Chapter 11: Property, Plant, and Equipment and Intangible Assets: Utilization and Disposition Intermediate Accounting 1

A change in estimate should be reflected in the financial statements of the

current period and future periods therefore previous statements will not be changed. Most changes in estimate do not require a company to justify the change.

Straight-line depreciation produces a higher net income than

accelerated methods in the early years of an asset's life.

For amortization of an intangible asset, we refer to the allocation base as the

amortization base.

The retirement depreciation method records depreciation when assets are disposed of

and measures depreciation as the difference between the proceeds received and cost. The retirement system issues a FIFO cost flow approach in determining the cost of assets.

Intangible assets with indefinite useful lives should be tested for impairment annually

and more frequently if events or changes in circumstances indicate that it is more likely than not that the asset is impaired.

Declining-balance depreciation methods multiply beginning-of-year book value, not depreciable base, by an

annual rate that is a multiple of the straight-line rate.

The composite depreciation method is used when assets are physically dissimilar but

are aggregated anyway to gain the convenience of a collective depreciation calculation. For instance, composite depreciation can be used for all of the depreciable assets in one manufacturing plant, even though individual assets in the composite may have widely diverse service lives.

Depreciation, depletion, and amortization are processes that allocate an

asset's cost to periods of benefit.

Assets should not be grouped for determining impairment unless those

assets are dependent on one another.

By the replacement method, depreciation is recorded when

assets are replaced

The goodwill impairment loss can't extend the

book value of goodwill.

An asset or group of assets classified as held for sale is measured at the lower of its

book value, or fair value minus cost to sell.

Additions involve adding a new major component to an existing asset and should be

capitalized because future benefits are increased. For example, adding a refrigeration unit to a delivery truck increases the capacity of the truck, thus increasing its future benefits.

The costs incurred to successfully defend an intangible right should be

capitalized.

Property, plant, and equipment or an intangible asset to be disposed of by sale is

classified as held for sale and measured at the lower of the asset's book value or the asset's fair value less cost to sell.

GAAP allows a company to change from one depreciation method to another if the

company can justify the change.

Errors involving property, plant, and equipment, and intangible assets include

computational errors in the calculation of depreciation, depletion, or amortization and mistakes made in determining whether expenditures should be capitalized or expensed. These errors can affect many years.

A gain or loss is recognized for the difference between the

consideration received and the asset's book value.

Depreciation is a process of

cost allocation, not valuation.

Book value is the asset's

cost minus accumulated depreciation. Book value is sometimes called the carrying value or carrying amount.

Accumulated depreciation (a contra-asset account) represents the

cumulative amount of the asset's cost that has been depreciated in all prior years including the current year.

For depletion of natural resources, we refer to the allocation base as the

depletion base

Depletion per ton =

depletion base / estimated extractable tons

The sum-of-the-years'-digits (SYD) method multiples the

depreciable base by a declining fraction.

The process of allocating the cost of plant and equipment over the periods they are used to produce revenues is known as

depreciation

Retirement and replacement methods are acceptable only in situations when the

distortion in depreciation expense does not have a material effect on income because these methods are likely to produce aggregate expense measurements that differ from individual calculations.

The most common declining-balance method is known as the

double-declining-balance (DDB) method. Under this method, we multiply the asset's beginning-of-year book value by double (or 200%) the straight-line rate.

Accumulated depreciation methods report higher depreciation in

earlier years.

The straight-line method depreciates an

equal amount of the depreciable base to each year of the asset's service life. The depreciable base is simply divided by the number of years in the asset's life to determine annual depreciation.

Allocation base is the difference between the cost of the asset and its

estimated residual value.

Property, plant, and equipment, and finite-life intangible assets are tested for impairment only when

events or changes in circumstances indicate book value may not be recoverable. This might happen from the following: A significant decrease in market price A significant adverse change in how the asset is being used or in its physical condition. A significant adverse change in legal factors or in the business climate. An accumulation of costs significantly higher than the amount originally expected for the acquisition or construction of an asset. A current-period loss combined with a history of losses or a projection of continuing losses associated with the asset. A realization that the asset will be disposed of significantly before the end of its estimated useful life.

Many companies do not capitalize any expenditure unless it

exceeds a predetermined amount that is considered material.

Goodwill is an intangible asset whose cost is not

expensed through periodic amortization.

Expenditures for repairs and maintenance generally are

expensed when incurred.

The costs incurred to unsuccessfully defend an intangible right should be

expensed.

