Principles of accounting II

CHAPTER TWO

2 ACCOUNTING FOR PLANT ASSETS AND

INTANGUBLE ASSETS

2.1 Characteristics of plant assets

Assets are alienated on the balance sheet as current or plant assets. Current assets are those assets that will
be sold, used up, or turned in to cash in the current accounting period, such as cash, receivables,
merchandise inventory, and supplies., where as plant assets are long-lived tangible assets that are of a
permanent nature, used in the operations of a business and not held for sale in the ordinary course of the
business.

Generally, Plant assets have the following characteristics:

 A useful life of more than one year
 acquired for use in the normal operation of the business
 not intended for sale to customers/for investment
 Yield services over many years/bundle of future services
 Physical substance (tangible, capable of being touched and seen)
 Plant assets are often called fixed assets, capital assets or property, plant and equipment

Example of plant assets

Land, buildings, warehouse, Farm equipment, Furniture, Machinery, computers, returnable containers,
lease hold improvements, and tools are all examples of plant assets. However, buildings that are not longer
used in the normal course of business , land held for speculative reasons and land held as a prospective
building cite are not plant assets.
Accounting issues related with property, plant and equipment

2.2 Initial cost of plant assets

The cost of a plant asset includes all normal expenditures necessary to acquire the asset and get it ready for
use. In more clear terms, in addition to the invoice price, the cost of a plant asset includes:
 Delivery costs
 Installation costs
 Sales tax
 Insurance costs while in transit, and any other normal and reasonable cost of getting the
asset ready for use in the normal course of business.

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Principles of accounting II
However, costs that result from carelessness, vandalism, and other abnormal causes are not necessary costs
and therefore are not part of the cost of a plant asset. Such expenditures are reported as operating expenses.

2.3 The nature of depreciation

Almost all plant assets with the exception of land either wear out with the passage of time (become
obsolete as technology improves) or become inadequate to meet the needs of an expanding business. That
is to mean that from time to time plant assets decline in their usefulness, but does not hold true for land.

As plant assets decline in their usefulness, a part of their cost should be transferred to an expense account
called depreciation expense. The process of allocating the cost of a plant asset over its useful life is referred
to as depreciation. Thus, depreciation is an allocation process, not a valuation process.

a) Recording depreciation
Depreciation is recorded in an end- of- period adjusting entry that debits a depreciation Expense account
and credits a contra-asset account called Accumulated Depreciation account.
In short, the depreciation expense for a period is recorded with the following entry.
Depreciation Expense -----------------------------xxx
Accumulated depreciation-Equipment------------------------xxx
(To record depreciation expense of equipment)
b) Factors that are included in calculating depreciation expense
It is paramount essential to consider three factors while determining depreciation for a plant asset. These
factors are:
1. Initial cost of the plant asset/cost of the asset
 All the so called necessary costs of acquiring the plant asset
2. Estimated salvage value/scrap value/trade-in-value/residual value
 The amount that an asset is expected to be worth at the end of its useful life
3. Estimated useful life or economic life
 The number of years the asset is expected to remain useful is called economic life of the plant
asset. the economic life of a plant asset may be given in terms of time(years), number of miles
driven, output produced, number of pages printed, number of copies made and etc.

2.4 Methods of calculating depreciation

There are different methods to calculate depreciation. The most common methods are:
1. The straight line method
2. The unit-of-production method
3. The accelerated method: a. Double declining method
b. Sum-of-years-digit method
We will view each method one by one.
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Principles of accounting II

2.4.1. The straight line method

The straight line method calls for an equal charge for depreciation expense over each of the accounting
periods in the life of a plant asset. The basic assumption in using this method is that equal amount of
benefit is expected to be derived from the plant asset over its useful life.

This method is based on the following formula.

Annual depreciation Expense = Cost - Salvage value

Economic life of the assets
►Cost-Salvage value=Depreciable cost

Illustration
Suppose that on January2, 1990, an organization purchased a piece of machinery for Birr 18,000. The
organization estimates that the asset will have a useful life of five years and a salvage value of Br.2000.
Required:
1. If the organization uses the straight line method, determine:
a. The depreciable cost
b. The depreciation expense for the period, and record it
c. The book value/ carrying value of the asset at the end of 2000

Solution
a. Depreciable Cost=Br.18,000-Br.2,000 =Br.16,000
b. Annual depreciation expense= DC/ EL =Br.16,000/5 = Br3,200/year

The annual depreciation is recorded with the following entry.

