Chapter Two

Property, Plant & equipment; Intangible Assets and Natural Resources

2.1 Property, plant & Equipment

2.1.1 Nature of PPE

Property, plant & Equipment (PPE) are resources that have three characteristics: they
have a physical substance (a definite size and shape), are used in the operations of a
business, and are not intended for sale to customers. These assets are expected to
provide services to the company for a number of years. They are also called long-
lived assets, plant assets or fixed assets, or non-current assets. Except for land, PPEs
decline in service potential over their useful lives.

2.1.2 Cost of PPE (Measurement at the time of recognition)

All costs required to bring an asset into working condition should be recorded as part of
the cost of the asset at the time of recognition. Elements of such costs include its
purchase price plus fright costs and any directly attributable costs incurred to bring the
asset to the location and operating condition as expected by management, including the
costs of site preparation, delivery and handling, installation, set-up and testing.

These costs are capitalized and are not to be expensed in the period in which they are
incurred, which means it should appear on the balance sheet as an asset. Otherwise,
the cost should be reported as an expense on the income statement. Capitalized costs
are normally expected to last more than a year.

Only costs necessary for preparing a long-lived asset for use should be included as a
cost of the asset. Unnecessary costs that do not increase the asset’s usefulness are
recorded as an expense. For example, the following costs are included as an expense:
• Vandalism
• Mistakes in installation
• Uninsured theft
• Damage during unpacking and installing
• Fines for not obtaining proper permits from governmental agencies

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 2.1.3 Measurement After Recognition

A. Depreciation of PPE

As we have discussed earlier, land has an unlimited life and therefore can provide
unlimited services. On the other hand, other fixed assets such as equipment,
machinery, and buildings lose their ability, over time, to provide services i.e., their
usefulness to the company and revenue-producing ability will decline over their useful
life because of wear and tear. As a result, their cost should be transferred to expense
accounts in a systematic manner during their expected useful lives. This periodic
transfer of cost to expense is called depreciation.

The adjusting entry to record depreciation is usually made at the end of each month or
at the end of the year. This entry debits Depreciation Expense and credits a contra
asset account entitled Accumulated Depreciation or Allowance for Depreciation.
The use of a contra asset account allows the original cost to remain unchanged in the
fixed asset account.

Factors that cause a decline in the ability of a fixed asset to provide services may be identified
as physical depreciation or functional depreciation.

 Physical Depreciation: occurs from wear and tear while in use and from the action of
the weather i.e., from exposure to the elements, such as wind and sun.

 Functional Depreciation (Obsolescence): occurs when a fixed asset is no longer able

to provide services at the level for which it was intended because of improvements or
evolution in technology. For example, a personal computer made in the 1980s would
not be able to provide an Internet connection because computers keep getting more
efficient and powerful. Such advances in technology during this century have made
functional depreciation an increasingly important cause of depreciation.

Accounting for Depreciation

Three factors are considered in determining the amount of depreciation expense to be

recognized each period. These three factors are (a) the fixed asset’s initial cost, (b) it
expected useful life or service life/productive life, and (c) its estimated value at the
end of its useful life. This third factor is called the residual value, scrap value,
salvage value, or trade-in value.

A fixed asset’s residual value at the end of its expected useful life must be estimated at
the time the asset is placed in service. If a fixed asset is expected to have little or no

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 residual value when it is taken out of service, then its initial cost should be spread
over its expected useful life as depreciation expense. If, however, a fixed asset is
expected to have a significant residual value, the difference between its initial cost and
its residual value, called the asset’s depreciable cost, is the amount that is spread over
the asset’s useful life as depreciation expense.

The three methods used most often to compute depreciation are (1) straight-line, (2)
units of-production, and (3) declining-balance. Each method is acceptable under
IFRS. Management selects the method(s) it believes to be appropriate. Once a
company chooses a method, it should apply it consistently over the useful life of
the asset. Consistency enhances the comparability of financial statements.
Depreciation
affects the statement of financial position through accumulated depreciation and the
income statement through depreciation expense.

