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Ch. 9: Property, Plant, & Equipment 1

Chapter 9Property, Plant, and Equipment

In this chapter you will learn how property, plant, and equipment affect businesses, how they are controlled, accounted for, and reported in financial statements.

What Are Property, Plant, and Equipment?

Property, plant, and equipment are resources with lives longer than one year, used in normal business operations, and which provide benefits through their physical form. Examples of property, plant, and equipment owned by merchandising companies are automobiles used by salespersons, delivery trucks, buildings in which stores operate, land (on which buildings are located), office furniture and equipment (such as desks, chairs, and computers), and store equipment (such as lights, display counters, and sales terminals).

Property, plant, and equipment are major parts of a large category of resources known as long-lived assets. As the name implies, long-lived assets are resources with lives greater than one year. Other long-lived assets that are not considered property, plant, and equipment are investments and intangible assets. Investments are resources owned primarily for their expected increase in value. For example, a company might purchase shares of stock of another company with the hope the stock price will increase. Other examples of investments are land or buildings held for resale, not held for use in the company.

Because property, plant, and equipment provide benefits through their physical form, they are examples of tangible assets. Some long-lived assets, such as copyrights, trademarks, and patents, are valuable because they provide legal benefits, not physical benefits. For example, you cannot drive around town in a copyright, but it does protect your company from other companies selling computer software your company developed. Resources that provide benefits in non-physical form are called intangible assets.

In terms of the accounting equation, property, plant, and equipment are assets, as shown below. The numbers in parentheses refer to the chapters in which the items are discussed.

AssetsCurrent AssetsCash and cash equivalents (6)Accounts receivable (7)Allowance for Uncollectible Accounts (7)

Merchandise inventory (8)Property, plant, and Equipment (9)

= Liabilities + Stockholders' EquityRevenuesSales (7)Sales Returns & Allowances (7)

Cost of Goods Sold (8)Operating ExpensesUncollectible Accounts Expense (7)

Bank Service Expense (6)Other Revenues & ExpensesInterest Revenue (6)Interest Expense (6)

The amount of property, plant, and equipment differs from company to company. For example, Exxon Mobil, the largest oil and gas company in the United States, reported property, plant, and equipment of $139 billion on December 31, 2009. This $139 billion was approximately 60% of Exxon Mobil’s December 31, 2009 total assets. Royal Dutch Shell, the largest oil and gas company outside of the United States, reported property, plant, and equipment of $132 billion on

2 Ch. 9: Property, Plant, & Equipment

December 31, 2009. The $132 billion was approximately 45% of Royal Dutch Shell’s December 31, 2009 total assets. One year earlier, on December 31, 2008, Exxon Mobil’s property, plant, and equipment were $121 billion or approximately 53% of Exxon Mobil’s total assets.

The Nature of Property, Plant, and Equipment

Property, plant, and equipment present difficulties for managers because they are often quite large in dollar amount and because they affect more than one accounting period. The large dollar amounts of property, plant, and equipment require managers to exercise much care before investing in such resources. For example, Exxon Mobil spent more than $57 billion on property, plant, and equipment during the three years ended December 31, 2009. To put this is perspective, consider during this three-year time period Exxon Mobil's net income was approximately $108 billion. Thus, Exxon Mobil invested in property, plant, and equipment more than 50% of all additional resources its management generated through operating the company in the three years. When management makes decisions involving such large dollar amounts, they must be very careful because the resources cannot be quickly generated through operations. If the property, plant, and equipment purchases prove to be mistakes, the company may have to operate for several years to recover the dollar amounts lost through poor decisions.

A second difficulty presented by property, plant, and equipment is that as they are used up, the dollar amount used up in a given period must be reported as an expense on that period's income statement, similar to the manner in which supplies expense and insurance expense must be reported. This requires managers to be able to measure the amount of the asset used up in any given period. Measuring the dollar amount of property, plant, and equipment used up is much more difficult than measuring the amount of supplies or prepaid insurance used up. For example, it is relatively easy to determine the amount of insurance Target used up in a year. This dollar amount is specified in the insurance contracts Target negotiated with its insurance companies. On the other hand, to determine the dollar amount of a Target store that has been "used up" in a year may be very difficult. Even though you know the building will eventually wear out or become too inefficient to be used, it is virtually impossible to determine how much of the wear and tear or obsolescence is due to any specific year. These and other accounting issues arising as a result of owning property, plant, and equipment will be explored in this chapter.

Sources of Property, Plant, and Equipment

There are two primary sources of property, plant, and equipment. First, companies convert some of their other resources into property, plant, and equipment. For example, after a company collects cash for its accounts receivable, it could use some cash to purchase a sales terminal, computer, desk, or delivery truck. Secondly, companies borrow cash and use it to acquire property, plant, and equipment. For example, a company could borrow $10,000,000 from a bank and use the cash to buy land and a building. Of course, it is also possible for companies to acquire property, plant, and equipment by obtaining cash from owners and then using the cash to obtain property, plant, and equipment. Although possible, this source is not nearly as common as companies converting other resources into property, plant, and equipment or borrowing cash to acquire them.

Converting other resources into property, plant, and equipment When a company converts one or more resources into property, plant, and equipment, the effect on


the company is its total resources and total sources of resources remain unchanged. For example, consider the effect of a company using $25,000 cash to purchase a delivery truck. The purchase of the delivery truck increases the company's resources (assets) by $25,000. On the other hand, the company's cash payment decreases its resources by $25,000. Thus, the company's total resources remain unchanged, as shown below.

Total Resources

=Sources of Borrowed Resources

+Sources of

Owner Invested Resources

+Sources of

Management Generated Resources

Assets = Liabilities + Stockholders' Equity+ $25,000- $25,000

At the time the company receives the truck and pays for it, it would record an increase in the long-lived asset, Delivery Trucks, and a decrease in its cash resource. If you remember assets increase with debits and a journal entry must have debits equal to credits, the process of recording the delivery truck purchase is quite simple, as shown below.

Date DescriptionPostingRef. Debits Credits

Dec. 2 Delivery Trucks 171 25,000Cash 111 25,000

Delivery truck purchase

In actual business practice, companies use various account names for recording property, plant, and equipment, such as a delivery truck. Other common account names include transportation equipment, autos and trucks, and delivery equipment.

Borrowing resources to acquire property, plant, and equipment Due to the large dollar amounts often required for the purchase of property, plant, and equipment, most companies borrow cash to buy such assets. The cash is usually borrowed for many years. Hopefully, the property, plant, and equipment will generate more than enough cash to allow the companies to repay the amount borrowed and still have enough cash left for the companies to use for other purposes. This is one way companies increase their resources over time.

As will be explained in detail in Chapter 11, cash is often borrowed for long periods of time through companies issuing bonds. When companies issue bonds, they receive cash resources. Since the source of the cash was borrowing, bonds represent liabilities to the issuing company. For example, if a company borrows $10,000,000 cash by issuing $10,000,000 in bonds, the company's resources (cash) would increase by $10,000,000 and its sources of resources (bonds payable) would also increase by $10,000,000, as seen below.

Total Resources


+Sources of


+Sources of


Assets = Liabilities + Stockholders' Equity+ $10,000,000 = + $10,000,000

At the time the company receives the cash, it would record an increase in cash and an increase in its liability bonds payable. Since assets increase with debits and a journal entry must have debits equal to credits, the process of recording the receipt of cash is quite simple, as shown below.



Dec. 9 Cash 111 10,000,000Bonds Payable 221 10,000,000Issue of long-term bonds

If the company uses the $10,000,000 cash to buy land of $500,000 on which a $9,500,000 building is located, the company's total resources would remain unchanged: some resources would increase while cash resources would decrease, as shown below.

Total Resources


+Sources of


+Sources of


Assets = Liabilities + Stockholders' Equity+ $500,000

+ $9,500,000- $10,000,000

At the time the company buys the land and building and pays cash, it would record an increase in land, an increase in buildings, and a decrease in cash. Again remembering assets increase with debits and a journal entry must have debits equal to credits, the process of recording the purchase of the land and building is quite simple, as shown below.


Dec. 10 Land 151 500,000Buildings 161 9,500,000

Cash 111 10,000,000Land and building purchase

Borrowing resources to acquire property, plant, and equipment: leasing An increasingly popular source of property, plant, and equipment is leasing. For example, on December 31, 2009, Exxon Mobil was committed to over $10 billion of future lease payments for property, plant, and equipment. The effects of leasing are very similar to the effects of borrowing through issuing bonds, as shown earlier. Although there are different types of leases, the result of some long-term leases is companies acquire the use of the assets and they are responsible for making lease payments for many periods. When you enroll in more advanced accounting courses you will have the opportunity to learn a great deal about leasing. For our purposes, you should be aware when companies do acquire property, plant, and equipment through leasing, they record an increase in resources (leased assets) and an increase in sources of resources (lease liabilities).

