© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 11 Operational Assets: Utilization and Impairment

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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 operational assets be expensed in periods when the future revenues are earned.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 11-3 Cost Allocation – An Overview Some of the cost is expensed 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 11-4 Caution! Depreciation, depletion, and amortization are used for cost allocation, not valuation! Cost Allocation – An Overview

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 11-5 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 11-6 Depreciation of Operational Assets 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 11-7 Depreciation on the Balance Sheet Net property, plant, & equipment is the undepreciated cost (book value) of plant assets.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 11-8 Straight-Line (SL) The most widely used and most easily understood method. Results in the same amount of depreciation expense in each year of the asset’s service life.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 11-9 On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of 5 years and residual value of $5,000. What is the annual straight-line depreciation? On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of 5 years and residual value of $5,000. What is the annual straight-line depreciation? Straight-Line (SL)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Straight-Line (SL)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Residual Value Note that at the end of the asset’s useful life, BV = Residual Value Straight-Line (SL)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Life in Years Depreciation Straight-Line (SL)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Accelerated methods result in more depreciation expense in the early years of an asset’s useful life and less depreciation expense in later years of an asset’s useful life. Accelerated Methods Note that total depreciation over the asset’s useful life is the same as the SL Method.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide SYD depreciation is computed as follows: Sum-of-the-Years’ Digits (SYD)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide On January 1, we purchase equipment for $50,000 cash. The equipment has a service life of 5 years and an estimated residual value of $5,000. Using SYD, compute depreciation expense for the first two years. Sum-of-the-Years’ Digits (SYD)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Use this in your computation of SYD Depreciation Expense for Years 1 & 2. Sum-of-the-Years’ Digits (SYD)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Sum-of-the-Years’ Digits (SYD)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Residual Value Sum-of-the-Years’ Digits (SYD)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Life in Years Depreciation Sum-of-the-Years’ Digits (SYD)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Declining-Balance (DB) Methods DB depreciation Based on the straight- line rate multiplied by an acceleration factor. Computations initially ignore residual value. DB depreciation Based on the straight- line rate multiplied by an acceleration factor. Computations initially ignore residual value. Stop depreciating when: BV=Residual Value Stop depreciating when: BV=Residual Value

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Double-Declining-Balance (DDB) DDB depreciation is computed as follows: Note that the Book Value will get lower each time depreciation is computed!

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide On January 1, we purchase equipment for $50,000 cash. The equipment has a service life of 5 years and an estimated residual value of $5,000. What is depreciation expense for the first two years using double-declining-balance? Double-Declining-Balance (DDB)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Double-Declining-Balance (DDB)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide We usually have to force depreciation expense in the latter years to an amount that brings BV = Residual Value. We usually have to force depreciation expense in the latter years to an amount that brings BV = Residual Value. Double-Declining-Balance (DDB)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Life in Years Depreciation Double-Declining-Balance (DDB)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Activity-Based Depreciation 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 like: Service hours, or Units-of-Production Depreciation is not taken for idle assets. This approach looks different.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Units-of-Production

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide On January 1, we purchased equipment for $50,000 cash. The equipment is expected to produce 100,000 units during its life and has an estimated residual value of $5,000. If 22,000 units were produced this year, what is the amount of depreciation expense? Units-of-Production

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Units-of-Production

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Use of Various Depreciation Methods

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Depreciation Disclosures Depreciation expense. Balances of major classes of depreciable assets. Accumulated depreciation by asset or in total. General description of depreciation methods used. Depreciation expense. Balances of major classes of depreciable assets. Accumulated depreciation by asset or in total. General description of depreciation methods used.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Assets are grouped by common characteristics. A “composite rate” is calculated. Annual depreciation is determined by: the composite rate × the total group acquisition cost. Accumulated depreciation records are not maintained for individual assets. Assets are grouped by common characteristics. A “composite rate” is calculated. Annual depreciation is determined by: the composite rate × the total group acquisition cost. Accumulated depreciation records are not maintained for individual assets. Group and Composite Methods

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Apply the composite rate to the total cost of the assets. If assets in the group are sold, or new assets added, the composite rate remains the same. When an asset in the group is sold or retired, debit Accumulated Depreciation for the difference between the asset’s cost and the proceeds. Apply the composite rate to the total cost of the assets. If assets in the group are sold, or new assets added, the composite rate remains the same. When an asset in the group is sold or retired, debit Accumulated Depreciation for the difference between the asset’s cost and the proceeds. Group and Composite Methods

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide The approach is based on the units- of-production method. As natural resources are “used up”, or depleted, the cost of the natural resources must be expensed. Depletion of Natural Resources

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Depletion of Natural Resources

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide ABC Mining acquired a tract of land containing ore deposits. Total costs of acquisition and development were $1,000,000. ABC estimated the land contained 40,000 tons of ore. Depletion of Natural Resources

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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 Depletion of Natural Resources

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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 Depletion of Natural Resources

