spiceland chapter 11 - university of texas at el pasoutminers.utep.edu/sglandon/sglandon/acct… ·...

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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Chapter ElevenChapter ElevenOperational Assets:

Utilization and Impairment


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Some of the cost is expensed each period.

Cost Allocation – An Overview

ExpenseAcquisitionCost

(Balance Sheet) (Income Statement)

The matching principle requires that part of the acquisition cost of operational assets be

expensed in periods when the future revenues are earned.


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Some of the cost is expensed each period.

ExpenseAcquisitionCost

(Balance Sheet) (Income Statement)

Depreciation, depletion, and amortization are cost allocation processes used to help meet the matching principle requirements.


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Type ofOperational Expense

Asset Debit

Intangible Amortization Intangible Asset

Account Credited

Accumulated Depreciation

Property, Plant, & Equipment Depreciation

Natural Resource Depletion Natural Resource Asset

Caution! Depreciation, depletion, and amortization

are used for cost allocation, not valuation!



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Cost allocation requires three pieces of information for each asset:

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.

Allocation Base

Service Life

Allocation Method

Measuring Cost Allocation


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Depreciation of Operational Assets

Time-based MethodsStraight-line (SL)Accelerated Methods

Sum-of-the-years’-digits (SYD)Declining Balance (DB)

Activity-based methodsUnits-of-production method (UOP).

Group andcomposite methods

Taxdepreciation


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Depreciation on theBalance Sheet

Net property, plant, & equipment is the undepreciated cost (book value) of plant assets.


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Straight-Line (SL)

The most widely used and most

easily understood method.

Results in the same amount of depreciation expense in each year of the asset’s service

life.


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On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of 5 years and

residual value of $5,000.

What is the annual straight-line depreciation?

Straight-Line (SL)


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Straight-Line (SL)


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Depreciation Accumulated Accumulated UndepreciatedExpense Depreciation Depreciation Balance

Year (debit) (credit) Balance (book value)50,000$

1 9,000$ 9,000$ 9,000$ 41,000 2 9,000 9,000 18,000 32,000 3 9,000 9,000 27,000 23,000 4 9,000 9,000 36,000 14,000 5 9,000 9,000 45,000 5,000

45,000$ 45,000$

Residual ValueNote that at the end of the asset’s

useful life, BV = Residual Value

Straight-Line (SL)


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0100020003000400050006000700080009000

1 2 3 4 5

Life in Years

Dep

reci

atio

nStraight-Line (SL)


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Accelerated methods result in more depreciation expense in the early years of an

asset’s useful life and less depreciation expense in later years of an asset’s useful life.

Accelerated Methods

Note that total depreciation over the

asset’s useful life is the same as the SL Method.


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SYD depreciation is computed as follows:

Sum-of-the-Years’ Digits (SYD)


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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, compute depreciation expense for the first two years.



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Use this in your computation of SYD Depreciation Expense for Years 1 & 2.



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Depreciation Accumulated UndepreciatedExpense Depreciation Balance

Fraction (debit) Balance (book value)50,000$

5/15 15,000$ 15,000$ 35,000 4/15 12,000 27,000 23,000 3/15 9,000 36,000 14,000 2/15 6,000 42,000 8,000 1/15 3,000 45,000 5,000

45,000$ Residual Value



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02000400060008000

10000120001400016000

1 2 3 4 5

Life in Years

Dep

reci

atio

nSum-of-the-Years’ Digits (SYD)


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Declining-Balance (DB) Methods

DB depreciationBased on the straight-

line rate multiplied by an acceleration factor.

Computations initially ignore residual value.

Stop depreciating when:

BV=Residual Value


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Double-Declining-Balance (DDB)

DDB depreciation is computed as follows:

Note that the Book Value will get lower each time

depreciation is computed!


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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 expense forthe first two years using

double-declining-balance?



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Depreciation Accumulated UndepreciatedExpense Depreciation Balance

Year (debit) Balance (book value)50,000$

1 20,000$ 20,000$ 30,000 2 12,000 32,000 18,000 3 7,200 39,200 10,800 4 4,320 43,520 6,480 5 1,480 45,000 5,000

45,000$

We usually have to force depreciation expense in theWe usually have to force depreciation expense in thelatter years to an amount that brings BV = Residual Value.latter years to an amount that brings BV = Residual Value.



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02000400060008000

100001200014000160001800020000

1 2 3 4 5

Life in Years

Dep

reci

atio

nDouble-Declining-Balance (DDB)


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Activity-Based Depreciation

Depreciation can also be based on measures of input or output like:Service hours, orUnits-of-Production

Depreciation is not taken for idle assets.

This approach looks different.


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Units-of-Production


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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 expense?

Units-of-Production


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Units-of-Production


Slide11-30 Use of Various Depreciation

Methods

Proportion of Companies (Sample of 600)

576

227

5334 10

Straight Line

Declining Balance

Sum-of-the-years' digits

Other Accelerated

Units of Production

Other


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Depreciation Disclosures

Depreciation expense.Balances of major classes of

depreciable assets.Accumulated depreciation by asset or

in total.General description of

depreciation methods used.


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Assets are grouped by common characteristics.

A “composite rate” is calculated.Annual depreciation is determined by: the

composite rate × the total group acquisition cost.

Accumulated depreciation records are not maintained for individual assets.

Group and Composite Methods


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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 Depreciation for the difference between the asset’s cost and the proceeds.

Group and Composite Methods


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The approach is based on the units-

of-production method.

As natural resources are “used up”, or

depleted, the cost of the natural resources

must be expensed.

Depletion of Natural Resources


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ABC Mining acquired a tract of land containing ore

deposits. Total costs of acquisition and

development were $1,000,000. ABC estimated the land contained 40,000

tons of ore.



