Long-Term Assets I: Property Plant, and Equipment

The evolution of the circulating and noncirculating capital distinction of

assets and liabilities into the working capital concept has been accompanied by
the separate classification and disclosure of long-term assets. In this chapter we
examine one of the categories of long-term assetsproperty, plant, and
equipment. Long-term investments and intangibles are discussed in Chapter 10.
Property. Plant, and Equipment
The items of property, plant, and equipment generally represent a major
source of future service potential to the enterprise. These assets represent a
significant commitment of economic resources for companies in capital-intensive
industries, such as Ford in the automobile manufacturing industry, Boeing in the
airplane manufacturing industry, and Exxon Mobil in the oil exploration and
refining industry. Such companies may have as much as 75 percent of their total
assets invested in property, plant, and equipment. The valuation of property, plant,
and equipment assets is of interest to financial statement users because it indicates
the physical resources available to the firm and may also give some indication of
future liquidity and cash flows. These valuations are particularly important in
capital-intensive industries because property, plant, and equipment constitutes a
major component of the companys total assets. The objectives of plant and
equipment accounting are
1. Reporting to investors on stewardship.
2. Accounting for the use and deterioration of plant and equipment.
3. Planning for new acquisitions, through budgeting.
4. Supplying information for taxing authorities.
5. Supplying rate-making information for regulated industries.
Accounting for Cost
Many businesses commit substantial corporate resources to acquire
property, plant, and equipment. Investors, creditors, and other users rely on
accountants to report the extent of corporate investment in these assets. The initial
investment, or cost to the enterprise, represents the sacrifice of resources given up
in the past to accomplish future objectives. Traditionally, accountants have placed
a great deal of emphasis on the principle of objective evidence to determine the
initial valuation of long-term assets. Cost (the economic sacrifice incurred) is the
preferred valuation method used to account for the acquisition of property, plant,
and equipment because, as discussed in Chapter 4, cost is more reliable and
verifiable than other valuation methods such as discounted present value,
replacement cost, or net realizable value. There is also a presumption that the
agreed-upon purchase price represents the future service potential of the asset to
the buyer in an arms-length transaction.
Despite the reliability and verifiability of the purchase price as the basis
for initially recording property, plant, and equipment, the assignment of cost to
individual assets is not always as uncomplicated as might be expected. When
assets are acquired in groups, when they are self-constructed, when they are
acquired in nonmonetary exchanges, when property contains assets that are to be
removed, or when there are expected future costs assodated with
decommissioning an asset, certain accounting issues arise. These issues are
discussed in the following sections.
Group Purchases
When a group of assets is acquired for a lump-sum purchase price, such as
the purchase of land, buildings, and equipment for a single purchase price, the
total acquisition cost must be allocated to the individual assets so that an
appropriate amount of cost can be charged to expense as the service potential of
the individual assets expires. The most frequent, though arbitrary, solution to this
allocation problem has been to assign the acquisition cost to the various assets on
the basis of the weighted average of their respective appraisal values. Where
appraisal values are not available, the cost assignment may be based on the
relative carrying values on the sellers books. Since no evidence exists that either
of these values is the relative value to the purchaser, assignment by either of these
procedures would seem to violate the objectivity principle, but the use ot these
methods is usually justified on the basis of expediency and the lack of acceptable
alternative methods.
Self -Constructed Assets
Self-constructed assets give rise to questions about the proper components
of cost. Although it is generally agreed that all expenses directly associated with
the construction process should be included in the recorded cost of the asset
(material, direct labor, etc.), there are controversial issues regarding the
assignment of fixed overhead and the capitalization of interest, The fixed-
overhead issue has two aspects: (1) Should any fixed overhead be allocated? and
(2) If so, how much fixed overhead should be allocated? This problem has further
ramifications. If a plant is operating at less than full capacity and fixed overhead is
assigned to a self-constructed, charging the asset with a portion of the fixed
overhead will cause the profit margin on all other products to increase during the
period of construction. Three approaches are available to resolve this issue:
1. Allocate no fixed overhead to the self-construction project.
2. Allocate only incremental fixed overhead to the project.
3. Allocate fixed overhead to the project on the same basis as it is allocated to
other products.
Some accountants favor the first approach. They argue that the allocation
of fixed overhead is. arbitrary and therefore only direct costs should be
considered. Nevertheless, the prevailing opinion is that the construction of the
asset required the use of some amount of fixed overhead; thus, fixed overhead is a
proper component of cost. Consequently, no allocation is seen as a violation of the
historical cost principle.
When the production of other products has been discontinued to produce a
self-constructed asset, allocation of the entire amount of fixed overhead to the
remaining products will cause reported profits on these products to decrease. (The
same amount of overhead is allocated to fewer products.) Under these
circumstances, the third approach seems most appropriate. On the other hand, it
seems unlikely that an enterprise would discontinue operations of a profitable
product to construct productive facilities except in unusual circumstances.
When operations are at less than full capacity, the second approach is the
most logical. The decision to build the asset was probably connected with the
availability of idle facilities. Increasing the profit margin on existing products by
allocating a portion of the fixed overhead to the self-construction project will
distort reported profits.
A corollary to the fixed overhead allocation question is the issue of the
capitalization of interest charges during the period of the construction of the asset.
During the construction period, extra financing for materials and supplies will
undoubtedly be required, and these funds will frequently be obtained from
external sources. The central question is the advisability of capitalizing the cost
associated with the use of these funds. Some accountants have argued that interest
is a financing rather than an operating charge and should not be charged against
the asset. Others have noted that if the asset were acquired from outsiders, interest
charges would undoubtedly be part of the cost basis to the seller and would be
included in the sales price. In addition, public utilities normally capitalize both
actual and implicit interest (when their own funds are used) on construction
projects because future rates are based on the costs of services. Charging existing
products for the expenses associated with a separate decision results in an
improper matching of costs and revenues. Therefore, a more logical approach is to
capitalize incremental interest charges during the construction period. Once the
new asset is placed in service, interest is charged against operations.
The misapplication of this theory resulted in abuses during the early 1970s
when many companies adopted the policy of capitalizing all interest costs.
However, in 1974 the SEC established a rule preventing this practice. 1 Later, in
1979, the FASB issued SFAS No. 34, Capitalization of Interest Costs. 2 In this
release, the FASB maintained that interest should be capitalized only when an
asset requires a periodof time to be prepared for its intended use.
The primary objective of SFAS No. 34 was to recognize interest cost as a
significant part of the historical cost of acquiring an asset. The criteria for
determining whether an asset qualifies for interest capitalization are that the asset
must not yet be ready for its intended purpose and it must be undergoing activities
necessary to get it ready. Qualified assets are defined as (1) assets that are

