11-1 Intermediate Accounting James D. Stice Earl K. Stice © 2012 Cengage Learning PowerPoint...

11-1

Intermediate Accounting

James D. Stice Earl K. Stice

© 2012 Cengage Learning

PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine University

Investments in Noncurrent Operating Assets—Utilization and Retirement

Chapter 11Chapter 11

18th Edition

11-2

What is depreciation?

• Depreciation is not a process through which a company accumulates a cash fund to replace its long-lived fixed assets.

• Depreciation is not a way to compute the current value of long-lived assets.

• Depreciation is the systematic allocation of the cost of an asset over the different periods benefited by the use of the asset.

11-3

Factors Affecting the Periodic Depreciation Charge

• Asset cost

• Residual or salvage value

• Useful life

• Pattern of use

Four factors are taken into consideration in determining the appropriate amount of annual depreciation expense.

11-4

Depreciation Vocabulary

• Asset cost is the purchase cost plus any capitalized expenditures.

• Residual (salvage) value of property is an estimate of the amount for which the asset can be sold when it is retired.

• Useful life is the expected life of the asset in years, hours of service, or per unit of output.

(continued)

11-5

Useful Life

The physical factors that limit the service life of an asset are—

1) wear and tear,

2) deterioration and decay, and

3) damage or destruction.

The primary functional factor limiting the The primary functional factor limiting the useful life of assets is obsolescence.useful life of assets is obsolescence.

11-6

Depreciation Formula Symbols

The examples that follow assume the acquisition of a polyurethane plastic-molding machine at the beginning of 2013 by Schuss Boom Ski Manufacturing, Inc., at a cost of $100,000 with an estimated residual value of $5,000.

C = Asset costR = Estimated residual valuen = Estimated life in years, hours of service, or

units of outputr = Depreciation rate per period, per hour of

service, or per unit of outputD = Periodic depreciation charge

11-7

Time-Factor Methods

Straight-LineStraight-LineStraight-LineStraight-Line

• Of the time-factor methods, straight-line depreciation is by far the most popular.

• Straight-line depreciation relates to the passage of time and recognizes equal depreciation in each year of the life of the asset.

• This method assumes the asset is equally useful during each time period.

(continued)

11-8

Straight-Line Depreciation

Using data for the machine acquired by Schuss Boom Ski Manufacturing and assuming a 5-year life, annual depreciation is computed as follows:

C – R

ND = =

$100,000 – $5,000

5 years

= $19,000 per year

(continued)

11-9

Sum-of-the-Years’ Digits Method

SYD =[n (n + 1)]

2

SYD =[5 (5 + 1)]

2

SYD = 15

The sum-of-the-years’-digits depreciation method yields decreasing depreciation in each successive year. To determine the denominator, use the following formula (assuming 5 years):

Or, simple add Or, simple add 1 + 2 + 3 + 4 + 51 + 2 + 3 + 4 + 5

(continued)

11-10

tD =

SYD (C – R)

D =5

15 ($100,000 – $5,000)

D = $31,667

Now that we know the denominator, we can determine the depreciation for the year using the following formula, where “t” equals years remaining at the beginning of the period.

Sum-of-the-Years’ Digits Method

(continued)

11-11

For the second year, we reduce the numerator by one.

Sum-of-the-Years’ Digits Method

tD =

SYD (C – R)

D =4

15 ($100,000 – $5,000)

D = $25,333

(continued)

11-12

Declining-Balance Method

• The declining-balance depreciation method provides decreasing charges by applying a constant percentage rate to a declining asset book value. First, the constant percentage must be calculated.

• The most popular rate is two times the straight-line rate, and this method is called double-declining balance depreciation.

11-13

• Thus, the molding machine would have a straight-line rate of 20% (1/5). This number is doubled to arrive at the double-declining percentage of 40%.

