Reconciliation of PP&E

7. Lemonade Stand

Exercise Q1: Recall that on January 1, 2005, you bought a lemon squeezer and a lemonade stand for $30. You estimate that both of these fixed assets will have a useful life of three years, upon which they will be obsolete and be thrown away (assume straight-line depreciation). Calculate PP&E at the end of 2005, 2006, and 2007. [View full size image]

7. Lemonade Stand

Solution 1: [View full size image]

8. PP&E

Exercise Q1: A company has PP&E of $4,000 in January 1, 2006: It records depreciation of $800 during 2006. It buys five new machines for $500 during 2006. It sells two old machines for $100 during 2006. Calculate PP&E at December 31, 2006.

8. PP&E

Solution 1: Beginning PP&E = $4,000 – Depreciation = –$800 + New machines purchased = +$500 – Old machines sold = –$100 Ending PP&E = $3,600

Advanced Discussion: Capitalizing versus Expensing

Capitalizing involves the recording of costs/expenditures associated with fixed assets on the balance sheet and their depreciation (on the income statement) over their estimated useful lives. Expensing involves the immediate recording of costs/expenditures on the income statement.

Fixed assets (acquired or self-constructed) are capitalized and depreciated along with costs necessary to prepare those fixed assets for their service. These costs include:

• Transportation charges

• Freight and insurance costs

• Installation

• Other (sales tax)

• Fixed asset labor

• Materials

• Interest on debt borrowed in connection with that asset

Should Subsequent Costs Associated with Fixed Asset Purchases Be Capitalized or Expensed?

General guidelines dictate that costs incurred to achieve greater future benefits from fixed assets should be capitalized. Greater benefits may be in the form of:

• Increased quality or quantity or extended useful life of an asset

• Improvements to fixed assets

Since these costs raise the future benefits expected from those assets, they should therefore be capitalized and depreciated.

Expenditures that simply maintain the same level of operations should be expensed. Repairs and maintenance generally involve restoring an asset to and maintaining its operating condition, and are therefore immediately expensed.

Capitalizing versus Expensing: WorldCom Recall the WorldCom accounting scandal. Instead of recording $3.8 billion of operating costs as expenses (on the income statement), the company capitalized (on the balance sheet) and depreciated them over their useful life, artificially lowering its expenses and boosting its earnings.