COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Investments in Noncurrent Operating Assets – Utilization and Retirement Chapter 11 S t I c e | S t I c e | S k o u s e n Intermediate Accounting 16E Modified by Ms. Phassawan S.

Learning Objectives 1.Methods of Depreciation 2.Depletion of natural resources 3.Changes in estimates and methods into the computation of depreciation 4.Impairment using the U.S. GAAP 5.Account for the sale/exchange of depreciable assets

Depreciation The use of assets during the period should be reported as an expense of that period. Accounts estimates this cost by using a systematic method to allocate the recorded costs. Accumulated depreciation is the sum of all the asset cost that has been expensed in prior periods.

Depreciation Vocabulary 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. Book Value: Historical cost of the asset less accumulated depreciation. Accumulated Depreciation: Total depreciation recorded since acquisition.

Methods of Depreciation Time-factor Methods (1)Straight-line (2)Accelerated methods Sum-of-the-years’-digit Declining-balance Use-Factor Methods (1)Service-hours (2)Productive-output Group & Composite Methods

Time-Factor Method 1) Straight-line : This method recognizes equal periodic depreciation charges over the asset’s life. Depreciation = Cost – Residual Value Number of Years

2) Sum-of-the-years’-digits: This method yields decreasing depreciation in each successive year. SYD = [n (n + 1)] 2 t Depreciation = SYD x (Cost – Residual Value) t = years remaining in n at the beginning of the period Time-Factor Method

Depreciation (2008) = 5 15 x $95,000 = $31,667 EXAMPLE: ABC acquired a machine at the beginning of 2008 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. Depreciation (2009) = 4 15 x $95,000 = $25,333 Depreciation (2010) = 3 15 x $95,000 = $19,000

3) Declining-balance: This method provides decreasing charges by applying a constant percentage rate to a declining asset book value. F = declining balance factor Two times straight-line rate F = declining balance factor Two times straight-line rate Depreciation = F x (Cost – Accum. Depr.) Time-Factor Method

Depreciation (2008) =.40 x $100,000= $40,000 EXAMPLE: ABC acquired a machine at the beginning of 2008 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. = $24,000 Depreciation (2009) =.40 x ($100,000 – $40,000) Depreciation (2010) =.40 x ($100,000 – $64,000) = $14,400

Time-Factor Method $40,000 $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 $0 SL SYD DDB

Use-Factor Methods 1) 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. Example: ABC acquired a machine at the beginning of 2008 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. ABC operated 3,000 service hours in 2008 and 5,000 service hours each in 2009 and Depreciation = Cost – Residual Value X Hours used Number of Hours

Use-Factor Methods 2) 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. Example: ABC acquired a machine at the beginning of 2008 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. The firm produced 3,500 units in 2008, 4,200 units in 2009 and 4,100 units in Depreciation = Cost – Residual Value X Units used Total Number of Units

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

Group Depreciation (Both Methods) Estimated Annual Residual Depreciable Life Depreciation Asset Cost Value Cost in Years Expense (SL) A $ 2,000$ 120$ 1,8804$ 470 B6, , C12,0001,20010,800101,080 $20,000$1,620$18,380$2,500 Group depreciation rate to be applied to cost: $2,500 ÷ $20,000 = 12.5% Average life of assets: $18,380 ÷ $2,500 = years

Learning Objectives 1.Methods of Depreciation 2.Depletion of natural resources 3.Changes in estimates and methods into the computation of depreciation 4.Impairment using the U.S. GAAP 5.Account for the sale/exchange of depreciable assets

Depletion of Natural Resources Land containing mineral deposits is purchased at a cost of $5,500,000. After all mineral deposits have been extracted, its residual value is expected to be $250,000. In 2008, 80,000 tons of the estimated 1,000,000 tons are removed. Depletion charge per ton $5,500,000 – $250,000 1,000,000 tons = Depletion for 2008 = $5.25 x 80,000 tons= $420,000 = $5.25 If 80,000 tons are sold in the current year, $420,000 is part of cost of goods sold. If 60,000 tons are sold in the current year, $105,000 is reported as part of ending inventory.

Depletion The initial purchase: Mineral Deposits5,500,000 Cash5,500,000 Depletion for 2008: Depletion Expense420,000 Accumulated Depletion (or Mineral Deposits)420,000

Learning Objectives 1.Methods of Depreciation 2.Depletion of natural resources 3.Changes in estimates and methods into the computation of depreciation 4.Impairment using the U.S. GAAP 5.Account for the sale/exchange of depreciable assets

Change in Estimated Life A company purchased $50,000 of equipment and estimated a 10-year life. Using the straight- line method with no residual value, the annual depreciation would be $5,000. After four years, accumulated depreciation would amount to $20,000, and the remaining a book value would be $30,000. At the beginning of the fifth year, it is determined that the equipment will only last four more years.

