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Plant Assets and Depreciation

This lesson explains a little more about how depreciation expense is calculated. It also shows the other significant events in the life of plant assets: the purchase and retirement of those assets.

Depreciation expense spreads the cost of major equipment and assets over a period of time that spans a number of years.

Amortization is used to allocate the cost of intangible assets, such as patents, copyrights, trademarks, and franchises. Depletion is used to record the cost of natural resources extracted from the earth.

There are three main events in the life of any asset:

  1. acquisition
  2. useful life
  3. disposal or retirement

We will make journal entries for each of these events. Over the useful life we will enter depreciation expense. At the end of the life we will record any gain or loss at the time of disposal or retirement of the asset. Sometimes assets are traded for other assets, and that must be accounted for in the same manner as a disposal or retirement.

Fixed asset acquisition: Fixed asset accounts are debited for the actual cost of fixed assets. The correct account should be debited. Some companies use a Fixed Asset Subsidiary Ledger and show a control account on the Balance Sheet, called Property, Plant and Equipment (PPE) or something similar. In these cases all fixed assets acquisitions debit PPE and the subsidiary ledger carries the details pertaining to the asset.

Depreciable cost: Buildings, equipment, vehicles, computers, furniture and fixtures are all examples of depreciable assets. We will depreciate the depreciable cost of assets. This includes the purchase price paid, sales tax, shipping and installation costs, and possibly incidental costs if they are material. Cost of fixing damage caused during shipping and installation is treated as a Repair Expense.

Some costs are incidental to buying new equipment. A specialist might be hired to install a large printing press, or other specialized, complex piece of manufacturing equipment. This type of cost is included in the depreciable cost of the asset.

Sometimes employees have to be trained. The cost of training may be considered part of the depreciable cost, it the amount is material to the purchase of the asset. A brief training session for one or two machine operators will probably be an immaterial amount.

The cost of training the entire company's personnel when a new computer system is installed would probably be a material amount, especially in a large company. Every employee might require a day's training or more in the new system. The loss of productivity would be a material amount, and should be classified as part of the depreciable cost of the asset.

Recording Asset Acquisitions: If a company buys land, building, equipment etc. all at the same time, the total purchase price has to be divided correctly among the various assets.

Land is a non-depreciable asset. It falls into its own category in the books and on the Balance Sheet. Don't include land costs with other fixed asset costs, such as buildings. They must always be entered separately. Buildings will be depreciated; land will not be depreciated.

General Journal

Date
Account
Debit
Credit
Apr-15
Land
$5,000
Building
$45,000
 
Cash
$10,000
Mortgage Note Payable
$40,000
To record purchase of land and building
 
Apr-30
Manufacturing Equipment
$7,000
 
Computers and peripherals
$10,000
Computer software
$3,000
Accounts Payable
$20,000
To record purchase of equipment, computers and software

The Useful Life of an asset, is the period of time the company expects to use the asset in the business. It is also important that the asset be used as it is intended, and for the production of income. For instance, a computer that is being used as a doorstop is not contributing to the production of income, and it is also not being used as it was intended.

[Of course, at this point some very clever student will say something like, "What if the computer is used as part of an art project displayed in the foyer of an office building? It's not being used as intended nor in the production of income." Well, young Einstein, objects d'art are Investments, not depreciable plant assets. Nice try, but no banana for the monkey.]

Why do assets depreciate?

For Federal Income Tax purposes, depreciation is referred to as cost recovery. The government allows you to use the cost of plant assets to offset income. You recover your cost a little bit at a time, over a number of years. Each year you reduce your income tax expense, by an amount relative to the cost recovery amount for that year. It's a slightly strange concept if you're not involved in preparing income taxes. But it does make sense if you think about it a bit.

For financial statement purposes, depreciation reflects a number of different influences that each affect an asset over its useful life.

  • recognize physical deterioration
  • recognize obsolescence
  • recognize a reduction in market value
  • recognize benefits derived from using the asset
  • apply a logical, systematic cost allocation over a relevant period of time
  • apply the matching principle

Each of these is important to a company. When assets are purchased, the cost is reflected in the Balance Sheet. Depreciation expense transfers that cost to the Income Statement in order to reflect the effect of the items listed above, in the financial statements.

Usually, at this point, students are a showing a slight glaze over their eyes. I then reiterate that depreciation expense reduces income, which in turn cuts income taxes. Cutting our taxes, that's something most of us can relate to.

Depreciation Methods

These are three common depreciation methods. There are other methods. If you study international accounting, you will find that other countries deal with these issues in a very different way than in the US. There is an international movement to standardize accounting and reporting, particularly for global companies.

