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Insert Book Cover Picture. Operational Assets: Utilization and Impairment. 11. Learning Objectives. Explain the concept of cost allocation as it pertains to operational assets. LO1. Some of the cost is expensed each period. Acquisition Cost. Expense. (Balance Sheet). (Income Statement).

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learning objectives
Learning Objectives

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

LO1

cost allocation an overview

Some of the cost is expensed each period.

AcquisitionCost

Expense

(Balance Sheet)

(Income Statement)

Cost Allocation – An Overview

The matching principlerequires that part of the acquisition cost of operational assets be expensed in periods when the future revenues are earned.

cost allocation an overview1

Some of the cost is expensed each period.

AcquisitionCost

Expense

(Balance Sheet)

(Income Statement)

Cost Allocation – An Overview

Depreciation, depletion, and amortization are cost allocation processes used to help meet the matching principle requirements.

cost allocation an overview2
Cost Allocation – An Overview

Caution!

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

measuring cost allocation

The systematic approach used for allocation.

The estimated expected use from an asset.

Total amount of cost to be allocated.

Cost - Residual Value (at end of useful life)

Measuring Cost Allocation

Cost allocation requires three pieces of information for each asset:

Service Life

Allocation Base

Allocation Method

learning objectives1
Learning Objectives

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

LO2

depreciation of operational assets
Depreciation of Operational Assets

Group andcomposite methods

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

Taxdepreciation

Activity-based methods

Units-of-production method (UOP).

depreciation on the balance sheet
Depreciation on the Balance Sheet

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

straight line
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.

straight line1
Straight-Line

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 line3
Straight-Line

Residual Value

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

straight line4
Straight-Line

Depreciation

Life in Years

accelerated methods
Accelerated Methods

Accelerated methods result inmoredepreciation in the early years of an asset’s useful life andless 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 Straight-line Method.

sum of the years digits syd

2

Sum-of-the-Years’ Digits (SYD)

SYD depreciation is computed as follows:

sum of the years digits syd1
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.Using SYD, compute depreciation for the first two years.

sum of the years digits syd2

2

Sum-of-the-Years’ Digits (SYD)

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

sum of the years digits syd5
Sum-of-the-Years’ Digits (SYD)

Depreciation

Life in Years

declining balance db methods
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
Double-Declining-Balance (DDB)

DDB depreciation is computed as follows:

Note that the Book Value will get lower each time depreciation is computed!

double declining balance ddb1
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 forthe first two years usingdouble-declining-balance?

double declining balance ddb3
Double-Declining-Balance (DDB)

We usually have to force depreciation in the

latter years to an amount that brings BV = Residual Value.

double declining balance ddb4
Double-Declining-Balance (DDB)

Depreciation

Life in Years

activity based depreciation
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.

units of production1
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 disclosures
Depreciation Disclosures
  • Depreciation.
  • Balances of major classes of depreciable assets.
  • Accumulated depreciation by asset or in total.
  • General description ofdepreciation methods used.
group and composite methods
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.
group and composite methods1
Group and Composite Methods
  • 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, debitaccumulated depreciationfor the difference between the asset’s cost and the proceeds.
learning objectives2
Learning Objectives

Calculate the periodic depletion of a natural resource.

LO3

depletion of natural resources
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-of-production method.

depletion of natural resources2
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.

depletion of natural resources3
Depletion of Natural Resources

What is ABC’s unit depletion rate?

a. $40 per ton

b. $50 per ton

c. $25 per ton

d. $20 per ton

depletion of natural resources4
Depletion of Natural Resources

What is ABC’s unit depletion rate?

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

depletion of natural resources5
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. $325,000 & $225,000

b. $325,000 & $325,000

c. $225,000 & $225,000

d. $275,000 & $225,000

depletion of natural resources6
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. $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

learning objectives3
Learning Objectives

Calculate the periodic amortization of an intangible asset.

LO4

amortization of intangible assets

Economic Life

Legal Life

Amortization of Intangible Assets

The amortization process uses the straight-line method, but assumes residual value = 0.

Amortization period is the shorter of:

or

amortization of intangible assets1
Amortization of Intangible Assets

The amortization entry is:

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

amortization of intangible assets2
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?

amortization of intangible assets3
Amortization of Intangible Assets

Record the amortization entry.

amortization of intangible assets4
Amortization of Intangible Assets

Note that the patent will have a book value of $2,400 after this amortization entry is posted.

intangible assets not subject to amortization

Not amortized.

Subject to assessment for impairmentvalue and may bewritten down.

Intangible Assets Not Subjectto Amortization

Goodwill

partial period depreciation

May19

Partial-Period Depreciation

I bought an asset on May 19 this year. Do I get a full year’s depreciation?

partial period depreciation1
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.

learning objectives4
Learning Objectives

Explain the appropriate accounting treatment required when a change is made in the service life or residual value of an operational asset.

