McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. OPERATIONAL ASSETS: UTILIZATION AND IMPAIRMENT Chapter 11

Slide Some of the cost is expensed each period. Cost Allocation – An Overview Expense Acquisition Cost (Balance Sheet)(Income Statement) The matching principle requires that part of the acquisition cost of operational assets be expensed in periods when the future revenues are earned. Depreciation, depletion, and amortization are cost allocation processes used to help meet the matching principle requirements.

Slide Caution! Depreciation, depletion, and amortization are processes of cost allocation, not valuation! Cost Allocation – An Overview Depreciation on the Balance Sheet

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

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

Slide Straight-Line The most widely used and most easily understood method. Results in the same amount of depreciation in each year of the asset’s service life. On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of 5 years and estimated residual value of $5,000. What is the annual straight-line depreciation? On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of 5 years and estimated residual value of $5,000. What is the annual straight-line depreciation?

Slide Straight-Line Residual Value BV = Residual Value at the end of the asset’s useful life.

Slide Accelerated Methods Note that total depreciation over the asset’s useful life is the same as the Straight-line Method. Accelerated methods result in more depreciation in the early years of an asset’s useful life and less depreciation in later years of an asset’s useful life. SYD depreciation is computed as follows:

Slide 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 depreciation, compute depreciation for the first two years.

Slide Sum-of-the-Years’ Digits (SYD)

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

Slide Declining-Balance (DB) Methods DB depreciation Based on the straight-line rate multiplied by an acceleration factor. Computations initially ignore residual value. Stop depreciating when: BV = Residual Value Double-Declining-Balance (DDB) depreciation is computed as follows: Note that the Book Value will get lower each year.

Slide 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 for the first two years using double-declining-balance?

Slide Double-Declining-Balance (DDB) Depreciation forced so that BV = Residual Value. Life in Years Depreciation

Slide Units-of-Production

Slide 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?

Slide Use of Various Depreciation Methods

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

Slide Group and Composite Methods Assets are grouped by common characteristics. An average depreciation rate is used. Annual depreciation is the average rate × the total group acquisition cost. Accumulated depreciation records are not maintained for individual assets. Assets are grouped by common characteristics. An average depreciation rate is used. Annual depreciation is the average rate × the total group acquisition cost. Accumulated depreciation records are not maintained for individual assets. If assets in the group are sold, or new assets added, the composite rate remains the same. When an asset in the group is sold or retired, debit accumulated depreciation for the difference between the asset’s cost and the proceeds. If assets in the group are sold, or new assets added, the composite rate remains the same. When an asset in the group is sold or retired, debit accumulated depreciation for the difference between the asset’s cost and the proceeds.

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

Slide ABC Mining acquired a tract of land containing ore deposits. Total costs of acquisition and development were $1,100,000. ABC estimated the land contained 40,000 tons of ore, and that the land will be sold for $100,000 after the coal is mined. Depletion of Natural Resources What is ABC’s unit depletion rate? a.$40 per ton b.$50 per ton c.$25 per ton d.$20 per ton What is ABC’s unit depletion rate? a.$40 per ton b.$50 per ton c.$25 per ton d.$20 per ton Cost / Units $1,000,000 / 40,000 Tons = $25 Per Ton Cost / Units $1,000,000 / 40,000 Tons = $25 Per Ton

Slide For the year ABC mined 13,000 tons. What is the total amount of depletion for the year? a.$325,000 b.$315,000 c.$275,000 d.$225,000 Depletion of Natural Resources Depletion = 13,000 x $25 = $325,000

Slide Amortization of Intangible Assets The amortization process uses the straight-line method, but usually assumes residual value = 0. Amortization period is the shorter of economic life or legal life. The amortization entry is: Note that the amortization process does not use a contra-asset account.

Slide 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. For year 1, what is Torch’s amortization expense?

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

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

Slide 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. 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. Changes in Estimates

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

Slide Change in Depreciation Method prospectively, We account for these changes prospectively, exactly as we would any other change in estimate. A change in depreciation, amortization, or depletion method is considered a change in accounting estimate that is achieved by a change in accounting principle. On January 1, 2007, Matrix, Inc., purchased equipment for $400,000. Matrix expected a residual value $40,000, and a service life of 5 years. Matrix uses the double-declining- balance method to depreciate this type of asset. During 2009, the company switched from double-declining balance to straight-line depreciation. Let’s determine the amount of depreciation to be recorded at the end of 2009.

Slide Change in Depreciation Method 2009 Depreciation

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

Slide 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 when considered for sale. Test for impairment of value at least annually. Test for impairment of value when it is suspected that book value may not be recoverable

Slide Tangible and Finite-Life Intangibles An asset is impaired when... The undiscounted sum of its estimated future cash flows Measurement – Step 1 Its book value <

Slide Impairment loss = Book value Fair value – Measurement – Step 2 $0$250$125 Case 1: $50 book value. No loss recognized Case 2: $150 book value. No loss recognized Case 3: $275 book value. Loss = $275 - $125 Fair Value Undiscounted future cash flows Tangible and Finite-Life Intangibles Market value, price of similar assets, or PV of future net cash inflows. Reported as part of income from continuing operations.

Slide Step 2 Loss = BV of goodwill less implied value of goodwill. 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. One-step Process If BV of asset > FV, recognize impairment loss.

Slide Impairment of Value – Operational Assets to be Sold Impairment loss = Book value Fair value less cost to sell – Operational assets to be sold includes assets that management has committed to sell immediately in their present condition and for which sale is probable.

Slide Expenditures Subsequent to Acquisition Type of ExpenditureDefinitionUsual Accounting Treatment Repairs and Maintenance Expenditures to maintain a given level of benefits Expense in the period incurred AdditionsThe addition of a new major component to an existing asset Capitalize and depreciate over the remaining useful life of the original asset, or over the useful life of the addition, whichever is shorter ImprovementsThe replacement of a major component Capitalize and depreciate over the useful life of the improved asset RearrangementsExpenditures to restructure an asset without addition, replacement, or improvement If expenditures are material and clearly increase future benefits, capitalize and depreciate over the future periods benefited

Slide Appendix 11A ─ Comparison With MACRS (Tax Depreciation) Ignores residual value Provides for rapid write-off Rates based on asset “class lives” Most corporations use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes.

Slide Appendix 11B ─ Retirement and Replacement Methods of Depreciation Retirement Method Acquisitions: Record initial acquisitions of assets at cost in the asset account. Record subsequent acquisitions of assets at cost in the asset account Dispositions: Credit the asset account for cost. Debit depreciation expense for cost less the proceeds received. Replacement Method Acquisitions: Record initial acquisitions of assets at cost in the asset account. Record subsequent acquisitions with a debit to depreciation expense. Dispositions: Credit depreciation expense for the proceeds received. Used for groups of similar, low-valued assets with short service lives.

McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. End of Chapter 11