Declining-Balance Method

• Or you can use the following formula to get the straight-line rate: 1/n

11-14

Factors Suggesting the Use of an Accelerated Method

1)The anticipation of a significant contribution in early periods with the extent of the contribution to be realized in later periods being less definite.

2)The possibility that inadequacy or obsolescence may result in premature retirement of the asset.

11-15

Use-Factor Methods

Use-factor depreciation methods view asset exhaustion as related primarily to asset use or output and provide periodic charges varying with the degree of such services.

(continued)

11-16

• The first use-factor method we will examine is service-hours depreciation.

• This method is based on the theory that the purchase of an asset represents the purchase of a number of hours of direct service.

(continued)

Service-Hours Depreciation

11-17

The Schuss Boom Ski Manufacturing machine costs $100,000 and had a residual value of $5,000. It is estimated that the machine will perform for an estimated service life of 20,000 hours. Now we can determine the rate to be applied to each service hour.

(continued)

Service-Hours Depreciation

11-18

Service-Hours Depreciation

D =C – R

n

$100,000 – $5,000

20,000 hours =

D = $4.75 per hour

Equals the projected residual value

11-19

Productive-Output Depreciation

• Productive-output depreciation is based on the theory that an asset is acquired for the service it can provide in the form of production output.

• The Schuss Boom asset is estimated to have a productive life of 25,000 units.

• Assume the company produced 3,200 units in 2013 and 5,400 units in 2014.

(continued)

11-20

2013: 3,200 units $3.80 = $12,160

Annual depreciation for 2013 and 2014:

2014: 5,400 units $3.80 = $20,520

r =C – R

n$100,000 – $5,000

25,000 units=

r = $3.80 per unit

Productive-Output Depreciation

11-21

Group and Composite Depreciation

• Group depreciation groups similar assets into depreciation accounts (e.g., all of a company’s delivery vans).

• Composite depreciation refers to placing assets in the group that are related but dissimilar (e.g., all of a company’s desks, chairs, and computers).

• The group depreciation procedure treats a collection of assets as a single group.

(continued)

11-22

The rate of 12.5%, applied to the cost of existing assets, $20,000, results in annual depreciation of $2,500.

Group and Composite Depreciation

(continued)

11-23

Because the accumulated depreciation account applies to the entire group of assets, no book value can be calculated for any specific asset. If asset B were sold for $3,500 after two years, the following entry would be as follows:

Cash 3,500Accumulated Depreciation 2,500

Equipment 6,000

Group and Composite Depreciation

No gain or loss is recognized.No gain or loss is recognized.

11-24

Depreciation and IAS 16

The component approach is required under IASB standards. The following requirement is contained in IAS 16:

“Each part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item shall be depreciated separately.”

11-25

Depreciation and Accretion of an Asset Retirement Obligation

• Bryan Beach Company purchases and erects an oil platform at a total cost of $750,000. Bryan Beach is legally obligated to dismantle and remove the platform after 10 years.

• It is estimated that this will cost $100,000. Assuming an 8% interest rate, the present value of the obligation is $46,319 [46.319 (n = 10; i = 8%) $100,000].

(continued)

11-26

The journal entries to record the purchase of the oil platform and the recognition of the asset retirement obligation are as follows:Oil Platform 750,000

Cash 750,000

Oil Platform 46,319Asset Retirement Obligation 46,319

Depreciation and Accretion of an Asset Retirement Obligation

(continued)

11-27

The cost of the oil platform asset, including the estimated retirement obligation, is depreciated just like any other long-term asset.Depreciation Expense 79,632*

Accumulated Depreciation— Oil Platform 79,632

*Assuming straight-line depreciation [($750,000 + $46,319)/10]

Depreciation and Accretion of an Asset Retirement Obligation

(continued)

11-28

Each year an entry must be made to recognize the increase in the present value of the asset retirement obligation.Accretion Expense 3,706*

Asset Retirement Obligation 3,706

* ($46,319 x 0.08) = $3,706

Depreciation and Accretion of an Asset Retirement Obligation

11-29

• Natural resources (also called wasting assets) are consumed as the physical units representing these resources are removed and sold.