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide For the year ABC mined 13,000 tons and sold 9,000 tons. What is the total depletion cost and the total depletion expense? a.$325,000 & $225,000 b.$325,000 & $325,000 c.$225,000 & $225,000 d.$275,000 & $225,000 For the year ABC mined 13,000 tons and sold 9,000 tons. What is the total depletion cost and the total depletion expense? a.$325,000 & $225,000 b.$325,000 & $325,000 c.$225,000 & $225,000 d.$275,000 & $225,000 Depletion of Natural Resources

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide For the year ABC mined 13,000 tons and sold 9,000 tons. What is the total depletion cost and the total depletion expense? a.$325,000 & $225,000 b.$325,000 & $325,000 c.$225,000 & $225,000 d.$275,000 & $225,000 For the year ABC mined 13,000 tons and sold 9,000 tons. What is the total depletion cost and the total depletion expense? a.$325,000 & $225,000 b.$325,000 & $325,000 c.$225,000 & $225,000 d.$275,000 & $225,000 Depletion of Natural Resources Cost = 13,000 x $25 = $325,000 Expense = 9,000 x $25 = $225,000 Cost = 13,000 x $25 = $325,000 Expense = 9,000 x $25 = $225,000

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Amortization of Intangible Assets The amortization process uses the straight-line method, but assumes residual value = 0. Amortization period is the shorter of: Economic Life Legal Life or

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Amortization of Intangible Assets The amortization entry is: Note that the amortization process does not use a contra-asset account.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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? Amortization of Intangible Assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Record the amortization entry. Amortization of Intangible Assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Note that the patent will have a book value of $2,400 after this amortization entry is posted. Amortization of Intangible Assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Intangible Assets Not Subject to Amortization Not amortized. Subject to assessment for impairment value and may be written down. Goodwill

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide I bought an asset on May 19 this year. Do I get a full year’s depreciation? May 19 Partial-Period Depreciation

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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...

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Changes in Estimates Depreciation Expense is based on... ESTIMATED service life ESTIMATED residual value If the estimates change, the book value less any residual value at the date of change is depreciated over the remaining useful life.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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. 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide What happens if we change depreciation methods? Changes in Estimates

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Change in Depreciation Method 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. The cumulative after-tax effect on prior years’ income is reported as a separate income statement item in the year of the change.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Change in Depreciation Method Prior years’ statements remain unchanged, but pro forma income amounts are presented for all prior years presented for comparative purposes. The cumulative after-tax effect on prior years’ income is reported as a separate income statement item in the year of the change.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide During the fourth year of an asset’s life, XYZ, Inc. made a change from the double- declining balance to the straight-line method. The following schedule shows the effect of this change. Change in Depreciation Method

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide The $56,400 difference (net of tax) is presented as a separate item, increasing income, in the fourth year income statement. Change in Depreciation Method

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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. 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Recoverable cost < Book value An asset is impaired if... Expected future total undiscounted net cash inflows generated by use of the asset. Impairment of Value – Tangible and Finite-Life Intangibles Measurement – Step 1

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Reported as part of income from continuing operations. 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. Market value, price of similar assets, or PV of future net cash inflows. Fair value < recoverable value due to the time value of money. Impairment of Value – Tangible and Finite-Life Intangibles Measurement – Step 2

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide $0$250$125 Case 1: $50 Carrying value No loss recognized Case 1: $50 Carrying value No loss recognized Case 2: $150 Carrying value No loss recognized Case 2: $150 Carrying value No loss recognized Case 3: $275 Carrying value Loss = $275 - $125 Case 3: $275 Carrying value Loss = $275 - $125 Fair Value Recoverable Cost Impairment of Value – Tangible and Finite-Life Intangibles Measurement – Step 2

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Impairment of Value – Indefinite Life Intangibles Other Indefinite Life Intangibles Goodwill Step 1 If BV of business unit > FV, impairment indicated. Step 2 Loss = BV of goodwill less implied value of goodwill. One-step Process If BV of asset > FV, recognize impairment loss. One-step Process If BV of asset > FV, recognize impairment loss. Goodwill Example

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Parent Company purchased Sub Company for $500 million at a time when the fair value of Sub’s net identifiable assets were $400 million. Sub continued to operate as a separate company. At the end of the next year, Parent did a goodwill impairment test revealing the following: Impairment of Value – Goodwill Goodwill impaired?

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Impairment of Value – Goodwill

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Expenditures Subsequent to Acquisition Maintenanc e and ordinary repairs. Additions. Improvements (betterments), replacements, and extraordinary repairs. Rearrangement s and other adjustments.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Normally we debit an expense account for amounts spent on: Expenditures Subsequent to Acquisition

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Normally we debit the asset account for amounts spent on: Expenditures Subsequent to Acquisition

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Normally we debit the asset account for amounts spent on: Expenditures Subsequent to Acquisition

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Normally, we debit an other asset account for amounts spent on: Expenditures Subsequent to Acquisition

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Tax Depreciation Ignores residual value Provides for rapid write-off Percentages based on asset “class lives” Most corporations use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide We pulled quite a load in this chapter didn’t we? End of Chapter 11