Depreciation expense-------------------------3,200
Accumulated depreciation-Machinery-----------3,200
c. Book value
Book value is the difference between the cost of the plant asset and its accumulated depreciation. It is often
called the cost not yet allocated to expense.

Book value=Cost-Accumulated depreciation

Book Value=18,000-3,200 =br.14,800

Example2
On July30, 1995, an organization purchased machinery for br25, 000. The asset is expected to have an
estimated useful life of 7 years and salvage value of Br 4,000.
Required:
1. Determine the depreciable cost
2. Determine the amount of depreciation expense for the year1995 and 1996
3. Record the depreciation expense for the year 1995, and 1996 as of December31
4. Determine the book value of the asset at:
a. December31, 1995
b. December31, 1996

Compiled by Habtamu T. MU, CBE, DCS 3

Principles of accounting II

Solution
1. DC=br.25,000-br4,000 =br.21,000

2. Annual depreciation= DC/ Economic life =br.21,000/7years =br.3,000/year

However, the machinery had been used for 5months during 1995. Thus the depreciation expense for the
year 1995 is calculated as follows.
Depreciation expense for 1995= Annual depreciation * No. of months the asset is used/12
=br3,000* 5months/12 =br.1,250
►Since the asset was fully used during 1996; the depreciation expense is the annual depreciation. That is,
br.3000.
3. December31, 1995 Depreciation expense---------------------------1250
Accumulated depreciation-machinery---------------1250
December31, 1996 Depreciation expense----------------------------3000
Accumulated depreciation-machinery----------------3000

♣If an asset is purchased on or before the 15 th of the month, count the month, if purchased after the 15 th,
don't count the month.

2.4.2. The unit of production method

This method allocates cost based on the estimated productive life of the asset.
It involves two steps:
1. Determining depreciation per unit of production, and
2. Determining depreciation expense for the period

Each value is calculated with the following formulas.

1. Depreciation per unit= Cost- salvage value
Estimated units of production
2. Depreciation expense = Depreciation *No. of units produced during the period
for a period per unit
Illustration
A manufacturing business purchases a machine for br.25,000, with an estimated life of 80,000 units and an
estimated salvage value of br1,000. During its first year operation it produces 23,600 units. Calculate the
depreciation expense for the first year using the unit of production method.
Solution
Depreciation per unit=br.25,000-br.1000 =br.0.3/unit
80,000 units
Depreciation expense for the year=br. 0.3*23,600 =br.7,080

2.4.3. Accelerated method of depreciation

This method, unlike the firs method discussed so far, allows greater depreciation in the early years of an
asset's life and less depreciation as the asset gets older. The basic assumption underlying this method is that
greater benefits are to be derived from the asset in its early life. Perhaps this method is more realistic than
other methods because most assets depreciate at a greater rate during the first years of operation.
Accelerated methods of depreciation are of two types: Declining Balance method and Sum- of- the- year’s
digit method.
We will illustrate the declining balance method first and then the sum-of-the-years digit method.

a) Declining balance method

It applies a constant rate of depreciation to the declining book value of the asset. Often this method is called
double declining balance method. It is so called for the rate used in this method is twice the straight line
rate that is used in the straight line method.
Two steps are required to calculate the depreciation expense for any given period:

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Principles of accounting II

1. Determining the double declining rate

The double declining rate, abbreviated as DDR, is determined with the following formula.

DDR = 2(100%)
Useful life

2. Determining depreciation expense for the period

Once the double declining rate is calculated, the depreciation expense for any period is computed with the
following formula.

