Chapter 11 - Intermediate Accounting
Change in depreciation, Amortization, or Depletion Method
Change in accounting estimate that is achieved by a change in accounting principle Accounted for in the same way as any other change in accounting estimates Requires a clear justification as to why the new method is preferable, because this change in estimate is a result of a change in accounting principle
Group and composite depreciation methods Composite depreciation method
Collection of depreciable assets that are physically dissimilar but are aggregated anyway to gain the convenience of a collective depreciation calculation
Depreciation Methods Activity-based depreciation methods Units-of-production Method
Computes a depreciation rate per measure of activity and then multiplies this rate by actual activity to determine periodic depreciation
Group and Composite Depreciation Methods A delivery truck that costs $15,000 is sold for $3,000 in the year 2024. What is the journal entry?
Any actual gain or loss is included in the accumulated depreciation account Cash 3,000 Accumulated Depreciation 12,000 Vehicles 15,000
Retirement Depreciation Method
Asset account is increased for the cost of subsequent expenditure. When an item is disposed of, the asset account is credited for its cost Depreciation expense is recorded for the difference between the cost and the proceeds received.
Three methods to record the cost of improvements Reduction of accumulated depreciation
Asset account is left unaltered but its related accumulated depreciation is decreased. Book value is same as in capitalization of cost method but the cost and the accumulated depreciation amounts both differ under two methods
Why can estimating residual value for many assets be difficult?
Due to the uncertainty about the future
Intangible assets subject to amortization: residual value
Expected residual value of an intangible asset usually is zero. The residual value is not zero if at the end of the asset's useful life to the reporting entity the asset will benefit another entity
Expenditures that maintain a given level of benefits are ____ in the period they are incurred.
Expensed
Decision Makers' perspective - Selecting a Depreciation Method Accelerated methods
Results in more depreciation in the earlier years of an assets life. Taxation benefits derived through greater depreciation deduction. Unlike the LIFO conformity rule for inventory valuation, no constraints in using different depreciation methods for financial reporting and tax reporting
Comparison with MACRS (Tax Depreciation) Depreciation for Income tax purposes:
Influenced by the revenue needs of government as well as the desire to influence economic behavior
Repairs and Maintenance
Made to maintain a given level of benefits provided by the asset Do not increase future benefits Future benefits are not provided beyond those originally anticipated Expenditures for these activities should be expensed in the period incurred
Improvements Example: An existing refrigeration unit in a delivery truck could be replaced with a new but similar unit or with a new and improved refrigeration unit.
Methods used to record the cost of improvements: substitution, capitalization of new cost and reduction of accumulated depreciation.
What are examples of rearrangements?
The rearrangement of machinery on the production line to increase operational efficiency. The relocation of a company's operating plant or office building
Assets to be sold
There are assets that management has actively committed to immediately sell in their present condition and for which sale is probable. If book value exceeds fair value less cost to sell, an impairment loss is recognized for the difference. These assets are not depreciated or amortized. They are reported separately in the balance sheet
If retained earnings requires correction, the correction is reported as
a prior period adjustment
Expenditures that produce benefits beyond the current fiscal year are ________
capitalized (increase in net assets)
Property, plant, and equipment and intangible assets with finite useful lives are subject to
depreciation, depletion, or amortization
Previous years' financial statements are ________ restated
retrospectively
Residual values sometimes are immaterial and are assumed to be _____
zero
Change in estimates
Accounted for prospectively Reflected in the financial statements of the current and future periods. A disclosure note should describe the effect of a change in estimate for the current period on net income and related per share amounts
Additions
Adding a new major component to an existing asset should be CAPITALIZED because future benefits increased. Ex: adding a refrigeration unit to a delivery truck increases the capability of the truck, thus increasing its future benefits For a building addition, this might include the costs of tearing down and removing a wall of the existing building
Capitalizing vs. expensing
Capitalizing - increasing the assets book value and creating a new asset Expensing - maintaining given level of benefits
Depreciation Methods Accelerated methods
Declining pattern of depreciation, with higher depreciation in the earlier years of the asset's life and lower depreciation in later years.
