1. 11
Property, Plant, and Equipment and Intangible Assets: Utilization and Impairment
Chapter 11: Property, Plant, and Equipment and Intangible Assets: Utilization and Impairment.
Chapter 11 completes the discussion of accounting for property, plant, and equipment and intangible assets by addressing the allocation of the cost of these assets to the periods benefitted by their use. Expenditures subsequent to acquisition and impairment are also covered in this chapter.
McGraw-Hill/Irwin
2011, Royal University of Law and Economics

2. Cost Allocation – An Overview
The matching principle requires that part of the acquisition cost of property, plant, and equipment and intangible assets be expensed in periods when the future revenues are earned.
Depreciation, depletion, and amortization are cost allocation processes used to help meet the matching principle requirements.
Some of the cost is expensed each period.
Part I.
The matching principle requires that part of the acquisition cost of property, plant, and equipment and intangible assets be expensed in periods when the future revenues are earned. A portion of an asset’s cost is moved from the balance sheet to the income statement each period.
Part II.
Depreciation, depletion, and amortization are cost allocation processes. We allocate the cost of the asset to expense over its useful life in some rational and systematic manner. The unused portion of the asset’s cost appears on the balance sheet. We allocate a portion of the cost to expense on the income statement each accounting period. Accumulated depreciation represents the depreciation taken on the asset since its purchase, and is deducted from the asset’s cost on the balance sheet.
Depreciation, depletion, or amortization of an asset used in manufacturing a product is a part of the product cost that is included in inventory. The depreciation, depletion, or amortization does not immediately become an expense, but is expensed as part of cost of goods sold when the product is sold.
Expense
Acquisition Cost
(Balance Sheet)
(Income Statement)

3. Cost Allocation – An Overview
Caution! Depreciation, depletion, and amortization are processes of cost allocation, not valuation!
Part I.
Depreciation is term used for the cost allocation process for the plant and equipment category. Land is not depreciated.
Depletion is the cost allocation process for natural resources, and amortization refers to the allocation of intangible asset costs.
Depreciation, depletion, and amortization are processes used for cost allocation, not valuation. We do not want to confuse asset valuation, an economic concept, with allocation of acquisition costs to periods benefited by the use of the assets.
Part II.
Here you see an example of the property, plant, and equipment section of a balance sheet showing the assets at cost less the accumulated depreciation. Accumulated depreciation is a contra-asset account and is subtracted from the assets’ cost to determine book value. Net property, plant, & equipment is the undepreciated cost (book value) of plant assets. Book value is not equal to market value.
Depreciation on the Balance Sheet

4. Measuring Cost Allocation
Cost allocation requires three pieces of information for each asset:
Service Life
Allocation Base
Allocation Method
The estimated expected use from an asset.
Total amount of cost to be allocated.
Cost - Residual Value (at end of useful life)
The systematic approach used for allocation.
Regardless of the method used to calculate the amount of cost allocated to a period, we must have three items of information: (1) the estimated useful life of the asset; (2) the allocation base which is the cost of the asset less its estimated residual value at the end of its useful life, and (3) the allocation method.

5. Depreciation Group and composite methods Tax depreciation
Time-based Methods
Straight-line (SL)
Accelerated Methods
Sum-of-the-years’ digits (SYD)
Declining Balance (DB)
Tax depreciation
There are two general approaches to depreciation: time-based methods and activity based methods. The most commonly used time-based method is the straight-line method that results in an equal amount of depreciation in each period. The other time-based methods are referred to as accelerated methods because they result in a greater amount of depreciation in the earlier years of an assets life. Sum-of-the-years’ digits and declining balance are two accelerated methods.
Activity-based methods use a measure of an asset’s output in a period for the depreciation computation. Units-of-production is an activity-based method. We will examine each of these methods with examples as we study depreciation.
In addition to these methods, we will also cover group and composite methods, tax depreciation (Appendix 11A), and retirement and replacement methods (Appendix 11B).
Activity-based methods
Units-of-production method (UOP).

6. The most widely used and most easily understood method.
Straight-Line
The most widely used and most easily understood method.
Results in the same amount of depreciation in each year of the asset’s service life.
Part I.
The straight-line method is the most widely used and the most easily understood method of depreciation. It results in an equal amount of depreciation in each year of an asset’s useful life. The annual depreciation is determined by dividing the asset’s cost less its estimated residual value by the asset’s estimated useful life in years.
Part II.
Consider the following example. On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of five years and an estimated residual value of $5,000. What is the annual straight-line depreciation?
On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of 5 years and estimated residual value of $5,000.
What is the annual straight-line depreciation?

7. BV = Residual Value at the end of the asset’s useful life.
Straight-Line
Life in Years
Depreciation
Part I.
The annual depreciation is determined by dividing the asset’s cost of $50,000 minus its estimated residual value of $5,000 by the asset’s estimated useful life of five years. The result is annual depreciation of $9,000.
Part II.
Notice that depreciation is the same amount in each of the five years. The cost of the asset ($50,000) less accumulated depreciation at the end of any year is called book value. Book value decreases by $9,000 each year.
The book value is equal to the estimated residual value at the end of the asset’s useful life. We want this to be true regardless of the method we use. Accumulated depreciation increases by $9,000 each year.
In this graph you can clearly see that the amount of depreciation is the same each year, resulting in a horizontal straight line at $9.000.
Residual Value
BV = Residual Value at the end of the asset’s useful life.

