CHAPTER 9

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
assets: property, 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 are 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 ExxonMobil in
the oil exploration and refining industry. Such companies can 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 users of financial statements because it indicates the
physical resources available to the firm and can also give some indication of future liquidity
and cash flows. The objectives of plant and equipment accounting are as follows:
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 5, 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 arm’s‐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 associated 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 common, 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 seller’s books. Because 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 of 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 asset, 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 question of fixed overhead allocation 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 are often 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
Securities and Exchange Commission (SEC) established a rule preventing this practice. 1 In
1979, the Financial Accounting Standards Board (FASB) issued SFAS No. 34,
“Capitalization of Interest Costs”2 (see FASB ASC 835‐20). In this release, the FASB
maintained that interest should be capitalized only when an asset requires a period of time to
be prepared for its intended use.
The primary objective of the guidance contained at FASB ASC 835‐20 is 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 constructed or otherwise produced for
an enterprise’s own use and (2) assets intended for sale or lease that are constructed or
otherwise produced as discrete projects. The FASB ASC 835‐20‐15‐6 guidance excludes
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 being readied for use
are also excluded.
An additional issue addressed is the determination of the proper amount of interest to
capitalize. The FASB ASC 835‐20‐30 guidance indicates 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 amount 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 proceeds received from the sale of the
assets to the land because these costs are necessary to put the site in a state of readiness for
construction.
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 for 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 fair market value versus the
book value of the exchanged asset. That is, some have advocated that companies account for
these types of exchanges based on the fair value of the asset given up or the fair value of the
asset received, with a gain or loss recognized. Others argue that the exchanges should be
recorded at the book value of the asset(s) given up, with no gain or loss recognized. Still
others favor recognizing losses in all cases but deferring gains. In 1973, the APB took these
argument into consideration and released Opinion No. 29, “Accounting for Nonmonetary
Transactions” (see FASB ASC 845), which maintains that fair value should (generally) be
used as the basis of accountability.3 Therefore the cost of an asset acquired in a straight
exchange for another asset is the fair market value of the surrendered asset(s).
That is, if the exchanged assets were dissimilar, the presumption was that the earning process
was complete, and the acquired asset was recorded at the fair value of the asset(s) exchanged
including any gain or loss. This requirement existed for straight exchanges and for exchanges
accompanied by cash payments (also known as boot). For example, if Company G exchanges
a nonmonetary asset with a book value of $10,000 and fair market value of $13,000 plus
$2000 in cash for a dissimilar nonmonetary asset, then a gain of $3,000 should be recognized
($13,000 – $10,000), and the new asset is recorded with a book value of $15,000.
This general rule was originally subject to one exception. The original APB guidance stated
that exchanges should be recorded at the book value of the asset(s) given up when the
exchange was not the culmination of the earning process. Two examples of exchanges that do
not result in 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
Accounting for the exchange of similar productive assets was based on the original book
value of the asset(s) exchanged. Losses on the exchange of similar productive assets were
always recognized in their entirety whether or not boot (cash) was involved. However, gains
were never recognized unless boot was received. In the event boot was received, the amount
of the gain to be recognized was determined by the following formula:
CashReceived(Boot)CashReceived(Boot)
+FairValueofOtherAssetsReceived×TotalGain=RecognizedGainCash 
Received BootCash Received Boot+Fair Value of Other Assets 
Received×Total Gain=Recognized Gain
Later in 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets—An
Amendment of APB Opinion No. 29” 5 (see FASB ASC 845‐10). This amendment eliminated
the exception for nonmonetary exchanges of similar productive assets and replaced it with an
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. 6 For those exchanges that have
commercial substance, the accounting treatment is similar to that outlined in APB No. 29.
That is, the nonmonetary assets are accounted for at fair value with the appropriate
recognition of gains and losses. However, for those exchanges that lack commercial
substance, the assets are accounted for at their carrying (book) value. In these situations,
gains are not recognized unless cash (boot) is received, but all losses are recognized.
For those exchanges involving boot, if the nonmonetary exchange of assets has commercial
substance, the recorded cost of the asset received is equal to the fair value of the asset
relinquished plus the boot paid or minus the boot received. Gains and losses are recognized in
full. On the other hand, if the exchange of assets lacks commercial substance, then the cost of
the asset received is equal to the net carrying value of the asset relinquished plus the boot
paid or minus the boot received and the receiver of boot recognizes the portion of the gain
represented by the boot using the formula outlined earlier.7
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 the
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 for $1 per
year, and $40 million to lengthen the local airport runway so that it could accommodate wide‐
body cargo aircraft. The cost principle holds that the recorded values of assets should be
equal to the consideration given in return, but because 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 (see FASB ASC 605‐10‐15‐3) requires that the inflow of assets from a
donation be considered revenue (not donated capital).8 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 revenue has been earned. Alternatively,
it may be argued that the inflow represents a gain. This latter argument is consistent with the
conceptual framework 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.
Similarly, valuable natural resources may be discovered on property subsequent to its
acquisition, and the original cost might 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 framework 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 company’s profitability by computing the return‐on‐
assets (ROA) ratio. The sustainability of earnings is a major consideration in this process. For
capital‐intensive companies, a large portion of their asset base is investments in property,
plant, and equipment, and a major question for investors analyzing such companies concerns
their asset replacement policy. A company that has a large investment in property, plant, and
equipment and that fails to systematically replace those assets generally reports an increasing
return on assets over the useful life of its asset base. This occurs because the ROA
denominator decreases by the amount of the company’s annual depreciation expense,
resulting in an increasing return percentage for stable amounts of earnings. In addition, the
general pattern of rising prices tends to increase the selling price of the company’s product,
resulting in a further upward bias for the ROA percentage.
An examination of a company’s investing activity helps in analyzing the earnings
sustainability of its ROA percentage. For example, Hershey’s statement of cash flows,
contained in Chapter 7, reveals that the company acquired $345,947,000 and $323,551,000 of
property, plant, and equipment assets in 2014 and 2013, respectively. These amounts are 7.0
percent and 8.6 percent, respectively, of the gross property, plant, and equipment assets.
Tootsie Roll’s statement of cash flows reveals that the company acquired approximately
$10,704,000 and $15,752,000 of property, plant, and equipment assets in 2014 and 2013,
respectively, amounting to 2.2 percent and 3.3 percent of the purchase price of its property,
plant, and equipment assets. Both of these computations provide evidence that the
companies’ ROA percentages are not being distorted by a failure to systematically replace
their long‐term assets.

