CHAPTER 11 Property, Plant, and Equipment and Intangible Assets: Utilization and Impairment

Cost Allocation – An Overview The matching principle requires that part of the acquisition cost of property, plant, and equipment and intangible 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 allocated to each period. Expense* Acquisition Cost (Balance Sheet) (Income Statement) The matching principle requires that part of the acquisition cost of property, plant, and equipment and intangible assets 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. 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 in the balance sheet. We allocate a portion of the cost to expense in 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 in the balance sheet to net to the book value of the asset. Depreciation, depletion, or amortization of an asset used in manufacturing a product is a part of the product cost that is included in inventory. The depreciation, depletion, or amortization does not immediately become an expense, but is expensed as part of cost of goods sold when the product is sold. *Depreciation of an asset used to produce a product is a product cost that does not become an expense until the product is sold.

Cost Allocation – An Overview Caution! Depreciation, depletion, and amortization are processes of cost allocation, not valuation! Depreciation is a term used for the cost allocation process for the plant and equipment category. Land is not depreciated. Depletion is the cost allocation process for natural resources, and amortization refers to the allocation of intangible asset costs. Depreciation, depletion, and amortization are processes used for cost allocation, not valuation. We do not want to confuse asset valuation, an economic concept, with allocation of acquisition costs to periods benefited by the use of the assets. 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, and equipment is the undepreciated cost (book value) of plant assets. Book value is not equal to market value. Depreciation on the Balance Sheet

Measuring Cost Allocation Cost allocation requires three pieces of information for each asset: Service Life Allocation 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. To calculate the amount of cost allocated to a period, 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.

Depreciation Group and composite methods Tax depreciation Time-based Methods Straight-line (SL) Accelerated Methods Sum-of-the-years'-digits (SYD) Declining Balance (DB) Tax depreciation There are two general approaches to depreciation: time-based methods and activity-based methods. The most commonly used time-based method is the straight-line method that results in an equal amount of depreciation in each period. The other time-based methods are referred to as accelerated methods because they result in a greater amount of depreciation in the earlier years of an assets life. Sum-of-the-years'-digits and declining balance are two accelerated methods. Activity-based methods use a measure of an asset’s activity (input or output) in a period for the depreciation computation. Units-of-production is an activity-based method. We will examine each of these methods with examples as we study depreciation. In addition to these methods, we will also cover group and composite methods, tax depreciation (Appendix 11A), and retirement and replacement methods (Appendix 11B). Activity-based methods Units-of-production method (UOP).

Depreciation The following information for a piece of machinery will be used to illustrate some of the depreciation methods discussed in the following paragraphs.   Cost of machine $260,000 Estimated useful life 10 years Estimated salvage value $20,000 Productive life in hours 60,000 hours

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. 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. Consider the example shown. 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? 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 Use of the straight-line method results in a uniform charge to depreciation expense during each year of an asset’s service life. This method is based upon the assumption that the decline in an asset’s usefulness is the same each year. Although the straight-line method is easy to use, it rests on an assumption that, in most situations, is not realistic.

Accelerated Methods Double-Declining-Balance (DDB) method (Covered) 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. Sum-of-the-years’-digits (SYD) method (Not Covered) 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. 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. Double-Declining-Balance (DDB) method (Covered)

Declining-Balance (DB) Methods DB depreciation Based on the straight-line rate multiplied by an acceleration factor. Computations initially ignore residual value. Stop depreciating when: BV = Residual Value Double-Declining-Balance (DDB) depreciation is computed as follows: Declining-balance methods are based on the straight-line rate multiplied by an acceleration factor. The straight-line rate is equal to one divided by the estimated useful life. For example, if the useful life of an asset is ten years, the straight-line rate is one-tenth, or ten percent. Declining-balance methods initially ignore residual value, but we do not depreciate the asset below its residual value. The most common declining-balance method is double-declining balance. It gets its name because the rate is twice (double) the straight-line rate. For example, the straight-line rate for an asset with a ten-year life is one over ten, or ten percent. The double-declining-balance rate for the asset is two-tenths or twenty percent. We multiply the double-declining-balance rate times the book value of the asset. The book value declines each year as the asset is depreciated, resulting in less depreciation for each succeeding year. Note that the book value declines each year.

