS requires that each part of an item of property, plant,
and equipment that is significant to the total cost of the
asset must be depreciated separately.

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 Component Depreciation

Illustration: EuroAsia Airlines purchases an airplane for

€100,000,000 on January 1, 2016. The airplane has a useful life
of 20 years and a residual value of €0. EuroAsia uses the straight-
line method of depreciation for all its airplanes. EuroAsia identifies
the following components, amounts, and useful lives.

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 Component Depreciation

Computation of depreciation expense for

EuroAsia for 2016.

Depreciation journal entry for 2016.

Depreciation Expense 8,600,000
Accumulated Depreciation—Airplane 8,600,000

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 Component Depreciation

On the statement of financial position at the end of 2016,

EuroAsia reports the airplane as a single amount.

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 DEPRECIATION—COST ALLOCATION

Special Depreciation Issues

1. How should companies compute depreciation for
partial periods?

2. Does depreciation provide for the replacement of

assets?

3. How should companies handle revisions in

depreciation rates?

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 DEPRECIATION—COST ALLOCATION

Special Depreciation Issues

1. How should companies compute depreciation for
partial periods?
u Companies determine the depreciation expense
for the full year and then

u prorate this depreciation expense between the two

periods involved.

This process should continue throughout the useful life of

the asset.

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 Depreciation and Partial Periods

Illustration—(Four Methods): Maserati Corporation purchased a

new machine for its assembly process on August 1, 2015. The cost
of this machine was €150,000. The company estimated that the
machine would have a salvage value of €24,000 at the end of its
service life. Its life is estimated at 5 years and its working hours are
estimated at 21,000 hours. Year-end is December 31.

Instructions: Compute the depreciation expense under the

following methods.
(a) Straight-line depreciation. (c) Sum-of-the-years’-digits.
(b) Activity method (d) Double-declining balance.

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 Depreciation and Partial Periods

Straight-line Method

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 Depreciation and Partial Periods

Activity Method (Assume 800 hours used in 2015)

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 Depreciation and Partial Periods
5/12 = .416667
Sum-of-the-Years’-Digits Method 7/12 = .583333

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LO 4
 Depreciation and Partial Periods

Sum-of-the-Years’-Digits Method (another way)

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 Depreciation and Partial Periods

Double-Declining Balance Method

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 DEPRECIATION—COST ALLOCATION

Special Depreciation Issues

2. Does depreciation provide for the replacement of
assets?
u Does not involve a current cash outflow.

u Funds for the replacement of the assets come from

the revenues.

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 DEPRECIATION—COST ALLOCATION

Special Depreciation Issues

3. How should companies handle revisions in
depreciation rates?
u Accounted for in the current and prospective periods

u Not handled retrospectively

u Not considered errors or extraordinary items

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 Revision of Depreciation Rates

Arcadia HS, purchased equipment for $510,000 which was

estimated to have a useful life of 10 years with a residual value
of $10,000 at the end of that time. Depreciation has been
recorded for 7 years on a straight-line basis. In 2015 (year 8), it
is determined that the total estimated life should be 15 years
with a residual value of $5,000 at the end of that time.

Questions:
l What is the journal entry to correct No Entry
the prior years’ depreciation? Required

l Calculate the depreciation expense

for 2015.
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 Revision of Depreciation Rates

Equipment cost $510,000

Salvage value - 10,000
Depreciable base 500,000
Useful life (original) 10 years
Annual depreciation $ 50,000 x 7 years = $350,000

Balance Sheet (Dec. 31, 2014)

Equipment $510,000
Accumulated depreciation 350,000
Net book value (NBV) $160,000

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 Revision of Depreciation Rates

Net book value $160,000 Depreciation

Salvage value (new) 5,000 Expense calculation
Depreciable base 155,000 for 2015.
Useful life remaining 8 years
Annual depreciation $ 19,375

Journal entry for 2015

Depreciation Expense 19,375

Accumulated Depreciation 19,375

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 IMPAIRMENTS

Recognizing Impairments
A long-lived tangible asset is impaired when a company is not
able to recover the asset’s carrying amount either through
using it or by selling it.

On an annual basis, companies review the asset for

indicators of impairments—that is, a decline in the asset’s
cash-generating ability through use or sale.

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 Recognizing Impairments

If impairment indicators are present, then an impairment test

must be conducted.

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 Recognizing Impairments
Example: Assume that Cruz Company performs an impairment
test for its equipment. The carrying amount of Cruz’s equipment is
€200,000, its fair value less costs to sell is €180,000, and its
value-in-use is €205,000.

