Acquisition and Disposition of Property, Plant, and Equipment

Acquisition and Disposition of Property, Plant, and Equipment

Companies like Boeing, Target, and Starbucks use assets of a durable nature. Such assets are called property, plant, and equipment. Other terms commonly used are plant assets and fixed assets. We use these terms interchangeably. Property, plant, and equipment include land, building structures (offices, factories, warehouses), and equipment (machinery, furniture, tools).

Characteristics of Property, Plant, and Equipment

The major characteristics of property, plant, and equipment are as follows.

They are acquired for use in operations and not for resale

Only assets used in normal business operations are classified as property, plant, and equipment. For example, an idle building is more appropriately classified separately as an investment. Land developers or subdividers classify land as inventory.

They are long-term in nature and usually depreciated

Property, plant, and equipment yield services over a number of years. Companies allocate the cost of the investment in these assets to future periods through periodic depreciation charges.

The exception land, which is depreciated only if a material decrease in value occurs, such as a loss in the fertility of agricultural land because of poor crop rotation, drought, or soil erosion.

They possess physical substance

Property, plant, and equipment are tangible assets characterized by physical existence or substance. This differentiates them from intangible assets, such as patents or goodwill.

Unlike raw materials, however, property, plant, and equipment do not physically become part of a product held for resale.

Acquisition of Property, Plant, and Equipment

Most companies use historical cost as the basis for valuing property, plant, and equipment. Historical cost measures the cash or cash equivalent price of obtaining the asset and bringing it to the location and condition necessary for its intended use.

For example, companies like Kellogg Co. consider the purchase price, freight costs, sales taxes, and installation costs of a productive asset as part of the asset’s cost. It then allocates these costs to future periods through depreciation.

Further, Kellogg adds to the asset’s cost any related costs incurred after the asset’s acquisition, such as additions, improvements, or replacements, if they provide future service potential. Otherwise, Kellogg expenses these costs immediately.

After acquisition, companies should not write up property, plant, and equipment to reflect fair value when it is above cost. The main reasons for this position are as follows.

  1. Historical cost involves actual, not hypothetical, transactions and so is the most reliable.
  2. Companies should not anticipate gains and losses but should recognize gains and losses only when the asset is sold.

Even those who favor lair value measurement for inventory and financial instruments often take the position that property, plant, and equipment should not be revalued. The major concern is

the difficulty of developing a reliable, fair value for these types of assets.

For example, how does one value a General Motors automobile manufacturing plant or a nuclear power plant owned by some consolidated group?

However, if the fair value of the property, plant, and equipment is less than its carrying amount, the asset may be written down.

These situations occur when the asset is impaired or when the asset is being held for sale. A long-lived asset classified as held for sale should be measured at the lower of its carrying amount or fair value, less the cost to sell.

In such cases, a reasonable valuation for the asset can be obtained based on its sales price. A long-lived asset is not depreciated if it is classified as held for sale. This is because such assets are not being used to generate revenues.

Cost of Land

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All expenditures made to acquire land and prepare it for use are considered part of the land cost. For example, when Walmart or Home Depot purchases land to build a new store, their land costs typically include;

  1. the purchase price,
  2. closing costs such as title fees, attorney’s fees, and recording fees,
  3. costs incurred to prepare the land for its intended use, like grading, filling, draining, and clearing,
  4. the assumption of any liens, mortgages, or encumbrances on the property,
  5. any additional land improvements that have an indefinite life.

When Home Depot buys land to construct a building, it considers all costs incurred up to the excavation for the new building as land costs. Activities like the removal of old buildings, clearing, grading, and filling are considered land costs because they are necessary to prepare the land for its intended purpose.

Home Depot treats any proceeds from preparing the land, such as salvage receipts from the demolition of an old building or the sale of cleared timber, as reductions in the land’s price.

Generally, land is categorized as part of Property, Plant, and Equipment (PPE).

However, if the primary purpose of acquiring and holding land is speculative, a company should more appropriately classify the land as an investment. For real estate concerns holding land for resale, the land should be classified as inventory.

