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There is no standard rule as to the minimum length of life necessary for an asset
to be classified as a plant asset. Such assets must be capable of providing
repeated use or benefit, and are normally expected to last more than a year.
However, an asset need not actually be used on an ongoing basis or even often.
For example, items of stand by equipment held for use in the event of a break
down of regular equipment or for use only during g peak periods of activity are
included in plant assets.
Long-term assets acquired for resale in the normal course of business are not
classified as plant assets, regardless of their permanent nature or the length of
time they are held. For example, undeveloped land or other real estate Acquired
as an investment for resale should be listed on the balance sheet in the asset
section entitled investments.
Characteristics of plant Assets
An asset to be considered as a plant asset it must fulfill the following three
characteristics:
(1)
(2)
(3)
T he asset must be owned and held for use and not for resale (investment)
The asset must have an expected life of more than one year (are long-lived).
The asset must have physical characteristics (be tangible in nature)
Purchase price
Sales taxes
Brokers commissions
Title fees
Surveying fees
(2) Buildings
The costs of constructing a building include:
Architects fees
Engineers fees
Insurance costs incurred during construction
Interest on money borrowed to finance construction
Walkways to and around the building, and
All other necessary costs related to the project
Solution:
(1) Purchase price
Cash
Short term note
Legal fees
Cost of demolishing an old building
Less: Salvage value
Acquisition cost of the land
Br 40,000
80, 000
Br120, 000
6,000
Br 16,000
(4,200)
11,800
Br 137,800
(2) Land
137,800
Cash
57,800
Notes Receivable
80,000
Example 2: L Company purchased a heavy machine to be used in its factory for
Br 150,000, less a 2% cash discount. The company paid a fine of Br 5,750 because an
employee hauled the machine over city streets without securing the required permits.
The machine was installed at a cost of Br 4,000 and testing costs of $1,500 were incurred
to place the machine in operation.
Required:
1) Determine the cost of the machinery to be reported on the balance sheet.
2) Journalize the acquisition of the machinery.
Solution:
(1) Purchase price
Br 150,000
Less: Cash discounts
3,000
Br 147,000
Installation cost
4,000
Testing costs
1,500
Br 152,500
(2) Machinery
152,500
Cash
152,500
4.3. Depreciation of Plant Assets
Land has unlimited life and therefore can proved unlimited services. On the other
hand, other plant assets such as equipment, buildings, and land improvements lose
their ability, over time, to provide services. As a result, the costs of equipment
buildings and land improvements should be transferred to expense accounts in a
systematic manner during their expected useful lives. This periodic cost
expiration is called depreciation.
(1) Physical depreciation: Caused by wear and tear from use and from the action of
the elements decreases usefulness.
(2) Functional depreciation: Caused by in adequacy and obsolescent decreases
usefulness
- A plant asset becomes inadequate if its capacity is not able to meet the
demands of increased production.
- A plant asset is obsolete if the item it produces is no longer in demands or
if a newer machine can produce in item of better quality at the same or
lower cost
- The obsolescence of an asset is its decline in usefulness brought a bout by
inventions and technological progress.
The use of a plant asset in business operations transforms a plant asset cost into an
operating expense. Depreciation, then, is a cost of operating a business.
Common Misconceptions
The meaning g of the term depreciation as used in accounting is often
misunderstood because the same term is also used in business to mean a
decline in market value of an asset. However, the amount of a plant
assets unexpired cost reported in the balance sheet usually does not agree
with the amount that could be realized from its sale. Plant assets are held
for use in a business rather than for sale. It is assumed that the business
will continue as a going concern. Thus a decision to dispose of a plant
asset is based mainly on the usefulness of the asset to the business and not
on its market value.
Another common misunderstandings that depreciation accounting
provides cash needed to replace plant assets as they wear out. The cash
account is neither increased nor decreased by the periodic entries that
transfer the cost of plant assets to depreciation expense accounts. The
misunderstanding probably occurs because depreciation unlike expense
accounts. T he misunderstanding probably occurs because depreciation
unlike most expenses, does not require an outlay of cash in the period in
which it is recorded.
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The initial cost of acquiring an asset includes all amounts spent to get an asset in
place and ready for use.
Useful life refers to the length of time the company owning the asset intends to use it
useful life is not necessarily the same time period as either economic life or physical
life. The economic life of a car may be seven years and its physical life may be l0
year but if a company was a policy of tracing cars every three years the useful life for
depreciation purposes is three years.
Useful life may be expressed in year months working yours hours units of
production
Residual value (or salvage value) is the amount of money the company expects to
recover less disposal costs on the date of plant asset is scrapped sold or trade - in.