8. Accelerated Methods Sum-of-the-years’-digits (SYD) depreciation
Accelerated methods result in more depreciation in the early years of an asset’s useful life and less depreciation in later years of an asset’s useful life.
Note that total depreciation over the asset’s useful life is the same as the straight-line method.
Part I.
Accelerated methods result in more depreciation in the early years of an asset’s useful life and less depreciation in later years of an asset’s useful life. The total amount of depreciation over the asset’s useful life is the same as the straight-line method.
Part II.
Sum-of-the-years’-digits depreciation is calculated by multiplying cost minus residual value times a fraction that declines each year of an asset’s useful life.
The numerator of the fraction is a number equal to the remaining useful life of the asset. For an asset with a four-year life, the numerator would be four for the first year, three for the second year, two for the third year and one for the fourth year
The denominator of the fraction is constant. It is the sum of the digits in the asset’s life from one to n, where n is the number of years in the asset’s life. For example, if the estimated life is four years, the sum of the digits is 1 plus 2 plus 3 plus 4, a total of 10.
Sum-of-the-years’-digits (SYD) depreciation

9. Sum-of-the-Years’ Digits (SYD)2
On January 1, we purchase equipment for $50,000 cash. The equipment has a service life of 5 years and an estimated residual value of $5,000. Using SYD depreciation, compute depreciation for the first two years.
Part I.
The formula on your screen is a more efficient way of computing the sum-of-the-years’ digits. For the same asset with a four year life, the computation is 4 plus 1 equals 5, times 4 equals 20, divided by 2 equals 10, the same result as summing the individual digits.
In our example, we will use the same information for the sum-of-the-years’-digits method that we used for the straight-line method.
On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of five years and estimated residual value of $5,000.
Using the sum-of-the-years-digits method, compute depreciation for the first two years.
Part II.
First , we compute the sum-of-the-years’ digits (SYD). The sum of the years is equal to 5 plus 1 equals 6, times 5 equals 30, divided by 2 equals 15.

10. Sum-of-the-Years’ Digits (SYD)
The numerator in the fraction is five for the first year. We multiply the fraction 5 over 15 times the cost minus salvage value to obtain the first year’s depreciation of $15,000.
The numerator in the fraction is four for the second year. We multiply the fraction 4 over 15 times the cost minus salvage value to obtain the second year’s depreciation of $12,000.

11. Sum-of-the-Years’ Digits (SYD)
Residual Value
Notice that depreciation is less each succeeding year of the asset’s life. Accumulated depreciation increases by each year by the amount of the depreciation expense. At the end of the five year period the accumulated depreciation is $45,000, resulting in a book value of $5,000. The book value is equal to the estimated residual value at the end of the asset’s useful life. We want this to be true regardless of the method we use.
In the graph you can clearly see that the amount of depreciation expense declines each year using the sum-of-the-years’-digits method.
Depreciation
Life in Years

12. Declining-Balance (DB) Methods
DB depreciation
Based on the straight-line rate multiplied by an acceleration factor.
Computations initially ignore residual value.
Stop depreciating when:
BV = Residual Value
Double-Declining-Balance (DDB) depreciation is computed as follows:
Part I.
Declining-balance methods are based on the straight-line rate multiplied by an acceleration factor. The straight-line rate is equal to one divided by the estimated useful life. For example, if the useful life of an asset is ten years, the straight-line rate is one tenth, or ten percent.
Declining-balance methods initially ignore residual value, but we do not depreciate the asset below its residual value.
Part II.
The most common declining-balance method is double-declining balance. It gets its name because the rate is twice (double) the straight-line rate. For example, the straight-line rate for an asset with a ten-year life is one over ten, or ten percent. The double declining balance rate for the asset would be is two tenths or twenty percent.
We multiply the double-declining balance rate times the book value of the asset. The book value declines each year as the asset is depreciated, resulting in less depreciation for each succeeding year.
Note that the Book Value will get lower each year.

13. Declining-Balance (DB) Methods
On January 1, we purchase equipment for $50,000 cash. The equipment has a service life of 5 years and an estimated residual value of $5,000. What is depreciation for the first two years using double-declining-balance?
Part I.
We will use the same information for the double-declining-balance method.
On January 1, we purchase equipment for $50,000 cash. The equipment has a service life of 5 years and an estimated residual value of $5,000. What is depreciation for the first two years using the double-declining-balance method?
Part II.
The double-declining-balance rate for a five-year asset is two times the straight line rate of 20 percent. In the first year the book value of the asset is equal to its cost of $50,000. The first year’s depreciation is 40 percent of $50,000 of $20,000.
The book value for the second year is $50,000 minus the first year’s depreciation of $20,000, or $30,000. The second year’s depreciation is 40 percent of $30,000, or $12,000.

14. Declining-Balance (DB) Methods
Depreciation forced so that BV = Residual Value.
Notice that depreciation is greater in the early years and less each succeeding year of the asset’s life. Accumulated depreciation increases each year by the amount of the depreciation expense. While we always want the book value to be equal to estimated residual value at the end of the asset’s useful life, it just will not work properly using the double-declining-balance method. We usually have to force depreciation in the latter years to an amount that allows the book value to be equal to the estimated residual value.
At the end of the five-year period, the accumulated depreciation is $45,000, resulting in a book value of $5,000. The book value is equal to the estimated residual value at the end of the asset’s useful life. We want this to be true regardless of the method we use.
In the graph you can clearly see that the amount of depreciation declines each year using the double-declining-balance method.
Depreciation
Life in Years

15. Units-of-Production
The units-of-production depreciation computation is much like the straight-line method. We divide cost minus residual value by estimated useful life in both methods. However, the useful life is measured in units of output using the units-of-production method, resulting in a depreciation rate per unit of production.
Once we compute the depreciation rate per unit of output, we may calculate depreciation for the period by multiplying the depreciation rate per unit times the number of units produced in the current period.

