Ch. 10 & 11 - PP&E (Part 2), Intangibles, and Impairment Issues

depreciable fraction =

# of years remaining in the asset's life -------------------------------------------- n (n+1) / 2 n = useful life

Composite Depreciation Method

- physically dissimilar assets are aggregated for convenience of a collective depreciation calculation.

Research

- planned search or investigation aimed at discovery of new knowledge.

Trademark or tradename

- the exclusive right to display a word, slogan, symbol, or emblem that distinctively identifies a company, product, or service. The trademark is protected by the US patent office for 10 years and is renewable indefinitely. -Indefinitely life, so don't amortize.

Development

- translation of knowledge into a plan/design for a product or process.

Franchises

-The seller (franchisor) grants the buyer (franchisee) the right to use the franchisor's trademark or tradename. -EX: fast-food outlets, automobile dealerships, motels

When is the only time the "assets" that make up goodwill can be objectively valued (i.e., when is goodwill recorded)?

-When one company acquires another company -Goodwill is a "Residual Asset".

Capitalization Policy

1. Developed Technology - capitalize based on its FMV and amortize over its EUL. 2. In-Process R & D a. On acquisition date - capitalized as an indefinite-lived intangible - not amortized - subject to annual impairment testing b. If it becomes successful - amortize over its EUL. c. If the project is abandoned - expense immediately.

R&D PURCHASED IN BUSINESS ACQUISITIONS Two Types:

1. Developed Technology - technological feasibility has been achieved. 2. In-Process R&D - has not yet reach the feasibility stage.

US GAAP - IFRS DIFFERENCES related to impairment

1. IFRS skips the first stage of impairment test (the "recoverability test") & goes straight to the impairment calc if indicators suggest that impairment may have occurred. --Implication: IFRS requires more impairment losses to be recognized. 2. IFRS allows the recovery of the impairment losses --This rule offsets Rule #1 (above). More impairments under IFRS, so IFRS allows reversals.

criteria for assets being held for sale

1. Management commits to a plan to sell the asset. 2. The asset is available for immediate sale in its present condition. 3. An active plan to locate a buyer and sell the asset has been initiated. 4. The completed sale of the asset is probably and expected to occur within one year. 5. The asset is being offered for sale at a reasonable price that reflects its current FMV. 6. Management's action indicates the plan is unlikely to change significantly or be withdrawn.

Impairment of Indefinite Life Other than Goodwill

1. One stage test. Skip recoverability (i.e., Step 1 from our previous impairment test), and just consider whether FMV has dropped below book value. If FMV < book value, record the resulting loss: Impairment Loss = FMV - Book Value

operational assets typically fall into one of two categories:

1. PROPERTY, PLANT AND EQUIPMENT or FIXED ASSETS 2. INTANGIBLE ASSETS

Two types of payments are made to the franchisor:

1. The initial payment (plus any legal costs) is capitalized as an intangible asset. 2. Any subsequent period payments made over the life of the franchise agreement are expensed as incurred, usually called Royalty Expense.

What factors should be considered at the time the asset is put into use with respect to depreciation?

1. The service life of the asset ("useful life") 2. The allocation base (i.e., depreciable base) 3. The depreciation method being used

recoverability test

A test to determine whether an impairment of a long-lived asset has occurred. If the sum of the expected future net cash flows (undiscounted) is less than the carrying amount of the asset, the asset is considered impaired. If the test indicates impairment has occurred, the company then computes the amount of the impairment loss to record, based on a fair value test.

Why does GAAP allow this exception to the rule of expensing all R&D costs when it comes to software development costs?

After technological feasibility, company can be more certain that costs will lead to future benefits.

The service life of the asset ("useful life")

Amount of use the company expects (expressed in time or activity)

Costs incurred after technological feasibility but before the software is available for sale to customers (e.g., coding costs, testing costs) are:

Capitalized as an intangible asset ("software development")

The allocation base (i.e., depreciable base)

Cost - Salvage Value = Amount to be depreciated

Purchased patent:

Costs include purchase price, filing fees to secure it, and legal fees to defend the patent.

A company may not reduce Goodwill below zero. Therefore, the maximum amount of loss that can be recorded (based on the calculation above) is capped at:

The book value of Goodwill

When should a company test for impairment?

