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Intermediate Financial Accounting I Operational Assets: Utilization and Disposition.

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2 Intermediate Financial Accounting I Operational Assets: Utilization and Disposition

3 2 Objectives of the Chapter A.To learn depreciation methods for financial reporting purposes. B.To study income tax depreciation including Accelerated Cost Recovery System (ACRS) and modified ACRS. C. To discuss the accounting issues related to asset impairments.

4 Operational Assets: Utilization and Disposition3 A. Depreciation (For Financial Reporting Purposes) 1. Time-based methods a. Straight-Line. b. Sum-of-the-Years’-Digits (SYD). c. Declining-Balance. 2. Activity-based method u Unit-of-Production. 3. Special methods a. Group Depreciation. b. Composite Depreciation. c. Retirement and Replacement Methods.

5 Operational Assets: Utilization and Disposition4 iGAAP: Depreciation  iGAAP, as in US GAAP, perceives depreciation as a cost allocation of an asset over the asset’s life.  iGAAP, as in US GAAP, allows depreciation methods such as straight line, diminishing-balance, and unit-of-production.  IFRS requires component depreciation. GAAP permits component deprecation but is rarely applied.

6 Operational Assets: Utilization and Disposition5 For Financial Reporting Purposes 1.Time-Based Methods n Depreciation Methods based on the passage of time: a. Straight-Line Method. b. Sum-of-the-Years’-Digits (SYD). c. Declining-Balance. b and c are called the accelerated depreciation methods (or the decreasing charge methods).

7 Operational Assets: Utilization and Disposition6 A.1a. Straight-Line Method n Cost is allocated evenly through the life of the P.P.E. n Example 1: Machine costing $10,000 was purchased on 1/1/x1. The estimated residual value of the machine is $2,000 and the estimated life of the machine is 4 years. Depreciation Expense per year: ($10, ,000)/ 4 = $2,000 12/31/x1 Depreciation Expenses2,000 Accumulated Depreciation2,000

8 Operational Assets: Utilization and Disposition7 1a. Straight-Line Method (Partial Year Depreciation) n Example 2 :Using the information in example 1, except that the machine was purchased on 3/11/x1. Companies normally compute depre. on the basis of nearest full month. Depreciation Expense of year x1 ==> [($10,000-2,000)/4] x (10/12) = $1,667

9 Operational Assets: Utilization and Disposition8 1a. Straight-Line Method Example 2 (contd.) B/S (Year x1) P.P.E. Machine$10,000 Acc. Depr. (1,667) Net B/V 8,333 B/S (Year x2) P.P.E Machine$10,000 Acc. Depr. (3,667) Net $6,337 B/S (Year x3) P.P.E Machine$10,000 Acc. Depr. (5,667) Net $ 4,333 B/S (Year x4) P.P.E Machine$10,000 Acc. Depr. (7,667) Net 2,333 (Book value = Cost - Acc. Depr)

10 Operational Assets: Utilization and Disposition9 1b. Sum-of-the-Years’-Digits (SYD) n Example 1: Machine costing $10,000 was purchased on 1/1/x1 with an estimated residual value of $2,000 and an estimated life of 4 years. Depr. **Book Value Year*Depr. BaseFractionExpenseat the end x1$8,0004/10$3,2006,800 x2$8,0003/10$2,4004,400 x3$8,0002/10$1,6002,800 x4$8,0001/10$8002,000 * Depr. Base= Cost - Residual Value ** Book Value= Cost - Acc. Depreciation

11 Operational Assets: Utilization and Disposition10 1b. S-Y-D (contd.) n Example 2: (Partial Year) Same information as in example 1 on page 8 except that the machine was purchased on 2/21/x1 rather than on 1/1/x1. The depr. period of Year x1 = 10 months

12 Operational Assets: Utilization and Disposition11 1b. S-Y-D Example 2 (contd.) Annual Depr. By S-Y-DDepr. Year Method Months Computation Exp 1x1$3, /12x3200=$2,667 2x2$2,400122/12x /12x2400=$2,533 3x3$1,600122/12x /12x1600=$1,733 4x4$800122/12x /12x800=$934 5x5-22/12x800=$133

13 Operational Assets: Utilization and Disposition12 1c. Declining-Balance Method n Depreciation Exp.= constant rate  book value at the beginning of the period u Residual value is not considered in the computation. u Assets cannot be depreciated below the residual value. u The constant rate is expressed as a function of a straight-line annual depreciation rate.

14 Operational Assets: Utilization and Disposition13 1c. Declining-Balance Method (contd.) n Example of constant rate: Double- 150% LifeS-LDeclining-Declining- ofDepr. Balance Balance Asset Rate Depr. Rate Depr. Rate 4yrs25%50%37.5% 5yrs20%40%30% 10yrs10%20%15%

15 Operational Assets: Utilization and Disposition14 1. Time-Based Methods Double Declining-Balance Method n Example 1: Machine costing $10,000 purchased on 1/1/x1, with a residual value of $2,000 and an estimated life of 4 years. A double declining-balance method is used to depreciate the machine. Thus, the constant rate is twice of the S-L Depr. Rate (2 x 25% = 50%).