Current period's depreciation expense= DDR * BV * No. of months used

12

Where: DDR is double declining rate

BV is book value
Illustration
A milk processing firm purchased an asset on January1, 1996, for br80,000, with an estimated useful life of
four years and expected salvage value of br4,000.
Required: compute the amount of depreciation for: a. 1992, b. 1993, c. 1994, and d. 1995?
Solution
DDR= (100%) 2 =50%
4
a. Depreciation expense, 1992=(50% * 80,000) *12/12 =br. 40,000
b. Depreciation expense, 1993=50% * (80,000-40,000)*12/12 =br. 20,000
c. Depreciation expense, 1994=50% * (80,000-60,000) =br. 10,000
d. Depreciation expense, 1995=(br.10,000-6,000) =br. 4,000 (♦Since an asset can't be depreciated below its
expected salvage value, depreciation stops when the book value reaches the salvage valve)

Summary
Year Cost DDR Depreciation Accumulated Book value
expense depreciation- -End of year
End of year
1992 80, 000 50% 40, 000 40, 000 40, 000
1993 80, 000 50% 20, 000 60, 000 20, 000
1994 80, 000 50% 10, 000 70, 000 10, 000
1995 80, 000 50% 4, 000 74, 000 6, 000

Note that in the declining balance method Salvage value is not considered in determining the depreciation
rate, and it is also ignored in computing periodic depreciation

Exercise
A bank purchased office machinery on June19, 1995, for br.75,000, with an estimated life of four years and
an expected salvage value of br5,000. Calculate the depreciation expense for 1995 and 1996 using the
double declining balance method?
b) Sum-of-the years-digit method
This method, just like the double declining method, provides greater depreciation expense in the early years
of the asset's useful life.
Under this method the depreciation expense for a period is computed with the following formula:
Depreciation expense = DC (n-i)
SY

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Principles of accounting II

Where: DC is depreciable cost=Cost-salvage value

n is estimated useful life of the asset
i is the number of years the asset is used before the current period
SY is sum of the years
►A short cut formula to use in finding the sum of the years (SY) is:

SY = n(n+1)
2
♠n is estimated useful life of the asset
Example 1
Assume that in early January 1991 a delivery van was purchased by Hibret Bank. Further assume the van
had a cost of br.21,000, an estimated salvage value of br.3,000, and an estimated useful life of 5 years.
Using the sum-of-years digit method the depreciation expense for the years 1992 through 1996 is calculated
as follows.
Solution
1. Depreciable Cost=DC=21,000-3,000 =br. 18,000
2. Sum of years= SY= 5(5-1)/2 = 15

Depreciation expense, for 1991=DC* n-i/SY =18,000 * (5-0)/15 =18,000* 5/15 =br. 6,000

Depreciation expense, for 1992=18, 000 * (5-1)/15 =18, 000 * 4/15 =br. 4,800
Depreciation expense, for 1993=18,000 *(5-2)/15 =18,000 * 3/15 =br. 3,600
Depreciation expense, for 1994=18, 000 *(5-3)/15 =18, 000 * 2/15 =br.2, 400
Depreciation expense, for 1995=18, 000 * (5-4)/15 =18, 000 *1/15 =br. 1,200
Year Amount of depreciation
1992 Br.6, 000
1993 Br.4, 800
1994 Br.3, 600
1995 Br.1, 200
 Pass the required entry for each year?

Example 2
Assume that Hibret's van was purchased on October1 (instead of early January).Compute the amount of
depreciation for the year1992, 1993, 1994 and 1995 using the sum of the years digit method and pass the
necessary journal entry?
Solution
1. Depreciation expense for 1991
► Prorate the depreciation because Hibret used the asset only for 3 months during 1992
►DE for 1992(3 months) = (DC * (n-I)) No. of months used during the year
SY 12
=br18, 000 (5-0) *3/12 =br. 1,500
15
2. Depreciation expense for 1992
►DE for 1993= 18, 000 *5/15 *9/12 + 18,000 *4/15 *3/12 =4,500+1200 =br. 5,700
3. Depreciation expense for 1993
►DE for 1994=18,000*(5-1)/15 *9/12 + 18,000*(5-2)/15 *3/12 =3,600+900 =br. 4,500
4. Depreciation expense for 1994
►DE for 1995=18,000*(5-2)/15 *9/12 + 18,000*(5-3)/15 * 3/12 =2,700+600 =br. 3,300
5. Depreciation expense for 1995
►DE for 1996=18000*(5-3)/15+18000*(5-4)/15*3/12 =1800+300 =br. 2,100
6. Depreciation expense for 1996
►DE for 1997=18000*(5-4)/15 * 9/12 =br. 900

Compiled by Habtamu T. MU, CBE, DCS 6

Principles of accounting II

2.5 Revision of periodic depreciation

A business may commit an error while estimating the salvage value and or the useful life of a plant asset.
When such errors occur, the revised estimates are used to determine the amount of the remaining
undepreciated asset cost to be charged as an expense in future periods.

