This book is licensed under a Creative Commons by-nc-sa 3.0 license. See the license for more details, but that basically means you can share this book as long as you credit the author (but see below), don't make money from it, and do make it available to everyone else under the same terms.
This content was accessible as of December 29, 2012, and it was downloaded then by Andy Schmitz in an effort to preserve the availability of this book.
Normally, the author and publisher would be credited here. However, the publisher has asked for the customary Creative Commons attribution to the original publisher, authors, title, and book URI to be removed. Additionally, per the publisher's request, their name has been removed in some passages. More information is available on this project's attribution page.
For more information on the source of this book, or why it is available for free, please see the project's home page. You can browse or download additional books there. To download a .zip file containing this book to use offline, simply click here.
At the end of this section, students should be able to meet the following objectives:
Question: The retail giant Walmart owns thousands of huge outlets and supercenters located throughout the United States as well as in many foreign countries. These facilities contain a wide variety of machinery, fixtures, and the like such as cash registers and shelving. On its January 31, 2011, balance sheet, Walmart reports “property and equipment, net” of over $105 billion, a figure that made up almost 60 percent of the company’s total assets. This monetary amount was more than twice as large as any other asset reported by this business. Based on sheer size, the information conveyed about this group of accounts is extremely significant to any decision maker analyzing Walmart or another similar company. In creating financial statements, what is the underlying meaning of the monetary figure reported for property, equipment, and the like? What information is conveyed by the $105 billion balance disclosed by Walmart?
Answer: Four accounts make up the property and equipment reported by Walmart:
These are common titles, but a variety of other names are also used to report similar asset groups such as property, plant, and equipment (PP&E), fixed assets, and plant assets. Regardless of the name that is applied, the starting basis in reporting property, equipment, and any other tangible operating assets with a life of over one year is historical costAll the normal and necessary amounts incurred to get an asset into the position and condition to help generate revenues; it is the starting basis for the balance sheet presentation of assets such as inventory, land, and equipment..
This initial accounting is consistent with the recording process demonstrated previously for inventory. When available, accountants like historical cost because it is objective. Cost reflects the amount sacrificed to obtain land, machinery, buildings, furniture, and so forth. It can usually be determined when an arm’s length acquisition takes place: a willing buyer and a willing seller, both acting in their own self-interests, agree on an exchange price.
Thus, the cost incurred to obtain property and equipment provides information to decision makers about management policy and decision making. Cost indicates the amount management chose to sacrifice in order to gain the use of a specific asset. Unless the seller was forced to dispose of the property in a hurry (because of an urgent need for funds, as an example), cost is likely to approximate fair value when purchased. However, after the date of acquisition, the figure reported on the balance sheet will probably never again reflect the actual value of the asset.
Subsequently, for each of these operating assets that has a finite life (and most pieces of property and equipment other than land do have finite lives), the matching principle necessitates that the historical cost be allocated to expense over the anticipated years of service. This depreciationA mechanically derived pattern allocating the cost of long-lived assets such as buildings and equipment to expense over the expected number of years that they will be used by a company to help generate revenues. expense is recognized systematically each period as the company utilizes the asset to generate revenue.
For example, if equipment has a life of ten years, all (or most) of its cost is assigned to expense over that period. This accounting resembles the handling of a prepaid expense such as rent. The cost is first recorded as an asset and then moved to expense over time in some logical fashion as the utility is consumed. At any point, the reported net book value for the asset is the original cost less the portion of that amount that has been reclassified to expense. For example, Walmart actually reported property and equipment costing $148 billion but then disclosed that $43 billion of that figure had been moved to expense leaving the $105 billion net asset balance. As the future value becomes a past value, the asset account shrinks to reflect the cost reclassified to expense.
Question: The basic accounting for property and equipment resembles that utilized for prepaid expenses such as rent and insurance. Do any significant differences exist between the method of reporting prepaid expenses and the handling of operating assets like machinery and equipment?
Answer: One important mechanical distinction does exist when comparing the accounting for prepayments and that used for property and equipment having a finite life. With a prepaid expense (such as rent), the asset is directly reduced over time as the cost is assigned to expense. Prepaid rent balances get smaller each day as the period of usage passes. This reclassification creates the rent expense reported on the income statement.
In accounting for property and equipment, the asset does not physically shrink. A seven-story building does not become a six-story building and then a five-story building. As the utility is consumed, buildings and equipment do not get smaller; they only get older. To reflect that reality, a separate accumulated depreciationA contra-asset account created to measure the cost of a depreciable asset (such as buildings and equipment) that has been assigned to expense to date. accountAs discussed in the coverage of accounts receivable and the allowance for doubtful accounts, an account that appears with another but as a direct reduction is known as a contra account. Accumulated depreciation is a contra account that decreases the reported cost of property and equipment to reflect the portion of that cost that has now be assigned to expense. is created to represent the total amount of the asset’s cost that has been reclassified to expense. Through this approach, information about the original cost continues to be available. For example, if equipment is reported as $30,000 and the related accumulated depreciation currently holds a balance of $10,000, the reader knows that the asset cost $30,000, but $10,000 of that amount has been expensed since the date of acquisition. If the asset has been used for two years to generate revenue, $6,000 might have been moved to expense in the first year and $4,000 in the second. The $20,000 net book valueOriginal cost of a depreciable asset such as buildings and equipment less the total amount of accumulated depreciation to date; it is also called net book value or carrying value. appearing on the balance sheet is the cost that has not yet been expensed because the asset still has future value.
As indicated previously, land does not have a finite life and, therefore, remains reported at historical cost with no assignment to expense and no accumulated depreciation balance.
