CHAPTER FIVE

Property, Plant, and Equipment (IAS 16)

Property, Plant & equipment:- are assets which are of a permanent nature used in the operation
of business, and not held for sale in the ordinary course of the business and are classified on the
balance sheet as plant assets. We can also call them as fixed asset used either alone or in various
combinations. Example: equipment, furniture, tools, machinery, building and land. Plant assets
are ordinarily expected to last more than a year even though there is no standard criterion as to
the minimum length of life.

5.1. Acquisition and disposition of property, plant and equipment

5.1.1 Characteristics of property plant and equipment.

The major characteristics of property, plant, and equipment are as follows:

1. They are acquired for use in operations and not for resale. Only assets used in normal
business operations are classified as property, plant, and equipment. For example, an
idle building is more appropriately classified separately as an investment.
2. They are long-term in nature and usually depreciated. Property, plant, and equipment
yield services over a number of years. Companies allocate the cost of the investment in these
assets to future periods through periodic depreciation charges. The exception is land, which
is depreciated only if a material decrease in value occurs, such as a loss in fertility of
agricultural land because of poor crop rotation, drought, or soil erosion.
3. They possess physical substance. Property, plant, and equipment are tangible assets
characterized by physical existence or substance. This differentiates them from intangible
assets, such as patents or goodwill. Unlike raw material, however, property, plant, and
equipment do not physically become part of a product held for resale.

5.1.2 Acquisition of property, plant, and equipment

Most companies use historical cost as the basis for valuing property, plant, and Equipment.
Historical cost measures the cash or cash equivalent price of obtaining the asset and bringing it to
the location and condition necessary for its intended use. The cost of an item of property, plant
and equipment comprises:
 Its purchase price; including duties and taxes, less trade discounts and rebates;
 Any costs directly attributable to bringing the asset to the location and condition
necessary for it to be capable of operating in the manner intended by management; and
 The initial estimate of the costs of dismantling and removing the items and restoring the
site on which it is located.
Cost of an asset = Sum of all the costs incurred to bring the asset to its intended
purpose, net of all discounts.
The cost of a plant asset is its purchase price plus taxes, purchase commissions, and all other
amounts paid to ready the asset for its intended use.