Example
Assume that a plant asset purchased for br130, 000 and originally estimated to have a useful life of 30 years
and a residual value of br10, 000 has been depreciated for 10 years by straight line method. During the
eleventh year, it is estimated that the remaining useful life is 25 years and that the residual value is br5000.
Required: Determine the depreciation expense for each of the remaining 25 years?

Solution
Yearly depreciation expense before revision:
DE=130,000-10,000 =br. 4000
30
* The asset was used for 10 years before revision.
Balance of accumulated depreciation to date of revision=4000*10 =br. 40,000
Book value to date of revision=130,000-40,000 =br. 90,000
Yearly depreciation expense after revision:
Book value end of the 10th year ---------------------90,000
Less: revised salvage value--------------------------- (5,000)
Depreciable cost------------------------------------------85,000
Yearly depreciation expense after revision= DC/revised useful life =85, 000/25 =br. 3, 400

2.6 Capital and revenue expenditures

Expenditures for plant assets may occur after the assets are purchased and placed in service. The concern of
this topic is to discuss how to account for expenditures in connection with a plant asset after it has been
placed in service.
Some expenditure during the life of a plant asset benefit only one accounting period-the current period,
other expenditures add to an asset's value or extend its life. These expenditures are generally classified in
to:
1. Revenue expenditures, and
2. Capital expenditures

1. Revenue expenditures
Revenue expenditures are expenditures that benefit only the current period and are debited to expense
account. Such expenditures are often called income statement expenditures. In general revenue
expenditures are small in amount (not material) but frequent.
Example of revenue expenditures include:
* Ordinary repairs
* Maintenance expenses
* Supplies
* Repainting of a building
Illustration
Suppose that a window in a warehouse building of Lemat multipurpose cooperative is broken and br120
cash is paid to repair it. The cash paid to repair the window is recorded with the following entry.
Repair expense-----------------------120
Cash--------------------------------------120

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Principles of accounting II

2. Capital expenditure
Capital expenditures are expenditures that benefit more than just the current period. Some capital
expenditures add value to the plant asset; others add life. Thus capital expenditures are classified in to two:
Additions and betterments, and extraordinary repairs.

a. Additions and betterments

Additions and betterments are capital expenditures that add value to the plant asset and are debited to the
plant asset account. They are often called balance sheet expenditures.

Addition refers to adding on of a new part to the plant asset, such as adding an air conditioner to a car, and
adding a new wing to a building.
Betterment refers improvement of a plant asset, such as the replacement of existing old part for a new one.

b. Extraordinary repairs
These are capital expenditures that prolong (extend) the life of the plant asset, and are debited to the related
Accumulated Depreciation account. For instance, if a firm pays br400 for a major overhaul of a six-year old
car and if this expenditure prolongs the life of the asset, the expenditure would be recorded with the
following entry:
Accumulated depreciation---------------------------------------- 400
Cash--------------------------------------------------------------------------400

Exercise
Assume that a truck costing br370, 000 has no estimated salvage value with an estimated service life of 10
years. After the truck has been depreciated for the last 7 years by the straight line method, an extraordinary
repair for br24, 000 has been made. This extraordinary repair increases the remaining life of the asset to 6
years (instead of 3 years)
Required
a. Record the extraordinary repair made?
b. Determine the annual depreciation expense for the remaining 6 years of life?