Straight-Line Method

The straight-line method provides for the same amount of depreciation expense for
each year of the asset’s useful life. To compute depreciation expense under the
straight-line method, companies need to determine depreciable cost. Depreciable cost
is the cost of the asset less its residual value. It represents the total amount subject to
depreciation.

Under the straight-line method, to determine annual depreciation expense, we divide

depreciable cost by the asset’s useful life. The rate of depreciation is the same in
each year.

For example, assume that the cost of a depreciable asset is Birr 24,000, its estimated
residual value is Birr 2,000, and its estimated life is 5 years. The annual depreciation is
computed as follows:

Br. 24,000 cost – Br. 2,000 estimated residual value = Birr 4,400 annual depreciation
5 years estimated life

Alternatively, a company can use an annual straight-line rate by applying the

percentage rate to the depreciable cost of the asset. This percentage is determined by
dividing 100% by the number of years of useful life. In the above example, the annual
depreciation of $4,400 can be computed by multiplying the depreciable cost of $22,000
by 20% (100%/5).

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 When an asset is used for only part of a year, the annual depreciation is prorated.
For example, assume that the fiscal year ends on December 31 and that the asset in the
above example is placed in service on October 1. The depreciation for the first fiscal
year of use would be Birr 1,100 (Birr 4,400 x 3/12).

The straight-line method is simple and is widely used. It provides a reasonable transfer
of costs to periodic expense when the asset’s use and the related revenues from its use
are about the same from period to period.

Units-of-Production Method

How would you depreciate a fixed asset when its service is related to use rather than
time? When the amount of use of a fixed asset varies from year to year, the units-
of-production method is more appropriate than the straight-line method. In such
cases, the units-of-production method better matches the depreciation expense with the
related revenue.

To apply this method, the useful life of the asset is expressed in terms of units of
productive capacity such as hours or miles. The total depreciation expense for each
accounting period is then determined by multiplying the unit depreciation by the units
of activity during the period.

For example, assume that a machine with a cost of Birr 24,000 and an estimated
residual value of Birr 2,000 is expected to have an estimated life of 10,000 operating
hours. The depreciation for a unit of one hour is computed as follows:

Birr 24,000 cost – Birr 2,000 estimated residual value = Birr 2.20 hourly
depreciation
10,000 estimated hours

Assuming that the machine was in operation for 2,100 hours during a year, the
depreciation for that year would be Birr 4,620 (Birr 2.20 x 2,100 hours).

Example 2: Suppose that a delivery truck cost Birr 20,000 and has an estimated residual value
of Birr 2,000 at an estimated useful life of 90,000 miles, the depreciation cost per mile would
be determined as follows:

Birr 20,000 Cost – Birr 2,000 Residual Value = Birr 0.20 per mile
90,000 miles

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Assuming the truck was driven 20,000 miles in the first year, the depreciation for that year
would be Birr 4,000 (Birr 0.20 x 20,000 miles).

The units-of-activity method is generally not suitable for buildings or furniture because
depreciation for these assets is more a function of time than of use.

Declining-Balance Method

The declining-balance method provides for a declining periodic expense over the
estimated useful life of the asset. To apply this method, the annual straight-line
depreciation rate is doubled. For example, the declining-balance rate for an asset
with an estimated life of 5 years is 40%, which is double the straight-line rate of 20%
(100%/5).

For the first year of use, the cost of the asset is multiplied by the declining balance
rate. After the first year, the declining book value (cost minus accumulated
depreciation) of the asset is multiplied by this rate.

To illustrate, the annual declining balance depreciation for an asset with an estimated 5-year
life and a cost of $24,000 is shown below.

You should note that when the declining-balance method is used, the estimated residual
value is not considered in determining the depreciation rate. It is also ignored in
computing the periodic depreciation. However, the asset should not be depreciated
below its estimated residual value. In the above example, the estimated residual value
was $2,000. Therefore, the depreciation for the fifth year is $1,110.40 ($3,110.40 -
$2,000.00) instead of $1,244.16 (40% x $3,110.40).