** You now have the background to do exercise 9.1.

Uses of Property, Plant, and Equipment

Property, plant, and equipment assets have many uses. For example, some merchandising companies own or lease automobiles for salespersons to use to service customers. Some companies use trucks to deliver products to customers. Land, buildings, and display equipment, such as display counters and clothes racks, are used to provide customers with access to products. Office furniture


and fixtures, such as desks, chairs, computers, and lights, are used to provide work areas for sales staff and office workers.

Similar to use of current assets, as property, plant, and equipment are used up, they must be expensed. Consider the results of using $150 of supplies. As discussed several times in previous chapters, as supplies are used up, the supplies asset decreases and stockholders' equity decreases through the recording of supplies expense. These results can be seen below.

Total Resources


+Sources of


+Sources of


Assets = Liabilities + Stockholders' Equity- $150 = - $150

The journal entry to record the $150 use of supplies would be:


Dec. 31 Supplies Expense 513 150Supplies 119 150

December supplies used

Similar to supplies, as property, plant, and equipment are used up, they are expensed, with the result being a decrease in resources (the property, plant, and equipment asset) and sources of resources (stockholders' equity decreases as the expense is recorded). Consider the effect of expensing $30,000 of $600,000 buildings, as shown below.

Total Resources


+Sources of


+Sources of


Assets = Liabilities + Stockholders' Equity- $30,000 = - $30,000

A comparison of the use of supplies with the use of the buildings shows the effects on the accounting equation are quite similar: resources and sources of resources decrease as the assets are used up. The journal entry to record the use of property, plant, and equipment, however, is not identical to the entry to record the use of current assets, such as supplies. The expense account in which the use of the property, plant, and equipment asset is recorded is called depreciation expense (not buildings expense). Furthermore, when property, plant, and equipment are used up, the asset account itself is not reduced for the amount used up. The amount of the asset used up is recorded in another asset account called accumulated depreciation (not buildings). Continuing the example of the $30,000 buildings expense, the following journal entry would result.


Dec. 31 Depreciation Expense, Buildings 525 30,000Accumulated Depreciation, Buildings 152 30,000

December depreciation

The process of using up or expensing property, plant, and equipment is called depreciation. The use of the asset does not directly reduce the asset account because it is common for users of financial statements to want to know the


original cost of property, plant, and equipment. To easily provide this information, the original cost is left in the asset account, while another asset account (accumulated depreciation) is used to show the amount of the asset used up. As a result of this process, property, plant, and equipment assets, such as buildings, are reported on the balance sheet in two related accounts, as follows.

Buildings $600,000Less: accumulated depreciation $30,000 $570,000

The $600,000 in the buildings account represents the original cost of the buildings. The $30,000 in the accumulated depreciation account represents the amount of buildings used up or expensed. The $570,000 represents the amount of buildings yet to be used up or expensed.

Consider what could happen after five years if, instead of using the accumulated depreciation account, the buildings account itself had been reduced by $30,000 each year. After five years the buildings account would show a balance of $450,000 [$600,000 - $150,000 ($30,000 per year times 5 years = $150,000)]. If this $450,000 dollar amount were reported on the balance sheet as an asset of the company, a reader of the balance sheet would be unable to determine the buildings’ original cost. Remember, the original cost was $600,000 not $450,000. Since it is common for financial statement users to want to know the original cost of property, plant, and equipment, the cost of using up such assets is not recorded as a direct reduction of the asset but is recorded in a separate accumulated depreciation account. At the end of five years, the company would report the following on its balance sheet.

Buildings $600,000Less: accumulated depreciation $150,000 $450,000

Once again, the $600,000 in the buildings account represents the original cost of the buildings. The $150,000 in the accumulated depreciation account represents the amount of the buildings used up or expensed by the end of five years. The $450,000 represents the amount of the buildings yet to be used up or expensed. Similar to the allowance for uncollectible accounts discussed in Chapter 7, the accumulated depreciation account is a contra asset because it normally has a credit balance instead of a debit balance like most assets.

At this stage, the most important point for you to understand about using property, plant, and equipment is they are expensed in a manner quite similar to the way in which other assets are expensed: they are expensed when they are used. The expense associated with property, plant, and equipment is called depreciation expense. In order to easily provide users of financial statements with information they want, as property, plant, and equipment are expensed (used up), the reduction of the resource is recorded in a separate contra asset account called accumulated depreciation.


Accounting for Property, Plant, and Equipment

The major issues in accounting for property plant and equipment involve determining (1) the dollar amount of the resource (asset), (2) the total dollar amount of the resource's depreciation expense as it is used up, (3) the periods in which to recognize the resource's depreciation expense, (4) the amount of depreciation expense to report in any specific year of the asset's life, and (5) the effects of disposing of the asset when it is no longer needed.


Determining the dollar amount of property, plant, and equipment resources The dollar amount to report as a property, plant, and equipment resource (asset) is a fairly straightforward concept. There are two basic requirements. First, the costs must benefit more than just the current time period and, second, the cost must be necessary to get the asset ready for use.

In order for a cost to be included as part of property, plant, and equipment, it must benefit more than the next twelve months. Remember, property, plant, and equipment are long-lived assets. If a cost benefits only the next twelve months, it would be considered a current asset, such as supplies, prepaid insurance, or prepaid rent. Such costs will eventually be expensed in the next twelve months as the asset is used up.

All costs benefiting more than the next twelve months and involved in getting the resource to the point where it can be used should be included as part of the asset. For example, if a merchandising company intends to buy a piece of land on which to build a parking lot, costs such as the following would properly be included in the land account: title search on the property, purchase price of the property, demolition of any construction on the property (remember, the land is to be used as a parking lot), and grading or landscaping required to provide drainage. Costs of insuring the parking lot for the next year would not be included in property, plant, and equipment. Such costs would be expensed or reported as prepaid insurance. Costs such as paving the parking lot or installing lighting fixtures or signs would be included as property, plant, and equipment, most likely reported in a land improvements account in order to keep them separate from the land account in which the cost of the parking lot land is recorded.

For the most part, determining the cost of property, plant, and equipment assets is relatively easy. Occasionally, however, the process can be quite complicated, as in cases where the assets are constructed by the company itself or when several assets are purchased together, such as a plot of land on which a building sits and the building contains some equipment. Such cases are more difficult, but the main idea remains the same: the dollar amount to report as property, plant, and equipment includes all costs benefiting more than the next twelve months and required to get the resources ready to be used.

For the purposes of illustrating the accounting for property, plant, and equipment, consider the purchase of a new delivery truck by the Lowell Merchandising Corporation. The company identified the following seven costs relating to the truck's purchase.

Item CostTruck sales price $22,000Sales tax $1,050Truck title $45Stereo system $1,905Registration for this year $250Insurance for one year $2,280Gasoline $30 Total cost $27,560

A review of the seven items involved in the purchase of the delivery truck shows only four of them benefit more than the next twelve months: the truck sales price, sales tax, title, and stereo system. The truck's $22,000 sales price is the purchase price the company agreed upon with the truck dealer. It is the dollar amount the company will pay the dealer for the truck. The $1,050 sales tax is the tax the state charged the company for the right to own the truck. Similarly, the $45 title fee was charged for the legal paperwork verifying the company owns the truck. Finally, the $1,905 stereo system is the cost of a


radio/CD system installed in the truck. The company believes the stereo system to be a necessity for maintaining driver satisfaction during the long hours spent in delivering products.

Three of the seven costs associated with the delivery truck would not be included in the delivery truck account. The truck's registration is a yearly fee charged by the state and city. As such, the $250 registration will benefit only the next twelve months and it should either be recorded as an asset, prepaid fees, or expensed as fees expense, miscellaneous expense, or a similar expense account. Similarly, the truck's $2,280 insurance is for one year and, thus will benefit the company only for the next twelve months. This $2,280 should be recorded as an asset, prepaid insurance, and expensed (insurance expense) at the rate of $190 per month ($2,280 / 12 months). Finally, the $30 payment for gasoline clearly will not benefit the company for more than the next twelve months. In fact, the gasoline will probably be used up in the next day or two, assuming the company has products to deliver to its customers. As a result, the $30 should be recorded as an expense, such as gasoline expense or delivery expense.

As a result of identifying and reviewing the costs associated with the purchase of the delivery truck, the cost to be reported in the company's delivery truck account is $25,000, consisting of the following.

