10.1 Acquisition and Depreciation of PP&E

10.1 Acquisition and Depreciation of PP&E

Property, Plant, and Equipment (PP&E), also known as fixed assets or long-lived tangible assets, are assets used in the regular operations of a business that have a useful life exceeding one year. Under US GAAP (ASC 360), PP&E is initially recorded at its historical cost. This historical cost principle dictates that the capitalized value of a fixed asset includes the purchase price and all reasonable, necessary expenditures incurred to acquire the asset, transport it to its designated location, and bring it to the condition necessary for its intended use.

Distinguishing capital expenditures (which are capitalized as assets on the balance sheet) from revenue expenditures (which are expensed on the income statement as incurred) is a fundamental concept tested on the CPA exam. Capital expenditures are outlays that provide future economic benefits, such as extending the useful life of an asset, increasing its efficiency, or improving its output quality. Conversely, revenue expenditures are ordinary, recurring costs required to maintain the asset in its normal operating condition, such as routine repairs, minor maintenance, and lubrication.

Classification of Capitalized Costs

Different categories of PP&E have specific rules regarding which costs must be capitalized:

Depreciation Concepts and Methods

Depreciation is the systematic and rational allocation of the capitalized cost of a tangible asset (less its estimated salvage value) over its estimated useful life. It is not a valuation technique; rather, it is a process of cost matching. Under US GAAP, the primary depreciation methods include:

1. Straight-Line Method

The straight-line method allocates an equal amount of depreciation expense to each full year of the asset's useful life. The formula is: $\text{Annual Depreciation} = \frac{\text{Cost} - \text{Salvage Value}}{\text{Useful Life}}$

Example: A machine is purchased for $120,000 with a salvage value of $20,000 and a 5-year useful life. Annual depreciation is: $(\$120,000 - \$20,000) / 5 = \$20,000$

The annual journal entry is:

Debit: Depreciation Expense          20,000
  Credit: Accumulated Depreciation       20,000

2. Double-Declining Balance (DDB) Method

DDB is an accelerated method that produces higher depreciation expense in the early years and lower expense in the later years. The straight-line rate is doubled, and this rate is applied to the asset's beginning-of-period book value (Cost minus Accumulated Depreciation). Important: Salvage value is NOT deducted when calculating the annual depreciation base, but the asset's book value cannot be depreciated below its estimated salvage value. $\text{DDB Rate} = \frac{2}{\text{Useful Life}}$ $\text{Depreciation Expense} = \text{Beginning Book Value} \times \text{DDB Rate}$

Example: For a $120,000 asset with a 5-year life and $20,000 salvage value:

• DDB Rate = 2 / 5 = 40% (0.40)
• Year 1: $120,000 \times 40% = $48,000. Ending Book Value (BV) = $72,000.
• Year 2: $72,000 \times 40% = $28,800. Ending BV = $43,200.
• Year 3: $43,200 \times 40% = $17,280. Ending BV = $25,920.
• Year 4: Applying 40% to $25,920 yields $10,368. However, this would reduce the BV to $15,552, which is below the salvage value of $20,000. Therefore, Year 4 depreciation is limited to: $\text{Depreciation} = \$25,920 - \$20,000 = \$5,920$
• Year 5: Depreciation is $0.

3. Sum-of-the-Years'-Digits (SYD) Method

SYD is another accelerated depreciation method. The depreciable base (Cost minus Salvage Value) is multiplied by a declining fraction. The denominator of the fraction is the sum of the digits representing the years of useful life: $\text{Denominator} = \frac{n(n+1)}{2}$ $\text{Depreciation Expense} = (\text{Cost} - \text{Salvage Value}) \times \frac{\text{Remaining Life at Start of Year}}{\text{Denominator}}$

Example: Using our $120,000 asset ($100,000 depreciable base) over 5 years:

• Denominator = (5 \times 6) / 2 = 15
• Year 1: $100,000 \times (5 / 15) = $33,333
• Year 2: $100,000 \times (4 / 15) = $26,667
• Year 3: $100,000 \times (3 / 15) = $20,000
• Year 4: $100,000 \times (2 / 15) = $13,333
• Year 5: $100,000 \times (1 / 15) = $6,667

4. Units-of-Production Method

This method is activity-based rather than time-based. It allocates depreciation based on the actual usage or output of the asset: $\text{Depreciation Rate per Unit} = \frac{\text{Cost} - \text{Salvage Value}}{\text{Total Estimated Units}}$ $\text{Depreciation Expense} = \text{Depreciation Rate per Unit} \times \text{Actual Units Produced}$

Example: A truck is purchased for $120,000 with a salvage value of $20,000. It is estimated to run for 100,000 miles over its life. The depreciation rate is ($120,000 - $20,000) / 100,000 = $1.00 per mile. If the truck is driven 15,000 miles in Year 1, the depreciation expense is $15,000.

Changes in Accounting Estimates (ASC 250)

Over time, management may obtain new information indicating that the asset's useful life or salvage value is different from the original estimate, or they may decide to change the depreciation method. Under US GAAP (ASC 250), changes in depreciation method, useful life, or salvage value are classified as changes in accounting estimates effected by a change in accounting principle.

These changes are accounted for prospectively. There is no retrospective restatement of prior financial statements, and no cumulative-effect catch-up adjustment on the current income statement or retained earnings. To calculate new depreciation:

1. Determine the asset's net book value (Carrying Value) at the date of change.
2. Subtract the revised estimated salvage value from the current Carrying Value to find the new depreciable base.
3. Allocate this new depreciable base over the remaining useful life of the asset using the selected depreciation method.

Example: A company purchased machinery on January 1, Year 1, for $80,000 with an estimated useful life of 8 years and a $8,000 salvage value. Straight-line depreciation was recorded for 3 years at ($80,000 - $8,000) / 8 = $9,000 per year.

• On January 1, Year 4, accumulated depreciation is $27,000 (3 \times $9,000).
• Net book value is $53,000 ($80,000 - $27,000).
• On this date, the company revises the remaining useful life to 3 years (total useful life of 6 years) and the salvage value to $5,000.
• The revised depreciation for Year 4 and subsequent years is: $\text{Revised Depreciation} = \frac{\$53,000 - \$5,000}{3} = \$16,000 \text{ per year}$