Initial Cost of Long Lived Assets: Videos & Practice Problems

Long-lived assets, often referred to as fixed assets, plant assets, or property, plant, and equipment (PPE), are essential components of a company's balance sheet. These assets are categorized into four main types: land, land improvements, buildings, and machinery (or equipment). Each of these categories plays a crucial role in a business's operations over multiple years.

The initial cost of acquiring these long-lived assets is not limited to the purchase price alone. It also includes all necessary expenditures required to make the asset ready for use. For instance, if a company purchases machinery for $10,000, additional costs such as taxes, installation fees, and other necessary expenditures must be factored into the total initial cost. This comprehensive approach ensures that the asset is fully operational upon acquisition.

According to Generally Accepted Accounting Principles (GAAP), the historical cost principle applies to fixed assets. This principle dictates that assets should be recorded at their historical cost, which encompasses the purchase price and any necessary expenditures. Unlike the fair value principle, which adjusts the value of investments based on market conditions, the historical cost principle maintains the recorded value of long-lived assets over time, reflecting their original cost rather than fluctuating market values.

Once the initial cost is established, the next step in the asset's lifecycle is depreciation. Depreciation accounts for the wear and tear of an asset over its useful life, which is the period during which the asset is expected to be productive. For example, if machinery is purchased for $10,000 and has a useful life of 10 years, it will be depreciated at a rate of $1,000 per year using the straight-line method. This method evenly distributes the cost of the asset over its useful life, impacting the income statement as a depreciation expense.

It is important to note that not all long-lived assets are depreciated. Land is a unique asset that does not depreciate because its value does not diminish over time. While buildings and machinery will deteriorate and lose value, land remains constant in its physical quantity and is recorded at its historical cost indefinitely.

To illustrate the accounting process, consider a company that purchases machinery for $10,000. The journal entry on the purchase date would involve debiting the machinery account for $10,000 and crediting cash for the same amount, reflecting the exchange of one asset for another without affecting the income statement. As the company depreciates the machinery over its useful life, it will record a $1,000 depreciation expense each year, debiting the depreciation expense account and crediting accumulated depreciation, a contra asset account that reduces the net book value of the machinery on the balance sheet.

In summary, understanding the acquisition and depreciation of long-lived assets is vital for accurate financial reporting. By adhering to the historical cost principle and recognizing the unique treatment of land, businesses can effectively manage their fixed assets and reflect their true value in financial statements.

The initial cost of land encompasses not only the purchase price but also all necessary expenditures to prepare the land for its intended use. When acquiring land, it is essential to consider various costs, including the cash paid, loans taken out, and additional expenses such as closing costs, attorney fees, and real estate broker commissions. For instance, if a company purchases land, the total cost will include the cash payment and any notes payable associated with the purchase.

In addition to the purchase price, necessary expenditures may include:

• Closing costs related to title searches and attorney fees.
• Real estate broker commissions.
• Property taxes and liens that the buyer assumes.
• Costs associated with removing old structures on the land, which must be factored in as they are essential for preparing the site for new construction.
• Any salvage value obtained from the removal of old structures, which should be deducted from the total cost.

It is important to note that land itself is not subject to depreciation, making it a unique fixed asset in accounting. This means that while buildings and equipment may lose value over time, the value of land remains constant.

To illustrate, consider a scenario where a company purchases land for a new factory. The company pays $40,000 in cash and signs a note payable for $160,000. Additional costs include $1,500 for attorney fees and a broker's commission of $25,100. If the land has an old warehouse that costs $12,000 to remove, but the company receives $3,000 from scrap metal, the net cost of removal would be $9,000. After these calculations, the total initial cost of the land would be $213,000, which includes all necessary expenditures.

The journal entry to record this transaction would involve debiting the land account for the total cost and crediting the cash account and notes payable accordingly. This process highlights the importance of capitalizing costs associated with land acquisition, ensuring that all relevant expenses are accurately reflected in the financial records.

Understanding the components that contribute to the initial cost of land is crucial for effective financial management and accounting practices, particularly when preparing for future land improvements or construction projects.

