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Property, Plant, and Equipment and Intangible Assets: Utilization and Impairment

PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin

Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Cost Allocation An Overview

The matching principle requires 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.
Some of the cost is expensed each period.

Acquisition Cost
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Expense
(Income Statement)

(Balance Sheet)

Cost Allocation An Overview

Asset Category Property, Plant, & Equipment Natural Resource Intangible Debit Depreciation Depletion Amortization Account Credited Accumulated Depreciation Natural Resource Asset Intangible Asset

Caution! Depreciation, depletion, and amortization are processes of cost allocation, not valuation!

Depreciation on the Balance Sheet

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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.

The systematic approach used for allocation.

Total amount of cost to be allocated.

Cost - Residual Value (at end of useful life)

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Depreciation
Group and composite methods Tax depreciation

Time-based Methods Straight-line (SL) Accelerated Methods Sum-of-the-years digits (SYD) Declining Balance (DB)

Activity-based methods
Units-of-production method (UOP).
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Straight-Line

The most widely used and most easily understood method.

Results in the same amount of depreciation in each year of the assets 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?
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Straight-Line
Annual Straight-line Depreciation = $ 9,000
Accumulated Depreciation (credit) $ 9,000 9,000 9,000 9,000 9,000 45,000

Depreciation

50,000

5,000

Year 1 2 3 4 5

Depreciation (debit) $ 9,000 9,000 9,000 9,000 9,000 45,000

Accumulated Depreciation Balance $ 9,000 18,000 27,000 36,000 45,000

Life in Years

Undepreciated Balance (book value) $ 50,000 41,000 32,000 23,000 14,000 5,000

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BV = Residual Value at the end of the assets useful life.

Residual Value

Accelerated Methods
Accelerated methods result in more depreciation in the early years of an assets useful life and less depreciation in later years of an assets useful life. Note that total depreciation over the assets useful life is the same as the straight-line method.

Sum-of-the-years-digits (SYD) depreciation

SYD = ( Cost Depreciation
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Residual ) Value

Remaining Years of Useful Life Sum-of-the-Years Digits*

Sum-of-the-Years Digits (SYD)

Sum-oftheYears'Digits (SYD) = ( Useful Life [ Useful Life 2 + 1 ] )

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.
SYD = ( = =
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5 30 15

[ 2

+ 1] ) 2

Sum-of-the-Years Digits (SYD)

SYD Depreciation Residual Value Remaining Years of Sum-of-theYears Digits 5 15

= (

Cost

= ( $50,000 =

$ 5,000 )

$15,000 Depreciation in Year 1 $ 5,000 ) 4 15

= ( $50,000 =

$12,000 Depreciation in Year 2

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Sum-of-the-Years Digits (SYD)

Fraction 5/15 4/15 3/15 2/15 1/15 Depreciation (debit) $ 15,000 12,000 9,000 6,000 3,000 45,000 Accumulated Depreciation Balance $ 15,000 27,000 36,000 42,000 45,000 Undepreciated Balance (book value) $ 50,000 35,000 23,000 14,000 8,000 5,000

Residual Value

Depreciation

16000 14000 12000 10000 8000 6000 4000 2000 0 1 2 3 4 5

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Life in Years

Declining-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) depreciation is computed as follows:

DDB = Book Value ( 2 Straight-line Rate )

Note that the Book Value will get lower each year.
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Declining-Balance (DB) Methods

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?

DDB =

Book Value

( 2 Straight-line Rate )

= $ 50,000 ( 2 20% ) = $ 20,000 1st Year Depreciation = ($50,000 - $20,000) (2 20%) = $ 12,000 2nd Year Depreciation
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Declining-Balance (DB) Methods

Year 1 2 3 4 5 Depreciation (debit) $ 20,000 12,000 7,200 4,320 1,480 45,000 Accumulated Depreciation Balance $ 20,000 32,000 39,200 43,520 45,000 Undepreciated Balance (book value) $ 50,000 30,000 18,000 10,800 6,480 5,000

Depreciation forced so that BV = Residual Value.

