Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Operational Assets: Utilization and Impairment 11 Insert Book Cover Picture

11-2 Learning Objectives Explain the concept of cost allocation as it pertains to operational assets.

11-3 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.

11-4 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.

11-5 Caution! Depreciation, depletion, and amortization are processes of cost allocation, not valuation! Cost Allocation – An Overview

11-6 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

11-7 Learning Objectives Determine periodic depreciation using both time-based and activity-based methods.

11-8 Time-based Methods Straight-line (SL) Accelerated Methods  Sum-of-the-years’ digits (SYD)  Declining Balance (DB) Time-based Methods Straight-line (SL) Accelerated Methods  Sum-of-the-years’ digits (SYD)  Declining Balance (DB) Activity-based methods Units-of-production method (UOP). Activity-based methods Units-of-production method (UOP). Group and composite methods Group and composite methods Tax depreciation Tax depreciation Depreciation of Operational Assets

11-9 Depreciation on the Balance Sheet Net property, plant & equipment is the undepreciated cost (book value) of plant assets.

11-10 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.

11-11 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? Straight-Line

11-12 Straight-Line

11-13 Residual Value Note that at the end of the asset’s useful life, BV = Residual Value Straight-Line

11-14 Life in Years Depreciation Straight-Line

11-15 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. Accelerated Methods Note that total depreciation over the asset’s useful life is the same as the Straight- line Method.

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

11-17 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 for the first two years. Sum-of-the-Years’-Digits (SYD)

Use this in your computation of SYD Depreciation for Years 1 & 2. Sum-of-the-Years’ Digits (SYD)

11-19 Sum-of-the-Years’ Digits (SYD)

11-20 Residual Value Sum-of-the-Years’ Digits (SYD)

11-21 Life in Years Depreciation Sum-of-the-Years’ Digits (SYD)

11-22 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

11-23 DDB depreciation is computed as follows: Note that the Book Value will get lower each time depreciation is computed! Double-Declining-Balance (DDB)

11-24 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? Double-Declining-Balance (DDB)

11-25 Double-Declining-Balance (DDB)

11-26 Double-Declining-Balance (DDB) We usually have to force depreciation in the latter years to an amount that brings BV = Residual Value. We usually have to force depreciation in the latter years to an amount that brings BV = Residual Value.

11-27 Life in Years Depreciation Double-Declining-Balance (DDB)

11-28 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.

11-29 Units-of-Production

11-30 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

11-31 Units-of-Production

11-32 Use of Various Depreciation Methods

11-33 Depreciation Disclosures  Depreciation.  Balances of major classes of depreciable assets.  Accumulated depreciation by asset or in total.  General description of depreciation methods used.  Depreciation.  Balances of major classes of depreciable assets.  Accumulated depreciation by asset or in total.  General description of depreciation methods used.

11-34  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. Group and Composite Methods

11-35  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. Group and Composite Methods

11-36 Learning Objectives Calculate the periodic depletion of a natural resource.

11-37 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 allocated to the units extracted. Depletion of Natural Resources

11-38 Depletion of Natural Resources

11-39 ABC Mining acquired a tract of land containing ore deposits. Total costs of acquisition and development were $1,100,000. ABC estimated the land contained 40,000 tons of ore, and that the land will be sold for $100,000 after the coal is mined. Depletion of Natural Resources

11-40 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

11-41 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

11-42 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 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 of Natural Resources

11-43 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 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 of Natural Resources Depletion = 13,000 x $25 = $325,000 Expense = 9,000 x $25 = $225,000 Depletion = 13,000 x $25 = $325,000 Expense = 9,000 x $25 = $225,000

11-44 Learning Objectives Calculate the periodic amortization of an intangible asset.

11-45 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

11-46 Amortization of Intangible Assets The amortization entry is: Note that the amortization process does not use a contra-asset account.

11-47 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

11-48 Record the amortization entry. Amortization of Intangible Assets

11-49 Note that the patent will have a book value of $2,400 after this amortization entry is posted. Amortization of Intangible Assets

11-50 Intangible Assets Not Subject to Amortization Not amortized. Subject to assessment for impairment value and may be written down. Goodwill

11-51 I bought an asset on May 19 this year. Do I get a full year’s depreciation? May 19 Partial-Period Depreciation

11-52 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...

11-53 Learning Objectives Explain the appropriate accounting treatment required when a change is made in the service life or residual value of an operational asset.

11-54 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.

11-55 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

11-56 Changes in Estimates What happens if we change depreciation methods?

