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Operational Assets: Utilization and Disposition

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1 Operational Assets: Utilization and Disposition

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. Operational Assets: Utilization and Disposition

3 A. Depreciation (For Financial Reporting Purposes)
4/11/2017 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 Unit-of-Production. 3. Special methods a. Group Depreciation. b. Composite Depreciation. c. Retirement and Replacement Methods. Operational Assets: Utilization and Disposition

4 Operational Assets: Utilization and Disposition
4/11/2017 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. Operational Assets: Utilization and Disposition

5 For Financial Reporting Purposes 1. Time-Based Methods
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). Operational Assets: Utilization and Disposition

6 A.1a. Straight-Line Method
Cost is allocated evenly through the life of the P.P.E. 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 Expenses 2,000 Accumulated Depreciation 2,000 Operational Assets: Utilization and Disposition

7 1a. Straight-Line Method (Partial Year Depreciation)
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 Operational Assets: Utilization and Disposition

8 1a. Straight-Line Method Example 2 (contd.)
(Book value = Cost - Acc. Depr) 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 Operational Assets: Utilization and Disposition

9 1b. Sum-of-the-Years’-Digits (SYD)
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. Base Fraction Expense at the end x1 $8,000 4/10 $3,200 6,800 x2 $8,000 3/10 $2,400 4,400 x3 $8,000 2/10 $1,600 2,800 x4 $8,000 1/10 $800 2,000 * Depr. Base= Cost - Residual Value ** Book Value= Cost - Acc. Depreciation Operational Assets: Utilization and Disposition

10 Operational Assets: Utilization and Disposition
1b. S-Y-D (contd.) 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 Operational Assets: Utilization and Disposition

11 1b. S-Y-D Example 2 (contd.)
Annual Depr. By S-Y-D Depr. Year Method Months Computation Exp 1 x1 $3, /12x3200= $2,667 2 x2 $2, /12x3200+ 10/12x2400= $2,533 3 x3 $1, /12x2400+ 10/12x1600= $1,733 4 x4 $ /12x1600+ 10/12x800= $934 5 x /12x800= $133 Operational Assets: Utilization and Disposition

12 1c. Declining-Balance Method
Depreciation Exp.= constant rate  book value at the beginning of the period Residual value is not considered in the computation. Assets cannot be depreciated below the residual value. The constant rate is expressed as a function of a straight-line annual depreciation rate. Operational Assets: Utilization and Disposition

13 1c. Declining-Balance Method (contd.)
Example of constant rate: Double % Life S-L Declining- Declining- of Depr. Balance Balance Asset Rate Depr. Rate Depr. Rate 4yrs 25% 50% 37.5% 5yrs 20% 40% 30% 10yrs 10% 20% 15% Operational Assets: Utilization and Disposition

14 1. Time-Based Methods Double Declining-Balance Method
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%). Operational Assets: Utilization and Disposition

15 Double Declining-Balance Method Example 1 (contd.)
Book Value of Asset at Beg. of Constant Depr. Book Value Year the Year Rate Exp. At the End x1 $10,000 50% $5,000 $5,000 x2 $5,000 50% 2,500 2,500 x3 $2,500 50% 500* 2,000* x4 2,000 50% 0 2,000 *Assets cannot be depreciated below the residual value. Operational Assets: Utilization and Disposition

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

17 Double Declining-Balance Method Example 2 (contd.) - Alternative I
Annual Depr. Using the Recognized D-D-B Months Computations Depr. Exp. 1 x1 $5, /12x5000= $4,167 2 x2 $2, /12x5000+ 10/12x2500= $2,916 3 x3 $ /12x2500+ 10/12x500= $834 4 x /12x500= $83 5 x Operational Assets: Utilization and Disposition

18 Double Declining-Balance Method Example 2 (contd.) - Alternative II
Book Book Value Value Year at Beg. Rate Depr. Exp At the End x1 $10,000 50% 10/12x(10,000 $5,833 x50%)= 4,167 x2 $5,833 50% 12/12x(5,833 2,916 x50%)= 2,917 x3 $2,916 50% 916 2,0001 x4 $2,000 50% 0 2,000 1.Assets cannot be depreciated below the residual value. Operational Assets: Utilization and Disposition

