Notes

Study the definition of the cost principle for accounting and its pros and cons. See examples of plant assets and learn how to determine the cost of plant assets.
Determining Cost
You have volunteered to buy prizes for the school's fun fair, and your budget is $100. The principal indicates that you will be reimbursed when you provide receipts for the items you purchased. You decide to go to the dollar store, but when you get there you learn that the store is under new management and nothing has been priced yet. You can't possibly get a receipt for what you're purchasing if you don't know how much anything costs!

Buying and recording a plant asset works basically the same way. You must be able to reliably determine the cost of the asset before it can be recorded in your business' financial statements.

Plant assets typically include larger items, such as buildings, equipment, machinery, and land. These assets are items that will provide an economic benefit for a number of years. When one purchases a plant asset, the cost of the item must be determined before the transaction can be recorded. Cost is measured in one of two ways: using the cash paid for the item if it was a cash transaction or determining the cash equivalent price that is equal to either the fair market value (FMV), the price that a seller could get in the marketplace, of the asset given up, or in cases where this value is not easy to determine, the fair market value of the asset received. Generally, the amount paid for any asset (something you own that has value) represents the historical cost (or the amount on an invoice) or market value (if the asset was transferred into the business by one of the owners or through the purchase of another business). The rules of GAAP insist on the cost principle, that is the amount paid for an asset will always be its value on the company books. This value can only be revised downward if the asset is significantly impaired. It does not go up because of inflation or increased market values.

Capital Expenditures vs. Revenue Expenditures
Capital expenditures are those expenses incurred for a capital asset that will extend the length of time that the asset is able to be used (its useful life). This includes all expenses to acquire an asset and make it ready for its intended use.

The process of adding expenses to a plant asset is known as capitalizing. Examples of costs that would be added to a plant asset include freight, installation costs, and taxes. These are added to the cost of the plant asset, depreciated over its useful life and not expensed in the current year.

For example, let's assume that a company purchased a new piece of equipment worth $400,000 for its plant. Additional costs included $10,000 for transportation to get the piece of equipment to the plant and $7,500 to construct a special base for the piece of equipment to rest on. Since the transportation cost and the cost of the special base are necessary to get the piece of equipment ready for its intended use, they must be added to the cost of the asset. Therefore, the cost of the equipment recorded on the balance sheet (which captures assets, liabilities and shareholders' equity) would be $417,500, or the purchase price + freight costs + the cost to construct the base (400,000 + 10,000 + 7,500).

Revenue Expenditures
Revenue expenditures represent expenditures for ordinary repairs and maintenance. The assumption is that the benefit from the expense incurred will be used up in the current period (i.e., the expenses will not extend how long the asset will last). Examples of revenue expenditures include things like annual insurance and oil changes on a company vehicle. Revenue expenditures are charged directly to an expense account in the year they are incurred.

For example, let's assume that the annual insurance on a company vehicle amounted to $1,500, and it costs $500 for quarterly maintenance on it. Should these costs be capitalized or expensed? These costs would be expensed because they won't provide an economic benefit that lasts longer than the current period.

Basket or Lump-Sum Purchase
A basket purchase refers to when one price is paid for a number of assets. The cost of the basket purchase needs to be allocated to each individual item so it can be properly recorded on the company's balance sheet. The total purchase price is allocated to each individual item based on the relative fair market value (FMV) of each item.

For example, let's assume DMS Company paid $40,000 to buy a building and some land. The land was recently appraised at $20,000, and the building was appraised at $30,000. We will now calculate the cost of each asset purchased.

Adjustments to Cost
Impairments
At some point in an asset's useful life, a company may become aware that the equipment no longer has the same value, which can happen due to a number of factors, like wear and tear over time or a change in technology. When an item's value is determined to be permanently impaired (the value will not come back), one must consider if the original cost can be recovered via future use or sale. If the original value cannot be recovered, then the asset must be written down to its net realizable value (NRV). The company will recognize a loss on the write-down, which will decrease its net income for the period.

Revaluation
Under International Financial Reporting Standards (IFRS), the cost of an asset can be increased in certain circumstances and is meant to ensure that the value of the asset does not differ significantly from its fair value at the date at which the financial statements are being prepared.

Depreciation
Property, plant and equipment assets are subject to depreciation; that is, the allocation of the cost of the asset over its useful life rather than only at the time of purchase. There is a cost associated with using a plant asset to earn revenue. Recording depreciation on an annual basis ensures that the cost of generating the revenue is recorded in the same period as the revenue itself. Depreciation is an expense that will reduce a company's net income. Depreciation does not apply to land because its useful life is infinite.

Lesson Summary
The cost of an asset includes all the costs involved with acquiring the asset and getting it ready for its intended use. The cost of a plant asset can only be recorded when it can be reliably measured.