Transcript Module 6, Part 3: PPE Costs to Capitalize Depreciation

Module 6, Part 3: PPE
(Property, Plant and Equipment)
1.
2.
3.
4.
5.
Costs to Capitalize
Depreciation
Asset Sale or Impairment
Disclosure
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, attorney’s 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 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.
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, 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)
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.
1
2
3
4
5
6
7
8
9
10
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3 years
33.33%
44.45
14.81
7.41
5 years
20.00%
32.00
19.20
11.52
11.52
5.76
7 years
14.29%
24.49
17.49
12.49
8.93
8.92
8.93
4.46
10 years
10.00%
18.00
14.40
11.52
9.22
7.37
6.55
6.55
6.56
6.55
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.
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