Chapter 6: Plant assets, natural resources and intangibles

Long-lived assets such as land, buildings, machines, trucks, oil wells and patents are used for many years. This chapter explains what goes into their cost, how that cost is spread over the years through depreciation, depletion and amortization, how to record the disposal of an asset, and how the asset turnover ratio measures how well assets generate sales. The case Garbage Inc shows that the estimates behind depreciation are also an ethical matter.

The cost of property, plant and equipment

Property, plant and equipment (PP&E, plant assets) are long-lived, tangible assets used in operations: land, buildings, equipment, furniture, fixtures, vehicles. Following the cost principle, a plant asset is recorded at historical cost: the purchase price plus taxes, commissions and all other amounts paid to get the asset ready for its intended use. Recording such costs as an asset is called capitalizing.

Example: land bought for $50,000, plus $4,000 back property taxes, $2,000 transfer taxes, $5,000 to remove an old building and a $1,000 survey fee: land cost = $62,000. Later fences, paving, lighting and signs for $20,000 are a separate asset, land improvements, which is depreciated; land itself is not. Similarly, a truck bought for $90,000 that is painted ($3,000), gets new tyres ($1,500) and an engine overhaul ($4,500) before it is placed in service costs $99,000.

Depreciation

Depreciation allocates the cost of a plant asset to expense over its useful life, following the matching principle. All assets except land wear out, and some become obsolete before they wear out (a newer asset does the job more efficiently). Three inputs are needed: the capitalized cost, the estimated useful life and the estimated residual value. Cost minus residual value is the depreciable cost.

The slides use a truck that cost $41,000 with a residual value of $1,000, a five-year life and an expected 100,000 miles (20,000, 30,000, 25,000, 15,000 and 10,000 miles in years 1 to 5).

Straight-line: equal depreciation each year.

Units-of-production: depreciation follows usage.

Year 1: 20,000 × 0.40 = $8,000; year 2: 30,000 × 0.40 = $12,000; and so on.

Double-declining-balance (DDB): an accelerated method, with more depreciation early and less later. Multiply the asset's book value at the start of each year by twice the straight-line rate. Residual value is ignored in the formula but the asset may not be depreciated below it.

In the last DDB year the expense is whatever brings book value down to the residual value. All three methods depreciate the same total; only the timing differs. Straight-line suits assets that generate revenue evenly (buildings); units-of-production suits assets that wear out through use (vehicles, machines); DDB suits assets that produce most in their early years (computers). In the first year straight-line gives the lowest expense and therefore the highest net income.

Partial year. An asset bought during the year is depreciated only for the months it was used. A copier bought on 31 July for $40,400 with a $2,000 residual value and four-year life: (40,400 − 2,000) / 4 × 5/12 = $4,000 for the year ending 31 December.

Change in estimate. When the useful life or residual value is revised, past depreciation is not corrected. The remaining book value minus the new residual value is spread over the remaining life.

Disposal of plant assets

An asset can be discarded, sold or exchanged. In every case follow four steps:

1. Bring depreciation up to date (to the disposal date).
2. Remove the asset and its accumulated depreciation from the books.
3. Record any cash received or paid.
4. Record the difference as a gain or a loss: gain (loss) = cash received − book value.

Example: equipment cost $10,000, accumulated depreciation at 31 December $8,000, annual depreciation $1,000. It is disposed of on 1 July. Step 1: six months of depreciation, $500, so accumulated depreciation is $8,500 and book value $1,500.

The entry for the sale at $4,000: Dr Cash 4,000, Dr Accumulated depreciation 8,500, Cr Equipment 10,000, Cr Gain on disposal 2,500. A fully depreciated asset that is discarded without a residual value gives neither a gain nor a loss.

Natural resources

Natural resources (oil, minerals, timber) come from the earth and are consumed. Spreading their cost over the quantity extracted is depletion, computed with the units-of-production method. An oil well costing $700,000 holds an estimated 70,000 barrels: $10 per barrel. Extracting 3,000 barrels gives depletion of $30,000 (Dr Depletion expense, Cr Accumulated depletion, a contra asset).

Intangible assets

Intangible assets have no physical form but carry valuable rights: patents, trademarks, copyrights and other creative works. Purchased intangibles are recorded at cost.

• Intangibles with a definite life are amortized: the cost is spread over the useful life, usually straight-line (Dr Amortization expense, Cr the intangible or Accumulated amortization). A patent gives a 20-year exclusive right, but it is amortized over its shorter useful life. Example: a patent bought for $200,000 with a five-year useful life: $40,000 a year.
• Intangibles with an indefinite life are not amortized but tested for impairment every year. Impairment occurs when the fair value of an asset falls below its book value; the company records a loss.
• Goodwill is the amount paid for a company above the market value of its net assets (assets minus liabilities). It is recorded only when a company is acquired, is not amortized, and is tested for impairment.

Asset turnover ratio

It shows the sales generated per dollar of assets; higher is better. Kohl's: 19,167 / ((12,469 + 13,389) / 2) = 19,167 / 12,929 = 1.48 times.

Case: Garbage Inc

Garbage Inc, a fast-growing Dutch waste company, presents five accounting changes to the class, each with a convincing story:

1. Trucks: extend the useful life from 8 to 10 years because of better maintenance and technology. Effect: lower yearly depreciation, higher profit.
2. Landfill: raise the residual (salvage) value by 5.6% because land prices rise. Effect: lower depreciable cost, lower depreciation, higher profit.
3. Impairment: postpone writing down trademarks and goodwill whose value has fallen, claiming the decline is temporary. Effect: assets and profit stay too high.
4. Interest: capitalize €750,000 of interest on long construction projects as part of the asset cost instead of expensing it. Effect: expenses lower now, depreciation higher later.
5. Tax planning to cut income tax expense by 12%, and finally hiring the company's own auditor as consultant for €150,000, which threatens the auditor's independence.

Each change on its own may be defensible, because depreciation and impairment rest on estimates. Together they all push profit up. The case is modelled on the Waste Management scandal: from 1992 the US company manipulated its records, among other things by stretching useful lives and inflating salvage values; in 1998 it admitted overstating earnings by $1.7 billion and its share price fell by more than a third. Its auditor, Arthur Andersen, also paid fines and the firm collapsed soon after the Enron affair, which is why there is now a Big Four instead of a Big Five. The lesson: estimates give management room, and that room can be abused.