1. OPERATIONAL ASSETS: UTILIZATION AND IMPAIRMENT
Chapter 11
OPERATIONAL ASSETS: UTILIZATION AND IMPAIRMENT
Chapter 11: Operational Assets Utilization and Impairment.
© 2009 The McGraw-Hill Companies, Inc.

2. 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)

3. 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.
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.

4. Depreciation of Operational Assets
Group and composite methods
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 of operational assets: 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 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).

5. Accelerated Methods SYD depreciation is computed as follows:
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.
SYD depreciation is computed as follows:
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.

6. 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:
Part I.
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.
Part II.
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, we saw that the straight-line rate for an asset with a ten-year life was one over tenth 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 will get lower each year.

7. Units-of-Production
The units-of-production depreciation computation is much like the straight-line method. We divide cost minus residual value by estimated useful life in both methods. However, the useful life is measured in units of output using the units-of-production method, resulting in a depreciation rate per unit of production.
Once we compute the depreciation rate per unit of output, we may calculate depreciation for the period by multiplying the depreciation rate per unit times the number of units produced in the current period.
Let’s look at an example.

8. 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.

9. Amortization of Intangible Assets
The amortization process uses the straight-line method, but usually assumes residual value = 0.
Amortization period is the shorter of economic life or legal life.
The amortization entry is:
Part I.
Amortization is the process of allocating the cost of an intangible asset to the periods benefited by its use. The amortization process uses the straight-line method, but usually assumes a zero residual value. The amortization period is the shorter if the intangible asset’s economic or legal life.
Part II.
The journal entry to record amortization requires a debit to amortization expense and a credit to the intangible asset account. We do not use a contra-asset account such as accumulated amortization when recording the amortization of intangible assets.
Let’s look at an example.
Note that the amortization process does not use a contra-asset account.

10. Intangible Assets Not Subject to Amortization
Goodwill
Not amortized.
Subject to assessment for impairment value and may be written down.
Goodwill can be created when one company buys another company. If the purchase price of the company is greater than the fair value of the net assets and liabilities acquired, we have goodwill associated with the transaction. Goodwill is not amortized. Each year we must test to see if there has been any impairment in the carrying value of the goodwill. If an impairment is determined to exist, we will reduce the goodwill account and recognize the loss in value.

11. Errors found in a subsequent accounting period are corrected by . . .
Error Correction
Errors found in a subsequent accounting period are corrected by . . .
Entries that restate the incorrect account balances to the correct amount.
Reporting the correction as a prior period adjustment to Beginning R/E.
Restating the prior period’s financial statements.
The correction of an error is necessary when a transaction is recorded incorrectly or not recorded at all. To correct an accounting 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.

12. Test for impairment of value when considered for sale.
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
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 operational asset is being held for use or held for sale. For operational 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 operational 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
Part III.
Intangible assets with indefinite useful lives, including goodwill are tested for impairment annually.
Part IV.
Operational 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

13. Tangible and Finite-Life Intangibles
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 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.
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14. Tangible and Finite-Life Intangibles
Measurement – Step 2
Impairment loss
Book value
Fair value = –
Reported as part of income from continuing operations.
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 operational 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 is reported as part of income from continuing operations.
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

15. 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.
Step 2 Loss = BV of goodwill less implied value of goodwill.
Part I.
The measurement of an impairment loss for goodwill is a two step process. Goodwill is inseparable from a particular business unit. So in step one we compare the fair value of the acquired company 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.
Part II
If impairment is indicated in step one, we calculate the amount of the impairment is step two. The impairment is equal to the excess of book value over fair value of the entire business. Because fair value of goodwill does not exist separately from the business, we imply the fair value of goodwill by subtracting the fair value of identifiable net assets from the fair value of the entire business, the same process that is used to initially determine goodwill in a business combination.
Part III.
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.

16. 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.
© 2008 The McGraw-Hill Companies, Inc.

17. End of Chapter 11 End of Chapter 11.
© 2008 The McGraw-Hill Companies, Inc.