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