Cost allocation is known as
Depreciation (for plant and equipment) Depletion (natural resources) Amortization (for intangible assets)
Replacement depreciation method Acquisition of 20 new calculators at $45 each is recorded as depreciation Disposal of 30 calculators by selling them secondhand to a bookkeeping firm for $5 each.
Depreciation expense 900 Cash 900 Cash 150 Depreciation expense 150
Improvements Replacements
New component with the same characteristics as the old component. New component with enhanced operating capabilities (It should be capitalized by increasing the book value of the related asset and depreciated over the useful life of the improved asset.
Measuring Cost allocation Service life
the estimated use that the company expects to receive from the asset
Impairment of Value
Implicit assumption in allocating the cost of an asset over its useful life: There has been no significant reduction in the anticipated total benefits or service potential of the asset
Retirements
Instead of selling a used asset, a company may retire (or abandon) the asset
Depreciation Method Time based depreciation methods Straight-line (SL) method
Allocates an equal amount of depreciable base to each year of the asset's service life. Cost minus salvage/estimated useful life(years) = annual depreciation expense;
Allocation Method Time-based method
Allocates the depreciable base according to the passage of time
Allocation method Activity-based method
Allocates the depreciable base using a measure of the asset's input or output
Service Life
Amount of use that the company expects to obtain from an asset before its disposal Expressed in units of time or in units of activity Ex: The estimated service life of a delivery truck could be expressed in terms of years or in terms of the number of miles that the company expects the truck to be driven before disposition.
Comparison with MACRS (Tax Depreciaton) Depreciation for financial reporting purposes:
An attempt to distribute the cost of the asset, less any anticipated residual value. Distributed over the estimated useful life in a systematic and rational manner that attempts to match revenues with the use of the asset.
Intangible assets not subject to amortization
An intangible asset that is determined to have an indefinite useful life is not subject to periodic amortization. Indefinite does not always mean permanent
Goodwill Level of testing is the reporting unit:
An operating segment of a company or a component of an operating segment for which discrete financial information is available and segment management regularly reviews the operating results of that component.
what situations can arise that cause a significant decline or impairment of those benefits or service potentials?
Building destroyed by fire before the asset is fully depreciated Remaining book value of the asset is written off as a loss Recognizing and measuring an impairment loss depends on whether the assets are: to be held and used, or are being held for sale
Errors involving property, plant, and equipment and intangible assets include
Computational errors in the calculation of depreciation, depletion, or amortization. Mistakes made in determining whether expenditures should be capitalized or expensed.
A disclosure note is needed the describe the impairment loss. The note should include:
Description of the impaired asset or asset group The facts and circumstances leading to the impairment The amount of the loss if not separately disclosed on the face of the income statement The method used to determine fair value
Dispositions
Gain or loss recognized for the difference between the consideration received and the asset's book value Selling price(consideration received) (credited) Less: book value of asset sold Original cost(debited) Accumulated depreciation(debit and credit) Gain/loss on sale of asset(credit)
Intangible assets with indefinite useful lives are subject to
impairment
Depreciation Methods Accelerated Methods Sum-of-the-years' digits (SYD)
multiplies depreciable base by a declining fraction
Intangible assets with indefinite useful lives are
not subject to amortization
Impairments and Cash Flow Estimates Discounted estimates of cash flows
often are used to estimate fair value to determine the amount of the loss.
Replacement Depreciation Method
Initial acquisition of assets is recorded the same way as by the retirement method Depreciation expense is the amount paid for new or replacement assets Any proceeds received from asset dispositions reduce depreciation expense
Improvements
Involves the replacement of a major component of an asset
Goodwill
It is a unique intangible asset. Unlike other assets, its cost can't be directly associated with any specific identifiable right and is not separable from the company as a whole.