Item CostTruck sales price $22,000Sales tax $1,050Truck title $45Stereo system $1,905 Delivery truck cost $25,000


Determining the total dollar amount of property, plant, and equipment to expense An expense is the dollar amount of a resource used up. It is a decrease in resources resulting from management operations. Remember, supplies expense is the dollar amount of supplies used up. Insurance expense is the dollar amount of insurance used up. Similarly, depreciation expense is the dollar amount of property, plant, and equipment assets used up in management operations.

In theory, the total dollar amount of property, plant, and equipment depreciation expense is relatively easy to determine. It is simply the difference between what the property, plant, and equipment cost when it was acquired and what it can be sold for when the company is through with it. The dollar amount for which an asset can be sold when a company is finished using it is called its residual value or salvage value. For example, continuing the example of the delivery truck, if the Lowell Merchandising Corporation estimates it can sell the delivery truck for $5,000 when it is finished using it, then the total depreciation expense of the truck would be $20,000, as shown below.

Delivery truck cost $25,000Less: estimated residual value $5,000Total depreciation expense $20,000

The fact that the company paid $25,000 is important but it is not the same as the total depreciation expense because the company expects to receive $5,000 for the truck when it is finished with it. Thus, in the long-run, the company expects its resources to decrease by only $20,000 as it uses up the truck. The $25,000 delivery truck will eventually be replaced by $5,000 cash. Thus, again, the


total decrease in resources over the life of the delivery truck is $20,000 which is shown below.

Total Resources


+Sources of


+Sources of



Many things easy in theory are often more difficult in practice. This is certainly the case with determining the total depreciation expense of property, plant, and equipment. As shown above, once the resource's cost is known, it is necessary to estimate its residual value. Since property, plant, and equipment resources have long lives, their residual values must be estimated many years in advance of their disposal. In some cases, such as with automobiles and trucks which may be used for only five or six years and for which resale markets exist, this process is relatively easy. In other cases, such as with buildings that may last 30 or 40 years, this can be quite difficult. Regardless of the ease or difficulty, the residual value must be estimated, otherwise the total depreciation expense cannot be determined. Fortunately, managers have been making these estimates for many years, so the process is familiar to them.

Determining the dollar amount of property (land) to expense is usually quite different than the accounting for plant and equipment. Historically, the land on which buildings are located in the United States has not declined in value. In fact, most land values have increased over time. As a result, such land is not expensed through depreciation. The cost of the land remains in the land account until the land is sold.


Determining the periods in which to record property, plant, and equipment resources' depreciation expense Like other resources, the periods in which property, plant, and equipment should be expensed are those periods in which the property, plant, and equipment are used. Taken together, these periods are known as the resources' useful lives. The useful life of a resource is the number of accounting periods it provides benefits to the company. Since property, plant, and equipment resources last for many years, not just a few months, their useful lives are commonly measured in years.

Continuing the delivery truck example, assume the Lowell Merchandising Corporation's management estimates the $25,000 truck will be used for five years, after which it will be sold for its $5,000 residual value. Since the useful life of the delivery truck is estimated to be five years, its $20,000 total depreciation expense should be recorded during this five-year period.

As was the case with residual value, you should note the useful lives of property, plant, and equipment must be estimated. Because such resources last for long times and because the future is uncertain, the resources' actual useful lives cannot be known with certainty until the assets stop providing benefits to the company. The useful lives must be estimated because management knows the resources will not last forever. They will wear out or become obsolete at some point. If the assets' useful lives are not estimated somehow, the assets cannot be expensed because the periods in which to record the depreciation expense will not be known. Of course, one alternative is not to expense the resources until the assets are completely used up. For example, instead of recording the $20,000 depreciation expense as the delivery truck is used during its five-year useful life, the company could wait until the truck is sold in year five and record the full $20,000 depreciation expense then. Management, creditors, owners, analysts,


the accounting profession, and others do not accept this approach, however, because they know the truck will be used in each of the five years, not just in year five. To record all the depreciation expense in year five and none of the expense in the first four years is illogical. It clearly does not appear to be reasonably related to the way in which the company used the truck. If the company uses the truck each year for five years, it should record some depreciation expense in each of the five years.

Although property, plant, and equipment resources' useful lives are estimates, they are not wild guesses on the part of managers. Useful lives are not determined through the use of random number tables, but rather they are determined through analysis and research. For example, to estimate the useful life of a delivery truck, managers could talk with truck dealers, insurance companies, truck mechanics, and managers in other companies. Furthermore, as time passes, managers gain more experience making such estimates. Finally, as you will see later in this chapter, when managers learn their estimates need to be revised, there are ways to easily include their revisions into the accounting system.

Determining the amount of depreciation expense to report in any specific year of the property, plant, and equipment asset's useful life When a company is ready to determine the amount of depreciation expense to report in any given year of an asset's life, management already knows or has estimated the asset's cost, residual value, and useful life. Thus, management knows the total depreciation expense and the number of years during which the expense is to be recorded. For example, continuing the delivery truck example, based on its estimates the Lowell Merchandising Corporation's management knows the truck's total depreciation expense should total $20,000 over its five-year useful life. Remember, the truck cost $25,000 but it will be sold for $5,000 five years after it is purchased. Thus, $20,000 of the company's resources will be used up over the five-year time period. The point of discussion in this section is how much of this $20,000 depreciation expense should be recorded in each year.

There are several different depreciation methods used to calculate the dollar amount of depreciation expense for each year of an asset's life. Described below are two common methods: straight-line and accelerated. As you consider these different methods, remember they are simply attempting to determine the dollar amount of depreciation expense to record in each year of an asset's useful life. Regardless of the depreciation method used, the results will be a reduction of assets and stockholders' equity. The accounts debited and credited in the journal entries to record the depreciation expense are the same, as again shown below for the delivery truck.


Dec. 31 Depreciation Expense, Delivery Truck 535 ???????Accum. Depr., Delivery Truck 154 ???????

Delivery truck depreciation

It is only the dollar amounts in the monthly or yearly entries that will differ according to different depreciation methods. Regardless of the depreciation method used, the total depreciation expense reported over the asset's useful life is the same. Remember, for example, the total depreciation expense over the life of the delivery truck is $20,000.

Straight-line depreciation Straight-line depreciation is the simplest and the most commonly used depreciation method. It is based on the idea that some assets provide relatively constant benefits each year during their lives. If


each year of an asset's life receives the same benefit from the asset, each year should be charged the same depreciation expense for the use of the asset.

To use the straight-line method of depreciating its delivery truck, the Lowell Merchandising Corporation would make the following calculations.

Straight-line Cost - Residual Valueannual depreciation = Useful Life

$25,000 - $5,000= 5 years

= $20,0005 years

= $4,000 per year

Using the straight-line depreciation method, the company would expense the truck's $20,000 by depreciating it in the following manner.


Year Depreciation Expense1 $4,0002 $4,0003 $4,0004 $4,0005 $4,000

Total $20,000

In year 1, the effect of expensing the delivery truck by the straight-line depreciation method is to reduce resources and sources of resources by $4,000, as shown below.

Total Resources


+Sources of


+Sources of



The journal entry to record the first year's depreciation of the delivery truck is shown below. Since the straight-line depreciation method results in $4,000 of depreciation expense each year for the truck, the company would make the same journal entry each year during the asset's five-year useful life.


19x1Dec. 31 Depreciation Expense, Delivery Truck 535 4,000

Accum. Depr., Delivery Truck 154 4,00019x1 depreciation

By using the straight-line method of depreciating the truck over its five-year useful life, the company would develop the following information.

Year

DepreciationExpensefor Year

Truck Cost atEnd of Year

Truck AccumulatedDepreciation atEnd of Year

1 $4,000 $25,000 $4,0002 $4,000 $25,000 $8,0003 $4,000 $25,000 $12,0004 $4,000 $25,000 $16,0005 $4,000 $25,000 $20,000

As the above data show, by using the straight-line depreciation method the company expenses (depreciates) the truck by the same amount ($4,000) each year. The depreciation process reduces resources and sources of resources each year by $4,000. Resources are reduced each year by the $4,000 increase in the truck's accumulated depreciation contra asset account. Sources of resources are reduced as stockholders' equity is reduced each year by the $4,000 charge to depreciation expense. (Remember, expenses decrease stockholders' equity.)

The straight-line depreciation method is by far the most often used method of depreciation. It is simple to use and it does not require some of the difficult estimates and measurements required by other, more complicated depreciation methods.


For purposes of illustrating the income statement effects of the straight-line depreciation method, if we make some very simple assumptions about the Lowell Merchandising Corporation, its income statement for its first year, 19x1 could appear as follows.