16 Operational Assets: Utilization and Disposition15 Double Declining-Balance Method Example 1 (contd.) Book Value of Asset at Beg. ofConstantDepr.Book Value Year the Year Rate Exp. At the End x1$10,00050%$5,000$5,000 x2$5,00050%2,5002,500 x3$2,50050%500*2,000* x42,00050%02,000 *Assets cannot be depreciated below the residual value.

17 Operational Assets: Utilization and Disposition16 Double Declining-Balance Method Example 2 (partial year) n Use the same information as the example on page 13, except that the machine was purchased on 3/10/x1. u The depreciation period of Year x1 = 10 months. u Two alternative treatments for the partial year depreciation of the declining- balance method are available as follow s:

18 Operational Assets: Utilization and Disposition17 Double Declining-Balance Method Example 2 (contd.) - Alternative I Annual Depr. Using the Recognized D-D-B MonthsComputationsDepr. Exp. 1x1$5, /12x5000=$4,167 2x2$2,500122/12x /12x2500=$2,916 3x3$500122/12x /12x500=$834 4x40122/12x500=$83 5x502--

19 Operational Assets: Utilization and Disposition18 Double Declining-Balance Method Example 2 (contd.) - Alternative II Book Book ValueValue Yearat Beg. Rate Depr. Exp. At the End x1$10,00050%10/12x(10,000$5,833 x50%)= 4,167 x2$5,83350%12/12x(5,8332,916 x50%)= 2,917 x3$2,91650%9162,000 1 x4$2,00050%02,000 1.Assets cannot be depreciated below the residual value.

20 Operational Assets: Utilization and Disposition19 1. Time-Based Methods A Comparison of Depreciation Methods Assuming expected life = 4 years 1. Straight-Line Method 2. S-Y-D Method 3. Declining-Balance Method Year Depreciation Expense 1 2 3

21 Operational Assets: Utilization and Disposition20 Changes In Depreciation Method (i.e., Change from D-D-B to S-L) n Accounting treatment ( SFAS No. 154: Accounting Changes and Error Corrections, effective 1/1/2006): n Treated as an accounting estimate change that is achieved by change in accounting principle. u Method: Prospective method. u The accounting for depreciation method change is an example of revising US GAAP to converge to iGAAP.

22 Operational Assets: Utilization and Disposition21 1. Time-Based Methods Changes In Depreciation Estimate n Accounting treatment: no retroactive effect and make no adjustment for the past years’ misstatement. Spread the remaining undepreciated balance (i.e., the book value) less the revised (new) residual value over the revised (new) estimate of the remaining life of the assets.

23 Operational Assets: Utilization and Disposition22 Example: (S-L Depr. Method) n Machine costing $10,000 acquired on 1/1/x1.Estimates on 1/1/x1 on 1/1/x3 Residual value$2,000$1,000 Life4 years5 years

24 Operational Assets: Utilization and Disposition23 Example: (Contd.) YearDepr. ExpAcc. DeprBook Value x1$2, ,0008,000 x2$2, ,0006,000 x3$1,6675,666.74,333.3 x4$1,6677,333.42,666.6 x5$1,6679,000.11, (10,000-2,000)/4 = $2, (6,000-1,000)/(5-2) =1666.7

25 Operational Assets: Utilization and Disposition24 For Financial Reporting Purposes 2. Activity-Based Method n Depreciation based on the usage of assets. Depreciation bases -- hours of usage or production units. Method: u Units-of-Production Method: depreciation based on the usage of the asset

26 Operational Assets: Utilization and Disposition25 2. Activity-Based Method Example n Machine costing $10,000 was purchased on 5/20/20x1 with an estimated residual value of $2,000 and an estimated service hours of 8,000 hours. Depreciation expense per hour = ($10, ,000)/8,000 hours = $1 per hour

27 Operational Assets: Utilization and Disposition26 2. Activity-Based Method Example (contd.) n During 20x1, the machine was used for 1,000 hours, the depreciation expense of 20x1: $1 x 1,000 = $1,000 J. E. 12/31/x1 Depreciation Expense1,000 Accumulated Depreciation1,000

28 Operational Assets: Utilization and Disposition27 For Financial Reporting Purposes 3. Special Methods a. Group Depreciation (Group-Rate Method). b. Composite Depreciation (Composite- Rate Method). c. Retirement and Replacement Methods (used by special Industries--public utilities and railroads).

29 Operational Assets: Utilization and Disposition28 3a.&b. Group and Composite Methods n One depreciation rate is applied to multiple assets (i.e., telephone poles, switch boards, etc). u Group Method: Used when assets have similar economic lives and other attributes. u Composite Method: Used when assets are physically dissimilar (i.e., a group of heterogeneous assets).

30 Operational Assets: Utilization and Disposition29 Group and Composite Methods (contd.) n Both methods apply a single straight-line rate based on the average service lives of the group assets. n Once the group depreciate rate is determined, it usually is used despite the addition or disposition of individual assets in the group.