Change in Estimated Life Depreciation Accumulated Year Computation Amount Depreciation 1$50,000/10=$5,000$ 5,000 2$50,000/10=5,00010,000 3$50,000/10=5,00015,000 4$50,000/10=5,00020,000 5$30,000/4=7,50027,500 6$30,000)/4=7,50035,000 7$30,000/4=7,50042,500 8$30,000)/4=7,50050,000 $50,000

Change in Depreciation Methods An asset is purchased for $120,000 with a 12- year expected useful life. Straight-line depreciation is used. After two years of use, the asset has a remaining book value of $100,000, with the remaining useful life 10 years. However, it is observed that the double declining balance method yields a better estimate of periodic deprecation. Compute depreciation expense for the consequent years.

Change in Depreciation Methods Straight-line rate = 1/remaining useful life = 1/10 = 10% Double-declining rate = 2*10% = 20% Remaining book value = $100,000 Year 3 depreciation expense = $100,000*0.2 = $20,000

Learning Objectives 1.Methods of Depreciation 2.Depletion of natural resources 3.Changes in estimates and methods into the computation of depreciation 4.Impairment using the U.S. GAAP 5.Account for the sale/exchange of depreciable assets

Impairment Meaning: Reduction in the expected cash flow to be generated by a long-term asset sufficient to warrant reducing the recorded value of assets –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. If management obtains information suggesting that the market value of the asset has declined, an impairment review should be conducted.

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.

Impairment ABC purchased a building five years ago for $600,000. With an expected life of 20 years and using straight-line depreciation, the building has a book value of $450,000 (cost 600,000-Acc. 150,000). Guangzhou estimates that the net cash inflow from the building will be $375,000 (25,000/year) for the next 15 years. The fair value of the building at this time is $230,000. Book value is compared to the undiscounted sum of future cash inflows to determine whether or not the building is impaired.

Impairment Since the undiscounted future cash flows ($375,000) are less than the book value ($450,000), the building is impaired. The impairment loss would be recorded as follows: Accumulated Depreciation— Building 150,000 Loss on Impairment of Building 220,000 Building (600, ,000)370,000 **The new value $230,000 = new cost of asset *impair loss = BV of asset - FMV

STEPS-Impairment 1.Compare BV and undiscounted cash flow If undiscounted CF < BV = impaired 2.Compute FMV Using the present value of cash flow (discounted) 3.Find the “loss on impairment” BV - FMV

Learning Objectives 1.Methods of Depreciation 2.Depletion of natural resources 3.Changes in estimates and methods into the computation of depreciation 4.Impairment using the U.S. GAAP 5.Account for the sale/exchange of depreciable assets

Account for Asset Retirement 1.Asset retirement by sales 2.Asset classified as held for sale 3.Asset retirement by exchange –Dissimilar assets –Similar assets

Asset Retirement by Sale On July 1, 2008, ABC sells for $43,600 machinery that is recorded on the books at a cost of $83,600 with accumulated depreciation as of January 1, 2008, of $50,600. Assume a 10 percent S/L rate. Depreciation Expense—Machinery 4,180 Accumulated Depreciation— Machinery4,180 (To record depreciation for 6 months in 2008) Cash 43,600 Accumulated Depreciation—Machinery 54,780 Machinery83,600 Gain on Sale of machinery14,780 (To record sale of machinery at gain)

Asset Classified as Held for Sale Management commits to a plan to sell a long-term operating asset. The asset is available for immediate sale. An active effort to locate a buyer is underway. It is probable that the sale will be completed within one year. No depreciation expense is recognized on a long-term asset classified as held for sale. Special accounting is required if the following conditions are satisfied:

Asset Classified as Held for Sale On July 1, 2008, Haas Company has a building that cost $100,000 and accumulated depreciation of $35,000. Haas commits to plans to sell the building by March 1, On July 1, 2008, the building has an estimated fair value of $40,000 and it is estimated that the selling costs on disposal will be $3,000. On July 1, 2008, Haas Company has a building that cost $100,000 and accumulated depreciation of $35,000. Haas commits to plans to sell the building by March 1, On July 1, 2008, the building has an estimated fair value of $40,000 and it is estimated that the selling costs on disposal will be $3,000. Building—Held for Sale (NRV)37,000 Loss on Held-for-Sale Classification28,000 Accumulated Depreciation—Building35,000 Building100,000 July 1:

Asset Classified as Held for Sale Building—Held for Sale18,000 Gain on Recovery Value—Held for Sale18,000 On December 31, the expected selling price is $58,000 (with the selling cost $3,000): ($58,000 – $3,000) – $37,000 Note that the gain is recognized only to the extent that it offsets a previously recognized loss ($28,000). If the net selling price was estimated to be $80,000, only $28,000 would be recognized as gain. If the net selling price was estimated to be less than $37,000, and additional loss would be recognized.