16. Units-of-Production
On January 1, we purchased equipment for $50,000 cash. The equipment is expected to produce 100,000 units during its life and has an estimated residual value of $5,000. If 22,000 units were produced this year, what is the amount of depreciation?
Part I.
We will use the same information for the units-of-production method, but for this example we will add the number of units produced for the first year.
On January 1, we purchased equipment for $50,000 cash. The equipment is expected to produce 100,000 units during its life and has an estimated residual value of $5,000.
If 22,000 units were produced this year, what is the amount of depreciation using the units-of-production method?
Part II.
We divide cost minus residual value by the number of units in the estimated service life to get the depreciation rate of $0.45 per unit. Next we multiply the depreciation rate of $0.45 per unit times the 22,000 units produced to get $9,900 of depreciation for the first year.

17. Use of Various Depreciation Methods
In a recent survey of large publicly traded companies, 494 of the companies indicated that they used the straight-line method of depreciation.

18. Component Depreciation, Depreciable Base, and Residual Value
U.S. GAAP vs. IFRS
Component Depreciation, Depreciable Base, and Residual Value
Component depreciation is allowed but not often used in practice.
The depreciable base is determined by subtracting estimated residual value from cost. Annual reviews of residual values are not required.
Each component of an item of property, plant, and equipment is depreciated separately if its cost is significant to the total cost of the item.
Depreciable base is determined by subtracting estimated residual value from cost. IFRS requires a review of residual values annually.
ISA No. 16 requires that each component of an item of property, plant, and equipment must be depreciated separately if its cost is significant in relation to the total cost of the item. In the U.S., component depreciation is allowed but is not often used in practice.
U.S. GAAP and IFRS determine depreciable base in the same way, by subtracting estimated residual value from cost. However, IFRS requires a review of residual values at least annually.

19. Group and Composite Methods
Assets are grouped by common characteristics.
An average depreciation rate is used.
Annual depreciation is the average rate × the total group acquisition cost.
Accumulated depreciation records are not maintained for individual assets.
If assets in the group are sold, or new assets added, the composite rate remains the same.
When an asset in the group is sold or retired, debit accumulated depreciation for the difference between the asset’s cost and the proceeds.
To reduce record keeping costs, group and composite depreciation methods aggregate assets to depreciate them collectively rather than individually. Group and composite methods differ only in criteria used to aggregate the assets for depreciation.
We implement either method by applying a single straight-line rate based on the average service lives of the aggregated asset. Annual depreciation is determined by multiplying the average rate times the total group acquisition cost. Accumulated depreciation records are not maintained for individual assets.
If assets in the group are sold, or new assets added, the composite rate remains the same. When an asset in the group is sold or retired, we debit accumulated depreciation for the difference between the asset’s cost and the proceeds. No gain or loss is recorded.

20. Valuation of Property, Plant, and Equipment
U.S. GAAP vs. IFRS
Valuation of Property, Plant, and Equipment
Property, plant, and equipment is reported in the balance sheet at cost less accumulated depreciation (book value).
Revaluation is prohibited.
Property, plant, and equipment may be reported at cost less accumulated depreciation, or alternatively, at fair value (revaluation).
If revaluation is chosen, all assets within a class of property, plant, and equipment must be revalued on a regular basis.
Under U.S. GAAP a company reports property, plant, and equipment in the balance sheet at cost less accumulated depreciation (book value). ISA No. 16 allows a company to report property, plant, and equipment at cost less accumulated depreciation, or, alternatively, at its fair value (revaluation). If a company chooses revaluation, all assets within a class of property, plant, and equipment must be revalued on a regular basis. U.S. GAAP prohibits revaluation.
If the revaluation option is chosen, the way the company reports the difference between fair value and book value depends on which amount is higher:
If fair value is higher than book value, the difference is reported as other comprehensive income (OCI) which then accumulates in a “revaluation surplus: (sometimes called revaluation reserve) account in equity.
If book value is higher than fair value, the difference is reported as an expense in the income statement. An exception is when a revaluation surplus account relating to the same asset has a balance from a previous increase in fair value, that balance is eliminated before debiting revaluation expense.

21. Depletion of Natural Resources
As natural resources are “used up,” or depleted, the cost of the natural resources must be allocated to the units extracted.
The approach is based on the units-of-production method.
In general, natural resources can be thought of as anything extracted from our natural environment such as coal, oil, and iron ore. Allocation of the cost of natural resources is called depletion. Total cost, including exploration and development, is charged to depletion over the periods benefited.
We use the units-of-production method to compute depletion, and report natural resources at their cost less accumulated depletion.
We begin the process of calculating depletion expense by determining the depletion expense per unit of the natural resource. The numerator of the equation contains the resource cost less any estimated residual value. The denominator of the equation is our estimated total capacity of the natural resource we expected to extract. For oil we express the denominator in terms of barrels and for coal or iron ore we use tons.
Once we compute the depletion rate per unit of output, we may calculate depletion for the period by multiplying the depletion rate per unit times the number of units extracted.
Let’s look at an example.