• The computation of depletion expense is an adaption of the productive-output method of depreciation.

• Perhaps the most difficult problem is estimating the amount of resources available for economical removal from the land.

Depletion of Natural Resources

(continued)

11-30

• Land containing mineral deposits is purchased at a cost of $5,500,000. It is expected to have a residual value of $250,000.

• The natural resource supply is estimated at 1,000,000 tons. The unit-depletion charge and the total depletion charge for the first year, assuming the withdrawal of 80,000 tons, are calculated on Slide 11-51.

Depletion of Natural Resources

(continued)

11-31

Depletion charge per ton

$5,500,000 – $250,000

1,000,000 tons=

Depletion charge per ton

= $5.25

Depletion for 2013 = $5.25 80,000 tons

= $420,000

Depletion of Natural Resources

(continued)

11-32

Record the initial purchase as follows:Mineral Deposits 5,500,000

Cash 5,500,000

Record the depletion for 2013 as follows:Depletion Expense 420,000

Accumulated Depletion (or Mineral Deposits) 420,000

Depletion of Natural Resources

If only 60,000 tons are sold, $105,000 is If only 60,000 tons are sold, $105,000 is reported as part of ending inventory.reported as part of ending inventory.

11-33

Change in Estimated Life

• A company purchased $50,000 of equipment and estimated a 10-year life. Using the straight-line method with no residual value, the annual depreciation would be $5,000.

• After four years, accumulated depreciation would amount to $20,000, and the remaining book value would be $30,000.

• Early in the fifth year, a reevaluation of the life indicates only four more years of service can be expected from the asset.

(continued)

11-34

Change in Estimated Units of Production

A change in accounting for natural resources occurs when the estimate of the recoverable units changes as a result of further discoveries, improved extraction processes, or changes in sales prices that indicate changes in the number of units that can be extracted profitably.

(continued)

11-35

• Land is purchased at a cost of $5,500,000 with estimated net residual value of $250,000. The original estimate of natural resources in the land was 1,000,000 tons.

• In the second year of operations, 100,000 tons of ore are withdrawn. At the end of that year appraisers indicate a remaining tonnage of 950,000.

Change in Estimated Units of Production

(continued)

11-36

Cost assignable to recoverable tons as of the beginning of second year:

Deduct: Depletion charge for first year 420,000

Balance of cost subject to depletion $4,830,000

$5,250,000

Original costs applicable to depletable resources

Change in Estimated Units of Production

(continued)

11-37

Estimated recoverable tons as of the beginning of second year:

Number of tons withdrawn in 2nd year 100,000Estimated recoverable tons as ofthe end of the second year

950,000Total recoverable tons as of the

beginning of the second year1,050,000

Depletion charge per ton for second year: $4,830,000/1,050,000 = $4.60

Depletion charge for second year: 100,000 $4.60 = $460,000

Change in Estimated Units of Production

(continued)

11-38

Cost assignable to recoverable tons as of the beginning of second year:

Original costs applicable to depletableresources

$5,250,000Add: Additional costs incurred in 2nd year

525,000

$5,775,000Deduct: Depletion charge for first year

420,000Balance of cost subject to depletion

$5,355,000Estimated recoverable tons as of the

beginning of second year

1,050,000Depletion charge per ton for second year: $5,355,000/1,050,000 = $5.10Depletion for second year: 100,000 × $5.10 = $510,000

Change in Estimated Units of Production

11-39

Change in Depreciation Method

• Another change in estimate occurs when the actual pattern of consumption of an asset doesn’t match the pattern of consumption implicit in the depreciation method.

• Example: An asset is purchased for $120,000 with a 12-year expected useful life and zero salvage value. After two years of straight line depreciation, the asset has a remaining book value of $10,000.

(continued)

11-40

Change in Depreciation Method

• The company decides the double-declining-balance method would yield a better estimate of periodic depreciation.