The relationship among the three factors and the periodic depreciation expense can be
show as follows
Initial cost
Minus
Residual Value
equals
Depreciable
Cost
(3) Useful life
Y
r
1
Y
r
2
1
Y
r
3
1
Y
r
4
1
Y
r
5
1
Regardless of the methods (s) chosen the company must disclose its depreciation method
in the footnotes to its financial statements. This information will always be included in
the first footnote which contains a summary of significant accounting polices.
The illustrations of the four depreciation methods given below are based on the following
data: On January 1, 2000 a machine was purchased for Br 27, 000 with an estimated
useful life of 10 years, or 50, 000 units of output and an estimated salvage value of
Br 2000.
1. Straight line method
The straight line method is simple and is widely used.
The straight- line depreciation method provides for equal amounts of periodic
expenses over the estimated useful life of the asset.
It provides a reasonable allocation of costs to periodic expense when the usage of the
asset and the related revenues from its use are about the same form period to period
The formula for calculating deprecation under the straight- line method is
When an asset is used for only part of a bear the annual depreciation is prorated for
example, Assume the previous example but the machinery purchased on January 1, 2000
was placed in a usable condition on June 20, 2000. The depreciation for 2000 would be
Br 1250 (Br2500X6/12) computed on the basis of 6 months.
For ease in applying the straight line method the annual depreciation may be converted to
percentage of depreciable cost. This percentage is determined by dividing 100% by the
number of years of useful life. For example a useful life of 20 years converts to a 5%
(100 % 20) rate, 8 years converts to a 12.5% (100% 8) rate and so on. To further
illustrate the straight line rate for the above example is 10% (100 10). The annual
depreciation of Br 2500 can be computed by multiplying the depreciable cost of Br
25,000 by 10%.
The depreciation rate may also be expressed as a fraction. For example the annual
straight line rate for an asset with 10- year useful is 1/10.
Use of the straight line method is appropriate for assets where (1) time rather than
obsolescence is the major factor limiting the assets life and (2) relatively constant
amounts of periodic services are relived from the asset. Assets that possess these features
include pipelines fencing and storage tanks.
2. Units of production (out put) method
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cost of the asset less the estimated salvage value to compute the periodic depreciation
expense.
The formula is:
Number of years of useful life
Periodic
remaining at beginning
Depreciation =
of accounting period
Asset - Estimated
Expense
SOYD
Cost Salvage value
The years are totaled to find SOYD. For an asset with a 10 year useful life,
SOYD=10+9+8+7+6+5+4+3+2+1=55.
Alternatively, rather than adding the digits for all year together, the following formula can
be used to find the SOYD for any given number of periods:
SOYD = n (n+1)/2
Where n is the number of periods in the assets useful life. Thus, SOYD for an asset with
a 10 year useful life is:
SOYD = 10(10 + 1) = 55
2
The SOYD method is applied to the data given earlier for the $27,000 machine as
follows. First, determine that at the beginning of year 1 (2000), the machine has 10 years
of useful life remaining. Then, using the formula above, compute the first years
depreciation as 10/55 times $25,000 (the $27,000 cost less the $2,000 salvage value). The
depreciation for the first year is $4,545. Note that the fraction gets smaller every year,
resulting in a declining depreciation charge for each successive year.
4. Double-Declining Balance Method.
The double declining-balance (DDB) method of computing periodic depreciation
charges is applied by first calculating the straight-line depreciation rate. The straight-line
rate is calculated by dividing 100% by the number of years of useful life of the asset.
Then multiply this rate by 2. The resulting rate is applied to the declining book value of
the asset. Salvage value is ignored in marking annual calculation. However at the point
where book value is equal to the salvage value no more depreciations taken. The formula
for DDB depreciation is:
Deprecation = (2 Straight-line rate) (Asset Accumulated)
Expense
Cost
depreciation
The straight-line rate is 10% (100%/10 years) which, when doubled yields a DDB rate of
20%. Since at the beginning of year 1 no accumulated depreciation has been recorded, the
calculation is based on cost. In each of the following years, the calculation is based on
book value at the beginning of the year.
In the 10th year, depreciation could be increased to $1,624 if the asset is to be retired and
its salvage value is still $2,000.
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Cost of Machine
Birr 35,000
Accum. Depreciation before extraordinary repair
Br. 24,500
Less: extraordinary repair (Debited to Accum. Depr.).3000
21,500
Depr.).3000
Book value (carrying value) after extraordinary repair
Br.13,500
Revised Annual periodic depreciation= 13500.
2,250
13500.2,250
6 years
Revenue expenditures
Revenue expenditures are expenditures incurred in order to maintain the normal
operating efficiency of the asset.
Among the more usual kinds of revenue expenditures for plant asset are the repairs,
maintenance, lubrication, Cleaning and inspection necessary to keep an asset in good
working condition.