19 1. Time-Based Methods A Comparison of Depreciation Methods
4/11/2017 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 Operational Assets: Utilization and Disposition

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

21 1. Time-Based Methods Changes In Depreciation Estimate
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. Operational Assets: Utilization and Disposition

22 Example: (S-L Depr. Method)
Machine costing $10,000 acquired on 1/1/x1. Estimates Estimates on 1/1/x1 on 1/1/x3 Residual value $2,000 $1,000 Life 4 years 5 years Operational Assets: Utilization and Disposition

23 Operational Assets: Utilization and Disposition
Example: (Contd.) Year Depr. Exp Acc. Depr Book Value x1 $2,0001 2,000 8,000 x2 $2,0002 4,000 6,000 x3 $1,667 5, ,333.3 x4 $1,667 7, ,666.6 x5 $1,667 9, ,000 1. (10,000-2,000)/4 = $2,000 2. (6,000-1,000)/(5-2) =1666.7 Operational Assets: Utilization and Disposition

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

25 2. Activity-Based Method Example
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 Operational Assets: Utilization and Disposition

26 2. Activity-Based Method Example (contd.)
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 Expense 1,000 Accumulated Depreciation 1,000 Operational Assets: Utilization and Disposition

27 For Financial Reporting Purposes 3. Special Methods
4/11/2017 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). Operational Assets: Utilization and Disposition

28 3a.&b. Group and Composite Methods
One depreciation rate is applied to multiple assets (i.e., telephone poles, switch boards, etc). Group Method: Used when assets have similar economic lives and other attributes. Composite Method: Used when assets are physically dissimilar (i.e., a group of heterogeneous assets). Operational Assets: Utilization and Disposition

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

30 Group and Composite Methods (contd.)
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. Operational Assets: Utilization and Disposition

31 Examples (Group Method)
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) Operational Assets: Utilization and Disposition

32 3a. Group Method Example I
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. Exp 10,000 Acc. Depr. 10,000 12/31/x2 Depr. Exp 10,000 12/13/x3 Depr. Exp 10,000 12/31/x4 Depr. Exp 10,000 Operational Assets: Utilization and Disposition

33 3a. Group Method Example I (contd.)
Five machines were sold (disposed) on 3/5/x5 for $1,500 each. J.E. (The Retirement of 5 machines) 3/5/x5 Cash 7,500 Acc. Depr. 40,000 Loss on Disposal 2,500 Machine 50,000 Operational Assets: Utilization and Disposition

34 3a. Group Method Example II
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 Expenses 10,000 Accumulated Depreciation 10,000 ($50, x % = $10,000) (Total Cost) x (Group Rate) Operational Assets: Utilization and Disposition

35 3a. Group Method Example II (contd.)
12/31/x2 (Group Depreciation Expenses for Year x2) Depreciation Expenses 10,000 Accumulated Depreciation 10,000 ($50,000 x 20% = $10,000) 3/10/x3 (the disposal of the first machine) Cash 6,000 Accumulated Depreciation 4,000a Machine 10,000 a. No gain or loss can be recognized. Operational Assets: Utilization and Disposition

36 3a. Group Method Example II (contd.)
12/31/x3 (Group Depreciation Expenses for Year x3) Depreciation Expenses 8,000 Accumulated Depreciation 8,000 [($50,000 - $10,000) x 20% = $8,000] Cost for the Group rate remaining 4 machines Machine 50, ,000 40,000 Operational Assets: Utilization and Disposition

37 3a. Group Method Example II (contd.)
8/9/x4 (Sold 2 machines for $5,000 each) Cash 10,000 Accumulated Depreciation 10,000a Machine 20,000 a. No gain or loss can be recognized 12/31/x4 (Depreciation Expenses for Year x4) Depreciation Expenses 2,000b Accumulated Depreciation 2,000 [($50,000 - $10, ,000) x 20% = $4,000] Cost for the remaining 2 machines Group rate b. See explanations on page 36. Operational Assets: Utilization and Disposition

38 3a. Group Method Example II (contd.)
Accumulated Depreciation (Before 12/31/x4) Year x3 …4,000 10,000 … Year x1* Year x4…10,000 10,000 … Year x2 8,000 … Year x3 14, ** * 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 Operational Assets: Utilization and Disposition

