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

1. Costs to Capitalize2. Depreciation3. Asset Sale or Impairment4. Disclosure5. Ratios

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1. What Costs to Capitalize?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?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?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, attorney’s fees, building permits, etc.

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1. What Costs to Capitalize1. 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. Depreciation2. DepreciationDepreciation is a method of cost

allocation.– it is used to allocate the capitalized cost

of PP&E 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. xxBook value = Cost - A/D (accum. depr.)

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2. Depreciation2. DepreciationDepreciation methods

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

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Class ExampleClass 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 = $2,000Calculate depreciation expense for the

first two years under each of the following methods.

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(1) Units-of-production (Activity)(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(2) Straight-LineAnnual depreciation =

Cost - Salvage Estimated Life

= 10,000 - 2,000 = $2,000 per year 4 years

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(3)(3) Double Declining BalanceDouble Declining BalanceDDB 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(4) MACRSMACRS (modified accelerated cost

recovery system) is a technique developed by the IRS for tax reporting. It utilizes combinations of DDB, 150%DB, 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)(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)(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(4) MACRS - continuedUsing 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 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 6.5610 6.5511 3.28

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Depreciation - change in estimateDepreciation - change in estimateBecause 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 Sale3. 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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3.3. Disposal - continuedDisposal - continuedUsing 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 2,000Accumulated Depr. 8,000

Automobiles 10,000

2. Assume the asset is sold for $3,000:Cash 3,000Accumulated Depr. 8,000

Automobiles 10,000Gain on sale 1,000

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3. Asset Impairment3. Asset ImpairmentPPE 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. Disclosure4. 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. Ratios5. RatiosPPE Turnover =

Sales Average PPE, netIndicates 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.