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CHAPTER 11Property, Plant, and Equipmentand Intangible Assets:Utilization and Impairment
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Some of the cost is allocated to each period.
Some of the cost is allocated to each period.
Expense*Expense*AcquisitionCost
AcquisitionCost
(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.
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.
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.
*Depreciation of an asset used to produce a product is a product cost that does not become an expense until the
product is sold.
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AssetCategory 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!
Depreciation on the
Balance Sheet
Cost Allocation – An Overview
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Cost allocation requires three piecesof information for each asset:
The estimated The estimated expected use from expected use from
an asset. an asset.
The estimated The estimated expected use from expected use from
an asset. 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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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
TaxTaxdepreciationdepreciation
TaxTaxdepreciationdepreciation
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 $260,000Estimated useful life 10 yearsEstimated salvage value $20,000Productive life in hours 60,000 hours
Depreciation
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Straight-Line
The most widely The most widely used and most used and most
easily understood easily understood method.method.
The most widely The most widely used and most used and most
easily understood easily understood method.method.
Results in the same Results in the same amount of amount of
depreciation in each depreciation in each year of the asset’s year of the asset’s
service life.service life.
Results in the same Results in the same amount of amount of
depreciation in each depreciation in each year of the asset’s year of the asset’s
service life.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?
Cost less salvage
Estimated service lifeDepreciation 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 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.
Straight-Line
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Accelerated Methods
Note that total depreciation over the asset’s useful
life 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.
Sum-of-the-years’-digits (SYD) method (Not Covered)
Double-Declining-Balance (DDB) method (Covered)
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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.
Stop depreciating when:
BV = Residual Value
Double-Declining-Balance (DDB) depreciationis computed as follows:
Note that the book value declines each year.
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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 onof the Year Declining DepreciationBook Value X Balance = ChargeYear 1 $260,000 X 20% = $52,000Year 2 $208,000 X 20% = $41,600
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Units-of-Production
(Cost less salvage)X hours this year
Total estimated hoursDepreciation 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.
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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.
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Amortization of Intangible AssetsFor 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:
A contra-asset account is generally not used when recording the amortization of
intangible assets.
Amortization expense .................................. $$$Intangible asset ………………........ $$$
To record amortization expense.
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Not amortized.
Subject to assessment for impairment ofvalue and may be
written down.
Goodwill and Trademarks
Intangible Assets not Subject to Amortization
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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 DepreciationAsset Cost Value Cost Life (Straight-Line)A $ 65,000 $ 5,000 $ 60,000 5 yrs. $12,000B 148,000 18,000 130,000 10 yrs. 13,000C 95,000 11,000 84,000 12 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)
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Partial Year DepreciationIn 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)
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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
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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 In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on nature of the error and the impact of its correction on net income, income before extraordinary items, and net income, income before extraordinary items, and
earnings per share.earnings per share.
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Impairment of Value
Long-term assetsto be held and usedLong-term assets
to be held and usedLong-term assets
held for saleLong-term assets
held for sale
Tangible andintangible with finiteuseful lives
Tangible andintangible with finiteuseful lives
Intangibleswith
indefiniteuseful lives
Intangibleswith
indefiniteuseful lives
GoodwillGoodwill
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.Accounting treatment differs.Accounting treatment differs.Accounting treatment differs.
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Finite-Life Assets to be Held and Used
An asset is impaired when . . .
The undiscounted sum of its
estimated future cash flows
Measurement – Step 1Measurement – Step 1
Itsbookvalue
<
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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 – $125
Fair valueUndiscounted future
cash flows
Market value, price of similar assets,
or PV of future net cash inflows.
Reported in the incomestatement as a separate component of operating
expenses
Finite-Life Assets to be Held and Used
Exercise 22, 23, 25, 26
Important differences in accounting for impairment of value for property, plant, and equipment and finite-life intangible assets between U.S. GAAP and IAS No. 36.
U.S. GAAP IFRSWhen to Test When events or changes in Assets must be assessed for indicators of
circumstances indicate that impairment at the end of each reporting book value may not be period. Indicators of impairment are similar recoverable. to U.S. GAAP.
Recoverability An impairment loss is There is no equivalent recoverability test. required when an asset’s An impairment loss is required when an asset’s book value exceeds book value exceeds the higher of the asset’s the undiscounted sum of value-in- use (present value of estimated the asset’s estimated future future cash flows) and fair value less costs to cash flows. sell.
Measurement The impairment loss is the The impairment loss is the difference between difference between book book value and the “recoverable amount” (the value and fair value. higher of the asset’s value-in-use and fair value
less costs to sell).
Subsequent Prohibited. Required if the circumstances that caused theReversal of Loss impairment are resolved.
Let’s look at an illustration highlighting the important differences between GAAP and IFRS: The Jasmine Tea Company has a factory that has significantly decreased in value due to technological innovations in the industry. Below are data related to the factory’s assets:
($ 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 ($15.5million).
The impairment loss is the difference between:Book value and Recoverable amount = $18.5 million - $16 million =$2.5M
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Impairmentloss =
Bookvalue
Fair value lesscost to sell–
Assets held for saleinclude assets that management
has committed to sell immediately intheir present condition andfor which sale is probable.
Assets Held for Sale
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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.
GoodwillGoodwill
Step 1 If BV of reporting unit > FV, impairment
indicated.
Step 1 If BV of reporting unit > FV, impairment
indicated.
Other Indefinite-life intangibles
Other Indefinite-life intangibles
One-Step Process
If BV of asset > FV, recognize
impairment loss.
One-Step Process
If BV of asset > FV, recognize
impairment loss.
Indefinite-Life Intangibles (Ex 26)
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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
Expenditures Subsequentto Acquisition
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End of Chapter 11