When land is held as an investment, the question arises about the accounting treatment for taxes, insurance, and other direct costs incurred while holding the land. Many believe that these costs should be capitalized because the investment is not generating revenue at the current time.

Companies generally follow this approach, except when the asset is currently producing revenue, such as a rental property.

Example of Cost of Land:

Example 1: Simple Purchase of Land

Company A buys a piece of land for $200,000. The closing costs, which include attorney fees, title search, and recording fees, total $10,000.

Table 1: Acquisition of Land – Example 1

DescriptionDebit ($)Credit ($)
Total Debits210,000
Total Credits210,000

Calculation of Land Cost:

Land Cost = Purchase Price + Closing Costs
= 200,000 + 10,000
= 210,000

Example 2: Land Purchase with Building Demolition

Company B buys a piece of land with an old building on it for $300,000. The cost to demolish the building amounts to $20,000. After the demolition, the company is able to sell scrap materials for $5,000.

Table 2: Acquisition of Land – Example 2

DescriptionDebit ($)Credit ($)
Total Debits315,000
Total Credits315,000

Calculation of Land Cost:

Land Cost = Purchase Price + Demolition Costs − Proceeds from Sale of Scrap
= 300,000 + 20,000 − 5,000
= 315,000

Cost of Buildings

The cost of buildings should include all expenditures related directly to their acquisition or construction. These costs include;

  1. Materials, labor, and overhead costs incurred during construction.
  2. Professional fees and building permits. Generally, companies contract others to construct their buildings.

Companies consider all costs incurred, from excavation to completion, as part of the building costs.

But how should companies account for an old building that is on the site of a newly proposed building? Is the cost of removal of the old building a cost of the land or a cost of the new building?

Recall that if a company purchases land with an old building on it, then the cost of demolition less its salvage value is the cost of getting the land ready for its intended use and relates to the land rather than to the new building. In other words, all costs of getting an asset ready for its intended use are costs of that asset.

Example of Cost of Buildings:

Example 1: Direct Purchase of a Building

Company A purchases a building for $500,000. Additional costs include legal fees of $10,000 and renovation costs of $40,000 to prepare the building for use.

Table 1: Acquisition of Building – Example 1

DescriptionDebit ($)Credit ($)
Total Debits550,000
Total Credits550,000

Calculation of Building Cost:

Building Cost = Purchase Price + Legal Fees + Renovation Costs
= 500,000 + 10,000 + 40,000
= 550,000

Example 2: Purchase of Land with a Building

Company B buys a property for $600,000, which includes both land and a building. The land is valued at $200,000, and the building is valued at $400,000. Additional costs for renovation amount to $50,000.

Table 2: Acquisition of Building – Example 2

DescriptionDebit ($)Credit ($)
Total Debits650,000
Total Credits650,000

Calculation of Building Cost:

Building Cost = Value of Building in Purchase + Renovation Costs
= 400,000 + 50,000
= 450,000

Cost of Equipment

The term “equipment” in accounting includes delivery equipment, office equipment, machinery, furniture and fixtures, furnishings, factory equipment, and similar fixed assets.

The cost of such assets includes the purchase price, freight and handling charges incurred, insurance on the equipment while in transit, cost of special foundations if required, assembling and installation costs, and costs of conducting trial runs.

Costs thus include all expenditures incurred in acquiring the equipment and preparing it for use.

Example of Cost of Equipment:

Example 1: Simple Purchase of Equipment

Company A buys a new machine for its manufacturing facility at a cost of $50,000. Shipping and handling charges amount to $2,000, and installation costs are $3,000.

Table 1: Acquisition of Equipment – Example 1

DescriptionDebit ($)Credit ($)
Total Debits55,000
Total Credits55,000

Calculation of Equipment Cost:

Equipment Cost = Purchase Price + Shipping and Handling + Installation Costs
= 50,000 + 2,000 + 3,000
= 55,000

Example 2: Purchase with Trade-in

Company B buys a new printing machine for $100,000. It trades in an old machine originally purchased for $20,000 with an accumulated depreciation of $15,000. The fair value of the old machine is $5,000. Installation costs for the new machine are $10,000.