A company buys equipment for $100,000 with a ten-year life. Three years later, the company produces financial statements and prepares a balance sheet. The asset is not impaired in any way. What figure is reported for this equipment?
The correct answer is choice c: $100,000 less the accumulated depreciation recorded for these three years.
The historical cost ($100,000) serves as the beginning basis for the financial reporting of property and equipment. This monetary figure is then systematically transferred to expense over the life of the asset. The total amount of the expense recognized to date is recorded in an accumulated depreciation account. The book value to be shown on the balance sheet for this equipment is its historical cost less the accumulated depreciation to date.
Question: Walmart reports property and equipment with a net book value of $105 billion. However, that figure has virtually nothing to do with the value of these assets. They might actually be worth hundreds of billions. Decision makers analyze financial statements in order to make decisions about an organization at the current moment. Are these decision makers not more interested in the fair value of these assets than in what remains of historical cost? Why are property and equipment not reported at fair value? Is fair value not a much more useful piece of information than cost minus accumulated depreciation when assessing the financial health and prospects of a business?
Answer: The debate among accountants, company officials, investors, creditors, and others over whether various assets should be reported based on historical cost or fair value has raged for many years. There is no easy resolution. Good points can be made on each side of the argument. As financial accounting has evolved over the decades, rules for reporting certain assets (such as many types of stock and debt investments where exact market prices can be readily determined) have been changed to abandon historical cost in favor of reflecting fair value. However, no such radical changes in U.S. GAAP have taken place for property and equipment. Reporting has remained relatively unchanged for many decades. Unless the value of one of these assets has been impaired or it is going to be sold in the near future, historical cost less accumulated depreciation remains the basis for balance sheet presentation.
The fair value of property and equipment is a reporting alternative preferred by some decision makers, but only if the amount is objective and reliable. That is where the difficulty begins. Historical cost is both an objective and a reliable measure, determined through a transaction between a willing buyer and a willing seller. In contrast, any gathering of “experts” could assess the value of a large building or an acre of land at widely differing figures with equal certitude. No definitive value can possibly exist until sold. What is the informational benefit of a number that is so subjective? Furthermore, the asset’s value might change radically on a daily basis rendering previous assessments useless. For that reason, historical cost, as adjusted for accumulated depreciation, remains the accepted method for reporting property and equipment on an owner’s balance sheet.
Use of historical cost is supported by the going concern assumption that has long existed as part of the foundation of financial accounting. In simple terms, a long life is anticipated for virtually all organizations. Officials expect operations to continue for the years required to fulfill the goals that serve as the basis for their decisions. They do not plan to sell property and equipment prematurely but rather to utilize these assets for their entire lives. Consequently, financial statements are constructed assuming that the organization will function until all of its assets are consumed. Unless impaired or a sale is anticipated in the near future, the fair value of property and equipment is not truly of significance to the operations of a business. It might be interesting information but it is not directly relevant if no sale is contemplated.
However, the estimated fair value of a company’s property and equipment is a factor that does influence the current price of ownership shares traded actively on a stock exchange. For example, the price of shares of The Coca-Cola Company is certainly impacted by the perceived value of its property and equipment. A widely discussed calculation known as market capitalizationFigure computed by multiplying a company’s current stock price times the number of ownership shares outstanding in the hands of the public; it is used to gauge the fair value of a business as a whole. is one method used to gauge the fair value of a business as a whole. Market capitalization is determined by multiplying the current price of a company’s stock times the number of ownership shares outstanding. For example, approximately 2.3 billion shares of The Coca-Cola Company were in the hands of investors at December 31, 2010. Because the stock was selling for $65.77 per share on that day, the company’s market capitalization was about $151 billion. This figure does not provide a direct valuation for any specific asset but does give a general idea as to whether fair value approximates net book value or is radically different.
Following is a continuation of our interview with Robert A. Vallejo, partner with the accounting firm PricewaterhouseCoopers.
Question: In U.S. GAAP, land, buildings, and equipment have traditionally been reported at historical cost less the accumulated depreciation recognized to date. Adjustment to fair value is prohibited unless the asset’s value has been impaired. Because of the conservative nature of accounting, increases in value are ignored completely until proven through a disposal. Thus, land might be worth $20 million but only shown on the balance sheet as $400,000 if that amount reflects cost. According to IFRS, can increases in the fair value of these assets be reported?
Rob Vallejo: Under IFRS, a company can elect to account for all or specific types of assets using fair value. In that instance, the designated assets are valued each reporting period, adjusted up or down accordingly. Based on my experience working with companies reporting under IFRS, companies do not elect to account for fixed assets using fair value. This decision is primarily due to the administrative challenges of determining fair value each and every reporting period (quarterly for US listed companies) and the volatility that would be created by such a policy. Financial officers and the financial investors that follow their stocks rarely like to see such swings, especially those swings that cannot be predicted. However, in the right circumstances, using fair value might be a reasonable decision for some companies.
Land, buildings, and equipment are reported on a company’s balance sheet at net book value, which is historical cost less any portion of that figure that has been assigned to expense. Over time, the cost balance is not directly reduced. Instead, the expensed amount is maintained in a separate contra asset account known as accumulated depreciation. Thus, the asset’s cost remains readily apparent as well as net book value. Land and any other asset that does not have a finite life continue to be reported at cost. Unless the value of specific items has been impaired or an asset is to be sold in the near future, fair value is never used in reporting land, buildings, and equipment. It is not viewed as an objective or reliable amount. In addition, because such assets are usually not expected to be sold, fair value is of limited informational benefit to decision makers.