Property, Plant, & Equipment

By: John HannaJustin Byrd

Property, Plant, & Equipment

PP&E is a part of generally every company in the country

PP&E is also known as “fixed assets” Can include assets from office

equipment, manufacturing equipment, heavy machinery, and buildings just to name a few

What we will cover…. Overview Controller’s Role Capital Budgeting Process Method of Evaluating Projects (Payback,

Accountant’s, Discounted Cash Flow) Hurdle Rates Project Risk Analysis Inflation Ranking Capital Projects Post-Project Appraisals Other Aspects of Fixed Assets

PP&E Planning is critical to long-term health of an

organization (Investment, Financial Performance)

Investment issues (Long recovery period, possible bankruptcy)

Break-even point is higher for companies when investing in PP&E (depreciation, insurance, property taxes, maintenance)

Technological advances in today’s society cause companies to continually invest in more PP&E Increase Productivity Increased ROI Analytical Approaches

Role of Controller

Financial knowledge is needed to evaluate the acquisition decisions of purchasing new fixed assets. The Controller and his or her team must take appropriate steps to determine the benefit of purchasing new equipment.

Once the CEO and Board of Directors agree to the investment, the Controller must properly account for the asset and measure depreciation as well as performance throughout the asset’s useful life.

Role of Controller Controller’s Tasks for PP&E

Review all requests for probable rate of return In business plan, include all assets needing to be

purchased and determine if sufficient funds are present and the sales number that needs to be met in order to cover purchase

Planning and Control Lease, Rent, or Buy Insurance Coverage Depreciation Policy Internal Control Property Records (Location, Transfers, etc) Reporting System (Maintenance, Idle Time, Cost vs.

Budget)

Capital Budgeting Controller should be involved in planning Provided to the CEO and other senior executives

to select certain projects that will be undertaken Spending must be kept within an established

limit For larger projects, inform management how the

assets is operating as well as anticipated earnings

Capital Budget – 9 Steps

Capital Budget – 9 Steps 1.) Planning period, determine spending limits 2.) Present worthy capital investment projects

(ROR, expansion) 3.) Preliminary screening of proposals 4.) Once screened, classify new projects by need

and benefit 5.) Review, compatible with resources? Rate of

Return? 6.) Present data to Board of Directors or CEO 7.) When time to purchase, authorize from

management 8.) Periodic reports, cost to date, cost to

completion 9.) Post-completion audit, actual vs. estimated

cash flow

Limit of Capital Budget Top management will set budget, and is

determined by setting a maximum amount to spend towards capital expenditures.

Factors include…. Strategic Plans Stage of Business Cycle Current and Anticipated Inflation Rates Anticipated Competitor Actions Age and Condition of Present Plant Equipment Growth Prospects of Company Capital Structure of Company (Debt to Asset ratio) Internal Cash Generation/Spending

Capital Expenditure Proposals

All decisions to purchase will go to top management

Factors to replace old equipment Salvage Value of Used Equipment Investment and Installation Costs Useful Life of New Asset Operating Cost

Factors for expansion of facilities Market New Products Increase Sales Quantity New Project’s ROR Marketing

Evaluating Projects Since companies cannot undertake every capital

expenditure, evaluations of analytical data is examined to select the appropriate projects 1.) Estimate expected capital outlay and estimated

future cash flow 2.) Relate future benefits to cost 3.) Evaluate Risk and determine vs. the estimated rate

of return Three Methods

Payback Method Accountant’s Method Discounted Cash Flow Method

Payback Method Amount of time needed to pay back original

investment from product’s cash flows Advantages

Company is low on cash and can pay back over a short period

Risky investments Identify profitability, eliminates undesirable projects

Disadvantages Confuses recovery of investment with profitability Early liquidity is prominent, rejects longer projects Useful life is not considered, can discard asset as soon

as payback is met

Accountant’s Method

Compares earnings vs. outstanding investment instead of initial investment

Based on making available the depreciation recovered from other capital investments instead of charging against original investment

