Property, plant, and equipment (PP&E/PPE) are tangible assets that a company possesses for a long duration. They are typically fixed assets such as trucks, machinery, factories, and land, which facilitate the company’s operations and expansion and are not for resale.
PP&E assets are subject to depreciation over their useful life and can be sold for their salvage value.
Assets are future economic benefits that are obtained or controlled by an entity as a result of past transactions or events ie;
Fixed assets are initially recorded at their historical value, which is the amount paid for the asset + all other costs required to make it ready for use
Examples of other costs required to make a fixed asset ready for use include:
Subsequently measured at:
Initial Cost:Â Â Â Â Â Â Â Â Â Â Â Â Â xxxx
less: DepreciationÂ Â Â Â Â Â Â xxxx
less: ImpairmentÂ Â Â Â Â Â Â Â xxxx
Value of fixed assetÂ Â Â Â Â xxxxx
Under US GAAP (Generally Accepted Accounting Principles), depreciation is defined as the systematic allocation of the cost of a fixed asset over its useful life. Depreciation is recorded as an expense in a company’s financial statements, reflecting the decrease in the asset’s value over time due to wear and tear, obsolescence, or other factors.
The purpose of depreciation under US GAAP is to match the cost of the asset with the revenue it generates during its useful life. This provides a more accurate representation of a company’s financial performance, as it accounts for the wear and tear on its assets and the corresponding reduction in their value.
Note:-
Land is never depreciated because the useful life of the land is unlimited
Journal entry
DepreciationÂ Expense Dr
Accumulated Depreciation Cr
US GAAP requires companies to select a depreciation method that reflects the pattern of the asset’s use and the expected rate of decline in its value. The most commonly used depreciation methods under US GAAP are straight-line depreciation, declining balance depreciation, and units-of-production depreciation.
SLM depreciation assumes that the asset depreciates at a constant rate over its useful life, which makes it easy to calculate and understand. The method simply takes the total cost of the asset, subtracts the estimated salvage value, and divides the result by the number of years of useful life. This provides a clear picture of the asset’s depreciation over time, which can then be recorded as an expense on the company’s financial statements.
Let’s learn all these depreciation Methods using one example
Example :
ABC Ltd, a US company, purchased machinery worth $500,000. The machine is expected to have a life of 4 years and is expected to produce 10,000 units of output during its lifespan. The machinery is also expected to have a salvage value of $100,000 at the end of its useful life.
Let’s dive into calculating the depreciation for ABC Ltd’s machinery using the straight-line method. This method assumes that the asset depreciates at a constant rate over its useful life, which makes it easy to calculate and understand.
To calculate the yearly depreciation, we first need to determine the depreciable base, which is the cost of the asset minus the estimated salvage value. In this case, the depreciable base is $500,000 – $100,000 = $400,000.
Next, we divide the depreciable base by the useful life of the asset in years. In this case, the useful life is 4 years, so the annual depreciation expense would be $400,000 / 4 = $100,000.
So, the yearly depreciation expense for ABC Ltd’s machinery using the SLM method would be $100,000 for each of the 4 years of its useful life. This means that at the end of the asset’s useful life, the total accumulated depreciation would be $400,000, which is the depreciable base we calculated earlier, and the book value will be 0.
Let’s explore another method for calculating depreciation – the double declining balance method. This method is more complex than the straight-line method but can be useful for assets that experience more rapid depreciation in their early years.
To calculate the double declining balance depreciation, we first need to determine the asset’s straight-line depreciation rate. This is done by dividing 100% by the asset’s useful life in years. In this case, the straight-line depreciation rate would be 100% / 4 = 25%.
Next, we need to double the straight-line depreciation rate to determine the double declining balance rate. So, the double declining balance rate for this asset would be 25% x 2 = 50%.
Year | Particulars | Amount |
---|---|---|
1 | Opening BV | $500,000 |
Depreciation | $500,000 * 50% = $250,000 | |
Carrying Value (Opening BV - Depreciation) | $250,000 ($500,000 - $250,000) | |
Carrying Value | $250,000 | |
2 | Opening BV | $250,000 |
Depreciation | $125,000 | |
Carrying Value | $125,000 | |
3 | Opening BV | $125,000 |
Depreciation | $25,000 | |
Carrying Value | $100,000 |
Here we stop the depreciation at year 3 with $25,000 even though there is $125,000 left to depreciate this is because we have to adjust the depreciation expense so that we don’t depreciate below salvage value
“Sum of the years’ digits depreciation” is a depreciation method used in accounting to allocate the cost of an asset over its useful life. This method assumes that the depreciation expense should be higher in the earlier years of an asset’s life and lower in the later years.
