Question

Explain the financial analysis of Property, Plant and Equipment . by explaining cost allocation for assets, depreciation for assets, depreciation process and the methods of depreciation used. Recognition and Measurement Issues.

Answer 1

Property Plant and equipment:

All expenses necessary to get the plant property and equipment in place and in the condition to be used are part of the cost of the asset (Capital expenditure). These include the purchase price actually   paid, freight, permits (if required), installation, initial set up etc.

Principles of accounting:

According to matching principle of accounting, revenue should be matched with the expenses incurred to earn the revenue.

According to period of time principle, all the expenses and revenues for the reporting period should be recognized in the financial report of the period.

Property, Plant and Equipment is used for more than one year, hence the cost of these items need to be recognized only in part during one year as per matching and period of time principles.

This part expense recognized in a year is called depreciation. The balance amount remains as carrying value in the balance sheet

Hence depreciation is the part of initial cost of asset charged to revenue (as per matching principle) for its use.

Hence, it is logical that the depreciation expense and the useful life of the asset are related.

The capitalized costs of the assets are needed to be depreciated within its useful life.

Methods of depreciation:

Depreciation based on time:

• Straight-line method : Depreciation is uniform over the years.

Depreciation =(Initial cost-Salvage Value)/Useful life

This is simplest and most widely used method

• Declining balance method
• Sum=of-the-years’digits method

Depreciation based on use: Under this method depreciation is charged based on activities like hours used or output/ production quantity..