mcgraw-hill /irwin© 2009 the mcgraw-hill companies, inc. operational assets: utilization and...
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McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.
OPERATIONAL ASSETS: OPERATIONAL ASSETS: UTILIZATION AND UTILIZATION AND IMPAIRMENTIMPAIRMENT
Chapter 11
Slide 2
11-2
Some of the cost is expensed each period.Some of the cost is expensed each period.
Cost Allocation – An OverviewCost Allocation – An Overview
ExpenseExpenseAcquisitionCost
AcquisitionCost
(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.
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.
Depreciation, depletion, and amortization are cost allocation processes used to help meet the
matching principle requirements.
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11-3
OperationalAsset Debit
Intangible Amortization Intangible Asset
Account Credited
Accumulated Depreciation
Property, Plant, & Equipment
Depreciation
Natural Resource DepletionNatural Resource
Asset
Caution! Depreciation, depletion, and amortizationare processes of cost allocation, not valuation!
Cost Allocation – An OverviewCost Allocation – An Overview
Depreciation on the
Balance Sheet
Slide 4
11-4
Cost allocation requires three pieces of information for each asset:
The estimated expected use from an asset.
The estimated expected use from an asset.
Total amount of cost to be allocated.
Cost - Residual Value (at end of useful life)
Total amount of cost to be allocated.
Cost - Residual Value (at end of useful life)
The systematic approach used for allocation.
The systematic approach used for allocation.
Allocation Base
Allocation Base
Service Life
Service Life
Allocation Method
Allocation Method
Measuring Cost AllocationMeasuring Cost Allocation
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Time-based MethodsStraight-line (SL)Accelerated Methods
Sum-of-the-years’ digits (SYD)Declining Balance (DB)
Time-based MethodsStraight-line (SL)Accelerated Methods
Sum-of-the-years’ digits (SYD)Declining Balance (DB)
Activity-based methodsUnits-of-production method (UOP).
Activity-based methodsUnits-of-production method (UOP).
Group andcomposite methods
Group andcomposite methods
Taxdepreciation
Taxdepreciation
Depreciation of Operational AssetsDepreciation of Operational Assets
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Straight-LineStraight-Line
The most widely used and most easily understood method.
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.
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?
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 $5,000.
What is the annual straight-line depreciation?
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11-7
Straight-LineStraight-Line
Accumulated Accumulated UndepreciatedDepreciation Depreciation Depreciation Balance
Year (debit) (credit) Balance (book value)50,000$
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 ValueBV = Residual Value at the
end of the asset’s useful life.
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Accelerated MethodsAccelerated Methods
Note that total depreciation over the asset’s usefullife is the same as the Straight-line Method.
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.
SYD depreciation is computed as follows:
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2
Sum-of-the-Years’ Digits (SYD)Sum-of-the-Years’ Digits (SYD)
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 $5,000. Using SYD depreciation, compute depreciation for the first two years.
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Sum-of-the-Years’ Digits (SYD)Sum-of-the-Years’ Digits (SYD)
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Accumulated UndepreciatedDepreciation Depreciation Balance
Fraction (debit) Balance (book value)50,000$
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$
Accumulated UndepreciatedDepreciation 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
Sum-of-the-Years’ Digits (SYD)Sum-of-the-Years’ Digits (SYD)
0
2000
4000
6000
8000
10000
12000
14000
16000
1 2 3 4 5
Life in Years
Dep
reci
atio
n
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Declining-Balance (DB) MethodsDeclining-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) depreciationis computed as follows:
Note that the Book Value will get lower each year.
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Double-Declining-Balance (DDB)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 $5,000.What is depreciation for the first two years using
double-declining-balance?
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Accumulated UndepreciatedDepreciation Depreciation Balance
Year (debit) Balance (book value)50,000$
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$
Accumulated UndepreciatedDepreciation 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$
Double-Declining-Balance (DDB)Double-Declining-Balance (DDB)
Depreciation forced so that BV = Residual Value.
02000400060008000100001200014000160001800020000
1 2 3 4 5
Life in Years
Dep
reci
atio
n
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11-15
Units-of-ProductionUnits-of-Production
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Units-of-ProductionUnits-of-ProductionOn 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?
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11-17
Use of Various Depreciation MethodsUse of Various Depreciation Methods
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Depreciation DisclosuresDepreciation Disclosures
Depreciation.Balances of major classes of depreciable
assets.Accumulated depreciation by asset or in
total.General description of
depreciation methods used.
Slide 19
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Group and Composite MethodsGroup and Composite MethodsAssets 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.
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.
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.
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11-20
The approach is based on the units-of-
production method.
Depletion of Natural ResourcesDepletion of Natural Resources
As natural resources are “used up”, or depleted, the cost of the
natural resources must be allocated to the units extracted.
Slide 21
11-21
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.
Depletion of Natural ResourcesDepletion of Natural Resources
What is ABC’s unit depletion rate?
a. $40 per ton
b. $50 per ton
c. $25 per ton
d. $20 per ton
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
$1,000,000 / 40,000 Tons
= $25 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. What is the total amount of depletion for the year?
a. $325,000
b. $315,000
c. $275,000
d. $225,000
Depletion of Natural ResourcesDepletion of Natural Resources
Depletion = 13,000 x $25 = $325,000Depletion = 13,000 x $25 = $325,000
Slide 23
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Amortization of Intangible AssetsAmortization 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 notuse a contra-asset account.
