Module 6, Part 3: PPE (Property, Plant and Equipment)

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Module 6, Part 3 PPE(Property, Plant and
Equipment)

1. Costs to Capitalize
2. Depreciation
3. Asset Sale or Impairment
4. Disclosure
5. Ratios

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1. What Costs to Capitalize?

• General Rule
• Capitalize (add to an asset account) the costs to
  acquire the asset and to prepare it for its
  intended use.
• Note for all acquisitions, part of the cost is
  the purchase price, specifically the cash
  equivalent purchase price (the amount we would
  pay if we paid cash). This excludes any cost of
  financing the purchase (interest expense).

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1. What Costs to Capitalize?

• Land
• purchase price, clearing costs, survey costs,
  back taxes, closing costs, some landscaping (if
  permanent in nature).
• Land improvements
• purchase price, for some landscaping (temporary),
  parking lots, sidewalks, etc.

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1. What Costs to Capitalize?

• Machinery and equipment
• purchase price, freight, installation, assembly,
  trial runs, testing and inspection during set up.
• Buildings
• purchase price (or cost to construct), closing
  costs, attorneys fees, building permits, etc.

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1. What Costs to Capitalize

• Self-constructed assets
• include cost of materials, labor, and overhead.
• may also include interest cost during
  construction. The interest costs are calculated
  under specific rules, based on the length of time
  of the construction period, and the borrowing
  rates of the company.

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2. Depreciation

• Depreciation is a method of cost allocation.
• it is used to allocate the capitalized cost of
  PPE over the years benefited (matching)
• Note depreciation will decrease the carrying
  value of the asset, but it is not a valuation
  technique (i.e., book value is not market value)
• Journal entry
• Depreciation Expense xx
• Accumulated Depr. xx
• Book value Cost - A/D (accum. depr.)

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2. Depreciation

• Depreciation methods
• (1) Activity (units-of-production)
• (2) Straight-line
• (3) Double-declining balance
• (4) MACRS (income tax depreciation)

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Class Example

• Given the following information regarding an
  automobile purchased by the company on January 2,
  2005
• Cost to acquire 10,000
• Estimated life 4 years
• Estimated miles 100,000 miles
• Salvage value 2,000
• Calculate depreciation expense for the first two
  years under each of the following methods.

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(1) Units-of-production (Activity)

• Assume that the car was driven 20,000 miles in
  the year 2005, and 30,000 miles in 2006.
• Annual depreciation
• Cost - Salvage Value x Current Activity
  
• Total expected activity
• For 2005 10,000 - 2,000 x 20,000 1,600
  100,000 miles
• For 2006 10,000 - 2,000 x 30,000 2,400
• 100,000 miles

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(2) Straight-Line

• Annual depreciation
• Cost - Salvage
• Estimated Life
• 10,000 - 2,000 2,000 per year
• 4 years

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(3) Double Declining Balance

• DDB is an accelerated depreciation technique. It
  generates more expense in the early years and
  less in the later years.
• Annual depreciation (Cost - A/D)
• where A/D is the accumulated depreciation for
  all prior years, and the percentage is double the
  straight line rate, or 2 x 1/Estimate life. In
  the example, the 2 x 1/4 2/4 50.
• Depreciation expense (D.E.)for
• 2005 50 x (10,000 - 0) 5,000
• 2006 50 x(10,000-5,000) 2,500

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(4) MACRS

• MACRS (modified accelerated cost recovery system)
  is a technique developed by the IRS for tax
  reporting. It utilizes combinations of DDB,
  150DB, and SL to calculate a table of
  percentages that can be applied to any
  depreciable asset.
• Additionally, the IRS assumes no salvage value,
  and a half year in the first and last year of
  depreciation (some limitations on fourth quarter
  purchases).