39 3a. Group Method Example II (contd.)
9/20/x5 (Discard the Last Two Machines) Accumulated Depreciation (Before 12/31/x5) x ,000 10,000 … x1 x ,000 10,000 … x2 8,000 … x3 2,000 … x4 16,000 Accumulated Depreciation 16,000 Loss on Disposal 4,000 Machine 20,000 Operational Assets: Utilization and Disposition

40 3a. Group Method Comments
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) Cannot depreciate group assets to below their residual value. (Example, see journal entry of example II on 12/31/x4) Operational Assets: Utilization and Disposition

41 3a. Group Method Comments (contd.)
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) Operational Assets: Utilization and Disposition

42 3a. Group Method Example III (calculating new group depr. rate)
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. Operational Assets: Utilization and Disposition

43 3a. Group Method Example III (contd.)
Journal Entries: 3/5/x1 (Purchasing of 5 machines on 3/5/x1) Machine 50,000 Cash 50,000 12/31/x1 (Recording Depr. Exp. for Year x1) Depreciation Expense 10,000 Accumulated Depreciation 10,000 12/31/x2 (Depreciation Expenses of Year x2) Operational Assets: Utilization and Disposition

44 3a. Group Method Example III (contd.)
Cash 7,000 Accumulated Depreciation 3,000 Machine 10,000 12/31/x3 Depreciation Expense 8,000 Accumulated Depreciation 8,000 8/19/x4 Machine 12,000 Cash 12,000 Operational Assets: Utilization and Disposition

45 3a. Group Method Example III (contd.)-New Group Depreciation Rate
Depreciation Expense = [($15,000+$12,000)1 - ($2,000x4+2,000)2]/1.6 years3 = $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. Operational Assets: Utilization and Disposition

46 3a. Group Method Example III (contd.)
Journal Entries: 9/10/x4 Cash 10,000 Accumulated Depreciation 10,000 Machine 20,000 12/31/x4 Depreciation Expense1 6,538 Accumulated Depreciation 6,538 1. (62, ,000) x 20.43% = $6,538 Operational Assets: Utilization and Disposition

47 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 Expenses 4,4621 Accumulated Depreciation 4,462 Cash 4,500 Accumulated Depreciation 26,000 Loss on Disposal 1,500 Machine 32,000 1. See explanation on next page. Operational Assets: Utilization and Disposition

48 3a. Group Method Example III (contd.)
Machine 3/x1 50, ,000 … 4/x3 8/x4 12, ,000 … 9/x3 32,000 Accumulated Depreciation 4/x3… 3, ,000 … 12/x1 9/x4 …10, ,000 … 12/x2 8,000 … 12/x3 6,538 … 12/x4 21,538 Operational Assets: Utilization and Disposition

49 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 = $4,462 20.43% x $32,000 = $6,538 > $4,462 ==> Depreciation exp. for Year x5 = $4,462 Operational Assets: Utilization and Disposition

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

51 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 Expense 56,000 Accumulated Depreciation 56,000 Operational Assets: Utilization and Disposition

52 3b. Composite Method Comments
Apply to a group of dissimilar assets. No partial year depreciation. All rules that are applied to the group depreciation method also are applied to the composite depreciation method. No gain or loss can be recognized when composite assets are retired except for the last piece (pieces) of assets being disposed. Operational Assets: Utilization and Disposition

53 3b. Composite Method Comments (contd.)
Cannot depreciate assets remained in the group to below the residual value If a new asset is purchased, a new composite rate may be calculated. Operational Assets: Utilization and Disposition

54 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). i.e., Trunk 101 was sold on 3/8/x2 for $1,000. The cost for truck 101 is $8,000. Operational Assets: Utilization and Disposition

55 Retirement of Composite Assets (contd.)
3/8/x2 Cash 1,000 Accumulated Depr. 7,000 Truck 8,000 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 Operational Assets: Utilization and Disposition

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

57 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 Operational Assets: Utilization and Disposition

58 3c. Retirement and Replacement Methods Example (cont.)
Journal entries (under the retirement method) 20x2 Small Tools , Cash , to record the acquisition of small tools 20x3 Small Tools , Cash , to record the additional small tool acquisition Operational Assets: Utilization and Disposition

