Investments in Noncurrent Operating Assets--Utilization and Retirement

Learning Objectives Use straight-line, accelerated, use-factor, and group depreciation methods to compute annual depreciation expense. Discuss the issues impacting proper amortization of intangible assets. Apply the productive-output method to the depletion of natural resources.

Learning Objectives Incorporate changes in estimates into the computation of depreciation for current and future periods. Identify whether an asset is impaired and measure the amount of the impairment loss, using U.S. GAAP and international accounting standards. Account for the sale of depreciable assets in exchange for cash and in exchange for other depreciable assets.

Learning Objectives EXPANDED MATERIAL Compute depreciation for partial periods, using both straight-line and accelerated methods. Understand the depreciation methods underlying the MACRS income tax depreciation system.

Time Line of Business Issues ACQUIRE long-term operating assets ESTIMATE and RECOGNIZE an asset’s use (depreciation, amortization, and depletion) CHANGE estimates related to an asset’s life

Time Line of Business Issues MONITOR asset value for possible declines DISPOSE of a depreciable asset

Factors Affecting the Periodic Depreciation Charge Asset cost Residual or salvage value Useful life Pattern of use

Depreciation--Financial Statement Impacts Income Statement Balance Sheet Statement of Cash Flows C. Assets XX P P & E XXXX Acc. Dep. (XX) Total XXXX Liab. XXX OE XXX Total XXXX Revenue XXXX COGS XXX Gr. Profit XXX Dep. Exp. (XX) Net Inc. XXX From Oper. Net Inc. XXX Dep. Exp. XX Net Cash XXX

Depreciation--Financial Statement Impacts Income Statement Balance Sheet Statement of Cash Flows C. Assets XX P P & E XXXX Acc. Dep. (XX) Total XXXX Liab. XXX OE XXX Total XXXX Revenue XXXX COGS XXX Gr. Profit XXX Dep. Exp. (XX) Net Inc. XXX From Oper. Net Inc. XXX Dep. Exp. XX Net Cash XXX

Depreciation--Financial Statement Impacts Income Statement Balance Sheet Statement of Cash Flows C. Assets XX P P & E XXXX Acc. Dep. (XX) Total XXXX Liab. XXX OE XXX Total XXXX Revenue XXXX COGS XXX Gr. Profit XXX Dep. Exp. (XX) Net Inc. XXX From Oper. Net Inc. XXX Dep. Exp. XX Net Cash XXX Indirect Method

Depreciation Vocabulary Book Value: Historical cost of the asset less accumulated depreciation. Depreciation: Periodic charge for cost allocation of long-term assets. Accumulated Depreciation: Total depreciation recorded since acquisition. Asset Cost: Purchase cost plus any capitalized expenditures. Residual Value: Estimated resale value of the asset upon retirement. Useful Life: Estimated life of asset in years, hours of service, or per unit of output.

Depreciation Illustration Costs incurred are deferred until future periods. They are recorded as an asset and the costs are assigned to future periods. Depreciable Cost (Asset) Period 1 Period 2 Period 3

Depreciation Illustration Depreciable Cost (Asset) A depreciation method is selected to assign these costs to future periods. Period 1 Period 1 Period 2 Period 3

Depreciation Illustration Depreciable Depreciable Cost (Asset) A depreciation method is selected to assign these costs to future periods. Cost Period 2 Period 1 Period 2 Period 3

Depreciation Illustration The allocation of a deferred cost, in this case depreciation expense, has no direct effect on cash. The allocation is based on the depreciable cost, useful life, and depreciation method. Depreciable Cost (Asset) Cost (Asset) Period 3 Period 1 Period 2 Period 3

Depreciation Methods Time-Factor Methods Straight-line: This method recognizes equal periodic depreciation charges over the asset’s life. Accelerated methods: Sum-of-the-years’-digits--This method yields decreasing depreciation in each successive year. Declining-balance--This method provides decreasing charges by applying a constant percentage rate to a declining asset book value.

Depreciation Methods Use-Factor Methods Service hours: This depreciation method is based on the theory that purchase of an asset represents the purchase of a number of hours of direct service. Productive output: This method is based on the theory that an asset is acquired for the service it can provide in the form of production output.

Group and Composite Methods Depreciation Methods Group and Composite Methods This approach treats an entire group of assets as if the group were one asset. Group: Used when the assets in the group are similar. Composite: Used when the assets in the group are related, but dissimilar.

Depreciation Methods Schuss Boom Ski Manufacturing acquired a polyurethane plastic-molding machine at the beginning of 2002 for $100,000. It has an estimated life of five years, 20,000 hours, or 25,000 units. The estimated residual value is $5,000. In 2002, the equipment was used 3,000 hours to produce 3,500 units.

