BE 11-7

Report
Topic 5
Operating Assets –
Utilization and Impairment
Depreciation Methods
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
11-2
Cost Allocation – An Overview
The matching principle requires that part of
the acquisition cost of operational assets be
expensed in periods when the future revenues
are earned.
Some of the cost is expensed each period.
Acquisition
Cost
(Balance Sheet)
Expense
(Income Statement)
11-3
Cost Allocation – An Overview
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
(Balance Sheet)
Expense
(Income Statement)
11-4
Cost Allocation – An Overview
Type of
Operational
Asset
Debit
Property, Plant, &
Equipment
Depreciation
Natural Resource
Depletion
Intangible
Amortization
Account Credited
Accumulated
Depreciation
Natural Resource
Asset
Intangible Asset
Caution!
Depreciation, depletion, and amortization are
processes of cost allocation, not valuation!
11-5
Cost Allocation - Judgments
Cost allocation requires developing three
estimates for each asset:
Useful
(Service)
Life
Allocation
Base
The estimated expected
use from an asset.
Allocation
Method
The systematic approach
used for allocation.
Total amount of cost to be allocated.
Cost - Residual Value (at end of useful life)
11-6
Depreciation of Operational Assets
Time-based Methods
Straight-line (SL)
Accelerated Methods
Sum-of-the-years’ digits (SYD)
Declining Balance (DB)
Group and
composite
methods
Tax
depreciation
Activity-based methods
Units-of-production method (UOP).
11-7
Depreciation on the Balance Sheet
Net property, plant & equipment is the undepreciated cost
(book value) of operating assets.
11-8
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?
11-9
Straight-Line
SYD depreciation is quickly computed using Excel.
11-10
Straight-Line
Year
1
2
3
4
5
Depreciation
(debit)
Accumulated
Depreciation
(credit)
Accumulated
Depreciation
Balance
$
$
$
$
9,000
9,000
9,000
9,000
9,000
45,000
$
9,000
9,000
9,000
9,000
9,000
45,000
9,000
18,000
27,000
36,000
45,000
Undepreciated
Balance
(book value)
$
50,000
41,000
32,000
23,000
14,000
5,000
Residual Value
Note that at the end of the asset’s
useful life, BV = Residual Value
11-11
Depreciation
Straight-Line
9000
8000
7000
6000
5000
4000
3000
2000
1000
0
1
2
3
Life in Years
4
5
11-12
Accelerated Methods
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.
Note that total
depreciation over the
asset’s useful life is the
same as the Straightline Method.
11-13
Sum-of-the-Years’ Digits (SYD)
SYD depreciation is quickly computed using Excel.
The formula is as follows:
SYD
= ( Cost
Depreciation
* Sum-oftheYears'Digits
= (
Residual
–
) ×
Value
Useful
Life
× [
Useful
Life
2
5+4+3+2+1= 15
Remaining Years
of Useful Life
Sum-of-the-Years
Digits*
+ 1 ] )
11-14
Sum-of-the-Years’-Digits (SYD)
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.
Use Excel’s SYD function to compute
depreciation
for the five years.
11-15
Sum-of-the-Years’ Digits (SYD)
11-16
Sum-of-the-Years’ Digits (SYD)
Sum-of-the-Years
@SYD
Cost
50,000
50,000
50,000
50,000
50,000
Salvage Value
5,000
5,000
5,000
5,000
5,000
Estimated Life
5
5
5
5
5
Period
1
2
3
4
5
Period Depreciation
15,000
12,000
9,000
6,000
3,000 45,000
11-17
Sum-of-the-Years’ Digits (SYD)
Depreciation
16000
14000
12000
10000
8000
6000
4000
2000
0
1
2
3
Life in Years
4
5
11-18
Declining-Balance (DB) Methods
DB depreciation