To calculate the sum of the years’ digits depreciation, you need to first determine the asset’s useful life and then add the digits of the years together. For example, if an asset has a useful life of 5 years, you would add 5+4+3+2+1 to get a total of 15.
Next, you would allocate the depreciation expense based on the ratio of the remaining years of useful life to the total of the digits. For example, in the second year of an asset’s life with a useful life of 5 years, you would allocate 4/15 of the depreciable value, in the third year you would allocate 3/15, and so on. This method results in higher depreciation expense in the early years of an asset’s life and lower depreciation expense in the later years.
Now let’s take our first example question that we used earlier for calculating depreciation expenses using other depreciation methods, and try to calculate the depreciation expenses using SYD.
Calculations
To calculate the depreciation expense for each year using the sum of the digits method, you first need to find the total sum of the digits. In this case, the total sum of the digits is:
4 + 3 + 2 + 1 = 10
or to easily find the Sum-of-the-Years’-Digits we can use the formula. Sum-of-the-Years’-Digits = n(n+1)/2
Where n= useful life of the asset, here in our question useful life is 4 years so Sum-of-the-Years’-Digits= 4(4+1)/2 =10
Next, you need to determine the depreciable value of the machinery, which is the cost of the machinery minus its expected salvage value. In this case, the depreciable value is:
$500,000 – $100,000 = $400,000
Now you can calculate the annual depreciation expense for each year using the following formula:
Depreciation Expense = (Remaining Useful Life / Total Sum of the Digits) x Depreciable Value
Year | Remaining Useful Life | Total Sum of Digits | Depreciable Value | Depreciation Expense |
---|---|---|---|---|
1 | 4 | 10 | $400,000 | $160,000 |
2 | 3 | 10 | $400,000 | $120,000 |
3 | 2 | 10 | $400,000 | $80,000 |
4 | 1 | 10 | $400,000 | $40,000 |
In the first year, the remaining useful life of the machinery is 4 years, so the depreciation expense would be:
(4 / 10) x $400,000 = $160,000
In the second year, the remaining useful life of the machinery is 3 years, so the depreciation expense would be:
(3 / 10) x $400,000 = $120,000
In the third year, the remaining useful life of the machinery is 2 years, so the depreciation expense would be:
(2 / 10) x $400,000 = $80,000
Finally, in the fourth year, the remaining useful life of the machinery is 1 year, so the depreciation expense would be:
(1 / 10) x $400,000 = $40,000
Therefore, the total depreciation expense for the 4-year life of the machinery using the sum of the digits method would be:
$160,000 + $120,000 + $80,000 + $40,000 = $400,000
To calculate depreciation using the units of production method, you need to follow these steps:
Determine the total number of units that the machinery is expected to produce during its useful life. In this case, it is 10,000 units.
Calculate the depreciation cost per unit of output by subtracting the expected salvage value from the total cost of the machinery and dividing the result by the expected number of units produced.
Depreciation cost per unit = (Total cost – Salvage value) / Expected units produced Depreciation cost per unit = ($500,000 – $100,000) / 10,000 Depreciation cost per unit = $40 per unit
For example, in the first year, if 2,500 units of output are produced, the depreciation expense would be:
Depreciation expense = Depreciation cost per unit x Units produced in the first year Depreciation expense = $40 per unit x 2,500 units Depreciation expense = $100,000
Similarly, you can calculate the depreciation expense for each year of the machinery’s useful life by multiplying the number of units produced during that year by the depreciation cost per unit.
By using the units of production method, you can allocate the depreciation cost of the machinery based on its actual usage, which provides a more accurate reflection of the machinery’s wear and tear over time.
In the US, the Internal Revenue Service (IRS) prescribes the method of depreciation to be used for tax purposes.
If an asset with a value of $200,000 was purchased on June 30th and has a useful life of 3 years, what is the annual depreciation amount using the MACRS depreciation method?
Assuming the asset has a useful life of 3 years, we can use the MACRS (Modified Accelerated Cost Recovery System) depreciation method to calculate the annual depreciation amount. The MACRS method is commonly used in the United States to calculate depreciation for tax purposes.
First, we need to determine the asset’s cost basis, which is the initial value of the asset before depreciation. In this case, the asset has a value of $200,000.
