1. Operational Assets: Utilization, Impairment, and Postacquisition Costs
Chapter 11
Operational Assets: Utilization, Impairment, and Postacquisition Costs

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.
Some of the cost is expensed each period.
Expense
Acquisition Cost
(Balance Sheet)
(Income Statement)

3. Cost Allocation – An Overview
Amortization and depletion are cost allocation processes used to help meet the matching principle requirements.
Some of the cost is expensed each period.
Expense
Acquisition Cost
(Balance Sheet)
(Income Statement)

4. Cost Allocation – An Overview
Caution!
Amortization and depletion are used for cost allocation, not valuation!

5. 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.

6. Amortization 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 amortization
Activity-based methods
Units-of-production method (UOP).

7. Amortization on the Balance Sheet
Net property, plant, & equipment is the unamortized cost (book value) of plant assets.

8. The most widely used and most easily understood method.
Straight-Line (SL)
The most widely used and most easily understood method.
Results in the same amount of amortization expense in each year of the asset’s service life.

9. Straight-Line (SL)
The Hogan Manufacturing Company purchased a machine for $250,000. The company expects the service life of the machine to be five years. During that time it is expected that the machine will produce 140,000 units. The anticipated residual value is $40,000. The machine will be disposed of after five years of use.

10. Actual unit production during the five years of the assets life was:
Straight-Line (SL)
Actual unit production during the five years of the assets life was:
Year ,000, Year ,000,
Year ,000, Year 4 - 8,000,
Year ,000
Total - 130,000

11. Straight-Line (SL)

12. Note that at the end of the asset’s useful life, BV = Residual Value
Straight-Line (SL)
Residual Value
Note that at the end of the asset’s useful life, BV = Residual Value

13. Note that at the end of the asset’s useful life, BV = Residual Value
Straight-Line (SL)
Residual Value
Note that at the end of the asset’s useful life, BV = Residual Value

14. Straight-Line (SL)
Amortization
Life in Years

15. Accelerated Methods
Accelerated methods result in more amortization expense in the early years of an asset’s useful life and less amortization expense in later years of an asset’s useful life.
Note that total amortization over the asset’s useful life is the same as the SL Method.

16. Sum-of-the-Years’ Digits (SYD)
SYD amortization is computed as follows:

17. Sum-of-the-Years’ Digits (SYD)
Referring back to the Hogan example.
The asset cost was $250,000, the salvage value was $40,000, and the estimated service life was five years.
Using SYD, compute amortization expense for the first two years.

18. Sum-of-the-Years’ Digits (SYD)
Use this in your computation of SYD Amortization Expense for Years 1 & 2.

19. Sum-of-the-Years’ Digits (SYD)

20. Sum-of-the-Years’ Digits (SYD)
Residual Value

21. Sum-of-the-Years’ Digits (SYD)
Amortization
Life in Years

22. Declining-Balance (DB) Methods
DB depreciation
Based on the straight-line rate multiplied by an acceleration factor.
Computations initially ignore residual value.
Stop amortizing when:
BV=Residual Value

23. Double-Declining-Balance (DDB)
DDB amortization is computed as follows:
Note that the Book Value will get lower each time amortization is computed!

24. Double-Declining-Balance (DDB)
Referring back to the Hogan example.
The asset cost was $250,000, the salvage value was $40,000, and the estimated service life was five years.
What is the amortization expense for the first two years using double-declining-balance?

25. Double-Declining-Balance (DDB)

26. Double-Declining-Balance (DDB)
We usually have to force amortization expense in the
latter years to an amount that brings BV = Residual Value.

27. Double-Declining-Balance (DDB)
Amortization
Life in Years

28. Activity-Based Amortization
This approach looks different.
Amortization can also be based on measures of input or output like:
Service hours, or
Units-of-Production
Amortization is not taken for idle assets.

29. Units-of-Production

30. Actual unit production during the five years of the asset’s life was:
Units-of-Production
Actual unit production during the five years of the asset’s life was:
Year ,000, Year ,000,
Year ,000, Year 4 – 8,000,
Year 5 – 16,000
Total – 130,000

31. Units-of-Production

32. Amount necessary to reduce book value to residual value.
Units-of-Production
Amount necessary to reduce book value to residual value.

33. Units-of-Production
Amortization
Life in Years

34. Use of Various Amortization Methods
% of Companies
Straight Line
90%
Declining balance 2%
Accelerate methods
Units of production 6%

35. Amortization Disclosures
Amortization expense.
Balances of major classes of capital assets.
Accumulated amortization by asset or in total.
General description of amortization methods used.

36. Group and Composite Methods
Assets are grouped by common characteristics.
A “composite rate” is calculated.
Annual amortization is determined by: the composite rate × the total group acquisition cost.
Accumulated amortization records are not maintained for individual assets.

37. Group and Composite Methods
Apply the composite rate to the total cost of the assets.
If assets in the group are sold, or new assets added, the composite rate remains the same.
When an asset in the group is sold or retired, debit Accumulated Amortization for the difference between the asset’s cost and the proceeds.