Based on the straightline rate multiplied by an
acceleration factor.
Computations initially
ignore residual value.
Stop depreciating
when:
BV=Residual Value
11-19
Double-Declining-Balance (DDB)
DDB depreciation is easy to compute using Excel function =ddb
The formula is as follows:
DDB =
Book
Value
× ( 2 ÷ Useful Life )
Note that the Book Value
will get lower each time
depreciation is computed!
11-20
Double-Declining-Balance (DDB)
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 five two years using
double-declining-balance?
11-21
Double-Declining-Balance (DDB)
11-22
Double-Declining-Balance (DDB)
Double Declining Balance
@DDB
Cost
50,000 50,000
Salvage Value
5,000
5,000
Estimated Life
5
5
Year
1
2
Period Depreciation $20,000 $12,000
50,000
5,000
5
3
$7,200
50,000
5,000
5
4
$4,320
50,000
5,000
5
5
$1,480
$45,000
Excel will stop depreciation when the BV = Residual Value.
11-23
Depreciation
Double-Declining-Balance (DDB)
20000
18000
16000
14000
12000
10000
8000
6000
4000
2000
0
1
2
3
Life in Years
4
5
11-24
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.
This approach
looks different.
11-25
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
11-26
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?
11-27
Units-of-Production
Units of Production
Cost
Salvage Value
Estimated Life-Units
Per Unit
Current Production
Period Depreciation $
50,000
5,000
100,000
0.45
22,000
9,900
11-28
Use of Various Depreciation Methods
11-29
Comparison With MACRS (Tax Depreciation)
Covered in Income Tax Course & Referred to in Intermediate III
Most corporations use the Modified
Accelerated Cost Recovery System
(MACRS) for tax purposes.
Provides
for rapid
write-off
Ignores
residual
value
Rates based
on asset
“class lives”
11-30
Depreciation Disclosures
 Depreciation.
 Balances
of major classes of depreciable
assets.
 Accumulated depreciation by asset or in
total.
 General description of
depreciation methods used.
11-31
Partial-Period Depreciation
I bought an asset on May
19 this year. Do I get a full
year’s depreciation?
May
19
11-32
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 ½ of a year of depreciation in the
year of acquisition, and the other ½ in
the year of disposal.
11-33
Partial Year – Demo Problem
On March 31,2009 Canseco Plumbing Fixtures
purchased equipment for $30,000. Residual value at the
end of an estimated four-year service life is expected to
be $2,000. The company expects the machine to operate
for 10,000 hours. Calculate depreciation expense for
2009 and 2010 using straight line depreciation method
(a) Partial Year basis
(b) Half Year Convention
11-34
Partial Year – Demo Problem
SLM for a full year:
[$30,000 - 2,000]/4 = $7,000
a.
2009 $7,000 x 9/12
=
2010 $7,000 x 12/12
=
b.
2009 $7,000 x 50%
=
2010 $7,000 x 100%
=
$5,250
$7,000
$3,500
$7,000
11-35
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 asset’s cost and the proceeds.
GROUP AND COMPOSITE DEPRECIATION
 Page 243.
If there are no changes in the assets contained in the group, depreciation of
$52,800 per year (16% x $330,000) will be recorded for 5.15 years.
11-36
11-37
BE 11-4
Mondale Winery depreciates its equipment using
the group method. The cost of equipment
purchased in 2013 totaled $425,000. The
estimated residual value of the equipment was
$40,000 and the group depreciation rate was
determined to be 18%.
 What is the annual depreciation for the group?
 If equipment that cost $42,000 is sold in 2014 for
$35,000, what amount of gain or loss will the
company recognize for the sale?

11-38
BE 11-4 Solution

Annual depreciation will equal the group rate
multiplied by the depreciable base of the group:


($425,000 – 40,000) x 18% = $69,300
Since depreciation records are not kept on an
individual asset basis, dispositions are recorded
under the assumption that the book value of the
disposed item exactly equals any proceeds
received and no gain or loss is recorded. Any
actual gain or loss is implicitly included in the
accumulated depreciation account.
11-39
BE 11-4 Solution
Journal entry for sale
 Cash
 Acc. Dep (difference)
Equipment (cost)