22. Depletion of Natural Resources
ABC Mining acquired a tract of land containing ore deposits. Total costs of acquisition and development were $1,100,000. ABC estimated the land contained 40,000 tons of ore, and that the land will be sold for $100,000 after the coal is mined. What is ABC’s depletion rate?
Depletion rate = 1,000,000 ÷ 40,000 Tons = $25 Per Ton
Part I.
ABC Mining acquired a tract of land containing ore deposits. Total costs of acquisition and development were $1,100,000. ABC estimated the land contained 40,000 tons of ore, and that the land will be sold for $100,000 after the coal is mined. What is ABC’s depletion rate?
Part II.
We divide the $1,100,000 cost minus the $100,000 residual value by the number of units in the estimated service life to get the depletion rate of $25 per ton.
For the year ABC mined 13,000 tons. What is the total amount of depletion for the year?
Part III.
We multiply the depletion rate of $25 per ton times the 13,000 mined to get $325,000 of total depletion. Depletion is a product cost that is included in the cost of coal inventory. The depletion is then included in cost of goods sold in the income statement when the coal is sold.
For the year ABC mined 13,000 tons. What is the total amount of depletion for the year?
Depletion = 13,000 tons × $25per ton = $325,000

23. Valuation of Biological Assets
U.S. GAAP vs. IFRS
Valuation of Biological Assets
Biological assets, such as timber tracts, are valued at cost less accumulated depletion.
Biological assets are valued at fair value less estimated costs to sell.
Living animals and plants, including the trees in a timber tract or in a fruit orchard, are referred to as biological assets. Under U.S.GAAP, a timber tract is valued at cost less accumulated depletion and a fruit orchard at cost less accumulated depreciation. Under IFRS, biological assets are valued at their fair value less estimated costs to sell.

24. Amortization of Intangible Assets
The amortization process uses the straight-line method, but usually assumes residual value = 0.
Amortization period is the shorter of the asset’s legal or contractual life.
The amortization entry is:
Amortization expense $$$
Intangible asset ……………… $$$
To record amortization expense.
Amortization is the process of allocating the cost of an intangible asset to the periods benefited by its use. The amortization process uses the straight-line method, but usually assumes a zero residual value. The amortization period is the shorter of the intangible asset’s legal or contractual life.
The journal entry to record amortization requires a debit to amortization expense and a credit to the intangible asset account. Companies generally do not use a contra-asset account such as accumulated amortization when recording the amortization of intangible assets.
Let’s look at an example.
A contra-asset account is generally not used when recording the amortization of intangible assets.

25. Amortization of Intangible Assets
Torch, Inc. has developed a new device. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal registration fees. The device has a contractual (useful) life of 5 years. The legal life is 20 years.
For year 1, what is Torch’s amortization expense?
Part I.
Torch, Inc. has developed a new device. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal registration fees. The device has a contractual (useful) life of 5 years. The legal life is 20 years. At the end of year 1, what is Torch’s amortization expense?
Part II.
Since the five-year economic life is shorter than the twenty-year legal life for this patent, we will amortize the patent over five years.
The amortization expense is the asset’s cost of $3,000 divided by its economic life of five years, resulting in annual amortization of $600. The journal entry to record amortization requires a debit to amortization expense for $600 and a credit to the patent account for $600. The patent will have a book value of $2,400 after the amortization entry is posted.
Amortization expense
Patent ………………
To record amortization of patent.

26. Intangible Assets not Subject to Amortization
Goodwill and Trademarks
Not amortized.
Subject to assessment for impairment of value and may be written down.
Goodwill and trademarks have indefinite useful lives and are not amortized into the results of operations, but instead are reviewed for impairment annually, or more often if impairment indicators arise. If an impairment is determined to exist, we will reduce the asset account and recognize the loss in value.

27. Valuation of Intangible Assets
U.S. GAAP vs. IFRS
Valuation of Intangible Assets
Intangible assets are reported at cost less accumulated amortization.
U.S.GAAP prohibits revaluation of any intangible asset.
Intangible assets may be reported at (1) cost less accumulated amortization or (2) fair value, if fair value can be determined in an active market.
If revaluation is chosen, all assets within the class of intangibles must be revalued on a regular basis.
Goodwill cannot be revalued.
IAS No. 38 allows a company to value an intangible asset subsequent to initial valuation at (1) cost less accumulated amortization or (2) fair value, if fair value can be determined by reference to an active market. If revaluation is chosen, all assets within the class of intangibles must be revalued on a regular basis. Goodwill, however, cannot be revalued. U.S.GAAP prohibits revaluation of any intangible asset.
The revaluation option is possible only if fair value can be determined by reference to an active market, making the option relatively uncommon. However, the option possibly could be used for intangibles such as franchises and certain license agreements.
If the revaluation option is chosen, the accounting treatment is similar to the way we applied the revaluation option for property, plant, and equipment earlier. The way the company reports the difference between fair value and book value depends on which amount is higher. If fair value is higher than book value, the difference is reported as other comprehensive income (OCI) and then accumulated in a revaluation surplus account in equity. If book value is higher than fair value, the difference is expensed.

28. Partial-Period Depreciation
Pro-rating the depreciation based on the date of acquisition is time-consuming and costly. A commonly used alternative is the . . .
Half-Year Convention
Take ½ of a year of depreciation in the year of acquisition, and the other ½ in the year of disposal.
To this point we have discussed assets that were purchased at the beginning of a year and depreciated for a full year. Relatively few assets will actually be purchased on January 1. When an operational asset is acquired during the year, depreciation is calculated for the fraction of the year the asset is owned.
Pro-rating the depreciation based on the date of acquisition is time-consuming and costly. A commonly used alternative is the half-year convention. Using this convention, a company would record one-half year of depreciation in the year of acquisition, and one-half year of depreciation in the year of disposal.

29. ESTIMATED service life ESTIMATED residual value
Changes in Estimates
ESTIMATED service life
ESTIMATED residual value
Changes in estimates are accounted for prospectively. The book value less any residual value at the date of change is depreciated over the remaining useful life. A disclosure note should describe the effect of a change.
The service life and the residual value used in depreciation computations are both estimates. Like all estimates, new information may come to light that will cause us to revise our previous estimate. Changes in estimates are accounted for prospectively. The book value, less any residual value at the date of change, is depreciated over the remaining useful life. A disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related pershare amounts for the current period.
Let’s look at an example of a change in useful life.
On January 1, equipment was purchased that cost $30,000, has a useful life of ten years and no salvage value. At the beginning of the fourth year, it was decided that there were only five years remaining, instead of seven years. Calculate depreciation expense for the fourth year using the straight-line method.
On January 1, equipment was purchased that cost $30,000, has a useful life of 10 years and no salvage value. At the beginning of the fourth year, it was decided that there were only 5 years remaining, instead of 7 years.
Calculate depreciation expense for the fourth year using the straight-line method.