2.7 Disposal of plant assets

Plant assets that are no longer useful may be disposed off. A plant asset may be disposed-off by:
1. Discarding
2. Selling
3. Exchange/Trading in

2.7.1 Discarding of Plant Assets

If a plant asset is no longer useful to the business and has no market value, the asset is discarded (thrown
away or burnt).
There are two situations of discarding plant assets:
1. Discarding a fully depreciated plant asset, and
2. Discarding a plant asset with book value

1. Discarding a fully depreciated plant asset

When a fully depreciated plant asset is discarded, no gain or loss occurs because there is no book value.
That is if a fully depreciated asset is discarded, the plant asset account and its related accumulated
depreciation account are equal in amount.

Example
Assume that an item of equipment acquired at cost of br12, 000 became fully depreciated at december31,
1994. On January10, 1995, the asset was discarded as worthless.

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Principles of accounting II
Required: record the entry on January 10, 1995?

Solution
Book value=0, because the asset is fully depreciated, that is cost=Accumulated depreciation
Thus,
Accumulated depreciation----------------------12,000
Equipment----------------------------------------------12,000

What is the accounting treatment for an asset that is fully depreciated, but continues to be
used in a business?

An asset that is fully depreciated and continues to be used in the business will be
reported on the balance sheet at its cost along with its accumulated depreciation. There
will be no depreciation expense recorded after the asset is fully depreciated. No entry is
required until the asset is disposed of through retirement, sale, salvage, etc.
To illustrate this, let’s assume that a machine with a cost of $100,000 was expected to
have a useful life of five years and no salvage value. The company depreciated the asset
at the rate of $20,000 per year for five years. If the machine is used for three more
years, the depreciation expense will be $-0- in each of those three years. During those
three years, the balance sheet will report its cost of $100,000 and its accumulated
depreciation of $100,000 for a book value of $-0-.

2. Discarding a plant asset with a book value

When a plant asset with a book value is discarded, a loss will result. The loss can be recognized for both
accounting and taxes purposes.
Example
A cooperative business owns an automobile that was purchased on January4, 1992, at a cost of br14, 000. It
has been depreciated using the straight line method at the rate of br2, 400 a year. On April1, 1994, the
automobile was damaged beyond repair in an accident. An insurance check for br4, 400 was received and
the asset was discarded.

Required: prepare journal entries to:

a) Record depreciation on date of disposal, April1, 1994?
b) Record the disposal of the plant asset?

Solution
If a plant asset that is not fully depreciated is discarded, the first step in recording the disposal is to
determine the amount of depreciation to date of disposal. The second step is to record the unrecorded
depreciation to date of disposal .The third step is to determine the book value of the asset on date of
disposal. And the last step is to record the disposal of the plant asset.
Step1. Depreciation expense to date of disposal:
- The automobile was used for 3 months during 1994. The amount of depreciation to date of
disposal would be:
Depreciation=Annual depreciation * No. of months used =2,400*3/12 =br.600
12
Step2. Recording the unrecorded depreciation:
Depreciation expense------------------------------600
Accumulated depreciation-Equipment---------------600
Step3. Book value to date of disposal
The asset was used for 2years and 3 months.
Balance of accumulated depreciation to date of disposal=2,400*2+600 =br.5,400
Book Value= 14, 000-5, 400 =br.8,600

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Principles of accounting II
Loss on disposal=8, 600-4, 400 =4, 200
Step4. Recording the disposal of the asset:
Cash--------------------------------------------------4,400
Loss on disposal-------------------------------------------------------4,200
Accumulated depreciation- Automobile---------5,400
Automobile---------------------------------------------------14,000

2.7.2 Sale of plant assets

A plant asset which is no longer useful to the business but useful to other businesses can be sold.
Three outcomes are possible when a plant asset is sold. It may be sold:
1. for its book value-with no loss no gain
2. above its book value- at a gain,
3. below its book value-at a loss
Exercise
On January 3, 1990, a cooperative business purchased office equipment for br.4,500. Since that time, the
office equipment has been depreciated at the rate of br.900 a year. On may1, 1994, midway in to the fifth
year of the asset's life, it is sold for: 1. Br.600 and 2. Br.800 3. Br.450?
Required: taking each case independently, record the necessary entry on date of sale?