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 5)
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 expire—that is, it is expensed
(see Chapter 5 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 generally agree that cost reflects
future service potential at acquisition. However, in subsequent periods, expectations about
future resource flows can change. Also, the discount rate used to measure the present value of
the future service potential can 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 might
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 currently 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. 9 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
cost‐based 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. However, neither of these
approaches provides 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 depreciation 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
classified as property, plant, and equipment. Because depreciation is a form of cost
allocation, all depreciation concepts are related to some view of income measurement. A
strict interpretation of the FASB’s 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 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 depreciation 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.10 [See FASB ASC 360‐10‐35‐4.]
The AICPA’s view of depreciation 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 depreciation for accounting purposes.
Moreover, we do not support the view that business decisions should be affected by
accounting rules. In 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 the 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 asset’s useful service life may be less than its physical life, and
factors other than wear and tear should be examined to establish the useful service life.
Various authors have suggested possible obsolescence, inadequacy, supersession, and
changes in the social environment as factors to be considered in establishing the expected
service life. For example, jet airplanes have replaced most of the airlines’ propeller‐driven
planes, and ecological factors have caused changes in manufacturing processes in the steel
industry. Estimating such factors requires a certain amount of clairvoyance—a quality
difficult to acquire.
Depreciation Methods
Most of the controversy in depreciation accounting revolves around the question of the
appropriate method that should be used to allocate the depreciation base over its estimated
service life. Theoretically, the expired cost of the asset should be related to the value received
from the asset in each period; however, it is extremely difficult to measure these amounts.
Accountants have, therefore, attempted to estimate expired costs by other methods—namely,
straight line, accelerated, and units of activity.