30. Changes in Estimates What happens if we change depreciation methods?
The depreciation expense for each of the first three years is $3,000 ($30,000 cost divided by the original estimated useful life of ten years). The accumulated depreciation for the first three years totals $9,000, computed by multiplying the $3,000 of depreciation each year times three years.
The undepreciated cost (book value) of the equipment on the date of change is $21,000, computed by subtracting $9,000 of accumulated depreciation from the $30,000 cost.
To calculate the amount of straight-line depreciation for each of the remaining five years of the equipment’s life, we divide the $21,000 book value of the equipment by five years. The resulting straight-line depreciation is $4,200 per year.
Now, let’s see how to account for a change in depreciation method.
What happens if we change depreciation methods?

31. Change in Depreciation Method
A change in depreciation, amortization, or depletion method is considered a change in accounting estimate that is achieved by a change in accounting principle.
We account for these changes prospectively, exactly as we would any other change in estimate.
On January 1, 2009, Matrix, Inc., purchased equipment for $400,000. Matrix expected a residual value $40,000, and a service life of 5 years. Matrix uses the double-declining-balance method to depreciate this type of asset. During 2011, the company switched from double-declining balance to straight-line depreciation. The residual value remained at $40,000. Let’s determine the amount of depreciation to be recorded at the end of 2011.
A change in depreciation, amortization, or depletion method is considered a change in accounting estimate that is achieved by a change in accounting principle. We account for these changes prospectively, exactly as we would any other change in estimate. However, in the case of a change in depreciation method, the required disclosure note must also provide justification for why the new method is preferable. Let’s look at an example.
On January 1, 2009, Matrix, Inc., a calendar year-end company purchased equipment for $400,000. Matrix expected a residual value $40,000, and a service life of five years. Matrix uses the double-declining-balance method to depreciate this type of asset. During 2011, the company switched from double-declining balance to straight-line depreciation. Let’s determine the amount of depreciation to be recorded at the end of 2011.

32. Change in Depreciation Method
Part I
Double-declining-balance depreciation for 2007 was $160,000 ($400,000 cost times forty percent). For 2008 the double-declining-balance depreciation was $96,000 ($240,000 book value times forty percent). Accumulated depreciation for the first two years totals $256,000.
Part II.
The undepreciated cost (book value) of the equipment on January 1, 2009, the date of the change, is $144,000, computed by subtracting $256,000 of accumulated depreciation from the $400,000 cost of the equipment. To calculate the amount of straight-line depreciation for each of the remaining three years of the equipment’s life, we divide the remaining depreciable amount of $104,000 ($144,000 – 40,000) by three years. The resulting straight-line depreciation is $34,667 per year.
For each of the remaining three years of the equipment’s life (2009, 2010, 2011), the adjusting entry for depreciation is the same. We debit depreciation expense for $34,667 and credit accumulated depreciation for $34,667.
Note that the prospective approach used for the change in accounting method affected only 2009, the year of the change, and 2010 and There is no restatement of prior years’ depreciation for 2007 and 2008.
December 31, 2011:
Depreciation expense ,667
Accumulated depreciation ,667
To record depreciation expense.

33. Error Correction
Errors found in a subsequent accounting period are corrected by . . .
 Entries that restate the incorrect account balances to the correct amount.
 Restating the prior period’s financial statements.
 Reporting the correction as a prior period adjustment to Beginning R/E.
The correction of an error is necessary when a transaction is recorded incorrectly or not recorded at all. To correct an accounting error found in a subsequent period, we restate prior year’s statements that are presented for comparative purposes to reflect the impact of the change. We adjust the balance in each account affected to appear as if the error had never occurred. If retained earnings is one of the accounts whose balance needs to be adjusted, we adjust the beginning balance of retained earnings for the earliest period reported in the comparative statements. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary items, and earnings per share.
In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary items, and earnings per share.

34. Impairment of Value Accounting treatment differs.
Test for impairment of value when considered for sale.
Impairment of Value
Accounting treatment differs.
Long-term assets to be held and used
Long-term assets held for sale
Tangible and intangible with finite useful lives
Intangible with indefinite useful lives
Goodwill
Part I.
Impairment is the loss of a significant portion an asset’s benefits through casualty, obsolescence, or lack of demand for the asset’s services. If an asset’s value decreases and cannot be recovered through future use or sale, the asset is considered to be impaired and it should be written down to its net realizable value.
We recognize and measure impairment loss differently depending on whether the asset is being held for use or held for sale. For assets being held for use, different guidelines apply to tangible and intangible assets with finite useful lives and intangible assets with indefinite useful lives. Finally, because goodwill is a unique intangible asset with an indefinite useful life, there is yet another difference in accounting treatment.
Part II.
Tangible assets and finite life intangible assets are tested for impairment when events or changes in circumstances indicate that the book value may not be recoverable
Intangible assets with indefinite useful lives, including goodwill are tested for impairment annually.
Operational assets held for sale are tested for impairment when considered for sale.
Test for impairment of value at least annually.
Test for impairment of value when it is suspected that book value may not be recoverable