20000

Depreciation

15000 10000 5000 0 1 2 3 4 5

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Life in Years

Units-of-Production

Depreciation rate per unit of output

Acquisition Cost

Residual Value

Estimated Output in Units

Depreciation Depreciation = rate per unit

Units of output

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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?

Depreciation rate per unit

Depreciation

$50,000 $5,000 = 100,000

= = = Depreciation rate per unit $0.45 $9,900

= $0.45

Units of output 22,000

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Use of Various Depreciation Methods

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U.S. GAAP vs. IFRS

Component Depreciation, Depreciable Base, and Residual Value
Component depreciation is allowed but not often used in practice. The depreciable base is determined by subtracting estimated residual value from cost. Annual reviews of residual values are not required. Each component of an item of property, plant, and equipment is depreciated separately if its cost is significant to the total cost of the item. Depreciable base is determined by subtracting estimated residual value from cost. IFRS requires a review of residual values annually.

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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 assets cost and the proceeds.

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U.S. GAAP vs. IFRS

Valuation of Property, Plant, and Equipment

Property, plant, and equipment is reported in the balance sheet at cost less accumulated depreciation (book value). Revaluation is prohibited.

Property, plant, and equipment may be reported at cost less accumulated depreciation, or alternatively, at fair value (revaluation). If revaluation is chosen, all assets within a class of property, plant, and equipment must be revalued on a regular basis.

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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.

Depletion rate = per unit

Cost of Natural Resource

Residual Value

Estimated Recoverable Units

Total Depletion Cost

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Unit Depletion Rate

Units Extracted

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 ABCs depletion rate? Depletion rate = 1,000,000 40,000 Tons = $25 Per Ton For the year ABC mined 13,000 tons. What is the total amount of depletion for the year? Depletion = 13,000 tons $25per ton = $325,000
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U.S. GAAP vs. IFRS

Valuation of Biological Assets

Biological assets, such as timber tracts, are valued at cost less accumulated depletion.

Biological assets are valued at fair value less estimated costs to sell.

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Amortization of Intangible Assets

The amortization process uses the straight-line method, but usually assumes residual value = 0.
Amortization period is the shorter of the assets 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.
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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 contractual (useful) life of 5 years. The legal life is 20 years. For year 1, what is Torchs amortization expense?
Use the shorter of contractual life (5 years) or legal life (20 years).
Amortization = Cost Contractual life = $3,000 5 years = $ 600 per year
600 600

Amortization expense ................................... Patent ........................

To record amortization of patent.
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Intangible Assets not Subject to Amortization

Goodwill and Trademarks

Not amortized.
Subject to assessment for impairment of value and may be written down.

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U.S. GAAP vs. IFRS

Valuation of Intangible Assets

Intangible assets are reported at cost less accumulated amortization. U.S.GAAP prohibits revaluation of any intangible asset.

Intangible assets may be reported at (1) cost less accumulated amortization or (2) fair value, if fair value can be determined in an active market. If revaluation is chosen, all assets within the class of intangibles must be revalued on a regular basis. Goodwill cannot be revalued.

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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 of a year of depreciation in the

year of acquisition, and the other in the year of disposal.

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Changes in Estimates
ESTIMATED service life ESTIMATED residual value

Changes in estimates are accounted for prospectively. The book value less any residual value at the date of change is depreciated over the remaining useful life. A disclosure note should describe the effect of a change.
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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Changes in Estimates

Asset cost Accumulated depreciation ($3,000 per year 3 years) Remaining book value Divide by remaining life Revised annual depreciation

$ 30,000 9,000 21,000 5 $ 4,200

What happens if we change depreciation methods?

