CHAPTER 11Property, Plant, and Equipmentand Intangible Assets:Utilization and Impairment
Some of the cost is allocated to each period. AcquisitionCost Expense* (Balance Sheet) (Income Statement) Cost Allocation – An Overview The matching principlerequires that part of the acquisition cost of property, plant, and equipment and intangible 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 of an asset used to produce a product is a product cost that does not become an expense until the product is sold.
Cost Allocation – An Overview Caution!Depreciation, depletion, and amortizationare processes of cost allocation, not valuation! Depreciation on the Balance Sheet
The systematic approach used for allocation. The estimated expected use from an asset. Total amount of cost to be allocated. Cost – Residual Value (at end of useful life) Measuring Cost Allocation Cost allocation requires three piecesof information for each asset: Service Life Allocation Base Allocation Method
Depreciation Group andcomposite methods • Time-based Methods • Straight-line (SL) • Accelerated Methods • Sum-of-the-years'-digits (SYD) • Declining Balance (DB) Taxdepreciation Activity-based methods Units-of-production method (UOP).
Depreciation The following information for a piece of machinery will be used to illustrate some of the depreciation methods discussed in the following paragraphs. Cost of machine $260,000 Estimated useful life 10 years Estimated salvage value $20,000 Productive life in hours 60,000 hours
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?
Straight-Line Use of the straight-line method results in a uniform charge to depreciation expense during each year of an asset’s service life. This method is based upon the assumption that the decline in an asset’s usefulness is the same each year. Although the straight-line method is easy to use, it rests on an assumption that, in most situations, is not realistic.
Accelerated Methods Accelerated methods result inmoredepreciation in the early years of an asset’s useful life andless depreciation in later years of an asset’s useful life. Note that total depreciation over the asset’s usefullife is the same as the straight-line method. Sum-of-the-years’-digits (SYD) method (Not Covered) Double-Declining-Balance (DDB) method (Covered)
DB depreciation Based on the straight-line rate multiplied by an acceleration factor. Computations initially ignore residual value. Declining-Balance (DB) Methods Stop depreciating when: BV = Residual Value Double-Declining-Balance (DDB) depreciationis computed as follows: Note that the book value declines each year.
Declining-Balance (DB) Methods The declining-balance method utilizes a depreciation rate that is some multiple of the straight-line method. One popular method is twice the straight-line rate.Thus, in our example the 10-year asset life would translate into a 20% declining rate. Beginning Rate on of the Year Declining Depreciation Book Value X Balance = Charge Year 1 $260,000 X 20% = $52,000 Year 2 $208,000 X 20% = $41,600
When the activity method (units of production) is used, depreciation is assumed to be a function of productivity rather than the passage of time. This method is most appropriate for assets such as machinery or automobiles where depreciation can be based on units produced or miles driven. Illustration: Assume the machine was used for 6,800 hours in the first year of its useful life.
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.
Amortization of Intangible Assets For an intangible asset with a finite useful life, we allocate capitalized costs over the asset’s useful life using the straight-line method, normally with a zero residual value. An intangible asset’s useful life may be limited by legal, regulatory, or contractual provisions. In other cases, the useful life may be less than the legal or contractual life. The amortization entry is: Amortization expense .................................. $$$ Intangible asset ………………........ $$$ To record amortization expense. A contra-asset account is generally not used when recording the amortization of intangible assets.
Not amortized. Subject to assessment for impairment ofvalue and may bewritten down. Intangible Assets not Subject to Amortization Goodwill and Trademarks
Group and composite methods Involve averaging the service life of many assets and applying depreciation as though a single unit existed. The composite approach refers to a collection of dissimilar assets, whereas the group approach refers to a collection of assets with similar characteristics. The method of computation for group or composite is essentially the same: find an average and depreciate on that basis. For example, the following assets would have the following composite rate and life. Original Salvage Depreciable Useful Depreciation AssetCost Value Cost Life (Straight-Line) A $ 65,000 $ 5,000 $ 60,000 5 yrs. $12,000 B 148,000 18,000 130,000 10 yrs. 13,000 C 95,000 11,000 84,00012 yrs. 7,000 $308,000$34,000$274,000$32,000 Composite Rate: $32,000/308,000 = 10.39% Composite Life:$274,000/32,000 = 8.56 years These assets will be depreciated at $32,000 per year for 8.56 years (Ex 9)
Partial Year Depreciation In general, depreciation should be based on the number of months an asset is used during an accounting period. If a decreasing charge depreciation method is used for assets purchased during an accounting period, a slight modification is appropriate. When this situation occurs, determine depreciation expense for the full year and prorate the expense between the two periods involved. This process continues throughout the service life of the asset. Exercise 6 (1 & 3)
Change in Accounting Estimates The estimates involved in the depreciation process are sometimes subject to revision as a result of unanticipated occurrences.Such revisions are classified as changes in accounting estimates and should be handled in the current and prospective periods. Exercise 16
Error Correction (Not Covered) 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. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary items, and earnings per share.