Exhibit 9-1Lowell Merchandising Corporation

Income Statementfor the Year Ended December 31, 19x1

Sales (assumed) $320,000Cost of Goods Sold (assumed) $240,000Gross Profit $80,000Operating Expenses (including $4,000 depreciation) $50,000Income from Operations $30,000Other Revenues and (Expenses) (assumed) ($2,000)Income Before Taxes $28,000Income Taxes Expense (40% rate assumed) $11,200Net Income $16,800

You should note the delivery truck’s $4,000 depreciation expense is included in the operating expenses section of the above income statement. Operating expenses reduce income from operations, income before taxes, income taxes expense, and net income. The larger operating expenses become, the smaller become income from operations, income before taxes, income taxes expense, and net income. On the other hand, the smaller operating expenses become, the larger become income from operations, income before taxes, income taxes expense, and net income. For those company's interested in net income and income taxes expense, depreciation methods such as straight-line are very important because they can significantly affect income taxes expense and net income, as will be examined more fully later.


Accelerated depreciation: double-declining-balance Some assets provide more benefits during the early years of their lives. For example, some equipment may become less usable as it becomes older because it will be out of service as it is repaired more often. Some other assets provide the same amount of service each year but become more expensive to maintain as they get older. For example, some automobiles and trucks may require more and more maintenance as they become older and wear out. For assets such as these, managers sometimes prefer depreciation methods that produce higher depreciation expense in the assets' earlier years than their later years.

Consider again the Lowell Merchandising Corporation’s delivery truck. Suppose the company predicts maintenance on the truck will be as follows.

YearEstimatedMaintenance

1 $3002 $5003 $1,0004 $1,8005 $2,400

Total $6,000

Based on the company’s estimates of maintenance costs, the total cost of owning and maintaining the delivery truck is $26,000 for five years: $20,000 for buying


and using the truck (depreciation expense) plus $6,000 for maintenance. Suppose the company wants to keep the cost of owning and maintaining the truck constant each year during its useful life because it expects to be able to make approximately the same number of customer deliveries each year. To do so, the company would want to recognize total depreciation and maintenance costs of $5,200 per year ($26,000 / 5 years = $5,200). Since the company estimates maintenance costs will increase over the truck’s useful life, it would need to recognize decreasing amounts of depreciation expense over the truck’s useful life in order for the total costs of ownership and maintenance to remain constant. Such depreciation expense amounts could be calculated as shown below. Remember the company has predicted the annual maintenance costs, as shown earlier, and also knows the total depreciation expense over the truck’s useful life will be $20,000.

Year

Total Cost ofOwning andMaintenance

MaintenanceCost Depreciation Expense

1 $5,200 $300 $4,900 ($5,200 - $300)2 $5,200 $500 $4,700 ($5,200 - $500)3 $5,200 $1,000 $4,200 ($5,200 - $1,000)4 $5,200 $1,800 $3,400 ($5,200 - $1,800)5 $5,200 $2,400 $2,800 ($5,200 - $2,400)

Totals $26,000 $6,000 $20,000

You should note several items in the above data. First, the $5,200 annual cost of owning and maintenance was calculated by dividing the $26,000 total cost of ownership and maintenance by the delivery truck’s five-year useful life ($26,000 / 5 years = $5,200). The annual depreciation expense was calculated by subtracting each year's estimated maintenance cost from this $5,200. Finally, note the depreciation expense decreases each year, starting at $4,900 in year one and ending at $2,800 in year five.

As the calculations in the above data show, it is possible to develop a depreciation pattern resulting in greater depreciation expense in the early years of an asset’s life and lesser depreciation expense in the later years. Such a depreciation pattern is called accelerated depreciation because it expenses the asset faster than the straight-line depreciation method. Remember, the annual straight-line depreciation expense for the delivery truck was $4,000.

While many companies may prefer to record more depreciation in the early years of an asset’s useful life, they would prefer to avoid the difficulty of predicting such things as maintenance costs. Fortunately, several common accelerated depreciation methods have been developed to quickly expense assets without requiring estimates of other costs, such as maintenance.

One common accelerated depreciation method is the double-declining-balance method. The name “double-declining-balance” stems from the manner in which the depreciation method works. The double part of the name stands for twice (or double) the straight-line depreciation method rate. Remember the delivery truck had a useful life of five years. Thus, the straight-line depreciation rate is one-fifth (1/5) per year. From this, the double-declining-balance method rate for the delivery truck would be two-fifths (2/5) per year ( 2 x 1/5 = 2/5). The declining-balance part of the double-declining-balance name indicates that the annual depreciation expense is based on the asset’s dollar balance at the beginning of the year for which depreciation expense is being calculated. Remember, property, plant, and equipment assets, like the delivery truck, are reported in two separate accounts. The delivery truck’s $25,000 original cost appears in the delivery truck asset account, while the amount of the truck that has been expensed through depreciation appears in the accumulated depreciation,


delivery truck contra asset account. The declining-balance referred to in the double-declining-balance depreciation method is the difference between the delivery truck asset account and the accumulated depreciation, delivery truck contra asset account. Remember, the difference between the two accounts represents the cost of the delivery truck yet to be used up or expensed through depreciation.

For the first year of the delivery truck’s useful life, the double-declining-balance depreciation would be calculated as follows.

Double-declining-balanceyear one depreciation = Rate x

Asset’sdeclining balance

= 2 x (1 / useful life) xcost – accumulated depreciation at beginning of year

= 2 x (1/5) x $25,000 - $0

= 2/5 (or 40%) x $25,000

= $10,000

In year 1, the effect of expensing the delivery truck by the double-declining-balance depreciation method is to reduce resources and sources of resources by $10,000, as shown below.

Total Resources


+Sources of


+Sources of



The journal entry to record the first year's depreciation of the delivery truck is shown below. The company would make the same journal entry each year during the asset's useful life, with only the dollar amounts differing from year to year as discussed in the following paragraphs.


19x1Dec. 31 Depreciation Expense, Delivery Truck 535 10,000

Accum. Depr., Delivery Truck 154 10,00019x1 depreciation

By using the double-declining-balance method of depreciating the truck for its first year, the company would develop the following information.

Year




1 $10,000 $25,000 $10,000

For purposes of illustrating the income statement effects of the double-declining-balance depreciation method, if we again make some very simple


assumptions about the Lowell Merchandising Corporation, its income statement for its first year, 19x1 could appear as follows.




Sales (assumed) $320,000Cost of Goods Sold (assumed) 240,000Gross Profit $80,000Operating Expenses (including $10,000 depreciation) $56,000Income from Operations $24,000Other Revenues and (Expenses) (assumed) ($2,000)Income Before Taxes $22,000Income Taxes Expense (40% rate assumed) $8,800Net Income $13,200

You should note the delivery truck’s $10,000 depreciation expense was included in the operating expenses section of the above income statement. Compared to results of the straight-line depreciation method shown earlier in Exhibit 9-1, the double-declining-balance depreciation method resulted in $6,000 higher operating expenses ($56,000 - $50,000). These higher operating expenses reduced income from operations by $6,000 ($30,000 - $24,000), income before taxes by $6,000 ($28,000 -$22,000), income taxes expense by $2,400 ($11,200 - $8,800), and net income by $3,600 ($16,800 - $13,200). Once again, for those company's interested in net income and income taxes expense, depreciation methods, such as straight-line and double-declining-balance are very important because they can significantly affect income taxes expense and net income, as will be examined more fully later.

For the second year of the delivery truck’s useful life, the double-declining-balance depreciation would be calculated as follows.

Double-declining-balanceyear two depreciation = Rate x

Asset’sDeclining balance

= 2 x (1 / useful life) xCost – accumulated depreciation at beginning of year

= 2 x (1/5) x $25,000 - $10,000

= 2/5 (or 40%) x $15,000

= $6,000

Note in the above calculations the double-declining-balance rate for the truck remained at 2/5 (or 40%) while its declining-balance at the beginning of the year changed from $25,000 to $15,000. Remember the declining-balance referred to in the double-declining-balance depreciation method is the difference between the delivery truck asset account and the accumulated depreciation, delivery truck contra asset account. At the beginning of the second year, the delivery truck account balance was a debit of $25,000, while the accumulated depreciation, delivery truck contra account balance was a credit of $10,000. Thus, the delivery truck’s declining-balance at the beginning of year two was $15,000 ($25,000 - $10,000).

Continuing the illustration of the income statement effects of the double-declining-balance depreciation method, if we make the same very simple


assumptions about the company, its income statement for its second year, 19x2 could appear as follows.



