Long-lived, Revenue-producing Assets. Expected to Benefit Future Periods

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1 Section 8 - Property, Plant, Equipment (Fixed Assets), and Depletable Resources Types of Assets Long-lived, Revenue-producing Assets 10-1 Expected to Benefit Future Periods Tangible Property, Plant, Equipment & Natural Resources Intangible No Physical Substance General Rule for Cost Capitalization The initial cost of an asset includes the purchase price and all expenditures necessary to bring the asset to its desired condition and location for use.

2 10-2 Costs to be Capitalized Equipment Net purchase price Taxes Transportation costs Installation costs Testing and trial runs Land (not depreciable) Purchase price Real estate commissions Attorney s fees Title search Title transfer fees Title insurance premiums Removing old buildings

3 10-3 Costs to be Capitalized Land Improvements Separately identifiable costs of Driveways Parking lots Fencing Landscaping Private roads Buildings Purchase price Attorney s fees Commissions Reconditioning

4 10-4 Costs to be Capitalized Natural Resources Acquisition costs Exploration costs Development costs Restoration costs Intangible Assets Patents Copyrights Trademarks Franchises Goodwill The initial cost of an intangible asset includes the purchase price and all other costs necessary to bring it to condition and location for use, such as legal and filing fees.

5 Cost Allocation An Overview 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. Some of the cost is allocated to each period. Acquisition Cost Expense* *Depreciation (Balance Sheet) of an asset used to produce (Income a product Statement) is a product cost that does not become an expense until the product is sold.

6 Cost Allocation An Overview 10-6 Asset Category Property, Plant, & Equipment Natural Resource Debit Depreciation Depletion Account Credited Accumulated Depreciation Natural Resource Asset Intangible Amortization Intangible Asset Caution! Depreciation, depletion, and amortization are processes of cost allocation, not valuation! Depreciation on the Balance Sheet

7 10-7 Measuring Cost Allocation Cost allocation requires three pieces of information for each asset: Service Life Allocation Base Allocation Method The estimated expected use from an asset. The systematic approach used for allocation. Total amount of cost to be allocated. Cost Residual Value (at end of useful life)

8 10-8 Depreciation Time-based Methods Straight-line (SL) Accelerated Methods Sum-of-the-years'-digits (SYD) Declining Balance (DB) Activity-based methods Units-of-production method (UOP). Group and composite methods Tax depreciation

9 10-9 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. Example: 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?

10 Straight-Line Annual Straight-line $ 50,000 $ 5,000 = Depreciation 5 = $ 9,000 Depreciation Life in Years Accumulated Accumulated Undepreciated Depreciation Depreciation Depreciation Balance Year (debit) (credit) Balance (book value) $ 50,000 1 $ 9,000 $ 9,000 $ 9,000 41, ,000 9,000 18,000 32, ,000 9,000 27,000 23, ,000 9,000 36,000 14, ,000 9,000 45,000 5,000 $ 45,000 $ 45,000 BV at the end of the asset s useful life = Residual Value. Residual Value

11 10-11 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 straight-line method. Sum-of-the-years -digits (SYD) depreciation SYD Depreciation = ( Cost Residual Value ) Remaining Years of Useful Life Sum-of-the-Years' Digits

12 10-12 Sum-of-the-Years -Digits (SYD) Sum-of-the- Years' Digits (SYD) = ( Useful Life [ Useful Life ] ) Example: 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 depreciation, compute depreciation for the first two years. SYD = ( 5 [ ] ) 2 = 30 2 = 15

13 10-13 Sum-of-the-Years'-Digits (SYD) SYD Depreciation = ( Cost Residual Value ) Remaining Years of Sum-of-the- Years' Digits = ( $ 50,000 $ 5,000 ) = $ 15,000 Depreciation in Year 1 = ( $ 50,000 5,000 = $ 12,000 Depreciation in Year 2 $ )

14 Sum-of-the-Years'-Digits (SYD) Accumulated Undepreciated Depreciation 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, Residual Value Depreciation Life 4 in Years 5

15 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) depreciation is computed as follows: DDB = Book Value ( 2 Straight-line Rate ) Note: the new book value (declines each year) is used in the formula.