When conditions exist that suggest there is a significant decline in future benefits.

Asset held for sale

When management plans to sell PP&E or an Intangible Asset, but the sale hasn't yet happened

R & D costs pertain to

activities prior to the start of "commercial production".

If an asset (e.g., equipment) is purchased specifically for a single R&D project (with no alternative future use), its cost is

considered R&D and expensed immediately.

Unit of Production DEPRECIATION EXPENSE =

Depreciation rate per unit * Activity this year

R&D costs are expensed as incurred. What is the FASB's logic for this decision?

Difficult to associate R&D costs with specific future benefits. Expense all costs to avoid overstating assets.

Regardless of the method used, the entry for depreciation expense is...

Dr. Depreciation Expense Cr. Accumulated Depreciation

J/E if expensing

Dr. Repair and Maintenance Expense Cr. Cash

Examples of the types of costs that should be CAPITALIZED, include those that:

Extend the asset's useful life Increase production/operating efficiency Increase quality of goods

impairment loss equation

FMV-carrying value (net book value)

FV of Net Assets =

FV of identifiable assets - FV of liabilities

· Capitalize costs that are expected to provide:

Increased future benefits (i.e., make the asset BETTER than it originally was)

Under U.S. GAAP, is this loss "recoverable" (i.e., reversible) in the future if the FMV of the asset goes back up?

No. Impairment is permanent under U.S. GAAP.

Expense in the current period if expenditures:

Simply maintain a given level of benefits, but don't make the asset better than it originally was.

DDB DEPRECIATION EXPENSE =

(Cost - A/D) * (Rate of Depreciation/Useful Life) Rate of Depreciation: e.g., 2 if double-declining

SOYD DEPRECIATION EXPENSE =

(Cost - Salvage Value) * Depreciable Fraction

Depreciation Rate per Unit =

(Cost - Salvage Value) / Total expected activity in the asset's life

straight line depreciation

(cost - salvage value) / useful life

Additions

- Adding a new major component to an existing asset (e.g., adding a new wing to a building; adding a refrigeration unit to a delivery truck).

Improvements

- Replacing a major component of an existing asset (e.g., replacing an old air conditioning system in a building with an updated model).

Goodwill

- a unique intangible asset. Its cost cannot be directly associated with any specifically identifiable right, and it is not separable from the company itself. It represents the value of a company over and above its identifiable tangible and intangible assets. Goodwill can emerge because of a company's reputation, its trained employees and management team, or any other unique features of the company.

Patent

- an exclusive right to manufacture a product or use a process. 20-year life - Limited life, so amortize.

Group Depreciation Method

- depreciable assets with similar lives and other attributes are grouped together for depreciation purposes. -don't recognize gain or loss when you sell an asset

Copyright

- exclusive right of protection given to a creator of a published work (e.g., book, film, song). Accounting for copyrights is virtually the same as patents. -Life of the creator + 70 years. -Companies usually use a shorter life to be conservative. -Limited life, so amortize.

net book value when using the double declining method changes every year because

we depreciate the asset every year

Because salvage value is not included in our calculation, in the final year of the asset's life, depreciation expense =

whatever amount is needed to be left with salvage value.

The initial valuation of intangible assets depend on

whether the assets are purchased or developed internally.

Developed patent:

· Costs to develop (the product/process) are expensed. -Research & Development Expense · Legal and filing fees to secure the patent are capitalized. · Legal fees & other costs of successful defending a patent are added to the patent.

START-UP AND ORGANIZATIONAL COSTS:

· Expense as incurred - not capitalized · Book / Tax Difference - For tax purposes, start-up costs & organization costs are capitalized and amortized.

Typical R&D costs include:

· salaries, wages, and other labor costs of personnel engaged in R&D activities -Including if the company hires someone outside the company to perform R&D · costs of materials consumed · a reasonable allocation of indirect costs related to R&D activities

Sum-of-the-Years-Digits (SOYD) - Calculate depreciation based on a

decreasing fraction of depreciable cost.

When an asset is classified as held for sale, it is no longer

depreciated or amortized. Instead, it is valued at the lower of cost or its FMV.