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What is ABC’s unit depletion rate?

a. $40 per ton b. $50 per tonc. $25 per tond. $20 per ton



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What is ABC’s unit depletion rate?

a. $40 per ton b. $50 per tonc. $25 per tond. $20 per ton

Cost / Units

$1,000,000 / 40,000 Tons

= $25 Per Ton



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For the year ABC mined 13,000 tons and sold 9,000 tons. What is the total depletion cost and the total depletion expense?

a. $325,000 & $225,000 b. $325,000 & $325,000c. $225,000 & $225,000d. $275,000 & $225,000



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For the year ABC mined 13,000 tons and sold 9,000 tons. What is the total depletion cost and the total depletion expense?

a. $325,000 & $225,000 b. $325,000 & $325,000c. $225,000 & $225,000d. $275,000 & $225,000


Cost = 13,000 x $25

= $325,000

Expense = 9,000 x $25

= $225,000


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Amortization of Intangible Assets

The amortization process uses the straight-line method, but assumes

residual value = 0.

Amortization period is the shorter of:

Economic Life

Legal Life

or


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The amortization entry is:

Note that the amortization process does not use a contra-asset account.


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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.At the end of year 1, what is Torch’s

amortization expense?



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Record the amortization entry.



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Note that the patent will have a book value of $2,400 after this amortization entry is posted.



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Intangible Assets Not Subjectto Amortization

Not amortized.Subject to assessment

for impairmentvalue and may be

written down.

Goodwill


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I bought an asset on May 19 this year. Do I get a

full year’s depreciation?

May19

Partial-Period Depreciation


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Partial-Period Depreciation

Half-Year ConventionTake ½ of a year of depreciation in the year of acquisition, and the other ½ in

the year of disposal.

Pro-rating the depreciation based on the date of acquisition is time-consuming

and costly. A commonly used alternative is the . . .


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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.


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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.



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Asset cost 30,000$ Accumulated depreciation ($3,000 per year × 3 years) 9,000 Remaining book value 21,000 Divide by remaining life ÷ 5Revised annual depreciation 4,200$

What happens if we change depreciation methods?



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Change in Depreciation Method

We account for these changes prospectivelyprospectively,, exactly as we would any

other change in estimate.

A change in depreciation, amortization, or depletion method is considered a change in accounting estimate that is achieved by a

change in accounting principle.


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On January 1, 2003, Matrix, Inc., a calendar year-end company purchased equipment for $400,000. Matrix expected a residual value

$40,000, and a service life of 5 years. Matrix uses double-declining-balance method to depreciate this type of asset. During 2005,

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 2005.

Change in Depreciation Method


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Change in Depreciation MethodDepreciation - 2003 160,000$ ($400,000 × 40%)Depreciation - 2004 96,000 [($400,000 - $160,000) × 40%]Total Depreciation 256,000$

Cost of asset 400,000$ Accumulated depreciation (256,000) Undepreciated balance 144,000 Remaining service life ÷ 3 Annual depreciation 48,000$

2005 Depreciation


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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.


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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.


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Impairment of Value

Accounting treatment differs.

Operational assetsto be held and used

Operational assetsheld to be sold

Tangible andintangible with finiteuseful lives

Intangiblewith

indefiniteuseful lives

Goodwill


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Impairment of Value

Accounting treatment differs.

Operational assetsto be held and used

Operational assetsheld to be sold

Tangible andintangible with finiteuseful lives

Intangiblewith

indefiniteuseful lives

Goodwill

Test for impairment of value 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


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Recoverable cost < Book valueAn asset is impaired if . . .

Expected future total undiscounted net cash

inflows generated by use of the asset.

Impairment of Value – Tangible and Finite-Life Intangibles

Measurement – Step 1


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Reported aspart of

income fromcontinuingoperations.

Impairmentloss =

Bookvalue

Fairvalue–

Market value, price of similar assets, or PV of future net cash inflows.Fair value < recoverable value due to the time value of money.




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$0 $250$125

Case 1:$50 Carrying valueNo loss recognized

Case 2:$150 Carrying valueNo loss recognized

Case 3:$275 Carrying valueLoss = $275 - $125

FairValue

RecoverableCost




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Impairment of Value – Indefinite Life Intangibles

Other IndefiniteLife Intangibles Goodwill

Step 1 If BV of business unit > FV, impairment indicated.

Step 2 Loss = BV of goodwill less implied value of

goodwill.

One-step ProcessIf BV of asset > FV, recognize

impairment loss.

Goodwill Example


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Parent Company purchased Sub Company for $500 million at a time when the fair value of Sub’s net identifiable assets were

$400 million. Sub continued to operate as a separate company. At the end of the next year, Parent did a goodwill impairment

test revealing the following:

Impairment of Value – Goodwill

Book value of Sub's assets, including $100 million of goodwill 440$

Sub's fair value 350$ Fair value of Sub's identifiable assetsexcluding goodwill 325$

Goodwillimpaired?


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Impairment of Value – Goodwill


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Expenditures Subsequentto Acquisition

Maintenance and

ordinary repairs.

Additions.

Improvements (betterments),

replacements, and extraordinary

repairs.

Rearrangements and other

adjustments.


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Normally we debit an expense account for amounts spent on:



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Normally we debit the asset account for amounts spent on:



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Normally we debit the asset account for amounts spent on:



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Normally, we debit an asset account for amounts spent on:



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Tax Depreciation

Ignores residual

value

Provides for rapid write-off

Percentages based on

asset “class lives”

Most corporations use the Modified Accelerated Cost Recovery System

(MACRS) for tax purposes.


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We pulledquite a load in this

chapter didn’twe?

End of Chapter 11

spiceland chapter 11 - university of texas at el pasoutminers.utep.edu/sglandon/sglandon/acct… ·...

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