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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Topic 5 Operating Assets – Utilization and Impairment Depreciation Methods.

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Presentation on theme: "Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Topic 5 Operating Assets – Utilization and Impairment Depreciation Methods."— Presentation transcript:

1 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Topic 5 Operating Assets – Utilization and Impairment Depreciation Methods

2 11-2 Some of the cost is expensed each period. Cost Allocation – An Overview Expense Acquisition Cost (Balance Sheet)(Income Statement) The matching principle requires that part of the acquisition cost of operational assets be expensed in periods when the future revenues are earned.

3 11-3 Cost Allocation – An Overview Some of the cost is expensed each period. Expense Acquisition Cost (Balance Sheet)(Income Statement) Depreciation, depletion and amortization are cost allocation processes used to help meet the matching principle requirements.

4 11-4 Caution! Depreciation, depletion, and amortization are processes of cost allocation, not valuation! Cost Allocation – An Overview

5 11-5 Cost allocation requires developing three estimates for each asset: The estimated expected use from an asset. Total amount of cost to be allocated. Cost - Residual Value (at end of useful life) Total amount of cost to be allocated. Cost - Residual Value (at end of useful life) The systematic approach used for allocation. Allocation Base Useful (Service) Life Allocation Method Cost Allocation - Judgments

6 11-6 Time-based Methods Straight-line (SL) Accelerated Methods  Sum-of-the-years’ digits (SYD)  Declining Balance (DB) Time-based Methods Straight-line (SL) Accelerated Methods  Sum-of-the-years’ digits (SYD)  Declining Balance (DB) Activity-based methods Units-of-production method (UOP). Activity-based methods Units-of-production method (UOP). Group and composite methods Group and composite methods Tax depreciation Tax depreciation Depreciation of Operational Assets

7 11-7 Depreciation on the Balance Sheet Net property, plant & equipment is the undepreciated cost (book value) of operating assets.

8 11-8 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. 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? 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?

9 11-9 Straight-Line SYD depreciation is quickly computed using Excel.

10 11-10 Residual Value Note that at the end of the asset’s useful life, BV = Residual Value Straight-Line

11 11-11 Life in Years Depreciation Straight-Line

12 11-12 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. Accelerated Methods Note that total depreciation over the asset’s useful life is the same as the Straight- line Method.

13 SYD depreciation is quickly computed using Excel. The formula is as follows: Sum-of-the-Years’ Digits (SYD) = 15

14 11-14 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. Use Excel’s SYD function to compute depreciation for the five years. Sum-of-the-Years’-Digits (SYD)

15 11-15 Sum-of-the-Years’ Digits (SYD)

16 11-16 Sum-of-the-Years’ Digits (SYD) Cost 50,000 Salvage Value 5,000 Estimated Life55555 Period12345 Period Depreciation 15,000 12,000 9,000 6,000 3,000 45,000

17 11-17 Life in Years Depreciation Sum-of-the-Years’ Digits (SYD)

18 11-18 Declining-Balance (DB) Methods DB depreciation  Based on the straight- line rate multiplied by an acceleration factor.  Computations initially ignore residual value. DB depreciation  Based on the straight- line rate multiplied by an acceleration factor.  Computations initially ignore residual value. Stop depreciating when: BV=Residual Value Stop depreciating when: BV=Residual Value

19 11-19 DDB depreciation is easy to compute using Excel function =ddb The formula is as follows: Note that the Book Value will get lower each time depreciation is computed! Double-Declining-Balance (DDB)

20 11-20 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 five two years using double-declining-balance? Double-Declining-Balance (DDB)

21 11-21 Double-Declining-Balance (DDB)

22 11-22 Double-Declining-Balance (DDB) Excel will stop depreciation when the BV = Residual Value.

23 11-23 Life in Years Depreciation Double-Declining-Balance (DDB)

24 11-24 Activity-Based Depreciation  Depreciation can also be based on measures of input or output like:  Service hours, or  Units-of-Production  Depreciation is not taken for idle assets.  Depreciation can also be based on measures of input or output like:  Service hours, or  Units-of-Production  Depreciation is not taken for idle assets. This approach looks different.

