LM08 Long Lived Assets

Part 1

1. Introduction & Acquisition of Property, Plant and Equipment

1.1 Introduction

Long-lived assets are defined as those assets that are expected to provide future economic benefits extending more than one year.

These assets include:

• Tangible assets also known as fixed assets or property, plant, and equipment. Examples include land, buildings, furniture, machinery, etc.
• Intangible assets lack physical substance. Examples include patents, trademarks, etc.
• Financial assets include investments in equity or debt securities issued by other entities.

There are two important questions in accounting for a long-lived asset:

• What cost should be shown on the balance sheet?
• How should this cost be allocated over the life of an asset?

1.2 Acquisition of Long-Lived Assets

Upon acquisition, long-term tangible assets such as property, plant, and equipment are recorded on the balance sheet at cost, which is the same as fair value. An asset’s cost might include expenditures in addition to purchase price. The question is how should these costs be treated – expensed or capitalized?

If the expenditure on an asset is expected to provide benefits beyond one year in the future, the costs are usually capitalized. The costs are expensed if they are not expected to provide benefits in future periods.

1.3 Property, Plant, and Equipment

Property, plant, and equipment are recorded at cost at acquisition. In addition to the purchase price, the cost includes all expenditures necessary to get the asset ready for intended use. For instance, readying the factory for installation of a machine is included in the cost. But if any training is required for the staff to operate the machine, that is expensed and not capitalized. Subsequent costs are capitalized if they are expected to provide benefits beyond one year, otherwise they are expensed. Companies might have different approaches towards expensing/capitalizing costs. An analyst should understand the impact of expensing/capitalizing decisions on financial statements and ratios. All the capitalized costs related to the long-lived assets are recorded in the balance sheet.

Example

Acme Inc. purchased a machine for $ 10,000. In addition, the following costs were incurred:

• $200 for delivery.
• $300 for installation.
• $100 to train staff on using the machine.
• $1,000 to reinforce floor to support machine.
• $500 to paint the factory.

1. Which costs will be capitalized and which will be expensed?
2. How will the treatment of these expenditures affect the company’s financial statements?

Solution to 1:

Capitalized amount = purchase price + costs that are involved in extending asset’s life or getting it ready to use = $10,000 + $200 + $300 + $1000 = $11,500.

Training cost is expensed because if the trained staff leaves the company, then it doesn’t provide a long-term benefit to the business. Expensed costs = $100 + $500 = $600.

Solution to 2:

Balance sheet: PP&E increases by $11,500 and cash decreases by $11,500.

Income statement: An expense of $600 towards training staff and painting. Also a depreciation expense spread over the useful life of the asset appears on the income statement.

Cash flow statement: CFI decreases by $11,500 and CFO decreases by $600.

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