35,000
7,000
42,000
11-40
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 unitsof-production
method.
11-41
Depletion of Natural Resources
Depletion rate
=
per unit
Total
Depletion
Cost
=
Cost of Natural
Resource
Residual
–
Value
Estimated Recoverable Units
Unit Depletion
Rate
×
Units
Extracted
11-42
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.
11-43
Depletion of Natural Resources
What is ABC’s unit depletion rate?
a.
b.
c.
d.
$40 per ton
$50 per ton
$25 per ton
$20 per ton
11-44
Depletion of Natural Resources
What is ABC’s unit depletion rate?
Cost / Units
a.
b.
c.
d.
$40 per ton
$50 per ton
$25 per ton
$20 per ton
$1,000,000 / 40,000 Tons
= $25 Per Ton
11-45
Depletion of Natural Resources
For the year ABC mined 13,000 tons and sold
9,000 tons. What is the total depletion and the
depletion expense?
a.
b.
c.
d.
$325,000 & $225,000
$325,000 & $325,000
$225,000 & $225,000
$275,000 & $225,000
11-46
Depletion of Natural Resources
For the year ABC mined 13,000 tons and sold
9,000 tons. What is the total depletion and the
depletion expense?
Depletion = 13,000 x $25
a.
b.
c.
d.
$325,000 & $225,000
$325,000 & $325,000
$225,000 & $225,000
$275,000 & $225,000
= $325,000
Expense = 9,000 x $25
= $225,000
11-47
Amortization of Intangible Assets
The amortization process uses the
straight-line method, but assumes
residual value = 0.
Economic
Life
Amortization period
is the shorter of:
or
Legal
Life
11-48
Amortization of Intangible Assets
The amortization entry is:
GENERAL JOURNAL
Date
Description
Amortization Expense
Intangible Asset
Page 42
PR
Debit
Credit
$$$
Note that the amortization process does
not use a contra-asset account.
$$$
11-49
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
useful life of 5 years. The legal life is 20
years.
At the end of year 1, what is Torch’s
amortization expense?
11-50
Amortization of Intangible Assets
Use the shorter of economic life
(5 years) or legal life (20 years).
Amortization
= Cost
÷ Economic life
= $3,000 ÷ 5 years
= $ 600 per year
Record the amortization entry.
11-51
Amortization of Intangible Assets
GENERAL JOURNAL
Date
Description
Amortization Expense
Patent
Page 42
PR
Debit
Credit
600
600
Note that the patent will have a book value of
$2,400 after this amortization entry is posted.
Intangible Assets Not Subject
to Amortization
11-52
Goodwill
Not amortized.
Subject to assessment
for impairment
value and may be
written down.
11-53
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 residual value. At the beginning of
the fourth year, it was decided that there were only 5 years
remaining, instead of 7 years.
Calculate depreciation for the fourth
year using the straight-line method.
11-54
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?
11-55
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, 2011, Matrix Inc. purchased office 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 2013, the company switched from double-declining balance to
straight-line depreciation. The residual value remained at $40,000. Let’s
determine the amount of depreciation to be recorded for 2013.
11-56
Change in Depreciation Method
Depreciation - 2011
Depreciation - 2012
Total Depreciation
$
$
160,000 ($400,000 × 40%)
96,000 [($400,000 - $160,000) × 40%]
256,000
Cost of asset
$
Less: Accumulated depreciation
Undepreciated balance
$
Less: residual value
New depreciable amount
Remaining service life
÷
Annual depreciation
$
December 31, 2013:
Depreciation expense ...................................
Accumulated depreciation................
To record depreciation expense.
400,000
256,000
144,000
(40,000)
104,000
3
34,667
34,667
34,667
11-57
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.
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.
11-58
Brief Exercise 11-7
At the beginning of 2011, Robotics, Inc. acquired
a manufacturing facility for $12 million. $9 million
of the purchase price was allocated to the
building. Depreciation for 2011 and 2012 was
calculated using the straight-line method, a 25year useful life, and a $1 million residual value.
 In 2013, the estimates of useful life and residual
value were changed to 20 years and $500,000,
respectively.
 What is depreciation on the building for 2013?

11-59
Brief Exercise 11-7
Original calculation of annual depreciation
Cost $
9,000,000
Residual value $
1,000,000
useful
25
annual depreciation
$320,000
accumulated depreciation
$640,000
Recalculation of annual depreciation
Undepreciated cost
$8,360,000
Revised residual value
$500,000
remaining useful life
18
revised annual depreciation $
436,667
Work this using Excel function =SLN
11-60
Brief Exercise 11-8

Refer to the situation described in BE 11-7.
Assume that instead of changing the useful life
and residual value, in 2013 the company
switched to the double-declining-balance
depreciation method. How should Robotics
account for the change? What is depreciation on
the building for 2013?
11-61
Brief Exercise 11-8
a
change in the depreciation method reflects:
estimated future benefits from the asset,
the pattern of receiving those benefits, or
the company’s knowledge about those benefits
Voluntary changes in accounting principles are
reported retrospectively
11-62
Brief Exercise 11-8
Original calculation of annual depreciation using SLN
Cost $
9,000,000
Residual value $
1,000,000
useful
25
annual depreciation
$320,000
accumulated depreciation
$640,000
Recalculation of annual depreciation using DDB
Undepreciated cost
$8,360,000
residual value
$1,000,000
remaining useful life
23
revised annual depreciation $
726,957
A disclosure note should justify that the change is preferable and
describe the effect of the change on any financial statement line
items and per share amounts affected for all periods reported.
11-63
Brief Exercise 11-9

Refer to the situation described in BE 11-7.
Assume that 2011 depreciation was incorrectly
recorded as $32,000. This error was discovered
in 2013. How should Robotics account for the
error? What is depreciation on the building for
2013 assuming the error was judged material,
no change in estimate of useful life or residual
value? (ignore income tax)
11-64
Brief Exercise 11-9

Errors are retrospectively restated to reflect the
correction. If retained earnings is one of the
incorrect accounts, the correction is reported as
a prior period adjustment to the beginning
balance in the statement of shareholders’ equity.