The declining-balance method charges the higher depreciation expense in early years
with the higher benefits received in these years. It also recognizes lower depreciation

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 expense in later years, when the asset’s contribution to revenue is less. It assumes that
many plant assets are most efficient when new and so provide the greatest benefits in
their first year.
B. Capital Expenditures and Revenue Expenditures

The costs of acquiring fixed assets, adding to a fixed asset, improving a fixed asset, or
extending a fixed asset’s useful life are called capital expenditures. Capital
expenditures are recorded in asset accounts because they benefit several future
accounting periods.

Costs that benefit only the current period or costs incurred for normal maintenance and
repairs are called revenue expenditures. For example, trucks, machines, and other
equipment require periodic tune-ups and routine repairs. Expenditures of this type are
recorded in expense accounts because their benefits are realized in the current period.

2.1.4 Disposal (Derecognition) of PPE

Fixed assets that are no longer useful may be discarded, sold, or traded for other fixed
assets. The details of the entry to record a disposal will vary. In all cases, however, the
book value of the asset must be removed from the accounts. The entry for this
purpose debits the asset’s accumulated depreciation account for its balance on the date
of disposal and credits the asset account for the cost of the asset.

A) Discarding Fixed Assets

When fixed assets are no longer useful to the business and have no residual or market
value, they are discarded. To illustrate, assume that an item of equipment acquired at a
cost of $25,000 is fully depreciated at December 31, the end of the preceding fiscal
year. On February 14, the equipment is discarded.

The entry to record this is as follows:

Feb 14 Accumulated Depreciation- Equipment ……………………… 25,000

Equipment………………………………. 25,000
To write off equipment discarded

If an asset has not been fully depreciated, depreciation should be recorded prior to
removing it from service and from the accounting records.

To illustrate, assume that equipment costing $6,000 is depreciated at an annual straight-

line rate of 10%. In addition, assume that on December 31 of the preceding fiscal year,

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 the accumulated depreciation balance, after adjusting entries, is $4,750. Finally, assume
that the asset is removed from service on the following March 24. The entry to record
the depreciation for the three months of the current period prior to the asset’s removal
from service is as follows:

Mar 24 Depreciation Expense - Equipment……………………………….. 150

Accumulated Depreciation - Equipment…………………………. 150
To record current depreciation on equipment discarded ($600 x 3/12).

The discarding of the equipment is then recorded by the following entry:

Mar 24 Accumulated Depreciation – Equipment…………………………. 4,900
Loss on Disposal of Fixed Assets………………………………… 1,100
Equipment……………………..……………….. 6,000
To write off equipment discarded.

The loss of $1,100 is recorded because the balance of the accumulated depreciation
account ($4,900) is less than the balance in the equipment account ($6,000). I.e., the
company retires a fixed asset before it is fully depreciated. Losses on the discarding of
fixed assets are nonoperating items and are normally reported in the Other Expense
section of the income statement.

B) Selling Fixed Assets

The entry to record the sale of a fixed asset is similar to the entries illustrated above,
except that the cash or other asset received must also be recorded. If the selling price is
more than the book value of the asset, the transaction results in a gain. If the
selling price is less than the book value, there is a loss.

To illustrate, assume that equipment is acquired at a cost of $10,000 and is depreciated

at an annual straight-line rate of 10%. The equipment is sold for cash on October 12 of
the eighth year of its use. The balance of the accumulated depreciation account as of
the preceding December 31 is $7,000. The entry to update the depreciation for the nine
months of the current year is as follows:

Oct 12 Depreciation Expense––Equipment…………………………….. 750

Accumulated Depreciation––Equipment……………………………. 750
To record current depreciation on equipment sold ($10,000 x ¾ x 10%).

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 After the current depreciation is recorded, the book value of the asset is $2,250
($10,000 - $7,750). The entries to record the sale, assuming three different selling
prices, are as follows:

Sold at book value, for $2,250. No gain or loss.