16 10-16 Declining-Balance (DB) Methods Example: 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 first two years using double-declining-balance? DDB = Book Value ( 2 Straight-line Rate ) = $ 50,000 ( 2 20% ) = $ 20,000 1st Year Depreciation = ($50,000 - $20,000) (2 20%) = $ 12,000 2nd Year Depreciation

17 Declining-Balance (DB) Methods Accumulated Undepreciated Depreciation Depreciation Balance Year (debit) Balance (book value) $ 50,000 1 $ 20,000 $ 20,000 30, ,000 32,000 18, ,200 39,200 10, ,320 43,520 6, ,480 45,000 5,000 $ 45,000 Depreciation forced so that BV = Residual Value Depreciation Life in Years

18 10-18 Units-of-Production Depreciation rate per unit of activity = Acquisition cost Residual value Estimated life in units of activity Depreciation = Depreciation rate per unit of activity Units of activity

19 10-19 Units-of-Production Example: 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 $50,000 $5,000 = rate per unit 100,000 = $0.45 Depreciation = Depreciation rate per unit Units of output = $ ,000 = $9,900

20 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.

21 10-21 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. Example: 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.

22 10-22 Changes in Estimates Asset cost $ 30,000 Accumulated depreciation ($3,000 per year 3 years) 9,000 Remaining book value 21,000 Divide by remaining life 5 Revised annual depreciation $ 4,200 What happens if we change depreciation methods?

23 10-23 Change in Depreciation Method A change in depreciation, amortization, or depletion method is considered a change in accounting estimate that is a result of (achieved by) a change in accounting principle. Account for these changes prospectively, exactly the same as 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. Determine the amount of depreciation to be recorded for 2013.

24 10-24 Change in Depreciation Method Depreciation $ 160,000 ($400,000 40%) Depreciation ,000 [($400,000 - $160,000) 40%] Total Depreciation $ 256,000 Cost of asset $ 400,000 Less: Accumulated depreciation 256,000 Undepreciated balance $ 144,000 Less: residual value (40,000) New depreciable amount 104,000 Remaining service life 3 Annual depreciation $ 34,667 December 31, 2013: Depreciation expense... 34,667 Accumulated depreciation... 34,667 To record depreciation expense.

25 Group and Composite Methods Both methods depreciate assets collectively not individually. Group method: Assets are grouped by common characteristics such as similar service lives and other attributes, e.g., fleet of delivery vehicles (trucks, vans). Composite method: Assets are physically dissimilar, but are aggregated anyway for convenience, e.g., one manufacturing plant assets, even though they all may have widely devise service lives. Caluations: 1. Total depreciation per year = adding each group s (or composite) initial depreciation amount per year altogether. 2. Average depreciation rate = total depreciation amount per year (1 st yr.) / total asset costs ((calculated after the initial depreciation amount per year is determined). 3. Annual depreciation (including new assets) = the average rate the total group acquisition cost. Accumulated depreciation records are not maintained for individual assets

26 10-26 Group and Composite Methods Cont d 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. No gain or loss is recorded.

27 10-27 U.S. GAAP vs. IFRS Component Depreciation, Depreciable Base, and Residual Value Component (item) depreciation is allowed (not required) but not often used in practice. The depreciable base is determined by subtracting estimated residual value from cost. Annual reviews of residual values are not required. Each component of an item of property, plant, and equipment is required to depreciate separately if its cost is significant to the total cost of the item. Depreciable base is determined by subtracting estimated residual value from cost. IFRS requires a review of residual values annually.

