Operational Assets: Utilization and Impairment

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Operational Assets:

Utilization and Impairment

11Insert Book Cover

Picture

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Learning Objectives

Explain the concept of cost allocation as it pertains to operational assets.

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Some of the cost is expensed each period.Some of the cost is expensed each period.

Cost 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.

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Some of the cost is expensed each period.Some of the cost is expensed each period.

ExpenseExpenseAcquisitionCost

AcquisitionCost

(Balance Sheet) (Income Statement)

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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Type ofOperational

Asset Debit

Intangible Amortization Intangible Asset

Account Credited

Accumulated Depreciation

Property, Plant, & Equipment

Depreciation

Natural Resource DepletionNatural Resource

Asset

Caution! Depreciation, depletion, and amortization are

processes of cost allocation, not valuation!


11-6

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 Allocation

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Learning Objectives

Determine periodic depreciation using both time-based and activity-based methods.

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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 Assets

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Depreciation on the Balance Sheet

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

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Straight-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.

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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 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?

Straight-Line

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Straight-Line

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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 ValueResidual Value

Note that at the end of the asset’s useful life, BV = Residual Value

Note that at the end of the asset’s useful life, BV = Residual Value

Straight-Line

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0100020003000400050006000700080009000

1 2 3 4 5

Life in Years

De

pre

cia

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Straight-Line

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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.

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.

Accelerated Methods

Note that total depreciation over the

asset’s useful life is the same as the Straight-

line Method.

Note that total depreciation over the

asset’s useful life is the same as the Straight-

line Method.

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2

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 for the first two years.

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 for the first two years.

Sum-of-the-Years’-Digits (SYD)

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2

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

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


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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$


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 ValueResidual Value


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0

2000

4000

6000

8000

10000

12000

14000

16000

1 2 3 4 5

Life in Years

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Declining-Balance (DB) Methods

DB depreciation

Based on the straight-line rate multiplied by an acceleration factor.

Computations initially ignore residual value.

DB depreciation

Based on the straight-line rate multiplied by an acceleration factor.

Computations initially ignore residual value.

Stop depreciating when:

BV=Residual Value

Stop depreciating when:

BV=Residual Value

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DDB depreciation is computed as follows:

Note that the Book Value will get lower each time

depreciation is computed!

Note that the Book Value will get lower each time

depreciation is computed!

Double-Declining-Balance (DDB)

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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 forthe first two years using

double-declining-balance?

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 forthe first two years using

double-declining-balance?


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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$


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 in thelatter years to an amount that brings BV = Residual Value.

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

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02000400060008000100001200014000160001800020000

1 2 3 4 5

Life in Years

De

pre

cia

tio

n


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Activity-Based Depreciation

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

Units-of-Production

Depreciation is not taken for idle assets.

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

Units-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?

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?

Units-of-Production

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Units-of-Production

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Recent Survey of Large Public Companies (Sample of 684)

580

227

4130 4

Straight Line

Declining Balance

Sum-of-the-years' digits

Other Accelerated

Units of Production

Other

Use of Various Depreciation Methods

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Depreciation Disclosures

Depreciation. Balances of major classes of depreciable

assets. Accumulated depreciation by asset or in

total. General description of

depreciation methods used.

Depreciation. 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.

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.

Group and Composite Methods

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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.

Group and Composite Methods

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Learning Objectives

Calculate the periodic depletion of a natural resource.

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The approach is based on the units-

of-production method.

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 allocated to the units extracted.

As natural resources are “used up”, or

depleted, the cost of the natural resources must be allocated to the units extracted.

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 $1,100,000.

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.


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What is ABC’s unit depletion rate?

a. $40 per ton

b. $50 per ton

c. $25 per ton

d. $20 per ton


a. $40 per ton

b. $50 per ton

c. $25 per ton

d. $20 per ton


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a. $40 per ton

b. $50 per ton

c. $25 per ton

d. $20 per ton


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


11-42

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

a. $325,000 & $225,000

b. $325,000 & $325,000

c. $225,000 & $225,000

d. $275,000 & $225,000


a. $325,000 & $225,000

b. $325,000 & $325,000

c. $225,000 & $225,000

d. $275,000 & $225,000


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a. $325,000 & $225,000

b. $325,000 & $325,000

c. $225,000 & $225,000

d. $275,000 & $225,000


a. $325,000 & $225,000

b. $325,000 & $325,000

c. $225,000 & $225,000

d. $275,000 & $225,000


Depletion = 13,000 x $25

= $325,000

Expense = 9,000 x $25

= $225,000

Depletion = 13,000 x $25

= $325,000

Expense = 9,000 x $25

= $225,000

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Learning Objectives

Calculate the periodic amortization of an intangible asset.