59 3c. Retirement and Replacement Methods Example (cont.)
Journal entries (retirement method cont.) 20x3 Cash Depreciation expense , Small tools , to record sale/depre. of small tools Operational Assets: Utilization and Disposition

60 3c. Retirement and Replacement Methods Example (cont.)
Journal entries (under the replacement method) 20x2 Small Tools , Cash , to record the acquisition of small tools 20x3 Small Tools , Cash , to record the additional small tool acquisition Operational Assets: Utilization and Disposition

61 3c. Retirement and Replacement Methods Example (cont.)
Journal entries (replacement method cont.) 20x3 Cash Depreciation expense , Small tools , to record sale/depre. of small tools Operational Assets: Utilization and Disposition

62 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…). Operational Assets: Utilization and Disposition

63 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. Operational Assets: Utilization and Disposition

64 Operational Assets: Utilization and Disposition
The Use of Alternative Depreciation Methods -- Statistics from a Survey of 600 Companies Source: Accounting Trends and Techniques1 1.There are more than 600 responses because many companies use more than one method of depreciation. Method 2010 2007 2001 1998 1991 1990 Straight Line 488 592 576 578 558 560 Declining balance 10 16 22 26 28 38 Sum of the years’ digits 3 5 7 8 11 An Accelerated method (not specified) 17 27 53 50 70 69 Units of production 23 34 39 Group/composite 1 9 Operational Assets: Utilization and Disposition

65 Miscellaneous Points Related To Depreciation
Group method is applied to a group of homogeneous assets with similar lives and attributes (may or may not have the same residual value). Composite method is used when assets are physically dissimilar but are aggregated for convenience. 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). Operational Assets: Utilization and Disposition

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

67 For Income Tax Reporting Purposes B. Income Tax Depreciation
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 3.Modified ACRS: MACRS applies to assets purchased in 1987 or later. Operational Assets: Utilization and Disposition

68 Tax Depreciation ACRS & MACRS vs. GAAP
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. Operational Assets: Utilization and Disposition

69 Tax Depreciation 2. ACRS (Skip)
Classify depreciable assets into five classes (i.e., 3, 5 ,10, 15 and 18 year classes). Have a tax rate table for each class. 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. Operational Assets: Utilization and Disposition

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

71 Tax Depreciation 3. MACRS
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. Operational Assets: Utilization and Disposition

72 MACRS Depreciation Methods
Depreciation Method Property Class Double-Declining Balance 3,5,7 or 10-year property 150% Declining Balance 15 or 20-year property Straight-Line 27.5 or 39 year property Operational Assets: Utilization and Disposition

73 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. Operational Assets: Utilization and Disposition

74 MACRS Property Classes (contd.)
15-year property: roads, shrubbery, low-income housing, sewage treatment plants. 20-year property: certain real estate. 27.5 -year property: residential rental property. 39-year property: nonresidential real property. Operational Assets: Utilization and Disposition

75 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. Operational Assets: Utilization and Disposition

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

77 Operational Assets: Utilization and Disposition
MACRS Example (contd.) Year Depr. Exp Dep.% BookV x1 $200,00040%0.5 = 40,000 20% 160,000 x2 160,000  40% = 64,000 32% 96,000 x3 96,000  40% = 38, % 57,600 x4 57,600  40% = 23, % 34,560 x5 34,560/ 1.51 = 23, % 11,520 x6 11, % 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. Operational Assets: Utilization and Disposition

78 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 Operational Assets: Utilization and Disposition

79 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. Operational Assets: Utilization and Disposition

80 Table 11A-3 Re- covery 3-year 5-year 7-year 10-year 15-year 20-year
MACRS DEPR. RATES BY CLASS OF PROPERTY . Re- covery 3-year year year year year year Year (200% DB) (200% DB) (200% DB) (200% DB) (150% DB) (150% DB) * * * 6 ……… * 5.90* 4.888 * * Switchover to straight-line depreciation. Operational Assets: Utilization and Disposition 80