Depreciation of $32,000 should have been
recorded. ($8,000,000  25 years). Therefore,
2011 retained earnings tax is overstated by
$288,000 ($320,000 – 32,000) and accumulated
depreciation is understated by the same
amount. The following journal entry is needed to
record the error correction (ignoring income tax):
11-65
Brief Exercise 11-9
Retained Earnings
Accumulated Depreciation
288,000
288,000
Only the annual depreciation is reported in 2013.
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 item, and
earnings per share.
11-66
Test for
impairment
of value when
considered
for sale.
Impairment of Value
Accounting treatment differs.
Long-term assets
to be held and used
Tangible
and
Operating assets
intangible
with finite
useful lives
Intangibles
with
indefinite
useful lives
Test for impairment of value
when it is suspected that book
value may not be recoverable.
Long-term assets
held for sale
Goodwill
Test for
impairment of
value at least
annually.
Test for
impairment of
value when it is
likely that the
fair value of a
reporting unit is
less than its
book value.
11-67
Operating 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
11-68
Operating Assets to be Held and Used
Measurement – Step 2
Impairment
loss
=
Reported in the income
statement as a separate
component of operating
expenses
$0
Book
value
Market value, price of similar assets,
or PV of future net cash inflows.
Fair value
$125
Case 1: $50 book value.
No loss recognized
–
Fair
value
Undiscounted future
cash flows
$250
Case 3: $275 book value.
Loss = $275 – $125
Case 2: $150 book value. No loss recognized
11-69
Operating Assets to be Held and Used
Because Acme Auto Parts has seen its sales steadily decrease due to the
decline in new car sales, Acme’s 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 equipment’s remaining useful life will be only
$140 million, and that the equipment’s fair value is $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.
11-70
Operating Assets to be Held and Used
Because Acme Auto Parts has seen its sales steadily decrease due to the
decline in new car sales, Acme’s 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 equipment’s remaining useful life will be only
$140 million, and that the equipment’s fair value is $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.
80,000,000
150,000,000
230,000,000
11-71
Indefinite-Life Intangibles
This item covered in Advanced Accounting
Goodwill
Step 1 If BV of reporting unit
> FV, impairment indicated.
Step 2 Loss = BV of goodwill
less implied value of goodwill.
Other Indefinitelife intangibles
One-Step Process
If BV of asset > FV,
recognize
impairment loss.
11-72
Brief Exercise 11-10

Collison and Ryder Company (C&R) has been
experiencing declining market conditions for its
sportswear division. Management decided to
test the operational assets of the division for
possible impairment. The test revealed the
following:
book value of division’s assets, $26.5 million;
fair value of division’s assets, $21 million;
sum of estimated future cash flows generated from the
division’s assets, $24 million.

What amount of impairment loss should C&R
recognize?
11-73
Brief Exercise 11-10

Because the undiscounted sum of future cash
flows of $24 million is less than book value of
$26.5 million, there is an impairment loss. The
impairment loss is calculated as follows:
11-74
Expenditures Subsequent to Acquisition
Maintenanc
e and
ordinary
repairs.
Rearrangement
s and other
adjustments.
Improvements
(betterments),
replacements,
and extraordinary
repairs.
Additions
.
11-75
Expenditures Subsequent to Acquisition
Normally we debit an expense
account for amounts spent on:
11-76
Expenditures Subsequent to Acquisition
Normally we debit the asset account
for amounts spent on:
11-77
Expenditures Subsequent to Acquisition
Normally we debit the asset account
for amounts spent on:
11-78
Expenditures Subsequent to Acquisition
Normally, we debit an asset account
for amounts spent on
Rearrangements :
changes made in an existing process for
improved output or improved efficiency.
Normally, the cost of rearrangements are
capitalized
11-79
Brief Exercise 11-16

Demmert Manufacturing incurred the following
expenditures during the current fiscal year:
- annual maintenance on its machinery, $5,400;
remodeling of offices, $22,000;
rearrangement of the shipping and receiving area resulting in
an increase in productivity, $35,000;
addition of a security system to the manufacturing facility,
$25,000.

How should Demmert account for each of these
expenditures?
11-80
Brief Exercise 11-16
Annual maintenance on machinery, $5,400 This is an example of normal repairs and
maintenance. Future benefits are not increased;
therefore the expenditure should be expensed in
the period incurred.
 Remodeling of offices, $22,000 - This is an
example of an improvement. The cost of the
remodeling should be capitalized and
depreciated, either by direct capitalization of the
cost, or a reduction of accumulated depreciation.

11-81
Brief Exercise 11-16
Rearrangement of the shipping and receiving
area, $35,000 - This is an example of a
rearrangement. Because the rearrangement
increased productivity, the cost should be
capitalized and depreciated.
 Addition of a security system, $25,000 - This
is an example of an addition. The cost of the
security system should be capitalized and
depreciated.


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