Plant, Property & Equipment (Long-Term Assets)
When a firm puts PP&E on the balance sheet it is said to be capitalized, because it is believed that PP&E is to generate future revenues. As the firm realizes the benefits from the PP&E, the cost of the PP&E is transfered from the balance sheet to the income statement in the form of depreciation expense. Therefore depreciation is consistent with the matchine principle of accounting.
The matching principle is a fundamental concept in accrual accounting that requires revenues and their associated expenses to be recognized in the same accounting period. This principle ensures that the financial statements provide a more accurate and consistent representation of a company's financial performance.
PP&E Account
The BASE equation for accounting for changes in PP&E is:
\[ \begin{aligned} \text{Begin Balance} &+ \text{Capital Expenditure} \\ &- {\text{Gross Value Sold or Disposed}} \\ &= \text{End Balance (assuming no Impairment)} \end{aligned} \]The PP&E account is an asset account on the balance sheet. To account for a PP&E transaction, the following four questions must be answered:
- What is the acquisition cost?
- How much is the estimated salvage value?
- What is the expected useful life?
- What is the depreciation pattern (e.g. straight-line vs. accelerated)?
The first two items above account for the amount that will be depreciated and the last two account for how the amount will be depreciated over time.
The useful life is independent of the physical life of the asset. In general, the longer the useful life, the lower the salvage value.
Most firms use straight-line depreciation for accounting purposes and accelerated depreciation for tax purposes.
The straight-line method of depreciation expense per period (usually a year) is calculated as:
\[ \text{Depreciation expense per year} = \frac{\text{Acquisition Cost} - \text{Salvage Value}}{\text{Estimated Useful Life}} \]The \(\text{Acquisition Cost} - \text{Salvage Value}\) is known as the \(\text{Depreciation Base}\).
Then each year this value is added to the Accumulated Depreciation account on the balance sheet (a contra asset account) and subtracted from the retained earnings account. This expense then also shows up on the income statement as depreciation expense.
A contra asset account is used to record reductions in the value of an asset.
The purpose of depreciation is to match the cost of assets with the benefit they provide in each period.
Accumulated Depreciation Account
\[ \begin{aligned} \text{Begin Balance} &+ \text{Depreciation Expenses} \\ &- {\text{Accumulated Depreciation of Disposed Assets}} \\ &= \text{End Balance } \end{aligned} \]When a Company Changes its Depreciation Policy
If a company decides to change the depreciation policy by changing the useful life and the salvage value, they can reassess the salvage value and then recalculate the per-period depreciation expense going forward as:
\[ \frac{\text{Net book value} - \text{Salvage value}}{\text{Estimated useful life}} \]Sale of an Asset
When the company decides to sell the asset, they calculate the Net Book value or just Book value which is equal to the Gross value or Historical Cost less the Accumulated Depreciation. Then the sales gain/loss is calculated as Sale Price less Net Book Value.
Gain or Loss on Sale formula:
\[ \begin{aligned} &\text{Gain or Loss on Sale}\\ &=\text{Sales Price} - \text{Book Value}\\ &=\text{Sales Price} - (\text{Gross PP&E} - \text{Accumulated Depreciation})\\ &= \text{Accumulated Depreciation} - (\text{Gross PP&E} - \text{Sales Price})\\ &= \text{Accounting Depreciation} - \text{Economic Depreciation}\\ \end{aligned} \]If a company were to manipulate depreciation to make it aPP&Ear they had more or less net income, it could be construed as "cooking the books". Although, there are many legitimate reasons that a company may change how it is accounting for depreciation that are not nefarious.
It can be seen that if a company consistently depreciates assets by too conservatively (choosing to accumulate depreciation more slowly), then the book value of their assets will be higher than the market value of the assets at the end of the lifetime of the asset and they will consistently show losses on sale of assets.
If a company consistently depreciates assets by too aggressively (accumulating depreciation expense at a faster rate), then their book value will be lower than the net salvage value will be below the market value and they will consistently have gains on sales of assets.
Recording the Sale of an Asset Transaction
If the proceeds from the sale are higher than the book value (also known as carrying amount), a gain is recognized; conversely, if the proceeds are lower, a loss is recorded. This gain or loss is typically reported as a separate line item in the income statement, either as 'gain on sale of PP&E' or 'loss on sale of PP&E,' respectively. The recognition of these gains or losses helps provide a comprehensive view of a company's financial performance and the efficiency of its asset management.
The cost or gross value of the asset is then subtracted from the PP&E account and the accumulated depreciation is removed from the Accumulated Depreciation account. Any gain or loss is then added to the Retained Earnings account.
Asset Impairment
When we decide that the book value of an asset is worth more than the market value of the asset, we can impair the asset. This is done by making an impairment entry in the Accumulated Depreciation account that effectively reduces the net book value of the asset.
In an impairment transaction, the amount is added to the depreciation account and subtracted from the retained earnings account.
Depreciation has been called an "unattractive expense" because the asset is paid for in advance and then only expensed over the years as the asset provides value.
PP&E Impact on Financial Statements
- The income statement contains depreciation expense.
- The balance sheet contains accumulated depreciation. When a transaction adds to accumulated depreciation it is offset by subtracting the same amount from retained earnings.
- The balance sheet contains PP&E as an asset.
- Depreciation does not affect the statement of cash flows. It is however added back to net income in the statement of cash flows to determine cash flow from operations since depreciation is a non-cash expense.
- Cash from purchase and sale of PP&E is generally recorded on the statement of cash flows under the investing section.
Conclusion
We explored PP&E, which are long-term assets vital for businesses to produce goods and services. We discussed the four key questions to account for PP&E, including acquisition cost, estimated salvage value, expected useful life, and depreciation pattern.
We addressed the potential changes in a company's depreciation policy and the consequences of manipulating depreciation to alter net income. Recognizing the difference between accounting depreciation and economic depreciation is essential for evaluating a company's financial performance and its gains or losses on the sale of assets.
Lastly, we touched upon asset impairment, which occurs when the book value of an asset is worth more than its market value. This concept is important to understand as it affects the net book value of the asset, and consequently, the financial statements.
A comprehensive understanding of inventory, PP&E, depreciation, and asset impairment is crucial for businesses and investors alike. These concepts impact financial statements and play a significant role in evaluating a company's financial health. By having a solid grasp of these aspects, stakeholders can make better decisions and contribute to the growth and success of a company.