Straight Line.
The straight‐line method allocates an equal portion of the depreciable cost of an asset to each
period the asset is used. Straight‐line depreciation is often justified on the basis of the lack of
evidence to support other methods. Because it is difficult to establish evidence that links the
value received from an asset to any particular period, the advocates of straight‐line
depreciation accounting argue that other methods are arbitrary and therefore inappropriate.
Use of the straight‐line method implies that the asset is declining in service potential in equal
amounts over its estimated service life.

Accelerated.
The sum‐of‐the‐year’s‐digits and the fixed‐percentage‐of‐declining‐base (declining balance)
are the most commonly encountered methods of accelerated depreciation. 11 These methods
result in larger charges to expense in the earlier years of asset use, although little evidence
supports the notion that assets actually decline in service potential in the manner suggested by
these methods. Advocates contend that accelerated depreciation is preferred to straight‐line
depreciation because as the asset ages, the smaller depreciation charges are associated with
higher maintenance charges. The resulting combined expense pattern provides a better match
against the associated revenue stream. Accelerated depreciation methods probably give
balance sheet valuations that are closer to the actual value of the assets in question than
straight‐line methods do because most assets lose their value more rapidly during the earlier
years of use. But, because depreciation accounting is not intended to be a method of asset
valuation, this factor should not be viewed as an advantage of using accelerated depreciation
methods.

Units of Activity.
When assets (e.g., machinery) are used in the actual production process, it may be possible to
determine an activity level, such as the total expected output to be obtained from these assets.
Depreciation may then be based on the number of units of output produced during an
accounting period. The activity measures of depreciation assume that each product produced
during the asset’s existence receives the same amount of benefit from the asset. This
assumption may or may not be realistic. In addition, care must be exercised in establishing a
direct relationship between the measurement unit and the asset. For example, when direct
labor hours are used as a measure of the units of output, a decline in productive efficiency in
the later years of the asset’s use can cause the addition of more direct labor hours per product,
which would result in charging more cost per unit.
isclosure of Depreciation Methods.
Most U.S. companies use straight‐line depreciation, as shown by a recent survey, which
reported that 488 of the 600 firms surveyed used straight‐line depreciation for at least some
of their assets.12 Both Hershey and Tootsie Roll use straight‐line depreciation for financial
reporting purposes. The following is excerpted from Tootsie Roll’s summary of significant
accounting policies:
Property, plant, and equipment:
Depreciation is computed for financial reporting purposes by use of the straight‐line method
based on useful lives of 20 to 35 years for buildings and 5 to 20 years for machinery and
equipment. Depreciation expense was $20,758, $20,050, and $19,925 in 2014, 2013, and
2012, respectively.

CAPITAL AND REVENUE EXPENDITURES

The initial purchase and installation of plant and equipment does not necessarily eliminate
additional expenditures associated with these assets. Almost all productive facilities require
periodic maintenance that should be charged to current expense. The cost of the asset to the
enterprise includes the initial cost plus all costs associated with keeping the asset in working
order. However, if additional expenditures give rise to an increase in future service potential,
these expenditures should not be charged to current operations. Expenditures that increase
future service potential should be added to the remaining unexpired cost of the asset and be
charged to expense over the estimated remaining period of benefit.
In most cases, the decision to expense or capitalize plant and equipment expenditures
subsequent to acquisition is fairly simple and is based on whether the cost incurred is
“ordinary and necessary” or “prolongs future life.” But often this decision becomes more
complicated, and additional rules have been formulated that assist in determining whether an
expenditure should be recorded as a capital improvement. If the asset’s life is increased, the
efficiency provided is increased, or if output is increased, its service potential has increased,
and the cost of an expenditure should be capitalized and written off over the expected period
of benefit. All other expenditures made subsequent to acquisition should be expensed as
incurred.

