Ifa I Chapter 5
Ifa I Chapter 5
Ifa I Chapter 5
CHAPTER 5
Property, Plant, and Equipment: are tangible long-lived resources that are used in the operation
of the business & are not intended for sale to customers. Property, plant, and equipment include
land, building structures (offices, factories, warehouses), and equipment (machinery, furniture,
tools).
The major characteristics of property, plant, and equipment are as follows.
They are acquired for use in operations and not for resale
They possess physical substance: they can be seen & founded, they have physical existence.
Companies recognize property, plant, and equipment when the cost of the asset can be measured reliably and
it is probable that the company will obtain future economic benefits.
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.
Companies value property, plant, and equipment in subsequent periods using either the cost method or fair
value (revaluation) method. Companies can apply the cost or fair value method to all the items of property,
plant, and equipment or to a single class or classes of property, plant, and equipment. For example, a
company may value land (one class of asset) after acquisition using the revaluation accounting method and,
at the same time, value buildings and equipment (other classes of assets) at cost.
Most companies use the cost method—it is less expensive to use because the cost of an appraiser is not
needed. In addition, the revaluation (fair value) method generally leads to higher asset values, which means
that companies report higher depreciation expense and lower net income.
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Cost of land
The cost of land includes all expenditures incurred to acquire land and to make it ready for use
including the following:
(1) the purchase price; (2) closing costs, such as title to the land, attorney’s fees, and recording fees;
(3) costs incurred in getting the land in condition for its intended use, such as grading, filling,
draining, and clearing; (4) assumption of any liens, or encumbrances on the property; and (5) any
additional land improvements that have an indefinite life.
Cost of land improvements
The cost of land improvements includes all expenditures incurred to improve the land that are
maintained and replaced by the owner. These costs include costs of private driveways, sidewalks,
fences, parking lots and lighting. Note that the major reason to separate land and land improvements
will be clear when we consider depreciation issues. As you will soon see, land is considered to have
an indefinite life and is not depreciated. Alternatively, you know that parking lots, irrigation
systems, fences and other land improvements do wear and tear out, and, therefore these are
subjected to depreciation.
Cost of buildings
The costs of buildings include all expenditures incurred that are directly related to purchase or
construction of buildings. These costs include purchase price, professional fees that means, the costs
architect fees to design the building, construction costs incurred from excavation to completion and
costs of building permits.
Costs of machineries and equipment
Costs of equipment and machineries include all expenditures incurred in acquiring the equipment
and preparing it for use which includes purchase price, shipping costs like freight, handling charges
and insurance on the equipment while in transit, installation costs like the cost of special
foundation, assembly and installation and set up costs or costs of conducting trial runs.
Self-constructed assets
Occasionally, companies (particularly in the railroad and utility industries) construct their own
assets. Determining the cost of such fixed assets can be a problem. Without a purchase price or
contract price, the company must allocate costs and expenses in order to arrive at the cost of the
self-constructed asset. Materials and direct labour used in construction pose no problem; these costs
can be traced directly to work and material orders related to the fixed assets constructed. However,
the assignment of indirect costs of manufacturing creates special problems. These indirect costs,
called overhead or burden, include power, heat, light, insurance, property taxes on factory buildings
and equipment, factory supervisory labour, depreciation of fixed assets, and supplies. These costs
might be handled in one of two ways:
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2. Charge construction with all costs of funds employed, whether identifiable or not. Under this
method maintains that one part of the cost of construction is the cost of financing, whether by
debt, cash, or stock financing and
3. Capitalize only the actual interest costs incurred during construction. This approach relies on
the historical cost concept that only actual transactions are recorded.
Valuation of Property, Plant, and Equipment
As with other assets, companies should record property, plant, and equipment at the fair value of what they
give up or at the fair value of the asset received, whichever is more clearly evident. However, the process of
asset acquisition sometimes obscures fair value.
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A. Cash Discounts
When a plant asset is purchased subject to a cash discount, the discount (whether taken or not) is
considered a reduction in the cost of the asset. The ground reason is that the additional payment
made due to the deferring of the payment is not the cost of the asset rather it is the penalty of late
payment. And the amount of discount lost will be treated as loss and not part of cost of the asset
acquired.
Example:
1. A corporation purchased equipment for Br. 70,000 and arranged to pay a cash discount of 2%
provided that payment was made within 10 days. Suppose that cash payment was made within
the discount period, the cost of the equipment is Br. 68,600 [70,000 – (2% x 70,000)].
2. Again consider company purchasing equipment for Br. 50,000 with cash discount of 2% made
available if payment was made within 10 days. Suppose that payment is not made within the
discount period, the cost of the equipment is Br. 49,000 [50,000 – (2% x 50,000)].