Accountant’s Method

Advantages Easier than Discounted Cash Flow

Method Disadvantages

Depreciation method is critical Time Value of Money

Rate of Return doesn’t change

Discounted Cash Flow Method

Important factor of method is when cash is received and when it can be reinvested

Two methods IRR (Internal Rate of Return) NPV (Net Present Value)

Discounted Cash Flow Method

IRR Method Used as a method to determine maximum

constant earnings from an asset over its useful life and relate to the breakeven point

Four Steps Amount and year of investment Determine cash flow per year after tax Apply discount factors (2) and find present worth Calculate with various discount factors until it

correlates to original investment

Discounted Cash Flow Method

IRR Advantages Proper allocation to cash flow and time value

of investments Easy with the use of cash to purchase items

(Capital vs. expenses) Financial analysts can compare other projects Models the cost-of-capital approach

IRR Disadvantages Difficult and complex Calculations are not quickly done Reinvestment = Calculated Rate of Return

Discounted Cash Flow Method

NPV Method Considers time value of money Difference between two is NPV uses a

predetermined rate, which is the rate the company uses to consider taking the risk of the capital investment

To acquire a new product, the total of the PV of cash flow exceeds the proposed investment

A failed attempt to a capital investment is when the NPV is negative

Hurdle Rates

Minimum ROR a project should earn to be acceptable

Businesses in different industries and even each line of business within a company can have different hurdle rates

Business risks determine rates in departments as well as ROR in each division will be different

Different business strategies may exist to establish different hurdle rates

Basis of hurdle rate is cost of capital

Project Risk Analysis

Important factors for decision-maker to know Expected rate of return Probability of receiving expected rate of

return Sensitivity analysis

Range of possible returns Should include probability of each of the

possible returns When depreciation or other expenses

roll off books

Project Risk Analysis

Sensitivity Analysis Mathematical technique where changes

may be made to any of the input factors and consequences of a events that take place

Those who estimate the return on investment know that the estimate is dependent on assumptions

Important to estimate how much an error can affect results

Knowing the potential cost and probability of an error occurring allows the controller or analyst focus on most important variables

Project Risk Analysis

Hurdle Rate Minimum rate of return that a capital

project should earn before being deemed acceptable

Investments in capital assets should not only recoup costs, they should pass the hurdle rate

Is usually the discount rate used in considering alternative investments

Used in other contexts as well

Project Risk Analysis

New Manufacturing Environment Automation is primary source of expense

reduction, but… Prior to purchase of automation equipment,

should look into other options Rearrange plant floor, more streamline

procedures, eliminate non-value added function Investments becoming more significant

A machine may cost X dollars, but an automated factory may cost 50X dollars

One must decide how best to allocate costs to optimize value

Equipment is becoming increasingly complex, so benefits should be more tangible

Inflation

Questions to consider regarding inflation Should adjustments be made for

inflation in cash flows? Should inflation rates be used for

different cost factors? Should the hurdle rate be adjusted for

inflation? “Using of proper discount rate, depends on whether the

benefits and costs are measured in real or nominal terms. To be consistent and free from inflation bias, the cash flows should match with discount rate.”(Kannadhasan)

Ranking Capital Projects

Projects should be ranked in order of priority Should be practically grouped so

management can focus on the more important and promising projects

Grouping example: Absolutely Essential Highly Necessary Economically Justified Projects All Other

Ranking Capital Projects

Projects usually ranked by economic return Information important for ranking and

presentation to management Priority Rate of Return Total Cost Reasons For Benefits of Risks Associated with Project

Post-Project Appraisals

Despite good analysis of costs and risks, sometimes projects do not meet the expected rate of return Without appraisal, management is unaware of

the causes of problems or that they even exist Why this shortfall occurred is important

for management to ascertain Shows what steps can be taken to improve

investment planning and control Factors on which to focus

Cash flow, break-even points, and actual vs. estimates of operating expenses

Post-Project Appraisals

Advantages of well-planned post-project appraisal May detect weaknesses in strategic planning

that lead to poor decisions May detect environmental factors that

influence business which were not foreseen Experience can focus attention on basic

weaknesses in overall plans, policies, and procedures

Can detect strengths/weaknesses in individual performance

May enable corrections in current projects prior to completion of commitments or expenditures