Declining-Balance (DB) Methods The declining-balance method utilizes a depreciation rate that is some multiple of the straight-line method. One popular method is twice the straight-line rate. Thus, in our example the 10-year asset life would translate into a 20% declining rate.   Beginning Rate on of the Year Declining Depreciation Book Value X Balance   = Charge Year 1 $260,000 X 20% = $52,000 Year 2 $208,000 X 20% = $41,600

Units-of-Production The units-of-production method is a depreciation computation much like the straight-line method. We divide cost minus residual value by estimated useful life in both methods. However, using the units-of-production method, the useful life is measured in units of activity, resulting in a depreciation rate per unit of activity. Some examples of activity measures are units of output or units of input such as machine hours for equipment, or miles driven for vehicles. Once we compute the depreciation rate per unit of activity, we may calculate depreciation for the period by multiplying the depreciation rate per unit of activity times the number of units of activity for the current period.

When the activity method (units of production) is used, depreciation is assumed to be a function of productivity rather than the passage of time. This method is most appropriate for assets such as machinery or automobiles where depreciation can be based on units produced or miles driven. Illustration: Assume the machine was used for 6,800 hours in the first year of its useful life.

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. 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. We begin the process of calculating depletion expense by determining the depletion 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.

Amortization of Intangible Assets For an intangible asset with a finite useful life, we allocate capitalized costs over the asset’s useful life using the straight-line method, normally with a zero residual value. An intangible asset’s useful life may be limited by legal, regulatory, or contractual provisions. In other cases, the useful life may be less than the legal or contractual life. The amortization entry is: Amortization is the process of allocating the cost of an intangible asset to the periods benefited by its use. For an intangible asset with a finite useful life, we allocate capitalized costs over the asset’s useful life using the straight-line method, normally with a zero residual value. An intangible asset’s useful life may be limited by legal, regulatory, or contractual, provisions. In other cases, the useful life may be less than the legal or contractual life. For example, the useful life of a patent may be less than its legal life of 20 years if obsolescence is expected to limit the longevity of a protected product. The journal entry to record amortization requires a debit to amortization expense and a credit to the intangible asset account. Companies generally do not use a contra-asset account such as accumulated amortization when recording the amortization of intangible assets. Let’s look at an example. Amortization expense .................................. $$$ Intangible asset ………………........ $$$ To record amortization expense. A contra-asset account is generally not used when recording the amortization of intangible assets.

Intangible Assets not Subject to Amortization Goodwill and Trademarks Not amortized. Subject to assessment for impairment of value and may be written down. Goodwill and trademarks have indefinite useful lives and are not amortized, but instead are reviewed for impairment annually, or more often if impairment indicators arise. If an impairment is determined to exist, we will reduce the asset account and recognize the loss in value.

Group and composite methods Involve averaging the service life of many assets and applying depreciation as though a single unit existed. The composite approach refers to a collection of dissimilar assets, whereas the group approach refers to a collection of assets with similar characteristics. The method of computation for group or composite is essentially the same: find an average and depreciate on that basis. For example, the following assets would have the following composite rate and life.   Original Salvage Depreciable Useful Depreciation Asset Cost   Value   Cost   Life   (Straight-Line) A $ 65,000 $ 5,000 $ 60,000 5 yrs. $12,000 B 148,000 18,000 130,000 10 yrs. 13,000 C 95,000 11,000 84,000 12 yrs. 7,000 $308,000 $34,000 $274,000 $32,000 Composite Rate: $32,000/308,000 = 10.39% Composite Life: $274,000/32,000 = 8.56 years  These assets will be depreciated at $32,000 per year for 8.56 years (Ex 9)

Partial Year Depreciation In general, depreciation should be based on the number of months an asset is used during an accounting period. If a decreasing charge depreciation method is used for assets purchased during an accounting period, a slight modification is appropriate. When this situation occurs, determine depreciation expense for the full year and prorate the expense between the two periods involved. This process continues throughout the service life of the asset. Exercise 6 (1 & 3)

Change in Accounting Estimates The estimates involved in the depreciation process are sometimes subject to revision as a result of unanticipated occurrences. Such revisions are classified as changes in accounting estimates and should be handled in the current and prospective periods. Exercise 16

Error Correction (Not Covered) 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. The correction of an error is necessary when a transaction is recorded incorrectly or not recorded at all. To correct a material error found in a subsequent period, we restate prior year’s statements that are presented for comparative purposes to reflect the impact of the change. We adjust the balance in each account affected to appear as if the error had never occurred. If retained earnings is one of the accounts whose balance needs to be adjusted, we adjust the beginning balance of retained earnings for the earliest period reported in the comparative statements. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary items, and earnings per share. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary items, and earnings per share.