81 Operational Assets: Utilization and Disposition
Table 11A-3 (contd.) Re- covery 3-year year year year year year Year (200% DB) (200% DB) (200% DB) (200% DB) (150% DB) (150% DB) 11 ……………………………… Operational Assets: Utilization and Disposition 81

82 Tax Versus GAAP Depreciation
4/11/2017 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. Operational Assets: Utilization and Disposition

83 Operational Assets: Utilization and Disposition
4/11/2017 C. Asset Impairmentsa Unlike inventory which is reported at LCM, PPE and Intangibles are reported at cost except for impairments. 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 Operational Assets: Utilization and Disposition

84 Operational Assets: Utilization and Disposition
4/11/2017 C. Asset Impairments (all intangibles related impairments (i.e., C1b and C1c) should be deferred until chapter 12 is discussed) C.1: Operational Assets Held for Use Tangible assets and intangible assets with finite life (i.e., patens, copyrights). Intangible assets with indefinite life other than goodwill (i.e., trade names). Goodwill C.2: Operational Assets Held for Sale C.3: Operational Assets Held to be Disposed of other than by Sale Operational Assets: Utilization and Disposition

85 Operational Assets: Utilization and Disposition
4/11/2017 C.1a Operational Assets Held for Use – Tangible Assets and Finite-Life Intangibles (Patents, etc) 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. For the purpose of this test, assets are grouped at the lowest level in which the cash flows of each group are independent. Operational Assets: Utilization and Disposition

86 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. Operational Assets: Utilization and Disposition

87 Operational Assets: Utilization and Disposition
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) Operational Assets: Utilization and Disposition

88 Operational Assets: Utilization and Disposition
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. Operational Assets: Utilization and Disposition

89 Step 1: Conduct the Recoverability Test
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. Operational Assets: Utilization and Disposition

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

91 Write Off the Impaired Amount
Recognition of Impairment Loss: Loss on Impairment1 $$$$$ Accumulated Depre. $$$$$ 1. Reported as part of income from continuing operations, not extraordinary losses. Operational Assets: Utilization and Disposition

92 Operational Assets: Utilization and Disposition
4/11/2017 Impairment (contd.) 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. No restoration of impaired loss is allowed for tangibles and finite-life intangibles assets held for use. Operational Assets: Utilization and Disposition

93 iGAAP –Assets Impairments
4/11/2017 iGAAP –Assets Impairments iGAAP, as in US GAAP, allows reporting impairments on PPE. iGAAP, as in GAAP, use fair value test to measure the impairments. 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). Operational Assets: Utilization and Disposition

94 iGAAP – PPE Valuation and Impairment (contd.)
4/11/2017 iGAAP – PPE Valuation and Impairment (contd.) 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). Operational Assets: Utilization and Disposition

95 Operational Assets: Utilization and Disposition
Impairment (contd.) 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. Operational Assets: Utilization and Disposition

96 Operational Assets: Utilization and Disposition
C.1.b. Intangibles with indefinite life Other than Goodwill – (Held-for-Use) 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. Test of Impairment: one-step test => Compare book value with the fair value. Operational Assets: Utilization and Disposition

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

98 C.1.c. Impairment for Goodwill (SFAS 142)
The cost of goodwill cannot be directly associated with any specific identifiable right. 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. Operational Assets: Utilization and Disposition

99 C.1.c. Impairment for Goodwill (cont.)
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. 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 Operational Assets: Utilization and Disposition

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

101 Impairment for Goodwill (cont.)
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. Operational Assets: Utilization and Disposition

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

103 Impairment for Goodwill (cont.)
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 Operational Assets: Utilization and Disposition

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

105 C.2 Impairment for Operational Assets to be Sold (SFAS 144)
If the impaired asset is to be disposed ofa by sale, the following principles apply: 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. Operational Assets: Utilization and Disposition

106 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. Operational Assets: Utilization and Disposition

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

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

109 Summary of Asset Impairment: Assets Held to Be Disposed of
Asset Type When to Test Impair. 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 Operational Assets: Utilization and Disposition

110 The Impact of SFAS 144 on the Disposal Loss of Discontinued operations
SFAS 144 applied to assets for both continuing and discontinued operations (Par. 41). 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. Operational Assets: Utilization and Disposition

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

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

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

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


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