Operating Assets – Utilization and Impairment Depreciation Methods

Operating Assets – Utilization and Impairment Depreciation Methods
Topic 5 Operating Assets – Utilization and Impairment Depreciation Methods

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. The matching principle requires that part of the acquisition cost of an operational asset be expensed in periods when the future revenues are earned. A portion of an asset’s cost is moved from the balance sheet to the income statement each period. Expense Acquisition Cost (Balance Sheet) (Income Statement)

Depreciation, depletion and amortization are cost allocation processes used to help meet the matching principle requirements. Some of the cost is expensed each period. Depreciation, depletion, and amortization are cost allocation processes. We allocate the cost of the asset to expense over its useful life in some rational and systematic manner. The unused portion of the asset’s cost appears on the balance sheet. We allocate a portion of the cost to expense on the income statement each accounting period. Accumulated depreciation represents the depreciation taken on the asset since its purchase, and is deducted from the asset’s cost on the balance sheet. Expense Acquisition Cost (Balance Sheet) (Income Statement)

Depreciation is term used for the the cost allocation process for operational assets in the property plant and equipment category. Land is not depreciated.. Depletion is the cost allocation process for natural resource operational assets, and amortization refers to the allocation of intangible asset costs.. Depreciation, depletion, and amortization are processes of cost allocation, not for valuation. We do not want to confuse asset valuation, an economic concept, with allocation of acquisition costs to periods benefited by the use of operational assets. Caution! Depreciation, depletion, and amortization are processes of cost allocation, not valuation!

Cost Allocation - Judgments
Cost allocation requires developing three estimates for each asset: Useful (Service) Life Allocation Base Allocation Method Total amount of cost to be allocated. Cost - Residual Value (at end of useful life) The systematic approach used for allocation. The estimated expected use from an asset. Regardless of the method used to calculate depreciation expense, we must have three items of information: (1) the estimated useful life of the asset; (2) the allocation base which is the cost of the asset less its estimated residual value at the end of its useful life, and (3) the allocation method.

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 There are two general approaches to depreciation of operational assets: time-based methods and activity based methods. The most commonly used time-based method is the straight-line method that results in an equal amount of depreciation in each period. The other time-based methods are referred to as accelerated methods because they result in a greater amount of depreciation in the earlier years of an assets life. Sum-of-the-years’ digits and declining balance are two accelerated methods. Activity-based methods use a measure of an asset’s output in a period for the depreciation computation. Units-of-production is an activity-based method. We will examine each of these methods with examples as we study depreciation. In addition to these methods, we will also cover group and composite methods, tax depreciation (Appendix 11A), and retirement and replacement methods (Appendix 11B).. Activity-based methods Units-of-production method (UOP).

Depreciation on the Balance Sheet
On your screen, you see an example of the property, plant and equipment section of a balance sheet showing the assets at cost less the accumulated depreciation. Accumulated depreciation is a contra-asset account and is subtracted from the assets’ cost to determine book value. Book value is the undepreciated cost of the asset. It is not equal to market value. Net property, plant & equipment is the undepreciated cost (book value) of operating assets.

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. The straight-line method is the most widely used and the most easily understood method of depreciation. It results in an equal amount of depreciation in each year of an asset’s useful life. The annual depreciation is determined by dividing the asset’s cost less its estimated residual value by the asset’s estimated useful life in years. Consider the example shown. On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of five years and an 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?

SYD depreciation is quickly computed using Excel.
Straight-Line SYD depreciation is quickly computed using Excel. The annual depreciation is determined by dividing asset’s cost of $50,000 minus its estimated residual value of $5,000 by the asset’s estimated useful life of five years. The result is annual depreciation of $9,000.

Note that at the end of the asset’s useful life, BV = Residual Value
Straight-Line Notice that depreciation is the same amount in each of the five years. If we plot this amount on a graph for each year, it would be a straight-line. That’s why this method got its name. Accumulated depreciation increases by $9,000 each year. The cost of the asset ($50,000) less accumulated depreciation at the end of any year is called book value. Book value decreases by $9,000 each year. The book value is equal to the estimated residual value at the end of the asset’s useful life. We want this to be true regardless of the method we use. Residual Value Note that at the end of the asset’s useful life, BV = Residual Value

Straight-Line Depreciation Life in Years
In this graph of each year’s depreciation, you can clearly see the straight-line nature of the method. Life in Years

Accelerated Methods 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. 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. The total amount of depreciation over the asset’s useful life is the same as the straight-line method.