Time-Factor Methods Straight-Line Method Cost - Residual Value Depreciation = Cost - Residual Value Number of Years Depreciation = $100,000 - $5,000 5 Depreciation = $19,000

Time-Factor Methods Straight-Line Method $35,000 $28,000 $21,000 $14,000 $7,000 $0 Depreciation Expense 2002 2003 2004 2005 2006

Time-Factor Methods Sum-of-the-Years’-Digits Method [n (n + 1)] SYD = 2 SYD = [5 (5 + 1)] 2 SYD = 15

Time-Factor Methods Sum-of-the-Years’-Digits Method t Depreciation = SYD x (Cost - Residual Value) Depreciation (2002) = 5 15 x $95,000 t = years remaining in n at the beginning of the period Depreciation (2002) = $31,667

Time-Factor Methods Sum-of-the-Years’-Digits Method $35,000 $28,000 $21,000 $14,000 $7,000 $0 Depreciation Expense 2002 2003 2004 2005 2006

Time-Factor Methods Declining-Balance Method Depreciation = F x (Cost - Accum. Depr.) Depreciation (2002) = .40 x $100,000 F = declining balance factor (e.g., 150% or 200%) Depreciation (2002) = $40,000 Note: Do not depreciate below salvage value. Optional: Switch to straight-line when it yields higher depreciation.

Time-Factor Methods Declining-Balance Method $42,000 $35,000 $28,000 $21,000 $14,000 $7,000 $0 Depreciation Expense 2002 2003 2004 2005 2006

Total Estimated Service Life of Asset Use Factor Methods Service Hours Method Depreciation = Cost - Residual Value Number of Hours Depreciation = $100,000 - $5,000 20,000 hours Total Estimated Service Life of Asset Depreciation = $4.75 per hour Depreciation (2002) = $4.75 x 3,000 Depreciation (2002) = $14,250

Use Factor Methods Productive-Output Method Cost - Residual Value r (per unit) = Cost - Residual Value Total Number of Units r (per unit) = $100,000 - $5,000 25,000 units r (per unit) = $3.80 per unit Depreciation (2002) = $3.80 x 3,500 Depreciation (2002) = $13,300

Group Depreciation Group similar assets into depreciation accounts. Calculate annual depreciation charge at the straight-line rate times the group’s book value. Recognize gains and losses only when all assets in the group have been retired. Referred to as composite depreciation when the assets in the group are related but dissimilar.

Depletion Land containing mineral deposits is purchased at a cost of $5,500,000. The cost to restore the land to its original state after removal of the resources is estimated to be $200,000 (then it can be sold for $450,000). In 2002, 80,000 tons of the estimated 2,000,000 tons are removed.

Depletion $5,500,000 - $250,000 Depletion charge per ton = 1,000,000 tons = $450,000 - $200,000 Depletion charge per ton = $5.25 Depletion for 2002 = $5.25 x 80,000 tons Depletion for 2002 = $420,000

Impairment Before the end of an asset’s useful life, events occur that impair its value. This requires an immediate write-down of the asset.

Impairment 1. When should an asset be reviewed for possible impairment? An impairment review should be conducted whenever there has been a material change in the way an asset is used or in the business environment. Also, if management obtains information suggesting that the market value of the asset has declined.

Impairment 2. When is an asset impaired? An asset is impaired when the undiscounted sum of estimated future cash flows from an asset is less than the book value of the asset. The sum of the undiscounted future cash flows will always be greater than the fair value of the asset.

Impairment 3. How should an impairment loss be measured? The impairment loss is the difference between the book value of the asset and the asset’s fair value. The fair value can be approximated using the present value of estimated future cash flows from the asset.

Impairment 4. What information should be disclosed about an impairment? Disclosure should include a description of the impaired asset, reasons for the impairment, a description of the measurement assumptions, and the business segment or segments affected.

Asset Retirement-- General Procedure Remove old asset from books: debit Accumulated Depreciation; credit the asset. Record new asset at fair market value: debit asset Record any cash received or paid: debit or credit Cash as appropriate. Record any gain or loss: debit loss account or credit gain account.

Asset Retirement-- Determining Gain or Loss (FMV New Asset + Cash Received) less (Book Value Old Asset + Cash Paid) If answer is greater than zero, record a gain. If answer is less than zero, record a loss.

Asset Retirement-- Unusual Considerations NO Record transaction according to general procedure. Let’s take a closer look at this last section. Are assets similar in nature? YES Are the parties in the same line of business? NO Record transaction according to general procedure. YES Does the transaction create a gain? NO Record transaction according to general procedure. Zero YES 25% or more Defer all gains What percentage of the transaction’s FMV is in cash? Record transaction using general procedure. Less than 25% Less than 25% Party receiving cash defers a portion of all gains Party paying cash defers all gains.

Asset Retirement-- Unusual Considerations Yes Defer all gains. Zero 25% or more Record transaction using general procedure. What percentage of the transaction’s FMV is in cash? Less than 25% Party paying cash defers all gains. Party receiving cash defers a portion of all gains

Nearest month makes the most intuitive sense. Partial Periods Nearest whole month. Nearest whole year. Half-year convention. No depreciation in year of acquisition; full year depreciation in year of retirement. Full year depreciation in year of acquisition; no depreciation in year of retirement. Nearest month makes the most intuitive sense.

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