and Intangible Assets: Utilization and Impairment 11-2 Some of the cost is allocated to each period. Expense* Acquisition Cost (Balance Sheet) (Income Statement) 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. Cost Allocation An Overview *Depreciation of an asset used to produce a product is a product cost that does not become an expense until the product is sold. 11-3 Asset Category 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 processes of cost allocation, not valuation! Depreciation on the Balance Sheet Cost Allocation An Overview 11-4 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 11-5 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). Group and composite methods Tax depreciation 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 Depreciation 11-7 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? Cost less salvage Estimated service life Depreciation Charge ($260,000 $20,000) 10 $24,000 Use of the straight-line method results in a uniform charge to depreciation expense during each year of an assets service life. This method is based upon the assumption that the decline in an assets 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.
Straight-Line 11-9 Accelerated Methods Note that total depreciation over the assets useful life is the same as the straight-line method. 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. Sum-of-the-years-digits (SYD) method (Not Covered) Double-Declining-Balance (DDB) method (Covered) 11-10 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 declines each year. 11-11 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 11-12 Acquisition cost
Residual value Estimated life in units of activity Depreciation rate per unit of activity = Depreciation = Depreciation rate per unit of activity
Units of activity Units-of-Production (Cost less salvage)X hours this year Total estimated hours Depreciation Charge ($260, 000 $20, 000 X 6, 800) 60, 000 $27, 200 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. 11-14 The approach is based on the units-of- production method. 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. Cost of Natural Resource
Residual Value Estimated Recoverable Units Depletion Rate per Unit = Total Depletion Cost = Unit Depletion Rate
Units Extracted 11-15 Amortization of Intangible Assets For an intangible asset with a finite useful life, we allocate capitalized costs over the assets useful life using the straight-line method, normally with a zero residual value. An intangible assets 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: A contra-asset account is generally not used when recording the amortization of intangible assets. Amortization expense .................................. $$$ Intangible asset ........ $$$ To record amortization expense. 11-16 Not amortized. Subject to assessment for impairment of value and may be written down. Goodwill and Trademarks Intangible Assets not Subject to Amortization 11-17 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 Asset Cost 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 84,000 12 yrs. 7,000 $308,000 $34,000 $274,000 $32,000
These assets will be depreciated at $32,000 per year for 8.56 years (Ex 9) 11-18 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) 11-19 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 11-20 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 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. 11-21 Impairment of Value Long-term assets to be held and used Long-term assets held for sale Tangible and intangible with finite useful lives Intangibles with indefinite useful 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. Test for impairment of value when it is likely that the fair value of a reporting unit is less than its book value. Accounting treatment differs. 11-22 Finite-Life Assets to be Held and Used An asset is impaired when . . . The undiscounted sum of its estimated future cash flows Measurement Step 1 Its book value < 11-23 Impairment loss = Book value Fair value
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 $125 Fair value Undiscounted future cash flows Market value, price of similar assets, or PV of future net cash inflows. Reported in the income statement as a separate component of operating expenses Finite-Life Assets to be Held and Used Exercise 22, 23, 25, 26 Important differences in accounting for impairment of value for property, plant, and equipment and finite-life intangible assets between U.S. GAAP and I AS No. 36.
U.S. GAAP IFRS When to Test When events or changes in Assets must be assessed for indicators of circumstances indicate that impairment at the end of each reporting book value may not be period. Indicators of impairment are similar recoverable. to U.S. GAAP.
Recoverability An impairment loss is There is no equivalent recoverability test. required when an assets An impairment loss is required when an assets book value exceeds book value exceeds the higher of the assets the undiscounted sum of value-in- use (present value of estimated the assets estimated future future cash flows) and fair value less costs to cash flows. sell.
Measurement The impairment loss is the The impairment loss is the difference between difference between book book value and the recoverable amount (the value and fair value. higher of the assets value-in-use and fair value less costs to sell).
Subsequent Prohibited. Required if the circumstances that caused the Reversal of Loss impairment are resolved. Lets look at an illustration highlighting the important differences between GAAP and IFRS:
The Jasmine Tea Company has a factory that has significantly decreased in value due to technological innovations in the industry. Below are data related to the factorys assets:
($ 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 ($15.5million).
The impairment loss is the difference between: Book value and Recoverable amount = $18.5 million - $16 million =$2.5M 11-27 Impairment loss = Book value Fair value less cost to sell
Assets held for sale include assets that management has committed to sell immediately in their present condition and for which sale is probable. Assets Held for Sale 11-28 Step 2 Loss = BV of goodwill less implied value of goodwill. Goodwill Step 1 If BV of reporting unit > FV, impairment indicated. Other Indefinite- life intangibles One-Step Process If BV of asset > FV, recognize impairment loss. Indefinite-Life Intangibles (Ex 26) 11-29 Type of Expenditure Definition Usual Accounting Treatment Repairs and Maintenance Expenditures to maintain a 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 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 Expenditures Subsequent to Acquisition 11-30 End of Chapter 11