Sales (assumed) $320,000Cost of Goods Sold (assumed) $240,000Gross Profit $80,000Operating Expenses (including $6,000 depreciation) $52,000Income from Operations $28,000Other Revenues and (Expenses) (assumed) ($2,000)Income Before Taxes $26,000Income Taxes Expense (40% rate assumed) $10,400Net Income $15,600

You should note the delivery truck’s $6,000 depreciation expense for year two was included in the operating expenses section of the above income statement. Compared to results of the straight-line depreciation method shown earlier in Exhibit 9-1 (remember the straight-line depreciation method results in the same depreciation expense each year), the double-declining-balance depreciation method resulted in $2,000 higher operating expenses ($52,000 - $50,000). These higher operating expenses reduced income from operations by $2,000 ($30,000 - $28,000), income before taxes by $2,000 ($28,000 -$26,000), income taxes expense by $800 ($11,200 - $10,400), and net income by $1,200 ($16,800 - $15,600). Once again, for those company's interested in net income and income taxes expense, depreciation methods, such as straight-line and double-declining-balance are very important because they can significantly affect income taxes expense and net income.

If the Lowell Merchandising Corporation were to use the double-declining-balance method of depreciating the truck over its five-year useful life, it would develop the following information.

Year




1 $10,000 (see above) $25,000 $10,0002 $6,000 (see above) $25,000 $16,0003 $3,600 [(2/5) x ($25,000 - $16,000)] $25,000 $19,6004 $400 (see below) $25,000 $20,0005 $0 (see below) $25,000 $20,000

In applying the double-declining-balance method to the delivery truck, notice the depreciation expense for years four and five appear to be unusual. A straightforward calculation of the double-declining-balance depreciation for year four would yield $2,160 [(2/5) x ($25,000 - $19,600)]. However, if the truck were to be depreciated for $2,160 in year four, the total depreciation expense over four years would equal $21,760 ($10,000 + $6,000 + $3,600 + $2,160). Since the total depreciation expense for the truck is limited to $20,000, however, the depreciation expense for year four cannot be $2,160. In fact, since depreciation expense of $19,600 ($10,000 + $6,000 + $3,600) was recorded in the first three years of the truck’s life, the depreciation expense for year four is limited to a maximum of $400 ($20,000 - $19,600), as shown above. Furthermore, since the full $20,000 of depreciation expense is recorded in the first four years, year five’s


depreciation expense is $0. This suggests the double-declining-balance depreciation method must be used with care.

The result of the double-declining-balance depreciation method is a pattern of depreciation resulting in high depreciation expense in the early years of an asset’s life and decreasing depreciation expense as the asset gets older. Thus, for those companies wanting to recognize more depreciation in the early years of assets’ lives, the double-declining-balance depreciation method appears more reasonable than the straight-line depreciation method.


Straight-line and double-declining-balance compared As the income statements presented earlier in Exhibits 9-1, 9-1, and 9-3 showed, different depreciation methods can have different effects on a company’s financial statements. Presented below is a comparison of the Lowell Merchandising Corporation's depreciation of its delivery truck under the two methods.

Depreciation Per Year

Year Straight-line (SL)Double-declining-balance (DDB) SL - DDB

1 $4,000 $10,000 - $6,0002 $4,000 $6,000 - $2,0003 $4,000 $3,600 + $4004 $4,000 $400 + $3,6005 $4,000 $0 + $4,000

Totals $20,000 $20,000 $0

As the above data show, both straight-line and double-declining-balance depreciation methods recognize the same $20,000 total depreciation expense over the delivery truck’s useful life. The difference between the methods is in the amount of depreciation expense recorded in any specific year. The straight-line depreciation method results in the same amount of depreciation expense ($4,000) each year of the truck’s life. On the other hand, the double-declining-balance depreciation method results in higher depreciation expense in the early years and lower depreciation expense in the later years.

Companies would select the straight-line depreciation method for those assets providing fairly constant benefits each year. The double-declining-balance depreciation method would be used for assets providing more benefits in the early years and assets for which other costs of ownership, such as maintenance, increase significantly in the later years.

A comparison of the company's net income under the two depreciation methods is presented below. You can verify the straight-line results by reviewing the straight-line income statement presented earlier in Exhibit 9-1. You can verify the double-declining-balance results for the first two years by reviewing the double-declining-balance income statements presented earlier in Exhibits 9-2 and 9-3.

Net Income Per Year

Year Straight-line (SL)Double-declining-Balance (DDB) SL – DDB

1 $16,800 (Exhibit 9-1) $13,200 (Exhibit 9-2) + $3,6002 $16,800 (Exhibit 9-1) $15,600 (Exhibit 9-3) + $1,2003 $16,800 (Exhibit 9-1) $17,040 - $2404 $16,800 (Exhibit 9-1) $18,960 - $2,1605 $16,800 (Exhibit 9-1) $19,200 - $2,400


Totals $84,000 $84,000 $0

As the above data show, both straight-line and double-declining-balance depreciation methods recognize the same $84,000 total net income over the delivery truck’s useful life. The difference between the methods is in the amount of net income reported in each specific year. The straight-line depreciation method results in the same amount of net income ($16,800) each year of the truck’s life. On the other hand, the double-declining-balance depreciation method results in lower net income in the early years and higher net income in the later years. As you try to use this information, remember it was based on some very simple assumptions about the Lowell Merchandising Corporation. The purpose of the assumptions was to illustrate the effects of depreciation, thus all other effects were ignored.


A comparison of the company's income taxes expense under the two depreciation methods is presented below. You can verify some of the dollar amounts by reviewing the income statements presented earlier in Exhibits 9-1, 9-2, and 9-3.

Income Taxes Expense Per Year

Year Straight-line (SL)Double-declining-Balance (DDB) SL - DDB

1 $11,200 (Exhibit 9-1) $8,800 (Exhibit 9-2) + $2,4002 $11,200 (Exhibit 9-1) $10,400 (Exhibit 9-3) + $8003 $11,200 (Exhibit 9-1) $11,360 - $1604 $11,200 (Exhibit 9-1) $12,640 - $1,4405 $11,200 (Exhibit 9-1) $12,800 - $1,600

Totals $56,000 $56,000 $0

As the above data show, both straight-line and double-declining-balance depreciation methods recognize the same $56,000 total income taxes expense over the delivery truck’s useful life. The difference between the methods is in the amount of income taxes expense reported in each specific year. The straight-line depreciation method results in the same amount of income taxes expense ($11,200) each year of the truck’s life. On the other hand, the double-declining-balance depreciation method results in lower income taxes expense in the early years and higher income taxes expense in the later years. As you try to use this information, again remember it was based on some very simple assumptions about the Lowell Merchandising Corporation. The purpose of the assumptions was to illustrate the effects of depreciation, thus all other effects were ignored.

Using the income taxes expense data shown above, it is possible to understand another reason why managers are very interested in using accelerated depreciation methods, such as the double-declining-balance method. Again, as shown above, if the Lowell Merchandising Corporation depreciated its delivery truck by the double-declining-balance method it would have had to pay $2,400 less income taxes in year 1 than it would have had to pay if it had used the straight-line method. This means instead of paying $2,400 to the government, the company could have kept it and invested it during year 2. To simplify the analysis, assume income taxes are paid at the end of the year. If the company were conservative and invested the $2,400 in a certificate of deposit having a 5% interest rate, the $2,400 would earn $120 in interest during year 2 ($2,400 x .05 = $120). This interest, in turn, would be taxed at a rate of 40% (assumed) for $48. Thus, the company would get to keep $72 ($120 - $48). This $72 would be an increase in the company’s resources resulting simply from using the double-


declining-balance depreciation method instead of the straight-line method in year 1 and investing any postponed taxes payments. The total cash benefits of using the double-declining-balance method over the asset’s five-year life are shown below.


Benefits of Accelerated Depreciation

Year

Income Taxes ExpenseSL - DDB

Beginning Cash

Availableto Investin CDs

5%Interest Earned on

CDs

40% Income Taxes on Interest

Interest After Income Taxes

1 + $2,400 $0.00 $0.00 $0.00 $0.002 + $800 $2,400.00 $120.00 $48.00 $72.003 - $160 $3,272.00 $163.60 $65.44 $98.164 - $1,440 $3,210.16 $160.51 $64.20 $96.315 - $1,600 $1,866.47 $93.32 $37.33 $55.99

Yrs. 1 thru 5 $0 $322.46 $537.43 $214.97 $322.46

Some of the above calculations are a bit complicated. For example, consider year 3’s $3,272 cash available to invest in CDs. This amount is the sum of the $2,400 income taxes expense not paid in cash in year 1 plus the $72 interest after taxes earned on this $2,400 invested in year 2 plus the $800 income taxes expense not paid in year 2. The $3,210.16 cash available to invest in CDs in year 4 is the sum of the $2,400 income taxes expense not paid in year 1 plus the $72 interest after taxes earned on this $2,400 in year 2 plus the $800 income taxes expense not paid in year 2 plus the $98.16 interest after taxes earned in year 3 less the $160 additional income taxes that would have to be paid in year 3. Although the calculations may be complicated, the above data show that by choosing to use the double-declining-balance depreciation method for its truck and investing cash not paid in taxes, the Lowell Merchandising Corporation would have $322.46 more resources at the end of five years than if it had used the straight-line depreciation method. Once again, some very simple assumptions were made in the above calculations. As you enroll in more advanced accounting and finance courses you will learn to process more realistic assumptions.