Long-term assets to be held and used Long-term assets held for sale Test for impairment of value when considered for sale. Impairment of Value Accounting treatment differs. Long-term assets to be held and used Long-term assets held for sale Test for impairment of value when it is likely that the fair value of a reporting unit is less than its book value. Tangible and intangible with finite useful lives Intangibles with indefinite useful lives Goodwill Part I. Impairment is the loss of a significant portion an asset’s benefits through casualty, obsolescence, or lack of demand for the asset’s services. If an asset’s value decreases and cannot be recovered through future use or sale, the asset is considered to be impaired and it should be written down to its net realizable value. We recognize and measure impairment loss differently depending on whether the asset is being held for use or held for sale. For assets being held for use, different guidelines apply to tangible and intangible assets with finite useful lives and intangible assets with indefinite useful lives. Finally, because goodwill is a unique intangible asset with an indefinite useful life, there is yet another difference in accounting treatment. Part II. Tangible assets and finite life intangible assets are tested for impairment when events or changes in circumstances indicate that the book value may not be recoverable Intangible assets with indefinite useful lives, other than goodwill, are tested for impairment annually. For goodwill, companies are allowed to evaluate relevant events and circumstances to determine whether it is “more likely than not” (a likelihood of more than 50 percent) that the fair value of a reporting unit is now less than its book value. Only if that’s determined to be the case will the company perform the first step of the two-step goodwill impairment test. Long-term assets held for sale are tested for impairment 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.

Finite-Life Assets to be Held and Used Measurement – Step 1 An asset is impaired when . . . The undiscounted sum of its estimated future cash flows Its book value Determining the amount of impairment loss to record on a tangible 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. <

Finite-Life Assets to be Held and Used Exercise 22, 23, 25, 26 Measurement – Step 2 Impairment loss Book value Fair value = – Reported in the income statement as a separate component of operating expenses Market value, price of similar assets, or PV of future net cash inflows. Undiscounted future cash flows Part I. If it is determined that an impairment loss has occurred on a tangible asset or on a finite-life intangible asset in step one, the second step in the process is to determine the amount of the impairment loss. The impairment loss is the amount by which book value exceeds fair value. If fair value cannot be determined in the market place, it is estimated as the discounted sum (present value) of the estimated future cash flows from the asset. Recall that undiscounted cash flows are used in step one. An impairment loss normally is reported in the income statement as a separate component of operating expenses. Part II. Let’s look at an example illustrating two steps of the process. In case one, the undiscounted sum of estimated future cash flows of $250 is greater than the book value of $50, so there is no impairment (step one). In case two, the undiscounted sum of estimated future cash flows of $250 is greater than the book value of $150, so there is no impairment (step one). In case three, the undiscounted sum of estimated future cash flows of $250 is less than the book value of $275, so there is an impairment (step one). The amount of the impairment is equal to the $275 book value of the asset less the $125 fair value of the asset (step two). Fair value $0 $125 $250 Case 1: $50 book value. No loss recognized Case 3: $275 book value. Loss = $275 – $125 Case 2: $150 book value. No loss recognized

Important differences in accounting for impairment of value for property, plant, and equipment and finite-life intangible assets between U.S. GAAP and IAS No. 36. U.S. GAAP IFRS When to Test When events or changes in Assets must be assessed for indicators of circumstances indicate that impairment at the end of each reporting book value may not be period. Indicators of impairment are similar recoverable. to U.S. GAAP. Recoverability An impairment loss is There is no equivalent recoverability test. required when an asset’s An impairment loss is required when an asset’s book value exceeds book value exceeds the higher of the asset’s the undiscounted sum of value-in- use (present value of estimated the asset’s estimated future future cash flows) and fair value less costs to cash flows. sell. Measurement The impairment loss is the The impairment loss is the difference between difference between book book value and the “recoverable amount” (the value and fair value. higher of the asset’s value-in-use and fair value less costs to sell). Subsequent Prohibited. Required if the circumstances that caused the Reversal of Loss impairment are resolved.