Table 2: Acquisition of Equipment – Example 2

DescriptionDebit ($)Credit ($)
Equipment (New)105,000
Accumulated Depreciation15,000
Total Debits120,000
Equipment (Old)20,000
Total Credits120,000

Calculation of New Equipment Cost:

New Equipment Cost = Purchase Price (New) + Installation Costs − Fair Value of Old Equipment
= 100,000 + 10,000 − 5,000
= 105,000

Disposition of Property, Plant, and Equipment

A company, like Intel, may retire plant assets voluntarily or dispose of them by sale, exchange, involuntary conversion, or abandonment.

Regardless of the type of disposal, depreciation must be taken up to the date of disposition. Then, Intel should remove all accounts related to the retired asset. Generally, the book value of the specific plant asset does not equal its disposal value.

As a result, a gain or loss develops.

Depreciation is an estimate of cost allocation and not a valuation process. and if gain or loss is really a correction of net income for the years during which Intel used the fixed asset.

Intel should show gains or losses on the disposal of plant assets in the income statement along with other items from customary business activities.

However, if it sold, abandoned, spun off, or otherwise disposed of the ‘operations of a component of a business,’ then it should report the results separately in the discontinued operations section of the income statement.

That is, Intel should report any gain or loss from the disposal of a business component with the related results of discontinued operations.

Some object to the recognition of a gain or loss in certain involuntary conversions. For example, the federal government often condemns forests for national parks. The paper companies that owned these forests must report a gain or loss on the condemnation.

However, companies such as Georgia-Pacific contend that no gain or loss should be reported because they must replace the condemned forest land immediately and so are in the same economic position as they were before. The issue is whether condemnation and subsequent purchase should be viewed as one or two transactions.

GAAP requires “that a gain or loss be recognized when a nonmonetary asset is involuntarily converted to monetary assets even though an enterprise reinvests or is obligated to reinvest the monetary assets in replacement nonmonetary assets.

Disposition of Property, Plant, and Equipment (PPE) refers to the act of selling, exchanging, retiring, or otherwise disposing of a long-term asset. This could happen for various reasons, such as obsolescence, sale of a business segment, or replacement with newer assets.

Proper accounting is essential to ensure an accurate reflection of the financial position and performance of a company.

Example of Disposition of Property, Plant, and Equipment

Here are two examples that involve the Disposition of Property, Plant, and Equipment

Example 1: Sale of a Vehicle

Let’s say Company A sells a delivery truck for $12,000. The truck originally cost $25,000, and its accumulated depreciation at the time of sale is $15,000.

Table 1: Disposition of Delivery Truck

DescriptionDebit ($)Credit ($)
Cash received12,000
Accumulated depreciation15,000
Total Debits27,000
Vehicle cost25,000
Gain on sale of asset (calculated)2,000
Total Credits27,000

Calculation of Gain on Sale:

Gain on Sale = Selling Price−(Original Cost−Accumulated Depreciation)
= 12,000−(25,000−15,000)
= 12,000−10,000

Example 2: Retirement of Machinery

Company B decides to retire an old machine that is no longer usable. The machine initially cost $50,000 and has an accumulated depreciation of $40,000 at the time of retirement.

Table 2: Retirement of Old Machine

DescriptionDebit ($)Credit ($)
Accumulated Depreciation40,000
Loss on Retirement10,000
Total Debits50,000
Machine Cost50,000
Total Credits50,000

Calculation of Loss on Retirement:

Loss on Retirement = Original Cost − Accumulated Depreciation
= 50,000 − 40,000
= 10,000

Miscellaneous Problems

If a company scraps or abandons an asset without any cash recovery, it recognizes a loss equal to the asset’s book value.

If scrap value exists, the gain or loss that occurs is the difference between the asset’s scrap value and its book value. If an asset still can be used even though it is fully depreciated, it may be kept on the books at historical cost less depreciation.

Companies must disclose in notes to the financial statements the amount of fully depreciated assets in service. For example, Petroleum Equipment Tools Inc., in its annual report, disclosed the amount of fully depreciated assets included.