28 10-28 U.S. GAAP vs. IFRS Valuation of Property, Plant, and Equipment Property, plant, and equipment is reported in the balance sheet at cost less accumulated depreciation (book value). Revaluation is prohibited. Property, plant, and equipment may be reported at cost less accumulated depreciation, or alternatively, at fair value (revaluation), even if FV is higher. If revaluation is elected, all assets within a class of property, plant, and equipment are required to be revalued on a regular basis. Revaluation is used infrequently.

29 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 Rate per Unit = Cost of Natural Resource Residual Value Estimated Recoverable Units Total Depletion Cost = Unit Depletion Rate Units Extracted

30 Depletion of Natural Resources Example: 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. What is ABC s depletion rate? For the year ABC mined 13,000 tons, and sold 10,000 tons. What is the total amount of depletion for the year? 1. Calculate Depletion Base: Depletion rate = 1,000,000 40,000 tons = $25 per ton 2. Record units extracted and cost of goods sold as depletion for the year: Depletion = 10,000 tons sold $25per ton = $250,000 J E: Depletion - Ore (cost of goods sold) 250,000 Ore Inventory (direct material) 75,000 Accumulated Depletion (13,000 x 25) 325,000 (or debit Depletion, credit Ore Deposit instead of credit Accum Depletion) Balance Sheet Ore Deposit 1,100,000 Less: accumulated depletion 325, ,

31 Oil and Gas Accounting Exploration Costs in Unsuccessful Wells Two acceptable accounting alternatives Successful efforts method Full-cost method Unsuccessful wells exploration costs (dry holes) are expensed. Unsuccessful wells exploration costs (dry holes) are capitalized. FASB preferred all companies to use the successful efforts method, but political pressure prevented it. Both are acceptable.

32 10-32 Oil and Gas Accounting - Example The Shannon Oil Company incurred $2,000,000 in exploration costs for each of 10 oil wells in Eight of the 10 wells were dry holes. Prepare the journal entries to record the exploration costs under both of the acceptable methods. Successful Efforts: Oil deposit... 4,000,000 Exploration expense 16,000,000 Cash. 20,000,000 Full Cost: Oil deposit... 20,000,000 Cash. 20,000,000

33 U.S. GAAP vs. IFRS Valuation of Biological Assets Biological assets, such as timber tracts, are valued at cost minus accumulated depletion. Biological assets are valued at fair value less estimated costs to sell (harvest and delivery), i.e., net realizable value. Changes in fair value are recognized in the income statement.

34 Asset Retirement Obligations Restoring Land Often encountered with natural resource extraction when the land must be restored to a useable condition. Recognize the restoration costs as a liability & a corresponding increase in the related asset. Record at fair value, usually the present value of future cash outflows associated with the restoration.

35 10-35 Lump-Sum Purchases Several assets are acquired for a single price that may be lower than the sum of the individual asset fair values. Allocation of the lump-sum price is based on relative fair values of the individual assets. Asset 1 Asset 2 Asset 3 On May 13, land and building were purchased for $200,000 cash. The appraised value of the building is $162,500, and the land is appraised at $87,500. How much of the $200,000 purchase price will be allocated to the building account?

36 Lump-Sum Purchases Appraised % of Purchase Assigned Asset Value Value Price Cost (a) (b)* (c) (b c) Land $ 87,500 35% $ 200,000 $ 70,000 Building 162,500 65% 200, ,000 Total $ 250,000 $ 200,000 * $87,500 $250,000 = 35% The building will be allocated $130,000 of the total purchase price of $200,000. May 13: Land... 70,000 Building.. 130,000 Cash ,000 To record lump-sum purchase of land and building.