Based on cash analyses like the above, companies have tremendous incentives to use accelerated depreciation techniques. However, the income statement effects of accelerated depreciation methods may not be desirable for most assets. Remember, if assets provide benefits relatively equally over their useful lives, straight-line depreciation is more reasonable. As a result, companies could be forced to choose between wanting equal annual depreciation expense for income statement purposes and accelerated depreciation expense for tax purposes. In fact, the government and the accounting profession recognize the difficulty of this choice and they allow companies to use depreciation methods for their financial statements that differ from the depreciation methods used for income tax reporting. As a result, most companies use straight-line depreciation for their financial statements and accelerated depreciation for income tax reporting.

To standardize the use of accelerated depreciation, the federal government created a special accelerated depreciation technique called the Accelerated Cost Recovery System (ACRS), which was later revised and became the Modified Accelerated Cost Recovery System (MACRS). If companies want to use accelerated depreciation for income tax reporting, they must use MACRS. Companies may still use the straight-line method if they prefer. The use of the MACRS system makes it easy for companies to compute depreciation expense and, more importantly from the government’s standpoint, makes it easier for them to verify the companies’ calculations. Because of some of the specific requirements of MACRS depreciation, it can be used only for income tax reporting. MACRS is not acceptable for use by companies in the preparation of their financial statements.

** You now have the background to do exercises 9.8 and 9.9 and problems 9.3 and 9.4.


Disposing of property, plant, and equipment resources When resources are disposed of, the effects on the company depend upon how the disposal is accomplished and what resources, if any, are received. For example, resources can be disposed of by being sold or they can be traded in on other resources. Resources can also be scrapped or thrown away, but this may be viewed as simply selling them at the price of $0. The following paragraphs discuss the effects of disposing of resources by selling them. Due to some of the more specialized accounting treatments required, the effects of disposing of resources through trading them in on other resources are covered in more advanced accounting courses.

When assets are sold, one effect is resources are reduced by the dollar amount of the assets sold. Another effect is resources are increased by the dollar amount of the assets received for the sold assets. If the net result is a change in resources, then sources of resources must have changed as well. For example, consider the effects on the Lowell Merchandising Corporation if it disposes of its delivery truck at the beginning of the third year of its useful life. If the company uses the straight-line depreciation method, the delivery truck would be in the company's accounting system as a $17,000 resource (asset) as shown below. The $8,000 accumulated depreciation balance represents two years' depreciation at $4,000 per year.

Delivery Truck $25,000Less: accumulated depreciation $8,000 $17,000

If the company disposes of the truck and receives nothing for it, in other words, if the company scraps the truck, the effect would be a $17,000 reduction in resources and sources of resources, as follows.

Total Resources


+Sources of


+Sources of



Since the delivery truck is included as a $17,000 asset in the company's accounting system, it is easy to understand why resources decrease by $17,000 when the truck is scrapped. However, the $17,000 reduction in stockholders' equity may not be as easy to see. In effect, the disposal of the truck is similar to the company's using up some of its supplies. When supplies are used up, assets decrease and stockholders' equity decreases through the recognition of supplies expense. When the truck is scrapped, stockholders' equity decreases because, in effect, the truck was "used up." To keep the effects of disposals separate from more common uses of resources, the "using up" of the truck through disposal is not called an expense but is called a loss on disposal of delivery truck.

To record the disposal of the delivery truck, the dollar amounts related to the delivery truck in the accounting system must be eliminated because the truck no longer belongs to the company. Remember, the delivery truck is reported in two accounts. The $25,000 cost of the truck is a debit balance in the delivery truck account and the $8,000 of the truck depreciated in the first two years is a credit balance in the accumulated depreciation, delivery truck account. To eliminate the $25,000 debit balance we must credit the delivery truck account. To eliminate the $8,000 credit balance we must debit the accumulated depreciation, delivery truck account. Since debits must equal credits, we need a


$17,000 debit to something, which in this case is the loss on disposal of delivery truck account. The entry is as follows.


Jan. 2 Accum. Depr., Delivery Truck 172 8,000Loss on Disposal of Delivery Truck 611 17,000

Delivery Truck 171 25,000Delivery truck disposal

Note how the above entry is similar to the entry debiting supplies expense and crediting supplies when supplies are used up. Note also the $17,000 loss is reasonable because $17,000 in resources went out of the business and nothing was received for them.

If, instead of being scrapped, the delivery truck had been sold for $5,000 cash, the effect on the company would have been only a $12,000 reduction in resources, as shown below. $5,000 of resources (cash) came into the company, while $17,000 (the truck) went out.

Total Resources


+Sources of


+Sources of


Assets = Liabilities + Stockholders' Equity+ $5,000 = - $12,000- $17,000 =

The journal entry required to record the sale of the truck for $5,000 would be as follows. Note the loss on disposal of delivery truck is only $12,000, representing the decrease in resources.


Jan. 2 Cash 111 5,000Accum. Depr., Delivery Truck 172 8,000Loss on Disposal of Delivery Truck 611 12,000

Delivery Truck 171 25,000Delivery truck disposal

If the company received $20,000 when the delivery truck was sold, the effect on the company would have been a $3,000 increase in resources, as shown below. $20,000 of resources (cash) came into the company, while $17,000 (the truck) went out.

Total Resources


+Sources of


+Sources of


Assets = Liabilities + Stockholders' Equity+ $20,000 = + $3,000- $17,000 =

The journal entry required to record the sale of the truck for $20,000 would be as follows.



Jan. 2 Cash 111 20,000Accum. Depr., Delivery Truck 172 8,000

Delivery Truck 171 25,000Gain on Disposal of Deliv. Truck 612 3,000

Delivery truck disposal

Notice in the above journal entry how the $3,000 increase in resources resulted in a gain on disposal of delivery truck. The gain was recorded to recognize the $3,000 increase in resources had to come from somewhere: it did not just magically appear. In this case, the increase in resources came from management receiving $20,000 for a $17,000 resource ($25,000 - $8,000).

Similar to interest revenue and interest expense, any gain or loss on the disposal of property, plant, and equipment is reported in the other revenues and expenses section of the income statement. This is done primarily to keep such effects separate from the more significant aspects of merchandising businesses: the buying and selling of merchandise.

The most important point to remember about disposing of property, plant, and equipment is resources are affected if an asset is disposed of for dollar amounts greater or less than the asset's dollar amounts in the accounting system. If less assets are received than eliminated, resources decrease. If more assets are received than eliminated, resources increase. When disposed of, the asset's dollar amounts must be eliminated from two accounts: the asset account and the contra asset account, accumulated depreciation. Any difference between the dollar amount of assets received and disposed of is reported as a gain or loss on disposal.


Financial Statement Reporting of Property, Plant, and Equipment

Property, plant, and equipment are reported as assets on the balance sheet as shown below. The cost of each asset is reported on one account while the cost of the asset used up or expensed is reported in a second account called accumulated depreciation.

AssetsCurrent AssetsCash $18,330Accounts Receivable $75,000Less: Allowance for Uncollectible Accounts $1,500 $73,500Merchandise Inventory $210,000

Total Current Assets $301,880

Property, Plant, and EquipmentLand $30,000Buildings $120,000Less: Accumulated Depreciation $40,000 $80,000Equipment $150,000Less: Accumulated Depreciation $50,000 $100,000Autos & Trucks $95,000Less: Accumulated Depreciation $55,000 $40,000

Total Property, Plant, & Equipment $250,000

Depreciation expense is reported in the income statement as part of operating expenses. It is included in selling expenses if related to assets used


in selling products or reported as general and administrative expenses if related to general management activities.


Sales $400,000Cost of Goods Sold $160,000Gross Profit $240,000Operating Expenses

Salaries and Wages Expense $103,000Depreciation Expense $10,000Supplies Expense $3,000Utilities Expense $9,000Rent and Insurance Expense $14,000Uncollectible Accounts Expense $1,000

Total Operating Expenses $140,000Income from Operations $100,000Other Revenues and (Expenses) ($1,000)Income Before Taxes $99,000Income Taxes Expense $34,650Net Income $64,350

** You now have the background to do problems 9.1 and 9.2.

Chapter 9 Critical Points

• Property, plant, and equipment are resources with lives longer than one year, used in normal business operations, and providing benefits through their physical form.