The present value of future cash flows often is used as a measure of

fair value

A company does not have to use the same depreciation method for both

financial and income tax purposes.

For assets held for sale, if fair value minus cost to sell is less than book value, an

impairment loss is recognized for the difference.

Activity-based methods are conceptually superior to time-based methods but often are

impractical to apply in practice.

Sometimes, the analysis is easier if you re-create the entries actually recorded

incorrectly and those that would have been recorded if the error hadn't occurred, and then compare them.

The costs of material rearrangements should be capitalized if they clearly

increase future benefits.

A period cost is reported as an expense in the reporting period in which it is

incurred

Goodwill is the most common intangible asset with an

indefinite useful life. Recall that goodwill is measured as the difference between the purchase price of a company and the fair value of all of the identifiable net assets required (tangible and intangible assets minus the fair value of liabilities assumed).

Trademarks or tradenames often are considered to have

indefinite useful lives.

The allocation of intangible asset cost is called amortization. We allocate the cost of an

intangible asset over its service or useful life.

For intangibles used in the manufacture of a product, amortization is a product cost and

is included in the cost of inventory (and doesn't become an expense until the inventory is sold).

A product cost is reported as an expense (cost of goods sold) when the related product

is sold

Most intangible assets have a finite useful life. This means their estimated useful life is

limited in nature. We allocate the capitalized cost less any estimated residual value of an intangible asset to the periods in which the asset is expected to contribute to the company's revenue-generating activities.

The most logical way to allocate an asset's cost to periods of an asset's use is to

measure the usefulness of the asset in terms of productivity.

The units-of-production method computes a depreciation rate per measure of activity and then

multiplies this rate by actual activity to determine periodic depreciation.

An analyst must decide whether to consider asset impairment losses as temporary in

nature or as a part of permanent earnings.

At the time of retirement, the asset account and the corresponding accumulated depreciation account are removed from the books and a loss equal to the remaining book value of the asset is recorded because there will be

no monetary consideration received. When there is a formal plan to retire an asset, but before the actual retirement, there may be some revision in depreciation due to a change in the estimated service life or residual value.

The cost of an intangible asset with an indefinite useful life is

not amortized.

Intangible assets with finite useful lives will be amortized, and those with indefinite useful lives will

not be amortized.

Depreciation expense is the portion of the asset's cost that is allocated to an expense in

the current year.

The units-of-production method often is used to determine depreciation and amortization on assets used in

the extraction of natural resources.

Many companies have a formal policy to use accelerated depreciation for approximately

the first half of an asset's service life and then switch to the straight-line method for the remaining life of the asset.

Estimating residual value for many assets can be very difficult due to uncertainty about

the future. For this reason, along with the fact that residual values often are immaterial, many companies simply assume a residual value of zero. Companies usually do not disclose estimated residual values.

For natural resources, we refer to cost allocation as depletion, and for intangible assets, we refer to it as amortization. While the terms depreciation, depletion, and amortization differ across types of assets, they conceptually refer to the same idea-

the process of allocating an asset's cost over the periods it is used to produce revenues.

The depreciation rate is applied to the

total cost of the group or composite for the period.

Depletion of the cost of natural resources usually is determined using the

unit-of-production method. Service life is the estimated amount of natural resources to be extracted (for example, tons of minerals or barrels of oil).

The service life, or useful life, can be expressed in

units of time or in units of activity.

Changes in depreciation, amortization, or depletion methods are accounted for the same

way as a change in accounting estimate.

By writing off large amounts of assets, companies significantly reduce earnings in the

year of the write-off but are able to increase future earnings by lowering future depreciation, depletion, or amortization.

If a company underestimates future net cash flows, fair value is understated. This has two effects:

(1) the current year's income is unrealistically low due to the impairment loss being overstated and (2) future income is unrealistically high because depreciation, depletion, and amortization are based on understated assets values.

Determining whether an impairment loss has occurred and for how much to record the loss is a two-step process:

1. Recoverability test: An impairment occurs when the undiscounted sum of estimated future cash flows from an asset is less than the asset's book value. 2. Measurement: If the recoverability test from step 1 indicates an impairment has occurred, an impairment loss is recorded for the amount by which the asset's fair value is less than its book value.

Intangible assets with an indefinite useful life are those with no foreseeable limit on the period of time over which the asset is expected to contribute to the cash flows of the entity.

In other words, there are no legal, contractual, or economic factors that are expected to limit their useful life to a company.

Allocation base

The cost of the asset expected to be consumed during its service life.

Service life

The estimated use that the company expects to receive from the asset. Also called useful life.

