PP&E - Fixed Assets and Depreciation

Property, Plant and Equipment (PP&E)

What are they?

1. PP&E, or fixed assets, are acquired for use in operations and are not intended for resale. Fixed assets are long – term, physical assets, that are subject to depreciation (except for Land).

2. PP&E must be shown separately on the balance sheet or footnotes at original (historical) cost:

   a. Land (property – no depreciation).

   b. Land improvements can be depreciated.

   b. Buildings (plant, factory, warehouse, office, etc.)

   c. Equipment, (machinery, tools, furniture, fixtures, etc.)

3. accumulated depreciation is a contra-asset account that serves as an offset to the asset accounts shown above.

   Cost (debit balance) - accumulated depreciation (credit balance) = net book value (net debit)

PP&E - Cont’d

1. Note: any insurance paid on equipment after transit will be expensed. However, insurance on equipment while in transit is capitalized, since the machine has not yet reached its intended location and insurance during transit is a necessary cost to acquire a machine and prepare it for use.

PP&E - Cont’d 2

1. When a company acquires equipment by using a note payable, the cost of the equipment should be recorded at its present value at the date of acquisition.

2. In other words, we know that equipment is recorded at its historical cost, this includes: the present value of the note payable.

3. Plus, direct cost necessary to bring the equipment to its intended, use (e.g. shipping, Installation, testing.)

Cost of land

1. Note: do not add current year taxes to land cost. This gets expensed.

2. Unlike Land, land improvements can be depreciated.

3. Special assessments are always land cost. Land owners assessed for one time charge represents additional land cost.

Basket purchase – land and building

1. In a basket purchase, allocate the purchase price based on the ratio of appraised values of individual items.

Capitalization of interest

1. This is self constructed fixed assets – NOT inventory.

2. Avoidable interest = interest that wouldn’t have been incurred if the construction hadn’t happened

Avoidable interest

1. The calculation of avoidable interest:

2. Interest rate times average accumulated expenditures for construction.

3. Average accumulated expenditures are the payments that could’ve been avoided. Had there been no construction.

4. Evenly throughout the year example: a company paid $160,000 to a contractor for building a warehouse.

5. Average accumulated expenditures would be 0+ $160,000 / 2 = $80,000 average accumulated expenditures. If the interest rate is 10% avoidable interest is therefore $8,000.

6. Final step is to compare avoidable interest to actual interest paid, $10,000.

7. Capitalize the higher of the two, $8000 is capitalize, $2000 is expense immediately.

Avoidable interest - Cont’d

You must use weighted average for the calculation of avoidable interest when the payments to the Contractor are not made evenly throughout the year.

Equipment cost capitalization

1. If old assets carrying value is known, right off old asset and record the new asset.

2. If old assets carrying value is unknown, debit accumulated depreciation for the cost of the new asset and credit cash/accounts payable.

Capitalization of interest.

1. If constructing a warehouse, an office building, a factory for use in business, you can capitalize the interest on any loan to help finance the construction.

2. The interest during construction is added to the capitalized cost of the building. The interest cost will ultimately be expensed through depreciation.

3. Do NOT capitalize interest on loans to construct inventory, or loans to buy inventory.

4. Do NOT capitalize before construction or after construction, during construction – yes.

5. Do NOT capitalize interest during intentional delays in construction, however, do capitalize interest during ordinary, delays in construction.

6. Do NOT capitalize interest if you haven’t started spending money for materials, labor, and overhead. (the amount of capitalized interest is not directly based on the amount borrowed.)

Capitalization of interest. Cont’d

1. See attached pictures for when interest capitalization period starts.

2. Under US GAAP, interest can only be capitalized when all three of the following conditions are met:

   1) expenditures, for the asset are being incurred (e.g., materials, labor, permits.)

   2) construction activities are in progress

   3) interest cost is being incurred

Capitalization of interest. Cont’d 2

1. Remember, you must capitalize the lower of the 2 interest calculations the interest given and the weighted average accumulated expenditure that you calculate.

Capitalization of interest. Cont’d 3

Note: the amount of interest capitalized can never exceed the actual interest cost.

Capitalization of interest. Cont’d 4

Calculating construction. Interest cost.

Capitalization of interest period

1. The capitalization of interest period begins when three conditions are present:

   a. Expenditures for the asset have been made (e.g., attorney, or architect hired).

   b. Activities. (such as filing permits) that are necessary to get the asset ready for its intended use are in progress.

   c. Interest cost is being incurred.

Impairment- test review

Impairments of long-lived assets.

1. The carrying amount is not recoverable when cost minus accumulated depreciation exceeds the undiscounted cash flows expected to result from continued use of the asset. (Note: ignore discounted cash flow unless you have an impairment, in which case you will then use the discounted future cash flow less the carrying value to determine the amount of the impairment.)

2. If the carrying amount is not recoverable, an impairment loss is recognized on the income statement from continuing operations, and the asset is written down to fair value.