1 Securities and Exchange Commission, Accounting Series Release No. 163,

Capitalization of Interest by Companies Other Than Public Utilities

(Washington: SEC. 1974).

2 Financial Accounting Standards Board, Statement of Financial Accounting

Standards No. 34, Capitalization of Interest Costs (Stamford, CT: FASB, 1979),

para. 9. proceeds received from the sale of the assets to the land, since these costs

are necessary to put the site in a state of readiness for construction.

constructed or otherwise produced for an enterprises own use and (2) assets
intended for sale or lease that are constructed or otherwise produced as discrete
projects. SFAS No. 34 also excluded interest capitalization for inventories that are
routinely manufactured or otherwise produced in large quantities on a repetitive
basis. Assets that are in use or are not undergoing the activities necessary to get
them ready for use are also excluded.
An additional issue addressed by SFAS No.34 was the determination of
the proper amount of interest to capitalize. The FASB decided that the amount of
interest to be capitalized is the amount that could have been avoided if the asset
had not been constructed. Two interest rates may be used: the weighted average
rate of interest charges during the period and the interest charge on a specific debt
instrument issued to finance the project. The amount of avoidable interest is
determined by applying the appropriate interest rate to the average amouni of
accumulated expenditures for the asset during the construction period. The
specific interest is applied first, then if there are additional average accumulated
expenditures, the average rate is applied to the balance. The capitalized amount is
the lesser of the calculated avoidable interest and the actual interest incurred. In
addition, only actual interest costs on present obligations may be capitalized, not
imputed interest on equity funds.
Removal of Existing Assets
When a firm acquires property containing existing structures that are to be
removed, a question arises concerning the proper treatment of the cost of
removing these structures. Current practice is to assign removal costs less any