B. Deferred Payments
When a plant asset is acquired by issuing a long-term liability, the cost of the plant asset is equal to
the present value of the future cash payments.
Example: Suppose that ABC Company purchased land by issuing a Br. 500,000, 5-year
noninterest bearing note on January 1 of year 1 when the market rate of interest was 10%; the note
is to be repaid in 5 equal instalments of Br. 100,000 on December 31 of year 1, year 2, year 3, year
4 and Year 5.
1 − (1.1)–5
Cost of land = Br. 100,000 [ ]
0.1
Cost of land = Br. 100,000X3.79079
Cost of land = Br. 379, 079
C. Issuance of securities
When a plant asset is acquired by issuing securities, the cost of the plant asset is equal to either the
fair market value of the securities issued or the fair market value of the plant assets themselves
provided that the fair market value of the securities is not determinable.
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Illustration:
i. Mega Corporation purchased machinery by issuing 2,000 shares of common stock with a par
value of Br. 40 and a fair market value of Br. 75. Suppose that the fair market value of the
machinery was Br. 154,000, then, the cost of the machine acquired is Birr 150,000, computed as
follows: (Birr 75 per share X 2,000 shares) = Br.150, 000.
ii. If the value of the common stocks of Mega Corporation is unknown, the value of the machine
shall be equal to the fair market value of the machine which is equal to Birr 154,000.
D. Lump-sum purchase
It is not unusual for a group of operational assets to be acquired for a single sum. If these assets are
indistinguishable, for example, 5 identical delivery trucks purchased for a lump sum price of Br.
200,000, valuation is obvious, each of the trucks would be valued at Br. 40,000 (Br.200,000 5).
however, if the lump-sum purchase involves different assets, it is necessary to allocate the lump
sum acquisition price among the separate items, usually in proportion to the individual assets’
relative fair market values.
Illustration:
ABC Company purchased an existing factory for a single sum of Birr 2,100,000. This price
includes the costs of title to the land, factory building and equipment. An independent appraisal
estimated the market values of the assets (if these would be purchased separately) at Birr
800,000 for the land, Birr 1,000,000 for the factory and Birr 700,000 for the building. The lump
sum purchase price of Birr 2,100,000 is allocated to the individual separate assets as follows:
Step 1: Determine the percentage of the market value of each asset to the total sum.
Step 2: Multiply the percentage of each asset’s market value (computed in step 1 above) by the
lump-sum price to get the cost of the assets and the following journal entry is recorded:
E. Donated assets
On occasion, companies acquire operational assets through donation. Local government Chapter
might provide land or pay all or some of the cost of new office building or manufacturing plant to
entice a company to locate in its geographical boundaries; so that the factory brought jobs to the
society and increase revenues to the city. Assets donated by unrelated parties should be recorded at
their fair value based on either an available market price or an appraisal value. This is not a
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departure from historical cost valuation. The treatment of the transaction is equivalent to the donor
contributing cash to the company and the company using the cash to acquire the asset. The
contribution revenue should be recognized for the excess of the fair market value of the plant asset
over any costs incurred to acquire the plant asset (legal fees, title costs, etc).
Illustration: XYZ Manufacturing Company a corporation received land with a fair market value of
Br. 790,000 from a city with the stipulation that a factory be built on the land; the corporation
incurred legal fees of Birr 20,000 to obtain title to the land.
Required:
a. Determine the cost of the land and contribution revenue.
b. Pass the journal entry on the book of the XYZ Company.
Solution
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Land...................................................790,000
Cash..........................................................................20,000
Contribution Revenue.................................................770,000
(To record the acquisition of land)
Concept of Depreciation
Depreciation- is the process of allocating the cost of a plant asset over its useful (service) life in a
rational and systematic manner. The basic purpose of depreciation is to provide the
proper matching of expense with revenues in accordance with the matching principle.
Depreciation is a process of cost allocation, not a process of assets valuation. Accountants make
no attempt to measure the change in an assets mkt. value during ownership, because plant assets
are not held for resale.
Depreciation does not mean that the business sets aside or accumulates cash to replace assets as
they become fully depreciated. Establishing such a cash fund is decision entirely separate from
depreciation. Accumulate depreciation is that portion of the plant asset's cost that has already
been recorded as expense.
Causes of Depreciation
The two major causes of depreciation are physical deterioration & obsolescence.
a. Physical Deterioration – occurs from wear & tear while in use as well as from the action of the
weather (exposure to sun, wind, and other climatic factors)
b. Obsolescence (Function Depreciation) - is the process of becoming out of date before the assets
physically wears out.