Sum-of-the-Years’ Digits (SYD)
SYD depreciation is quickly computed using Excel. The formula is as follows: 2 Sum-of-the-years’-digits depreciation is calculated by multiplying cost minus residual value times a fraction that declines each year of an asset’s useful life. The numerator of the fraction is a number equal to the remaining useful life of the asset. For an asset with a four-year life, the numerator would be four for the first year, three for the second year, two for the third year and one for the fourth year The denominator of the fraction is constant. It is the sum of the digits in the asset’s life from one to n, where n is the number of years in the asset’s life. For example, if the estimated life is four years, the sum of the digits is 1 plus 2 plus 3 plus 4, a total of 10. The formula on your screen is a more efficient way of computing the sum. For the same asset with a four year life, the computation is 4 plus 1 equals 5, times 4 equals 20, divided by 2 equals 10, the same result as summing the digits above. = 15

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. Use Excel’s SYD function to compute depreciation for the five years. We will use the same information for the sum-of-the-years’-digits method. On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of five years and estimated residual value of $5,000. Using the sum-of-the-years-digits method, compute depreciation for the first two years.

The sum of the years is equal to 5 plus 1 equals 6, times 5 equals 30, divided by 2 equals 15.

Cost 50,000 Salvage Value 5,000 Estimated Life 5 Period 1 2 3 4 Period Depreciation 15,000 12,000 9,000 6,000 3,000 45,000 The numerator in the fraction is five for the first year. We multiply the fraction 5 over 15 times the cost minus salvage value to obtain the first year’s depreciation of $15,000. The numerator in the fraction is four for the second year. We multiply the fraction 4 over 15 times the cost minus salvage value to obtain the second year’s depreciation of $12,000.

Depreciation In this graph you can clearly see that the amount of depreciation expense declines each year using the sum-of-the-years’- digits method.. 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 Declining-balance methods are based on the straight-line rate multiplied by an acceleration factor. The straight-line rate is equal to one divided by the estimated useful life. For example, if the useful life of an asset is ten years, the straight-line rate is one tenth, or ten percent. Declining-balance methods initially ignore residual value, but we do not depreciate the asset below its residual value.

Double-Declining-Balance (DDB)
DDB depreciation is easy to compute using Excel function =ddb The formula is as follows: The most common declining-balance method is double-declining balance. It gets its name because the rate is twice (double) the straight-line rate. For example, we saw that the straight-line rate for an asset with a ten-year life was one over tenth or ten percent. The double declining balance rate for the asset is two tenths or twenty percent. We multiply the double-declining balance rate times the book value of the asset. The book value declines each year as the asset is depreciated, resulting in less depreciation for each succeeding year. Note that the Book Value will get lower each time depreciation is computed!

On January 1, we purchase equipment for $50,000 cash. The equipment has a service life of 5 years and an estimated residual value of $5,000. What is depreciation for the five two years using double-declining-balance? We will use the same information for the double-declining-balance method. 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 the double-declining-balance method?

The double-declining-balance rate for a five-year asset is two divided by five, or forty percent. In the first year the book value of the asset is equal to its cost of $50,000. The first year’s depreciation is forty percent of $50,000 of $20,000. The book value for the second year is $50,000 minus the first year’s depreciation of. $20,000, or $30, The second year’s depreciation is forty percent of $30,000, or $12,000.

Notice that depreciation is greater in the early years and less each succeeding year of the asset’s life. Accumulated depreciation increases each year by the amount of the depreciation expense. While we always want the book value to be equal to estimated residual value at the end of the asset’s useful life, it just will not work properly using the double-declining-balance method. We usually have to force depreciation in the latter years to an amount that allows the book value to be equal to the estimated residual value. At the end of the five-year period, the accumulated depreciation is $45,000, resulting in a book value of $5,000. The book value is equal to the estimated residual value at the end of the asset’s useful life. We want this to be true regardless of the method we use. Excel will stop depreciation when the BV = Residual Value.

Depreciation In this graph you can clearly see that the amount of depreciation declines each year using the double-declining-balance method. 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. Depreciation can also be based on measures of input or output such as service hours or units produced. If an asset is idle, there is no depreciation.