LO5

changes in estimates
Changes in Estimates

Depreciation Expense is based on . . .

ESTIMATED service life

ESTIMATED 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.

changes in estimates1
Changes in Estimates

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.

changes in estimates2
Changes in Estimates

What happens if we change depreciation methods?

learning objectives5
Learning Objectives

Explain the appropriate accounting treatment required when a change in depreciation method is made.

LO6

change in depreciation method

We account for these changes prospectively, exactly as we would any other change in estimate.

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.

change in depreciation method1
Change in Depreciation Method

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.

learning objectives6

Explain the appropriate treatment required when an error in accounting for an operational asset is discovered.

LO7

Learning Objectives
error correction

Entries that restate the incorrect account balances to the correct amount.

Reporting the correction as a prior period adjustment to Beginning R/E.

Restating the prior period’s financial statements.

Error Correction

Errors found in a subsequent accounting period are corrected by . . .

learning objectives7
Learning Objectives

Identify situations that involve a significant impairment of the value of operational assets and describe the required accounting procedures.

LO8

impairment of value
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.
impairment of value1
Impairment of Value

Accounting treatment differs.

Operational assetsto be held and used

Operational assetsheld to be sold

Tangible andintangible with finiteuseful lives

Intangiblewithindefiniteuseful lives

Goodwill

impairment of value2

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.

Impairment of Value

Accounting treatment differs.

Operational assetsto be held and used

Operational assetsheld to be sold

Tangible andintangible with finiteuseful lives

Intangiblewithindefiniteuseful lives

Goodwill

impairment of value tangible and finite life intangibles
Impairment of Value –Tangible and Finite-Life Intangibles

An asset is impaired if . . .

Measurement – Step 1

Recoverable cost < Book value

Expected future totalundiscounted net cash inflows generated by use of the asset.

impairment of value tangible and finite life intangibles1
Impairment of Value –Tangible and Finite-Life Intangibles

Measurement – Step 2

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.

Reported aspart ofincome fromcontinuingoperations.

impairment of value tangible and finite life intangibles2

Case 1:

$50 book value

No loss recognized

Case 3:

$275 book value

Loss = $275 - $125

Case 2:

$150 book value

No loss recognized

Impairment of Value –Tangible and Finite-Life Intangibles

Measurement – Step 2

FairValue

RecoverableCost

$0

$125

$250

impairment of value indefinite life intangibles

Step 1 If BV of business unit > FV, impairment indicated.

One-step Process

If BV of asset > FV, recognize impairment loss.

Step 2 Loss = BV of goodwill less implied value of goodwill.

Goodwill Example

Impairment of Value –Indefinite Life Intangibles

Other IndefiniteLife Intangibles

Goodwill

impairment of value goodwill
Impairment of Value – Goodwill

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:

Goodwillimpaired?

impairment of value operational assets to be sold

Impairmentloss

Bookvalue

Fair value lesscost to sell

=

Impairment of Value –Operational Assets to be Sold

Operational assets to be soldincludes assets that managementhas committed to sell immediately intheir present condition andfor which sale is probable.

learning objectives8
Learning Objectives

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

LO9

expenditures subsequent to acquisition
Expenditures Subsequent to Acquisition

Improvements (betterments), replacements, and extraordinary repairs.

Maintenance and ordinary repairs.

Rearrangements and other adjustments.

Additions.

expenditures subsequent to acquisition1
Expenditures Subsequent to Acquisition

Normally we debit an expenseaccount for amounts spent on:

Maintenance

& Ordinary

Repairs

expenditures subsequent to acquisition2
Expenditures Subsequent to Acquisition

Normally we debit the asset account for amounts spent on:

Improvements

Replacements

Extraordinary

Repairs

expenditures subsequent to acquisition3
Expenditures Subsequent to Acquisition

Normally we debit the assetaccount for amounts spent on:

Additions

expenditures subsequent to acquisition4
Expenditures Subsequent to Acquisition

Normally, we debit an assetaccount for amounts spent on:

Reaarangements

and Other

Adjustments

tax depreciation

Provides for rapid write-off

Rates based on asset “class lives”

Tax Depreciation

Most corporations use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes.

Ignores residual value

retirement and replacement methods of depreciation
Retirement and ReplacementMethods of Depreciation

Used for groupsof similar, low-valued assetswith short service lives.

retirement and replacement methods of depreciation1
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.

Retirement and ReplacementMethods of Depreciation
retirement and replacement methods of depreciation2
Retirement 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.

Prepare the entries to record thesetransactions using the retirement and replacement methods.

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