Acct 3311 - Class 21 Chapter 11 DEPRECIATION, IMPAIRMENTS, AND DEPLETION Sommers – Intermediate I

Is Accounting Helpful for Valuation? Conceptual Framework (FASB) Purpose of Accounting: “financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise.” Caveat: Accounting information “may help those who desire to estimate the value of a business enterprise, but financial accounting is not designed to measure directly the value of an enterprise.”

Discussion Questions Q11–1 Distinguish among depreciation, depletion, and amortization.

Cost Allocation Depreciation is the accounting process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset. Allocating costs of long-term assets: Fixed assets = Depreciation expense Intangibles = Amortization expense Natural resources = Depletion expense

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. Depreciation, depletion, and amortization are cost allocation processes used to help meet the matching principle requirements. Some of the cost is expensed each period. Part I. The matching principle requires that part of the acquisition cost of an operational asset be expensed in periods when the future revenues are earned. A portion of an asset’s cost is moved from the balance sheet to the income statement each period. Part II. Depreciation, depletion, and amortization are cost allocation processes. We allocate the cost of the asset to expense over its useful life in some rational and systematic manner. The unused portion of the asset’s cost appears on the balance sheet. We allocate a portion of the cost to expense on the income statement each accounting period. Accumulated depreciation represents the depreciation taken on the asset since its purchase, and is deducted from the asset’s cost on the balance sheet. Expense Acquisition Cost (Balance Sheet) (Income Statement)

Cost Allocation – An Overview Caution! Depreciation, depletion, and amortization are processes of cost allocation, not valuation! Part I. Depreciation is term used for the cost allocation process for operational assets in the property plant and equipment category. Land is not depreciated. Depletion is the cost allocation process for natural resource operational assets, and amortization refers to the allocation of intangible asset costs. Depreciation, depletion, and amortization are processes of cost allocation, not for valuation. We do not want to confuse asset valuation, an economic concept, with allocation of acquisition costs to periods benefited by the use of operational assets. Part II. Here you see an example of the property, plant and equipment section of a balance sheet showing the assets at cost less the accumulated depreciation. Accumulated depreciation is a contra-asset account and is subtracted from the assets’ cost to determine book value. Net property, plant & equipment is the undepreciated cost (book value) of plant assets. Book value is not equal to market value. Depreciation on the Balance Sheet

Discussion Questions Q11–7 What basic questions must be answered before the amount of the depreciation charge can be computed?

Measuring Cost Allocation Cost allocation requires three pieces of information for each asset: Service Life Depreciable 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. Regardless of the method used to calculate depreciation expense, we must have three items of information: (1) the estimated useful life of the asset; (2) the allocation base which is the cost of the asset less its estimated residual value at the end of its useful life, and (3) the allocation method.

Estimation of Service Life Service life often differs from physical life. Companies retire assets for two reasons: Physical factors (casualty or expiration of physical life). Economic factors (inadequacy, supersession, and obsolescence).

Depreciable Base How much is value going to decrease while company owns it? This amount has to be transferred to expense during the period that the company is using the item.

Methods of Depreciation The profession requires the method employed be “systematic and rational.” Examples include: Activity method (units of use or production). Straight-line method. Sum-of-the-years’-digits. Declining-balance method. Group and composite methods. Hybrid or combination methods. Accelerated methods Special methods

Straight-Line Time: Activity: Part I. The straight-line method is the most widely used and the most easily understood method of depreciation. It results in an equal amount of depreciation in each year of an asset’s useful life. The annual depreciation is determined by dividing the asset’s cost less its estimated residual value by the asset’s estimated useful life in years. Part II. Consider the following example. On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of five years and an estimated residual value of $5,000. What is the annual straight-line depreciation?