Land improvements refer to enhancements made to a parcel of land, such as driveways, parking lots, fences, and irrigation systems. Unlike the land itself, which has an indefinite lifespan, these improvements have a limited useful life and are considered depreciable assets. When accounting for land improvements, the cost incurred is recorded in an asset account specifically designated for land improvements.

In situations where a property is leased rather than owned, leasehold improvements can be made. These are enhancements made to a leased property that remain the asset of the lessee, even though the property itself is owned by another party. For example, if a company leases a building and constructs walls to create office spaces, those walls are classified as leasehold improvements. The cost of these improvements is also recorded as an asset, but the depreciation period differs from that of land improvements.

Land improvements are depreciated over their useful life, which is determined by the expected duration of the improvement's functionality. For instance, if a fence built on owned land has a useful life of 20 years, it will be depreciated over that period. Conversely, leasehold improvements are depreciated over the term of the lease. If a company leases a building for 10 years and builds walls that have a useful life of 20 years, the depreciation will only occur over the 10-year lease term, not the full 20 years.

To illustrate, consider a company that spends $20,000 to build walls in a leased office space. The journal entry to record this transaction would involve debiting the leasehold improvements account for $20,000, reflecting the asset created, and crediting cash for the same amount. This entry signifies that the company has made a leasehold improvement, which will be depreciated over the duration of the lease.

In summary, while both land improvements and leasehold improvements are treated as assets, the key distinction lies in their depreciation periods. Land improvements are depreciated over their useful life, while leasehold improvements are depreciated over the lease term. Understanding these differences is crucial for accurate financial reporting and asset management.

Buildings, as a category of plant assets, share several characteristics with other assets like land, equipment, and land improvements. When accounting for buildings, it is essential to include all costs necessary to prepare the building for its intended use. This means that any expenses incurred to make the building operational are part of its initial cost. If a building cannot be used without incurring these expenses, they must be included in the total cost.

In cases where a building is constructed rather than purchased, there is an important consideration regarding financing. If a loan is taken out to finance the construction of the building, the interest on that loan can be included in the cost of the building. This is a crucial distinction; when purchasing an existing building, interest cannot be included in the asset's cost. Therefore, understanding whether the building is constructed or purchased is vital for accurate accounting.

Like land improvements and equipment, buildings are subject to depreciation over their useful life. Depreciation is the process of allocating the cost of a tangible asset over its useful life, reflecting the wear and tear or obsolescence of the asset. It is important to familiarize oneself with the concept of useful life, as it will frequently arise in accounting discussions.

To solidify your understanding, consider practicing a problem that involves calculating the initial cost of a building and determining the appropriate journal entry. This exercise will reinforce the concepts discussed and help you apply them in practical scenarios.

In the context of accounting and financial management, understanding the costs associated with equipment and machinery is crucial. These terms are often used interchangeably, and it is essential to recognize that all costs necessary to prepare the equipment for use should be included in its initial cost. This encompasses various expenses, such as taxes and unique accommodations required for the equipment to function properly within a facility.

For instance, if a piece of equipment requires a special platform for installation, the cost of constructing that platform is considered part of the equipment's cost. Similarly, any delivery expenses incurred to transport the equipment to the site are also included, as without these costs, the equipment would not be available for use.

Once the equipment is operational, ongoing costs such as maintenance, insurance, and taxes are categorized as expenses rather than part of the initial cost. It is important to differentiate between these initial costs and subsequent expenses, as the latter do not contribute to the equipment's readiness for use.

Furthermore, equipment is subject to depreciation, similar to buildings and land improvements. Depreciation reflects the reduction in value of the equipment over its useful life, which is a critical aspect of financial reporting. However, it is important to note that land itself is not depreciated, while improvements made to the land, buildings, and equipment are.

In summary, when determining the initial cost of equipment, all necessary expenses to make it ready for use should be included, while ongoing costs are treated as separate expenses. Understanding these distinctions is vital for accurate financial management and reporting.