31 Operational Assets: Utilization and Disposition30 Group and Composite Methods (contd.) n When these methods are applied: 1. No partial year depreciation regardless of when these assets were purchased. 2. No gain or loss can be recognized in disposition of group assets except for the disposition of last piece(s) of assets in the group. 3. Cannot depreciate the remaining assets to below their residual value.

32 Operational Assets: Utilization and Disposition31 Examples (Group Method) n Five machines were purchased on 3/5/x1 at $10,000 each. All machines were expected to last 4 years with a residual value of $2,000 each. Depreciation expense per year = ($50,000-10,000)/4 = $10,000 Group annual depreciation rate = $10,000/$50,000 = 20% (of cost)

33 Operational Assets: Utilization and Disposition32 3a. Group Method Example I n Use the information on page 29 (assuming no early retirement or new purchase within 4 years), the following J.E. would be recorded at the end of year: 12/31/x1 Depr. Exp10,000 Acc. Depr.10,000 12/31/x2 Depr. Exp10,000 Acc. Depr.10,000 12/13/x3 Depr. Exp10,000 Acc. Depr.10,000 12/31/x4 Depr. Exp10,000 Acc. Depr.10,000

34 Operational Assets: Utilization and Disposition33 3a. Group Method Example I (contd.) n Five machines were sold (disposed) on 3/5/x5 for $1,500 each. J.E. (The Retirement of 5 machines) 3/5/x5Cash7,500 Acc. Depr.40,000 Loss on Disposal 2,500 Machine50,000

35 Operational Assets: Utilization and Disposition34 3a. Group Method Example II n Use information on page 29 and assume one machine was sold for $6,000 on 3/10/x3. Two were sold for $5,000 each on 8/9/x4 and the last two were discarded on 9/20/x5. 12/31/x1 (Recording the group depreciation expenses for Year x1) Depreciation Expenses10,000 Accumulated Depreciation10,000 ($50,000 x 20% = $10,000) (Total Cost) x (Group Rate)

36 Operational Assets: Utilization and Disposition35 3a. Group Method Example II (contd.) 12/31/x2 (Group Depreciation Expenses for Year x2) Depreciation Expenses10,000 Accumulated Depreciation10,000 ($50,000 x 20% = $10,000) 3/10/x3 (the disposal of the first machine) Cash 6,000 Accumulated Depreciation4,000 a Machine10,000 a. No gain or loss can be recognized.

37 Operational Assets: Utilization and Disposition36 3a. Group Method Example II (contd.) 12/31/x3 (Group Depreciation Expenses for Year x3) Depreciation Expenses8,000 Accumulated Depreciation8,000 [($50,000 - $10,000) x 20% = $8,000] Cost for the Group rate remaining 4 machines Machine 50,000 10,000 40,000

38 Operational Assets: Utilization and Disposition37 3a. Group Method Example II (contd.) 8/9/x4 (Sold 2 machines for $5,000 each) Cash10,000 Accumulated Depreciation10,000 a Machine20,000 a. No gain or loss can be recognized 12/31/x4 (Depreciation Expenses for Year x4) Depreciation Expenses2,000 b Accumulated Depreciation2,000 [($50,000 - $10, ,000) x 20% = $4,000] Cost for the remaining 2 machines Group rate b. See explanations on page 36.

39 Operational Assets: Utilization and Disposition38 3a. Group Method Example II (contd.) Accumulated Depreciation (Before 12/31/x4) Year x3 …4,00010,000 … Year x1* Year x4…10,00010,000 … Year x2 8,000 … Year x3 14,000 ** * Therefore, book value of the last two machines before depreciation of Year x4 => $20, ,000 = $6,000 ** As a result, maximum depreciation expense allowed for the last 2 machines => (why??) $6,000 - (2,000x2) = $2,000

40 Operational Assets: Utilization and Disposition39 3a. Group Method Example II (contd.) 9/20/x5 (Discard the Last Two Machines) Accumulated Depreciation (Before 12/31/x5) x3...4,00010,000 … x1 x4...10,00010,000 … x2 8,000 … x3 2,000 … x4 16,000 Accumulated Depreciation16,000 Loss on Disposal4,000 Machine20,000

41 Operational Assets: Utilization and Disposition40 3a. Group Method Comments n No gain or loss can be recognized for the disposal of group assets except for the last unit(s). (Example, see example II, Journal Entry for 3/10/x3 and 8/9/x4) n Cannot depreciate group assets to below their residual value. (Example, see journal entry of example II on 12/31/x4)

42 Operational Assets: Utilization and Disposition41 3a. Group Method Comments (contd.) n If a similar asset were purchased and added to the group, a new group depreciation rate may be computed as follows: (Book value of the old in the group + cost of the new asset - estimated residual value of the group) / (weighted average lives of the assets in the group) (see example III)

43 Operational Assets: Utilization and Disposition42 3a. Group Method Example III (calculating new group depr. rate) n Use the example on page 29. Additional information is as follows: One machine was sold on 4/10/x3 for $7,000. A similar new machine was acquired on 8/19/x4 for $12,000 with an expected life of 4 years and $2,000 residual value. Two machines were sold on 9/10/x4 for $5,000 each. The last three machines were sold on 10/5/x5 for $1,000, $2,000 and $1,500, respectively.