Example 1a: Straight Line Depreciation On January 1, 2011, the Excel Delivery Company purchased a delivery van for $33,000. At the end of its five-year service life, it is estimated that the van will be worth $3,000. During the five- year period, the company expects to drive the van 100,000 miles. Calculate annual depreciation for the five-year life of the van using: Straight line

Example 1b: Activity Based Depreciation On January 1, 2011, the Excel Delivery Company purchased a delivery van for $33,000. At the end of its five-year service life, it is estimated that the van will be worth $3,000. During the five- year period, the company expects to drive the van 100,000 miles. Calculate annual depreciation for the five-year life of the van using: Units of production using miles driven as a measure of output, and the following actual mileage: ($33,000 – $3,000) / 100,000 miles = $0.30 / mile deprec rate Year Miles 2011 22,000 2012 24,000 2013 15,000 2014 20,000 2015 21,000

Example 1b: Continued On January 1, 2011, the Excel Delivery Company purchased a delivery van for $33,000. At the end of its five-year service life, it is estimated that the van will be worth $3,000. During the five- year period, the company expects to drive the van 100,000 miles. Calculate annual depreciation for the five-year life of the van using: Units of production using miles driven as a measure of output, and the following actual mileage: Year Miles Depreciation 2011 22,000 2012 24,000 2013 15,000 2014 20,000 2015 21,000

Declining-Balance Method Sometimes called a Decreasing-Charge Method or an Accelerated Method Declining-Balance Method. Utilizes a depreciation rate (percentage) that is some multiple of the straight-line method. Does not deduct the salvage value in computing the depreciation base.

Accelerated Methods 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 Note that total depreciation over the asset’s useful life is the same as the Straight-line Method Declining-Balance depreciation – Based on the straight-line rate multiplied by an acceleration factor Computations initially ignore residual value Stop depreciating when BV = Residual Value Note that the Book Value will get lower each year Part I. 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. The total amount of depreciation over the asset’s useful life is the same as the straight-line method. Part II. Sum-of-the-years’-digits depreciation is calculated by multiplying cost minus residual value times a fraction that declines each year of an asset’s useful life. The numerator of the fraction is a number equal to the remaining useful life of the asset. For an asset with a four-year life, the numerator would be four for the first year, three for the second year, two for the third year and one for the fourth year The denominator of the fraction is constant. It is the sum of the digits in the asset’s life from one to n, where n is the number of years in the asset’s life. For example, if the estimated life is four years, the sum of the digits is 1 plus 2 plus 3 plus 4, a total of 10. Acceleration Factor

Example 1c: Continued On January 1, 2011, the Excel Delivery Company purchased a delivery van for $33,000. At the end of its five-year service life, it is estimated that the van will be worth $3,000. During the five- year period, the company expects to drive the van 100,000 miles. Calculate annual depreciation for the five-year life of the van using: Double-declining balance   Year Book Value Beg of Year X Rate per Year =    Depreciation End of Year 2011 $33,000 2 / 5 $13,200 $19,800 2012 19,800 7,920 11,880 2013 4,752 7,128 2014 2,851 4,277 2015 * 1,277 * 3,000 Total $30,000

Use of Various Depreciation Methods In a recent survey of large publicly traded companies, 592 of the companies indicated that they used the straight-line method of depreciation. The straight-line method is used by the majority of companies because it is the easiest method to understand and to apply.

Example 2: DDB to Straight Line On January 2, 2011, the Jackson Company purchased equipment to be used in its manufacturing process. The equipment has an estimated life of eight years and an estimated residual value of $30,625. The expenditures made to acquire the asset were as follows: Purchase price $154,000 Freight charges 2,000 Installation charges 4,000 Jackson’s policy is to use the double-declining-balance (DDB) method of depreciation in the early years of the equipment’s life and then switch to straight line halfway through the equipment’s life. Calculate depreciation for each year of the asset’s eight-year life.    Year Book Value Beg of Year   X Depreciation Rate per Year = End of Year 2011 2012 2013 2014

Example 2: Continued Year Book Value Beg of Year X Depreciation    Year Book Value Beg of Year   X Depreciation Rate per Year = End of Year 2011 $160,000 2 / 8 $ 40,000 $120,000 2012 120,000 30,000 90,000 2013 22,500 67,500 2014 16,875 50,625 2015 * 5,000 45,625 2016 40,625 2017 35,625 2018 30,625 Total $129,375 * Switch to straight-line in 2015:   ($50,625 – $30,625) / 4 years = $5,000 per year