Let’s look at an illustration highlighting the important differences between GAAP and IFRS:   The Jasmine Tea Company has a factory that has significantly decreased in value due to technological innovations in the industry. Below are data related to the factory’s assets: ($ in millions) Book value $18.5 Undiscounted sum of estimated future cash flows 19.0 Present value of future cash flows 16.0 Fair value less cost to sell (determined by appraisal) 15.5 What amount of impairment loss should Jasmine Tea recognize, if any, under U.S. GAAP? Under IFRS?

U.S. GAAP There is no impairment loss. The sum of undiscounted estimated future cash flows exceeds the book value. IFRS Jasmine should recognize an impairment loss of $2.5 million. Indicators of impairment are present: Book value exceeds both: -Value-in-use (present value of cash flows) and -Fair value less costs to sell. The recoverable amount is $16 million calculated as the higher of -Value-in-use ($16 million) and -Fair value less costs to sell ($15.5 million). The impairment loss is the difference between: Book value and Recoverable amount = $18.5 million - $16 million =$2.5M

Assets Held for Sale Assets held for sale include assets that management has committed to sell immediately in their present condition and for which sale is probable. 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. Impairment loss = Book value Fair value less cost to sell –

Indefinite-Life Intangibles (Ex 26) Other Indefinite- life intangibles One-Step Process If BV of asset > FV, recognize impairment loss. Goodwill Step 1 If BV of reporting unit > FV, impairment indicated. Step 2 Loss = BV of goodwill less implied value of goodwill. The measurement of an impairment loss for goodwill is a two-step process. Goodwill is inseparable from a particular reporting unit. A reporting unit is an operating segment of a company or a component of an operating segment for which discrete financial information is available and segment managers regularly review the operating results of that component. In step one we compare the fair value of the reporting unit to its book value to see if an impairment is indicated. If the book value is greater than the fair value, there is an impairment of goodwill. Companies are allowed to evaluate relevant events and circumstances to determine whether it is “more likely than not” (a likelihood of more than 50 percent) that the fair value of a reporting unit is now less than its book value. Only if that’s determined to be the case will the company perform the first step of the two-step goodwill impairment test. If impairment is indicated in step one, we calculate the amount of the impairment in step two. Because fair value of goodwill does not exist separately from the reporting unit, and cannot be measured directly (no separate market value or separate present value of cash flows), we imply the fair value of goodwill by subtracting the fair value of all identifiable net assets from the fair value of the entire reporting unit, the same process that is used to initially determine goodwill in a business combination. The impairment loss is then equal to the amount by which the book value of goodwill exceeds the implied fair value of goodwill. The measurement of an impairment loss for indefinite-life intangible assets other than goodwill is a one-step process. If book value is greater than fair value, an impairment loss is recognized for the difference.

Expenditures Subsequent to Acquisition Type of Expenditure Definition Usual Accounting Treatment Repairs and Maintenance Expenditures to maintain a given level of benefits Expense in the period incurred Additions The addition of a new major component to an existing asset Capitalize and depreciate over the remaining useful life of the original asset, or over the useful life of the addition, whichever is shorter Improvements The replacement of a major component Capitalize and depreciate over the useful life of the improved asset Rearrangements Expenditures to restructure an asset without addition, replacement, or improvement If expenditures are material and clearly increase future benefits, capitalize and depreciate over the future periods benefited After a plant asset is purchased, the company may incur additional expenditures on that asset. The accounting issue is deciding whether to capitalize these expenditures or to expense them in the period incurred. We normally use the following procedures: Expenditures for maintenance and ordinary repairs are normally expensed. These types of expenditures maintain the normal operating condition and do not extend the useful life beyond the original estimate. Expenditure for additions usually increase the productive capacity and are capitalized. Expenditures for improvements, replacements, and extraordinary repairs either increase the useful life beyond the original estimate, or increase productive output, or both. These expenditures are normally capitalized. Rearrangements are changes made in an existing process for improved output or improved efficiency. Normally, the cost of rearrangements are capitalized.

End of Chapter 11 End of Chapter 11.