44 Operational Assets: Utilization and Disposition43 3a. Group Method Example III (contd.) Journal Entries: 3/5/x1 (Purchasing of 5 machines on 3/5/x1) Machine50,000 Cash50,000 12/31/x1 (Recording Depr. Exp. for Year x1) Depreciation Expense10,000 Accumulated Depreciation10,000 12/31/x2 (Depreciation Expenses of Year x2) Depreciation Expense10,000 Accumulated Depreciation10,000

45 Operational Assets: Utilization and Disposition44 3a. Group Method Example III (contd.) 4/10/x3 Cash 7,000 Accumulated Depreciation3,000 Machine10,000 12/31/x3 Depreciation Expense8,000 Accumulated Depreciation 8,000 8/19/x4 Machine12,000 Cash12,000

46 Operational Assets: Utilization and Disposition45 3a. Group Method Example III (contd.)- New Group Depreciation Rate Depreciation Expense = [($15,000+$12,000) 1 - ($2,000x4+2,000) 2 ]/1.6 years 3 = $10,625 New Group Depreciation Rate = $10,625 / ($40, ,000) 4 = 20.43% 1.Book Value of the remaining 4 machines. 2.Residual value of 4 remaining machines and the new one. 3.The W-A lives of remaining machines and the new one =>[(4-3) x 4 + 4] / 5 = 1.6 (years) 4.Total cost of 4 remaining machines and the new one.

47 Operational Assets: Utilization and Disposition46 3a. Group Method Example III (contd.) Journal Entries: 9/10/x4 Cash10,000 Accumulated Depreciation10,000 Machine20,000 12/31/x4 Depreciation Expense 1 6,538 Accumulated Depreciation6, (62, ,000) x 20.43% = $6,538

48 Operational Assets: Utilization and Disposition47 3a. Group Method Example III (contd.) 10/5/x5 sold the last 3 machines (update the depreciation expenses for Year x5 because the group is not fully depreciated to the residual value of $6,000) Depreciation Expenses4,462 1 Accumulated Depreciation4,462 Cash4,500 Accumulated Depreciation26,000 Loss on Disposal1,500 Machine32, See explanation on next page.

49 Operational Assets: Utilization and Disposition48 3a. Group Method Example III (contd.) Machine 3/x150,00010,000 … 4/x3 8/x412,00020,000 … 9/x3 32,000 Accumulated Depreciation 4/x3…3,00010,000 … 12/x1 9/x4…10,00010,000 … 12/x2 8,000 … 12/x3 6,538 … 12/x4 21,538

50 Operational Assets: Utilization and Disposition49 3a. Group Method Example III (contd.) * Book value of the last 3 machines on 10/5/x5 before the adjusting entry = $32, ,538 = 10,462 Residual Value of the last 3 machines = $2,000 x 3 = $6,000 ==> max. depreciation expenses for Year x5 = 10, ,000 = $4, % x $32,000 = $6,538 > $4,462 ==> Depreciation exp. for Year x5 = $4,462

51 Operational Assets: Utilization and Disposition50 Special Methods b. Composite Method (Apply to a group of dissimilar assets with different expected lives and different salvage value) u Example: (All assets were purchased on 2/1/x1)

52 Operational Assets: Utilization and Disposition51 3b. Composite Method Example (contd.) Composite Rate = $56,000/ $224,000 = 25% Composite Life = $190,000/56,000 = 3.39 (years) 12/31/x1 Depreciation Expense56,000 Accumulated Depreciation56,000

53 Operational Assets: Utilization and Disposition52 3b. Composite Method Comments n Apply to a group of dissimilar assets. No partial year depreciation. n All rules that are applied to the group depreciation method also are applied to the composite depreciation method. n No gain or loss can be recognized when composite assets are retired except for the last piece (pieces) of assets being disposed.

54 Operational Assets: Utilization and Disposition53 3b. Composite Method Comments (contd.) n Cannot depreciate assets remained in the group to below the residual value n If a new asset is purchased, a new composite rate may be calculated.

55 Operational Assets: Utilization and Disposition54 3b. Composite Method Retirement of Composite Assets (Similar accounting treatment as for the retirement of group assets -- no gain or loss can be recognized except for the disposal of the last asset(s) in the group). u i.e., Trunk 101 was sold on 3/8/x2 for $1,000. The cost for truck 101 is $8,000.

