chapter 10

 Property, Plant, and Equipment

LEARNING OBJECTIVE 1

Identify property, plant, and equipment and its related costs.

Companies like Hon Hai Precision (TWN), Tata Steel (IND), and Royal Dutch

Shell (GBR and NLD) use assets of a durable nature. Such assets are called

property, plant, and equipment. Other terms commonly used are plant assets

and fixed assets. We use these terms interchangeably. Property, plant, and

equipment is defined as tangible assets that are held for use in production or

supply of goods and services, for rentals to others, or for administrative purposes;

they are expected to be used during more than one period. [1] (See the

Authoritative Literature References section near the end of the chapter.) Property,

plant, and equipment therefore includes land, building structures (offices,

factories, warehouses), and equipment (machinery, furniture, tools). The major

characteristics of property, plant, and equipment are as follows.

1. They are acquired for use in operations and not for resale. Only assets

used in normal business operations are classified as property, plant, and

equipment. For example, an idle building is more appropriately classified

separately as an investment. Property, plant, and equipment held for possible

price appreciation are classified as investments. In addition, property, plant,

and equipment held for sale or disposal are separately classified and reported

on the statement of financial position. Land developers or subdividers classify

land as inventory.

2. They are long-term in nature and usually depreciated. Property, plant,

and equipment yield services over a number of years. Companies allocate the

cost of the investment in these assets to future periods through periodic

depreciation charges. The exception is land, which is depreciated only if a

material decrease in value occurs, such as a loss in fertility of agricultural land

because of poor crop rotation, drought, or soil erosion.

3. They possess physical substance. Property, plant, and equipment are

tangible assets characterized by physical existence or substance. This

differentiates them from intangible assets, such as patents or copyrights.

Unlike raw material, however, property, plant, and equipment do not

physically become part of a product held for resale.

Acquisition of Property, Plant, and Equipment

Most companies use historical cost as the basis for valuing property, plant, and

equipment (see Underlying Concepts). Historical cost measures the cash or

cash equivalent price of obtaining the asset and bringing it to the location and

condition necessary for its intended use.

Underlying Concepts

Fair value is relevant to inventory but less so for property, plant, and

equipment which, consistent with the going concern assumption, are held for

use in the business, not for sale like inventory.

Companies recognize property, plant, and equipment when the cost of the asset can

be measured reliably and it is probable that the company will obtain future

economic benefits. [2] For example, when Starbucks (USA) purchases coffee

makers for its operations, these costs are reported as assets because they can be

reliably measured and benefit future periods. However, when Starbucks makes

ordinary repairs to its coffee machines, it expenses these costs because the primary

period benefited is only the current period.

In general, companies report the following costs as part of property, plant, and

equipment. [3]

1

1. Purchase price, including import duties and non-refundable purchase taxes,

less trade discounts and rebates. For example, British Airways (GBR)

indicates that aircraft are stated at the fair value of the consideration given

after offsetting manufacturing credits.

2. Costs attributable to bringing the asset to the location and condition necessary

for it to be used in a manner intended by the company. For example, when

Skanska AB (SWE) purchases heavy machinery from Caterpillar (USA), it

capitalizes the costs of purchase, including delivery costs.

Companies value property, plant, and equipment in subsequent periods using

either the cost method or fair value (revaluation) method. Companies can apply the

cost or fair value method to all the items of property, plant, and equipment or to a

single class or classes of property, plant, and equipment. For example, a company

may value land (one class of asset) after acquisition using the revaluation

accounting method and, at the same time, value buildings and equipment (other

classes of assets) at cost.

Most companies use the cost method—it is less expensive to use because the cost

of an appraiser is not needed. In addition, the revaluation (fair value) method

generally leads to higher asset values, which means that companies report higher

depreciation expense and lower net income. This chapter discusses the cost

method; we illustrate the (fair value) revaluation method in Chapter 11.

Cost of Land

All expenditures made to acquire land and ready it for use are considered part of

the land cost. Thus, when Auchan (FRA) or ÆON (JPN) purchases land on which

to build a new store, land costs typically include (1) the purchase price; (2) closing

costs, such as title to the land, attorney’s fees, and recording fees; (3) costs incurred

in getting the land in condition for its intended use, such as grading, filling,

draining, and clearing; (4) assumption of any liens, mortgages, or encumbrances on

the property; and (5) any additional land improvements that have an indefinite life.