Oct 12 Cash ……………………………………………………….………. 2,250
Accumulated Depreciation––Equipment…………...………………. 7,750
Equipment…………………………………….. 10,000

Sold below book value, for $1,000. Loss of $ 1,250

Oct 12 Cash ……………………………………………………….………. 1,000
Accumulated Depreciation––Equipment…………...………………. 7,750
Loss on disposal of Fixed Assets…………………………………… 1,250
Equipment………………….…………….…….. 10,000

Sold above book value, for $2,800. Gain 550

Oct 12 Cash ……………………………………………….………. 2,800
Accumulated Depreciation––Equipment ……….…..………. 7,750
Equipment …………………………………….. 10,000
Gain on disposal of Fixed Assets ……………… 550

2.1.5 Internal Controls of Plant Assets

Because of their dollar value and long-term nature, it is important to design and apply
effective internal controls over fixed assets. Such controls should begin with
authorization and approval procedures for the purchase of fixed assets. Controls should
also exist to ensure that fixed assets are acquired at the lowest possible costs. One
procedure to achieve this objective is to require competitive bids from preapproved
vendors.

As soon as a fixed asset is received, it should be inspected and tagged for control
purposes and recorded in a subsidiary ledger. This establishes the initial accountability
for the asset. Subsidiary ledgers for fixed assets are also useful in determining
depreciation expense and recording disposals.

Fixed assets should be insured against theft, fire, flooding, or other disasters. They
should also be safeguarded from theft, misuse, or other damage. For example, fixed
assets that are highly open to theft, such as computers, should be locked or otherwise
protected when not in use. For computers, safeguarding also includes climate controls

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 and special fire-extinguishing equipment. Procedures should also exist for training
employees to properly operate fixed assets such as equipment and machinery.

A physical inventory of fixed assets should be taken periodically in order to verify the
accuracy of the accounting records. Such an inventory would detect missing, obsolete,
or idle fixed assets. In addition, fixed assets should be inspected periodically in order to
determine their condition.

Careful control should also be exercised over the disposal of fixed assets. All disposals
should be properly authorized and approved. Fully depreciated assets should be
retained in the accounting records until disposal has been authorized and they are
removed from service.

2.2 Intangible Assets

Nature and Classification of Intangible Assets

Patents, copyrights, trademarks, and goodwill are long-lived assets that are useful in the
operations of a business and are not held for sale. These assets are called intangible assets
because they do not exist physically.

A) Patents

According to the Ethiopian patent act, i.e., a Proclamation Concerning Inventions, Minor
Inventions and Industrial Designs Proclamation No. 123/1995, patent is an invention
that is new and is industrially applicable, then it will be patentable.

In Ethiopia patents will be granted by the Ethiopian Intellectual Property Office, the
office entrusted with the powers of registration and protection of Intellectual property
rights, including Patents. If an inventor is granted the patent of invention, the invention
will be valid for a period of 15 years. But the validity of the patent may be extended
for a further 5 years provided that proof is furnished that the invention is being
properly worked in Ethiopia.

An individual or a business may purchase patent rights from others, or it may obtain
patents developed by its own research and development efforts. The initial cost of a
purchased patent, including any related legal fees, is debited to an asset account. This
cost is written off, or amortized, over the years of the patent’s expected usefulness. This
period of time may be less than the remaining legal life of the patent. The estimated
useful life of the patent may also change as technology or consumer tastes change.

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 The patent holder amortizes the cost of a patent over its legal life or its useful life,
whichever is shorter. Companies consider obsolescence and inadequacy in determining
useful life. These factors may cause a patent to become economically ineffective before
the end of its legal life.
The straight-line method is normally used to determine the periodic amortization.
When the amortization is recorded, it is debited to an expense account and credited
directly to the patents account. A separate contra asset account is usually not used for
intangible assets.

To illustrate the computation of patent amortization, assume that National Labs purchases
a patent at a cost of $720,000. If National estimates the useful life of the patent to be
eight years, the annual amortization expense is $90,000 ($720,000/8). National records
the annual amortization as follows.