• The straight-line depreciation rate is 10% (1/n = 1/10 = 10%). Double that rate is 20%.

• Year 3 depreciation is $100,000 x 0.20, or $20,000.

11-41

Accounting for Asset Impairment

FASB Statement No. 144 addresses four questions: 1. When should an asset be reviewed

for possible impairment?

An impairment review should be conducted whenever there has been a material change in the way an asset is used or in the business environment.

(continued)

11-42

2. When is an asset impaired? An asset is impaired when the

undiscounted sum of estimated future cash flows from an asset is less than the book value of the asset.

Accounting for Asset Impairment

(continued)

11-43

3. How should an impairment loss be measured? The impairment loss is the difference

between the book value of the asset and the asset’s fair value.

The fair value can be approximated using the present value of estimated future cash flows from the asset.

(continued)

Accounting for Asset Impairment

11-44

4. What information should be disclosed about an impairment? Disclosure should include a description

of the impaired asset, reasons for the impairment, a description of the measurement assumptions, and the business segment or segments affected.

Accounting for Asset Impairment

(continued)

11-45

International Accounting for Asset Impairment: IAS 36

• IAS 36 requires that a company recognize an impairment loss whenever the “recoverable amount” of an asset is less than its book value.

• Recoverable amount is the higher of the selling price of the asset or the discounted future cash flows associated with the asset’s use.

• IAS 36 allows for the reversal of an impairment loss if events in subsequent years suggest the asset is no longer impaired.

11-46

• Intangible assets are to be amortized by the straight-line method unless there is strong justification for using another method.

• Because companies must disclose both the original cost and the accumulated amortization for an amortizable intangible, the credit should be to a separate accumulated amortization account.

Amortization and Impairment of Intangible Assets Subject to Amortization

(continued)

11-47

Impairment of Intangibles Not Subject to Amortization

The FASB describes the following examples of intangibles with indefinite lives:• Broadcast licenses often have a renewal

period of 10 years. Because renewal is virtually automatic, such licenses are considered to have an indefinite life.

• A trademark right is granted for a limited time, but can be renewed almost routinely. If economic factors suggest that the trademark will continue to have value in the foreseeable future, then its useful life is indefinite.

(continued)

11-48

Procedures in Testing Goodwill for Impairment

• The procedure in testing goodwill for impairment is a four step test.

• Buyer Company acquired Target Company on January 1, 2013. As part of the acquisition, $1,000 in goodwill was recognized; this goodwill was assigned to Buyer’s Manufacturing unit. For 2013, earnings for the Manufacturing unit were $350.

(continued)

11-49

Procedures in Testing Goodwill for Impairment

• Separately traded companies with operations similar to the manufacturing reporting unit have market values approximately equal to six times earning.

(continued)

11-50

Procedures in Testing Goodwill for Impairment

As of December 31, 2013, book and fair values of assets and liabilities of the Manufacturing reporting units are as follow:

Book Values Fair Values

Identifiable assets $3,500 $4,000Goodwill 1,000 ?Liabilities 2,000 2,000

(continued)

11-51

Procedures in Testing Goodwill for Impairment

1. Compute the fair value of each reporting unit to which goodwill has been assigned.

(continued)

Using the earnings multiple, the fair value of the Manufacturing reporting unit is estimated to be $2,100 ($350 x 6).

11-52

Procedures in Testing Goodwill for Impairment

2. If the fair value of the reporting unit exceeds the net book value of the assets and liabilities of the reporting unit, the goodwill is assumed to not be impaired and no impairment is recognized.

(continued)

The net book value of the assets and liabilities of the Manufacturing reporting unit is $2,500 [($3,500 +$1,000) – $2,000]. Since $2,100 (step 1) is less than $2,500, further computations are needed.