In practice, there are two general approaches that attempt to obtain this systematic and rational allocation.

The first approach allocates the cost base according to the passage of time. Methods following this approach are referred to as time-based methods. The second approach allocates an asset's cost base using a measure of the asset's input or output. This is an activity-based method.

Allocation method

The pattern in which the allocation base is expected to be consumed.

After using property, plant, and equipment, companies will sell or retire those assets.

When selling property, plant, and equipment for monetary consideration (cash or a receivable), the seller recognizes a gain or loss for the difference between the consideration received and the book value of the asset sold.

Goodwill:

When the test for impairment: At least annually, and more frequently if indicated. Option to first choose qualitative assessment to determine if quantitative measurement is then necessary. Impairment test: If fair value of the reporting unit is less than its book value, a goodwill impairment loss is recognized for the difference. The impairment loss recognized can't exceed the book value of goodwill.

Indefinite-life intangible assets (other than goodwill):

When to test for impairment: At least annually, and more frequently if indicated. Option to first choose qualitative assessment to determine if quantitative measurement is then necessary. Impairment test: if fair value is less than book value, an impairment loss is recognized for the difference.

Held for sale:

When to test for impairment: At the time of classification as held for sale and thereafter. Impairment test: If fair value minus cost to sell is less than book value, an impairment loss is recognized for the difference.

Property, plant, and equipment and finite-life intangible assets:

When to test for impairment: When events or circumstances indicate book value may not be recoverable. Impairment test: Step 1- An impairment loss is required only when book value is not recoverable (undiscounted sum of estimated future cash flows less than book value). Step 2- The impairment loss is the amount by which fair value is less than book value.

For intangible assets not used in production, such as the franchise cost,

periodic amortization is expensed in the period incurred.

Expected obsolescence can shorten service life below

physical life.

If retained earnings are one of the incorrect accounts, the correction is reported as a

prior period adjustment to the beginning balance in the statement of shareholders' equity.

For assets used in the manufacture of a product, depreciation, depletion, or amortization is considered a

product cost to be included as part of the cost of inventory. Eventually, when the product is sold, it becomes part of the cost of goods sold. For assets not used in production, primarily plant and equipment and certain intangibles used in the selling and administrative functions of the company, depreciation, and amortization is reported as period expenses in the income statement.

Like depletion, amortization expense traditionally is credited to the asset account itself

rather than to accumulated amortization. However, the use of a contra asset account is acceptable. Many companies choose to report intangible assets for their net amount on the face of the balance sheet and then report the amount of amortization in a disclosure note.

Expenditures made to restructure an asset without addition, replacement, or improvement are termed

rearrangements. The objective is to create a new capability for the asset and not necessarily to extend its useful life. Examples include the rearrangement of machinery on the production line to increase operational efficiency and the relocation of a company's operating plant or office building.

If fair value is less than book value, an impairment loss is r

recognized for the difference

Group and composite depreciation methods aggregate assets to

reduce the recordkeeping costs of determining periodic depreciation.

In certain situations, residual value can be estimated by

referring to a company's prior experience or to publicly available information concerning resale values of various types of assets.

Expenditures classified as improvements involve the

replacement of a major component of an asset. The replacement can be a new component with the same characteristics as the old component or a new component with enhanced operating capabilities. The costs of improvements usually are capitalized. The cost of improvement usually increases future benefits and should be capitalized by increasing the book value of the related asset and depreciated over the useful life of the improved asset.

No gain or loss is recorded when a group or composite asset is

retired or sold.

All methods provide the

same total depreciation over an asset's life.

The process of cost allocation requires that 3 factors be established at the time the asset is put into use. These factors are

service life, allocation base, and allocation method.

An asset held for use should be written down if there has been a

significant impairment of value.

An implicit assumption in allocating the cost of an asset over its useful life is that there has been no

significant reduction in the anticipated total benefits or service potential of the asset. Situations can arise, however, that cause a significant decline or impairment of those benefits or service potential.

The group depreciation method defines the collection as depreciable assets that share

similar service lives and other attributes. For example, group depreciation could be used for fleets of vehicles or collections of machinery. Both approaches are similar in that they involve applying a single straight-line rate based on the average service lives of the assets in the group or composite.

Activity-based depreciation methods estimate service life in terms of

some measure of productivity.

The allocation method used should be

systematic and rational and correspond to the pattern of asset use.

Physical life provides the upper bound for service life of

tangible, long-lived assets.

A goodwill impairment loss is indicated when the fair value of the reporting unit is less

than its book value.