Partial-Period Depreciation Pro-rating the depreciation 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 depreciation in the year of acquisition, and the other ½ in the year of disposal That said, unless told otherwise for class you calculate based on months! To this point we have discussed assets that were purchased at the beginning of a year and depreciated for a full year. Relatively few assets will actually be purchased on January 1. When an operational asset is acquired during the year, depreciation is calculated for the fraction of the year the asset is owned. Pro-rating the depreciation based on the date of acquisition is time-consuming and costly. A commonly used alternative is the half-year convention. Using this convention, a company would record one-half year of depreciation in the year of acquisition, and one-half year of depreciation in the year of disposal.

Example 3: Partial-Period On October 1, 2011, the Allegheny Corporation purchased machinery for $115,000. The estimated service life of the machinery is 10 years and the estimated residual value is $5,000. The machine is expected to produce 220,000 units during its life. Calculate depreciation for 2011 and 2012 using each of the following methods. Partial-year depreciation is calculated based on the number of months the asset is in service. Straight line. Double-declining balance. One hundred fifty percent declining balance. Units of production (units produced in 2011, 10,000; units produced in 2012, 25,000).

Example 3: Continued Straight-line:   $115,000 – 5,000 = $11,000 per year 10 years 2011 $11,000 x 3/12 = $ 2,750 2012 $11,000 x 12/12 = $11,000

Example 3: Continued Double-declining balance: 2011 $115,000 x 2/10 x 3/12 = $ 5,750 2012 ($115,000 - 5,750) x 2/10 = $21,850 One hundred fifty percent declining balance: 2011 $115,000 x 1.5/10 x 3/12 = $ 4,313 2012 ($115,000 - 4,313) x 1.5/10 = $16,603

Example 3: Continued Units-of-production: $115,000 – 5,000 = $.50 per unit depreciation rate 220,000 units 2011 10,000 units x $.50 = $ 5,000 2012 25,000 units x $.50 = $12,500

Special Depreciation Methods Choice of method depends on nature of the assets involved: Group method used when the assets are similar in nature and have approximately the same useful lives. Composite approach used when the assets are dissimilar and have different lives. Companies are also free to develop tailor-made depreciation methods, provided the method results in the allocation of an asset’s cost in a systematic and rational manner (Hybrid or Combination Methods).

Discussion Questions Q11–10 What are the major factors considered in determining what depreciation method to use?

Impairments When the carrying amount of an asset is not recoverable, a company records a write-off referred to as an impairment. Events leading to an impairment: Significant decrease in the fair value of an asset. Significant change in the manner in which an asset is used. Adverse change in legal factors or in the business climate. An accumulation of costs in excess of the amount originally expected to acquire or construct an asset. A projection or forecast that demonstrates continuing losses associated with an asset.

Measuring Impairments Review events for possible impairment. If the review indicates impairment, apply the recoverability test. If the sum of the expected future net cash flows from the long-lived asset is less than the carrying amount of the asset, an impairment has occurred. 3. Assuming an impairment, the impairment loss is the amount by which the carrying amount of the asset exceeds the fair value of the asset. The fair value is the market value or the present value of expected future net cash flows.

Impairments

Finite-life Assets to be Held and Used Step 1 – Recoverability An asset is impaired when the undiscounted sum of its estimated future cash flows is less than its book value Step 2 – Measurement Impairment loss is book value less fair value (Market value, price of similar assets, or PV of future net cash inflows) Impairment loss is reported as part of income from continuing operations Undiscounted future cash flows Fair Value $0 $125 $250 Determining the amount of impairment loss to record on a tangible operational asset or on a finite life intangible asset is a two-step process. The first step is to determine if an impairment has occurred. An asset is impaired if the undiscounted sum of its estimated future cash flows is less than its book value. Case 1: $50 book value. No loss recognized Case 3: $275 book value. Loss = $275 - $125 Case 2: $150 book value. No loss recognized

Example 5: Asset Impairment Chadwick Enterprises, Inc., operates several restaurants throughout the Midwest. Three of its restaurants located in the center of a large urban area have experienced declining profits due to declining population. The company’s management has decided to test the operational assets of the restaurants for possible impairment. The relevant information for these assets is presented below. Book value $6.5 million Estimated undiscounted sum of future cash flows 4.0 million Fair value 3.5 million Determine the amount of the impairment loss, if any.