Units-of-Production The units-of-production depreciation computation is much like the straight-line method. We divide cost minus residual value by estimated useful life in both methods. However, the useful life is measured in units of output using the units-of-production method, resulting in a depreciation rate per unit of production. Once we compute the depreciation rate per unit of output, we may calculate depreciation for the period by multiplying the depreciation rate per per unit times the number of units produced in the current period. Let’s look at an example.

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? We will use the same information for the units-of-production method, but for this example we will add the number of units produced for the first year. 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 using the units-of-production method?

Units-of-Production We divide cost minus residual value by the number of units in the estimated service life to get the depreciation rate of $0.45 per unit. Next we multiply the depreciation rate of $0.45 per unit times the 22,000 units produced to get $9,900 of depreciation for the first year.

Use of Various Depreciation Methods
A recent survey of large U.S. publicly traded companies indicated that the majority of the companies surveyed used the straight-line method of depreciation. Similarly, a recent survey of large companies preparing their financial statements according to IFRS reports that in 2009, 93% of the surveyed companies used the straight-line method.

Provides for rapid write-off Rates based on asset “class lives”
Comparison With MACRS (Tax Depreciation) Covered in Income Tax Course & Referred to in Intermediate III Most corporations use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes. When filing a tax return most corporations use the modified accelerated cost recovery system developed by the Internal Revenue Service. The modified accelerated cost recovery system is an accelerated depreciation method. It was designed to permit companies to quickly write-off the cost of long-lived tangible assets and thereby stimulate investment in new assets. Residual value is ignored. Assets are categorized into classes based on life, and each class has a stated depreciation rate. Provides for rapid write-off Rates based on asset “class lives” Ignores residual value

Depreciation Disclosures
Balances of major classes of depreciable assets. Accumulated depreciation by asset or in total. General description of depreciation methods used. The choice of depreciation methods can impact reported income. Following the principle of consistency, companies avoid switching depreciation methods from period to period without good reason. Financial statement disclosure concerning depreciation should include the amount of depreciation, balances of major classes of depreciable assets, accumulated depreciation by asset or in total, and a general description of the depreciation methods used.

Partial-Period Depreciation
I bought an asset on May 19 this year. Do I get a full year’s depreciation? May 19 To this point we have discussed assets that were purchased at the beginning of a year and depreciated for a full year. Relatively few assets will actually be purchased on January 1. When an operational asset is acquired during the year, depreciation is calculated for the fraction of the year the asset is owned.

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. Pro-rating the depreciation based on the date of acquisition is time-consuming and costly. A commonly used alternative is the half-year convention. Using this convention, a company would record one-half year of depreciation in the year of acquisition, and one-half year of depreciation in the year of disposal.

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

Partial Year – Demo Problem
SLM for a full year: [$30, ,000]/4 = $7,000 a. $7,000 x 9/12 = $5,250 $7,000 x 12/12 = $7,000 b. $7,000 x 50% = $3,500 $7,000 x 100% = $7,000

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. 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. To reduce record keeping costs, group and composite depreciation methods aggregate assets to depreciate them collectively rather than individually. Group and composite methods differ only in criteria used to aggregate the assets for depreciation. We implement either method by applying a single straight-line rate based on the average service lives of the aggregated asset. Annual depreciation is determined by multiplying the average rate times 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, we debit accumulated depreciation for the difference between the asset’s cost and the proceeds. No gain or loss is recorded.

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

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

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

BE 11-4 Solution Journal entry for sale Cash 35,000
Acc. Dep (difference) 7,000 Equipment (cost) 42,000

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. The approach is based on the units-of-production method. In general, natural resources can be thought of as anything extracted from our natural environment such as coal, oil, and iron ore. Allocation of the cost of natural resources is called depletion. Total cost, including exploration and development, is charged to depletion over the periods benefited We use the units-of-production method to compute depletion, and report natural resources at their cost less accumulated depletion.

We begin the process of calculating depletion expense by determining the depletion expense per unit of the natural resource. The numerator of the equation contains the resource cost less any estimated residual value. The denominator of the equation is our estimated total capacity of the natural resource we expected to extract. For oil we express the denominator in terms of barrels and for coal or iron ore we use tons. Once we compute the depletion rate per unit of output, we may calculate depletion for the period by multiplying the depletion rate per unit times the number of units extracted. Let’s look at an example.

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. 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. The following questions will require us to calculate depletion for ABC Mining.

