Plant Assets, Natural Resources, and Intangibles

Introduction

Plant assets, also known as property, plant, and equipment (PP&E), are long-term tangible assets used in the operations of a business. Depreciation is the process by which the cost of these assets is allocated over their useful lives. Understanding depreciation is essential for accurate financial reporting and decision-making in financial accounting.

Accounting for Depreciation on Plant Assets

Book Value of Plant Assets

• Book Value is the value at which an asset is carried on the balance sheet. It is calculated as:

• Plant assets are recorded at their book value on the balance sheet.

Depreciation: Definition and Purpose

• Depreciation is the systematic allocation of a plant asset's cost to expense over its useful life.

• It is necessary because plant assets wear out, become obsolete, and lose value over time.

• Depreciation matches the cost of the asset against the revenue it helps generate each period.

• Depreciation expense is reported on the income statement.

• Land is not depreciated because it does not have a finite useful life.

Depreciation and Revenue Generation

• Depreciation allocates costs to the periods in which the asset helps generate revenue, ensuring proper matching of expenses and revenues.

• Example: An airplane with a useful life of 20 years will have its cost allocated over those years as it generates revenue.

Measuring Depreciation

Key Factors in Depreciation Calculation

• Cost: The purchase price plus all costs necessary to get the asset ready for use.

• Estimated Useful Life: The expected period over which the asset will be used in operations.

• Estimated Residual Value: The expected cash value of the asset at the end of its useful life.

Depreciation Methods

Overview of Depreciation Methods

• Straight-line method

• Units-of-production method

• Double-declining balance method

Depreciation Computation Data Example

Straight-Line Method

Concept and Calculation

• Assigns an equal amount of depreciation to each period of the asset's useful life.

• Annual depreciation expense is calculated as:

• Example: For a truck with a depreciable cost of $40,000 and a useful life of 5 years:

per year

Straight-Line Depreciation Schedule Example

*Years of useful life = 5; Rate = 0.2

Units-of-Production (UOP) Method

Concept and Calculation

• Depreciation is based on the actual usage of the asset, not time.

• Depreciable cost is divided by total estimated units of production to determine depreciation per unit:

• Depreciation expense for each period is:

• Example: For a truck with $40,000 depreciable cost and 100,000 miles estimated usage:

per mile

Units-of-Production Depreciation Schedule Example

Double-Declining-Balance (DDB) Method

Concept and Calculation

• The DDB method is an accelerated depreciation method that writes off a larger portion of the asset's cost in the early years.

• It multiplies the asset's book value at the beginning of the year by twice the straight-line rate:

• Residual value is ignored initially; the final year depreciation is a "plug" to reduce book value to estimated residual value.

Double-Declining-Balance Depreciation Schedule Example

*Final-year depreciation is a plug amount to reduce book value to estimated salvage value.

Comparing Depreciation Methods

Best Use Cases for Each Method

• Straight-line: Best for assets that generate revenue evenly over time.

• Units-of-production: Best for assets that wear out due to usage.

• Double-declining-balance: Best for assets that generate more revenue in the early years of their useful life.

Comparison Table: Amount of Depreciation per Year

Depreciation Patterns Through Time

• Straight-line: Depreciation expense remains constant each year.

• Units-of-production: Depreciation expense varies with asset usage.

• Accelerated (DDB): Depreciation expense is higher in early years and decreases over time.

Depreciation Methods Used by Companies

• According to a survey of 600 companies:

Depreciation for Partial Years

Partial-Year Depreciation

• When an asset is purchased partway through the year, depreciation must be prorated for the period of ownership.

• Example: If a building is purchased on September 1 for $500,000, with a 20-year life and $80,000 residual value, and the accounting year ends May 31, depreciation for the first year is calculated based on the months owned.

Formula for Partial-Year Depreciation:

Summary

• Depreciation is a key concept in financial accounting for allocating the cost of plant assets over their useful lives.

• Three main methods—straight-line, units-of-production, and double-declining-balance—offer different patterns of expense recognition.

• Choosing the appropriate method depends on the asset's usage and revenue generation pattern.