Example 5: Continued Step 1: Recoverability Book Value > Undisc Future CFs 6.5 > 4.0 Step 2: Measurement Book value $6.5 million Fair value 3.5 million Impairment loss $3.0 million

Example 5b: Asset Impairment Chadwick Enterprises, Inc., operates several restaurants throughout the Midwest. Three of its restaurants located in the center of a large urban area have experienced declining profits due to declining population. The company’s management has decided to test the operational assets of the restaurants for possible impairment. The relevant information for these assets is presented below. Book value $6.5 million Estimated undiscounted sum of future cash flows 6.8 million Fair value 5.0 million Determine the amount of the impairment loss, if any.

Example 5b: Continued Step 1: Recoverability Book Value < Undisc Future CFs 6.5 < 6.8 Because the undiscounted sum of future cash flows of $6.8 million exceeds book value of $6.5 million, there is no impairment loss.

Example 6: Asset Impairment General Optic Corporation operates a manufacturing plant in Arizona. Due to a significant decline in demand for the product manufactured at the Arizona site, an impairment test is deemed appropriate. Management has acquired the following information for the assets at the plant: Cost $32,500,000 Accumulated depreciation 14,200,000 General’s estimate of the total cash flows to be generated by selling the products manu- factured at its Arizona plant, not discounted to present value 15,000,000 The fair value of the Arizona plant is estimated to be $11,000,000. Determine the amount of impairment loss, if any. If a loss is indicated, where would it appear in General Optic’s multiple-step income statement?

Example 6: Continued An impairment loss is indicated because the estimated undiscounted sum of future cash flows of $15 million is less than the book value of $18.3 million. The amount of the loss to be reported is calculated using the estimated fair value rather than the undiscounted future cash flows:  Book value $18,300,000 Estimated fair value 11,000,000 Impairment loss $ 7,300,000 The loss would appear in the income statement along with other operating expenses.

Example 6: Asset Impairment General Optic Corporation operates a manufacturing plant in Arizona. Due to a significant decline in demand for the product manufactured at the Arizona site, an impairment test is deemed appropriate. Management has acquired the following information for the assets at the plant: Cost $32,500,000 Accumulated depreciation 14,200,000 General’s estimate of the total cash flows to be generated by selling the products manu- factured at its Arizona plant, not discounted to present value 15,000,000 The fair value of the Arizona plant is estimated to be $11,000,000. Determine the amount of impairment loss, if any. If a loss is indicated, where would it appear in General Optic’s multiple-step income statement? If a loss is indicated, prepare the entry to record the loss.

Example 6: Continued An impairment loss is indicated because the estimated undiscounted sum of future cash flows of $15 million is less than the book value of $18.3 million. The amount of the loss to be reported is calculated using the estimated fair value rather than the undiscounted future cash flows:  Book value $18,300,000 Estimated fair value 11,000,000 Impairment loss $ 7,300,000 The loss would appear in the income statement along with other operating expenses. Loss on impairment 7,300,000 Accumulated depreciation 14,200,000 Plant assets 21,500,000

Assets Held for Sale Impairment loss = Book value Assets held for sale include assets that management has committed to sell immediately in their present condition and for which sale is probable. 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. The impairment loss is the amount by which book value exceeds fair value less the cost to sell.

Depletion and Amortization 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. The approach is based on the units-of-production method. Part I. In general, natural resources can be thought of as anything extracted from our natural environment such as coal, oil, and iron ore. Allocation of the cost of natural resources is called depletion. Total cost, including exploration and development, is charged to depletion over the periods benefited. We use the units-of-production method to compute depletion, and report natural resources at their cost less accumulated depletion. Part II. We begin the process of calculating depletion expense by determining the depletion expense per unit of the natural resource. The numerator of the equation contains the resource cost less any estimated residual value. The denominator of the equation is our estimated total capacity of the natural resource we expected to extract. For oil we express the denominator in terms of barrels and for coal or iron ore we use tons. Once we compute the depletion rate per unit of output, we may calculate depletion for the period by multiplying the depletion rate per unit times the number of units extracted. Let’s look at an example.