A. Cost of Land
Because land is a non-depreciable asset except some exceptional cases, costs assigned to it
should be those costs that directly relate to land’s unlimited life. Together with clearing and
grading costs, costs of removing unwanted structures from newly acquired land are considered
part of the cost to prepare the land for its intended use and are added to its purchase price.
Government assessments for water lines, sewers, roads, and other such items are considered part
of the land’s cost because maintenance of these items is the responsibility of the government;
thus, to the landowner, they have unlimited life. These types of improvements are distinguished
from similar costs for landscaping, parking lots, and interior sidewalks that are installed by the
owner and must be replaced over time. The improvements that owners are responsible for are
generally classified as land improvements and depreciated. Generally, land is accounted as non-
depreciable assets.
Example, Suppose Smart Touch needs property and purchases land for $50,000 with a note
payable for the same amount on August 1, 2011. Smart Touch also pays cash as follows:
 $4,000 in property taxes in arrears, $2,000 in transfer taxes, $5,000 to remove an old
building, and a $1,000 survey fee. What is the company’s cost of this land?
Purchase price of land ………………………………….$50,000
Add related costs:
Property taxes in arrears……………. $4,000
Transfer taxes…………………………… 2,000
Removal of building …………………….5,000
Survey fee………………………………….1, 000 12,000
Total cost of land………………………………… $62,000
The entry to record the purchase of the land on August 1, 2011, follows:
Land ……………….62, 000
Notes payable……………. 50,000
Cash ……………………….12, 000
Suppose Smart Touch then pays $20,000 for fences, paving, lighting, landscaping, and signs on
February 15, 2012. The following entry records the cost of these land improvements:
Land Improvements………… 20,000
Cash …………………………..20,000
Land and land improvements are two entirely separate assets. Recall that land is not
depreciated. However, the cost of land improvements is depreciated over that asset’s useful
life.
B. Cost of Buildings.
The cost of buildings should include all expenditures related directly to their acquisition or
construction. These costs include (1) materials, labor, and overhead costs incurred during
construction, and (2) professional fees and building permits. Generally, companies contract
others to construct their buildings. Companies consider all costs incurred, from excavation to
completion, as part of the building costs. But how should companies account for an old building
that is on the site of a newly proposed building? Is the cost of removal of the old building a cost
of the land or a cost of the new building? Recall that if a company purchases land with an old
building on it, then the cost of demolition less its salvage value is a cost of getting the land ready
for its intended use and relates to the land rather than to the new building. In other words, all
costs of getting an asset ready for its intended use are costs of that asset.
Cost of Equipment
The term ―equipment‖ in accounting includes delivery equipment, office equipment, machinery,
furniture and fixtures, furnishings, factory equipment, and similar fixed assets. The cost of such
assets includes the purchase price, freight and handling charges incurred, insurance on the
equipment while in transit, cost of special foundations if required, assembling and installation
costs, and costs of conducting trial runs. Any proceeds from selling any items produced while
bringing the equipment to the location and condition for its intended use (such as samples
produced when testing equipment) should reduce the cost of the equipment. Costs thus include
all expenditures incurred in acquiring the equipment and preparing it for use.
 Self-Constructed Assets
Occasionally, a building, machines or equipment may be constructed by a business enterprise for
its own use. Because, this method is an economic method of acquisition or the quality and
specifications of the assets may be controlled better if it’s self constructed. The cost of assets in
these situations includes,
 Materials and direct labor cost and
 Overhead can be handled in two ways:
1. Assign no fixed overhead. 2. Assign a portion of all overhead to the construction
process. Most Companies use the second method extensively
Companies can handle overhead in one of two ways:
1. Assign no fixed overhead to the cost of the constructed asset. The major argument for this
treatment is that overhead is generally fixed in nature. As a result, this approach assumes that the
company will have the same costs regardless of whether or not it constructs the asset. Therefore,
to charge a portion of the overhead costs to the equipment will normally reduce current expenses
and consequently overstate income of the current period. However, the company would assign to
the cost of the constructed asset variable overhead costs that increase as a result of the
construction.
2. Assign a portion of all overhead to the construction process. This approach, called a full-
costing approach, assumes that costs attach to all products and assets manufactured or
constructed. Under this approach, a company assigns a portion of all overhead to the construction
process, as it would to normal production. Advocates say that failure to allocate overhead costs
understates the initial cost of the asset and results in an inaccurate future allocation
Valuation of PP&E
Like other assets, companies should record property, plant, and equipment at the fair value of
what they give up or at the fair value of the asset received, whichever is more clearly evident.
However, the process of asset acquisition sometimes obscures fair value. For example, if a
company buys land and buildings together for one price, how does it determine separate values
for the land and buildings? We examine these types of accounting problems in the following
sections.
1. Cash Discounts
When a company purchases plant assets subject to cash discounts for prompt payment, how should it
report the discount? If it takes the discount, the company should consider the discount as a reduction in
the purchase price of the asset. But should the company reduce the asset cost even if it does not take the
discount? Two points of view exist on this question. One approach considers the discount— whether
taken or not—as a reduction in the cost of the asset. The rationale for this approach is that the real cost of
the asset is the cash or cash equivalent price of the asset. In addition, some argue that the terms of cash
discounts are so attractive that failure to take them indicates management error or inefficiency. With
respect to the second approach, its proponents argue that failure to take the discount should not always be
considered a loss. The terms may be unfavorable, or it might not be prudent for the company to take the
discount. At present, companies use both methods, though most prefer the former method.
2. Lump-Sum Purchases
Allocate the total cost among the various assets on the basis of their relative fair market values.
A company may pay a single price for several assets as a group a basket purchase for accounting,
the company must identify the cost of each asset. The total cost paid (100%) is divided among
the assets according to their relative sales or market values. This is called the relative-sales
value method.
Example: Suppose Smart Touch paid a combined purchase price of $100,000 on March 1, 2012,
for the land and building. An appraisal performed a month before the purchase indicates that the
land’s market (sales) value is $30,000 and the building’s market (sales) value is $90,000. It is
clear that Smart Touch got a good deal, paying less than fair market value, which is $120,000 for
the combined assets. But how will Smart Touch allocate the $100,000 paid for both assets?
First, figure the ratio of each asset’s market value to the total for both assets combined.
The total appraised value is $120,000.
Land market value + Building market value = Total market value
$30,000 + $90,000 = $120,000
1. The land makes up 25% of the total market value, and the building 75%, as follows:
Asset MV % of total value total purchase Cost of each
price asset