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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, 2009, 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 2011, the company switched from double-declining balance to straight-line depreciation. The residual value remained at $40,000. Lets determine the amount of depreciation to be recorded at the end of 2011.
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Change in Depreciation Method

Depreciation - 2009 $ Depreciation - 2010 Total Depreciation $ 160,000 ($400,000 40%) 96,000 [($400,000 - $160,000) 40%] 256,000

Cost of asset Undepreciated balance Less: residual value New depreciable amount Remaining service life Annual depreciation

$ $

400,000 144,000 (40,000) 104,000 3 34,667

December 31, 2011: Depreciation expense ................................... Accumulated depreciation................

To record depreciation expense.

34,667 34,667

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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 periods 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.
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Impairment of Value
Accounting treatment differs.

Test for impairment of value when considered for sale.

Long-term assets to be held and used

Long-term assets held for sale

Tangible and intangible with finite useful lives

Intangible with indefinite useful lives

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
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Finite-life Assets to be Held and Used

Measurement Step 1
An asset is impaired when . . .

The undiscounted sum of its estimated future cash flows

<

Its book value

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Finite-life Assets to be Held and Used

Measurement Step 2
Impairment loss Reported as part of income from continuing operations. = Book value Fair value

Market value, price of similar assets, or PV of future net cash inflows.

$0

Fair Value $125

Undiscounted future cash flows $250 Case 3: $275 book value. Loss = $275 - $125

Case 1: $50 book value. No loss recognized

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Case 2: $150 book value. No loss recognized

Assets Held for Sale

Assets held for sale include assets that management has committed to sell immediately in their present condition and for which sale is probable.

Impairment loss
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Book value

Fair value less cost to sell

U.S. GAAP vs. IFRS

Impairment of Value: Property, Plant, and Equipment and Finite-life Intangible Assets
Assets are tested for impairment when events or changes in indicators suggest that book value may not be recoverable. An impairment loss is required when an assets book value exceeds the undiscounted sum of the estimated future cash flows.
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Assets must be assessed for circumstances of impairment at the end of each reporting period. An impairment loss is required when an assets book value exceeds the higher of the assets value-in-use (present value of estimated future cash flow) and fair value less costs to sell.

U.S. GAAP vs. IFRS

Impairment of Value: Property, Plant, and Equipment and Finite-life Intangible Assets
The impairment loss is the difference between book value and fair value. Reversals of impairment losses are prohibited. The impairment loss is the difference between book value and the recoverable amount, the higher of the assets valuein-use and fair value less costs to sell. An impairment loss is reversed if the circumstances that caused the impairment is resolved.

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Finite-life Assets to be Held and Used

Because Acme Auto Parts has seen its sales steadily decrease due to the decline in new car sales, Acmes management believes that equipment that originally cost $350 million, with a $200 million book value may not be recoverable. Management estimates that future undiscounted cash flows associated with the equipments remaining useful life will be only $140 million, and that the equipment could be sold now for $120 million. Has Acme suffered an impairment loss and if so, how should it be recorded?

Step 1 $140 million < $200 million Impairment loss is indicated.

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Finite-life Assets to be Held and Used

Because Acme Auto Parts has seen its sales steadily decrease due to the decline in new car sales, Acmes management believes that equipment that originally cost $350 million, with a $200 million book value may not be recoverable. Management estimates that future undiscounted cash flows associated with the equipments remaining useful life will be only $140 million, and that the equipment could be sold now for $120 million. Has Acme suffered an impairment loss and if so, how should it be recorded?

Step 2 Impairment loss = $200 million $120 million = $80 million

Impairment loss ................................... Accumulated depreciation ................... Equipment .
To record impairment loss.
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80,000,000 150,000,000 230,000,000

Indefinite-life Intangibles
Goodwill
Step 1 If BV of reporting unit > FV, impairment indicated. Step 2 Loss = BV of goodwill less implied value of goodwill.
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Other Indefinite Life Intangibles

One-step Process If BV of asset > FV, recognize impairment loss.