Assets Acquired in Noncash Transactions

In addition to cash transactions, assets may also be acquired by trading
equity securities, or one asset may be exchanged in partial or full payment [or
another (trade-in). When equity securities are exchanged for assets, the cost
principle dictates that the recorded value of the asset is the amount of
consideration given. This amount is usually the market value of the securities
exchanged. If the market value of the securities is not determinable, cost should be
assigned to the property on the basis of its fair market value. This procedure is a
departure from the cost principle and can be viewed as an example of the use of
replacement cost in current practice.
When assets are exchanged, for example, in trade-ins, additional
complications arise. Accountants have long argued the relative merits of using the
[air market value versus the book value of the exchanged asset. In 1973, the APB
released Opinion No. 29, Accounting for Nomnonetary Transactions, which
concluded that fair value should (generally) be used as the basis of accountability.3
Therefore, the cost of an asset acquired in a straight exchange [or another asset is
the fair market value of the surrendered asset.
This general rule was originally subject to one exception. In Opinion (Jo.
29 the APB stated that exchanges should be recorded at the book value of the asset
given up when the exchange is not the culmination of the earning process. Two
examples of exchanges that do not result iii the culmination of the earning process
were defined as follows:
1. Exchange of a product or property held for sale in the ordinary course of
business (inventory) for a product or property to be sold in the same line of
business to facilitate sales to customers other than parties to the exchange.
2. Exchange of a productive asset not held for sale in the ordinary course of
business for a similar productive asset or an equivalent interest in the same or
similar productive asset.4
Under APB Opinion No. 29, if the exchanged assets are dissimilar, the
presumption is that the earning process is complete, and the acquired asset s
recorded at the fair value of the asset exchanged including any gain r loss. This
requirement exists for straight exchanges and for exchanges accompanied by cash
payments (boot). For example, if Company G exchanges cash of $2,000, and an
asset with a book value of $10,000 and a fair market value of $13,000, for a
dissimilar asset, a gain of $3,000 should be recognized [$13,000 $10,000], and
the new asset is recorded at $15,000.

3 Accounting Principles Board, APB Opinion No. 29, Accounting for

Nonmonetary rransactions (New York: AICPA, 1973).

4 Ibid., para. 21.

 On the other hand, accounting for the exchange of similar productive
assets originally took a somewhat different form. According to the provisions of
APB Opinion No. 29, losses on the exchange of similar productive assets are
always recognized in their entirety whetheror.not boot (cash) is involved.
However, gains were never recognized unless boot was received. In 2004, the
FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets an Amendment
of APB Opinion No. 29.5 The amendment eliminates the APB Opinion No. 29
exception for nonmonetary exchanges of similar productive assets and replaces it
with a general exception for exchanges of nonmonetary assets that do not have
commercial substance. A nonmonetary exchange has commercial substance if the
future cash flows of the entity are expected to change significantly as a result of
the exchange. For these exchanges, the book value of the asset exchanged is to be
used to measure the asset acquired in the exchange. Thus, no gains are to be
recognized; however, a loss should be recognized if the fair value of the asset
exchanged is less than its book value (i.e., an impairment is evident). The
resulting amount initially recorded for the acquired asset is equal to the book
value of the exchanged asset (adjusted to its fair value, when there is an apparent
impairment) plus or minus any cash (boot) paid or received.

Donated and Discovery Values

Corporations sometimes acquire assets as gifts from municipalities, local
citizens groups, or stockholders as inducements to locate facilities in certain areas.
For example, in 1992 BMW automobile company announced it would build a
plant in the Greenville-Spartanburg area of South Carolina after the state offered
several incentives, including $70.7 million in reduced property taxes, $25 million
to buy land for the plant and lease it to BMW to $1 per year, and $40 million to
lengthen the local airport runway so that it could accommodate wide-body cargo
aircraft. The FASB has defined such contributions as transfers of cash or other

5 Statement of Financial Accounting Standard No. 153, Exchanges of

Nonmonetary Assets an Amendment of APB Opinion No. 29 (Norwich, CT:

FASB, 2004).
assets to an entity or settlement or cancellation of its liability from a voluntary
nonreciprocal transfer by another entity acting other than as an owner.6
The cost principle holds that the recorded values of assets should be equal
to the consideration given in return, but since donations are nonreciprocal
transfers, strict adherence to this principle will result in a failure to record donated
assets at all. On the other hand, failure to report values for these assets on the
balance sheet is inconsistent with the full disclosure principle.
Previous practice required donated assets to be recorded at their fair
market values, with a corresponding increase in an equity account termed donated
capital. Recording donated assets at fair market values is defended on the grounds
that if the donation had been in cash, the amount received would have been
recorded as donated capital. and the cash could have been used to purchase the
asset at its fair market value.
SFAS No. 116 requires that the inflow of assets from a donation be
considered revenue (not donated tapital).7 If so, the fair market value of the assets
received represents the appropriate measurement. However, the characterization
of donations as revenues may be flawed. According to SFAC No. 6, revenues arise
from the delivery or production of goods and the rendering of services. If the
contribution is a nonreciprocal transfer, then it is difficult to see how a revenue
has been earned. Alternatively, it may be argued that the inflow represents a gain.
This latter argument is consistent with the Conceptual Frameworks definition of a
gain, as resulting from peripheral or incidental transactions and with the definition
of comprehensive income as the change in net assets resulting from nonowner
transactions. Under this approach, the asset and gain would be recorded at the fair
market value of the asset received, thereby allowing full disclosure of the asset in
the balance sheet.