2.7.3 Exchange of plant assets

A business may exchange an old plant asset for another new plant asset. Exchange may involve similar
assets or dissimilar assets.
►Assets are similar when they perform the same function
► Assets are dissimilar when they perform different functions
When a plant asset is exchanged for another asset, a trade in allowance is received for the old asset. The
trade in allowance may be equal to, greater than, or less than the book value of the old plant asset.
►Boot is the amount of money that the purchaser must pay. It is the difference between
the price of the new asset (list price of the new asset) and the trade- in allowance. Boot is found with the
following formula.

Boot=List price - Trade-in-allowance

a) Determination of gain or loss on exchange
1. Compare the book value of the old asset to date of disposal and the trade-in allowance received for the
old asset.
2. If the trade-in allowance equals the book value of the old asset to date of disposal, no loss no gain
occurs.
3. If the trade-in allowance received is greater than the book value of the old asset, gain occurs.
4. If the trade-in allowance is less than the book value of the old asset, loss occurs.

a) Recognition of loss or gain on exchange

Recognition of loss or gain on exchange depends on the nature of the assets exchanged.
►If the exchange involves similar assets, don't recognize gain, but recognize any loss.
►If the exchange involves dissimilar assets, recognize any loss, or gain if any.
Entries on date of exchange/similar assets/
►When there is loss on exchange, the exchange transaction is recorded with the following entry:
Cost of new asset---------------------------------xxx
Accumulated depreciation-old------------------xxx
Loss on exchange---------------------------------xxx
Cost of Asset-old----------------------------------------------xxx
Cash/Account payable----------------------------------------xxx
►When there is gain (unrecognized gain), the exchange transaction is recorded with the following entry:
Cost of new asset-------------------------xxx
Accumulated depreciation-old----------xxx

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Principles of accounting II
Asset-old-------------------------------------xxx
Cash/Accounts-------------------------------xxx
Cost of new asset=List Price- Unrecognized gain
Or
Cost of new asset=Boot + Book value of old assets

2.8 Natural resources

A natural resource or wasting asset is a long-term asset that is purchased for the purpose of removing or
extracting natural resources, such as timber, oil, coal, gold, or gas.
►The expense resulting from the using up of natural resources is called depletion. The calculation of
depletion is similar to calculating depreciation by the units-of-production method. That is:
1. Determine depletion expense per unit
Depletion expense per unit=Cost of resources
Estimated output

2. Determine depletion expense for a period

Depletion expense for a year= Depletion expense per unit * No. of units extracted

►Once the depletion expense for a period is calculated, the period's depletion expense is recorded with the
following entry.
Depletion expense---------------------------------------xxx
Accumulated depletion-Natural resource-------------------xxx
Example
Assume that on April2, 2000, a Company purchased oil-drilling rights to a well for br.10,000,000. No
salvage value is expected, and it is estimated that the well will produce20, 000, 000 barrels of oil before it
is exhausted. If 150,000 barrels of oil were removed during 2000, calculate the depletion expense for the
year (2000).

Solution
1. Depletion expense per barrel= br10, 000000/20, 000000 =br.0.5/barrel
2. Depletion expense for 2000=br0.5 * 150, 000 =br.75,000

Depletion expense-----------------------------75,000
Accumulated depletion-oil well---------------------75,000

2.9 Intangible Assets

Intangible assets are long-term assets that lack physical substance and include such things as:
►Patents
►copy rights
►Trade marks
► Franchise

Since intangible assets will provide benefits for an estimated number of years (maximum 40 years), it is
appropriate that the cost of an intangible asset be written off over that number of years. The periodic write-
off of an intangible asset is called Amortization.

►Intangible assets are amortized using the straight line method. And the period's amortization expense is
recorded with the following entry.
Amortization expense--------------xxx

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Principles of accounting II
Intangible asset---------------------xxx
Example
Assume that on January9, 2002, a company purchased a patent for a new exercise machine at a cost of
br.96,000. Further assume that the owner estimates that the patent will benefit the company for 10 years.
Show the entry to record the cost of the patent, and the 2002 amortization expense.

Solution
Yearly Amortization expense=br.96,000/10years =br.9,600/year
Amortization expense---------------------9,600
Patent----------------------------------------------9,600
Note
* A contra asset account is not used in an entry for amortization
* The asset account is credited directly

Compiled by Habtamu T. MU, CBE, DCS 12