37 Noncash Acquisitions A. Issuance of equity securities B. Deferred payments (N/P) C. Donated assets D. Exchanges (this section talks about nonmonetary assets only) Nonmonetary Assets (& liabilities): Fluctuate in value with inflation & deflation. Nonmonetary owners may lose or gain with the rise or fall of the CPI, and the increase or decrease in the FV of the nonmonetary asset. Theses assets include: Marketable common stock (i.e., for investment & not equity stock), Inventory, Investment in sub (equity), PP&E (and accum depr), Intangible assets

38 Special Note about Monetary Assets Definition: Monetary assets (& liabilities) are fixed or denominated in dollars regardless of changes in specific prices or the general price level, i.e., CPI. The monetary assets acquired is recorded at: the fair value of the assets or consideration given up (amount paid) unless the fair value of the assets received or acquired is more clearly evident. They include: Cash, Bonds-nonconvertible, Accounts/Notes receivable (& allowance), Long-term receivables Monetary assets exchanges: Cost of the assets acquired = FV of the assets given up, unless the FV of the assets received is more clearly evident.

39 A. Issuance of Equity Securities (often to Newly Formed Companies Owners) for Assets Asset acquired is recorded at the fair value of the asset acquired or the market value of the securities issued, whichever is more clearly evident. If the securities received are not actively traded, the fair value of the asset received, as determined by appraisal, may be more clearly evident than the fair value of the securities. If the securities are actively traded, market value can be easily determined C. Donated Assets On occasion, companies acquire assets through donation, some by Gov. The receiving company is required to record: The donated asset at fair value. GAAP requires the difference be recorded as revenue. Building (FV) 20,000,000 Cash 16,000,000 Revenue donation of asset 4,000,000

40 10-40 B. Deferred Payments Note payable 1. with a Market interest rate 2. Less than market rate (unreasonable rate) or noninterest bearing Record asset at face value of note Because cash equivalent price is not known, record asset at present value of future cash flows.

41 B. Deferred Payments - Example On January 2, 2013, Midwestern Corporation purchased an industrial furnace by signing a 2-year noninterest-bearing note requiring $50,000 to be paid on December 31, The appropriate interest rate on notes of this nature is 10%. Prepare the required journal entries for Midwestern on January 2, 2013; December 31, 2013 (year-end); and December 31, 2014 (maturity). The cash equivalent price is not known, so the present value of the future cash payment must be used. Face amount of note $ 50,000 PV of $1, n =2, i =10% = PV of note (rounded) $ 41,323

42 B. Deferred Payments January 2, 2013: Furnace... 41,323 Discount on note payable... 8,677 Note payable... 50,000 To record furnace acquisition. December 31, 2013: Interest expense (10% of $41,323)... 4,132 Discount on note payable 4,132 To record interest expense. December 31, 2014: Interest expense (10% of ($41,323+$4,132))... 4,545 or, 8,677-4,132 Discount on note payable.... 4,545 To record interest expense. December 31, 2014 Note payable... 50,000 Cash ,000 To record payment of note.

43 10-43 D. Exchanges - Gain Situation Has Commercial Substance. Company usually records the cost of a nonmonetary asset acquired in exchange for another nonmonetary asset at the fair value of the asset given up, and immediately recognizes a gain.

44 10-44 Exchanges - Gain Situation w/o Boot Illustration: Interstate Transportation Company exchanged a number of used trucks plus cash for a semi-truck. The used trucks have a combined book value of $42,000 (cost $64,000 less $22,000 accumulated depreciation). Interstate s purchasing agent, experienced in the second-hand market, indicates that the used trucks have a fair market value of $49,000. In addition to the trucks, Interstate must pay $11,000 cash for the semi-truck. Interstate computes the cost of the semi-truck as follows.

45 10-45 Exchanges - Gain Situation w/o Boot Illustration: Interstate records the exchange transaction as follows: Semi-truck 60,000 Accumulated Depreciation Trucks 22,000 Trucks (used) 64,000 Gain on disposal of Used Trucks 7,000 Cash 11,000 Gain on Disposal

46 10-46 Exchanges - Gain Situation w/o Boot Lacks Commercial Substance No Cash Received. Now assume that Interstate Transportation Company exchange lacks commercial substance. That is, the economic position of Interstate did not change significantly as a result of this exchange. In this case, Interstate defers the gain of $7,000 and reduces the basis of the semitruck.

