The Balance Sheet : Plant and Equipment
September 14, 2007
The big-ticket items appear here. These are the fixed assets, which are not likely to be converted into cash during the business’s operating cycle. The plant and equipment account includes all the hard assets not sold to customers, such as office furniture, machinery, cars and trucks, and equipment. It includes those items that are expected to be around for more than a year and are depreciated, rather than expensed, items. Had Houston Sash & Door owned any real estate, there would also be a real estate account.
We’ve stated that the balance sheet tells us what the business paid for the assets, not what they’re worth now or what it would cost to replace them. Not only that, the total plant and equipment entry is net of accumulated depreciation. On December 31, 2003, the total cost of all the items that appear in the equipment, furniture, and fixtures ledgers was $60,868. Since then the owners of the business have taken $31,592 in depreciation deductions, so that the adjusted book value of this account is $29,276.
The problem is that businesses are allowed to front-load depreciation deductions in the early years of an asset’s life, at the expense of lower (or no) depreciaton deductions in later years. The deductions a business can take need not, and usually do not, have any relation to the actual useful life of the asset. For example, one of Houston Sash & Door’s milling machines may last for 20 years, but the business may write it off over 8 years. This means that the book value of depreciable assets (which includes all business real estate but the land itself) on the balance sheet is usually grossly understated, with no relation to market value or the replacement cost of similar items.
This means that the balance sheet doesn’t tell you what the equipment is worth. Not only that, but if you wind up buying the owner’s stock of the business rather than the individual assets, you’re going to take over the seller’s depreciation schedule. The more depreciation the seller took, the less that will be available to you. The less depreciation remaining for you to use, the less will be the expenses you can report and the higher will be your tax bill.
There’s one other thing you need to be careful about when examining a business’s fixed assets. If the business uses an asset but doesn’t own it, it won’t appear on the balance sheet. Let’s assume that Houston Sash & Door uses two trucks that are owned by Houston. When buying the business, you need to be careful to ascertain whether the owner intends to include assets that the business needs but doesn’t own. If not, you’re going to have to go out and buy these needed assets. The way to protect yourself is to have the seller prepare a detailed list of all the assets included in the sale. That way you won’t discover after the sale that a valuable asset you thought would be part of the sale wasn’t.
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