Land $30,000 $30,000/$120,000 $100,000 $25,000

= 25%
 Building 90,000 $90,000/$120,000 100,000 75,000
= 75%
Total $120,000 100% $100,000

For Smart Touch, the land cost $25,000 and the building cost $75,000.
Suppose Smart Touch paid by signing a note payable (deferred payments). The entry to record
the purchase of the land and building is as follows:

Land………………………., 25,000
Building…………………… 75,000
Notes payable …………………100,000
3. Issuance of Stock
When companies acquire property by issuing securities, such as common stock, the par
or stated value of such stock fails to properly measure the property cost. If trading of the
Stock is active; the market value of the stock issued is a fair indication of the cost of the
property acquired.
For example, Upgrade Living Co. decides to purchase some land for expansion of its carpeting
and cabinet operation. In lieu of paying cash for the land, the company issues to Deed land
Company 5,000 shares of common stock (par value $10) that have a fair market value of $12 per
share. Upgrade Living Co. records the following entry.
Land (5,000 _ $12) ………….60, 000
Common Stock ……………………… 50,000
Paid-In Capital in Excess of Par ……...10,000
If the company cannot determine the market value of the common stock exchanged,
it establishes the fair value of the property. It then uses the value of the property as the
basis for recording the asset and issuance of the common stock.
B. Exchanges of Nonmonetary Assets
Companies should recognize immediately any gains or losses on the exchange when the
transaction has commercial substance.
Exchange has commercial substance if the future cash flows change as a result of the
transaction. That is, if the two parties’ economic positions change, the transaction has
commercial substance. Companies should not value assets at more than their cash equivalent
price; if the loss were deferred, assets would be overstated.
Illustration: Information Processing, Inc. trades its used machine for a new model at Jerrod
Business Solutions Inc. The exchange has commercial substance. The used machine has a book
value of $8,000 (original cost $12,000 less $4,000 accumulated depreciation) and a fair value of
$6,000. The new model lists for $16,000. Jerrod gives Information Processing a trade-in
allowance of $9,000 for the used machine. Information Processing computes the cost of the new
asset as follows. Information Processing records this transaction as follows:
Equipment …………………………………………13,000
Accumulated Depreciation—Equipment 4,000
Loss on Disposal of Equipment …………. 2,000
Equipment ……………………………. 12,000
Cash …………………………………………………..7,000
Loss on Disposal

Exchanges—Gain Situation
Has Commercial Substance. Company usually records the cost of a nonmonetary asset
acquired in exchange for another nonmonetary asset at the fair value of the asset given up, and
immediately recognizes a gain.
Illustration: Interstate Transportation Company exchanged a number of used trucks plus cash
for a semi-truck. The used trucks have a combined book value of $42,000 (cost $64,000 less
$22,000 accumulated depreciation). Interstate’s purchasing agent, experienced in the secondhand
market, indicates that the used trucks have a fair market value of $49,000. In addition to the
trucks, Interstate must pay $11,000 cash for the semi-truck. Interstate computes the cost of the
semi-truck as follows.