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Amortization of Intangible AssetsAmortization of Intangible AssetsTorch, 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?
Slide 25
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Intangible Assets Not SubjectIntangible Assets Not Subjectto Amortizationto Amortization
Not amortized.
Subject to assessment for impairment
value and may bewritten down.
Goodwill
Slide 26
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Partial-Period Depreciation 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.
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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Depreciation Expense is based on . . .
ESTIMATED service life
ESTIMATED service life
ESTIMATED residual valueESTIMATED
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 $30,000, has a useful life of 10 years and no salvage value. At the beginning of the fourth year, it was decided that there were only 5 years
remaining, instead of 7 years. Calculate depreciation expense for the fourth
year using the straight-line method.
Changes in EstimatesChanges in Estimates
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Asset cost 30,000$ Accumulated depreciation ($3,000 per year × 3 years) 9,000 Remaining book value 21,000 Divide by remaining life ÷ 5Revised annual depreciation 4,200$
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?
Changes in EstimatesChanges in Estimates
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Change in Depreciation MethodChange in Depreciation Method
We account for these changes prospectivelyprospectively,, exactly as we would any other change in estimate.
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.
A change in depreciation, amortization, or depletion method is considered a change in accounting estimate that is achieved by a change in accounting principle.
On January 1, 2007, Matrix, Inc., purchased equipment for $400,000. Matrix expected a residual value $40,000, and a
service life of 5 years. Matrix uses the double-declining-balance method to depreciate this type of asset. During
2009, the company switched from double-declining balance to straight-line depreciation. Let’s determine the amount of
depreciation to be recorded at the end of 2009.
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Change in Depreciation MethodChange in Depreciation Method
Depreciation - 2007 160,000$ ($400,000 × 40%)Depreciation - 2008 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$
2009 Depreciation
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Error CorrectionError 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.
Slide 32
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Impairment of ValueImpairment of Value
Accounting treatment differs.Accounting treatment differs.
Operational assetsto be held and usedOperational assetsto be held and used
Operational assetsheld to be sold
Operational assetsheld to be sold
Tangible andintangible with finiteuseful lives
Tangible andintangible with finiteuseful lives
Intangiblewith
indefiniteuseful lives
Intangiblewith
indefiniteuseful lives
GoodwillGoodwill
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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Tangible and Finite-Life IntangiblesTangible and Finite-Life Intangibles
An asset is impaired when . . .
The undiscounted sum of its estimated future cash flows
Measurement – Step 1Measurement – Step 1
Itsbookvalue
<
Slide 34
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Impairmentloss =
Bookvalue
Fairvalue–
Measurement – Step 2
$0 $250$125
Case 1: $50 book value.No loss recognized
Case 2: $150 book value. No loss recognized
Case 3: $275 book value.Loss = $275 - $125
Fair ValueUndiscounted future
cash flows
Tangible and Finite-Life IntangiblesTangible and Finite-Life Intangibles
Market value, price of similar assets,or PV of future net cash inflows.
Reported as partof income from
continuing operations.
Slide 35
11-35
Step 2 Loss = BV of goodwill less implied value
of goodwill.
Step 2 Loss = BV of goodwill less implied value
of goodwill.
Impairment of Value Impairment of Value ––Indefinite Life IntangiblesIndefinite Life Intangibles
Other IndefiniteLife Intangibles Other IndefiniteLife Intangibles GoodwillGoodwill
Step 1 If BV of business unit > FV, impairment
indicated.
Step 1 If BV of business unit > FV, impairment
indicated. One-step Process
If BV of asset > FV, recognize
impairment loss.
One-step Process
If BV of asset > FV, recognize
impairment loss.
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Impairment of Value –Impairment of Value –Operational Assets to be SoldOperational Assets to be Sold
Impairmentloss =
Bookvalue
Fair value lesscost to sell–
Operational assets to be soldincludes assets that management
has committed to sell immediately intheir present condition andfor which sale is probable.
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Expenditures Subsequent to AcquisitionExpenditures Subsequent to Acquisition
Type of Expenditure Definition Usual Accounting TreatmentRepairs and Maintenance
Expenditures to maintaina 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 ofa 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 overthe future periods benefited
Slide 38
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Appendix 11A ─ Comparison With Appendix 11A ─ Comparison With MACRS (Tax Depreciation)MACRS (Tax Depreciation)
Ignores residual
value
Provides for rapid write-off
Rates based on asset
“class lives”
Most corporations use the Modified Accelerated Cost Recovery System
(MACRS) for tax purposes.
Most corporations use the Modified Accelerated Cost Recovery System
(MACRS) for tax purposes.
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Appendix 11B ─ Retirement and Appendix 11B ─ Retirement and Replacement Methods of DepreciationReplacement Methods of Depreciation
Retirement MethodAcquisitions:
• 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 MethodAcquisitions:
• 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.
Used for groups of similar, low-valuedassets with short service lives.
McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.
End of Chapter 11End of Chapter 11