Next, we need to determine the asset’s depreciation percentage using the MACRS system. For a 3-year asset, the percentage breakdown is as follows:
So, to calculate the annual depreciation amount, we can use the following formula:
Annual Depreciation = (Cost Basis x Depreciation Percentage)
Year 1: Annual Depreciation = ($200,000 x 33.33%) = $66,660
Year 2: Annual Depreciation = ($200,000 x 44.45%) = $88,900
Year 3: Annual Depreciation = ($200,000 x 14.81%) = $29,620
Year 4: Annual Depreciation = ($200,000 x7.41%) = $14,820
A company must choose a depreciation method that best matches its revenue and not based on the method which generates the desired net income. Considerations for which depreciation method should be used include :
Impairment of assets is an important topic in the Property, Plant, and Equipment CMA USA Part 1 syllabus. An impairment occurs when the carrying amount of an asset exceeds its recoverable amount, which is the higher of its fair value less costs to sell and its value in use.
This situation arises when the future economic benefits from an asset are lower than its carrying amount. Companies are required to conduct impairment tests at regular intervals to ensure that the assets are not overstated on the balance sheet.
Impairment can occur due to various reasons, such as technological changes, shifts in market demand, regulatory changes, or physical damage to the asset. When an impairment is identified, the company must recognize the impairment loss by reducing the carrying amount of the asset and recognizing the loss in the income statement.
Impairment testing is important because it ensures that assets are valued accurately, which helps investors and other stakeholders make informed decisions about the company’s financial performance and health.
Recoverability Test
Journal entry if there is an Impairment
Impairment LOSS Dr
Accumulated Depreciation Cr
Example :
Let’s say a company has a delivery truck that it purchased for $50,000 several years ago. The company believes that the market value of the truck has declined due to technological advancements and changes in market demand. The company conducts an impairment test and determines that the fair value of the truck is now only $30,000.
The carrying amount of the truck on the company’s books is $45,000, which is the original cost of the truck minus accumulated depreciation of $5,000.
To determine if the truck is impaired, the company needs to compare the carrying amount of the truck to its estimated future cash flows. If the sum of the estimated undiscounted cash flows associated with the truck is greater than its carrying value, then there is no impairment.
Let’s say the company estimates that the truck will generate $15,000 per year in cash flows for the next three years before it is sold. The sum of the estimated undiscounted cash flows associated with the truck would be:
$15,000 x 3 = $45,000
Since the sum of the estimated undiscounted cash flows is greater than the carrying value of the truck, there is no impairment. Even though the fair value of the truck is less than its carrying value, the truck does not need to be written down to its fair value and no impairment loss needs to be recognized.
However, if the company had estimated that the truck would only generate $10,000 per year in cash flows for the next three years, the sum of the estimated undiscounted cash flows would be:
$10,000 x 3 = $30,000
Since the sum of the estimated undiscounted cash flows is less than the carrying value of the truck, there is impairment. The truck must be written down to its fair value of $30,000, and the company must recognize an impairment loss of $15,000 ($45,000 carrying value minus $30,000 fair value). This impairment loss would be recognized as an expense in the income statement.
Under IFRS, the amount of an impairment loss is the difference between the carrying amount of the asset and the recoverable amount. The recoverable amount is the higher of (1) the fair value of the asset if sold minus the cost to sell, and (2) the asset’s value in use, which is the present value of the future cash flows to be generated by the asset in use, including its residual value.
Property, plant, and equipment (PP&E) are examples of fixed assets that are purchased by a company to be used in the production of goods or services.
Fixed assets are long-term assets that are purchased by a company to be used in the production of goods or services, rather than being sold directly to customers. Examples of fixed assets include property, plant, and equipment (PP&E) such as buildings, machinery, and vehicles.
Initial recording of fixed assets involves recording the cost of the asset in the accounting records, including any associated costs such as delivery, installation, and testing. Subsequent recording of fixed assets involves recording any changes in the value of the asset due to improvements, upgrades, or disposals.
Depreciation is the process of allocating the cost of a fixed asset over its useful life, to reflect its decreasing value as it is used over time. There are various methods of depreciation, including straight-line depreciation (SLM), double declining balance (DDB), sum-of-the-years digits (SYD), and units-of-production method.
SLM is the simplest and most common method, which allocates an equal amount of depreciation each year. DDB accelerates depreciation in the early years of an asset’s life, while SYD is a weighted average that also accelerates depreciation. The units-of-production method is based on the actual usage of the asset.
Depreciation for tax purposes may be calculated using the Modified Accelerated Cost Recovery System (MACRS) method, which is a form of accelerated depreciation that allows for larger deductions in the early years of an asset’s life.
The best method of depreciation depends on the nature of the asset, its expected useful life, and the company’s accounting policies.
Impairment occurs when the carrying value of a fixed asset exceeds its recoverable amount and requires the company to write down the value of the asset in its financial statements.
KEY TAKEAWAYS
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