Interstate records the exchange transaction as follows

Truck (semi) ……………………………….60,000
Accumulated Depreciation—Trucks 22,000
Trucks (used)…………………………………..64,000
Gain on Disposal of Truck…………………..7,000
Cash ……………………………………………11,000
5.1.3 Cost subsequent to acquisition
After installing plant assets and readying them for use, a company incurs additional costs that
range from ordinary repairs to significant additions. The major problem is allocating these costs
to the proper time periods. In determining how costs should be allocated subsequent to
acquisition, companies follow the same criteria used to determine the initial cost of property,
plant, and equipment. That is, they recognize costs subsequent to acquisition as an asset when the
costs can be measured reliably and it is probable that the company will obtain future economic
benefits. Evidence of future economic benefit would include increases in (1) useful life, (2)
quantity of product produced, and (3) quality of product produced. Generally, companies incur
four types of major expenditures relative to existing assets.

Additions-Additions should present no major accounting problems. By definition, companies

capitalize any addition to plant assets because a new asset is created. For example, the addition
of a wing to a hospital, or of an air conditioning system to an office, increases the service
potential of that facility. Companies should capitalize such expenditures and match them against
the revenues that will result in future periods. One problem that arises in this area is the
accounting for any changes related to the existing structure as a result of the addition. Is the cost
incurred to tear down an old wall, to make room for the addition, a cost of the addition or an
expense or loss of the period? The answer is that it depends on the original intent. If the company
had anticipated building an addition later, then this cost of removal is a proper cost of the
addition. But if the company had not anticipated this development, it should properly report the
removal as a loss in the current period on the basis of inefficient planning. Conceptually, the
company should remove the cost of the old wall and related depreciation and record a loss. It
should then add the cost of the new wall to the cost of the building. In these situations, it is
sometimes impracticable to determine a reasonable carrying amount for the old wall. Companies
therefore assume the old asset to have a zero carrying amount and simply add the cost of the
replacement to the overall cost.
Improvements and Replacements -Companies substitute one asset for another through
improvements and replacements. What is the difference between an improvement and a
replacement? An improvement (betterment) is the substitution of a better asset for the one
currently used (say, a concrete floor for a wooden floor). A replacement, on the other hand, is the
substitution of a similar asset (a wooden floor for a wooden floor). Many times, improvements
and replacements result from a general policy to modernize or rehabilitate an older building or
piece of equipment. The problem is differentiating these types of expenditures from normal
repairs. Does the expenditure increase the future service potential of the asset? Or, does it merely
maintain the existing level of service? Frequently, the answer is not clear-cut. Good judgment is
required to correctly classify these expenditures. If the expenditure increases the future service
potential of the asset, a company should capitalize it. The company should simply remove the
cost of the old asset and related depreciation and recognize a loss, if any. It should then add the
cost of the new substituted asset.
Rearrangement and Reorganization As indicated earlier, a company may incur rearrangement
or reorganization costs for some of its assets. The question is whether the costs incurred in this
rearrangement or reorganization are capitalized or expensed. IFRS indicates that the recognition
of costs ceases once the asset is in the location and condition necessary to begin operations as
management intended. As a result, the costs of reorganizing or rearranging existing property,
plant, and equipment are not capitalized but are expensed as incurred.
Repairs -ordinary Repairs A company makes ordinary repairs to maintain plant assets in
operating condition. It charges ordinary repairs to an expense account in the period incurred on
the basis that it is the primary period benefited. Maintenance charges that occur regularly include
replacing minor parts, lubricating and adjusting equipment, repainting, and cleaning. A company
treats these as ordinary operating expenses. It is often difficult to distinguish a repair from an
improvement or replacement. The major consideration is whether the expenditure benefits more
than one year or one operating cycle, whichever is longer. If a major repair (such as an overhaul)
