What you will learn to do: Identify PP&E
Let’s take another look at The Home Depot, Inc. balance sheet as of February 2, 2020.
See the balance sheet long description here.
The Home Depot, Inc. is using a semi-classified balance sheet. On a more traditional classified balance sheet, the asset section contains three sub-categories: (1) current assets; (2) PP&E; and (3) other categories such as intangible assets and long-term investments.
You’ve already studied three of the major classifications of current assets: (1) cash and cash equivalents, (2) accounts receivable, and (3) inventory. Other current assets include things like prepaid insurance, prepaid rent, employee receivables, and short-term notes receivable. All those current assets, as you have learned, will be converted into cash within a year (or at least within one operating cycle, which may be longer than a year in some cases).
As we continue to walk our way down the balance sheet, we come to noncurrent assets, the first and most significant of which is PP&E. At almost $23 billion, PP&E composes almost half of the total assets of $51 billion.
If you picture a business as a process that creates wealth for the owners, PP&E are the physical machine. Left by themselves, PP&E just sit there, but put into action by people with energy and purpose, they become a money-making machine. The most efficient use of these resources maximize profit.
To be classified as a plant asset, an asset must: (1) be tangible, that is, capable of being seen and touched; (2) have a useful service life of more than one year; and (3) be used in business operations rather than held for resale. Common plant assets are buildings, machines, tools, and office equipment.
What these assets all have in common, that also differentiates them from current assets, is that they are not going to turn into cash any time soon and their connection to revenue is indirect. With inventory, we saw a direct match between the cost of the product and the sales revenue. We recorded the purchase of inventory as an asset. When that asset sold and generated revenue, we moved the cost of the asset to cost of goods sold (COGS) and recorded the cost against the revenue in one of the most perfect examples of matching we’ve seen so far. We call that a product cost, as opposed to a period cost. Rent, insurance, and wages are examples of period costs that we match to revenues by posting them to the income statement accounts in the same period as the revenue, using time as our method of matching.
But what about a piece of equipment that generates a product that we sell? How do we match the expense of buying, running, and maintaining a large physical asset against the revenue that it indirectly generates?
We’ll tackle that question in the next section on depreciation, but first, let’s explore the idea of PP&E in a little more depth to determine what costs to include as part of the asset and what costs are simply period costs that we can expense as we go.