Materiality Thresholds for Capitalization
Many companies set materiality thresholds for the capitalization of any expenditure Ex: A company might decide to expense all expenditures under $1,000 regardless of whether or not future benefits are increased. Subsequent expenditures: repairs and maintenance, additions, improvements, and rearrangements
Expenditures Subsequent to Acquisition
Many long-lived assets require expenditures to repair, maintain, or improve them after their acquisition.
Depreciation Methods Accelerated Methods Declining balance methods
Multiplies beginning-of-year book value by an annaul rate that is a multiple of the Straight-line rate
Cost Allocation - Overview
Property, plant, and equipment and intangible assets are purchased with the expectation that they will provide future benefits, usually for several years. These assets are acquired to be used as part of revenue-generating operations The acquisition cost of these assets should be allocated to periods benefited by their use
Depletion of Natural Resources
Allocation of costs of natural resources Depletion base = cost - residual value depletion per unit = depletion base/estimated extractable units Journal entry: Depletion (depletion rate x units extracted) xxx Natural resources xxx
Software Development Costs
Amortization of capitalized software development costs begins when the product is available for general release to customers. The periodic amortization percentage is the greater of either percentage-of-revenue method or straight-line method
Retirement Depreciation Method Example - Journal entry Purchase of 100 handheld calculators at $50 acquisition cost each
Calculators 5,000 Cash 5,000
Retirement Depreciation Method Example - Journal entry Acquisition of 20 new calculators at $45 each.
Calculators 900 Cash 900 20 x 45 = 900
Retirement Depreciation Method Example - Journal entry (purchase of 100 handheld calculators at $50 acquisition cost each) Disposal of 30 calculators by selling them secondhand to a bookkeeping firm for $5 each.
Cash 150 depreciation expense (difference) 1,350 calculators 1,500 30 x 5 = 150 30 x 50 = 1500
Change in accounting Estimate journal entry
Depreciation expense xxx Accumulated depreciation xxx
Three Methods to record the cost of improvements Substitution
Disposition of the old component Acquisition of the new component
Key differences between the calculation of depreciation for financial reporting and the calculation of using MACRS are:
Estimated useful lives and residual values are not used in MACRS Firms can't choose among various accelerated methods under MACRS A half-year convention is used in determining the MACRS depreciation amounts
Rearrangements
Expenditures made to restructure an asset without addition, replacement, or improvement Objective: Create a new capability for the asset and not necessarily extend its useful life
Indefinite-life intangible assets examples
Goodwill, trademarks, and tradenames
Group and Composite Depreciation Methods
Group and composite depreciation methods depreciate assets collectively rather than individuals to reduce recordkeeping costs.
Measurement
If an impairment loss is recognized, the written-down book value becomes the new cost base for future cost allocation
If rearrangement expenditures are material
If they clearly increase future benefits, they should be capitalized and then expensed in the future periods benefits
At the time of retirement
The asset account and the corresponding accumulated depreciation account are removed from the books. A loss equal to the remaining book value of the asset is recorded.
Decision Makers' perspective: Understanding gains and losses
A gain on the sale of a depreciable asset means the asset was sold for more than its book value. The net increase in the book value of total assets is an accounting gain (not an economic gain) A loss signifies that the cash received is less than the book value of the asset being sold. There is a net decrease in the book value of total assets
Differences between IFRS and U.S. GAAP : impairment of value
U.S. GAAP - The impairment loss is measured as the difference between book value and fair value Reversals are prohibited If certain criteria are met, indefinite-life intangible assets should be combined for the required annual impairment test. IFRS- The impairment loss is the difference between book value and the recoverable amount Requires the reversal of an impairment loss if the circumstances that caused the impairment are resolved. Indefinite-life intangible assets may not be combined with other indefinite-life intangible assets for the required annual impairment test
Impairments and Cash Flow Estimates Undiscounted Estimates of cash flows
Used to determine whether an impairment loss has occurred.