56 Operational Assets: Utilization and Disposition55 Retirement of Composite Assets (contd.) 3/8/x2Cash1,000 Accumulated Depr.7,000 Truck8,000 At the end of the year, the composite rate 25% would be applied to: ($224, ,000) = $216,000 $216,000 x 25% = $54,000 12/31/x2 Depreciation Exp.54,000 Accumulated Depr.54,000

57 Operational Assets: Utilization and Disposition56 Special Methods c. Retirement and Replacement Methods n Used by public utilities and railroad companies which own many similar units of small value (i.e. poles, conductors, telephones,…). u Retirement Method: Charge the cost of the retired assets (less salvage) to depreciation expense. u Replacement Method: Charge the cost of newly purchased assets (less the salvage value of the replaced assets) to depreciation expense.

58 Operational Assets: Utilization and Disposition57 3c. Retirement and Replacement Methods Example In 20x2, Greenway Co. purchased small tools costing $10,000. In 20x3, tools originally costing $3,000 were sold for $100 and replaced with new tools costing $4,000. Determine the depreciation expense for the small tools for the year of 20x3. Under the retirement method: $2,900 Uner the replacement method:$3,900

59 Operational Assets: Utilization and Disposition58 3c. Retirement and Replacement Methods Example (cont.) J ournal entries (under the retirement method) 20x2 Small Tools 10,000 Cash 10,000 to record the acquisition of small tools 20x3 Small Tools 4,000 Cash 4,000 to record the additional small tool acquisition

60 Operational Assets: Utilization and Disposition59 3c. Retirement and Replacement Methods Example (cont.) Journal entries (retirement method cont.) 20x3 Cash 100 Depreciation expense 2,900 Small tools 3,000 to record sale/depre. of small tools

61 Operational Assets: Utilization and Disposition60 3c. Retirement and Replacement Methods Example (cont.) J ournal entries (under the replacement method) 20x2 Small Tools 10,000 Cash 10,000 to record the acquisition of small tools 20x3 Small Tools 4,000 Cash 4,000 to record the additional small tool acquisition

62 Operational Assets: Utilization and Disposition61 3c. Retirement and Replacement Methods Example (cont.) Journal entries (replacement method cont.) 20x3 Cash 100 Depreciation expense 3,900 Small tools 4,000 to record sale/depre. of small tools

63 Operational Assets: Utilization and Disposition62 3c. Retirement and Replacement Methods Comments 1.No depreciation expense recognized until assets are retired or replaced. 2.For railroad companies, these methods are rarely used after 1983 due to ICC required railroads to switch to traditional depreciation accounting (i.e., S-L method, SYD…).

64 Operational Assets: Utilization and Disposition63 Disclosure of Depreciation (APB No. 12) 1. Depreciation expense for the period. 2. Balances of major classes of depreciable assets at the balance sheet date. 3. Accumulated depreciation, either by major classes of depreciable assets or in total, at the balance sheet date. 4. A general description of the method or methods used with respect to major classes of depreciable assets.

65 Operational Assets: Utilization and Disposition64 The Use of Alternative Depreciation Methods -- Statistics from a Survey of 600 Companies Source: Accounting Trends and Techniques 1 1.There are more than 600 responses because many companies use more than one method of depreciation. Method Straight Line Declining balance Sum of the years’ digits An Accelerated method (not specified) Units of production Group/composite19

66 Operational Assets: Utilization and Disposition65 Miscellaneous Points Related To Depreciation n Group method is applied to a group of homogeneous assets with similar lives and attributes (may or may not have the same residual value). n Composite method is used when assets are physically dissimilar but are aggregated for convenience. n Hybrid of combination methods: GAAP allows any systematic and rational way to allocate costs. Steel industry uses a combination of straight-line and activity based method (a production variable method).

67 Operational Assets: Utilization and Disposition66 Miscellaneous Points Related To Depreciation (contd.) n Selection of a depreciation method is based on the goal of the company. n There is no cash flow involved in the deprecation. n The depreciation method change should not have an impact on stock price based on the efficient market hypothesis. n This is supported by some research (Kaplan & Roll, 1972). n Partial year depreciation is computed on the basis of the nearest full month.

68 Operational Assets: Utilization and Disposition67 For Income Tax Reporting Purposes B. Income Tax Depreciation n Tax Depreciation in different periods: 1.GAAP depreciation methods (i.e., S-L, SYD or DDB): Apply to assets acquired before 1981; cannot be depreciated to below the residual value. IRS published tables with estimated lives for depreciable assets. 2.ACRS: Accelerated Cost Recovery System applies to assets purchased between Modified ACRS: MACRS applies to assets purchased in 1987 or later.

69 Operational Assets: Utilization and Disposition68 Tax Depreciation ACRS & MACRS vs. GAAP n ACRS and MACRS differ with GAAP depreciation in the following aspects: a.a mandated tax life, which is generally shorter than the economic life; b.cost recovery on an accelerated basis; c.an assigned salvage value of zero (i.e., salvage = $0); d. Assume assets acquired in the mid- year.

70 Operational Assets: Utilization and Disposition69 Tax Depreciation 2. ACRS (Skip) n Classify depreciable assets into five classes (i.e., 3, 5,10, 15 and 18 year classes). n Have a tax rate table for each class. n Examples of classes: 3-year class: cars, light-duty trucks, equipment.. 5-year class: office furniture, heavy duty truck.. 10-year class: depreciable real estate.. 15-year class: 18-year class: buildings.