• Most companies acquire property, plant, and equipment by using some of their other resources or acquire them through borrowing.

• As property, plant, and equipment are used up, resources decrease and sources of resources decrease through depreciation expense.

• Property, plant, and equipment are reported in two separate asset accounts. The cost is reported in one account and the amount of the cost expensed through depreciation is reported in a contra asset account, accumulated depreciation.

• Depreciation expense is reported as an operating expense on merchandising company income statements.

• The dollar amount reported in a property, plant, and equipment asset account is the cost of getting the asset ready to be used.

• The total depreciation expense of using property, plant, and equipment is the difference between its cost and residual value.

• The expense of using property, plant, and equipment is recognized as depreciation expense in the period the asset is used.

• Two methods of calculating depreciation expense are the straight-line method and the double-declining-balance method.

• Accelerated depreciation methods, such as the double-declining-balance method, expense the cost of assets faster than the straight-line method.

• By expensing the cost of assets faster, accelerated depreciation has significant tax advantages.

• Most companies use straight-line depreciation for financial reporting purposes and accelerated depreciation for tax reporting purposes.

• When property, plant, and equipment are disposed of, the difference between the resources received and those disposed of is a gain or loss on disposal.

• Any gain or loss on disposal of property, plant, and equipment is reported as part of other revenues and expenses on the income statement.


• The following major topics have been examined so far.

AssetsCurrent AssetsCash and cash equivalents (6)Accounts receivable (7)Allowance for Uncollible Accounts (7)

Merchandise inventory (8)Property, plant, & equipmentLand (9)Buildings (9)Accumulated Depreciation, Buildings (9)

Autos & Trucks (9)Accumulated Depreciation, Autos & Trucks (9)

= Liabilities + Stockholders' EquityRevenuesSales (7)Sales Returns & Allowances (7)

Cost of Goods Sold (8)Operating ExpensesUncollectible Accounts Expense (7)

Depreciation Expense (9)Bank Service Expense (6)

Other Revenues & ExpensesInterest Revenue (6)Interest Expense (6)Gain or Loss on Disposal of Property, Plant, & Equipment (9)

Chapter Nine Questions

1. Define the term property, plant, and equipment.

2. Identify three examples of property, plant, and equipment.

3. What is the major difference between tangible and intangible assets?

4. Identify two examples of intangible assets.

5. How is the “using up” of property, plant, and equipment similar to the “using up” of supplies and insurance?

6. How is the “using up” of property, plant, and equipment different from the “using up” of supplies and insurance?

7. Identify two major sources of property, plant, and equipment.

8. What is the name of the expense account in which the use of property, plant, and equipment is recorded?

9. What is the name of the asset account in which the amount of property, plant, and equipment that has been used up is recorded?


10. What are the two basic requirements for determining if a dollar amount should be reported as part of property, plant, and equipment?

11. The total dollar amount of property, plant, and equipment’s depreciation expense is the difference between what two items?

12. Define the term residual value or salvage value.

13. Identify one important way in which the accounting for land differs from the accounting for buildings or equipment.

14. Define the term useful life.

15. What is the purpose all depreciation methods are attempting to accomplish?

16. What assumption does the straight-line depreciation method make concerning an asset’s benefits?

17. What assumption do accelerated depreciation methods often make concerning an asset’s benefits?

18. What does the word “double” stand for in double-declining-balance depreciation?

19. What do the words “declining-balance” stand for in double-declining-balance depreciation?

20. Why does accelerated depreciation result in companies having more resources than does straight-line depreciation?

21. What is the Modified Accelerated Cost Recovery System?

22. If as a result of disposing of some of its property, plant, and equipment a company’s resources decrease, in what "stockholders’ equity" account is the decrease recorded?

23. On which financial statement and in which section of the statement is a gain or loss on disposal of property, plant, and equipment reported?


Chapter Nine Exercises

Exercise 9.1: Buying Property, Plant, and Equipment

The Vigneau Corporation has been operating for approximately 15 years. During March, the company engaged in many transactions, some of which are presented below. Prepare the journal entries necessary to record the transactions. Before you prepare each journal entry, determine the transaction's effects on the company's resources and sources of resources. The first transaction has been completed for you.

March 3 Paid cash for $765 office supplies. The office supplies will be used during the next several months.

Total Resources


+Sources of


+Sources of


Assets = Liabilities + Stockholders' Equity+ $765- $765


March 3 Office Supplies 765Cash 765

Office supplies cash purchase

March 9 Paid $1,264 cash for office equipment. The office equipment will be used during the next three years.

Total Resources


+Sources of


+Sources of


Assets = Liabilities + Stockholders' Equity


March 9


March 13 Purchased $479 office supplies on account. The office supplies will be paid for in April and used during the next several months.

Total Resources


+Sources of


+Sources of




March 13

March 19 In order to acquire additional office equipment, the company issued bonds and received $80,000 cash.

Total Resources


+Sources of


+Sources of




March 19

March 24 Paid $78,643 cash for office equipment. The office equipment will be used during the next five years.

Total Resources


+Sources of


+Sources of




March 24


March 28 Purchased $1,909 office equipment on account. The office equipment will be paid for in April and used during the next four years.

Total Resources


+Sources of


+Sources of




March 28

Exercise 9.2: Using Property, Plant, and Equipment

Prepare journal entries to record the following transactions of the Chopra Corporation for the month of April. Before you prepare each journal entry, determine the transaction's effects on the company's resources and sources of resources.

April 30 The company’s trial balance shows office supplies of $1,875 and office supplies expense of $0. During April, $550 of office supplies had been used up.

Total Resources


+Sources of


+Sources of




April 30

April 30 Buildings are being depreciated at a rate of $4,000 per month.

Total Resources


+Sources of


+Sources of




April 30


April 30 The company’s trial balance shows prepaid insurance of $2,400 and insurance expense of $0. During April, $400 of insurance protection had been used up.

Total Resources


+Sources of


+Sources of




April 30

April 30 Office equipment is being depreciated at a rate of $2,500 per month.

Total Resources


+Sources of


+Sources of




April 30

April 30 The company’s trial balance shows prepaid rent of $0 and rent expense of $900. The company’s rental lease states that it costs the company $300 per month to use the space it rents.

Total Resources


+Sources of


+Sources of




April 30


April 30 Autos and trucks are being depreciated at a rate of $1,000 per month.

Total Resources


+Sources of


+Sources of




April 30

Exercise 9.3: Property, Plant, and Equipment Cost

The Antonelli Corporation is in the process of acquiring additional land and a building. After lengthy negotiations, the company agreed to pay $75,000 for the land and $2,500,000 for the building. In addition, the company must pay legal fees of $500 for a title search to guarantee the seller owns the land. Another $3,000 must be paid to complete landscaping the land and $21,000 must be paid to finish construction on the building. The Antonelli Corporation must pay $12,000 per year to insure the building and approximately $24,000 per year to heat and cool it.

1. Calculate the cost the Antonelli Corporation would record in its land account for the purchase of the additional land.

2. Calculate the cost the Antonelli Corporation would record in its buildings account for the purchase of the building.

Exercise 9.4: Property, Plant, and Equipment Expense

The Chinokoyev Corporation was founded in August. During its first few months the company spent the following amounts to acquire property, plant, and equipment: $95,000 for land, $5,000,000 for buildings, $3,000,000 for equipment, and $72,000 for delivery trucks. The land was expected to have an unlimited life and a residual value of at least $95,000. The buildings were expected to have a 40-year life and a residual value of $1,000,000. The equipment was expected to have a 10-year life and a residual value of $400,000. The delivery trucks were expected to have a 5-year life and a residual value of $7,000.


1. Calculate the total buildings depreciation expense the Chinokoyev Corporation will record over the 40-year life of the buildings.

2. Calculate the total equipment depreciation expense the Chinokoyev Corporation will record over the 10-year life of the equipment.

3. Calculate the total delivery trucks depreciation expense the Chinokoyev Corporation will record over the 5-year life of the delivery trucks.

4. Calculate the total land depreciation expense the Chinokoyev Corporation will record over the life of the land.

Exercise 9.5: Straight-line Depreciation

The Bloomfield Corporation’s fiscal year ends June 30. On July 1, the company paid $40,000 for new office equipment. The equipment had an estimated useful life of ten years and a residual value of $6,000. The company uses the straight-line depreciation method for all office equipment.

1. Calculate the total depreciation expense the Bloomfield Corporation will record over the 10-year life of the office equipment.

2. Calculate the depreciation expense for each of the ten years of the office equipment’s useful life.

3. Calculate the balance in the accumulated depreciation account on each June 30 over the office equipment’s 10-year useful life.