47 10-47 Exchanges - Gain Situation w/o Boot Illustration: ABC records the exchange transaction as follows: Trucks (semi) 53,000 Accumulated Depreciation Trucks 22,000 Trucks (used) 64,000 Cash 11,000

48 10-48 Exchanges - Gain Situation with Boot Lacks Commercial Substance Some Cash Received. When a company receives cash (sometimes referred to as boot ) in an exchange that lacks commercial substance, it may immediately recognize a portion of the gain. The general formula for gain recognition when an exchange includes some cash is as follows:

49 10-49 Exchanges - Gain Situation with Boot Illustration: Lily Corporation traded in used machinery with a book value of $60,000 (cost $110,000 less accumulated depreciation $50,000) and a fair value of $100,000. It receives in exchange a machine with a fair value of $90,000 plus cash of $10,000.

50 10-50 Exchanges - Gain Situation with Boot The portion of the gain a company recognizes is the ratio of monetary assets (cash in this case) to the total consideration received.

51 10-51 Exchanges - Gain Situation with Boot Lily would record the following entry: Cash 10,000 Machine 54,000 Accumulated Depreciation Machine 50,000 Machine 110,000 Gain on disposal of machine 4,000

52 10-52 Exchanges - Gain Situation with or w/o Boot Summary of Gain and Loss Recognition on Exchanges of Non-Monetary Assets

53 10-53 Exchanges - Gain Situation Comprehensive Example: Santana Company exchanged equipment used in its manufacturing operations plus $2,000 in cash for similar equipment used in the operations of Delaware Company. The following information pertains to the exchange. Santana Delaware Equipment (cost) $28,000 $28,000 Accumulated Depreciation 19,000 10,000 Fair value of equipment 13,500 15,500 Cash given up 2,000 Instructions: Prepare the journal entries to record the exchange on the books of both companies.

54 10-54 Exchanges - Gain Situation w/o Boot Calculation of Gain or Loss Santana Delaware Fair value of equipment received $15,500 $13,500 Cash received / paid (2,000) 2,000 Less: Book value of equipment ($28,000-19,000) (9,000) ($28,000-10,000) (18,000) Gain or (Loss) on Exchange $4,500 ($2,500)

55 Exchanges - Gain Situation w/o Boot Has Commercial Substance Santana: Equipment -New 15,500 Accumulated depreciation 19,000 Cash 2,000 Equipment -Old 28,000 Gain on exchange 4,500 Delaware: Cash 2,000 Equipment -New 13,500 Accumulated depreciation 10,000 Loss on exchange 2,500 Equipment -Old 28,000

56 Exchanges - Gain Situation w/o Boot Santana (Has Commercial Substance): Equipment 15,500 Accumulated depreciation 19,000 Cash 2,000 Equipment 28,000 Gain on disposal of equipment 4,500 Santana (LACKS Commercial Substance): Equipment (15,500 4,500) 11,000 Accumulated depreciation 19,000 Cash 2,000 Equipment 28,000

57 Exchanges - Gain Situation w/o Boot Delaware (Has Commercial Substance): Cash 2,000 Equipment 13,500 Accumulated depreciation 10,000 Loss on disposal of equipment 2,500 Equipment 28,000 Delaware (LACKS Commercial Substance): Cash 2,000 Equipment 13,500 Accumulated depreciation 10,000 Loss on disposal of equipment 2,500 Equipment 28,000

58 10-58 Contributions - non-monetary asset Accounting for Contributions Companies should use: should record the amount of the donation as an expense at the fair value of the donated asset. should recognize contributions received as revenues in the period received.

