Property, plant, and equipment are initially valued at their historical cost, which includes all costs incurred to acquire an asset, place it in its desired location, and make it operational. Costs include invoice amounts (less any discounts), sales taxes, transportation charges, installation costs, costs of trial runs to adjust equipment, and costs to refurbish equipment purchased in a used condition.
As an example, assume that a machine was purchased at an invoice price of $5,000. The sales tax was 7% and transportation charges were $145. The machine required a concrete base, which cost $80 for materials and $120 for labor. The machine’s total cost is calculated as follows:
Invoice cost – $5,000
Sales tax ($5,000 * .07) – 350
Transportation – 145
Concrete base ($80 + $120) – 200
Total cost – $5,695
To record the purchase, increase the asset machine and decrease the asset cash.
Initially valuing property, plant, and equipment at historical cost is quite reasonable. Because a firm’s managers have paid this amount, they certainly expect at least this level of benefit; otherwise, the asset would not have been acquired. Moreover, historical cost is an objective valuation basis, meaning it can easily be verified by examining invoices and canceled checks.
Sometimes, however, the proper accounting for asset acquisition and development is not obvious. Let’s examine Chambers Development, Inc., a business that develops landfill sites for waste disposal. In developing its sites, Chambers incurs public relations and legal costs, as well as costs to pay its executives who work on various projects. Conceptually, two accounting alternatives are possible for these costs. One option is to expense them immediately. The analysis involves a decrease in cash and a decrease in shareholders’ equity via an expense.
Because net income and shareholders’ equity are reduced, this approach is quite conservative.
The second option views these expenditures as part of the cost of the asset, “landfill sites.” Accordingly, these costs are capitalized; that is, the asset, landfill sites, is increased as these costs are incurred. The analysis decreases cash and increases landfill sites. Note that this is a much less conservative, perhaps even an aggressive, approach.
GAAP requires that costs be capitalized only when they reflect future economic benefits. Thus, one must ask, how closely tied are these expenditures to future economic benefits? At one time, Chambers capitalized these costs. Subsequently, however, the business began expensing those costs and restated prior years’ financial statements to reflect the more conservative accounting alternative. Such accounting issues can have serious consequences, and Chambers’ accounting practices were the subject of an SEC probe and a criminal investigation by the U.S. Attorney General’s Office.