Operational Assets: Utilization, Impairment, and Postacquisition Costs Chapter 11 Operational Assets: Utilization, Impairment, and Postacquisition Costs

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 Amortization and depletion 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! Amortization and depletion 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.

Amortization 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 amortization Activity-based methods Units-of-production method (UOP).

Amortization on the Balance Sheet Net property, plant, & equipment is the unamortized 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 amortization expense in each year of the asset’s service life.

Straight-Line (SL) The Hogan Manufacturing Company purchased a machine for $250,000. The company expects the service life of the machine to be five years. During that time it is expected that the machine will produce 140,000 units. The anticipated residual value is $40,000. The machine will be disposed of after five years of use.

Actual unit production during the five years of the assets life was: Straight-Line (SL) Actual unit production during the five years of the assets life was: Year 1 - 24,000, Year 2 - 36,000, Year 3 - 46,000, Year 4 - 8,000, Year 5 - 16,000 Total - 130,000

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

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) Amortization Life in Years

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

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

Sum-of-the-Years’ Digits (SYD) Referring back to the Hogan example. The asset cost was $250,000, the salvage value was $40,000, and the estimated service life was five years. Using SYD, compute amortization expense for the first two years.

Sum-of-the-Years’ Digits (SYD) Use this in your computation of SYD Amortization 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) Amortization 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 amortizing when: BV=Residual Value

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

Double-Declining-Balance (DDB) Referring back to the Hogan example. The asset cost was $250,000, the salvage value was $40,000, and the estimated service life was five years. What is the amortization expense for the first two years using double-declining-balance?

Double-Declining-Balance (DDB)

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

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

Activity-Based Amortization This approach looks different. Amortization can also be based on measures of input or output like: Service hours, or Units-of-Production Amortization is not taken for idle assets.

Units-of-Production

Actual unit production during the five years of the asset’s life was: Units-of-Production Actual unit production during the five years of the asset’s life was: Year 1 - 24,000, Year 2 - 36,000, Year 3 - 46,000, Year 4 – 8,000, Year 5 – 16,000 Total – 130,000

Units-of-Production

Amount necessary to reduce book value to residual value. Units-of-Production Amount necessary to reduce book value to residual value.

Units-of-Production Amortization Life in Years

Use of Various Amortization Methods % of Companies Straight Line 90% Declining balance 2% Accelerate methods Units of production 6%

Amortization Disclosures Amortization expense. Balances of major classes of capital assets. Accumulated amortization by asset or in total. General description of amortization methods used.

Group and Composite Methods Assets are grouped by common characteristics. A “composite rate” is calculated. Annual amortization is determined by: the composite rate × the total group acquisition cost. Accumulated amortization 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 Amortization for the difference between the asset’s cost and the proceeds.

Group and Composite Methods The Express Delivery Company began operations in 2005. It will amortize its fleet of delivery vehicles using the group method. The relevant information is as follows:

Group Amortization Group amortization rate = $52,800 / $330,000 = 16%

Group Amortization If a delivery truck in the above example that cost $15,000 is sold for $3,000 in 2006 the journal entry would be:

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 The Jackson Mining Company paid $1 million for the right to explore 500 acres of land in Newfoundland.

Depletion of Natural Resources Exploration costs are $800,000, intangible development costs were $500,000. New excavation equipment was purchased that cost $600,000. The residual value on the equipment is $60,000. The geologist estimates that 1 million tonnes of coal will be extracted over three years. 300,000 tonnes were extracted in 2005.

Depletion of Natural Resources The company has provided the following three cash flow possibilities (A, B and C) for the restoration costs to be paid in three years, after the extraction is completed: Cash Outflow Probability A $500,000 30% B 600,000 50% C 700,000 20%

Depletion of Natural Resources Purchase of rights to explore $1,000,000 Exploration costs 800,000 Development costs 500,000 Restoration costs 468,360 Total cost of coal deposit $2,768,360 $500,000 x .3 = $150,000 600,000 x .5 = 300,000 700,000 x .2 = 140,000 $590,000 Present value of $1, n=3, I=8% X .79383 = $468,360

Depletion of Natural Resources What is Jackson’s unit depletion rate? a. $2.40456 per tonne b. $2.50456 per tonne c. $2.76836 per tonne d. $20 per tonne

Depletion of Natural Resources What is Jackson’s unit depletion rate? a. $2.40456 per tonne b. $2.50456 per tonne c. $2.76836 per tonne d. $20 per tonne Cost / Units $2,768,360 / 1 million Tonnes = $2.76836 Per Tonne

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 Hollins began operations in 2005 and purchased a franchise for $200,000. The franchise agreement is for 10 years. Hollins also purchased a patent for $50,000, which has a remaining legal life of 13 years, however, the estimated useful life is 8 years. At the end of year 1, what is the amortization expense?