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Amortization of Intangible Assets

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

residual value = 0.

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:The amortization entry is:

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

11-47

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?

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.Not amortized.

Subject to assessment for impairment

value and may bewritten down.

Subject to assessment for impairment

value and may bewritten 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.

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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Learning Objectives

Explain the appropriate accounting treatment required when a change is made in the service

life or residual value of an operational asset.

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Changes in Estimates

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.

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.

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

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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Learning Objectives

Explain the appropriate accounting treatment required when a change in depreciation

method is made.

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Change 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.

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On January 1, 2004, 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 the double-declining-balance method to depreciate this type of asset. During 2006, 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 2006.

On January 1, 2004, 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 the double-declining-balance method to depreciate this type of asset. During 2006, 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 2006.


11-60


Depreciation - 2004 160,000$ ($400,000 × 40%)Depreciation - 2005 96,000 [($400,000 - $160,000) × 40%]Total Depreciation 256,000$

Cost of asset 400,000$ Accumulated depreciation (256,000) Undepreciated balance 144,000 Salvage value (40,000) Depreciation base 104,000 Remaining service life ÷ 3 Annual depreciation 34,667$

2006 Depreciation

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Learning Objectives

Explain the appropriate treatment required when an error in accounting for an operational

asset is discovered.

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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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Learning Objectives

Identify situations that involve a significant impairment of the value of operational assets

and describe the required accounting procedures.

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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.

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.Accounting treatment differs.

Operational assetsto be held and usedOperational assetsto be held and used

Operational assetsheld to be sold


Tangible andintangible with finiteuseful lives


Intangiblewith

indefiniteuseful lives

Intangiblewith


GoodwillGoodwill

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Impairment of Value

Accounting treatment differs.Accounting treatment differs.

Operational assetsto be held and usedOperational assetsto be held and used





Intangiblewith


Intangiblewith


GoodwillGoodwill

Test for impairment of value when it is suspected that book value may not be

recoverable

Test for impairment of value at least

annually.

Test for impairmentof value when

considered for sale.

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Recoverable cost < Book valueRecoverable cost < Book value

An asset is impaired if . . .

Expected future total undiscounted net cash

inflows generated by use of the asset.

Expected future total undiscounted net cash

inflows generated by use of the asset.

Impairment of Value –Tangible and Finite-Life Intangibles

Measurement – Step 1Measurement – Step 1

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Reported aspart of

income fromcontinuingoperations.

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.

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 book value

No loss recognized


No loss recognized


No loss recognized


No loss recognized


Loss = $275 - $125


Loss = $275 - $125

FairValue

RecoverableCost



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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 –Indefinite 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.

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:

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

11-73

Impairment of Value –Operational 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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Learning Objectives

Discuss the accounting treatment of repairs and maintenance, additions, improvements, and rearrangements to operational assets.

11-75

Expenditures Subsequent to Acquisition

Maintenance and

ordinary repairs.

Maintenance and

ordinary repairs.

Additions.Additions.

Improvements (betterments),

replacements, and extraordinary

repairs.

Improvements (betterments),

replacements, and extraordinary

repairs.

Rearrangements and other

adjustments.

Rearrangements and other

adjustments.

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Normally we debit an expense account for amounts spent on:


11-77

Normally we debit the asset account for amounts spent on:


11-78

Normally we debit the asset account for amounts spent on:


11-79

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


11-80

Appendix 11A

Comparison with MACRS (Tax Depreciation)

11-81

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 Replacement Methods

of Depreciation

11-83Retirement and ReplacementMethods of Depreciation

Used for groupsof similar, low-valued assets

with short service lives.

11-84

Retirement Method Acquisitions:

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.

Retirement Method Acquisitions:

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 Method Acquisitions:

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.

Replacement Method Acquisitions:

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.

Retirement and ReplacementMethods of Depreciation

11-85Retirement and ReplacementMethods of Depreciation

Acme Company has the followingtransactions for calculators:Initially purchased 100 calculators for $50 each.Purchased 20 additional calculators as replacements for $45 each.Sold 30 of the original calculators for $5 each.

Acme Company has the followingtransactions for calculators:Initially purchased 100 calculators for $50 each.Purchased 20 additional calculators as replacements for $45 each.Sold 30 of the original calculators for $5 each.

Prepare the entries to record thesetransactions using the retirement

and replacement methods.

Prepare the entries to record thesetransactions using the retirement

and replacement methods.

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Retirement Method of Depreciation

11-87

Replacement Method of Depreciation

11-88

End of Chapter 11

Documents

Operational Assets: Utilization and Impairment