25 11-25 Units-of-Production

26 11-26 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? Units-of-Production

27 11-27 Units-of-Production

28 11-28 Use of Various Depreciation Methods

29 11-29 Comparison With MACRS (Tax Depreciation) Covered in Income Tax Course & Referred to in Intermediate III Ignores residual value Provides for rapid write-off Rates based on asset “class lives” Most corporations use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes.

30 11-30 Depreciation Disclosures  Depreciation.  Balances of major classes of depreciable assets.  Accumulated depreciation by asset or in total.  General description of depreciation methods used.  Depreciation.  Balances of major classes of depreciable assets.  Accumulated depreciation by asset or in total.  General description of depreciation methods used.

31 11-31 I bought an asset on May 19 this year. Do I get a full year’s depreciation? May 19 Partial-Period Depreciation

32 11-32 Partial-Period Depreciation Half-Year Convention Take ½ of a year of depreciation in the year of acquisition, and the other ½ in the year of disposal. Half-Year Convention Take ½ of a year of depreciation in the year of acquisition, and the other ½ in the year of disposal. Pro-rating the depreciation based on the date of acquisition is time-consuming and costly. A commonly used alternative is the...

33 11-33 Partial Year – Demo Problem On March 31,2009 Canseco Plumbing Fixtures purchased equipment for $30,000. Residual value at the end of an estimated four-year service life is expected to be $2,000. The company expects the machine to operate for 10,000 hours. Calculate depreciation expense for 2009 and 2010 using straight line depreciation method (a) Partial Year basis (b) Half Year Convention

34 11-34 Partial Year – Demo Problem SLM for a full year: [$30, ,000]/4 = $7,000 a $7,000 x 9/12 =$5, $7,000 x 12/12 =$7,000 b $7,000 x 50% =$3, $7,000 x 100% =$7,000

35 11-35 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.  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.  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.

36 11-36 GROUP AND COMPOSITE DEPRECIATION  Page 243. If there are no changes in the assets contained in the group, depreciation of $52,800 per year (16% x $330,000) will be recorded for 5.15 years.

37 11-37 BE 11-4  Mondale Winery depreciates its equipment using the group method. The cost of equipment purchased in 2013 totaled $425,000. The estimated residual value of the equipment was $40,000 and the group depreciation rate was determined to be 18%.  What is the annual depreciation for the group?  If equipment that cost $42,000 is sold in 2014 for $35,000, what amount of gain or loss will the company recognize for the sale?

38 11-38 BE 11-4 Solution Annual depreciation will equal the group rate multiplied by the depreciable base of the group: ($425,000 – 40,000) x 18% = $69,300 Since depreciation records are not kept on an individual asset basis, dispositions are recorded under the assumption that the book value of the disposed item exactly equals any proceeds received and no gain or loss is recorded. Any actual gain or loss is implicitly included in the accumulated depreciation account.

39 11-39 BE 11-4 Solution  Journal entry for sale  Cash35,000  Acc. Dep (difference) 7,000 Equipment (cost)42,000

40 11-40 The approach is based on the units- of-production method. As natural resources are “used up”, or depleted, the cost of the natural resources must be allocated to the units extracted. Depletion of Natural Resources

41 11-41 Depletion of Natural Resources

42 11-42 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. Depletion of Natural Resources

43 11-43 What is ABC’s unit depletion rate? a.$40 per ton b.$50 per ton c.$25 per ton d.$20 per ton What is ABC’s unit depletion rate? a.$40 per ton b.$50 per ton c.$25 per ton d.$20 per ton Depletion of Natural Resources

44 11-44 What is ABC’s unit depletion rate? a.$40 per ton b.$50 per ton c.$25 per ton d.$20 per ton What is ABC’s unit depletion rate? a.$40 per ton b.$50 per ton c.$25 per ton d.$20 per ton Cost / Units $1,000,000 / 40,000 Tons = $25 Per Ton Cost / Units $1,000,000 / 40,000 Tons = $25 Per Ton Depletion of Natural Resources

45 11-45 For the year ABC mined 13,000 tons and sold 9,000 tons. What is the total depletion and the depletion expense? a.$325,000 & $225,000 b.$325,000 & $325,000 c.$225,000 & $225,000 d.$275,000 & $225,000 For the year ABC mined 13,000 tons and sold 9,000 tons. What is the total depletion and the depletion expense? a.$325,000 & $225,000 b.$325,000 & $325,000 c.$225,000 & $225,000 d.$275,000 & $225,000 Depletion of Natural Resources

