1. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Property, Plant, and Equipment and Intangible Assets: Utilization and Impairment 11 Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2. 11 - 2 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 property, plant, and equipment and intangible 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.

3. 11 - 3 Caution! Depreciation, depletion, and amortization are processes of cost allocation, not valuation! Depreciation on the Balance Sheet Cost Allocation – An Overview

4. 11 - 4 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

5. 11 - 5 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

6. 11 - 6 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?

7. 11 - 7 Residual Value BV = Residual Value at the end of the asset’s useful life. Straight-Line Life in Years Depreciation

8. 11 - 8 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. Sum-of-the-years’-digits (SYD) depreciation

9. 11 - 9 2 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.

10. 11 - 10 Sum-of-the-Years’ Digits (SYD)

11. 11 - 11 Residual Value Life in Years Depreciation Sum-of-the-Years’ Digits (SYD)

12. 11 - 12 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.

13. 11 - 13 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? Declining-Balance (DB) Methods

14. 11 - 14 Depreciation forced so that BV = Residual Value. Life in Years Depreciation Declining-Balance (DB) Methods

15. 11 - 15 Units-of-Production

16. 11 - 16 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? Units-of-Production

17. 11 - 17 Use of Various Depreciation Methods

18. 11 - 18 U.S. GAAP vs. IFRS Component depreciation is allowed but not often used in practice. The depreciable base is determined by subtracting estimated residual value from cost. Annual reviews of residual values are not required. Each component of an item of property, plant, and equipment is depreciated separately if its cost is significant to the total cost of the item. Depreciable base is determined by subtracting estimated residual value from cost. IFRS requires a review of residual values annually. Component Depreciation, Depreciable Base, and Residual Value

19. 11 - 19 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.

20. 11 - 20 U.S. GAAP vs. IFRS Property, plant, and equipment is reported in the balance sheet at cost less accumulated depreciation (book value). Revaluation is prohibited. Property, plant, and equipment may be reported at cost less accumulated depreciation, or alternatively, at fair value (revaluation). If revaluation is chosen, all assets within a class of property, plant, and equipment must be revalued on a regular basis. Valuation of Property, Plant, and Equipment

21. 11 - 21 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.

22. 11 - 22 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. What is ABC’s depletion rate? Depletion rate = 1,000,000 ÷ 40,000 Tons = $25 Per Ton Depletion of Natural Resources For the year ABC mined 13,000 tons. What is the total amount of depletion for the year? Depletion = 13,000 tons × $25per ton = $325,000

23. 11 - 23 U.S. GAAP vs. IFRS Biological assets, such as timber tracts, are valued at cost less accumulated depletion. Biological assets are valued at fair value less estimated costs to sell. Valuation of Biological Assets

24. 11 - 24 Amortization of Intangible Assets The amortization process uses the straight-line method, but usually assumes residual value = 0. Amortization period is the shorter of the asset’s legal or contractual life. The amortization entry is: A contra-asset account is generally not used when recording the amortization of intangible assets. Amortization expense..................................$$$ Intangible asset ………………........$$$ To record amortization expense.

25. 11 - 25 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 contractual (useful) life of 5 years. The legal life is 20 years. For year 1, what is Torch’s amortization expense? Amortization of Intangible Assets Amortization expense...................................600 Patent ………………........................600 To record amortization of patent.

26. 11 - 26 Not amortized. Subject to assessment for impairment of value and may be written down. Goodwill and Trademarks Intangible Assets not Subject to Amortization

27. 11 - 27 U.S. GAAP vs. IFRS Intangible assets are reported at cost less accumulated amortization. U.S.GAAP prohibits revaluation of any intangible asset. Intangible assets may be reported at (1) cost less accumulated amortization or (2) fair value, if fair value can be determined in an active market. If revaluation is chosen, all assets within the class of intangibles must be revalued on a regular basis. Goodwill cannot be revalued. Valuation of Intangible Assets

28. 11 - 28 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...

29. 11 - 29 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. 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

30. 11 - 30 What happens if we change depreciation methods? Changes in Estimates

31. 11 - 31 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, 2009, 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 2011, 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 at the end of 2011.

32. 11 - 32 Change in Depreciation Method December 31, 2011: Depreciation expense................................... 34,667 Accumulated depreciation................ 34,667 To record depreciation expense.

33. 11 - 33 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. 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.

34. 11 - 34 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 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

35. 11 - 35 Finite-life Assets to be Held and Used An asset is impaired when... The undiscounted sum of its estimated future cash flows Measurement – Step 1 Its book value <

36. 11 - 36 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 Market value, price of similar assets, or PV of future net cash inflows. Reported as part of income from continuing operations. Finite-life Assets to be Held and Used

37. 11 - 37 Impairment loss = Book value Fair value less cost to sell – Assets held for sale include assets that management has committed to sell immediately in their present condition and for which sale is probable. Assets Held for Sale

38. 11 - 38 U.S. GAAP vs. IFRS Assets are tested for impairment when events or changes in indicators suggest that book value may not be recoverable. An impairment loss is required when an asset’s book value exceeds the undiscounted sum of the estimated future cash flows. Assets must be assessed for circumstances of impairment at the end of each reporting period. An impairment loss is required when an asset’s book value exceeds the higher of the asset’s value-in-use (present value of estimated future cash flow) and fair value less costs to sell. Impairment of Value: Property, Plant, and Equipment and Finite-life Intangible Assets

39. 11 - 39 U.S. GAAP vs. IFRS The impairment loss is the difference between book value and fair value. Reversals of impairment losses are prohibited. The impairment loss is the difference between book value and the recoverable amount, the higher of the asset’s value- in-use and fair value less costs to sell. An impairment loss is reversed if the circumstances that caused the impairment is resolved. Impairment of Value: Property, Plant, and Equipment and Finite-life Intangible Assets

40. 11 - 40 Finite-life Assets to be Held and Used 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 could be sold now for $120 million. Has Acme suffered an impairment loss and if so, how should it be recorded?

41. 11 - 41 Finite-life Assets to be Held and Used Step 2 Impairment loss = $200 million – $120 million = $80 million Impairment loss................................... 80,000,000 Accumulated depreciation...................150,000,000 Equipment ……………………. 230,000,000 To record impairment loss. 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 could be sold now for $120 million. Has Acme suffered an impairment loss and if so, how should it be recorded?

42. 11 - 42 Step 2 Loss = BV of goodwill less implied value of goodwill. Goodwill Step 1 If BV of reporting unit > FV, impairment indicated. Other Indefinite Life Intangibles One-step Process If BV of asset > FV, recognize impairment loss. One-step Process If BV of asset > FV, recognize impairment loss. Indefinite-life Intangibles