Chapter 11 OPERATIONAL ASSETS UTILIZATION AND IMPAIRMENT Mc

Chapter 11 OPERATIONAL ASSETS: UTILIZATION AND IMPAIRMENT Mc. Graw-Hill /Irwin © 2009 The Mc. Graw-Hill Companies, Inc.

Slide 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. Acquisition Cost (Balance Sheet) Expense (Income Statement) 11 -2

Slide 3 Cost Allocation – An Overview Caution! Depreciation, depletion, and amortization are processes of cost allocation, not valuation! Depreciation on the Balance Sheet 11 -3

Slide 4 Measuring Cost Allocation Cost allocation requires three pieces of information for each asset: Service Life Allocation Base The estimated expected use from an asset. Allocation Method The systematic approach used for allocation. Total amount of cost to be allocated. Cost - Residual Value (at end of useful life) 11 -4

Slide 5 Depreciation of Operational Assets Time-based Methods l. Straight-line (SL) l. Accelerated Methods Sum-of-the-years’ digits (SYD) Declining Balance (DB) Group and composite methods Tax depreciation Activity-based methods Units-of-production method (UOP). 11 -5

Slide 6 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. 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? 11 -6

Slide 7 Straight-Line BV = Residual Value at the end of the asset’s useful life. Residual Value 11 -7

Slide 8 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. SYD depreciation is computed as follows: 11 -8

Slide 9 Sum-of-the-Years’ Digits (SYD) 2 On January 1, we purchase equipment for $50, 000 cash. The equipment has a service life of 5 years and an estimated residual value of $5, 000. Using SYD depreciation, compute depreciation for the first two years. 11 -9

Slide 10 Sum-of-the-Years’ Digits (SYD) 11 -10

Slide 11 Sum-of-the-Years’ Digits (SYD) Depreciation Residual Value Life in Years 11 -11

Slide 12 Declining-Balance (DB) Methods DB depreciation Based on the straight-line rate multiplied by an acceleration factor. Stop depreciating when: BV = Residual Value Computations initially ignore residual value. Double-Declining-Balance (DDB) depreciation is computed as follows: Note that the Book Value will get lower each year. 11 -12

Slide 13 Double-Declining-Balance (DDB) On January 1, we purchase equipment for $50, 000 cash. The equipment has a service life of 5 years and an estimated residual value of $5, 000. What is depreciation for the first two years using double-declining-balance? 11 -13

Slide 14 Double-Declining-Balance (DDB) Depreciation forced so that BV = Residual Value. Life in Years 11 -14

Slide 15 Units-of-Production 11 -15

Slide 16 Units-of-Production On January 1, we purchased equipment for $50, 000 cash. The equipment is expected to produce 100, 000 units during its life and has an estimated residual value of $5, 000. If 22, 000 units were produced this year, what is the amount of depreciation? 11 -16

Slide 17 Use of Various Depreciation Methods 11 -17

Slide 18 Depreciation Disclosures Depreciation. Balances of major classes of depreciable assets. Accumulated depreciation by asset or in total. General description of depreciation methods used. 11 -18

Slide 19 Group and Composite Methods Assets are grouped by common characteristics. An average depreciation rate is used. Annual depreciation is the average rate × the total group acquisition cost. Accumulated depreciation records are not maintained for individual 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 depreciation for the difference between the asset’s cost and the proceeds. 11 -19

Slide 20 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-ofproduction method. 11 -20

Slide 21 Depletion of Natural Resources ABC Mining acquired a tract of land containing ore deposits. Total costs of acquisition and development were $1, 100, 000. ABC estimated the land contained 40, 000 tons of ore, and that the land will be sold for $100, 000 after the coal is mined. What is ABC’s unit depletion rate? a. $40 per ton b. $50 per ton c. $25 per ton d. $20 per ton Cost / Units $1, 000 / 40, 000 Tons = $25 Per Ton 11 -21

Slide 22 Depletion of Natural Resources For the year ABC mined 13, 000 tons. What is the total amount of depletion for the year? a. b. c. d. $325, 000 $315, 000 $275, 000 $225, 000 Depletion = 13, 000 x $25 = $325, 000 11 -22