Like GAAP, IFRS requires research costs to be expensed in the period incurred. However, under IFRS, _______________ costs may be capitalized.

development -both expensed under GAAP. for IFRS only researches expensed.

salvage value

expected selling price of an asset at the end of its useful life

Because Property, Plant and Equipment are long-lived assets by nature, they often require

expenditures to repair, maintain, or improve them.

can only get goodwill when you

-buy an entire entity -can't create your own goodwill

1. ). Because the improvement is expected to provide increased future benefits, costs are capitalized by

-increasing the asset's book value. Dr. Asset Account or Accumulated Depreciation (A/D) Cr. Cash

Intangibles that typically are not amortized are those with ___________ lives and include:

-indefinite · Trademarks and tradenames · Goodwill

A change in depreciation method is accounted for

-prospectively. Change is made in the current period and going forward (no correction to prior periods).

Logic of accelerated methods

A company would use an accelerated method to record higher depreciation costs in earlier years, because the asset provides greater benefits in its early years. Thus, accelerated depreciation may provide a better matching of revenues and expenses.

Units-of-production (activity method): Logic:

A company would use units-of-production because they believe their machine will provide benefits (and use up its value) based on an activity...how many THINGS it produces or how many HOURS it runs.

Remaining Useful Life =

Total NEW Life - Period Already Depreciated

Goodwill Impairment Test

For Goodwill, impairment is indicated if: FMV of the reporting unit < book value of the reporting unit Impairment Loss = FMV of reporting unit - book value of reporting unit

If an impairment loss is determined, what is the journal entry to record it?

For PP&E: Dr. Loss on Impairment Cr. Accumulated Depreciation For Limited Life Intangibles : Dr. Loss on Impairment Cr. Intangible Asset (e.g., Copyright)

Why isn't there a recoverability test? (for previous slide)

Future cash flows are expected to continue indefinitely. Can't sum infinite cash flows.

Amortization of software development costs

Greater of: 1. % of revenue: Current Rev/Anticipated Rev = % * Software Develop Costs 2. SL Method

is the brand value the same a the financial statement book value?

NO. Book value only reflects direct costs of the trademark, while the brand value reflects expected future benefits.

The cost of an asset that has an alternative future use beyond the current R&D project is

NOT a current R&D expense. Instead, the asset is capitalized, and the related depreciation is included as R&D expense while it is used for R&D activities.

Pros and Cons of Straight line method

PRO: Simple and captures the decline in usefulness over time. CON: It assumes that economic usefulness of the asset and the wear and tear is the same every year (often not the case).

Goodwill =

Purchase price of the business - FV of net identifiable assets FV = Fair Value

2 stage impairment test

Step 1: Recoverability Test (to answer the question, "is the asset impaired?". -Test only applies to PPE & limited life intangibles Step 2: Measurement (compute the Impairment Loss)

Depreciation Methods

Straight-line depreciation; Accelerated depreciation (Sum of the years digits, declining method); Units-of-Production method

R&D costs associated with software development (whether sold or used internally) must be expensed, until the software reaches:

Technological feasibility, which is established when the company has completed all planning, designing, coding, and testing activities necessary to establish that the product can be produced to meet its design specifications.

What is Depletion?

The allocation of the cost of natural resources.

An impairment occurs when

The fair value falls materially below the book value -the carrying value (i.e., book value) of a fixed asset or an intangible asset is not recoverable...i.e., there has been a significant decline in the value of the asset. Impairment is a separate concept from depreciation/amortization.

What is commercial production?

The point where the company has no plans to materially change the product. This is the point that the product will be produced for sale to customers (inventory).

What method is used to calculate depletion?

The units-of-production (activity) method. Depletion per unit= Depletion Base (AKA depreciation base) ------------------------------------------------ Estimated extractable units

Declining Balance:

This method also uses a "depreciable fraction," where the rate of depreciation is calculated as a multiple of the straight-line rate. -"Double-declining" (DDB) is 2 times the straight-line rate

Intangible assets include

long lived, revenue producing assets that lack physical substance (e.g., patents, copyrights, goodwill, etc.)

The company continues to depreciate the asset until its

salvage value (if it has one) is reached.

The expense recognition principle argues that

the cost of these assets should be matched to these future benefits that are realized over time.

DEPRECIATION refers to the methods by which

the costs of the assets are allocated over time.

The costs of the addition are added to

the original asset and depreciated over the original asset's remaining useful life. Dr. Asset Account Cr. Cash