Expenditures can increase future benefits Future Benefits:
1. An extension of the useful life of the asset 2. An increase in the operating efficiency of the asset resulting in: increase in the quantity of goods or services produced, and decrease in future operating costs 3. An increase in the quality of the goods or services produced by the asset
Impairment Loss: Two-step process
1. Recoverability test Is the asset impaired? (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 impaired [step 1] record an impairment loss for the amount by which the asset's fair value is less than its book value. If not impaired, no impairment loss is recorded.
Decision Makers' perspective - Selecting a Depreciation Method Straight line method
Straight line method is easy. It results in less depreciation in the earlier years of an assets life compared to accelerated methods Positive effect on net income in earlier years Negative effect on net income in later years
Indefinite-Life Intangible Assets other than goodwill
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. If fair value is less than book value, an impairment loss is recognized for the difference There is no recoverability test If an impairment loss is recognized, the written-down book value becomes the new cost base for future cost allocation
Measurement Fair value
The amount at which the asset could be bought or sold in a current transaction between willing parties. If fair value is not determinable, it must be estimated. Fair value is often estimated as the discounted present value of future cash flows
Allocation Base
The amount of cost to be allocated over an asset's service life Initial value of the asset at its acquisition - residual (salvage) value = the amount expected to be received for the asset at the end of its service life less any anticipated disposal costs
Measuring cost allocation Allocation base
The cost of the asset expected to be consumed during its service life
Three Methods to Record the cost of improvements Capitalization of new cost
The cost of the improvement is included as a debit to the related asset account. The original cost and accumulated depreciation of the original component are not removed. Acceptable only if the book value of the original component has been reduced to an immaterial amount through prior depreciation.
If an intangible right is successfully defended
The litigation costs should be capitalized and amortized over the remaining useful life of the related intangible.
If an intangible right is unsuccessfully defended
The litigation costs should be expensed immediately as incurred because they provide no future benefit The book value of any intangible asset should be reduced to realizable value.
Intangible assets subject to amortization: allocation method
The method of amortization should reflect the pattern of use of the asset in generating benefits
Measuring cost allocation Allocation method
The pattern in which the allocation base is expected to be consumed
Measuring Cost Allocation
The process of cost allocation requires that three factors be established at the time the asset is put to use. These factors are service life, allocation base, and allocation method
Decision Makers' perspective - Selecting a Depreciation Method Activity-based depreciation
Typically provides a better match of revenues and expenses.
IFRS and U.S GAAP Valuation of Property, Plant, and Equipment
U.S. GAAP A company reports property, plant, and equipment (PP&E) in the balance sheet at cost less accumulated depreciation (book value). U.S. GAAP prohibits revaluation IFRS It allows a company to report property, plant, and equipment at book value or alternatively at its fair value (revaluation) If a company chooses revaluation, all assets within a class of PP&E must be revaluated on a regular basis.
Indefinite-Life Intangible Assets other than goodwill U.S. GAAP vs. IFRS
U.S. GAAP - A company can choose first to provide only a qualitative assessment of the likelihood of impairment to determine if quantitative measurement is then necessary. IFRS - Requires indefinite-life intangible assets other than goodwill to be tested for impairment at least annually.
IFRS and U.S. GAAP: Depreciation
U.S. GAAP - Component depreciation is allowed but is not often used in practice Depreciable base is determined by subtracting estimated residual value from cost Various depreciation methods are used in practice IFRS - Each component of an item of property, plant, and equipment must be depreciated seperately if its cost is significant in relation to the total cost of the item Depreciable base is determined by subtracting estimated residual value from cost. A review of residual values at least annually is required. Specifically mentions three depreciation methods: straight-line, units-of-production, and the diminishing balance method
Intangible assets subject to amortization: Useful life
Useful life: legal, regulatory, or contractual provisions often limit the useful life of an intangible asset. Useful life might sometimes be less than the asset's legal or contractual life
Group and Composite Depreciation Methods Group depreciation method
collection of depreciable assets that share similar service lives and other attributes
If rearrangement expenditures are not material or if it's uncertain that future benefits have increased
they should be expensed in the period incurred.