In today’s rapidly advance in technology, obsolescence is a more important consideration than
physical deterioration. E.g. a personal computer made in the 1980's would not be able to provide an
Internet connection.
Assets like computers, other electronic equipment & airplanes may become obsolete before they
physically deteriorate. An asset is obsolete when another asset can do the job better or more
efficiently.
Depreciation Methods
There are several alternative methods of computing depreciation. A business need not use the same
method of depreciation for all its various assets.
Depreciation is computed using one of the following different methods:
1. Straight line method
2. Chapters of output method
3. Declining balance method
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Like the inventory costing method, each method is acceptable under GAAP, thus it is up to the
management of the business to select a method, which is believed to be appropriate in the
circumstance. Depreciation affects the Balance sheet reports through the account of accumulated
depreciation, as well as the Income statement through the account of depreciation expense. Thus, its
proper accounting and record is imperative for financial reporting.
Three factors affect the computation of depreciation:
a. Cost - is the initial cost incurred in acquiring the asset. Cost is measured in accordance with the
cost principle of accounting.
b. Useful Life - is an estimate of the expected productive life, also called service life, of the asset.
Useful life maybe expressed in term of time, Chapters of activity such as machine hours, or in
Chapters of output.
c. Salvage Value - also called scrap or residual value is an estimate of the asset's value at the end
of its useful life.
o The full cost of a plant asset is depreciated if the asset is expected to have no residual value.
o The plant assets cost minus its estimated residual value is called the depreciable cost.
1. Straight - Line Method
Under the Straight - Line Method, an equal portion of the cost of the asset is allocated to each
period of use; consequently, this method is most appropriate when usage of an asset is fairly
uniform from year to year.
It is the simplest & most widely used method of computing depreciation.
The Straight Line Method depreciation assumed that a business receives equal benefits from
an asset each day of the asset's life. Straight Line, then, allocates an equal part of the total
cost to each day of an asset's useful life.
To illustrate, assume a delivery truck has a cost of Br.17, 000 a residual value of Br 2,000 and an
estimated useful life of five years. The annual computation of depreciation exp. will be as follows:
Straight - Line depreciation per year = Cost - Residual value
Useful life in years
= Br. 17,000.00 - Br. 2,000.00
5
= Br. 3,000.00
Depreciation Schedule – Straight-line method
Depreciation Accumulated
Depreciable Rate x Cost Depreciation Depreciation Book value
Year Expense
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Depreciation rates for various types of assets can conveniently be stated as percentages.
In the illustration, it was assumed that the asset was acquired on Jan. 1, the beginning of the
accounting period. If the asset had been acquired during the year, on October 1, it would have been
in use for only 3 months, or 3/12 of a year. Then, the depreciation expense for the three months
would be computed as follows:
The straight-line method predominates in practice. It is simple to apply, & it matches expenses with
revenues appropriately when the use of the asset is reasonably uniform throughout the service life.
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To illustrate, consider the previous e.g. of the Br. 17,000 delivery truck. To depreciate the truck by
the double declining balance method, we double the straight-line rate of 20% & apply the doubled
rate of 40% to the book value at the beginning of each year.
• The declining balance method produces a decreasing annual depreciation expense over the
useful life of the asset.
• The method is so named because computation of periodic depreciation is based on a declining
book value (cost less accumulated. depreciation) of the asset.
• The depreciation rate remains constant from year to year, but the book value to which the rate
is applied declines each year.
• Unlike the other depreciation methods, salvage value is ignored in determining the amount to
which the declining balance is applied. Salvage value, however, does limit the total
depreciation that can be taken. Depreciation stops when the asset's B.V. equals expected
salvage value.
• Because the declining balance method produces higher depreciation expense in the early
years than in the later years, it is considered an accelerated depreciation method.
If the asset has been acquired on October 1, rather than on January 1, depreciation for only 3
months would be computed as follows:
40% x Br. 17,000.00 x 3/12 = Br. 1,700
For the next year, the calculation would be, 40% x (17,000 -1,700) =Br. 1,620
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2. Sinking Fund Method: Sinking fund method of depreciation might be used when a fund is to be
accumulated to replace a plant asset at the end of its economic life. Under sinking fund method, the
amount of depreciation expense is equal to the increase in the asset replacement fund. The increase
in the fund consists of equal periodic deposit plus the interest revenue realized at the assumed rate
on the sinking fund balance. Annual deposit in the sinking fund under this method is given using the
following formula:
i
We shall illustrate the sinking fund method of depreciation with the same example as we
illustrated in the annuity method. The annual sinking fund deposit is calculated using the above
formula as follows:
Sinking Br . 800 , – Br . , 388
– Fund – deposit
= 000 67
(1 + 0 . 1 )
5
1
0.1
= Br. 120,000
A summary of the result of the sinking fund method of depreciation and the journal entry to record
deprecation for the five years is given below.