59 10-59 Contributions Contributions When a company contributes a non-monetary asset, it should record the amount of the donation as an expense at the fair value of the donated asset. Illustration: Kline Industries donates land to the city of Los Angeles for a city park. The land cost $80,000 and has a fair value of $110,000. Kline Industries records this donation as follows. Contribution Expense 110,000 Land 80,000 Gain on Disposal of Land 30,000

60 10-60 U.S. GAAP vs. IFRS Government Grants Fair value of donated assets granted by a governmental unit is recorded as revenue. Donated assets from a governmental unit are accounted for at fair value, but not recorded as revenue. Two alternatives: Deduct the fair value amount to determine the initial cost of the asset. Record the grant as deferred income and recognize it as income over the asset s useful life.

61 Fixed-Asset Turnover Ratio This ratio measures how effectively a company manages its fixed assets to generate revenue. Fixed-asset turnover ratio = Net sales Average fixed assets Gap Ross Stores Property, plant, and equipment (net) $ 2,563 $ 2,628 $ 984 $ 943 Net sales 14,664 7,866 $14,664 = 8.16 ($2,563 + $2,628)/2 = 5.65 $7866 ($984 + $943)/2 Ross Stores generates $2.51 more in sales dollars than GAP for each dollar invested in fixed assets.

62 Dispositions Update depreciation or amortization to date of disposal. Remove original cost of asset and accumulated depreciation or amortization from the books. The difference between book value of the asset and the amount received is recorded as a gain or loss. On June 30, 2013, MeLo Inc. sold equipment for $6,350 cash. The equipment was purchased on January 1, 2008, at a cost of $15,000. The equipment was depreciated using the straight-line method over an estimated 10-year life with zero residual value. MeLo last recorded depreciation on the equipment on December 31, 2012, its year-end. Prepare the journal entries necessary to record the disposition of this equipment.

63 10-63 Dispositions Update depreciation to date of sale. June 30, 2013: Depreciation expense ($15, years) ½) Accumulated depreciation To update depreciation to date of sale. Remove original asset cost and accumulated depreciation. Record the gain or loss. June 30, 2013: Accumulated depreciation... 8,250 Cash.... 6,350 Loss on sale. 400 Equipment... 15,000 To record sale of equipment. ($15, years) 5½ years) = $8,250 including $750

64 Impairment of Value Accounting treatment differs. Test for impairment of value when considered for sale Long-term assets to be held and used Long-term assets held for sale Tangible and 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. Goodwill Test for impairment of value at least annually or more. Other than Goodwill: Test for impairment of value when it is likely that the fair value of a reporting unit is < its book value.

65 Finite-Life Assets (Tangible & Intangible) to be Held and Used Measurement Step 1 Recoverability Test An asset is impaired when... The undiscounted sum of its estimated future cash flows < Its book value

66 10-66 Finite-Life Assets to be Held and Used Impairment loss = Measurement Step 2 Book value Fair value Reported in the income statement as a separate component of operating expenses Market value, price of similar assets, or PV of future net cash inflows. Undiscounted future Fair value cash flows $0 $125 $250 Case 1: $50 book value < FV. No loss recognized Case 2: $275 book value. Loss = $275 BV $125 FV

67 Finite-Life Assets to be Held and Used - example 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.

68 Finite-Life 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 BV $120 million FV = $80 million Impairment loss... 80,000,000 Accumulated depreciation ,000,000 Equipment. 230,000,000 To record impairment loss. (350, ,000FV) Or, Impairment loss 80,000,000 Accumulated depreciation 80,000,000 (see next page for the reason why only credit equipment 230,000.

69 10-69 Step 2 (Cont d) The reason why we debited impairment loss for $80 million, debited accumulated depreciation for $150 million, and credited equipment for $230 million ($350 million cost less $120 million fair value) is because the entry reduces the accumulated depreciation balance to zero and reduces the equipment account to its current fair value of $120 million.