71 Operational Assets: Utilization and Disposition70 2. ACRS (contd.) (Skip) Rate Table for ACRS: 3-year 5-year 10-year 15-year 25%15%18%5% 38%22%14%10% 37%21%12%9% 21%10%8% 21%10% 9%

72 Operational Assets: Utilization and Disposition71 Tax Depreciation 3. MACRS n MACRS was enacted by Congress in the Tax Reform Act of Assets are classified in 8 property classes instead of 5 classes as in ACRS. In addition, a specified GAAP depreciation method is used in computing the depreciation expense for all classes.

73 Operational Assets: Utilization and Disposition72 MACRS Depreciation Methods MACRS Depreciation Method Property Class u Double-Declining Balance3,5,7 or 10-year property u 150% Declining Balance15 or 20-year property u Straight-Line27.5 or 39 year property

74 Operational Assets: Utilization and Disposition73 MACRS Property Classes 3-year property: small tools, horses, assets used in R&D activities. 5-year property: automobiles, trucks, computers, peripheral equipment, office machines. 7-year property: office furniture,equipment. 10-year property: railroad tank cars, mobile homes.

75 Operational Assets: Utilization and Disposition74 MACRS Property Classes (contd.) 15-year property: roads, shrubbery, low- income housing, sewage treatment plants. 20-year property: certain real estate year property: residential rental property. 39-year property: nonresidential real property.

76 Operational Assets: Utilization and Disposition75 Principles Applied to MACRS 1.No residual value assigned (100% depreciation for tax purposes). All proceeds from the disposal of a fully depreciated asset are fully taxable. 2.Assume acquired in the mid-year (half-year convention). 3.When applying 150% declining balance(DB) method or DDB method, the depreciation method should be switched to S-L method if S-L method results in a higher depreciation expense than that of the DB method.

77 Operational Assets: Utilization and Disposition76 MACRS Example F Cost= $200,000 (purchased on 10/2/x1). F Expected life= 8 years. F Salvage= $40,000. F GAAP depr. method= Straight-Line. F MACRS life = 5 years. F MACRS method= Double-Declining Balance Method. F Disposal proceeds – 1/2/x9 = $22,000

78 Operational Assets: Utilization and Disposition77 MACRS Example (contd.) YearDepr. Exp Dep.%BookV x1$200,000  40%  0.5=40,00020%160,000 x2160,000  40%=64,00032%96,000 x396,000  40%=38, %57,600 x457,600  40%=23, %34,560 x534,560/ =23, %11,520 x611, %0 1.DDB depr for year x5 is 34,560  40% = 13,824. The S-L method results in a higher depr. exp. (i.e., $23,040) than that of DDB in year x5. Thus, the depr. Method should be switched to the S-L method in x5.

79 Operational Assets: Utilization and Disposition78 GAAP Depreciation and Gain/Loss at Disposal  Annual GAAP depreciation = ($200,000-40,000)/8 =$20,000  Accumulated GAAP depre. over 8 years = $20,000x8= $160,000  Disposal loss for finanical reporting = $22, ,000 = -18,000  Disposal gain for tax filing= $22,000 – 0 =22,000

80 Operational Assets: Utilization and Disposition79 Gain/Loss at Disposal (contd.)  Total expense recognized for tax filing = accumulated tax depreciation – disposal gain = $200, ,000= $178,000  Total GAAP expense = accumulated GAAP depreciation + disposal loss = $160,000+18,000=178,000  Even though the net effects on income (i.e., $178,000 total expense) are the same, MACRS enables companies to defer income tax payments to later years.

81 Operational Assets: Utilization and Disposition80 Table 11A-3 MACRS DEPR. RATES BY CLASS OF PROPERTY. Re- covery 3-year 5-year 7-year 10-year 15-year 20-year Year (200% DB) (200% DB) (200% DB) (200% DB) (150% DB) (150% DB) * * * ……… *5.90* * * Switchover to straight-line depreciation. 80

82 Operational Assets: Utilization and Disposition81 Table 11A-3 (contd.) Re- covery 3-year 5-year 7-year 10-year 15-year 20-year Year (200% DB) (200% DB) (200% DB) (200% DB) (150% DB) (150% DB) ………………………………

83 Operational Assets: Utilization and Disposition82 Tax Versus GAAP Depreciation  Purpose of tax depreciation: to raise revenue.  Purpose of GAAP depreciation: for financial reporting to fairly reflect the performance of a company.  With difference purposes, tax depreciation is different from GAAP depreciation.