11-53

3. If the fair value of the reporting unit is less than the net book value of the assets and liabilities of the reporting unit, then a new fair value of goodwill is computed. Goodwill value is always a residual value. Implied fair value of goodwill is calculated as

follows:

Procedures in Testing Goodwill for Impairment

(continued)

Estimated fair value of Manufacturing $2,100Fair value of identifiable assets – fair value of liabilities ($4,000 – $2,000) 2,000Implied fair value of goodwill $ 100

11-54

4. If the implied amount of goodwill computed in (3) is less than the amount initially recorded, a goodwill impairment loss is recognized for the difference.

Procedures in Testing Goodwill for Impairment

The implied fair value of goodwill is less than the recorded amount of goodwill ($100 < $1,000). The journal entry necessary to recognize goodwill impairment loss is as follows:

Goodwill Impairment Loss 900 Goodwill 900

11-55

Asset Retirement by Sale

On July 1, 2013, Landon Supply Co. sells machinery for $43,600 that is recorded on the books at a cost of $83,600 with accumulated depreciation as of January 1, 2013, of $50,600. Assume a 10 percent straight-line rate.

Depreciation Expense—Machinery 4,180 Accumulated Depreciation—

Machinery 4,180 To record depreciation for six months in 2013.

$83,600 x .10 x 6/12

(continued)

11-56

Asset Retirement by Sale

Cash 43,600 Accumulated Depreciation—Machinery 54,780

Machinery 83,600Gain on Sale of Machinery 14,780

To record sale of machinery at a gain.

[$43,600 – ($83,600 – $54,780)]

The entry to record the sale is as follows:

11-57

Asset Classified as Held for Sale

• Management commits to a plan to sell a long-term operating asset.

• The asset is available for immediate sale.

• An active effort to locate a buyer is underway.

• It is probable that the sale will be completed within one year.

Special accounting is required if the following conditions are satisfied:

(continued)

11-58

If the criteria are satisfied, two uncommon accounting actions are required. During the interval between being classified as held for sale and actually being sold:

1. No depreciation is to be recognized, and

2. The asset is to be reported at the lower of its book value or its fair value (less the estimated cost to sell).

Asset Classified as Held for Sale

(continued)

11-59

• On July 1, 2013, Haas Company has a building that cost $100,000 and accumulated depreciation of $35,000. Haas commits to plans to sell the building by March 1, 2013.

• On July 1, 2013, the building has an estimated fair value of $40,000 and it is estimated that the selling costs will be $3,000.

Asset Classified as Held for Sale

(continued)

11-60

Building—Held for Sale 37,000Loss on Held-for-Sale Classification 28,000 Accumulated Depreciation—Building 35,000

Building 100,000

The following entry would be made on July 1:

If the net realizable value had been greater than the book value of $65,000 ($100,000 $35,000), no journal entry would have been made.

(continued)

Asset Classified as Held for Sale

11-61

Building—Held for Sale 18,000Gain on Recovery Value—Held for Sale 18,000

($58,000 – $3,000) – $37,000

On December 31, 2013, the estimated selling price was $58,000 (with $3,000 estimated selling costs), the following journal entry would be necessary:

Asset Classified as Held for Sale

11-62

• When an operating asset is acquired in exchange for another nonmonetary asset, the new asset acquired is generally recorded at its fair market value or the fair value of the nonmonetary asset given in exchange, whichever is more clearly determinable.

• However, if the exchange has no real commercial substance, the asset received is sometimes recorded at the BOOK value of the asset given.