What is ABC’s unit depletion rate? a. $40 per ton b. $50 per ton c. $25 per ton d. $20 per ton First, let’s calculate ABC’s depletion rate.

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 The correct answer is choice c, $25 per ton. We divide the $1,100,000 cost minus the $100,000 residual value by the number of units in the estimated service life to get the depletion rate of $25 per ton.

For the year ABC mined 13,000 tons and sold 9,000 tons. What is the total depletion and the depletion expense? a. $325,000 & $225,000 b. $325,000 & $325,000 c. $225,000 & $225,000 d. $275,000 & $225,000 This question will require us to differentiate between tons mined and tons sold. Remember that depletion expense is based on number of tons sold.

For the year ABC mined 13,000 tons and sold 9,000 tons. What is the total depletion and the depletion expense? a. $325,000 & $225,000 b. $325,000 & $325,000 c. $225,000 & $225,000 d. $275,000 & $225,000 Depletion = 13,000 x $25 = $325,000 Expense = 9,000 x $25 = $225,000 The correct answer is choice a, $325,000 and $225,000. We multiply the depletion rate of $25 per ton times the 13,000 mined to get $325,000 of total depletion. However, only 9,000 tons of the coal were sold, and we calculate the amount of depletion expense based on the number of tons sold, not the number of tons mined. We multiply the depletion rate of $25 per ton times the 9,000 tons mined to get $225,000 of total depletion. The remainder of the depletion cost, $100,000, remains in inventory.

Amortization of Intangible Assets
The amortization process uses the straight-line method, but assumes residual value = 0. Economic Life Amortization is the process of allocating the cost of an intangible asset to the periods benefited by its use. The amortization process uses the straight-line method, but assumes a zero residual value. The amortization period is the shorter if the intangible asset’s economic or legal life. Amortization period is the shorter of: or Legal Life

The amortization entry is: The journal entry to record amortization requires a debit to amortization expense and a credit to the intangible asset account. We do not use a contra-asset account such as accumulated amortization when recording the amortization of intangible assets. Let’s look at an example. Note that the amortization process does not use a contra-asset account.

Torch, Inc. has developed a new device. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal registration fees. The device has a useful life of 5 years. The legal life is 20 years. At the end of year 1, what is Torch’s amortization expense? Torch, Inc. has developed a new device. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal registration fees. The device has a useful life of 5 years. The legal life is 20 years. At the end of year 1, what is Torch’s amortization expense?

Since the five-year economic life is shorter than the twenty-year legal life for this patent, we will amortize the patent over five years. The amortization expense is the asset’s cost of $3,000 divided by its economic life of five years, resulting in annual amortization of $600. Record the amortization entry.

The journal entry to record amortization requires a debit to amortization expense for $600 and a credit to the patent account for $600. The patent will have a book value of $2,400 after the amortization entry is posted. 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. Goodwill can be created when one company buys another company. If the purchase price of the company is greater than the fair value of the net assets and liabilities acquired, we have goodwill associated with the transaction. Goodwill is not amortized. Each year we must test to see if there has been any impairment in the carrying value of the goodwill. If an impairment is determined to exist, we will reduce the goodwill account and recognize the loss in value.

ESTIMATED service life ESTIMATED residual value
Changes in Estimates ESTIMATED service life ESTIMATED residual value Changes in estimates are accounted for prospectively. The book value less any residual value at the date of change is depreciated over the remaining useful life. A disclosure note should describe the effect of a change. The service life and the residual value used in depreciation computations are both estimates. Like all estimates, new information may come to light that will cause us to revise our previous estimate. Changes in estimates are accounted for prospectively. The book value, less any residual value at the date of change, is depreciated over the remaining useful life. A disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per share amounts for the current period. Let’s look at an example of a change in useful life. On January 1, equipment was purchased that cost $30,000, has a useful life of ten years, and no residual value. At the beginning of the fourth year, it was decided that there were only five years remaining, instead of seven years. Calculate depreciation for the fourth year using the straight-line method. On January 1, equipment was purchased that cost $30,000, has a useful life of 10 years, and no residual value. At the beginning of the fourth year, it was decided that there were only 5 years remaining, instead of 7 years. Calculate depreciation for the fourth year using the straight-line method.