occurs, several periods will benefit. A company should generally handle this cost as an
improvement or replacement.
Accountants divide spending made on plant assets into two categories:
● Capital expenditures
● Expenses (Revenue expenditures)
Capital expenditures are an outlay that will provide a benefit beyond the current period;
recorded as an asset (or debited to an asset account) because they;
● increase the asset’s capacity or efficiency, or
● extend the asset’s useful life.
Examples of capital expenditures include the purchase price plus all the other costs to bring an
asset to its intended use, as discussed in the preceding sections. Also, an extraordinary repair is a
capital expenditure because it extends the asset’s capacity or useful life. An example of an
extraordinary repair would be spending $3,000 to rebuild the engine on a five-year-old truck.
This extraordinary repair would extend the asset’s life past the normal expected life. As a result,
its cost would be debited to the asset account for the truck as follows:
Truck……………………..3,000
Cash ……………………………. 3,000
Revenue expenditures are benefits only the current period and charged to expense account, such
as repair or maintenance expense. Examples include the costs of maintaining equipment, such as
repairing the air conditioner on a truck, changing the oil filter, and replacing its tires. These
ordinary repairs are debited to Repairs and maintenance expense, as shown in the following
example, when the tires were replaced for $500:
Repairs and maintenance expense ………………….500
Cash ……………………………………500
5.1.4. Disposition of property, plant and equipment
A company may retire plant assets voluntarily or dispose of them by sale, exchange, involuntary
conversion and abandonment.
Fixed assets that are no longer useful may be discarded or sold. In such cases, the fixed asset is
removed from the accounts. Just because a fixed asset is fully depreciated, however, does not
mean that it should be removed from the accounts. If a fixed asset is still being used, its cost and
accumulated depreciation should remain in the ledger even if the asset is fully depreciated. This
maintains accountability for the asset in the ledger. If the asset was removed from the ledger, the
accounts would contain no evidence of the continued existence of the asset. In addition, cost and
accumulated depreciation data on such assets are often needed for property tax and income tax
reports.
Disposal (or Discarding) Fixed Assets
If a fixed asset is no longer used and has no residual value, it is discarded. The disposal of a
depreciable asset usually requires two journal entries:
1. An adjusting entry to update the depreciation expense and accumulated depreciation accounts.
2. An entry to record the disposal. The cost of the asset and any accumulated depreciation at the
date of disposal must be removed from the accounts.
To illustrate, assume that equipment acquired at a cost of $25,000 is fully depreciated at
December 31, 2011. On February 14, 2012, the equipment is discarded. The entry to record the
discard is as follows:
Accumulated Depreciation—Equipment ……………….25, 000
Equipment ………………………………… 25,000
If an asset has not been fully depreciated, depreciation should be recorded before removing the
asset from the accounting records.
Selling Fixed Assets
The entry to record the sale of a fixed asset is similar to the entries for discarding an asset. The
only difference is that the receipt of cash is also recorded. The difference between any cash
received on disposal of an asset and its book value at the date of disposal is treated as a gain or
loss on the disposal of the asset.
Assume that at the end of year 17, Southwest sold an aircraft that was no longer needed because
of the elimination of service to a small city. The aircraft was sold for $11 million cash. The
original cost of the flight equipment of $30 million was depreciated using the straight-line
method over 25 years with no residual value ($1.2 million depreciation expense per year). The
last accounting for depreciation was at the end of year 16.
Cash received …………………………………………………………………$11,000,000
Original cost of flight equipment ……………..$30,000,000
Less: Accumulated depreciation……………….. ($1,200,000 × 17 years) 20,400,000
Book value at date of sale ……………………………………………………….9,600,000
Gain on sale of flight equipment…………………………………………………………………$1,400,000
Depreciation expense must be recorded for year 17 before the entry for selling of the aircraft to
update the accumulated depreciation and depreciation expense.
Update depreciation expense for year 17:
Depreciation Expense ……………..1,200,000
Accumulated Depreciation………………….. 1,200,000
2. Record the sale:
Cash …………………………… 11,000,000
Accumulated Depreciation…….. 20,400,000
Flight Equipment……………………………………….. 30,000,000
Gain on Sale of Assets ……………………………………1,400,000