Asset Retirement by Exchange for Other Nonmonetary Assets

11-63

Nonmonetary Exchange without Commercial Substance

Example 1—No Cash InvolvedExample 1—No Cash InvolvedExample 1—No Cash InvolvedExample 1—No Cash Involved

Republic Manufacturing Company owns a molding machine that it decided to exchange for a machine owned by Logan Square Company. The following cost and market data relate to the two machines:

(continued)

11-64

The entry on Republic’s books to record the exchange will be:Machinery (new) 14,000Accumulated Depreciation—Machinery (old) 32,000

Machinery 46,000

The entry on Logan’s books to record the exchange will be:Machinery (new) 16,000Accumulated Depreciation—Machinery (old) 37,700Loss on Exchange of Machinery 300

Machinery (old) 54,000

Nonmonetary Exchange without Commercial Substance

11-65

Example 2—Small Amount of Cash InvolvedExample 2—Small Amount of Cash InvolvedExample 2—Small Amount of Cash InvolvedExample 2—Small Amount of Cash Involved

Assume the same facts as Example 1, except that it is agreed that Republic’s machine has a market value of $16,000 and Logan’s machine is worth $17,000. Republic pays Logan $1,000 cash.

Nonmonetary Exchange without Commercial Substance

(continued)

17,000

11-66

The entry on Republic’s books to record the exchange will be:Machinery (new) 15,000Accumulated Depreciation—Machinery (old) 32,000

Machinery (old) 46,000Cash 1,000

Nonmonetary Exchange without Commercial Substance

The book value of Logan’s machine is less than the fair value, indicating a $700 gain ($17,000 – $16,300). A portion of the gain should be recognized as having been earned.

(continued)

11-67

Nonmonetary Exchange without Commercial Substance

The amount to be recognized is computed using the following formula:Recognized gain

Cash receivedCash received + Fair value of

acquired asset

Total indicated gain

= x

For Logan:

$1,000$1,000 + $16,000

Recognized gain = x $700 = $41

(continued)

11-68

Nonmonetary Exchange without Commercial Substance

The entry on Logan’s books to record the exchange is as follows:Cash 1,000Machinery (new) 15,341Accumulated Depreciation—Machinery (old) 37,700

Machinery (old) 54,000Gain on Exchange of Machinery 41

11-69

Example 3—Large Amount of Cash InvolvedExample 3—Large Amount of Cash InvolvedExample 3—Large Amount of Cash InvolvedExample 3—Large Amount of Cash Involved

Assume the same facts as in Example 2, except that it is agreed that Republic’s machine has a fair value of $12,750 and Logan’s machine has a fair value of $17,000. Republic pays Logan $4,250 cash.

Nonmonetary Exchange without Commercial Substance

(continued)

11-70

The entry on Republic’s books to record the exchange will be:Machinery (new) 17,000Accumulated Depreciation—Machinery (old) 32,000Loss on Exchange of Machinery 1,250

Machinery (old) 46,000Cash 4,250

Nonmonetary Exchange without Commercial Substance

The entry on Logan’s books:Cash 4,250Machinery (new) 12,750Accumulated Depreciation—Machinery (old) 37,700

Machinery (old) 54,000Gain on Exchange of Machinery 700

11-71

1.Nearest whole month2.Nearest whole year3.Half-year convention4.No depreciation in year of acquisition;

full year depreciation in year of retirement.

5.Full year depreciation in year of acquisition; no depreciation in year of retirement.

Makes the Makes the most intuitive most intuitive sensesense

Depreciation for Partial Periods

(continued)

11-72

Sum-of-the-Years’-Digits MethodSum-of-the-Years’-Digits MethodSum-of-the-Years’-Digits MethodSum-of-the-Years’-Digits Method

Depreciation for Partial Periods

11-73

Declining-Balance MethodDeclining-Balance MethodDeclining-Balance MethodDeclining-Balance Method

Depreciation for Partial Periods

11-74

Income Tax Depreciation

• The term cost recovery was used in the tax regulations to emphasize that ACRS is not a standard depreciation method because the system is not based strictly on asset life or pattern of use.

• Salvage values are ignored.

• Depreciate over three to five years.

(continued)

11-75

The MACRS method for personal property also incorporates a half-year convention, meaning that one-half of a year’s depreciation is recognized on all assets purchased or sold during the year.

Income Tax Depreciation

11-76

Chapter 11Chapter 11

The EndThe EndThe EndThe End

$

₵

11-77