Understanding Plant Asset Depreciation

4.02 STUDY GUIDE ▪ Plant assets are assets that will be used for a number of years in the operation of a business. ▪ Plant assets may wear out, become outdated, or may no longer be needed. To match revenues earned with expenses incurred, the cost of a plant asset should be allocated to an expense account over the useful life of the asset. ▪ Land is considered to be a permanent plant asset and is not depreciated. ▪ The portion of the asset’s cost that is transferred to an expense account is known as depreciation expense. ▪ A plant asset is never depreciated below its estimated salvage value. ▪ Many plant assets depreciate more in the early years of useful life than in the later years. Charging more depreciation in the early years may be more accurate than charging the same each year. Declining-balance and sum-of-the-years’-digits methods are both accelerated methods of depreciation. ▪ Declining-balance rate is based on the straight-line rate. A declining-balance rate that is twice the straight-line rate is used in the double declining-balance method. ▪ Declining-balance method does not use the estimated salvage value to compute annual depreciation. The estimated salvage value is used only to limit the last year’s depreciation expense. ▪ Sum-of-the-years’-digits method of depreciation uses fractions based on the number of years of a plant asset’s useful life. ▪ Production-unit method of depreciation calculates estimated annual depreciation expense based on the amount of production expected from a plant asset. ▪ Regardless of the depreciation method used, the total depreciation expense over the useful life of an asset is the same. ▪ Each method presented conforms to generally accepted accounting principles. ▪ Most businesses use one of the methods to calculate depreciation for financial reporting purposes. ▪ Modified Accelerated Cost Recovery System is a depreciation method required by the Internal Revenue Service to be used for income tax calculation purposes for most plant assets placed in service after 1986. This method is generally referred to as MACRS. MACRS has prescribed periods for nine classes of useful life for plant assets. An asset is assigned to a specific class based on its characteristics and general life expectancy. ▪ With straight-line depreciation, the amount of depreciation expense is the same for each year of the asset’s useful life. With declining-balance and sum-of-the-years’-digits depreciation, the amount of depreciation expense is larger during the early years of the asset’s useful life. UNPACKED CONTENT I. Journalizing the Disposal of Plant Assets A. Discarding a plant asset with no book value 1. Credit the plant asset account for the original cost of the asset being disposed. 2. Debit Accumulated Depreciation for the total depreciation expense taken on the asset being disposed. 3. When posted, all amounts for the discarded asset are removed. B. Discarding a plant asset with book value 1. Record a partial year’s depreciation (if necessary) by debiting Depreciation Expense and crediting Accumulated Depreciation. 2. Credit the appropriate asset account for the original cost of the asset being disposed. 3. Debit Accumulated Depreciation for the amount of depreciation expense taken on the asset being disposed. 4. Debit Loss on Plant Assets for the remaining amount to reflect the loss incurred on the disposal of the asset. C. Selling a plant asset 1. Compute the gain or loss by subtracting the book value of the asset from the cash received from the sale. 2. Credit the appropriate asset account for the original cost of the asset being disposed. 3. Debit Accumulated Depreciation for the amount of depreciation expense taken on the asset being disposed. 4. Debit Cash for the amount of cash received from the sale of the asset. 5. If incurring a loss on the sale, debit Loss on Plant Assets for the remaining amount to reflect the loss on the sale. 6. If the sale results in a gain, credit Gain on Plant Assets for the remaining amount to reflect the gain on the sale. D. Trading a plant asset 1. Compute the original cost of the NEW asset by adding the book value of the asset traded and the cash paid in the trade. 2. Debit the appropriate plant asset account for the original cost of the NEW asset. 3. Credit the appropriate plant asset account for the original cost of the asset being traded. 4. Debit Accumulated Depreciation for the amount of depreciation expense taken on the asset being traded. 5. Credit Cash for the amount paid in the trade. II. Calculating Declining-Balance Method of Depreciation (Cost of Asset – Ignore Salvage Value) A. Book Value = Cost of Asset – Accumulated Depreciation B. (Book Value/Estimated Useful Life)X2=Declining-Balance Depreciated C. Declining-Balance Method ignores Salvage Value III. Calculating Sum-of-the-Years’-Digits Method of Depreciation A. Add the years’ digits. For example, a useful life of 5 years would be (1+2+3+4+5 = 15) B. The sum of the years’ digits is used to create fractions for each year with the years’ digits in reverse order. (Year 1 would have a fraction of 5/15; Year 5 would have a fraction of 1/15.) C. Multiply the total depreciation expense by the fraction for each year. D. The ending book value after the last year of depreciation should equal the plant asset’s salvage value. IV. Calculating Production-Unit Method of Depreciation A. Original Cost – Estimated Salvage Value = Estimated Total Depreciation Expense B. Estimated Total Depreciation Expense ÷ Estimated Useful Life (stated in production units) = Depreciation Rate (per production unit) C. Depreciation Rate x units produced = Annual Depreciation Expense