38. Group and Composite Methods
The Express Delivery Company began operations in It will amortize its fleet of delivery vehicles using the group method.
The relevant information is as follows:

39. Group Amortization
Group amortization rate = $52,800 / $330,000 = 16%

40. Group Amortization
If a delivery truck in the above example that cost $15,000 is sold for $3,000 in 2006 the journal entry would be:

41. Depletion of Natural Resources
As natural resources are “used up”, or depleted, the cost of the natural resources must be expensed.
The approach is based on the units-of-production method.

42. Depletion of Natural Resources

43. Depletion of Natural Resources
The Jackson Mining Company paid $1 million for the right to explore 500 acres of land in Newfoundland.

44. Depletion of Natural Resources
Exploration costs are $800,000, intangible development costs were $500,000. New excavation equipment was purchased that cost $600,000. The residual value on the equipment is $60,000. The geologist estimates that 1 million tonnes of coal will be extracted over three years. 300,000 tonnes were extracted in 2005.

45. Depletion of Natural Resources
The company has provided the following three cash flow possibilities (A, B and C) for the restoration costs to be paid in three years, after the extraction is completed:
Cash Outflow
Probability A
$500,000
30% B
600,000
50% C
700,000
20%

46. Depletion of Natural Resources
Purchase of rights to explore
$1,000,000
Exploration costs
800,000
Development costs
500,000
Restoration costs
468,360
Total cost of coal deposit
$2,768,360
$500,000 x .3 = $150,000
600,000 x .5 = ,000
700,000 x .2 = 140,000
$590,000
Present value of $1, n=3, I=8%
X = $468,360

47. Depletion of Natural Resources
What is Jackson’s unit depletion rate?
a. $ per tonne
b. $ per tonne
c. $ per tonne
d. $20 per tonne

48. Depletion of Natural Resources
What is Jackson’s unit depletion rate?
a. $ per tonne
b. $ per tonne
c. $ per tonne
d. $20 per tonne
Cost / Units
$2,768,360 / 1 million Tonnes
= $ Per Tonne

49. Amortization of Intangible Assets
The amortization process uses the straight-line method, but assumes residual value = 0.
Economic Life
Amortization period is the shorter of: or
Legal Life

50. Amortization of Intangible Assets
The amortization entry is:
Note that the amortization process does not use a contra-asset account.

51. Amortization of Intangible Assets
Hollins began operations in 2005 and purchased a franchise for $200,000. The franchise agreement is for 10 years. Hollins also purchased a patent for $50,000, which has a remaining legal life of 13 years, however, the estimated useful life is 8 years.
At the end of year 1, what is the amortization expense?

52. Amortization of Franchise
Record the amortization entry.

53. Amortization of Patent
Record the amortization entry.

54. Amortization of Intangible Assets

55. Intangible Assets Not Subject to Amortization
Goodwill
Not amortized.
Subject to assessment for impairment value and may be written down.

56. Partial-Period Amortization
I bought an asset on May 19 of this year. Do I get a full year’s amortization?
May 19

57. Partial-Period Amortization
Pro-rating the amortization 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 amortization in the year of acquisition, and the other ½ in the year of disposal.

58. Partial-Period Amortization
On April 1, 2005, the Hogan Manufacturing Company purchased a machine for $250,000. The company expects the service life of the machine to be five years and the anticipated residual value is $40,000. The company’s fiscal year end is December 31. Partial-year amortization is recorded on the basis of the number of months the asset is in service.

59. Partial-Period Amortization
Year
Straight-line
SYD
Double declining balance
2005
$42,000 x ¾ = $31,500
$70,000 x ¾ = $52,500
$100,000 x ¾ = $75,000
2006
$42,000
$70,000 x ¼ = $17,500
$56,000 x ¾ = $42,000
$100,000 x ¼ = $25,000
$60,000 x ¾ = $45,000

60. Changes in Estimates Amortization Expense is based on . . .
ESTIMATED service life
ESTIMATED residual value
If the estimates change, the book value less any residual value at the date of change is depreciated over the remaining useful life.

61. Calculate amortization expense for 2005 and the subsequent years.
Changes in Estimates
On January 1, 2003, equipment was purchased that cost $250,000, has a useful life of 5 years and salvage value of $40,000. The year end is December 31 and the straight line is used. During 2005 the company revised its estimate of service life from 5 years, to 8 years and also revised estimated residual value to $22,000.
Calculate amortization expense for 2005 and the subsequent years.

62. Changes in Estimates $250,000 Cost $42,000 x 2 years 84,000
Old amortization ($210,000/5 years)
166,000
Book value
22,000
Less revised residual value
144,000
Revised amortizable base /6
Estimated remaining life (8-2)
$24,000
New annual amortization

63. Change in Amortization Method
The cumulative after-tax effect on prior years’ income is reported as a prior period adjustment to opening retained earnings.
Difference between the reported Beginning R/E, and the Beginning R/E that would have resulted if the new accounting method had been used in all prior years.