4. Prepare the journal entry necessary to record the office equipment’s depreciation expense for the first year ended June 30. Before you prepare the journal entry, determine the transaction's effects on the company's resources and sources of resources.

Total Resources


+Sources of


+Sources of




June 30

5. Assume that the Bloomfield Corporation’s fiscal year ends on December, 31 instead of June 30. Prepare the journal entry necessary to record the office equipment’s depreciation expense for the first six months ended December 31. Before you prepare the journal entry, determine the transaction's effects on the company's resources and sources of resources.

Total Resources


+Sources of


+Sources of




Dec. 31

Exercise 9.6: Double-declining-balance Depreciation

The Rambarran Corporation’s fiscal year ends September 30. On October 1, the company paid $50,000 for new office equipment. The equipment had an estimated useful life of eight years and a residual value of $7,000. The company uses the double-declining-balance depreciation method for all office equipment.

1. Calculate the total depreciation expense the Rambarran Corporation will record over the 8-year life of the office equipment.


2. Calculate the depreciation expense for each of the eight years of the office equipment’s useful life.

3. Calculate the balance in the accumulated depreciation account on each September 30 over the office equipment’s 8-year useful life.

4. Prepare the journal entry necessary to record the office equipment’s depreciation expense for the year first ended September 30. Before you prepare the journal entry, determine the transaction's effects on the company's resources and sources of resources.

Total Resources


+Sources of


+Sources of




Sept. 30

5. Assume that the Rambarran Corporation’s fiscal year ends on December, 31 instead of September 30. Prepare the journal entry necessary to record the office equipment’s depreciation expense for the first three months ended December 31. Before you prepare the journal entry, determine the transaction's effects on the company's resources and sources of resources.

TotalResources


+Sources of


+Sources of




Dec. 31


Exercise 9.7: Income Effects of Depreciation Methods

The Wightman Corporation is planning to open a new store, which will require $80,000 of new equipment. Based on its estimates, the equipment will have a 4-year life and a residual value of $12,000. The company estimates the new store will generate average annual sales of $400,000, with an annual cost of goods sold of $150,000, and annual operating expenses (other than depreciation) of $200,000. The company’s expected income tax rate is 35%. The company has calculated depreciation of the new equipment as follows.

YearStraight-lineDepreciation

Double-DecliningBalance Depreciation

1 $17,000 $40,0002 $17,000 $20,0003 $17,000 $8,0004 $17,000 $0

Totals $68,000 $68,000

1. Calculate the Wightman Corporation’s expected net income for each of the four years if the company uses the straight-line depreciation method.

2. Calculate the Wightman Corporation’s expected net income for the total 4-year period if the company uses the straight-line depreciation method.

3. Calculate the Wightman Corporation’s expected net income for each of the four years if the company uses the double-declining-balance depreciation method.


4. Calculate the Wightman Corporation’s expected net income for the total 4-year period if the company uses the double-declining-balance depreciation method.

Exercise 9.8: Income Taxes Effects of Depreciation Methods

The Archambault Corporation purchased $100,000 of new equipment and expanded its operations. Based on its estimates, the equipment will have a 5-year life and a residual value of $20,000. The company estimates the new operations will generate average annual sales of $500,000, with an annual cost of goods sold of $200,000, and annual operating expenses (other than depreciation) of $240,000. The company’s expected income tax rate is 35%. The company has calculated depreciation of the new equipment as follows.

YearStraight-lineDepreciation

Double-DecliningBalance Depreciation

1 $16,000 $40,0002 $16,000 $24,0003 $16,000 $14,4004 $16,000 $1,6005 $16,000 $0

Totals $80,000 $80,000

1. Calculate the Archambault Corporation’s expected income taxes expense for each of the five years if the company uses the straight-line depreciation method.

2. Calculate the Archambault Corporation’s expected income taxes expense for the total 5-year period if the company uses the straight-line depreciation method.


3. Calculate the Archambault Corporation’s expected income taxes expense for each of the five years if the company uses the double-declining-balance depreciation method.

4. Calculate the Archambault Corporation’s expected income taxes expense for the total 5-year period if the company uses the double-declining-balance depreciation method.

Exercise 9.9: Income Taxes Advantage of Depreciation Methods

The McNamara Corporation is trying to decide whether it should depreciate its new equipment using the straight-line or double-declining-balance method. The company has calculated its income taxes expense resulting from the revenues and expenses related to the new equipment as follows.

YearStraight-line MethodIncome Taxes Expense

Double-Declining-BalanceMethod Income Taxes Expense

1 $14,000 $5,6002 $14,000 $11,3603 $14,000 $14,8164 $14,000 $18,2245 $14,000 $20,000

Totals $70,000 $70,000

Assume (1) the McNamara Corporation’s effective income tax rate is 35% (2) the company pays its taxes at the end of the year, and (3) the company expects to earn 10% before taxes on all cash not paid for income taxes.

Calculate the increase in resources the McNamara Corporation would have at the end of five years if the company uses the double-declining-balance depreciation method instead of the straight-line method.


Exercise 9.10: Property, Plant, and Equipment Disposal

On July 3, the Plisinski Corporation disposed of equipment that it no longer used. The equipment originally cost the company $76,000. On July 3, the equipment’s accumulated depreciation account had a balance of $68,000.

1. Calculate the company’s gain or loss if the company received $10,000 cash on disposal of the equipment.

2. Prepare the journal entry necessary to record the disposal of the equipment. Before you prepare the journal entry, determine the transaction's effects on the company's resources and sources of resources.

Total Resources


+Sources of


+Sources of




July 3

3. Calculate the company’s gain or loss if the company received $5,000 cash on disposal of the equipment.

4. Prepare the journal entry necessary to record the disposal of the equipment. Before you prepare the journal entry, determine the transaction's effects on the company's resources and sources of resources.

Total Resources


+Sources of


+Sources of




July 3


5. On which financial statement and in which section of the statement would the Plisinski Corporation report the gain or loss on disposal of the equipment?


Chapter Nine Problems

Problem 9.1: Reporting Property, Plant, & Equipment

Robert Distefano founded Distefano Products on September 1. During its first year the company had sales of $220,000, a cost of goods sold of $100,000, and operating expenses (not including depreciation) of $50,000. The company estimates its income taxes expense will be approximately 35% of income before taxes.

The company's equipment, all of which was purchased on September 1, cost $80,000, with an estimated residual value of $5,000, and a useful life of five years.

You have been asked by Robert Distefano to assist in deciding which depreciation method to use in accounting for the Distefano Products' activity for its first fiscal year ended August 31.

1. Calculate the Distefano Products' net income using the straight-line and double-declining-balance depreciation methods. Round all calculations to the nearest dollar.

Distefano ProductsIncome Statements

For the Year Ended August 31

Straight-line

Double-Declining-Balance

Sales $___________ $___________Cost of Goods Sold $___________ $___________Gross Profit $___________ $___________Operating ExpensesOther than depreciation $ 50,000 $___________Depreciation Expense $___________ $___________

Total Operating Expenses $___________ $___________Income Before Taxes $___________ $___________Income Taxes Expense $___________ $___________Net Income $___________ $ 24,700

2. How much more cash would Distefano Products have available on August 31, if it uses the double-declining-balance depreciation method instead of the straight-line method? _______________


3. Determine the following for Distefano Products:

Straight-line

Double-Declining-Balance

Equipment cost reported on the August 31 balance sheet at the end of its first year $ 80,000 $__________

Equipment accumulated depreciation dollar amount reported on the August 31 balance sheet at the end of its first year $_________ $__________

Equipment cost reported on the August 31 balance sheet at the end of its second year $_________ $__________

Equipment accumulated depreciation dollar amount reported on the August 31 balance sheet at the end of its second year $ 30,000 $__________

Problem 9.2: Accelerated Depreciation Tax Advantages

The Lecourt Corporation is trying to decide whether it should depreciate its new equipment using the straight-line method or double-declining-balance method. The company purchased the equipment on January 1, at a cost of $150,000, with an estimated residual value of $30,000, and a useful life of five years. The company pays its taxes at the end of each year and expects its effective income taxes rate to be 35%. The company expects to be able to invest at an after-tax rate of 4%.

Calculate the increase in resources the Lecourt Corporation can expect to have at the end of five years by using double-declining-balance depreciation instead of straight-line depreciation.

DateTax AdvantageDDB vs SL

Cash Availableto Invest

4% After-taxReturn

1 $___________ $ 0 $___________2 + $4,200.00 $___________ $___________3 $___________ $ 17,304.00 $___________4 - $7,560.00 $___________ $ 686.255 $___________ $___________ $___________

Totals $___________ $ 2,293.71 $___________

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