Ordinary repairs are expenditures that are necessary to keep an asset in good operating
conditions. Trucks must have tune-ups, their tires and batteries must be replaced
regularly, and other routine repairs must be made. Offices and halls must be painted
regularly, and broken tiles or woodwork must be replaced. Such repairs benefits only the
current period and therefore must be charged against the revenue in the current fiscal
period.
4.5. Disposals of plant assets
A plant asset rarely lasts exactly as long as its estimated life. If it lasts longer than its
estimated life, it is not depreciated past the point at which its carrying value equals its
residual value. The purpose of depreciation is to spread the depreciable cost of the asset
over the economic life of the asset. Thus, the total accumulated depreciation should never
exceed the total depreciable cost. If the asset is still used in the business beyond the end
of its estimated life, its cost and accumulated depreciation remain in the ledger accounts.
Proper records will thus be available for maintaining control over plant assets. If the
residual value is zero, the book value of a fully depreciated asset is zero until the asset is
disposed off. If such an asset is discarded, no gain or loss result. A plant asset may be
disposed by:
(1) Discarding it as worthless; (2) Selling it; or (3) Trading it in on a new asset
4.5.1. Recording Discarding of a Plant Asset
If a plant asset is of no further use to the business and cannot be sold or traded, then the
plant asset is discarded. If the asset has no book value (i.e., if it is fully depreciated), the
plant asset account is credited for the amount of the original cost of the item being
discarded. At the same time, the accumulated depreciation account is debited for the
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amount of the total accumulated depreciation of the item being discarded. In this case
neither gain nor loss is realized. On the other hand, if a plant asset has a book value (if
not fully depreciated) at the time it is discarded, the business incurs a loss.
Illustration
Suppose for example, on July 5, year 5, equipment that was acquired On Jan 10, year 1,
at a cost of Br. 11,000, is discarded as worthless. The discarded equipment has a carrying
value of Br. 2000 at the time of disposal. The carrying value is computed as the
difference between the cost of asset Br. 11,000 and accumulated depreciation, Br. 9000. A
loss equal to the carrying value should be recorded when the equipment is discarded.
Solution:
The journal entry required to discard the plant asset as of July 5, year 5, is:
Year 5
July 5. Accumulated Depreciation, Equipment 9000.00
Loss on disposal of plant Asset2000.00
Equipment .11000.00
(Discarding Equipment no longer used in the business)
4.5.2 Recording the Sale of Plant Asset
The entry to record the sale of an asset for cash is similar to the one illustrated above
except that the receipt of cash should also be recorded. The following entries show how
to record the sale of equipment under three assumptions about the selling price. In the
first case, the Br. 2000 cash received is exactly equal to the book value of the equipment
(which is equal to Br. 2000).
Case- 1 Sold at an amount equal to Book value, Br. 2000, no gain or loss results
Year 5
July 5. Cash 2000.00
Accumulated Depreciation, Equip...9000.00
Equipment ..11000.00
( Sale of equipment at an amount equal to book
value)
Case- 2 Sold at Br. 1500 cash; Loss of Br. 500, (BV = Br. 2000)
Year 5
July 5. Loss on sale of equipment.500.00
Accumulated Depreciation 9000.00
Cash .1500.00
Equipment11000.00
(Sale of equipment at less than the book value Loss of Br. 500)
Case- 3 Sold at Br. 3000 cash; gain of Br. 1000, cash received through
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Sale less book value of the asset (Br. 3000 Br. 2000)
Year 5
July 5.
Cash .3000.00
Accumulated Depr, Equipment9000.00
Equipment..11000.00
Gain on sale of plant asset...1000.00
(Sale of equipment at more than the book value; gain of Br. 1000,
(Br. 3000 Br.2000) recorded)
4.5.3. Recording Exchange of Plant Assets
Businesses also dispose of plant assets by trading them in on the purchase of other plant
assets. Exchanges may involve similar assets, such as an old machine traded-in on a
newer model, or dissimilar assets, such as a machine traded-in on a truck. In either case,
the purchase price is reduced by the amount of the trade-in allowance.
The basic accounting for exchanges of plant assets is similar to accounting for sales of
plant assets for cash. If the trade-in allowance received is greater than the carrying value
of the assets surrendered, there has been a gain. If the trade-in allowance is less than the
carrying value, there has been a loss.
There are special rules for recognizing these gains and losses, depending on the nature of
the assets exchanged.
Exchange
Losses
Gains
Recognized
Recognized
For Financial Reporting Purposes:
Of similar assets Yes.No
Of Dissimilar assets.. Yes.. Yes
For Income Tax purposes:
Of similar assets No..
Of dissimilar assets....Yes
No
Yes
Both Gains and Losses are recognized when a company exchanges dissimilar assets.
Assets are dissimilar when they perform different functions; assets are similar when they
perform the same function.
For financial reporting purposes, gains on exchanges of similar assets are not recognized
because the earning lives of the asset surrendered are not considered to be completed.
