Applying the Cost Principle to Compute Plant Assets

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  • 0:03 Determining Cost
  • 4:29 Adjustments to Cost
  • 5:59 Lesson Summary
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Lesson Transcript
Instructor: Deborah Schell

Deborah teaches college Accounting and has a master's degree in Educational Technology.

When purchasing a plant asset, we must determine its value and what can be included in the total cost. In this lesson, you'll learn how to apply the cost principle when computing 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).

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.

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