Long-term assets and depreciation
Long-term assets such as buildings, equipment, and vehicles serve a business for years. Depreciation spreads their cost over the years they are used.
Property, plant, and equipment
Property, plant, and equipment (PP&E) are tangible long-term assets used in operations: land, buildings, machinery, vehicles, and furniture. They are recorded at cost, including all costs to get them ready for use, such as purchase price, delivery, installation, and testing.
Capital versus revenue expenditures
Capital expenditures, such as adding a new wing or a major engine overhaul that extends useful life, are added to the asset's cost. Revenue expenditures, such as routine repairs and maintenance, are expensed immediately. Misclassifying expenses as capital inflates profit, as in the WorldCom fraud.
Depreciation basics
Depreciation allocates an asset's cost minus residual (salvage) value over its useful life. It is a cost allocation, not a measure of market value. Land is not depreciated because it does not wear out or get used up.
Straight-line method
Straight-line depreciation charges equal amounts each year: (cost - residual value) / useful life. For a 22,000-dollar machine with a 2,000 residual value and 5-year life, annual depreciation is 4,000 dollars. It is the most widely used method because of its simplicity.
Declining-balance method
The double-declining-balance method is an accelerated method: each year, depreciation = book value at the start of the year x (2 / useful life). It charges more depreciation early, suiting assets that lose value quickly, such as technology. Depreciation stops when book value reaches residual value.
Units-of-production method
The units-of-production method bases depreciation on usage: depreciation per unit = (cost - residual value) / total expected units (miles, hours, or units produced), multiplied by actual usage each period. It suits assets such as delivery trucks or mining equipment.
Disposals
When an asset is sold or scrapped, depreciation is updated to the disposal date, and the asset and its accumulated depreciation are removed. A gain or loss equals the cash received minus the asset's book value. Selling a machine with a book value of 3,000 for 4,000 produces a gain of 1,000.
Worked example
A delivery van costs 40,000 dollars, has a residual value of 4,000, and a useful life of 4 years. Straight-line: 9,000 per year. Double-declining-balance rate is 50%: year 1 depreciation = 40,000 x 50% = 20,000; year 2 = 20,000 x 50% = 10,000; year 3 = 10,000 x 50% = 5,000; year 4 = 1,000, bringing book value down to the 4,000 residual.
Key takeaways
PP&E is recorded at cost including costs to make it ready for use. Capital expenditures are capitalised; routine repairs are expensed. Depreciation allocates cost minus residual value over useful life; land is not depreciated. Straight-line charges equal amounts; double-declining-balance accelerates depreciation; units-of-production follows usage. Disposals produce gains or losses equal to proceeds minus book value.
Flashcard
Tangible long-term operating assets
Check your understanding
A machine with a book value of 6,000 dollars is sold for 4,500 dollars. What is the result?