€200,000 €205,000
No
Impairment

€180,000 €205,000
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 Recognizing Impairments
Example: Assume the same information for Cruz Company
except that the value-in-use of Cruz’s equipment is €175,000
rather than €205,000.
€20,000 Impairment Loss
ILLUSTRATION 11-15

€200,000 €180,000

€180,000 €175,000
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 Recognizing Impairments
Example: Assume the same information for Cruz Company
except that the value-in-use of Cruz’s equipment is €175,000
rather than €205,000.
€20,000 Impairment Loss
ILLUSTRATION 11-15

€200,000 €180,000

Cruz makes the following entry to record the impairment loss.

Loss on Impairment 20,000
Accumulated Depreciation—Equipment 20,000

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 Reversal of Impairment Loss

Illustration: Tan Company purchases equipment on January 1,

2015, for HK$300,000, useful life of three years, and no residual
value.

At December 31, 2015, Tan records an impairment loss of

HK$20,000.
Loss on Impairment 20,000
Accumulated Depreciation—Equipment 20,000
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 Reversal of Impairment Loss

Depreciation expense and related carrying amount after the

impairment.

At the end of 2016, Tan determines that the recoverable amount of

the equipment is HK$96,000. Tan reverses the impairment loss.

Accumulated Depreciation—Equipment 6,000

Recovery of Impairment Loss 6,000

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 IMPAIRMENTS

Cash-Generating Units
When it is not possible to assess a single asset for impairment
because the single asset generates cash flows only in
combination with other assets, companies identify the
smallest group of assets that can be identified that generate
cash flows independently of the cash flows from other assets.

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 IMPAIRMENTS

Impairment of Assets to Be Disposed Of

u Report the impaired asset at the lower-of-cost-or-net
realizable value (fair value less costs to sell).

u No depreciation or amortization is taken on assets held

for disposal during the period they are held.

u Can write up or down an asset held for disposal in future

periods, as long as the carrying amount after the write up
never exceeds the carrying amount of the asset before
the impairment.

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 IMPAIRMENTS

ILLUSTRATION 11-18
Graphic of Accounting for
Impairments

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 DEPLETION

Natural resources can be divided into two categories:

1. Biological assets (timberlands)

► Fair value approach

2. Mineral resources (oil, gas, and mineral mining).

► Complete removal (consumption) of the asset.

► Replacement of the asset only by an act of nature.

Depletion - process of allocating the cost of mineral resources.

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 DEPLETION

Establishing a Depletion Base

Computation of the depletion base involves:
1. Pre-exploratory costs.

2. Exploratory and evaluation costs.

3. Development costs.

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 DEPLETION

Write-off of Resource Cost

Normally, companies compute depletion on a units-of-
production method (activity approach). Depletion is a function
of the number of units extracted during the period.

Calculation:

Total Cost – Residual value

= Depletion Cost Per Unit
Total Estimated Units Available

Units Extracted x Cost Per Unit = Depletion

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 DEPLETION

Illustration: MaClede Co. acquired the right to use 1,000 acres

of land in South Africa to mine for silver. The lease cost is
€50,000, and the related exploration costs on the property are
€100,000. Intangible development costs incurred in opening the
mine are €850,000. MaClede estimates that the mine will provide
approximately 100,000 ounces of gold. ILLUSTRATION 11-19
Computation of Depletion Rate

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 DEPLETION

If MaClede extracts 25,000 ounces in the first year, then the

depletion for the year is €250,000 (25,000 ounces x €10).

Inventory 250,000
Accumulated Depletion 250,000

ILLUSTRATION 11-20
MaClede’s statement of financial position: Statement of Financial Position
Presentation of Mineral Resource

Depletion cost related to inventory sold is part of cost of goods sold.

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 DEPLETION

Estimating Recoverable Reserves

u Same as accounting for changes in estimates.

u Revise the depletion rate on a prospective basis.

u Divide the remaining cost by the new estimate of the

recoverable reserves.

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 DEPLETION

Liquidating Dividends - Dividends greater than the

amount of accumulated net income.

Illustration: Callahan Mining had a retained earnings balance

of £1,650,000, accumulated depletion on mineral properties of
£2,100,000, and share premium of £5,435,493. Callahan’s board
declared a dividend of £3 a share on the 1,000,000 shares
outstanding. It records the £3,000,000 cash dividend as follows.