Changes in Estimates What happens if we change depreciation methods?
The depreciation for each of the first three years is $3,000 ($30,000 cost divided by the original estimated useful life of ten years). The accumulated depreciation for the first three years totals $9,000, computed by multiplying the $3,000 of depreciation per year times three years. The undepreciated cost (book value) of the equipment on the date of change is $21,000, computed by subtracting $9,000 of accumulated depreciation from the $30,000 cost. To calculate the amount of straight-line depreciation for each of the remaining five years of the equipment’s life, we divide the $21,000 book value of the equipment by five years. The resulting straight-line depreciation is $4,200 per year. Now, let’s see how to account for a change in depreciation method. What happens if we change depreciation methods?

Change in Depreciation Method
A change in depreciation, amortization, or depletion method is considered a change in accounting estimate that is achieved by a change in accounting principle. We account for these changes prospectively, exactly as we would any other change in estimate. On January 1, 2011, Matrix Inc. purchased office equipment for $400,000. Matrix expected a residual value $40,000, and a service life of 5 years. Matrix uses the double-declining-balance method to depreciate this type of asset. During 2013, the company switched from double-declining balance to straight-line depreciation. The residual value remained at $40,000. Let’s determine the amount of depreciation to be recorded for 2013. A change in depreciation, amortization, or depletion method is considered a change in accounting estimate that is achieved by a change in accounting principle. We account for these changes prospectively, exactly as we would any other change in estimate. However, in the case of a change in depreciation method, the required disclosure note must also provide justification for why the new method is preferable. Let’s look at an example. On January 1, 2011, Matrix Inc., a calendar year-end company, purchased office equipment for $400,000. Matrix expected a residual value $40,000, and a service life of five years. Matrix uses the double-declining-balance method to depreciate this type of asset. During 2013, the company switched from double-declining balance to straight-line depreciation. Let’s determine the amount of depreciation to be recorded for 2013.

Change in Depreciation Method
Part I Double-declining-balance depreciation for 2011 was $160,000 ($400,000 cost times 40 percent). For 2012 the double-declining-balance depreciation was $96,000 ($240,000 book value times 40 percent). Accumulated depreciation for the first two years totals $256,000. Part II. The undepreciated cost (book value) of the equipment on January 1, 2013, the date of the change, is $144,000, computed by subtracting $256,000 of accumulated depreciation from the $400,000 cost of the equipment. To calculate the amount of straight-line depreciation for each of the remaining three years of the equipment’s life, we divide the remaining depreciable amount of $104,000 ($144,000 – 40,000) by three years. The resulting straight-line depreciation is $34,667 per year. For each of the remaining three years of the equipment’s life (2013, 2014, 2015), the adjusting entry for depreciation is the same. We debit depreciation expense for $34,667 and credit accumulated depreciation for $34,667. Note that the prospective approach used for the change in accounting method affected only 2013, the year of the change, and 2014 and There is no restatement of prior years’ depreciation for 2011 and 2012. December 31, 2013: Depreciation expense ,667 Accumulated depreciation ,667 To record depreciation expense.

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.  Restating the prior period’s financial statements.  Reporting the correction as a prior period adjustment to Beginning R/E. The correction of an error is necessary when a transaction is recorded incorrectly or not recorded at all. To correct a material error found in a subsequent period, we restate prior year’s statements that are presented for comparative purposes to reflect the impact of the change. We adjust the balance in each account affected to appear as if the error had never occurred. If retained earnings is one of the accounts whose balance needs to be adjusted, we adjust the beginning balance of retained earnings for the earliest period reported in the comparative statements. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary items, and earnings per share. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary items, and earnings per share.

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

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

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

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

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

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

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

Only the annual depreciation is reported in 2013.
Brief Exercise 11-9 Only the annual depreciation is reported in 2013. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary item, and earnings per share.

Impairment of Value Accounting treatment differs.
Test for impairment of value when considered for sale. Impairment of Value Accounting treatment differs. Long-term assets to be held and used Long-term assets held for sale Tangible and intangible with finite useful lives Intangibles with indefinite useful lives Goodwill Test for impairment of value when it is likely that the fair value of a reporting unit is less than its book value. Operating assets Part I. Impairment is the loss of a significant portion an asset’s benefits through casualty, obsolescence, or lack of demand for the asset’s services. If an asset’s value decreases and cannot be recovered through future use or sale, the asset is considered to be impaired and it should be written down to its net realizable value. We recognize and measure impairment loss differently depending on whether the asset is being held for use or held for sale. For assets being held for use, different guidelines apply to tangible and intangible assets with finite useful lives and intangible assets with indefinite useful lives. Finally, because goodwill is a unique intangible asset with an indefinite useful life, there is yet another difference in accounting treatment. Part II. Tangible assets and finite life intangible assets are tested for impairment when events or changes in circumstances indicate that the book value may not be recoverable Intangible assets with indefinite useful lives, other than goodwill, are tested for impairment annually. For goodwill, companies are allowed to evaluate relevant events and circumstances to determine whether it is “more likely than not” (a likelihood of more than 50 percent) that the fair value of a reporting unit is now less than its book value. Only if that’s determined to be the case will the company perform the first step of the two-step goodwill impairment test. Long-term assets held for sale are tested for impairment 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.