If the asset sold at book value there will not be record as gain or loss. However, if the aircraft
sold at an amount below its book value loss on sale of plant assets has debit balance.
Exchanging Fixed Assets
The general principle in exchanging asset is that the cost of a nonmonetary asset acquired in
exchange for another nonmonetary asset is the fair value of the asset surrendered. A gain or loss
is recognized on the exchange as the difference between the fair value of the asset surrendered
and its book value. When boot (monetary consideration) is given or received, the cost of the asset
acquired and the gain or loss in a nonmonetary exchange generally is determined by these
equations:
Cost of Asset Acquired = Fair Value of asset surrendered + Boot Paid or – Boot Received
Gain (Loss) = Fair Value of Asset Surrendered – Book Value of Asset Surrendered
Exchange of Dissimilar Assets
Dissimilar assets are assets that are not of the same general type, do not perform the same
function, and are not employed in the same line of business. All gains and losses are recognized
in full.
To illustrate, assume that ABC Company acquired equipment from XYZ Company in exchange
for building. The building cost $200,000, has a book value of $ 50,000, and has a market value
of $ 45,000. The equipment has cost of $150,000 and book value of $30,000 on XYZ’s books.
The fair value of the equipment is $40,000.
Required: prepare journal entries for both companies under the following cases:
1. No Boot received and Boot paid
2. ABC Company has Boot received of $10,000
3. ABC Company has Boot paid of $7,000
Case 1: No Boot
ABC Company XYZ Company
Equipment …………………45,000 Building …………………40,000
Accumulated Depreciation 150,000 Accumulated Depreciation……120,000
Loss ($45,000 – $50,000)….. 5,000 Equipment………… 150,000
Building…………… 200,000 Gain ($40,000 – $30,000)….10,000
Case 2: $10,000 Boot Received
ABC Company XYZ Company
Equipment………………. 35,000 Building …………50,000
Accumulated Depreciation 150,000 Accumulated Depreciation…………120,000
 Cash ………….. 10,000 Equipment ……..150,000
Loss ($45,000 – $50,000) ….5,000 Cash …………….10,000
Building ………………………200,000 Gain ($40,000 – $30,000)…10,000
Case 3: $7,000 Boot Paid
ABC Company XYZ Company
Equipment ……………… 52,000 Building ……………… 33,000
Accumulated Depreciation 150,000 Accumulated Depreciation .120,000
Loss ($45,000 – $50,000) …..5,000 Cash ……………… 7,000
Building …… 200,000 Equipment …….. 150,000
Cash ………………… 7,000 Gain ($40,000 – $30,000) ……..10,000
Exchange of Similar Assets
Similar assets are of the same general type, perform the same functions, and are used in the same
line of business. Loss is recognized in full, irrespective of whether boot is received or paid.
However, because of the conservatism convention, no gain is recognized on the disposal of the
original asset, and the newly acquired asset records at the book value of the asset surrendered.
When boot is involved in the exchange, it should recognize a gain in proportion to the boot
received for the reason that the earning process is complete to the extent that boot received. If
boot is paid, the gain is not recognized. Furthermore, if the boot is equal to or exceeds 25% of
the value of the exchange, the exchange is monetary and gain is recognized. Then, the special
rules discussed here do not apply and the exchange is recorded at fair value by both the recipient
and the payer of boot. That is, deferral or partial recognition of a gain occur only when the
exchange is nonmonetary, which means that the boot received must be less than 25% of the total
value of the exchange.
When the fair value of the asset being surrendered is less than the book value, the following
equation applies to record the exchange of similar assets and the boot is less than 25% of the
market value of the exchange:
Cost of asset acquired = Fair Value of asset surrendered + Boot Paid or – Boot Received
When the fair value of the asset being surrendered is greater than the book value, the following
equations apply:
Cost of asset acquired = Book Value of asset surrendered + Boot Paid Or
Cost of asset acquired = BV of asset surrendered – Boot Received + Gain recognized
Gain = Boot (FV of asset surrendered – BV of asset surrendered) (or Gain)
Boot + FV of asset acquired
Note: FV = Fair Value BV = Book Value
Example:
Scenario I: Exchange of similar assets: No Boot
Company A Company B
Cost of equipment surrendered ………………..$100,000 …………….$60,000
Accumulated Depreciation…………………………54,000 ………………32,000
Fair Value of equipment surrendered ………………40,000 …………… 40,000
 Company A Company B
Equipment ……………………40,000 Equipment …... 28,000
Accumulated Depreciation 54,000 Accumulated Depreciation …32,000
Loss ($40,000 – $46,000)…. 6,000 Equipment ………………60,000
Equipment ……100,000
Scenario II: Exchange of similar assets: Boot Received by company incurring a Loss and
Paid by company incurring a Gain.