For example, when ÆON purchases land for the purpose of constructing a building,

it considers all costs incurred up to the excavation for the new building as land

costs. Removal of old buildings—clearing, grading, and filling—is a land

cost because these activities are necessary to get the land in condition for

its intended purpose. ÆON treats any proceeds from getting the land ready for

its intended use, such as salvage receipts on the demolition of an old building or

the sale of cleared timber, as reductions in the price of the land.

In some cases, when ÆON purchases land, it may assume certain obligations on

the land, such as back taxes or liens. In such situations, the cost of the land is the

cash paid for it, plus the encumbrances. In other words, if the purchase price of the

land is ¥50,000,000 cash but ÆON assumes accrued property taxes of ¥5,000,000

and liens of ¥10,000,000, its land cost is ¥65,000,000.

ÆON also might incur special assessments for local improvements, such as

pavements, street lights, sewers, and drainage systems. It should charge these costs

to the Land account because they are relatively permanent in nature. That is, after

installation, they are maintained by the local government. In addition, ÆON should

charge any permanent improvements it makes, such as landscaping, to the Land

account. It records separately any improvements with limited lives, such as

private driveways, walks, fences, and parking lots, to the Land Improvements

account. These costs are depreciated over their estimated lives.

Generally, land is part of property, plant, and equipment. However, if the

major purpose of acquiring and holding land is speculative, a company more

appropriately classifies the land as an investment. If a real estate concern holds

the land for resale, it should classify the land as inventory.

In cases where land is held as an investment, what accounting treatment should be

given for taxes, insurance, and other direct costs incurred while holding the land?

Many believe these costs should be capitalized. The reason: They are not generating

revenue from the investment at this time. Companies generally use this approach

except when the asset is currently producing revenue (such as rental property).

Cost of Buildings

The cost of buildings should include all expenditures related directly to their

acquisition or construction. These costs include (1) materials, labor, and overhead

costs incurred during construction, and (2) professional fees and building permits.

Generally, companies contract others to construct their buildings. Companies

consider all costs incurred, from excavation to completion, as part of the building

costs.

But how should companies account for an old building that is on the site of a newly

proposed building? Is the cost of removal of the old building a cost of the land or a

cost of the new building? Recall that if a company purchases land with an old

building on it, then the cost of demolition less its residual value is a cost

of getting the land ready for its intended use and relates to the land

rather than to the new building. In other words, all costs of getting an asset

ready for its intended use are costs of that asset.

It follows that any costs that are not directly attributable to getting the building

ready for its intended use should not be capitalized. For example, start-up costs,

such as promotional costs related to the building’s opening or operating losses

incurred initially due to low sales, should not be capitalized. Also, general

administrative expenses (such as the cost of the finance department) should not be

allocated to the cost of the building.

Cost of Equipment

The term “equipment” in accounting includes delivery equipment, office

equipment, machinery, furniture and fixtures, furnishings, factory equipment, and

similar fixed assets. The cost of such assets includes the purchase price, freight and

handling charges incurred, insurance on the equipment while in transit, cost of

special foundations if required, assembling and installation costs, and costs of

conducting trial runs. Costs thus include all expenditures incurred in acquiring the

equipment and preparing it for use.

Self-Constructed Assets Occasionally, companies construct their own assets. Determining the cost of such

machinery and other fixed assets can be a problem. Without a purchase price or

contract price, the company must allocate costs and expenses to arrive at the cost of

the self-constructed asset. Materials and direct labor used in construction pose

no problem. A company can trace these costs directly to work and material orders

related to the fixed assets constructed.

However, the assignment of indirect costs of manufacturing creates special

problems. These indirect costs, called overhead or burden, include power, heat,

light, insurance, property taxes on factory buildings and equipment, factory

supervisory labor, depreciation of fixed assets, and supplies.

Companies can handle overhead in one of two ways:

1. Assign no fixed overhead to the cost of the constructed asset. The

major argument for this treatment is that overhead is generally fixed in nature.

As a result, this approach assumes that the company will have the same costs

regardless of whether or not it constructs the asset. Therefore, to charge a

portion of the overhead costs to the equipment will normally reduce current

expenses and consequently overstate income of the current period. However,

the company would assign to the cost of the constructed asset variable

overhead costs that increase as a result of the construction.