Establishing a Depletion Base Computation of the depletion base involves four factors: Acquisition cost. Exploration costs. Development costs. Restoration costs.

Example 7: Depletion At the beginning of 2011, Terra Lumber Company purchased a timber tract from Boise Cantor for $3,200,000. After the timber is cleared, the land will have a residual value of $600,000. Roads to enable logging operations were constructed and completed on March 30, 2011. The cost of the roads, which have no residual value and no alternative use after the tract is cleared, was $240,000. During 2011, Terra logged 500,000 of the estimated five million board feet of timber. Calculate the 2011 depletion of the timber tract and depreciation of the logging roads assuming the units-of-production method is used for both assets. Timber tract: Logging roads: $240,000 / 5,000,000 board feet = $0.048 per board foot 500,000 x $0.048 = $24,000 depreciation

Continuing Controversy Oil and Gas Industry has two acceptable accounting alternatives Successful efforts method – Exploration costs resulting in unsuccessful wells (dry holes) are expensed. Full-cost method – Exploration costs resulting in unsuccessful wells may be capitalized. Political pressure prevented the FASB from requiring all companies to use the successful efforts method.

MACRS vs. GAAP Modified Accelerated Cost Recovery System MACRS differs from GAAP in three respects: a mandated tax life, which is generally shorter than the economic life; cost recovery on an accelerated basis; and an assigned salvage value of zero. (Basically DDB with a half-year convention)

IFRS vs. GAAP RELEVANT FACTS - Similarities The definition of property, plant, and equipment is essentially the same under GAAP and IFRS. Under both GAAP and IFRS, changes in depreciation method and changes in useful life are treated in the current and future periods. Prior periods are not affected. GAAP recently conformed to IFRS in this area. The accounting for plant asset disposals is the same under GAAP and IFRS. The accounting for the initial costs to acquire natural resources is similar under GAAP and IFRS. Under both GAAP and IFRS, interest costs incurred during construction must be capitalized. Recently, IFRS converged to GAAP.

IFRS vs. GAAP RELEVANT FACTS - Similarities The accounting for exchanges of nonmonetary assets has recently converged between IFRS and GAAP. GAAP now requires that gains on exchanges of nonmonetary assets be recognized if the exchange has commercial substance. This is the same framework used in IFRS. GAAP also views depreciation as allocation of cost over an asset’s life. GAAP permits the same depreciation methods (straight-line, diminishing-balance, units-of-production) as IFRS.

IFRS vs. GAAP RELEVANT FACTS - Differences IFRS requires component depreciation. Under GAAP, component depreciation is permitted but is rarely used. Under IFRS, companies can use either the historical cost model or the revaluation model. GAAP does not permit revaluations of property, plant, and equipment or mineral resources. In testing for impairments of long-lived assets, GAAP uses a two-step model to test for impairments. As long as future undiscounted cash flows exceed the carrying amount of the asset, no impairment is recorded. The IFRS impairment test is stricter. However, unlike GAAP, reversals of impairment losses are permitted.

Example 8: GAAP vs. IFRS Depreciation On June 30, 2011, Rosetta Granite purchased a machine for $120,000. The estimated useful life of the machine is eight years and no residual value is anticipated. An important component of the machine is a specialized high-speed drill that will need to be replaced in four years. The $20,000 cost of the drill is included in the $120,000 cost of the machine. Rosetta uses the straight-line depreciation method for all machinery. Calculate depreciation for 2011 and 2012 applying the typical U.S. GAAP treatment. Repeat applying IFRS.

Example 8: Continued U.S. GAAP 2012: $120,000  8 = $15,000 IFRS: 2011: Truck: $100,000  8 = $12,500 x 6/12 = $ 6,250 Drill: $ 20,000  4 = $ 5,000 x 6/12 = 2,500 Total $ 8,750 2012: Truck: $100,000  8 = $12,500 Drill: $ 20,000  4 = 5,000 Total $17,500