35. Finite-life Assets to be Held and Used
Measurement – Step 1
An asset is impaired when . . .
The undiscounted sum of its estimated future cash flows
Its book value
Determining the amount of impairment loss to record on a tangible asset or on a finite life intangible asset is a two-step process. The first step is to determine if an impairment has occurred. An asset is impaired if the undiscounted sum of its estimated future cash flows is less than its book value.
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36. Finite-life Assets to be Held and Used
Measurement – Step 2
Impairment loss
Book value
Fair value = –
Reported as part of income from continuing operations.
Market value, price of similar assets, or PV of future net cash inflows.
Undiscounted future cash flows
Part I.
If it is determined that an impairment loss has occurred on a tangible asset or on a finite life intangible asset in step one, the second step in the process is to determine the amount of the impairment loss.
The impairment loss is the amount by which book value exceeds fair value. If fair value cannot be determined in the market place, it is estimated as the discounted sum (present value) of the estimated future cash flows from the asset. Recall that undiscounted cash flows are used in step one. An impairment is reported as part of income from continuing operations.
Part II.
Let’s look at an example illustrating two steps of the process.
In case one, the undiscounted sum of estimated future cash flows of $250 is greater than the book value of $50, so there is no impairment (step one). In case two, the undiscounted sum of estimated future cash flows of $250 is greater than the book value of $150, so there is no impairment (step one). In case three, the undiscounted sum of estimated future cash flows of $250 is less than the book value of $275, so there is an impairment (step one). The amount of the impairment is equal to the $275 book value of the asset less the $125 fair value of the asset (step two).
Fair Value $0
$125
$250
Case 1: $50 book value.
No loss recognized
Case 3: $275 book value.
Loss = $275 - $125
Case 2: $150 book value. No loss recognized

37. Assets Held for Sale
Assets held for sale include assets that management has committed to sell immediately in their present condition and for which sale is probable.
Assets held for sale include assets that management has committed to sell immediately in their present condition and for which sale is probable. The impairment loss is the amount by which book value exceeds fair value less the cost to sell.
Impairment loss =
Book value
Fair value less cost to sell –

38. U.S. GAAP vs. IFRS
Impairment of Value: Property, Plant, and Equipment and Finite-life Intangible Assets
Assets are tested for impairment when events or changes in indicators suggest that book value may not be recoverable.
An impairment loss is required when an asset’s book value exceeds the undiscounted sum of the estimated future cash flows.
Assets must be assessed for circumstances of impairment at the end of each reporting period.
An impairment loss is required when an asset’s book value exceeds the higher of the asset’s value-in-use (present value of estimated future cash flow) and fair value less costs to sell.
IFRS requires that assets must be assessed for circumstances of impairment at the end of each reporting period. Under U.S. GAAP, assets are tested for impairment only when events or changes in indicators suggest that book value may not be recoverable. IFRS indicators of impairment are similar to U.S. GAAP.
Under U.S. GAAP, An impairment loss is required when an asset’s book value exceeds the undiscounted sum of the estimated future cash flows. Under IFRS, an impairment loss is required when an asset’s book value exceeds the higher of the asset’s value-in-use (present value of estimated future cash flow) and fair value less costs to sell.

39. U.S. GAAP vs. IFRS
Impairment of Value: Property, Plant, and Equipment and Finite-life Intangible Assets
The impairment loss is the difference between book value and fair value.
Reversals of impairment losses are prohibited.
The impairment loss is the difference between book value and the recoverable amount, the higher of the asset’s value-in-use and fair value less costs to sell.
An impairment loss is reversed if the circumstances that caused the impairment is resolved.
Under U.S. GAAP, the impairment loss is measured as the difference between book value and fair value, while under IFRS the impairment loss is the difference between book value and the recoverable amount. The recoverable amount is the higher of the asset’s value-in-use (present value of estimated future cash flows) and fair value less costs to sell.
IFRS requires the reversal of an impairment loss if the circumstances that caused the impairment are resolved. Reversals are prohibited under U.S. GAAP.

40. Finite-life Assets to be Held and Used
Because Acme Auto Parts has seen its sales steadily decrease due to the decline in new car sales, Acme’s management believes that equipment that originally cost $350 million, with a $200 million book value may not be recoverable. Management estimates that future undiscounted cash flows associated with the equipment’s remaining useful life will be only $140 million, and that the equipment could be sold now for $120 million. Has Acme suffered an impairment loss and if so, how should it be recorded?
Part I.
Because Acme Auto Parts has seen its sales steadily decrease due to the decline in new car sales, Acme’s management believes that equipment that originally cost $350 million, with a $200 million book value, may not be recoverable. Management estimates that future undiscounted cash flows associated with the equipment’s remaining useful life will be only $140 million, and that the equipment could be sold now for $120 million. Has Acme suffered an impairment loss and if so, how should it be recorded?
Part II.
Step 1. Recoverability. The undiscounted sum of estimated future cash flows ($140 million) is less than book value ($200 Million), so an impairment is indicated.
Step 1 $140 million < $200 million Impairment loss is indicated.

41. Finite-life Assets to be Held and Used
Because Acme Auto Parts has seen its sales steadily decrease due to the decline in new car sales, Acme’s management believes that equipment that originally cost $350 million, with a $200 million book value may not be recoverable. Management estimates that future undiscounted cash flows associated with the equipment’s remaining useful life will be only $140 million, and that the equipment could be sold now for $120 million. Has Acme suffered an impairment loss and if so, how should it be recorded?
Step 2 Impairment loss = $200 million – $120 million = $80 million
Part I.
Since an impairment is indicated, we will proceed with step 2, measurement. The impairment loss of $80 million is equal to the book value of $200 million less the current fair value of $120 million.
Part II.
To record the loss, we debit impairment loss for $80 million, debit accumulated depreciation for $150 million, and credit equipment for $230 million ($350 million cost less $120 million fair value). The entry reduces the accumulated depreciation balance to zero and reduces the equipment account to its current fair value of $120 million.
Impairment loss ,000,000
Accumulated depreciation ,000,000
Equipment …………………… ,000,000
To record impairment loss.