Asset Retirement by Exchange (Dissimilar Assets) 1.Remove old asset from books: –debit Accumulated Depreciation; credit the asset. 2.Record new asset at fair market value : –debit asset at the new asset’s FMV or the FMV of the nonmonetary asset given in exchange, which ever is more clearly determinable. 3.Record any cash received or paid : –debit or credit Cash as appropriate. 4.Record any gain or loss on exchange : – debit loss account or credit gain account.

Asset Retirement by Exchange (Dissimilar Assets) CASE 1: On July 1, 2008, ABC retired the machinery that is recorded on the books at a cost of $83,600 with accumulated depreciation of $54,780 by exchanging it for delivery equipment that had a market value of $43,600. Delivery Equipment 43,600 Accumulated Depreciation—Machinery 54,780 Machinery83,600 Gain on Exchange of machinery14,780

Asset Retirement by Exchange (Dissimilar Assets) CASE 2: On July 1, 2008, ABC retired the machinery that is recorded on the books at a cost of $83,600 with accumulated depreciation of $54,780 by exchanging it for delivery equipment. Assume that the delivery equipment has no readily market price, but the machinery had a market value of $25,000. Delivery Equipment 25,000 Accumulated Depreciation—Machinery 54,780 Loss on Exchange of Machinery 3,820 Machinery 83,600

Asset Retirement by Exchange (Dissimilar Assets) CASE 3: On July 1, 2008, ABC retired the machinery that is recorded on the books at a cost of $83,600 with accumulated depreciation of $54,780 by exchanging it for delivery equipment. Assume that the delivery equipment has no readily market price. The machinery (with a market value of $25,000) were given in exchange for the delivery equipment and $3,000 cash. Cash 3,000 Delivery Equipment 22,000 Accumulated Depreciation—Machinery 54,780 Loss on Exchange of Machinery 3,820 Machinery 83,600

Asset Retirement by Exchange (Similar Assets) CASE 1: “No cash is involved in exchange” Republic’s book Machinery (new) 14,000 Acc. Depre.—Machinery (old) 32,000 Machinery (old)46,000 Machine to be exchanged RepublicLogan Costs$46,000$54,000 Acc. Depre.32,00037,700 BV14,00016,300 Market value16,000 Logan’s book Machinery (new) 16,000 Acc. Depre.—Machinery (old) 37,700 Loss on Exchange of Machinery 300 Machinery (old) 54,000 Loss $300 Gain $2,000 Gain is deferred, not recognized Loss is recognized immediately

Asset Retirement by Exchange (Similar Assets) CASE 2: “Transfer of a “small” amount of cash in exchange” Republic’s book Machinery (new) 15,000 Acc. Depre.—Machinery (old) 32,000 Machinery (old)46,000 Cash 1,000 Machine to be exchanged RepublicLogan Costs$46,000$54,000 Acc. Depre.32,00037,700 BV14,00016,300 Market value16,00017,000 Logan’s book Cash 1,000 Machinery (new) 15,300 Acc. Depre.—Machinery (old) 37,700 Machinery (old) 54,000 Gain $700 Gain $2,000 To make the exchange equal, Republic agrees to pay Logan $1,000 cash Deferred gains/ Recognized losses

Asset Retirement by Exchange (Similar Assets) CASE 3: “Transfer of a “large” amount of cash in exchange” Republic’s book Machinery (new) 17,000 Acc. Depre.—Machinery (old) 32,000 Loss on Exchange of machine 1,250 Machinery (old)46,000 Cash 4,250 Machine to be exchanged RepublicLogan Costs$46,000$54,000 Acc. Depre.32,00037,700 BV14,00016,300 Market value12,75017,000 Gain $700 Loss $1,250 To make the exchange equal, Republic agrees to pay Logan $4,250 cash (25%=4,250*17,000) Large = all gains/losses must be recognized

Asset Retirement by Exchange (Similar Assets) CASE 3: “Transfer of a “large” amount of cash in exchange” Logan’s book Cash 4,250 Machinery (new) 12,750 Acc. Depre.—Machinery (old) 37,700 Machinery (old) 54,000 Gain on Exchange of Machinery 700 To make the exchange equal, Republic agrees to pay Logan $4,250 cash Machine to be exchanged RepublicLogan Costs$46,000$54,000 Acc. Depre.32,00037,700 BV14,00016,300 Market value12,75017,000 Gain $700 Loss 1,250 Large = all gains/losses must be recognized

Asset Retirement by Exchange (Similar Assets) What percentage of the transaction’s FMV is in cash? 25% or more (large) Record transaction using general procedure. Defer all gains. Defer all gains. Zero Less than 25% (small) Party paying cash defers all gains. Party receiving cash defers a portion of all gains Yes A closer look:

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