Property Plant And Equipment And Intangible Assets Are

Let's delve into the world of accounting, specifically focusing on two key types of assets: Property, Plant, and Equipment (PP&E) and Intangible Assets. Understanding these assets is crucial for grasping a company's financial health, its operational capabilities, and its long-term value. This comprehensive exploration will cover their definitions, recognition criteria, depreciation/amortization methods, accounting treatment, and the significant differences between them.

Property, Plant, and Equipment (PP&E): Tangible Foundations

Property, Plant, and Equipment, often abbreviated as PP&E, represents the tangible, long-term assets a company uses in its operations to generate revenue. These assets are not intended for resale in the ordinary course of business. The "tangible" aspect is key; PP&E has a physical substance that can be seen and touched.

Examples of PP&E Include:

• Land: This encompasses land used for factories, office buildings, or other operational purposes.
• Buildings: Factories, warehouses, offices, retail stores, and any other structures used in business operations fall under this category.
• Machinery and Equipment: This is a broad category including manufacturing machinery, computers, vehicles, furniture, and fixtures.
• Vehicles: Cars, trucks, vans, and other transportation assets used for business activities.
• Furniture and Fixtures: Desks, chairs, shelves, and other items used to furnish office spaces and other facilities.

Initial Recognition and Measurement of PP&E

The initial recognition of PP&E occurs when an asset meets the following criteria:

• It is probable that future economic benefits associated with the asset will flow to the entity. This means the company expects the asset to contribute to its future revenue generation.
• The cost of the asset can be measured reliably. This implies that the company can accurately determine the purchase price and any other costs directly attributable to bringing the asset to its intended use.

Initial Measurement:

PP&E is initially measured at its cost. This includes:

• Purchase Price: The price paid for the asset, including import duties and non-refundable purchase taxes, less any trade discounts and rebates.
• Directly Attributable Costs: These are costs directly related to bringing the asset to its location and condition necessary for it to be capable of operating in the manner intended by management. Examples include:
  • Costs of employee benefits arising directly from the construction or acquisition of the item of PP&E.
  • Costs of site preparation.
  • Initial delivery and handling costs.
  • Installation and assembly costs.
  • Costs of testing whether the asset is functioning properly.
  • Professional fees.

Exclusions from Initial Cost:

Certain costs are not included in the initial cost of PP&E, such as:

• Costs of opening a new facility.
• Costs of introducing a new product or service (including costs of advertising and promotional activities).
• Costs of conducting business in a new location or with a new class of customer (including costs of staff training).
• Administration and other general overhead costs.

Subsequent Measurement of PP&E: Depreciation

After initial recognition, PP&E is subject to depreciation, which is the systematic allocation of the depreciable amount of an asset over its useful life. Depreciation recognizes that PP&E assets wear out or become obsolete over time. Land, however, is typically not depreciated because its useful life is generally considered indefinite.

Key Concepts in Depreciation:

• Depreciable Amount: The cost of an asset, or other amount substituted for cost, less its residual value.
• Useful Life: The period over which an asset is expected to be available for use by an entity, or the number of production or similar units expected to be obtained from the asset by an entity.
• Residual Value: The estimated amount that an entity would currently obtain from disposing of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.

Common Depreciation Methods:

• Straight-Line Method: This method allocates an equal amount of depreciation expense to each period of the asset's useful life. The formula is: (Cost - Residual Value) / Useful Life.
• Declining Balance Method: This is an accelerated depreciation method that allocates a higher amount of depreciation expense in the early years of the asset's life and a lower amount in later years. A common variant is the double-declining balance method, which uses twice the straight-line depreciation rate.
• Units of Production Method: This method allocates depreciation expense based on the asset's actual usage or output during a period. The formula is: ((Cost - Residual Value) / Total Estimated Production) * Actual Production During the Period.

Choosing a Depreciation Method:

The selection of a depreciation method depends on the pattern in which the asset's future economic benefits are expected to be consumed. The method should be applied consistently from period to period unless there is a change in the expected pattern of benefits.

Derecognition of PP&E

PP&E is derecognized (removed from the balance sheet) when:

• The asset is disposed of. This could be through a sale, exchange, or abandonment.
• No future economic benefits are expected from its use or disposal. This might occur when an asset becomes obsolete and has no salvage value.

The gain or loss on derecognition is the difference between the net disposal proceeds, if any, and the carrying amount of the asset. The gain or loss is recognized in profit or loss.

Intangible Assets: Invisible Value

Intangible assets are non-monetary assets without physical substance that provide a company with future economic benefits. Unlike PP&E, you cannot physically touch an intangible asset. Their value lies in the rights and privileges they confer to the owner.

Examples of Intangible Assets Include:

• Patents: Exclusive rights granted for an invention, allowing the holder to exclude others from making, using, or selling the invention.
• Trademarks: Distinctive signs, designs, or expressions that identify and distinguish goods or services of a particular source from those of others.
• Copyrights: Legal rights granted to the creator of original works of authorship, including literary, dramatic, musical, and certain other intellectual works.
• Franchises: Rights granted by a franchisor to a franchisee to operate a business under the franchisor's name and system.
• Goodwill: Arises when a company acquires another business for a price exceeding the fair value of the identifiable net assets acquired.
• Customer Lists: Databases of customer information that can be valuable for marketing and sales purposes.
• Software: Computer programs used by a company in its operations.