Operating Assets to be Held and Used
Measurement – Step 1 An asset is impaired when . . . The undiscounted sum of its estimated future cash flows Its book value Determining the amount of impairment loss to record on a tangible asset or on a finite-life intangible asset is a two-step process. The first step is to determine if an impairment has occurred. An asset is impaired if the undiscounted sum of its estimated future cash flows is less than its book value. <

Measurement – Step 2 Impairment loss Book value Fair value = – Reported in the income statement as a separate component of operating expenses Market value, price of similar assets, or PV of future net cash inflows. Undiscounted future cash flows Part I. If it is determined that an impairment loss has occurred on a tangible asset or on a finite-life intangible asset in step one, the second step in the process is to determine the amount of the impairment loss. The impairment loss is the amount by which book value exceeds fair value. If fair value cannot be determined in the market place, it is estimated as the discounted sum (present value) of the estimated future cash flows from the asset. Recall that undiscounted cash flows are used in step one. An impairment loss normally is reported in the income statement as a separate component of operating expenses. Part II. Let’s look at an example illustrating two steps of the process. In case one, the undiscounted sum of estimated future cash flows of $250 is greater than the book value of $50, so there is no impairment (step one). In case two, the undiscounted sum of estimated future cash flows of $250 is greater than the book value of $150, so there is no impairment (step one). In case three, the undiscounted sum of estimated future cash flows of $250 is less than the book value of $275, so there is an impairment (step one). The amount of the impairment is equal to the $275 book value of the asset less the $125 fair value of the asset (step two). Fair value $0 $125 $250 Case 1: $50 book value. No loss recognized Case 3: $275 book value. Loss = $275 – $125 Case 2: $150 book value. No loss recognized

Because Acme Auto Parts has seen its sales steadily decrease due to the decline in new car sales, Acme’s management believes that equipment that originally cost $350 million, with a $200 million book value, may not be recoverable. Management estimates that future undiscounted cash flows associated with the equipment’s remaining useful life will be only $140 million, and that the equipment’s fair value is $120 million. Has Acme suffered an impairment loss and, if so, how should it be recorded? Part I. Because Acme Auto Parts has seen its sales steadily decrease due to the decline in new car sales, Acme’s management believes that equipment that originally cost $350 million, with a $200 million book value, may not be recoverable. Management estimates that future undiscounted cash flows associated with the equipment’s remaining useful life will be only $140 million, and that the equipment’s fair value is $120 million. Has Acme suffered an impairment loss and, if so, how should it be recorded? Part II. Step 1. Recoverability. The undiscounted sum of estimated future cash flows ($140 million) is less than book value ($200 million), so an impairment is indicated. Step 1 $140 million < $200 million Impairment loss is indicated.

Because Acme Auto Parts has seen its sales steadily decrease due to the decline in new car sales, Acme’s management believes that equipment that originally cost $350 million, with a $200 million book value, may not be recoverable. Management estimates that future undiscounted cash flows associated with the equipment’s remaining useful life will be only $140 million, and that the equipment’s fair value is $120 million. Has Acme suffered an impairment loss and, if so, how should it be recorded? Step 2 Impairment loss = $200 million – $120 million = $80 million Part I. Since an impairment is indicated, we will proceed with step 2, measurement. The impairment loss of $80 million is equal to the book value of $200 million less the current fair value of $120 million. Part II. To record the loss, we debit impairment loss for $80 million, debit accumulated depreciation for $150 million, and credit equipment for $230 million ($350 million cost less $120 million fair value). The entry reduces the accumulated depreciation balance to zero and reduces the equipment account to its current fair value of $120 million. Impairment loss ,000,000 Accumulated depreciation ,000,000 Equipment …………………… ,000,000 To record impairment loss.