6 Financial Accounting Standards Board, Statement of Financial Accounting

Standards No. 116, Accounting for Contributions Received and Contributions

Made (Stamford, CT: FASI3, 1993), para. 5.

7 Ibid., para. 8.
 Similarly, valuable natural resources may be discovered on property
subsequent to its acquisitions and the original cost may not provide all relevant
information about the nature of the property. In such cases, the cost principle is
modified to account for the appraisal increase in the property. A corresponding
increase is reported as an unrealized gain in accumulated other comprehensive
income. An alternative practice consistent with the Conceptual Frameworks
definition of comprehensive income would be to recognize the appraisal increase
as a gain.

Financial Analysis of Property, Plant, and Equipment

In Chapter 6 we discussed analyzing a companys profitability by
computing the return on assets ratio. The sustainability of earnings is a major
consideration in this process. For capital-intensive companies a large portion of
their asset base will be investments in property, plant, and equipment, and a major
question for investors analyzing such companies is their asset replacement policy.
A company with a large investment in property, plant, and equipment that fails to
systematically replace those assets will generally report an increasing return on
assets over the useful life of its asset base. This occurs because the return on
assets denominator will decrease by the amount of the companys annual
depreciation expense, resulting in an increasing return percentage for stable
amounts of earnings. In addition, the general pattern of rising prices will tend to
increase the selling price of the companys product, resulting in a further upward
bias for the return on assets percentage.
An examination of a companys investing activity helps in analyzing the
earnings sustainability of its return on assets percentage. For example, Hersheys
statement of cash flows, contained in Chapter 7, reveals that the company
acquired $181 millionand $182 million of property, plant, and equipment assets in
2005 and 2004, respectively. These amounts are 5.2 percent and 5.4 percent,
respectively, of the original purchase price of its property, plant, and equipment
assets. Tootsie Rolls statement of cash flows reveals that the company acquired
approximately $15 million and $18 million of property, plant, and equipment
assets in 2005 and 2004, respectively, amounting to 4.5 percent and 5.6 percent of
the purchase price of its property, plant, and equipment assets. Both of these
computations provide evidence that the companies return on assets percentages
are not being distorted by a failure to systematically replace their long-term assets,
but that Hershey is replacing its assets more than twice as fast as is Tootsie Roll.