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(4) MACRS continued (optional slide)

• Example of MACRS for a 5 year category. Assume an
  asset purchased for 1,000 sometime during 2005.
  The IRS uses DDB for the first 3 years (remember,
  no salvage and 1/2 year in the first year), then
  switches to SL for later years (see next page)to
  stretch it out to 5 full years. DDB 2 x 1/5
  2/5 40.
• DE 2005 40(1,000 - 0) x1/2 200 (20)
• DE 2006 40(1,000-200) 320 (32)
• DE 2007 40(1,000 - 520) 192 (19.2)
• (Now A/D 712, and BV 1,000 - 712 288)
• DE 2008 288/2.5 yrs 115.20 (11.52)
• DE 2009 115.20 (11.52)
• DE 2010 (1/2)x 115.20 57.60 (5.76 )

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(4) MACRS continued (optional slide)

• Note that the switch is made in 2007. This is
  the point where the straight line depreciation
  for the year is greater than or equal to the
  accelerated depreciation.
• If you calculate the depr. expense using DDB for
  2007, you would get
• 40(1,000 - 712) 115.2
• This is the point where straight line and DDB
  cross. After this point, DDB will be less than
  SL for the remaining years.
• This is the point where the IRS, in its
  schedules, switches to straight line, to
  stretch the depreciation out to the total years
  of life.

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(4) MACRS - continued

• Using the previous calculations, the IRS
  developed a comprehensive set of percentages for
  all companies to use for depreciation expense for
  tax purposes.
• The categories are predefined by the IRS, and all
  the company must do is figure out which category
  each asset fits into.
• For example, automobiles fit into the five year
  category. The company would take the cost of the
  automobile (ignoring salvage), and multiply it by
  the indicated percentage to get the depreciation
  expense for the year (for calculation of income
  tax payable).
• The tables on the next page are excerpted from
  the IRS tables.

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MACRS Tables - selected years

• Yr. 3 years 5 years 7 years 10 years
• 1 33.33 20.00 14.29 10.00
• 2 44.45 32.00 24.49 18.00
• 3 14.81 19.20 17.49 14.40
• 4 7.41 11.52 12.49 11.52
• 5 11.52 8.93 9.22
• 6 5.76 8.92 7.37
• 7 8.93 6.55
• 8 4.46 6.55
• 9 6.56
• 10 6.55
• 11 3.28

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Depreciation - change in estimate

• Because depreciation is an estimate, and two of
  the three components are subject to variability,
  sometimes we need to make a change in estimate
  (either in the estimated life or the estimated
  salvage).
• The change in estimate affects only the current
  and future years we do not go back and change
  the previous years that have already been posted.

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3. Disposal Retirement or Sale

• Retirement - remove the asset and related A/D.
  If not fully depreciated, recognize loss.
• Sale - remove the asset and related A/D, then
  recognize cash received. The difference is a
  gain or loss.

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3. Disposal - continued

• Using earlier example (cost 10,000, salvage
  2,000). After 4 years straight-line, 8,000
  would be in A/D.
• 1. Assume the asset is retired (no cash received)
• Loss on retirement 2,000
• Accumulated Depr. 8,000
• Automobiles 10,000
• 2. Assume the asset is sold for 3,000
• Cash 3,000
• Accumulated Depr. 8,000
• Automobiles 10,000
• Gain on sale 1,000

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3. Asset Impairment

• PPE are recorded at cost, less A/D, and are not
  increased in value, even if market value
  indicates an increase.
• However, if the fair value of the asset is deemed
  to be below its book value, the asset is impaired
  and must be written down to fair value
  (conservatism) the loss is recognized in the
  period of impairment.
• Journal entry (text uses Asset Impairment
  Expense either account is located in other
  expenses and losses below income from
  operations)
• Loss on asset impairment xx
• Asset xx

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4. Disclosure

• The balance sheet is very limited in the
  presentation of PPE, usually one line of
  information, net of Accum. Depr.
• The footnotes show more information.
• Summary of Significant Accounting Policies,
  usually the first footnote in most financials,
  includes a general discussion of depreciation
  methods and average life of assets. Other
  footnotes may have more detailed schedules of
  asset categories, and original cost.

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5. Ratios

• PPE Turnover
• Sales
• Average PPE, net
• Indicates utilization of PPE higher ratio is
  preferable, indicting lower required capital
  investment for a given level of sales.
• Percent Used Up Accumulated Depr.
• Depreciable Asset Cost
• Indicates age of asset group. High percentage
  indicates need for replacement, and probable
  future capital expenditures.