Amortization of Franchise Record the amortization entry.

Amortization of Patent Record the amortization entry.

Amortization of Intangible Assets

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

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

Partial-Period Amortization Pro-rating the amortization 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 amortization in the year of acquisition, and the other ½ in the year of disposal.

Partial-Period Amortization On April 1, 2005, the Hogan Manufacturing Company purchased a machine for $250,000. The company expects the service life of the machine to be five years and the anticipated residual value is $40,000. The company’s fiscal year end is December 31. Partial-year amortization is recorded on the basis of the number of months the asset is in service.

Partial-Period Amortization Year Straight-line SYD Double declining balance 2005 $42,000 x ¾ = $31,500 $70,000 x ¾ = $52,500 $100,000 x ¾ = $75,000 2006 $42,000 $70,000 x ¼ = $17,500 $56,000 x ¾ = $42,000 $100,000 x ¼ = $25,000 $60,000 x ¾ = $45,000

Changes in Estimates Amortization 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.

Calculate amortization expense for 2005 and the subsequent years. Changes in Estimates On January 1, 2003, equipment was purchased that cost $250,000, has a useful life of 5 years and salvage value of $40,000. The year end is December 31 and the straight line is used. During 2005 the company revised its estimate of service life from 5 years, to 8 years and also revised estimated residual value to $22,000. Calculate amortization expense for 2005 and the subsequent years.

Changes in Estimates $250,000 Cost $42,000 x 2 years 84,000 Old amortization ($210,000/5 years) 166,000 Book value 22,000 Less revised residual value 144,000 Revised amortizable base /6 Estimated remaining life (8-2) $24,000 New annual amortization

Change in Amortization Method The cumulative after-tax effect on prior years’ income is reported as a prior period adjustment to opening retained earnings. 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 Amortization Method The cumulative after-tax effect on prior years’ income is reported as a prior period adjustment to opening retained earnings. Prior year’s income statement can be adjusted to reflect the new policy.

Changes in Amortization Method On January 1, 2003, equipment was purchased that cost $250,000, has a useful life of 5 years, and salvage value of $40,000. The year end is December 31 and the double declining method is used. During 2005 the company switched from double-declining balance to the straight-line method. Calculate the cumulative effect of the change.

Changes in Amortization Method DDB Straight Line 2003 amort. $100 ($250 x 40%) $42 ($210 / 5) 2004 amort. 60 ($150 x 40%) 42 ($210 / 5) Accumulated Amortization & 2003-04 $160 $84 Difference $76

Changes in Amortization Method The journal entry is:

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 - $250

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 Loss – Tangible Assets - Example The Alberta Corporation operates several factories that manufacture medical equipment. At the end of the 2005 fiscal year, a change in business climate related to a competitor’s innovative products indicated to management that the $170 million book value of the assets of one of Alberta’s factories may not be recoverable. Management is able to identify cash flows from this factory and estimates that they will be $150 million.

Impairment Loss – Tangible Assets - Example Change in circumstances requires investigation of possible impairment. Recoverability book value of $170 million exceeds undiscounted future cash flows of $150, indicating an impairment loss of $20 million.

Impairment of Value – Goodwill In 2004 Upjane acquired Pharmacopia (Pharm) for $500 million. Upjane reported $110 million in goodwill since the fair value was $500 million. At the end of 2005 the following information is available: Goodwill impaired?

Impairment of Value – Goodwill

Operational Assets to be Sold For operational assets held for sale, if book value exceeds fair value, an impairment loss is recognized for the difference.

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: Rearangements and Other Adjustments

Improvements - Example The Palmer Corporation replaced the air conditioning system in one of its office buildings that it leases to tenants. The cost of the old air conditioning system, $200,000, is included in the cost of the building. However, the company has separately amortized the air conditioning system. Amortization recorded up to the date of replacement totalled $160,000.

Improvements - Example The old system was removed and the new system installed at a cost of $230,000, which was paid in cash. Parts from the old system were sold for $12,000. There are three methods available to record this transaction:

Improvements - Example Option 1 This entry records the disposition of the old air conditioning equipment.

Improvements - Example This entry records the acquisition of the new air conditioning equipment, assuming that the original cost and accumulated amortization of the old equipment can be separately identified.

Improvements - Example Option 2 Include the net cost of the improvement as a debit to the related asset, without removing the original cost and accumulated amortization.

Improvements - Example Option 3 Leave the asset account unaltered but decrease the related accumulated amortization.

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?