Property, Plant and Equipment
Property, plant and equipment (also called tangible fixed assets) is a class of assets which have physical existence, which are held for a company’s internal use and which are expected to generate economic benefits for the company over more than one year.
There is hardly any business that do not require physical assets such as land, building, computers, vehicles, furniture, etc. Some require more physical assets and some require less. Industries or businesses requiring more fixed assets are called capital intensive, such as an oil refinery, a milk processing plant, etc. Those requiring less fixed assets but more labor are called labor intensive, such as an accounting firm, an event arrangement company, a bank, etc.
Expenditure incurred on purchase or construction of property, plant and equipment is called capital expenditure. Such an expenditure is capitalized which means that it is recorded on the balance sheet and written off as expense over the useful life of the fixed asset through a process called depreciation. This reduces the asset’s carrying amount on balance sheet.
Fixed assets are recognized by a company when it gains control over economic benefits generated from the assets. All fixed assets are recognized at their historical cost which is the reliable estimate of all costs that are necessary to bring it to its intended use. The capitalized cost of a fixed asset has different components depending on the class of asset:
- Cost of land includes: purchase price, transaction fees i.e. all legal fees, commissions, registration fees, etc. related to the purchase of land, cost of demolishing old buildings, etc.
- Cost of buildings includes: architect’s fee, building permit fee, construction contract price, excavation cost, etc.
- Cost leasehold improvement include: refurbishing, interior improvements, modifications, etc.
- Cost of plant: purchase price, labor cost, inspection cost, test run cost (less any profit on test run), etc.
Each fixed asset has a certain useful life, i.e. number of years for which the fixed asset is expected to generate economic benefits through continued use.
Salvage value (also called scrap value or residual value) is the expected value a fixed asset will have at the end of its useful life.
Fixed assets lose value as they get older due to wear and tear, obsolescence, etc. However, their value normally does not drop to zero even at the end of their useful life, because they normally have some secondary use or because the material used in the asset could be recycled into another fixed asset.
Since a fixed asset’s value will never drop below its salvage value, the amount that is charged to the income statement over the useful life of the asset is lower than its cost, this amount is called depreciable amount.
Depreciable amount = cost – salvage value
Since a fixed asset is expected to generate economic benefits over more than one period, the depreciable amount of the asset is written off over the useful life of the asset through a process called depreciation.
Depreciation expense is the amount subtracted from revenue in an accounting period on account of wear and tear, obsolescence, etc. of the asset.
Depreciation expenses = depreciable amount/useful life
Accumulated depreciation is a contra-asset account which accumulates total depreciation expense charged on a fixed asset over its useful life. It is subtracted from the cost of the asset to arrive at carrying value of the asset on the balance sheet.
Accumulated impairment losses
Sometimes a fixed asset may lose value which is not captured by the process of depreciation. For example in case of a fire or flood, a factory building may loose more than half of its value, which will result in recognition of impairment loss on the factory building. Such impairment losses are accumulated in ‘accumulated impairment loss account’ and subtracted from the cost of the asset.
Carrying value is the amount at which a fixed asset is presented on a balance sheet.
Carrying value = cost - accumulated depreciation - accumulated impairment losses
ZKB, Inc. recently purchased a milk-processing plant at a cost of $28 million. The cost included shipment to port of Gwadar. Freight for delivery of the plant components to the installation site amounted to $0.2 million. The installation contractor was paid an amount of $2 million which included all the costs related to installation, i.e. locally manufactured assembly components, labor, etc. The installation was completed on 10 April 2015. An independent firm carried out inspection at a cost of $0.5 million. Test run was conducted from 11 April 2015 to 30 April 2015 at a cost of $0.2 million. The test run production generated $0.1 million profit.
Calculate the amount at which the plant shall be capitalized on 1 May 2015.
The company charges depreciation on straight-line basis. The plant has a useful life of 10 years and salvage value of $3 million. Calculate the accumulated depreciation and carrying value at 30 April 2016 and 30 April 2017.
The cost at which the plant shall be recognized is calculated below:
|$ in million|
|Test run cost||0.2|
|Test run profit||(0.1)|
The recognition shall be made through the following journal entry:
|Accounts Payable||30.8 million|
Depreciable amount = cost – salvage value = 30.8 million – 3 million = $27.8 million
Depreciation for the first year = depreciable amount/useful life = $27.8 million/10 = $2.78 million
Accumulated depreciation at 30 April 2016 = $2.78 million
Carrying value at 30 April 2016 = $30.8 million - $2.78 million = 28.02 million
Depreciation for second year = $2.78 million
Accumulated depreciation at 30 April 2017 = $2.78 million + $2.78 million = $5.56 million
Carrying value at 30 April 2017 = $30.8 million - $5.56 million = $25.24 million