42. Indefinite-life Intangibles
Other Indefinite Life Intangibles
One-step Process
If BV of asset > FV, recognize impairment loss.
Goodwill
Step 1 If BV of reporting unit > FV, impairment indicated.
Part I.
The measurement of an impairment loss for goodwill is a two step process. Goodwill is inseparable from a particular reporting unit. A reporting unit is an operating segment of a company or a component of an operating segment for which discrete financial information is available and segment managers regularly review the operating results of that component. In step one we compare the fair value of the reporting unit to its book value to see if an impairment is indicated. If the book value is greater than the fair value, there is an impairment of goodwill.
If impairment is indicated in step one, we calculate the amount of the impairment in step two. Because fair value of goodwill does not exist separately from the reporting unit, and cannot be measured directly (no separate market value or separate present value of cash flows), we imply the fair value of goodwill by subtracting the fair value of all identifiable net assets from the fair value of the entire reporting unit, the same process that is used to initially determine goodwill in a business combination. The impairment loss is then equal to the amount by which the book value of goodwill exceeds the implied fair value of goodwill.
Part II.
The measurement of an impairment loss for indefinite life intangible assets other than goodwill is a one-step process. If book value is greater than fair value, an impairment loss is recognized for the difference.
Step 2 Loss = BV of goodwill less implied value of goodwill.

43. U.S. GAAP vs. IFRS
Impairment of Value: Indefinite-life Intangible Assets Other than Goodwill
Indefinite-life intangible assets other than goodwill are tested for impairment at least annually.
The impairment loss is the difference between book value and fair value.
Indefinite-life intangible assets other than goodwill are tested for impairment at least annually.
The impairment loss is the difference between book value and the recoverable amount, the higher of the asset’s value-in-use (present value of estimated future cash flows) and fair value less costs to sell.
Similar to U.S. GAAP, IFRS requires indefinite-life intangible assets other than goodwill to be tested for impairment at least annually. However, under U.S. GAAP, the impairment loss is measured as the difference between book value and fair value, while under IFRS the impairment loss is the difference between book value and the recoverable amount. The recoverable amount is the higher of the asset’s value-in-use (present value of estimated future cash flows) and fair value less costs to sell.

44. U.S. GAAP vs. IFRS
Impairment of Value: Indefinite-life Intangible Assets Other than Goodwill
Reversals of impairment losses are prohibited.
If certain criteria are met, indefinite-life intangible assets are combined for the required annual impairment test.
An impairment loss is reversed if the circumstances that caused the impairment is resolved.
Indefinite-life intangible assets may not be combined with other indefinite-life intangible assets for the required annual impairment test.
IFRS requires the reversal of an impairment loss if the circumstances that caused the impairment are resolved. Reversals are prohibited under U.S. GAAP.
IFRS prohibits the combination of indefinite-life intangible assets with other indefinite-life intangible assets for the required annual impairment test. Under U.S. GAAP, if certain criteria are met, indefinite-life intangible assets should be combined for the required annual impairment test.

45. Impairment of Value: Goodwill
U.S. GAAP vs. IFRS
Impairment of Value: Goodwill
Goodwill is tested for impairment at least annually.
Reversals of impairment losses are prohibited.
The level of testing (reporting unit) is a segment or a component of an operating segment for which discrete financial information is available.
Goodwill is tested for impairment at least annually.
Reversals of impairment losses are prohibited.
The level of testing (cash-generating unit) is the smallest identifiable group of assets that generates cash flows that are largely independent of the cash flows from other assets.
U.S. GAAP and IAS No. 36 both require goodwill to be tested for impairment at least annually, and both prohibit the reversal of goodwill impairment losses.
Under U.S. GAAP, the level of testing (reporting unit) is a segment or a component of an operating segment for which discrete financial information is available and segment managers regularly review the operating results of that component. Under IFRS, the level of testing (cash-generating unit) is the smallest identifiable group of assets that generates cash flows that are largely independent of the cash flows from other assets. A cash-generating unit cannot be lower than a segment.

46. Impairment of Value: Goodwill
U.S. GAAP vs. IFRS
Impairment of Value: Goodwill
Measurement of an impairment loss is a two-step process. In step one the fair value of the reporting unit is compared to its book value. A loss is indicated if the fair value is less than the book value. In step two, the impairment loss is calculated as the excess of book value of goodwill over the implied fair value of goodwill.
Measurement of an impairment loss is a one-step process. The recoverable amount of the cash-generating unit is compared to its book value. If the recoverable amount is less, goodwill is reduced before other assets are reduced.
Under U.S. GAAP, the measurement of an impairment loss for goodwill is a two-step process. In step one the fair value of the reporting unit is compared to its book value to see if an impairment is indicated. A loss is indicated if the fair value is less than the book value. In step two, the impairment loss is calculated as the excess of book value of goodwill over the implied fair value of goodwill. Because fair value of goodwill does not exist separately from the reporting unit, and cannot be measured directly (no separate market value or separate present value of cash flows), we imply the fair value of goodwill by subtracting the fair value of all identifiable net assets from the fair value of the entire reporting unit. The impairment loss is then equal to the amount by which the book value of goodwill exceeds the implied fair value of goodwill.
Under IFRS, the measurement of an impairment loss is a one-step process. The recoverable amount of the cash-generating unit is compared to its book value. If the recoverable amount is less, goodwill is reduced before other assets are reduced. Recall that the recoverable amount is the higher of fair value less costs to sell and value–in-use (present value of estimated future cash flows).