70 10-70 Assets Held for Sale Assets held for sale: assets that management has committed to sell immediately in their present condition and for which sale is probable. Impairment loss = Book value Fair value less cost to sell (NRV)

71 10-71 U.S. GAAP vs. IFRS Impairment of Value: Property, Plant, and Equipment and Finite-Life Intangible Assets Assets are tested for impairment when events or changes indicates that book value may not be recoverable. An impairment loss is required when an asset s book value > the undiscounted sum of the estimated future cash flows. Assets must be assessed for circumstances of impairment at the end of each reporting period. An impairment loss is required when an asset s book value > Recoverable amount: higher of the asset s value-in-use (i.e., present value of estimated future cash flow) and fair value less costs to sell (NRV).

72 10-72 U.S. GAAP vs. IFRS Impairment of Value: Property, Plant, and Equipment and Finite-Life Intangible Assets The impairment loss: book value - fair value. Reversals of impairment losses are prohibited. The impairment loss: book value -recoverable amount (the higher of the asset s value-in-use and fair value less costs to sell). An impairment loss is reversed if the circumstances that caused the impairment are resolved.

73 Self-Constructed Assets When self-constructing an asset, two accounting issues must be addressed: Overhead allocation to the self-constructed asset. Incremental overhead only Full-cost approach Treatment of interest incurred during construction Under certain conditions, interest incurred on qualifying assets is capitalized. Asset constructed: For a company s own use. As a discrete project for sale or lease. Interest that could have been avoided if the asset were not constructed and the money used to retire debt.

74 10-74 Interest Capitalization Capitalization begins when construction begins interest is incurred, and qualifying expenses are incurred. Capitalization ends when the asset is substantially complete and ready for its intended use, or when interest costs no longer are being incurred.

75 Interest Capitalization Interest is capitalized based on Average Accumulated Expenditures (AAE). Qualifying expenditures (construction labor, material, and overhead) weighted for the number of months outstanding during the current accounting period. If the qualifying asset is financed through a specific new borrowing If there is no specific new borrowing, and the company has other debt... use the specific rate of the new borrowing as the capitalization rate.... use the weighted average cost of other debt as the capitalization rate.

76 Interest Capitalization - Example Welling Inc. is constructing a building for its own use. Construction activities started on May 1 and have continued through Dec. 31. Welling made the following qualifying expenditures: May 1, $125,000; July 31, $160,000; Oct. 1, $200,000; and Dec. 1, $300,000. Welling borrowed $1,000,000 on May 1, from Bub s Bank for 10 years at 10% to finance the construction. The loan is related to the construction project and the company uses the specific interest method to compute the amount of interest to capitalize. Average Accumulated Expenditures Fraction of Construction Date Expenditure Period AAE 5/1 $ 125,000 8/8 $ 125,000 7/31 160,000 5/8 100,000 10/1 200,000 3/8 75,000 12/1 300,000 1/8 37,500 $ 785,000 $ 337,500

77 10-77 Interest Capitalization Since the $1,000,000 of specific borrowing is sufficient to cover the $337,500 of average accumulated expenditures (1MM > 337,500) for the year, use the specific borrowing rate of 10% to determine the amount of interest to capitalize. Interest = AAE Specific Borrowing Rate Time Interest = $337,500 10% 8/12 = $22,500 The loan, initiated on May 1, is outstanding for 8 months of the year.

78 Interest Capitalization If Welling had not borrowed specifically for this construction project, it would have used the weighted-average interest method. The weighted-average interest rate on other debt would have been used to compute the amount of interest to capitalize. For example, if the weighted-average interest rate on other debt is 12%, the amount of interest capitalized would be: Interest = AAE Weighted-average Rate Time Interest = $337,500 12% 8/12 = $27,000

79 10-79 Interest Capitalization If specific new borrowing had been insufficient to cover the average accumulated expenditures Capitalize this portion using the 12% weighted- average cost of debt.... Capitalize this portion using the 10% specific borrowing rate. AAE Other debt Specific new borrowing