Indefinite-Life Intangibles This item covered in Advanced Accounting
Other Indefinite- life intangibles One-Step Process If BV of asset > FV, recognize impairment loss. Goodwill Step 1 If BV of reporting unit > FV, impairment indicated. Step 2 Loss = BV of goodwill less implied value of goodwill. The measurement of an impairment loss for goodwill is a two-step process. Goodwill is inseparable from a particular reporting unit. A reporting unit is an operating segment of a company or a component of an operating segment for which discrete financial information is available and segment managers regularly review the operating results of that component. In step one we compare the fair value of the reporting unit to its book value to see if an impairment is indicated. If the book value is greater than the fair value, there is an impairment of goodwill. Companies are allowed to evaluate relevant events and circumstances to determine whether it is “more likely than not” (a likelihood of more than 50 percent) that the fair value of a reporting unit is now less than its book value. Only if that’s determined to be the case will the company perform the first step of the two-step goodwill impairment test. If impairment is indicated in step one, we calculate the amount of the impairment in step two. Because fair value of goodwill does not exist separately from the reporting unit, and cannot be measured directly (no separate market value or separate present value of cash flows), we imply the fair value of goodwill by subtracting the fair value of all identifiable net assets from the fair value of the entire reporting unit, the same process that is used to initially determine goodwill in a business combination. The impairment loss is then equal to the amount by which the book value of goodwill exceeds the implied fair value of goodwill. The measurement of an impairment loss for indefinite-life intangible assets other than goodwill is a one-step process. If book value is greater than fair value, an impairment loss is recognized for the difference.

Brief Exercise 11-10 Collison and Ryder Company (C&R) has been experiencing declining market conditions for its sportswear division. Management decided to test the operational assets of the division for possible impairment. The test revealed the following: book value of division’s assets, $26.5 million; fair value of division’s assets, $21 million; sum of estimated future cash flows generated from the division’s assets, $24 million. What amount of impairment loss should C&R recognize?

Brief Exercise 11-10 Because the undiscounted sum of future cash flows of $24 million is less than book value of $26.5 million, there is an impairment loss. The impairment loss is calculated as follows:

Expenditures Subsequent to Acquisition
Improvements (betterments), replacements, and extraordinary repairs. Maintenance and ordinary repairs. After a plant asset is purchased, the company may incur additional expenditures on that asset. These expenditures may be for repairs and maintenance, overhauls, upgrading the asset, and similar expenditures. The accounting issue is deciding whether to capitalize these expenditures or to expense them in the period incurred. Rearrangements and other adjustments. Additions.

Normally we debit an expense account for amounts spent on: Maintenance & Ordinary Repairs Expenditures for maintenance and ordinary repairs are normally expensed. These types of expenditures maintain the normal operating condition and do not extend the useful life beyond the original estimate.

Normally we debit the asset account for amounts spent on: Improvements Replacements Expenditures for improvements, replacements, and extraordinary repairs are normally capitalized. These types of expenditures either increase the useful life beyond the original estimate, or increase productive output, or both. Extraordinary Repairs

Normally we debit the asset account for amounts spent on: Additions Expenditure for additions usually increase the productive capacity and are capitalized.

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

Brief Exercise 11-16 Demmert Manufacturing incurred the following expenditures during the current fiscal year: - annual maintenance on its machinery, $5,400; remodeling of offices, $22,000; rearrangement of the shipping and receiving area resulting in an increase in productivity, $35,000; addition of a security system to the manufacturing facility, $25,000. How should Demmert account for each of these expenditures?

Brief Exercise 11-16 Annual maintenance on machinery, $5, This is an example of normal repairs and maintenance. Future benefits are not increased; therefore the expenditure should be expensed in the period incurred. Remodeling of offices, $22,000 - This is an example of an improvement. The cost of the remodeling should be capitalized and depreciated, either by direct capitalization of the cost, or a reduction of accumulated depreciation.

Brief Exercise 11-16 Rearrangement of the shipping and receiving area, $35, This is an example of a rearrangement. Because the rearrangement increased productivity, the cost should be capitalized and depreciated. Addition of a security system, $25, This is an example of an addition. The cost of the security system should be capitalized and depreciated.

Operating Assets – Utilization and Impairment Depreciation Methods

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Operating Assets – Utilization and Impairment Depreciation Methods

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