2. Assign a portion of all overhead to the construction process. This

approach, called a full-costing approach, assumes that costs attach to all

products and assets manufactured or constructed. Under this approach, a

company assigns a portion of all overhead to the construction process, as it

would to normal production. Advocates say that failure to allocate overhead

costs understates the initial cost of the asset and results in an inaccurate

future allocation.

Companies should assign to the asset a pro rata portion of the fixed overhead to

determine its cost. Companies use this treatment extensively because many believe

that it results in a better matching of costs with revenues. Abnormal amounts of

wasted material, labor, or other resources should not be added to the cost of the

asset. [4]

If the allocated overhead results in recording construction costs in excess of the

costs that an outside independent producer would charge, the company should

record the excess overhead as a period loss rather than capitalize it. This avoids

capitalizing the asset at more than its fair value. Under no circumstances should a

company record a “profit on self-construction.”

Borrowing Costs During Construction LEARNING OBJECTIVE 2

Discuss the accounting problems associated with the capitalization of

borrowing costs.

The proper accounting for borrowing costs

3 has been a long-standing

controversy. Three approaches have been suggested to account for the interest

incurred in financing the construction of property, plant, and equipment:

1. Capitalize no borrowing costs during construction. Under this

approach, interest is considered a cost of financing and not a cost of

construction. Some contend that if a company had used equity financing rather

than debt, it would not incur this cost. The major argument against this

approach is that the use of cash, whatever its source, has an associated implicit

interest cost, which should not be ignored.

2. Charge construction with all borrowing costs of funds employed,

whether identifiable or not. This method maintains that the cost of

construction should include the cost of financing, whether by cash, debt, or

equity. Its advocates say that all costs necessary to get an asset ready for its

intended use, including borrowing costs, are part of the asset’s cost. Interest,

whether actual or imputed, is a cost, just as are labor and materials. A major

criticism of this approach is that imputing the cost of equity capital is

subjective and outside the framework of an historical cost system.

3. Capitalize only the actual borrowing costs incurred during

construction. This approach agrees in part with the logic of the second

approach—that interest is just as much a cost as are labor and materials. But,

this approach capitalizes only borrowing costs incurred through debt financing.

(That is, it does not try to determine the cost of equity financing.) Under this

approach, a company that uses debt financing will have an asset of higher cost

than a company that uses equity financing. Some consider this approach

unsatisfactory because they believe the cost of an asset should be the same

whether it is financed with cash, debt, or equity.

Illustration 10.1 shows how a company might add borrowing costs (if any) to the

cost of the asset under the three capitalization approaches.

hal 774

Capitalization of Borrowing Costs

IFRS requires the third approach—capitalizing actual interest (with modifications)

(see Underlying Concepts). This method follows the concept that the historical

cost of acquiring an asset includes all costs (including borrowing costs) incurred to

bring the asset to the condition and location necessary for its intended use. The

rationale for this approach is that during construction, the asset is not generating

revenues. Therefore, a company should defer (capitalize) borrowing costs. Once

construction is complete, a company can utilize the asset in its operations. At this

point, the company should report borrowing as an expense in the determination of

net income. It follows that the company should expense any borrowing cost

incurred in purchasing an asset that is ready for its intended use. [6]

Underlying Concepts

The objective of capitalizing borrowing costs is to obtain a measure of

acquisition cost that reflects a company’s total investment in the asset and to

charge that cost to future periods benefitted.

To implement the capitalization approach for borrowing costs, companies consider

three items:

1. Qualifying assets.

2. Capitalization period.

3. Amount to capitalize.

Qualifying Assets

To qualify for the capitalization of borrowing costs, assets must require

a substantial period of time to get them ready for their intended use or

sale. A company capitalizes borrowing costs starting at the beginning of the

capitalization period (described in the next section). Capitalization continues until

the company substantially readies the asset for its intended use. 

Assets that qualify for borrowing cost capitalization include assets under

construction for a company’s own use (including buildings, plants, and large

machinery) and assets intended for sale or lease that require a substantial period of

time to produce (e.g., ships or real estate developments).

4

Examples of assets that do not qualify for interest capitalization are (1) assets that

are in use or ready for their intended use, and (2) inventories that are produced

over a short period of time.

Capitalization Period

The capitalization period is the period of time during which a company

capitalizes borrowing costs. It begins with the presence of three conditions:

1. Expenditures for the asset are being incurred.

2. Activities that are necessary to get the asset ready for its intended use or sale

are in progress.