64. Change in Amortization Method
The cumulative after-tax effect on prior years’ income is reported as a prior period adjustment to opening retained earnings.
Prior year’s income statement can be adjusted to reflect the new policy.

65. Changes in Amortization Method
On January 1, 2003, equipment was purchased that cost $250,000, has a useful life of 5 years, and salvage value of $40,000. The year end is December 31 and the double declining method is used. During 2005 the company switched from double-declining balance to the straight-line method.
Calculate the cumulative effect of the change.

66. Changes in Amortization Method
DDB
Straight Line
2003 amort.
$100 ($250 x 40%)
$42 ($210 / 5)
2004 amort.
60 ($150 x 40%)
42 ($210 / 5)
Accumulated
Amortization &
$160
$84
Difference
$76

67. Changes in Amortization Method
The journal entry is:

68. 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.

69. Impairment of Value
Occasionally, asset value must be written down due to permanent loss of benefits of the asset through . . .
Casualty.
Obsolescence.
Lack of demand for the asset’s services.

70. Impairment of Value 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

71. Test for impairment of value at least annually.
Test for impairment of value when it is suspected that book value may not be recoverable.
Test for impairment of value at least annually.
Accounting treatment differs.
Operational assets to be held and used
Operational assets held to be sold
Test for impairment of value when considered for sale.
Tangible and intangible with finite useful lives
Intangible with indefinite useful lives
Goodwill

72. Impairment of Value – Tangible and Finite-Life Intangibles
Measurement – Step 1
An asset is impaired if . . .
Recoverable cost < Book value
Expected future total undiscounted net cash inflows generated by use of the asset.

73. Impairment of Value – Tangible and Finite-Life Intangibles
Measurement – Step 2
Impairment loss
Book value
Fair value = –
Market value, price of similar assets, or PV of future net cash inflows.
Fair value < recoverable value due to the time value of money.
Reported as part of income from continuing operations.

74. Impairment of Value – Tangible and Finite-Life Intangibles
Measurement – Step 2
Fair Value
Recoverable Cost $0
$125
$250
Case 1:
$50 Carrying value
No loss recognized
Case 2:
$150 Carrying value
No loss recognized
Case 3:
$275 Carrying value
Loss = $275 - $250

75. 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.
Goodwill Example

76. Impairment Loss – Tangible Assets - Example
The Alberta Corporation operates several factories that manufacture medical equipment. At the end of the 2005 fiscal year, a change in business climate related to a competitor’s innovative products indicated to management that the $170 million book value of the assets of one of Alberta’s factories may not be recoverable.
Management is able to identify cash flows from this factory and estimates that they will be $150 million.

77. Impairment Loss – Tangible Assets - Example
Change in circumstances
requires investigation of possible impairment.
Recoverability
book value of $170 million exceeds undiscounted future cash flows of $150, indicating an impairment loss of $20 million.

78. Impairment of Value – Goodwill
In 2004 Upjane acquired Pharmacopia (Pharm) for $500 million. Upjane reported $110 million in goodwill since the fair value was $500 million. At the end of 2005 the following information is available:
Goodwill impaired?

79. Impairment of Value – Goodwill

80. Operational Assets to be Sold
For operational assets held for sale, if book value exceeds fair value, an impairment loss is recognized for the difference.

81. Expenditures Subsequent to Acquisition
Improvements (betterments), replacements, and extraordinary repairs.
Maintenance and ordinary repairs.
Rearrangements and other adjustments.
Additions.

82. Expenditures Subsequent to Acquisition
Normally we debit an expense account for amounts spent on:
Maintenance
& Ordinary
Repairs

83. Expenditures Subsequent to Acquisition
Normally we debit the asset account for amounts spent on:
Improvements
Replacements
Extraordinary
Repairs

84. Expenditures Subsequent to Acquisition
Normally we debit the asset account for amounts spent on:
Additions

85. Expenditures Subsequent to Acquisition
Normally, we debit an other asset account for amounts spent on:
Rearangements
and Other
Adjustments

86. Improvements - Example
The Palmer Corporation replaced the air conditioning system in one of its office buildings that it leases to tenants. The cost of the old air conditioning system, $200,000, is included in the cost of the building. However, the company has separately amortized the air conditioning system. Amortization recorded up to the date of replacement totalled $160,000.

87. Improvements - Example
The old system was removed and the new system installed at a cost of $230,000, which was paid in cash. Parts from the old system were sold for $12,000.
There are three methods available to record this transaction:

88. Improvements - Example
Option 1
This entry records the disposition of the old air conditioning equipment.

89. Improvements - Example
This entry records the acquisition of the new air conditioning equipment, assuming that the original cost and accumulated amortization of the old equipment can be separately identified.

90. Improvements - Example
Option 2
Include the net cost of the improvement as a debit to the related asset, without removing the original cost and accumulated amortization.

91. Improvements - Example
Option 3
Leave the asset account unaltered but decrease the related accumulated amortization.

92. We pulled quite a load in this chapter didn’t we?
End of Chapter 11
We pulled quite a load in this chapter didn’t we?