Depreciati Balance of
Realized on Accumulated Carrying
interest revenue Total expense depreciation amount
Annual (10% of fund fund Fund ledger of the plant
Year deposit balance) Increase balance account asset
0 Br.800,000
1 Br.120,000 120,000 120,000 120,000 120,000 680,000
2 120,000 Br.12,000 132,000 252,000 132,000 252,000 548,000
3 120,000 25,200 145,200 397,200 145,200 397,200 402,800
4 120,000 39,720 159,720 556,920 159,720 556,920 243,080
5 120,000 55,692 175,692 732,612 175,692 732,612 67,388
Br.600,000 132,612 732,612 732,612
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The entry to record the sale and the gain on disposal is as follows:
July 1. Cash 16,000
Accumulated. Dep. - Office furn.---------------49,000
Office furn.
60,000
Gain on Disposal --------------------------- 5,000
(To record sale of office furniture at a gain)
Loss on Disposal
Assume that instead of selling the office furniture for Br. 16,000, Guna trading sells it for Br. 9,000.
In this case, a loss of Br. 2,000 is computed as follows:
Cost of office furniture--------------------------Br. 60,000
Less: accumulated depreciation.------------- 49,000
Book value at date of disposal --------------- 11,000
Proceeds from sale ----------------------------- 9,000
Loss on disposal ------------------------------- Br.2,000
The entry to record the sale and the loss on disposal is as
follow: July 1. Cash
9,000 Accumulated dep. - office furn------49,000
Loss on disposal-------------------------------2,000
Office furniture
60,000
(To record sales of office furniture at a loss)
3. Exchanging Fixed Asset
Plant assets may also be disposed of trough exchange. Business often exchange (trade – in) their old
plant assets for similar assets that are newer and more efficient. Exchange can be for either similar
or dissimilar assets because exchanges of similar assets are more common; we will focus more on
the exchange for similar assets.
Exchange of similar assets involves assets of the same type. This occurs for example, when old
equipment is exchanged for new delivery equipment or when old office furniture is exchanged for
new office furniture.
At the time of exchange, the seller allows the buyer an amount for the old equipment traded in.
This amount called the trade in-allowance may be either greater or less than the book value of the
old equipment. The remaining balance- the amount owed – is either paid in cash or a liability is
recorded. It is normally called boot, which is its tax name.
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The cost recorded for the new asset can be determined in either of two ways:
i. Cost of new asset = List price of new asset - unrecognized gain
ii. Cost of new asset = Cash given or liability assumed + Book value of old asset
Gain Treatment
Assume that ABC Company decides to exchange its old delivery equipment for new delivery
equipment. The cost of the old equipment is Br. 4,000 and its related accumulated depreciation is
Br. 3,200. The dealer of the new equip. offers a Br. 1,100 trade-in allowance, and the cash market
price of the new equipment is Br. 5,000.
The cost of the new equipment and the gain, which is not recognized, is computed as
follows: Similar equipment acquired (new):
List price of new equipment---------------------------Br. 5,000
Trade-in allow on old equipment -------------------- 1,100
Cash to be paid at June 19, date of exchange-----------3,900
Equip. Traded - in (Old):
Cost of old equipment -------------------------------- Br. 4,000
Accumulated Depreciation at date of exchange -- 3,200
Book value at date of exchange -------------------- 800
Recorded Cost of New Equipment:
Method One
List price of new equipment ---------------------- Br. 5,000
Trade-in allowance ------------------------- Br. 1,100
Book value of old equipment---------------------800
Unrecognized gain on exchange-----------------------------300
Cost of new equipment ------------------------ Br. 4,700
Method Two
Book value of old equipment -------------------- Br. 800
Cash paid at date of exchange ----------------- 3,900
Cost of new equipment ------------------------------ 4,700
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Loss Treatment
When a loss occurs on the exchange of similar assets, it is recognized immediately, it is not
deferred. When there is a loss, the cost recorded for the new asset should be the market (list) price.
To illustrate, consider the previous e.g., but assume this time the company exchanged the
equipment by paying cash of Br. 4,600.
The entry to record the exchange, loss & cash Payment is as follows:
Equipment (new) 5,000
Accumulate depreciation – equipment------------------3.200
Loss on disposal 400
Equipment (old) ---------------------------------- 4,000
Cash 4,600
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