3. Borrowing cost is being incurred.

Capitalization continues as long as these three conditions are present. The

capitalization period ends when the asset is substantially complete and ready for its

intended use.

Amount to Capitalize

The amount of borrowing cost to be capitalized varies depending on whether there

is specific debt that has been incurred to fund the project or whether the project

is being funded from the general debt obligations of the company.

When the project is funded by specific debt, the amount capitalized is the actual

borrowing costs incurred during the capitalization period offset by any investment

income on temporary investments of funds made available from the borrowings. To

illustrate the issues related to the capitalization of borrowing costs funded by

specific debt, assume that on November 1, 2021, Shalla Company contracted Pfeifer

Construction Co. to construct a building for $1,400,000 on land costing $100,000

(purchased from the contractor and included in the first payment). Shalla made the

following payments to the construction company during 2022.

January 1 March 1 May 1 December 31 Total

$210,000 $300,000 $540,000 $450,000 $1,500,000

Pfeifer Construction completed the building, ready for occupancy, on December 31,

2022. Shalla had a 15 percent, three-year, $1,500,000, note to finance purchase of

land and construction of the building, dated December 31, 2021, with interest

payable annually on December 31. During 2021, a portion of the proceeds from the 

Valuation of Property, Plant, and Equipment

LEARNING OBJECTIVE 3

Explain accounting issues related to acquiring and valuing plant assets.

As with other assets, companies should record property, plant, and

equipment at the fair value of what they give up or at the fair value of the

asset received, whichever is more clearly evident. However, the process of

asset acquisition sometimes obscures fair value. For example, if a company buys

land and buildings together for one price, how does it determine separate values for

the land and buildings? We examine these types of accounting problems in the

following sections.

Cash Discounts

When a company purchases plant assets subject to cash discounts for prompt

payment, how should it report the discount? If it takes the discount, the company

should consider the discount as a reduction in the purchase price of the asset. But

should the company reduce the asset cost even if it does not take the discount?

Two points of view exist on this question. One approach considers the discount—

whether taken or not—as a reduction in the cost of the asset. The rationale for this

approach is that the real cost of the asset is the cash or cash equivalent price of the 

asset. In addition, some argue that the terms of cash discounts are so attractive that

failure to take them indicates management error or inefficiency.

With respect to the second approach, its proponents argue that failure to take the

discount should not always be considered a loss. The terms may be unfavorable, or

it might not be prudent for the company to take the discount. At present,

companies use both methods, though most prefer the former method. (For

homework purposes, treat the discount, whether taken or not, as a reduction in the

cost of the asset.)

Deferred-Payment Contracts

Companies frequently purchase plant assets on long-term credit contracts, using

notes, mortgages, bonds, or equipment obligations. To properly reflect cost,

companies account for assets purchased on long-term credit contracts at

the present value of the consideration exchanged between the

contracting parties at the date of the transaction.

For example, Greathouse Company purchases an asset today in exchange for a

$10,000 zero-interest-bearing note payable four years from now. The company

would not record the asset at $10,000. Instead, the present value of the $10,000

note establishes the exchange price of the transaction (the purchase price of the

asset). Assuming an appropriate interest rate of 9 percent at which to discount this

single payment of $10,000 due four years from now, Greathouse records this asset

at $7,084.30 ($10,000 × .70843). [See Table 6.2 for the present value of a single

sum, PV = $10,000 (PVF4,9%).]

When no interest rate is stated or if the specified rate is unreasonable, the company

imputes an appropriate interest rate. The objective is to approximate the interest

rate that the buyer and seller would negotiate at arm’s length in a similar

borrowing transaction. In imputing an interest rate, companies consider such

factors as the borrower’s credit rating, the amount and maturity date of the note,

and prevailing interest rates. The company uses the cash exchange price of

the asset acquired (if determinable) as the basis for recording the asset

and measuring the interest element.

To illustrate, Sutter AG purchases a specially built robot spray painter for its

production line. The company issues a €100,000, five-year, zero-interest-bearing

note to Wrigley Robotics for the new equipment. The prevailing market rate of

interest for obligations of this nature is 10 percent. Sutter is to pay off the note in

five €20,000 installments, made at the end of each year. Sutter cannot readily

determine the fair value of this specially built robot. Therefore, Sutter

approximates the robot’s value by establishing the fair value (present value) of the

note. Entries for the date of purchase and dates of payments, plus computation of

the present value of the note, are as followhal 783