84 Operational Assets: Utilization and Disposition83 C. Asset Impairments a n Unlike inventory which is reported at LCM, PPE and Intangibles are reported at cost except for impairments. n An impairment occurs when the book value of an asset is not fully recoverable. a. Based on SFAS No. 144: Accounting for the Impairment or Disposal of Long-Lived Assets and SFAS No. 142: Goodwill and Other Intangible Assets

85 Operational Assets: Utilization and Disposition84 C. Asset Impairments (all intangibles related impairments (i.e., C1b and C1c) should be deferred until chapter 12 is discussed) n C.1: Operational Assets Held for Use a. Tangible assets and intangible assets with finite life (i.e., patens, copyrights). b. Intangible assets with indefinite life other than goodwill (i.e., trade names). c. Goodwill n C.2: Operational Assets Held for Sale n C.3: Operational Assets Held to be Disposed of other than by Sale

86 Operational Assets: Utilization and Disposition85 C.1a Operational Assets Held for Use – Tangible Assets and Finite-Life Intangibles (Patents, etc) n SFAS No. 144 (effective 2002) requires test for impairment only when events or changes in circumstances indicate that the book value of this asset (or asset group) may not be recoverable. n For the purpose of this test, assets are grouped at the lowest level in which the cash flows of each group are independent.

87 Operational Assets: Utilization and Disposition86 Events or Changes in Circumstances Which May Lead to an Impairment The following are examples of such events or changes in circumstances: 1. A significant decrease in the market price of the asset (asset group). 2. A significant adverse change in how the asset is being used or in its physical condition. 3. A significant adverse change in legal factors or in the business climate that affects the value of the asset.

88 Operational Assets: Utilization and Disposition87 Events or Changes in Circumstances Which May Lead to an Impairment (Cont.) 4. An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of an asset. 5. A current-period loss combined with a history of losses or a projection of continuing losses associated with an asset. 6. A realization that the asset will be disposed of significantly before the end of its estimated life. (not in SFAS 121)

89 Operational Assets: Utilization and Disposition88 The Accounting Treatment for Impairment (for Held for Use Tangible and finite-Life Intangibles) Steps: 1. Conduct the Recoverability Test. 2. Compute the Impaired Amount.

90 Operational Assets: Utilization and Disposition89 Step 1: Conduct the Recoverability Test n Compare the book value (BV) of the asset with the undiscounted expected future cash flows (EFCF) of the asset (asset group). If BV > Undiscounted EFCF, the impairment has occurred and the impaired amount should be written off.

91 Operational Assets: Utilization and Disposition90 Step 2: Compute The Impaired Amount n Impaired amount = Book value - fair value (if the fair value is available) or n Impaired amount = Book value – estimated fair value 1 (if fair value is not available) 1. discounted present value of the future cash flows of the asset can be the estimated fair value

92 Operational Assets: Utilization and Disposition91 Write Off the Impaired Amount n Recognition of Impairment Loss: Loss on Impairment 1 $$$$$ Accumulated Depre.$$$$$ 1. Reported as part of income from continuing operations, not extraordinary losses.

93 Operational Assets: Utilization and Disposition92 Impairment (contd.) n After the write off, the fair value (or the estimated fair value if fair value is not available) becomes the new cost base for depreciation. n No restoration of impaired loss is allowed for tangibles and finite-life intangibles assets held for use.

94 Operational Assets: Utilization and Disposition93 iGAAP –Assets Impairments n iGAAP, as in US GAAP, allows reporting impairments on PPE. n iGAAP, as in GAAP, use fair value test to measure the impairments. n In determining the impairment loss, iGAAP compares the book value with the fair value (thus, iGAAP is more strict than US GAAP in this test).

95 Operational Assets: Utilization and Disposition94 iGAAP – PPE Valuation and Impairment (contd.) n iGAAP, unlike GAAP, permits write-ups for subsequent recoveries of impairment losses back to the amount before the impairments (i.e., the reversals of impairment losses).

96 Operational Assets: Utilization and Disposition95 Impairment (contd.) n Disclosure Requirements of impairment loss: 1. A description of the impaired asset or asset group. 2. The facts and circumstances leading to the impairment. 3.The amount of the loss. 4.The method used to determined the fair value.

97 Operational Assets: Utilization and Disposition96 C.1.b. Intangibles with indefinite life Other than Goodwill – (Held-for-Use) n For indefinite life intangibles (i.e., trade names) held for use, impairment test should be conducted at least annually or more often if events or changes in circumstances indicate an impairment. n Test of Impairment: one-step test => n Compare book value with the fair value.

98 Operational Assets: Utilization and Disposition97 C.1.b. (contd.) n If book value > fair value, impairment loss exits and should be recognized. n The fair value becomes the new cost base. n A recovery of the impairment loss is prohibited. n Disclosure requirements are similar to those of tangible and finite-life intangibles.

99 Operational Assets: Utilization and Disposition98 C.1.c. Impairment for Goodwill (SFAS 142) n The cost of goodwill cannot be directly associated with any specific identifiable right. n Also, goodwill cannot be separated from the company (or a reporting unit) a as a whole. a. An operating segment of a company or a component of an operating segment for which discrete financial information is available and segment management regularly review the operating results of that component.

