What is PP&E, and why must its cost be spread over time via depreciation rather than expensed immediately?
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The answer
PP&E stands for Property, Plant and Equipment, the long-lived tangible assets a company uses to run its business, like buildings, machinery, and equipment, rather than selling them to customers. Because these assets provide economic benefit over many years, accounting rules require that we spread their cost over that useful life through depreciation instead of expensing the entire purchase price immediately.
This is the matching principle: we recognize the cost of the asset in the same periods it helps generate revenue. If we expensed a whole factory in the year we buy it, we would mismatch the expense with the many future years of revenue that factory produces.
So we capitalize the cost onto the balance sheet as PP&E and then gradually expense it through depreciation over its useful life, which makes the income statement better reflect the ongoing cost of using those assets.
Balance sheet
| Cash | 150 |
| Accounts receivable | 120 |
| Inventory | 90 |
| Total current assets | 360 |
| PP&E, net | 400 |
| Goodwill | 150 |
| Other assets | 40 |
| Total assets | 950 |
| Accounts payable | 80 |
| Deferred revenue | 40 |
| Total current liabilities | 120 |
| Long-term debt | 380 |
| Total liabilities | 500 |
| Total equity | 450 |
| Total liabilities & equity | 950 |
Also asked as
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- Distinguish maintenance CapEx from growth CapEx, and explain why the distinction matters for estimating sustainable free cash flow.
- Walk through the impact on all three statements if depreciation increases by $10 with a 25% tax rate and no other changes.
- A company sells equipment with a net book value of $40 for cash proceeds of $55. Explain the income statement effect and how it is treated on the cash flow statement.
- Why do companies often use straight-line depreciation for financial reporting but an accelerated method for tax purposes, and what balance sheet item does this create?
- Explain capitalized interest during a construction period. Why does it understate reported interest expense while construction is ongoing?
- A company has beginning net PP&E of $600, CapEx of $95, depreciation of $70, and disposes of an asset with a net book value of $20 for cash proceeds of $12. Calculate ending net PP&E and the income statement and cash flow treatment of the disposal.
- A company's depreciation rises by $22 this year with no other changes and a 32% tax rate. Quantify the exact impact on EBIT, net income, CFO, ending cash, and ending PP&E, and confirm the balance sheet still balances.
- A company funds a two-year, $200/year construction project entirely with debt at 4% interest, capitalizing all construction-period interest. The completed asset (10-year useful life, straight-line, no salvage) is placed into service at the start of Year 3. In Year 5, it suffers an $15 impairment. Calculate the asset's total capitalized cost, its annual depreciation once in service, and its net book value at the end of Year 5.
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The rest of this topic
Depreciation, write-downs and the tax shield