Slide 23 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: Note that the amortization process does not use a contra-asset account. 11 -23

Slide 24 Amortization of Intangible Assets Torch, Inc. has developed a new device. Patent registration costs consisted of $2, 000 in attorney fees and $1, 000 in federal registration fees. The device has a useful life of 5 years. The legal life is 20 years. For year 1, what is Torch’s amortization expense? 11 -24

Slide 25 Intangible Assets Not Subject to Amortization Goodwill Not amortized. Subject to assessment for impairment value and may be written down. 11 -25

Slide 26 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. 11 -26

Slide 27 Changes in Estimates Depreciation 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. On January 1, equipment was purchased that cost $30, 000, has a useful life of 10 years and no salvage value. At the beginning of the fourth year, it was decided that there were only 5 years remaining, instead of 7 years. Calculate depreciation expense for the fourth year using the straight-line method. 11 -27

Slide 28 Changes in Estimates What happens if we change depreciation methods? 11 -28

Slide 29 Change in Depreciation Method A change in depreciation, amortization, or depletion method is considered a change in accounting estimate that is achieved by a change in accounting principle. We account for these changes prospectively, exactly as we would any other change in estimate. On January 1, 2007, Matrix, Inc. , purchased equipment for $400, 000. Matrix expected a residual value $40, 000, and a service life of 5 years. Matrix uses the double-decliningbalance method to depreciate this type of asset. During 2009, the company switched from double-declining balance to straight-line depreciation. Let’s determine the amount of depreciation to be recorded at the end of 2009. 11 -29

Slide 30 Change in Depreciation Method 2009 Depreciation 11 -30

Slide 31 Error Correction 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. 11 -31

Slide 32 Impairment of Value Test for impairment of value when considered for sale. Accounting treatment differs. Operational assets to be held and used Tangible and intangible with finite useful lives Intangible with indefinite useful lives Operational assets held to be sold Goodwill Test for impairment of value at least annually. Test for impairment of value when it is suspected that book value may not be recoverable 11 -32

Slide 33 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 11 -33

Slide 34 Tangible and Finite-Life Intangibles Measurement – Step 2 Impairment loss = Reported as part of income from continuing operations. $0 Book value Market value, price of similar assets, or PV of future net cash inflows. Fair Value $125 Case 1: $50 book value. No loss recognized – Fair value Undiscounted future cash flows $250 Case 3: $275 book value. Loss = $275 - $125 Case 2: $150 book value. No loss recognized 11 -34

Slide 35 Impairment of Value – Indefinite Life Intangibles Goodwill Step 1 If BV of business unit > FV, impairment indicated. Step 2 Loss = BV of goodwill less implied value of goodwill. Other Indefinite Life Intangibles One-step Process If BV of asset > FV, recognize impairment loss. 11 -35

Slide 36 Impairment of Value – Operational Assets to be Sold Operational assets to be sold includes 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 11 -36

Slide 37 Expenditures Subsequent to Acquisition Type of Expenditure Repairs and Maintenance Additions Definition Expenditures to maintain a given level of benefits Usual Accounting Treatment Expense in the period incurred The addition of a new major Capitalize and depreciate over the component to an existing asset 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 11 -37

Slide 38 Appendix 11 A ─ Comparison With MACRS (Tax Depreciation) Most corporations use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes. Provides for rapid write-off Ignores residual value Rates based on asset “class lives” 11 -38

Appendix 11 B ─ Retirement and Replacement Methods of Depreciation Slide 39 Used for groups of similar, low-valued assets with short service lives. Retirement Method Acquisitions: • Record initial acquisitions of assets at cost in the asset account. • Record subsequent acquisitions of assets at cost in the asset account Dispositions: • Credit the asset account for cost. • Debit depreciation expense for cost less the proceeds received. Replacement Method Acquisitions: • Record initial acquisitions of assets at cost in the asset account. • Record subsequent acquisitions with a debit to depreciation expense. Dispositions: • Credit depreciation expense for the proceeds received. 11 -39

End of Chapter 11 Mc. Graw-Hill /Irwin © 2009 The Mc. Graw-Hill Companies, Inc.