47. Impairment of Goodwill
Simmons Company recorded $150 million of goodwill when it acquired Blake Company. Blake continues to operate as a separate company and is considered to be a reporting unit. At the end of the current year Simmons noted the following related to Blake: (1) book value of net assets, including $150 million of goodwill is $500 million; (2) fair value of Blake is $400 million; and (3) fair value of Blake’s identifiable net assets, excluding goodwill is $350 million. Is goodwill impaired and if so, by what amount?
Part I.
Simmons Company recorded $150 million of goodwill when it acquired Blake Company. Blake continues to operate as a separate company and is considered to be a reporting unit. At the end of the current year Simmons noted the following related to Blake: (1) book value of net assets, including $150 million of goodwill is $500 million; (2) fair value of Blake is $400 million; and (3) fair value of Blake’s identifiable net assets, excluding goodwill is $350 million. Is goodwill impaired and if so, by what amount?
Part II.
Step 1. Recoverability. The book value of net assets including goodwill ($500 million) is greater than the fair value of the reporting unit ($400 million), so an impairment loss is indicated.
Step 1 $500 million > $400 million Impairment loss is indicated.

48. Impairment of Goodwill
Simmons Company recorded $150 million of goodwill when it acquired Blake Company. Blake continues to operate as a separate company and is considered to be a reporting unit. At the end of the current year Simmons noted the following related to Blake: (1) book value of net assets, including $150 million of goodwill is $500 million; (2) fair value of Blake is $400 million; and (3) fair value of Blake’s identifiable net assets, excluding goodwill is $350 million. Is goodwill impaired and if so, by what amount?
Since an impairment loss is indicated, we will proceed with step 2, measurement. First we determine the implied value of goodwill by subtracting the fair value of Blake’s net assets, excluding goodwill ($350 million), from Blake’s fair value ($400 million). Then we subtract the implied value of goodwill ($50 million) from the book value of goodwill ($150 million) to determine the impairment loss of $100 million.

49. Expenditures Subsequent to Acquisition
Type of Expenditure
Definition
Usual Accounting Treatment
Repairs and Maintenance
Expenditures to maintain a given level of benefits
Expense in the period incurred
Additions
The addition of a new major component to an existing asset
Capitalize and depreciate over the remaining useful life of the original asset, or over the useful life of the addition, whichever is shorter
Improvements
The replacement of a major component
Capitalize and depreciate over the useful life of the improved asset
Rearrangements
Expenditures to restructure an asset without addition, replacement, or improvement
If expenditures are material and clearly increase future benefits, capitalize and depreciate over the future periods benefited
After a plant asset is purchased, the company may incur additional expenditures on that asset. The accounting issue is deciding whether to capitalize these expenditures or to expense them in the period incurred. We normally use the following procedures:
expenditures for maintenance and ordinary repairs are normally expensed. These types of expenditures maintain the normal operating condition and do not extend the useful life beyond the original estimate.
expenditure for additions usually increase the productive capacity and are capitalized.
expenditures for improvements, replacements, and extraordinary repairs either increase the useful life beyond the original estimate, or increase productive output, or both. These expenditures are normally capitalized.
rearrangements are changes made in an existing process for improved output or improved efficiency. Normally, the cost of rearrangements are capitalized.

50. Costs of Defending Intangible Rights
U.S. GAAP vs. IFRS
Costs of Defending Intangible Rights
Litigation costs to successfully defend intangible rights are capitalized and amortized over the remaining useful life of the asset.
Litigation costs are expensed, except in rare situations when an expenditure increases future benefits.
Under U.S. GAAP litigation costs to successfully defend intangible rights are capitalized and amortized over the remaining useful life of the asset. Under IFRS, these costs are expensed, except in rare situations when an expenditure increases future benefits.

51. Appendix 11A – Comparison with MACRS (Tax Depreciation)
Most corporations use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes.
When filing a tax return most corporations use the modified accelerated cost recovery system developed by the Internal Revenue Service. The modified accelerated cost recovery system is an accelerated depreciation method. It was designed to permit companies to quickly write-off the cost of long-lived tangible assets and thereby stimulate investment in new assets. Residual value is ignored. Assets are categorized into classes based on life, and each class has a stated depreciation rate.
Provides for rapid write-off
Rates based on asset “class lives”
Ignores residual value

52. Appendix 11B – Retirement and Replacement Methods of Depreciation
Used for groups of similar, low-valued assets with short service lives.
Retirement Method
Acquisitions:
Record initial acquisitions of assets at cost in the asset account.
Record subsequent acquisitions of assets at cost in the asset account
Dispositions:
Credit the asset account for cost.
Debit depreciation expense for cost less the proceeds received.
Replacement Method
Acquisitions:
Record initial acquisitions of assets at cost in the asset account.
Record subsequent acquisitions with a debit to depreciation expense.
Dispositions:
Credit depreciation expense for the proceeds received.
The retirement and replacement methods of depreciation are used to depreciate low-valued assets with short service lives. Both methods use aggregate groups of similar assets.
Using either method, we record the initial cost of assets in an asset account. With the retirement method, we also record the cost of subsequent acquisitions of assets in the asset account. However, with the replacement method, we record the cost of subsequent acquisitions as depreciation expense.
We account for dispositions of assets in a group differently with the two methods. Using the retirement method, we record a disposition by crediting the asset account for the cost of the disposed asset, and we debit depreciation expense for the cost of the disposed asset less the proceeds received from its sale. Using the replacement method, we credit depreciation expense for the proceeds received from the sale of the asset.

53. End of Chapter 11
End of chapter 11.