46 11-46 For the year ABC mined 13,000 tons and sold 9,000 tons. What is the total depletion and the depletion expense? a.$325,000 & $225,000 b.$325,000 & $325,000 c.$225,000 & $225,000 d.$275,000 & $225,000 For the year ABC mined 13,000 tons and sold 9,000 tons. What is the total depletion and the depletion expense? a.$325,000 & $225,000 b.$325,000 & $325,000 c.$225,000 & $225,000 d.$275,000 & $225,000 Depletion of Natural Resources Depletion = 13,000 x $25 = $325,000 Expense = 9,000 x $25 = $225,000 Depletion = 13,000 x $25 = $325,000 Expense = 9,000 x $25 = $225,000

47 11-47 Amortization of Intangible Assets The amortization process uses the straight-line method, but assumes residual value = 0. Amortization period is the shorter of: Economic Life Legal Life or

48 11-48 Amortization of Intangible Assets The amortization entry is: Note that the amortization process does not use a contra-asset account.

49 11-49 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 useful life of 5 years. The legal life is 20 years. At the end of year 1, what is Torch’s amortization expense? 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 useful life of 5 years. The legal life is 20 years. At the end of year 1, what is Torch’s amortization expense? Amortization of Intangible Assets

50 11-50 Record the amortization entry. Amortization of Intangible Assets

51 11-51 Note that the patent will have a book value of $2,400 after this amortization entry is posted. Amortization of Intangible Assets

52 11-52 Intangible Assets Not Subject to Amortization Not amortized. Subject to assessment for impairment value and may be written down. Goodwill

53 11-53 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. On January 1, equipment was purchased that cost $30,000, has a useful life of 10 years, and no residual value. At the beginning of the fourth year, it was decided that there were only 5 years remaining, instead of 7 years. Calculate depreciation for the fourth year using the straight-line method. Changes in Estimates

54 11-54 What happens if we change depreciation methods? Changes in Estimates

55 11-55 Change in Depreciation Method prospectively, We account for these changes prospectively, exactly as we would any other change in estimate. A change in depreciation, amortization, or depletion method is considered a change in accounting estimate that is achieved by a change in accounting principle. On January 1, 2011, Matrix Inc. purchased office 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 2013, 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 for 2013.

56 11-56 Change in Depreciation Method December 31, 2013: Depreciation expense ,667 Accumulated depreciation ,667 To record depreciation expense.

57 11-57 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. 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.

58 11-58 Brief Exercise 11-7  At the beginning of 2011, Robotics, Inc. acquired a manufacturing facility for $12 million. $9 million of the purchase price was allocated to the building. Depreciation for 2011 and 2012 was calculated using the straight-line method, a 25- year useful life, and a $1 million residual value.  In 2013, the estimates of useful life and residual value were changed to 20 years and $500,000, respectively.  What is depreciation on the building for 2013?

59 11-59 Brief Exercise 11-7 Work this using Excel function =SLN

60 11-60 Brief Exercise 11-8  Refer to the situation described in BE Assume that instead of changing the useful life and residual value, in 2013 the company switched to the double-declining-balance depreciation method. How should Robotics account for the change? What is depreciation on the building for 2013?BE 11-7

61 11-61 Brief Exercise 11-8  a change in the depreciation method reflects: estimated future benefits from the asset, the pattern of receiving those benefits, or the company’s knowledge about those benefits Voluntary changes in accounting principles are reported retrospectively

62 11-62 Brief Exercise 11-8 A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported.

63 11-63 Brief Exercise 11-9  Refer to the situation described in BE Assume that 2011 depreciation was incorrectly recorded as $32,000. This error was discovered in How should Robotics account for the error? What is depreciation on the building for 2013 assuming the error was judged material, no change in estimate of useful life or residual value? (ignore income tax)BE 11-7

64 11-64 Brief Exercise 11-9  Errors are retrospectively restated to reflect the correction. If retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to the beginning balance in the statement of shareholders’ equity.  Depreciation of $32,000 should have been recorded. ($8,000,000  25 years). Therefore, 2011 retained earnings tax is overstated by $288,000 ($320,000 – 32,000) and accumulated depreciation is understated by the same amount. The following journal entry is needed to record the error correction (ignoring income tax):

65 11-65 Brief Exercise 11-9 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 item, and earnings per share. Only the annual depreciation is reported in 2013.