11-57 Learning Objectives Explain the appropriate accounting treatment required when a change in depreciation method is made.

11-58 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.

11-59 On January 1, 2004, Matrix, Inc., a calendar year-end company 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 2006, the company switched from double-declining balance to straight-line depreciation. Let’s determine the amount of depreciation to be recorded at the end of Change in Depreciation Method

11-60 Change in Depreciation Method 2006 Depreciation

11-61 Learning Objectives Explain the appropriate treatment required when an error in accounting for an operational asset is discovered.

11-62 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.

11-63 Learning Objectives Identify situations that involve a significant impairment of the value of operational assets and describe the required accounting procedures.

11-64 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.

11-65 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

11-66 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 it is suspected that book value may not be recoverable Test for impairment of value at least annually. Test for impairment of value when considered for sale.

11-67 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

11-68 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

11-69 $0$250$125 Case 1: $50 book value No loss recognized Case 1: $50 book value No loss recognized Case 2: $150 book value No loss recognized Case 2: $150 book value No loss recognized Case 3: $275 book value Loss = $275 - $125 Case 3: $275 book value Loss = $275 - $125 Fair Value Recoverable Cost Impairment of Value – Tangible and Finite-Life Intangibles Measurement – Step 2

11-70 Step 2 Loss = BV of goodwill less implied value of goodwill. Impairment of Value – Indefinite Life Intangibles Other Indefinite Life Intangibles Goodwill Step 1 If BV of business unit > FV, impairment indicated. One-step Process If BV of asset > FV, recognize impairment loss. One-step Process If BV of asset > FV, recognize impairment loss. Goodwill Example

11-71 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?

11-72 Impairment of Value – Goodwill

11-73 Impairment of Value – Operational Assets to be Sold Impairment loss = Book value Fair value less cost to sell – Operational assets to be sold includes assets that management has committed to sell immediately in their present condition and for which sale is probable.

11-74 Learning Objectives Discuss the accounting treatment of repairs and maintenance, additions, improvements, and rearrangements to operational assets.

11-75 Expenditures Subsequent to Acquisition Maintenanc e and ordinary repairs. Additions. Improvements (betterments), replacements, and extraordinary repairs. Rearrangement s and other adjustments.

11-76 Normally we debit an expense account for amounts spent on: Expenditures Subsequent to Acquisition

11-77 Normally we debit the asset account for amounts spent on: Expenditures Subsequent to Acquisition

11-78 Normally we debit the asset account for amounts spent on: Expenditures Subsequent to Acquisition

11-79 Normally, we debit an asset account for amounts spent on: Expenditures Subsequent to Acquisition

11-80 Appendix 11A Comparison with MACRS (Tax Depreciation)

11-81 Tax Depreciation Ignores residual value Provides for rapid write-off Rates based on asset “class lives” Most corporations use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes.

11-82 Appendix 11B Retirement and Replacement Methods of Depreciation

11-83 Retirement and Replacement Methods of Depreciation Used for groups of similar, low-valued assets with short service lives.

11-84 Retirement Method  Acquisitions: Record initial acquisitions of assets at cost in the asset account. Record subsequent acquisitions of assets at cost in the asset account  Dispositions: Credit the asset account for cost. Debit depreciation expense for cost less the proceeds received. Retirement Method  Acquisitions: Record initial acquisitions of assets at cost in the asset account. Record subsequent acquisitions of assets at cost in the asset account  Dispositions: Credit the asset account for cost. Debit depreciation expense for cost less the proceeds received. Replacement Method  Acquisitions: Record initial acquisitions of assets at cost in the asset account. Record subsequent acquisitions with a debit to depreciation expense.  Dispositions: Credit depreciation expense for the proceeds received. Replacement Method  Acquisitions: Record initial acquisitions of assets at cost in the asset account. Record subsequent acquisitions with a debit to depreciation expense.  Dispositions: Credit depreciation expense for the proceeds received. Retirement and Replacement Methods of Depreciation

11-85 Retirement and Replacement Methods of Depreciation Acme Company has the following transactions for calculators:  Initially purchased 100 calculators for $50 each.  Purchased 20 additional calculators as replacements for $45 each.  Sold 30 of the original calculators for $5 each. Acme Company has the following transactions for calculators:  Initially purchased 100 calculators for $50 each.  Purchased 20 additional calculators as replacements for $45 each.  Sold 30 of the original calculators for $5 each. Prepare the entries to record these transactions using the retirement and replacement methods.

11-86 Retirement Method of Depreciation   

11-87 Replacement Method of Depreciation   

11-88 End of Chapter 11