Cost Allocation
Capitalizing the cost of an asset implies that the asset has future service
potential. Future service potential indicates that the asset is expected to generate
or be associated with future resource flows. As those flows materialize, the
matching concept (discussed in Chapter 3) dictates that certain costs no longer
have future service potential and should be charged to expense during the period
the associated revenues are earned. Because the cost of property, plant, and
equipment is incurred to benefit future periods, it must be spread, or allocated, to
the periods benefited. The process of recognizing, or spreading, cost over multiple
periods is termed cost allocation. For items of property, plant, and equipment, cost
allocation is referred to as depreciation. As the asset is depreciated, the cost is said
to expirethat is, it is expensed. (See Chapter 4 for a discussion of the process of
cost expiration.)
As discussed earlier, balance sheet measurements should theoretically
reflect the future service potential of assets at a moment in time. Accountants
gene-rally agree that cost reflects future service potential at acquisition. However,
in subsequent periods, expectations about future resource flows may change. Also,
the discount rate used to measure the present value of the future service potential
may change. As a result, the asset may still be useful, but because of technological
changes, its future service potential at the end of any given period may differ from
what was originally anticipated. Systematic cost allocation methods do not
attempt to measure changes in expectations or discount rates. Consequently, no
systematic cost allocation method can provide balance sheet measures that
consistently reflect future service potential.
The historical cost accounting model presently dominant in accounting
practice requires that the costs incurred be allocated in a systematic and rational
manner. Thomas, who conducted an extensive study of cost allocation, concluded
that all allocation is based on arbitrary assumptions and that no one method of
cost allocation is superior to another.8 At the same time, it cannot be concluded
that the present accounting model provides information that is not useful for
investor decision making. A number of studies document an association between
accounting income numbers and stock returns. This evidence implies that
historical costbased accounting income, which employs cost allocation
methods, has information content. (See Chapter 4 for further discussion of this
issue.)
Depreciation
Once the appropriate cost of an asset has been determined, the reporting
entity must decide how to allocate its cost. At one extreme, the entire cost of the
asset could be expensed when the asset is acquired; at the other extreme, cost
could be retained in the accounting records until, disposal of the asset, when the
entire cost would be expensed. Iowever, neither of these approaches provides for a
satisfactory measure of periodic income because cost expiration would not be
allocated to the periods in which the asset is in use and thus would not satisfy the
matching principle. Thus, the concept of depredation was devised in an effort to
satisfy the need to allocate the cost of property, plant, and equipment over the
periods that receive benefit from use of long-term assets.
The desire of financial statement users to receive periodic reports on the
result of operations necessitated allocating asset cost to the periods receiving
benefit from the use of assets dassified as property, plant and equipment. Because
depredation is a form of cost allocation, all depredation concepts are related to
some view of income measurement. A strict interpretation of the FASBs
comprehensive income concept would require that changes in service potential be
recorded in income. Economic depreciation has been defined as the change in the
discounted present value of the items of property, plant, and equipment during a
period. If the discounted present value measures the service potential of the asset
8 Thomas, Arthur L., The Allocation Program in Financial Accounting Theory,

Studies in Accounting Research No. 3 (Evanston, IL: American Accounting

Association, 1969).
at a point in time, the change in service potential interpretation is consistent with
the economic concept of income.
As discussed in Chapter 5, recording cost expirations by the change in
service potential is a difficult concept to operationalize. Consequently,
accountants have adopted a transactions view of income determination, in which
they see income as the end result of revenue recognition according to certain
criteria, coupled with the appropriate matching of expenses with those revenues.
Thus, most depredation methods emphasize the matching concept, and little
attention is directed to balance sheet valuation. Depreciation is typically described
as a process of systematic and rational cost allocation that is not intended to result
in the presentation of asset fair value on the balance sheet. This point was first
emphasized by the Committee on Terminology of the AICPA as follows:
Depreciation accounting is a system of accounting which aims to distribute
the cost or other basic value of tangible capital assets, less salvage value
(if any), over the estimated useful life of the unit (which may be a group of
assets) in a systematic and rational manner. It is a process of allocation,
not valuation.9
The AICPAs view of depredation is particularly important to an
understanding of the difference between accounting and economic concepts of
income, and it also provides insight into many misunderstandings about
accounting depreciation. Economists see depreciation as the decline in the real
value of assets. Other individuals believe that depreciation charges and the
resulting accumulated depreciation provide the source of funds for future
replacement of assets. Still others have suggested that business investment
decisions are influenced by the portion of the original asset cost that has been
previously allocated. Accordingly, new investments cannot be made because the
old asset has not been fully depreciated. These views are not consistent with the
stated objective of depredation for accounting purposes. Moreover, we do not
support the view that business decisions should be affected by accounting rules. In

9 Accounting Terimnoloqy Bulletin No. 1, Review and Resume (New York:

AICPA, 1953), p. 9513.

the following section, we examine the accounting concept of depreciation more
closely.

The Depreciation Process

The depreciation process for long-term assets comprises three separate
factors:
1. Establishing the depreciation base.
2. Estimating the useful service life.
3. Choosing a cost apportionment method.

Depreciation Base
The depreciation base is that portion of the cost of the asset that should be
charged to expense over its expected useful life. Because cost represents the future
service potential of the asset embodied in future resource flows, the theoretical
depreciation base is the present value of all resource flows over the life of the
asset, until disposition of the asset. Hence, it should be cost minus the present
value of the salvage value. In practice, salvage value is not discounted, and as a
practical matter, it is typically ignored. Proper accounting treatment requires that
salvage value be taken into consideration, For example, rental car agencies
normally use automobiles for only a short period; the expected value of these
automobiles at the time they are retired from service would be material and should
be considered in establishing the depreciation base.

Useful Service Life

The useful service life of an asset is the period of time the asset is expected
to function efficiently. Consequently, an assets useful service life may be