Retained Earnings 1,650,000

Share Premium—Ordinary 1,350,000
Cash 3,000,000

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 DEPLETION

Presentation on the Financial Statements

Disclosures related to E&E expenditures should include:
1. Accounting policies for exploration and evaluation
expenditures, including the recognition of E&E assets.

2. Amounts of assets, liabilities, income and expense, and

operating cash flow arising from the exploration for and
evaluation of mineral resources.

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 REVALUATIONS

Recognizing Revaluations
Companies may value long-lived tangible asset subsequent
to acquisition at cost or fair value.
Network Rail (GBR) elected to use fair values to account for its
railroad network.

► Increased long-lived tangible assets by £4,289 million.

► Change in the fair value accounted for by adjusting the asset

account and establishing an unrealized gain.

► Unrealized gain is often referred to as revaluation surplus.

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 Recognizing Revaluation

Revaluation—Land
Illustration: Siemens Group (DEU) purchased land for
€1,000,000 on January 5, 2015. The company elects to use
revaluation accounting for the land in subsequent periods. At
December 31, 2015, the land’s fair value is €1,200,000. The entry
to record the land at fair value is as follows.

Land 200,000
Unrealized Gain on Revaluation - Land 200,000

Unrealized Gain on Revaluation—Land increases other comprehensive

income in the statement of comprehensive income.

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 Recognizing Revaluation

Revaluation—Depreciable Assets
Illustration: Lenovo Group (CHN) purchases equipment for
¥500,000 on January 2, 2015. The equipment has a useful life of
five years, is depreciated using the straight-line method of
depreciation, and its residual value is zero. Lenovo chooses to
revalue its equipment to fair value over the life of the equipment.
Lenovo records depreciation expense of ¥100,000 (¥500,000 ÷
5) at December 31, 2015, as follows.

Depreciation Expense 100,000

Accumulated Depreciation—Equipment 100,000

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 Recognizing Revaluation

Revaluation—Depreciable Assets
After this entry, Lenovo’s equipment has a carrying amount of
¥400,000 (¥500,000 - ¥100,000). Lenovo receives an
independent appraisal for the fair value of equipment at
December 31, 2015, which is ¥460,000.

Accumulated Depreciation—Equipment 100,000

Equipment 40,000
Unrealized Gain on Revaluation—Equipment 60,000

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 Recognizing Revaluation

Revaluation—Depreciable Assets

Under no circumstances can the Accumulated Other Comprehensive Income

account related to revaluations have a negative balance.

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 Recognizing Revaluation

Revaluations Issues
Company can select to value only one class of assets, say
buildings, and not revalue other assets such as land or equipment.
If a company selects only buildings,
► revaluation applies to all assets in that class of assets.
► A class of assets is a grouping of items that have a similar
nature and use in a company’s operations.
► Companies must also make every effort to keep the assets’
values up to date.

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 PRESENTATION AND ANALYSIS

Presentation of Property, Plant, Equipment,

and Mineral Resources
Depreciating assets, use Accumulated Depreciation.

Depleting assets may include use of Accumulated Depletion

account, or the direct reduction of asset.

Disclosures Basis of valuation (usually cost)

Pledges, liens, and other commitments

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 PRESENTATION AND ANALYSIS

Analysis of Property, Plant, and Equipment

Asset Turnover Ratio
Measures how
adidas AG
efficiently a company
uses its assets to
generate sales.

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 PRESENTATION AND ANALYSIS

Analysis of Property, Plant, and Equipment

Profit Margin on Sales
Measure of the ability
adidas AG to generate operating
income from a
particular level of
sales.

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 PRESENTATION AND ANALYSIS

Analysis of Property, Plant, and Equipment

Return on Assets (ROA)
Measures a firm’s
adidas AG success in using
assets to generate
earnings.

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 PRESENTATION AND ANALYSIS

Analyst obtains further insight into the behavior of ROA by

disaggregating it into components of profit margin on sales and
asset turnover as follows:

Rate of Return Profit Margin on Asset Turnover

= x
on Assets Sales

Net Income Net Income Net Sales

= x
Average Total Assets Net Sales Average Total Assets

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 PRESENTATION AND ANALYSIS

Analyst obtains further insight into the behavior of ROA by

disaggregating it into components of profit margin on sales and
asset turnover as follows:

Rate of Return Profit Margin on Asset Turnover

= x
on Assets Sales

€524 €524 €14,883

= x
(€11,651 + €11,237) / 2 €14,883 (€11,651 + €11,237) / 2

4.6% = 3.5% x 1.30

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 REVALUATION OF PROPERTY, PLANT, AND
APPENDIX 11A
EQUIPMENT

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