When a company trades-in an older machine on a newer machine of the same type, the
economic substance of the transaction is the same as that of a major renovation and
upgrading of the older machine.
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Accounting for exchange of similar assets is complicated by the fact that neither gains
nor losses are recognized for income tax purposes.
Loss Recognized on the Exchange
A loss is recognized for financial reporting purposes on all exchange in which a material
loss occurs.
Illustration
To illustrate the recognition of a loss, assume that the business exchange a machine with
a cost of Br. 11,000, and accumulated depreciation of Br. 9000 for a newer more modern
machine on the following terms:
Cost of new machine Birr 12000.
Trade-in Allowance for old machine (1500)
Cash payment required (Boot)..Birr 10500.
Solution
In the illustration above, the trade-in allowance (1500) is less than the carrying value (Br.
2000) of the old machine. The loss on the exchange is Br. 500, (Br. 2000 Br. 1500).
Therefore, the journal entry required to record the exchange of assets would be as
follows:
Year 5.
5.
July 5. Equipment (New)..12,000.00
Accum. Depreciation-Equip...9,000.00
Loss on Exchange of plant assets. 500.00
Equipment (old)11,000.00
Cash.. 10,500.00
4.6. Accounting for Intangible Assets and Natural Resources
Intangible Assets:
Assets: are long-term assets that do not have physical substance and in most
cases relate to legal rights or advantages held.
Intangible assets include patents, copyrights, trademarks, franchises, organization costs,
leaseholds, leasehold improvements, and goodwill. The allocation of intangible assets to
the periods they benefits is called amortization.
Intangible assets are accounted for at acquisition cost, that is, the amount paid for them.
Some intangible assets such as goodwill and trademarks may be acquired at little or no
cost. Even though they may have great value and be needed for profitable operations they
should not appear on the balance sheet unless they have been purchased from another
party at a price established in the market place.
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The, Accounting Principles Board (APB) has decided that a company should record as
assets the costs of Intangible assets acquired from others. However, the company should
record as expenses the cost of developing intangible assets. Also, intangible assets that
have a determinable useful life such as patents, copyrights, and leaseholds, should be
written off through periodic amortization over that useful life in much the same way that
plant assets are depreciated.
Even though some intangible assets, such as goodwill and trademarks, have no
measurable limit on their lives, they should also be amortized over a reasonable length of
time (not to exceed forty years).
Illustration
Assume that on Jan 2, 2002 MOHA Soft Drink Bottling Company purchased a patent on
a unique bottle cap for Br. 54,000.
The entry to record the patent would be as follows:
2002
Jan 2. Patent..54,000
Cash..54,000
(To record the purchase of Bottle cap patent)
Assume that MOHAs management determines that, although the patent for the bottle cap
will last for seventeen years, the product using the cap will be sold only for the next six
years. The entry to record the annual amortization would be as follows:
Amortization Expense..9,000.00
Patent9,000.00
(To record annual amortization of patent (Br. 54000/ 6 years))
Note that the patent account is reduced directly by the amount of the amortization
expense. This is in contrast to other long-term asset accounts in which depreciation or
depletion is accumulated in a separate contra account.
If the patent becomes worthless before it is fully amortized, the remaining carrying value
is written off as a loss. For instance, assume that after the first two years MOHA soft
Drink Bottling Companys chief competitors offers a bottle with a new type of cap that
makes MOHAs cap obsolete. The entry to record the loss is:
Loss on patent36,000.00
Patent36,000.00
(To record the loss resulting from patents becoming worthless)
Depletion of Natural Resources
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We now turn our attention to another group of long-lived assets natural resources, such as
minerals, oil, and timber or lumber. These natural resources are extracted from the earth.
Depletion is the accounting measure used to allocate the acquisition cost of natural
resources. Depletion differs from depreciation because depletion focuses specifically on
the physical use and exhaustion of the natural resources, while depreciation focuses more
broadly on any reduction of the economic value of a plant or fixed asset. The costs of
natural resources are usually classified as long-terms assets.
Depletion expense is the measure of that portion of long-term assets that is used up in a
particular period.
Illustration
Suppose for example, MIDROC Construction has acquired the right to use 10,000 acres
of land in Kibre-Mengist territory to mine for gold at a total cost of, Br. 10,000.000. The
Company estimated that the mine will; provide approximately 500,000 grams of gold.
The depletion rate established is computed in the following manner.
Total cost Salvage value
= Depletion cost per unit.
Total estimated units available
Br. 10,000,000 = Br. 20 per gram
500,000 units
If 100,000 grams are extracted in the first year, then the depletion for the year is 2000.000
(1000, 000 x Br. 20.00). The entry to record the depletion is therefore:
Depletion Expense..2,000,000
Accumulated Depletion.2, 000,000
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