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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Operational Assets:
Utilization and Impairment
11Insert Book Cover
Picture
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11-2
Learning Objectives
Explain the concept of cost allocation as it pertains to operational assets.
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11-3
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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11-4
Cost Allocation – An Overview
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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11-5
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!
Cost Allocation – An Overview
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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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11-7
Learning Objectives
Determine periodic depreciation using both time-based and activity-based methods.
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11-8
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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11-9
Depreciation on the Balance Sheet
Net property, plant & equipment is the undepreciated cost (book value) of plant assets.
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11-10
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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11-11
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 $5,000.
What is the annual straight-line depreciation?
Straight-Line
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11-12
Straight-Line
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Accumulated Accumulated UndepreciatedDepreciation Depreciation Depreciation Balance
Year (debit) (credit) Balance (book value)50,000$
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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11-14
0100020003000400050006000700080009000
1 2 3 4 5
Life in Years
De
pre
cia
tio
n
Straight-Line
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11-15
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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11-16
2
SYD depreciation is computed as follows:
Sum-of-the-Years’ Digits (SYD)
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11-17
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 $5,000.
Using SYD, compute depreciation for the first two years.
Sum-of-the-Years’-Digits (SYD)
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11-18
2
Use this in your computation of SYD Depreciation for Years 1 & 2.
Use this in your computation of SYD Depreciation for Years 1 & 2.
Sum-of-the-Years’ Digits (SYD)
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11-19
Sum-of-the-Years’ Digits (SYD)
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11-20
Accumulated UndepreciatedDepreciation Depreciation Balance
Fraction (debit) Balance (book value)50,000$
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$
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$ Residual ValueResidual Value
Sum-of-the-Years’ Digits (SYD)
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11-21
0
2000
4000
6000
8000
10000
12000
14000
16000
1 2 3 4 5
Life in Years
De
pre
cia
tio
n
Sum-of-the-Years’ Digits (SYD)
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11-22
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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11-23
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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11-24
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 $5,000.
What is depreciation forthe first two years using
double-declining-balance?
Double-Declining-Balance (DDB)
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11-25
Double-Declining-Balance (DDB)
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11-26
Accumulated UndepreciatedDepreciation Depreciation Balance
Year (debit) Balance (book value)50,000$
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$
Accumulated UndepreciatedDepreciation Depreciation Balance
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$
Double-Declining-Balance (DDB)
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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11-27
02000400060008000100001200014000160001800020000
1 2 3 4 5
Life in Years
De
pre
cia
tio
n
Double-Declining-Balance (DDB)
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11-28
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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11-29
Units-of-Production
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11-30
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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11-31
Units-of-Production
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11-32
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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11-33
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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11-34
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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11-35
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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11-36
Learning Objectives
Calculate the periodic depletion of a natural resource.
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11-37
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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11-38
Depletion of Natural Resources
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11-39
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 Resources
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11-40
What is ABC’s unit depletion rate?
a. $40 per ton
b. $50 per ton
c. $25 per ton
d. $20 per ton
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 Resources
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11-41
What is ABC’s unit depletion rate?
a. $40 per ton
b. $50 per ton
c. $25 per ton
d. $20 per ton
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
Cost / Units
$1,000,000 / 40,000 Tons
= $25 Per Ton
Depletion of Natural Resources
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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
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 Resources
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11-43
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
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 Resources
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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11-44
Learning Objectives
Calculate the periodic amortization of an intangible asset.
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11-45
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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Amortization of Intangible Assets
The amortization entry is:The amortization entry is:
Note that the amortization process does not use a contra-asset account.
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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?
Amortization of Intangible Assets
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Record the amortization entry.
Amortization of Intangible Assets
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Note that the patent will have a book value of $2,400 after this amortization entry is posted.
Amortization of Intangible Assets
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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 $30,000,
has a useful life of 10 years and no salvage value. At the
beginning of the fourth year, it was decided that there were
only 5 years remaining, instead of 7 years.
Calculate depreciation expense for the fourth year using the
straight-line method.
Changes in Estimates
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Asset cost 30,000$ 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 ($3,000 per year × 3 years) 9,000 Remaining book value 21,000 Divide by remaining life ÷ 5Revised annual depreciation 4,200$
Changes in Estimates
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
$40,000, and a service life of 5 years. Matrix uses the double-declining-balance method to depreciate this type of asset. During 2006, the
company switched from double-declining balance to straight-line depreciation. Let’s determine the amount of depreciation to be
recorded at the end of 2006.
Change in Depreciation Method
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Change in Depreciation Method
Depreciation - 2004 160,000$ ($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 Remaining service life ÷ 3 Annual depreciation 48,000$
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
Operational assetsheld to be sold
Tangible andintangible with finiteuseful lives
Tangible andintangible with finiteuseful lives
Intangiblewith
indefiniteuseful lives
Intangiblewith
indefiniteuseful lives
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
Operational assetsheld to be sold
Operational assetsheld to be sold
Tangible andintangible with finiteuseful lives
Tangible andintangible with finiteuseful lives
Intangiblewith
indefiniteuseful lives
Intangiblewith
indefiniteuseful lives
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.
Impairment of Value –Tangible and Finite-Life Intangibles
Measurement – Step 2Measurement – Step 2
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$0 $250$125
Case 1:$50 book value
No loss recognized
Case 1:$50 book value
No loss recognized
Case 2:$150 book value
No loss recognized
Case 2:$150 book value
No loss recognized
Case 3:$275 book value
Loss = $275 - $125
Case 3:$275 book value
Loss = $275 - $125
FairValue
RecoverableCost
Impairment of Value –Tangible and Finite-Life Intangibles
Measurement – Step 2Measurement – Step 2
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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
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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.
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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:
Expenditures Subsequent to Acquisition
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Normally we debit the asset account for amounts spent on:
Expenditures Subsequent to Acquisition
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Normally we debit the asset account for amounts spent on:
Expenditures Subsequent to Acquisition
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Normally, we debit an asset account for amounts spent on:
Expenditures Subsequent to Acquisition
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Appendix 11A
Comparison with MACRS (Tax Depreciation)
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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
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11-83Retirement and ReplacementMethods of Depreciation
Used for groupsof similar, low-valued assets
with short service lives.
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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
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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
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Replacement Method of Depreciation
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End of Chapter 11