Dec 31 Amortization Expense—Patents ……………………………. 90,000

Patents …………………………………….. 90,000
(To record patent amortization)

Rather than purchase patent rights, a business may incur significant costs in developing
patents through its own research and development efforts. Such research and
development costs are usually accounted for as current operating expenses in the period
in which they are incurred. Expensing research and development costs is justified
because the future benefits from research and development efforts are highly uncertain.

B) Copyrights and Trademarks

The exclusive right to publish and sell a literary, artistic, or musical composition is
granted by a copyright. Copyright, according to Ethiopian Copyright and Neighboring
Rights Protection Proclamation No. 410/2004, is protected for the life time as long as the
author lives plus 50 years after his/her death. The costs of a copyright include all costs of
creating the work plus any administrative or legal costs of obtaining the copyright. A
copyright that is purchased from another should be recorded at the price paid for it.
Copyrights are amortized over their estimated useful lives.

A trademark is a name, term, or symbol used to identify a business and its products. For
example, the distinctive red-and-white Coca-Cola logo is an example of a trademark.
Most businesses identify their trademarks with ® in their advertisements and on their
products.

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 The registration of a Trademark, according to the Ethiopian Trademark Proclamation,
will remain valid for a period of 7 years from the date of submission of the application
for registration and renewing the registration for 7-year periods thereafter.

If a company purchases the trademark or trade name, its cost is the purchase price. If a
company develops and maintains the trademark or trade name, any costs related to these
activities are expensed as incurred. Because trademarks and trade names have indefinite
lives, they are not amortized.

C) Goodwill

In business, goodwill refers to an intangible asset of a business that is created from such
favorable factors as desirable location, product quality, reputation, and managerial skill.
Goodwill allows a business to earn a rate of return on its investment that is often in
excess of the normal rate for other firms in the same business.

One could try to put a monetary value on the factors listed above (desirable location,
reputation and so on). But the results would be very subjective, and such subjective
valuations would not contribute to the reliability of financial statements. Therefore,
companies record goodwill only when an entire business is purchased. In that case,
goodwill is the excess of cost over the fair value of the net assets (assets less liabilities)
acquired.

Goodwill is not amortized because it is considered to have an indefinite life, but its
value should be written down if impaired. Companies report goodwill in the statement
of financial position under intangible assets.

2.3 Natural Resources

The fixed assets of some businesses include standing timber and resources extracted from
the ground, such as oil, gas, and minerals.

The acquisition cost of an extractable natural resource is the price needed to acquire the
resource and prepare it for its intended use. This process of transferring the cost of natural
resources to an expense account is called depletion. The amount of depletion is
determined by multiplying the quantity extracted during the period by the depletion rate.
This rate is computed by dividing the cost of the mineral deposit by its estimated size.

Computing depletion is similar to computing units-of-production depreciation. To

illustrate, assume that Lane Coal Company invests $50 million in a mine estimated to

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 have 10 million tons of coal and no residual value. In the first year, Lane extracts and
sells 800,000 tons of coal. Lane computes the depletion expense as follows.

$50,000,000 /10,000,000 = $5 depletion cost per ton

$5 x 800,000 = $4,000,000 annual depletion expense

Lane records depletion expense for the first year of operation as follow

Dec 31 Depletion Expense………………………………………… 4,000,000

Accumulated Depletion ……………………………………. 4,000,000

Like the accumulated depreciation account, Accumulated Depletion is a contra asset

account. It is reported on the balance sheet as a deduction from the cost of the mineral
deposit.

2.4 Financial Statement Presentation

Usually, companies combine plant assets and natural resources under “Property, plant,
and equipment” in the statement of financial position. They show intangibles separately.
Companies disclose either in the statement of financial position or the notes to the
financial statements the balances of the major classes of assets, such as land, buildings,
and equipment, and accumulated depreciation by major classes or in total. In addition,
they should describe the depreciation and amortization methods that were used, as well as
disclose the amount of depreciation and amortization expense for the period.

The following illustration shows a typical financial statement presentation of property,

plant, and equipment and intangibles. The notes to the company’s financial statements
present greater details about the accounting for its non-current tangible and intangible
assets.

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