Test for impairmentof value when consideredfor sale. Test for impairment of value at least annually. Test for impairment of valuewhen it is suspected that book value may not be recoverable. Impairment of Value Accounting treatment differs. Long-term assetsto be held and used Long-term assetsheld for sale Test for impairment of value when it is likely that the fair value of a reporting unit is less than its book value. Tangible andintangible with finiteuseful lives Intangibleswithindefiniteuseful lives Goodwill
An asset is impaired when . . . Finite-Life Assets to be Held and Used Measurement – Step 1 The undiscounted sum of its estimated future cash flows Itsbookvalue <
Finite-Life Assets to be Held and Used Exercise 22, 23, 25, 26 Measurement – Step 2 Impairmentloss Bookvalue Fairvalue = – Reported in the incomestatement as a separate component of operatingexpenses Market value, price of similar assets,or PV of future net cash inflows. Undiscounted futurecash flows Fair value $0 $125 $250 Case 3:$275 book value. Loss = $275 – $125 Case 1: $50 book value. No loss recognized Case 2: $150 book value. No loss recognized
Important differences in accounting for impairment of value for property, plant, and equipment and finite-life intangible assets between U.S. GAAPand IAS No. 36. U.S. GAAPIFRS When to Test When eventsor changes in Assets must be assessed for indicators of circumstances indicate that impairment at the end of each reporting book value may not be period. Indicators of impairment are similar recoverable. to U.S. GAAP. Recoverability An impairment loss is There is no equivalent recoverability test. required when an asset’s An impairment loss is required when an asset’s book value exceeds book value exceeds the higher of the asset’s the undiscounted sum ofvalue-in- use (present value of estimated the asset’s estimated future future cash flows) and fair value less costs to cash flows. sell. Measurement The impairment loss is the The impairment loss is the difference between difference between book book value and the “recoverable amount”(the value and fair value.higher of the asset’s value-in-use and fair value less costs to sell). Subsequent Prohibited. Required if the circumstances that caused the Reversal of Loss impairment are resolved.
Let’s look at an illustration highlighting the important differences between GAAP and IFRS: The Jasmine Tea Company has a factory that has significantly decreased in value due to technological innovations in the industry. Below are data related to the factory’s assets: ($ in millions) Book value $18.5 Undiscounted sum of estimated future cash flows 19.0 Present value of future cash flows 16.0 Fair value less cost to sell (determined by appraisal) 15.5 What amount of impairment loss should Jasmine Tea recognize, if any, under U.S. GAAP? Under IFRS?
U.S. GAAP There is no impairment loss. The sum of undiscounted estimated future cash flows exceeds the book value. IFRS Jasmine should recognize an impairment loss of $2.5 million. Indicators of impairment are present: Book value exceeds both: -Value-in-use (present value of cash flows) and -Fair value less costs to sell. The recoverable amount is $16 million calculated as the higher of -Value-in-use ($16 million) and -Fair value less costs to sell ($15.5 million). The impairment loss is the difference between: Book value and Recoverable amount = $18.5 million - $16 million =$2.5M
Impairmentloss Bookvalue Fair value lesscost to sell = – Assets Held for Sale Assets held for saleinclude assets that managementhas committed to sell immediately intheir present condition andfor which sale is probable.
Step 1 If BV of reporting 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. Indefinite-Life Intangibles (Ex 26) Other Indefinite-life intangibles Goodwill