Operational Assets: Utilization and Impairment Chapter 11 Operational Assets: Utilization and Impairment

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

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

Cost Allocation – An Overview Caution! Depreciation, depletion, and amortization are used for cost allocation, not valuation!

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

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

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

The most widely used and most easily understood method. Straight-Line (SL) The most widely used and most easily understood method. Results in the same amount of depreciation expense in each year of the asset’s service life.

What is the annual straight-line depreciation? Straight-Line (SL) On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of 5 years and residual value of $5,000. What is the annual straight-line depreciation?

Straight-Line (SL)

Note that at the end of the asset’s useful life, BV = Residual Value Straight-Line (SL) Residual Value Note that at the end of the asset’s useful life, BV = Residual Value

Straight-Line (SL) Depreciation Life in Years

Accelerated Methods Accelerated methods result in more depreciation expense in the early years of an asset’s useful life and less depreciation expense in later years of an asset’s useful life. Note that total depreciation over the asset’s useful life is the same as the SL Method.

Sum-of-the-Years’ Digits (SYD) SYD depreciation is computed as follows:

Sum-of-the-Years’ Digits (SYD) On January 1, we purchase equipment for $50,000 cash. The equipment has a service life of 5 years and an estimated residual value of $5,000. Using SYD, compute depreciation expense for the first two years.

Sum-of-the-Years’ Digits (SYD) Use this in your computation of SYD Depreciation Expense for Years 1 & 2.

Sum-of-the-Years’ Digits (SYD)

Sum-of-the-Years’ Digits (SYD) Residual Value

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

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

Double-Declining-Balance (DDB) DDB depreciation is computed as follows: Note that the Book Value will get lower each time depreciation is computed!

Double-Declining-Balance (DDB) 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 expense for the first two years using double-declining-balance?

Double-Declining-Balance (DDB)

Double-Declining-Balance (DDB) We usually have to force depreciation expense in the latter years to an amount that brings BV = Residual Value.

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

Activity-Based Depreciation This approach looks different. 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.

Units-of-Production

Units-of-Production On January 1, we purchased equipment for $50,000 cash. The equipment is expected to produce 100,000 units during its life and has an estimated residual value of $5,000. If 22,000 units were produced this year, what is the amount of depreciation expense?

Units-of-Production

Use of Various Depreciation Methods

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

Group and Composite Methods Assets are grouped by common characteristics. A “composite rate” is calculated. Annual depreciation is determined by: the composite rate × the total group acquisition cost. Accumulated depreciation records are not maintained for individual assets.

Group and Composite Methods Apply the composite rate to the total cost of the 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.

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

Depletion of Natural Resources

Depletion of Natural Resources ABC Mining acquired a tract of land containing ore deposits. Total costs of acquisition and development were $1,000,000. ABC estimated the land contained 40,000 tons of ore.

Depletion of Natural Resources 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 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

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

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

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

Amortization of Intangible Assets Torch, Inc. has developed a new device. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal registration fees. The device has a 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 Record the amortization entry.

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

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

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

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

Changes in Estimates Depreciation Expense is based on . . . ESTIMATED service life ESTIMATED residual value If the estimates change, the book value less any residual value at the date of change is depreciated over the remaining useful life.

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

What happens if we change depreciation methods? Changes in Estimates What happens if we change depreciation methods?

Change in Depreciation Method The cumulative after-tax effect on prior years’ income is reported as a separate income statement item in the year of the change. Difference between the reported Beginning R/E, and the Beginning R/E that would have resulted if the new accounting method had been used in all prior years.

Change in Depreciation Method The cumulative after-tax effect on prior years’ income is reported as a separate income statement item in the year of the change. Prior years’ statements remain unchanged, but pro forma income amounts are presented for all prior years presented for comparative purposes.

Change in Depreciation Method During the fourth year of an asset’s life, XYZ, Inc. made a change from the double- declining balance to the straight-line method. The following schedule shows the effect of this change. 16 11 16

Change in Depreciation Method The $56,400 difference (net of tax) is presented as a separate item, increasing income, in the fourth year income statement. 16 11 16

Errors found in a subsequent accounting period are corrected by . . . Error Correction Errors found in a subsequent accounting period are corrected by . . . Entries that restate the incorrect account balances to the correct amount. Reporting the correction as a prior period adjustment to Beginning R/E. Restating the prior period’s financial statements.

Impairment of Value Occasionally, asset value must be written down due to permanent loss of benefits of the asset through . . . Casualty. Obsolescence. Lack of demand for the asset’s services.

Impairment of Value Accounting treatment differs. Operational assets to be held and used Operational assets held to be sold Tangible and intangible with finite useful lives Intangible with indefinite useful lives Goodwill

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 at least annually. Accounting treatment differs. Operational assets to be held and used Operational assets held to be sold Test for impairment of value when considered for sale. Tangible and intangible with finite useful lives Intangible with indefinite useful lives Goodwill

Impairment of Value – Tangible and Finite-Life Intangibles Measurement – Step 1 An asset is impaired if . . . Recoverable cost < Book value Expected future total undiscounted net cash inflows generated by use of the asset.

Impairment of Value – Tangible and Finite-Life Intangibles Measurement – Step 2 Impairment loss Book value Fair value = – Market value, price of similar assets, or PV of future net cash inflows. Fair value < recoverable value due to the time value of money. Reported as part of income from continuing operations.

Impairment of Value – Tangible and Finite-Life Intangibles Measurement – Step 2 Fair Value Recoverable Cost $0 $125 $250 Case 1: $50 Carrying value No loss recognized Case 2: $150 Carrying value No loss recognized Case 3: $275 Carrying value Loss = $275 - $125

Impairment of Value – Indefinite Life Intangibles Other Indefinite Life Intangibles Goodwill Step 1 If BV of business unit > FV, impairment indicated. One-step Process If BV of asset > FV, recognize impairment loss. Step 2 Loss = BV of goodwill less implied value of goodwill. Goodwill Example

Impairment of Value – Goodwill Parent Company purchased Sub Company for $500 million at a time when the fair value of Sub’s net identifiable assets were $400 million. Sub continued to operate as a separate company. At the end of the next year, Parent did a goodwill impairment test revealing the following: Goodwill impaired?

Impairment of Value – Goodwill

Expenditures Subsequent to Acquisition Improvements (betterments), replacements, and extraordinary repairs. Maintenance and ordinary repairs. Rearrangements and other adjustments. Additions.

Expenditures Subsequent to Acquisition Normally we debit an expense account for amounts spent on: Maintenance & Ordinary Repairs

Expenditures Subsequent to Acquisition Normally we debit the asset account for amounts spent on: Improvements Replacements Extraordinary Repairs

Expenditures Subsequent to Acquisition Normally we debit the asset account for amounts spent on: Additions

Expenditures Subsequent to Acquisition Normally, we debit an other asset account for amounts spent on: Reaarangements and Other Adjustments

Provides for rapid write-off Percentages based on asset “class lives” Tax Depreciation Most corporations use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes. Provides for rapid write-off Percentages based on asset “class lives” Ignores residual value

We pulled quite a load in this chapter didn’t we? End of Chapter 11 We pulled quite a load in this chapter didn’t we?