Depreciation Method Comments
Straight-Line Method An easy method that allocates an equal amount of depreciation to each time period; salvage value is used.
Declining-Balance Method (200% & 150% DB) Allocates more depreciation expense to the early years of an asset's life, when it is new; since there should be less down-time and fewer repairs in the early years, the company should get more use out of the asset in the beginning of it's life; no salvage value is used.
MACRS (income tax method) Uses the double-declining balance method, but you only take one-half year's depreciation in the first year, and then you switch to the straight-line method in the middle of the asset's life, so a 5 year asset takes 6 years to depreciate. This method does not use salvage value.

Selling or Disposing of Fixed Assets

After selling or disposing of fixed assets, the company no longer has the asset. This requires a journal entry to remove everything in the accounting records relating to the asset.

The depreciable cost and accumulated depreciation relating to the asset must both be removed, or reversed. There might be a gain or loss when disposing of assets. There might also be incidental costs relating to disposing of the asset. All these things should be included in the journal entry recording the disposal.

Let's assume on September 1, the ledger shows these balances for a piece of equipment.

General Ledger
Equipment

Date Description
Debit
Credit
Balance
Sep-1 Balance forward
$7000
$7000
         

Accumulated Depreciation - Equipment

Date Description
Debit
Credit
Balance
Sep-1 Balance forward
$5600
($5600)
         

Removing these amounts from the books with a journal entry: When assets disposed of there might be a gain, loss or a wash (no gain or loss). In either case all such journal entries will start from the same place, removing the related asset cost and accumulated depreciation. This journal entry does not balance; is the beginnings of a journal entry, and must be completed when all the information is available.

General Journal

Date
Account
Debit
Credit
Sep-15
Accumulated Depreciation
$5,600
       
       
Equipment
$7,000
To record disposal of equipment

Notice the exact opposite of the account balances is entered for each account. This causes the account balances to go to zero after this journal entry is posted.

General Ledger
Equipment

Date Description
Debit
Credit
Balance
Sep-1 Balance forward
$7000
$7000
Sep-15 Disposal of asset
$7000
$0

Accumulated Depreciation - Equipment

Date Description
Debit
Credit
Balance
Sep-1 Balance forward
$5600
($5600)
Sep-15 Disposal of asset
$5600
$0

The asset and related accumulated depreciation have both been removed from the books.

Calculating Book Value

Book Value is the difference between the asset cost and accumulated depreciation.

Equipment cost $ 7,000
Less: accumulated depreciation -5,600
Book Value before sale $ 1,400

Gains and losses are calculated using the Book Value.

Equipment sold for a Gain

If the equipment is sold for more than its book value there will be a gain. Gains are similar to revenues, and will be recorded with a credit entry. Let's say the equipment is sold on September 15 for $2,000. The gain will be:

Selling Price $ 2,000<
Less: Book Value - 1,400
Gain $ 600

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

General Journal

Date
Account
Debit
Credit
Sep-15
Accumulated Depreciation
$5,600
Cash
$2,000
Gain on disposal of equipment
$ 600
Equipment
$7,000
To record disposal of equipment

The journal entry is now in balance. Did you notice what happened? The journal entry started with what we already knew - the cost and accumulated depreciation. We left 2 lines blank in the middle of the journal entry, so the sales price and gain or loss could be recorded.

Equipment sold for a Loss

If the equipment is sold for less than its book value there will be a loss. Losses are similar to expenses, and will be recorded with a debit entry. Let's say the equipment is sold on September 15 for $1,000. The loss will be:

Selling Price $ 1,000
Less: Book Value - 1,400
Loss ($ 400)

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

General Journal

Date
Account
Debit
Credit
Sep-15
Accumulated Depreciation
$5,600
Cash
$1,000
Loss on disposal of equipment
$ 400
Equipment
$7,000
To record disposal of equipment

Equipment sold for a Wash: If the equipment is sold equal to its book value there will be a wash. Let's say the equipment is sold on September 15 for $1,400.

Selling Price $ 1,400
Less: Book Value - 1,400
Wash $0

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places. In this case there is a wash, so no gain or loss is recorded. The equipment is simply removed from the books.

General Journal

Date
Account
Debit
Credit
Sep-15
Accumulated Depreciation
$5,600
Cash
$1,400
Equipment
$7,000
To record disposal of equipment

Equipment Junked

If the equipment is junked there will be a loss equal to its book value. We call this abandonment. The item is usually just thrown in the trash, or hauled to the dump. Sometimes a company will have to pay to have the item hauled away. Incidental costs are revenue expenditures, and are not included in calculating the capital gain or loss.

Selling Price $0
Less: Book Value - 1,400
Loss ($ 1,400)

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

General Journal

Date
Account
Debit
Credit
Sep-15
Accumulated Depreciation
$5,600
Loss on abandonment of equipment
$1,400
Equipment
$7,000
To record abandonment of equipment

Intangibles are assets that have no physical existence. They are legal assets or accounting assets, such as copyrights, patents, trademarks or goodwill. We use a simple form of amortization, usually straight-line, to allocate the cost of these items to expenses.

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