100 Operational Assets: Utilization and Disposition99 C.1.c. Impairment for Goodwill (cont.) n Step 1: The impairment test for goodwill is to compare the book value of a reporting unit for goodwill unit with the fair value of this reporting unit. n Reasons: 1)the value of goodwill is not associated with any specific cash flows of any specific asset; 2) goodwill is not separable from a particular reporting unit

101 Operational Assets: Utilization and Disposition100 Impairment for Goodwill (cont.) n If book value exceeds the fair value for the reporting unit of the goodwill, an impairment loss exists. n The impairment test should be conducted at least annually or more often if impairment indicated.

102 Operational Assets: Utilization and Disposition101 Impairment for Goodwill (cont.) n If goodwill is tested for impairment at the same time as other assets of the reported unit, the other assets must be tested first and adjusted for impairment (if any) prior to testing goodwill.

103 Operational Assets: Utilization and Disposition102 Impairment for Goodwill (cont.) n Step 2: If goodwill impairment exits, the goodwill impairment loss equals: n Book value of goodwill – implied fair value of goodwill a a The implied fair value of goodwill is calculated in the same way that goodwill is determined in a business combination.

104 Operational Assets: Utilization and Disposition103 Impairment for Goodwill (cont.) n Example of calculating implied goodwill of a reporting unit: Determination of Implied goodwill: Fair value of the reporting unit $400 million Fair value of the reporting unit's $330 million net assets (excluding goodwill ) Implied value of goodwill $ 70 million

105 Operational Assets: Utilization and Disposition104 Impairment for Goodwill (cont.) Determination of impairment loss: Book value of goodwill $320 million Implied fair value of goodwill 70 million Impairment loss 250 million

106 Operational Assets: Utilization and Disposition105 C.2 Impairment for Operational Assets to be Sold (SFAS 144) n If the impaired asset is to be disposed of a by sale, the following principles apply: n 1. An impairment test needs to be conducted when an asset is considered as held for sale. 2. A one-step test: impairment exists when book value exceeds fair vale. a. Assets which managers have actively committed to sell immediately in their present condition and for which sale is probable, including assets held for sale of discontinued operations.

107 Operational Assets: Utilization and Disposition106 Impairment for Operational Assets to be Sold (cont.) 3. The impaired amount = book value - (fair value - disposal cost) a,b. 4. No depreciation after the write-down. a. Fair value – disposal cost = the net realizable value b. if the asset is unsold in the subsequent period, the restoration of the impairment loss is allowed when the fair value rebounded in the subsequent period.

108 Operational Assets: Utilization and Disposition107 C.3 Impairment for Operational Assets to Be Disposed Other Than by Sale n Examples of this type of assets: assets to be abandoned, exchanged for a similar assets or distributed to owners in a spin-off. n SFAS 144 requires these assets to be treated as assets held for use until they are disposed of.

109 Operational Assets: Utilization and Disposition108 Summary of Asset Impairment: Assets Held for Use Asset TypeWhen to TestImpair. Test To be used: Tangible and Intangible (finite life)) Events indicate BV not recoverable Two-Step: 1. BV > EFCF 2. BV - FV Intangible (inde finite, excluding goodwill) Goodwill Annually or more often One-Step : BV – FV 1.BV (reporting unit) > FV 2. BV of goodwill – implied FV

110 Operational Assets: Utilization and Disposition109 Summary of Asset Impairment: Assets Held to Be Disposed of Asset TypeWhen to TestImpair. Test To be sold (including assets of discontinued operations) To be disposed of other than sale When considered held for sale Considered as held for use until disposal One-Step: BV > (FV-disposal cost) No depreciation after write-down Depre. Life needs to be revised based on APB 20

111 Operational Assets: Utilization and Disposition110 The Impact of SFAS 144 on the Disposal Loss of Discontinued operations n SFAS 144 applied to assets for both continuing and discontinued operations (Par. 41). n Therefore, the assets held for sale of the discontinued operations are also reported at the lower of book value or the (fair value - cost to sell), not at the net realizable value as prescribed in APB 30.

112 Operational Assets: Utilization and Disposition111 The Impact of SFAS 144 on the Disposal Loss of Discontinued operations (contd.) n Also, the future operating losses of the discontinued operations are no longer recognized before they occur under SFAS 144.

113 Operational Assets: Utilization and Disposition112 The Impact of SFAS 144 on the Disposal Loss of Discontinued operations (cont.) n The impairment loss (disposal loss) of the assets held for sale under the discontinued operations is reported as a component of the discontinued operations. n See Chapter 4 notes for detailed discussion of the reporting of the operating results and disposal results for discontinued operations.

114 Operational Assets: Utilization and Disposition113 Impairment Losses and Earnings quality n Similar to the write-down of inventory and restructuring costs, impairment losses can have significant adverse impact on the current year's income number. n When fair value needs to be estimated, the estimation of fair value requires the forecast of future cash flows generated by the asset.

115 Operational Assets: Utilization and Disposition114 Impairment Losses and Earnings quality (contd.) n Companies can understate future cash flows to understate the fair value and overstate the write-down amount. n By writing down large amounts of operational assets, companies are able to increase future earnings by lowering future depreciation, depletion or amortization.


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