Impairments of long-lived assets. Cont’d

1. US GAAP rules say to determine the present value, of the future cash flows, to make the impairment loss the largest it could possibly be, (more conservative approach)

2. Ex: carrying value of a machine is $500k (cost of $600k less Acc Dep of $100k)

3. Future undiscounted cash flows are expected to be $400,000.

4. This is an impairment since the cash flows expected are $400,000 and the machine carrying amount is $500,000. (Potentially a $100k impairment)

5. However, you must determine the present value of the future cash flows of $400,000.

   Note: you do NOT need to determine the present value, if the undiscounted cash flow in the initial step is greater than the carrying value.

6. If the present value of the future cash flows is $325,000, then the impairment loss recorded on the machine should be: $325,000 -$500,000 carrying amount equals impairment loss of $175,000.

7. The assets new carrying amount on the balance sheet is its fair value of $325,000.

Asset impairment – Intangible assets

Intangible assets follows the same two step test to determine impairment.

• Step 1: The Recoverability Test (Step I)

  • Purpose: Determines if the asset is impaired.

  • Method: Compares the asset group's carrying amount (book value) to the total sum of undiscounted future cash flows expected from its use and disposal.

  • Result: If the carrying amount is higher than the undiscounted cash flows, the asset is not recoverable, and the entity must proceed to Step 2.

• Step 2: The Fair Value Test (Step II - Measurement)

  • Purpose: Quantifies the impairment loss.

  • Method: The impairment loss is recorded as the amount by which the carrying amount exceeds the fair value of the asset. 

Note: if the asset is “held for use” not allowed to reverse the loss.

US GAAP does not allow for reversal of impairment loss on assets held for use.Thee

Intangible assets – Finite life versus Infinite life

1. Since trademark has an infinite life, capitalized cost is not amortized but tested for impairment annually.

2. Impairment testing of a trademark, should be done annually, using a one step test, comparing book value, and fair value. So, if the fair value falls below the carrying amount, the trademark is impaired.

3. Note: the key to Whether Intangible assets should be amortized or not is Finite versus Indefinite life. ( Finite life is amortized)

Intangible assets – Finite life

1. Intangible assets are capitalized and advertised over the shorter of the economic life or legal life.

2. Legal fees, incurred by a company in defending its patent rights should be capitalized to the patent account if successful.

3. Legal fees incurred by a company in an unsuccessful defense of its patent should be expensed.

   a. The cost must be expensed immediately as they do not provide future economic benefits (the criteria for capitalization)

Goodwill

1. Goodwill is an intangible asset with an indefinite life. Therefore, Goodwill is not amortized, but it’s tested for impairment, although tested differently than other intangible assets with an indefinite life.

2. Subsequent to acquisition, the cost to maintain, enhance, or repair purchased. Goodwill are expensed.

Depreciation

1. Do not depreciate assets held for sale.

2. If a company uses straight line depreciation and the question also gives you “Tax Depreciation method” ignore the tax depreciation method for FAR.

Declining balance

1. When assets are subject to rapid obsolescence, the accelerated method known as declining balance is used. Usually the straight line rate is doubled, but sometimes a smaller factor like 150% declining balance is used instead of 200%.

2. No salvage is subtracted in the first year, the depreciable base is the cost.

Double Declining balance

1. While using the double declining balance, even though there’s an estimated useful life, this may be shorter while calculating using double declining balance I.e. see picture, useful life was estimated at 10 years, but was depreciated in 8yrs.

Double Declining balance - Cont’d

Double Declining balance - Cont’d 2

Depreciation - Sum of the year’s digits

1. Unlike, the Double Declining method, You must subtract the salvage value in order to get the depreciable base, that’s the number that you’ll be depreciating.

2. unlike, the double declining method, your depreciable base amount stays the same over the period that it is being depreciated

Units of production (UOP)

1. The units of production depreciation method is an approach used to calculate the depreciation of an asset based on its actual usage, operational hours, or units produced, rather than the passage of time.

2. UOP method is particularly useful for assets, whose wear and tear is more closely related to how much they are used rather than how old they are.

UOP Cont’d

Composite depreciation

1. There’s no gains or losses recorded when you use the composite depreciation and you dispose of an asset.

2. Ex: DR Cash $xx

   DR Acc Depreciation (plug) $xx

   Cr Asset $xx

Composite depreciation - Cont’d

Composite rate of depreciation based on attached picture is $56,000 divided by $280,000 equals 20%.

Depletion

1. Cost allocation: the total cost of acquiring and developing the natural resource is allocated over the estimated quantity of the resource to be extracted.

2. Method of depletion: cost depletion is similar to units of production. Percentage depletion: allowed for tax purposes only.

3. If the extracted resource is intended for sale, then depletion is initially capitalized as inventory and recognized as COGS when the resource is sold. If the extracted resource is used internally for operations, depletion is recorded as an operating expense rather than COGS.

Depletion - Cont’d

Depletion - Cont’d 2