RECOGNITION AND MEASUREMENT ISSUES

Accounting depreciation methods are objective because they use historical cost. Moreover,
once the method is selected, the resulting depreciation charges are generally reliable.
Nevertheless, all accounting depreciation methods have similar recognition and measurement
problems. Given that fixed assets are intended to provide service potential over multiple
future years, each cost‐allocation method requires estimates of salvage value and useful life,
and given the rapidly changing competitive environment, revisions of these estimates may be
required each accounting period.
One can argue that accounting depreciation methods do not provide relevant information for
users. Users desire information that is useful in predicting future cash flows. Users are also
aware that management makes a decision each period either to reinvest in available long‐term
assets or to replace existing long‐term assets with new ones. Consequently, a current‐value
approach to depreciation may be more consistent with investors’ needs
Using a current‐value balance sheet approach to report depreciation would require knowledge
of the reinvestment value of each long‐term asset at the end of each accounting period. Such
a determination may be impracticable or even impossible. The assets in question may be old,
or they may be so specialized that there is no readily determinable market value. Alternative
discounted present‐value techniques require estimates of future cash flows that may be
unreliable, and appraisal values may not be realistic. Hence, there is no simple answer to the
determination of the most appropriate approach to depreciation. This determination depends,
to a large extent, on an individual’s perception of the necessary trade‐off between relevance
and faithful representation.

IMPAIRMENT OF VALUE
The SFAC No. 6 definition of assets indicates that assets have future service potential and
consequently value to the reporting entity. Having future service potential implies that the
asset is expected to generate future cash flows. When the present value of future cash flows
decreases, the value of the asset to the firm declines. If the decline in value over the life of the
asset is greater than the accumulated depreciation charges, the book value of the asset is
overstated, and the value of the asset is said to be impaired. Yet accountants have been
reluctant to apply the lower of cost or market (LCM) rule to account for property, plant, and
equipment.
The FASB, noting divergent practices in the recognition of impairment of long‐lived assets,
originally issued SFAS No. 121,13 now superseded, which addressed the matter of when
to recognize the impairment of long‐lived assets and how to measure the loss. This release
ignored current value as a determinant of impairment. Rather, it stated that impairment occurs
when the carrying amount of the asset is not recoverable. The recoverable amount is defined
as the sum of the future cash flows expected to result from use of the asset and its eventual
disposal. Under this standard, companies were required to review long‐lived assets (including
intangibles) for impairment whenever events or changes in circumstances indicate that book
value might not be recoverable. Examples indicating potential impairment included the
following:
1. A significant decrease in the market value of an asset
2. A significant change in the extent or manner in which an asset is used
3. A significant adverse change in legal factors or in business climate that affects the
value of assets
4. An accumulation of significant costs in excess of the amount originally expended to
acquire or construct an asset
5. A projection or forecast that demonstrates a history of continuing losses associated
with the asset
Although fair value was not used to determine impairment, SFAS No. 121 required that when
an impairment occurred, a loss was to be recognized for the difference between the carrying
value of an asset and its current value less estimated cost to dispose of the asset. The resulting
reduced carrying value of the asset became its new cost basis and was to be depreciated over
the remaining useful life of the asset.
In 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of
Long‐Lived Assets”14 (see FASB ASCs 360‐10‐35‐15 to 49). The FASB stated that the new
standard was issued because SFAS No. 121 did not address accounting for a segment of a
business accounted for as a discontinued operation, as originally required by APB Opinion
30. Consequently, two accounting models existed for disposing of long‐lived assets. The
Board decided to establish a single accounting model, based on the framework established
in SFAS No. 121, for long‐lived assets to be disposed of by sale.