Project Risk Analysis

Other Aspects of Fixed Assets

Working Capital Increases in working capital may be required to

purchase additional inventory and accounts receivable

Decreases may create need for additional investment

Lease vs. Buy NPV should be used to compare a lease acquisition

against a purchase acquisition Idle Equipment

Controller should inform management about losses from idle equipment and place responsibility

Losses from idle equipment can derive from depreciation, property tax, insurance, and utilities

Other Aspects of Fixed Assets

Idle Equipment Three causes of idle time

Those controllable by production staff Poor planning; lack of materials, tools, power;

machine breakdowns; improper supervision Those resulting from administrative

decisions Building of additional capacity (short-term idle)

until demand builds to match capacity Those arising from economic causes

Seasonal demand or excess capacity in industry

Other Aspects of Fixed Assets

Internal Control Requirements Surrounding Equipment Identify all fixed assets by affixing serial

numbers or bar codes to items Transfer of equipment between departments

only with written approval for security of physical property

Necessary to track both for insurance and depreciation purposes

Prevent equipment from leaving plant without property pass signed by appropriate authority

Perform physical inventory on all fixed assets Maintain detailed records on each piece of

equipment

Other Aspects of Fixed Assets

Internal Control Requirements Surrounding Equipment Review purchase requisitions to ensure small

accounts not made to avoid approval of higher authority

Review retirements of fixed assets Can assets can be used by another department or do

they have another other use? Secure bids on sizeable transactions Provide for proper insurance coverage during

construction of equipment and when complete Review expenses to ensure capital

expenditures no treated as expenses

Other Aspects of Fixed Assets

Internal Control Requirements Surrounding Equipment Track the following items for capital

projects Amount authorized Actual commitments to date Actual costs incurred to date Estimated cost to complete Indicated total cost Indicated overrun or under run compared to

project budget

Other Aspects of Fixed Assets

Plant and Equipment Records Necessary adjunct to effective control Convenient source of information for

planning, control, insurance, and tax purposes

Records should include: Name of asset, type of equipment, control

number, description, size, model, style, serial number, motor number, purchased new or used, date purchased, vendor name, invoice number, purchase order number, location, account number, transfer information, basis, date retired, sold to, scrapped, cost recovered, depreciation information

Other Aspects of Fixed Assets

Plant and Equipment in Relation to Taxes Many cities and states levy real and

personal property taxes or enforce franchise taxes based on value

Maintenance of records can be means of satisfying IRS

Plant and property values, through depreciation expense, is important for federal income tax

The burden of proof is on the taxpayer regarding correctness of claimed depreciation

Handout

Overview

What is Property, Plant, and Equipment? What is the controller’s role in the

budgeting, acquisition, and retirement of these assets?

What are the most recognized methods to evaluate a capital budget project?

How are capital projects ranked? Why should a post-project appraisal be

performed? What other issues factor into the capital

budgeting process?

Work Cited "Beauliey Pleads Guilty to Tax Fraud-CEO of Beaulieu to Step Down from

Corporate Position". Department of Homeland Security. September 17, 2009 <http://www.ice.gov/pi/news/newsreleases/articles/070615rome.htm>.

Kannadhasan, M. "Effects of Inflation on Capital Budgeting Decisions-An Analytical Study ". Investopedia. September 17, 2009 <http://www.bim.edu/pdf/lead_article/profkannadhasan.pdf>.

"Project Risk and Analysis". CFOonthego. September 19, 2009 <http://www.youtube.com/watch?v=bOP-YLkCla8>.

"Property, Plant, and Equipment". Investopedia. September 17, 2009 <http://www.investopedia.com/terms/p/ppe.asp

Roehl-Anderson, Janice, and Steven Bragg. The Controller's Function-The Work of the Managerial Accountant. Hoboken: Wiley, 2005.