Company A Company B
Cost of equipment surrendered ……………………….$100,000 …………..$60,000
Accumulated Depreciation ………………………………54,000 ……………32,000
Fair Value of equipment surrendered ……………………40,000 …………..35,000
Cash received (paid) ………………………………………5,000 …………...(5,000)
Company A Company B
Equipment ($40,000 – 5,000)….. 35,000 Equipment ($28,000 – $5,000)33,000
Accumulated Depreciation ………54,000 Accumulated Depreciation ...32,000
Loss ($40,000 – $46,000)………… 6,000 Equipment….. 60,000
Cash ……………………………5,000 Cash ………….5, 000
Equipment ……………………….100, 000
Scenario III: Exchange of similar assets: Boot Received by company incurring a Gain and
Paid by company incurring a Loss
Company A Company B
Cost of equipment surrendered ………………… $100,000 ……………….$60,000
Accumulated Depreciation …………………………80,000 ………………….32,000
Fair Value of equipment surrendered ………………30,000 ………………….27,000
Cash received (paid) …………………………………3,000 …………………..(3,000)
Company A Company B
Equipment……………… ….18,000 Equipment ($27,000 + $3,000)…30,000
Accumulated Depreciation 80,000 Accumulated Depreciation …….32, 000
Cash ……………………… 3,000 Loss ($27,000 - $28,000) …………1,000
Equipment………………… 100,000 Equipment ………………………60,000
Gain …………………………….1,000 Cash …………………………..3,000
Equipment = ($20,000 – 3,000 + 1,000) = 18,000
Gain = Boot × (FV – BV) of asset surrendered
Boot + FV of asset acquired
= $3,000 × ($30,000 - $20,000) = $1,000
$3,000 + $27,000
5.2 Deprecation, impairments and revaluation
Over time, fixed assets, with the exception of land, lose their ability to provide services. Thus,
the costs of fixed assets such as equipment and buildings should be recorded as an expense over
their useful lives. This periodic recording of the cost of fixed assets as an expense is called
depreciation. Because, land has an unlimited life, it is not depreciated except some
circumstances. Depreciation is not a process of valuation. Businesses do not record depreciation
based on changes in the asset’s market (sales) value. Depreciation is recapturing the cost
invested in the asset. Depreciation does not mean that the business sets aside cash to replace an
asset when it is used up. Depreciation has nothing to do with cash.
Depreciation of a plant asset is based on three main factors: These are
a) Initial cost b) Useful (service life) c) Residual value