66 11-66 Impairment of Value Long-term assets to be held and used Long-term assets held for sale Tangible and intangible with finite useful lives Intangibles with indefinite useful lives Goodwill Test for impairment of value 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. Test for impairment of value when it is likely that the fair value of a reporting unit is less than its book value. Accounting treatment differs. Operating assets

67 11-67 Operating Assets to be Held and Used An asset is impaired when... The undiscounted sum of its estimated future cash flows Measurement – Step 1 Its book value <

68 11-68 Impairment loss = Book value Fair value – Measurement – Step 2 $0$250$125 Case 1: $50 book value. No loss recognized Case 2: $150 book value. No loss recognized Case 3: $275 book value. Loss = $275 – $125 Fair value Undiscounted future cash flows Market value, price of similar assets, or PV of future net cash inflows. Reported in the income statement as a separate component of operating expenses Operating Assets to be Held and Used

69 11-69 Operating Assets to be Held and Used Step 1 $140 million < $200 million Impairment loss is indicated. 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’s fair value is $120 million. Has Acme suffered an impairment loss and, if so, how should it be recorded?

70 11-70 Step 2 Impairment loss = $200 million – $120 million = $80 million Impairment loss ,000,000 Accumulated depreciation ,000,000 Equipment ……………………. 230,000,000 To record impairment loss. Operating 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’s fair value is $120 million. Has Acme suffered an impairment loss and, if so, how should it be recorded?

71 11-71 Step 2 Loss = BV of goodwill less implied value of goodwill. Goodwill Step 1 If BV of reporting unit > FV, impairment indicated. Other Indefinite- life intangibles One-Step Process If BV of asset > FV, recognize impairment loss. One-Step Process If BV of asset > FV, recognize impairment loss. Indefinite-Life Intangibles This item covered in Advanced Accounting

72 11-72 Brief Exercise  Collison and Ryder Company (C&R) has been experiencing declining market conditions for its sportswear division. Management decided to test the operational assets of the division for possible impairment. The test revealed the following: book value of division’s assets, $26.5 million; fair value of division’s assets, $21 million; sum of estimated future cash flows generated from the division’s assets, $24 million.  What amount of impairment loss should C&R recognize?

73 11-73 Brief Exercise  Because the undiscounted sum of future cash flows of $24 million is less than book value of $26.5 million, there is an impairment loss. The impairment loss is calculated as follows:

74 11-74 Expenditures Subsequent to Acquisition Maintenanc e and ordinary repairs. Additions. Improvements (betterments), replacements, and extraordinary repairs. Rearrangement s and other adjustments.

75 11-75 Normally we debit an expense account for amounts spent on: Expenditures Subsequent to Acquisition

76 11-76 Normally we debit the asset account for amounts spent on: Expenditures Subsequent to Acquisition

77 11-77 Normally we debit the asset account for amounts spent on: Expenditures Subsequent to Acquisition

78 11-78 Normally, we debit an asset account for amounts spent on Rearrangements : changes made in an existing process for improved output or improved efficiency. Normally, the cost of rearrangements are capitalized Expenditures Subsequent to Acquisition

79 11-79 Brief Exercise  Demmert Manufacturing incurred the following expenditures during the current fiscal year: - annual maintenance on its machinery, $5,400; remodeling of offices, $22,000; rearrangement of the shipping and receiving area resulting in an increase in productivity, $35,000; addition of a security system to the manufacturing facility, $25,000.  How should Demmert account for each of these expenditures?

80 11-80 Brief Exercise  Annual maintenance on machinery, $5,400 - This is an example of normal repairs and maintenance. Future benefits are not increased; therefore the expenditure should be expensed in the period incurred.  Remodeling of offices, $22,000 - This is an example of an improvement. The cost of the remodeling should be capitalized and depreciated, either by direct capitalization of the cost, or a reduction of accumulated depreciation.

81 11-81 Brief Exercise  Rearrangement of the shipping and receiving area, $35,000 - This is an example of a rearrangement. Because the rearrangement increased productivity, the cost should be capitalized and depreciated.  Addition of a security system, $25,000 - This is an example of an addition. The cost of the security system should be capitalized and depreciated.


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