Initial Recognition and Measurement of Intangible Assets

Similar to PP&E, the initial recognition of an intangible asset occurs when:

• It is probable that the expected future economic benefits that are attributable to the asset will flow to the entity.
• The cost of the asset can be measured reliably.

Initial Measurement:

Intangible assets are initially measured at cost. The cost depends on how the asset was acquired:

• Separate Acquisition: The cost includes the purchase price, import duties, and non-refundable purchase taxes, after deducting trade discounts and rebates, and any directly attributable costs of preparing the asset for its intended use.
• Acquisition as Part of a Business Combination: Intangible assets acquired in a business combination are recognized at their fair value at the acquisition date.
• Government Grant: An intangible asset may be acquired free of charge, or for nominal consideration, by way of a government grant.
• Internally Generated Intangible Assets: This is where it gets tricky. The costs of internally generating intangible assets are split into two phases:
  • Research Phase: Costs incurred during the research phase are expensed as incurred. Research is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.
  • Development Phase: Costs incurred during the development phase are capitalized (recognized as an asset) only if certain criteria are met. Development is the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use.

Capitalization Criteria for Development Costs (Often Remembered as "PIRATE"):

• Probable future economic benefits: The company must be able to demonstrate that the intangible asset will generate probable future economic benefits.
• Intention to complete: The company must intend to complete the intangible asset and use or sell it.
• Resources available: The company must have the resources to complete the intangible asset and use or sell it.
• Ability to use or sell: The company must be able to use or sell the intangible asset.
• Technical feasibility: The company must be able to demonstrate the technical feasibility of completing the intangible asset so that it will be available for use or sale.
• Expenditure reliably measured: The company must be able to measure the expenditure attributable to the intangible asset reliably.

Subsequent Measurement of Intangible Assets: Amortization

After initial recognition, intangible assets are classified as having either a finite useful life or an indefinite useful life. The classification determines how the asset is subsequently accounted for.

• Intangible Assets with a Finite Useful Life: These assets are amortized over their useful life. Amortization is the systematic allocation of the amortizable amount of an asset over its useful life. The amortizable amount is the cost of the asset, or other amount substituted for cost, less its residual value. The residual value of an intangible asset is assumed to be zero unless there is a commitment by a third party to purchase the asset at the end of its useful life, or there is an active market for the asset and residual value can be determined. The amortization method should reflect the pattern in which the asset's future economic benefits are expected to be consumed. If that pattern cannot be determined reliably, the straight-line method is used.
• Intangible Assets with an Indefinite Useful Life: These assets are not amortized. Instead, they are tested for impairment at least annually. Impairment occurs when the recoverable amount of an asset is less than its carrying amount. The recoverable amount is the higher of the asset's fair value less costs to sell and its value in use. If an impairment loss is recognized, the carrying amount of the asset is reduced to its recoverable amount, and the impairment loss is recognized in profit or loss.

Goodwill:

Goodwill is a special type of intangible asset that always has an indefinite useful life and is therefore not amortized. It is tested for impairment annually. Goodwill represents the premium paid when acquiring a business over the fair value of the identifiable net assets acquired.

Derecognition of Intangible Assets

An intangible asset is derecognized (removed from the balance sheet) when:

• The asset is disposed of.
• No future economic benefits are expected from its use or disposal.

The gain or loss on derecognition is the difference between the net disposal proceeds, if any, and the carrying amount of the asset. The gain or loss is recognized in profit or loss.

Key Differences Between PP&E and Intangible Assets: A Summary

Accounting Treatment: A Comparative View

Here's a brief overview of how PP&E and Intangible Assets appear on the financial statements:

Balance Sheet:

• Both PP&E and Intangible Assets are classified as non-current assets (also known as long-term assets) on the balance sheet. They are presented separately, often with subcategories (e.g., "Property, Plant, and Equipment, Net" or "Intangible Assets, Net"). The "Net" indicates that accumulated depreciation/amortization has been deducted.

Income Statement:

• Depreciation Expense (for PP&E) and Amortization Expense (for intangible assets with finite lives) are recognized on the income statement. These expenses reduce net income.
• Impairment Losses (for both PP&E and intangible assets) are also recognized on the income statement.
• Gains or Losses on Disposal of PP&E or intangible assets are recognized on the income statement.

Statement of Cash Flows:

• Purchases of PP&E are classified as Investing Activities and represent a cash outflow.
• Sales of PP&E are classified as Investing Activities and represent a cash inflow.
• The impact of depreciation and amortization is added back to net income in the Operating Activities section when using the indirect method because these are non-cash expenses.

Conclusion: Understanding Asset Fundamentals

Property, Plant, and Equipment and Intangible Assets are fundamental components of a company's asset base. Understanding their definitions, recognition criteria, depreciation/amortization methods, and accounting treatment is critical for analyzing financial statements and assessing a company's financial health and long-term prospects. While they differ in their physical nature, both types of assets play a vital role in generating revenue and creating value for shareholders. Accurately accounting for these assets ensures that financial statements provide a true and fair view of a company's financial position and performance. The distinctions between tangible and intangible, finite and indefinite, and the nuances of impairment testing versus amortization are all key to a thorough financial analysis.