a) Initial cost: It includes all expenditures necessary to get the asset in place and ready for use.
b) Expected useful life: It is the length of service the business expects from the asset. It may be
expressed in years, units of output, miles or other measures. For example the useful life of the
building is stated in years. The useful life of a bookbinding machine may be stated as a number
of books the machine is expected to bind that is its expected output. A reasonable measure of a
delivery trucks useful life is the total number of miles the truck is expected to travel. Companies
base such estimates on past experience and information from industry trade magazines and
government publication.

C) Estimated residual value: is also called scrap value, salvage value, or trade in value. It is the
expected cash value of the asset at the end of its useful life. In other words it is the part of the
asset’s cost that the company expects to be returned at the end of assets useful life.
Note:-
a. In computing depreciation, residual value is not depreciated because the business
expects to receive this amount from disposal of asset.
b. The full cost of plant asset is depreciated if the asset expected to have no residual value.
c. Depreciable cost-It is a cost that will be spread over the assets useful life as
depreciationexpense.
Depreciable cost =plant asset cost – residual value

We assume that all assets placed in or taken out of service during the first half of a month is
treated as if the event occurred on the first day of that month. Likewise, all fixed asset additions
and deductions during the second half of a month are treated as if the event occurred on the first
day of the next month.

 Depreciation methods
Four basic methods exist for computing depreciation; a) Straight Line , b) Units of depreciation
, c) Declining balance method,

1) Straight-Line Method
Under this method, depreciation is the same for each year of the assets useful life .It is measured
solely by the passage of time .In order to compute depreciation expense; it is necessarily to
determine depreciable cost. Depreciable cost is then divided by the assets useful life to determine
depreciation expense.

Assets cost __ Salvage value = Depreciable cost

Depreciable cost / Useful life =Annual Depreciation Expense

Example: The computations in this section use information about a machine that inspects
athletic shoes before packaging. Manufacturers such as Converse, Reebok, Adidas, and Fila use
this machine. Data for this machine are

If this machine is purchased on December 31, 2010, and used throughout its predicted useful life
of five years, the straight-line method allocates an equal amount of depreciation to each of the
years 2011 through 2015. We make the following adjusting entry at the end of each of the five
years to record straight-line depreciation of this machine.

Dec. 31 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . .1,800

Accumulated Depreciation—Machinery . . . . . . . . 1,800

To record annual depreciation

The $1,800 Depreciation Expense is reported on the income statement among operating
expenses. The $1,800 Accumulated Depreciation is a contra asset account to the Machinery
account in the balance sheet

We also can compute the straight-line depreciation rate, defined as 100% divided by the number
of periods in the asset’s useful life. For the inspection machine, this rate is 20% (100% /5, or 1/5
per period). We use this rate, along with other information, to compute the machine’s straight-
line depreciation
2. Units-of-Production Method

The straight-line method charges an equal share of an asset’s cost to each period. If plant assets
are used up in about equal amounts each accounting period, this method produces a reasonable
matching of expenses with revenues. However, the use of some plant assets varies greatly from
one period to the next. A builder, for instance, might use a piece of construction equipment for a
month and then not use it again for several months. When equipment use varies from period to
period, the units- of-production depreciation method can better match expenses with revenues.
Units-of production depreciation charges a varying amount to expense for each period of an
asset’s useful life depending on its usage.

A two-step process is used to compute units-of-production depreciation. We first compute

depreciation per unit by subtracting the asset’s salvage value from its total cost and then dividing
by the total number of units expected to be produced during its useful life. Units of production
can be expressed in product or other units such as hours used or miles driven. The second step is
to compute depreciation expense for the period by multiplying the units produced in the period
by the depreciation per unit. Assume 7000 shoes are expected to be sold at first year
3. Double Declining-Balance Method

An accelerated depreciation method yields larger depreciation expenses in the early years of an
asset’s life and less depreciation in later years. The most common accelerated method is the
declining-balance method of depreciation, which uses a depreciation rate that is a multiple of the
straight-line rate and applies it to the asset’s beginning-of-period book value. The amount of
depreciation declines each period because book value declines each period. A common
depreciation rate for the declining-balance method is double the straight-line rate. This is called
the double-declining-balance (DDB) method. This method is applied in three steps: (1) compute
the asset’s straight-line depreciation rate, (2) double the straight-line rate, and (3) compute
depreciation expense by multiplying this rate by the asset’s beginning-of-period book value

The three-step process is to (1) divide 100% by five years to determine the straight-line rate of
20%, or 1/5, per year, (2) double this 20% rate to get the declining-balance rate of 40%, or 2/5,
per year, and (3) compute depreciation expense as 40%, or 2/5, multiplied by the beginning-of-
period book value

The double-declining-balance depreciation schedule is shown in the schedule follows the

formula except for year 2015, when depreciation expense is $ 296.

This $296 is not equal to 40% * $,296, or $518.40. If we had used the $518.40 for depreciation
expense in 2015, the ending book value would equal $777.60, which is less than the $1,000
salvage value. Instead, the $1,296 is computed by subtracting the $1,000 salvage value from the
$,296 book value at the beginning of the fifth year (the year when DDB depreciation cuts into
salvage value)