Chp.11

IFRS Component Depreciation

IFRS requires that firms separately depreciate each part or component of a fixed asset that is significant in relation to the asset's total cost. For example, the purchase of a building would involve a number of different components, such as the foundation and frame, heating and air conditioning systems, and other non-weight bearing parts. After the firm identifies the components, the methodology to depreciate is identical to our prior discussion. Although US GAAP allows the components-based approach, it does not require it. Consequently, most firms the report under US GAAP do not separate their depreciable assets into components.

Basket Purchase: Heterogenous Assets

In basket purchases involving heterogenous assets, the firm must properly allocate the total costs to the individual accounts to be reported on the balance sheet (e.g. manufacturing equipment, building, land, and inventory) Ex. A firm pays one price for a piece of land that has four buildings on it. At what amounts does the firm initially record the land and each of the four buildings? The relative fair value method allocates the total purchase cost to the individual assets acquired in a single transaction by assigning the total cost incurred based on the percentage that each asset's fair value bears to the total fair value of the assets purchased.

Partial-year Depreciation

In reality, firms purchase PPE throughout the year. Thus, they must use a partial-year depreciation. In practice, firms employ a large variety of methods to compute partial-year depreciation that assume the firm purchased the asset at certain fixed points during the year. Half-Year Convention - the firm records a half year of depreciation for an asset acquired during the year of purchase (the assumption is that the firm acquired the asset at the midpoint of the year). The company also records a half-year's depreciation in the final year of the asset's life. Ex. For an asset purchase on May 1 with a 5-year useful life, the firm take a half year of depreciation in year 1 and year 6 Other approaches assume that the firm acquired the asset at the beginning or the middle of the month it was placed in service. Partial year depreciation using the straight-line method is shown in Ex 11.15

Straight-Line Method (SL)

In recent years, US firms depreciated over 90% of tangible fixed assets using the straight-line method. The SL Method applies a constant rate of depreciation against a constant depreciable cost. The firm determines the rate of depreciation by taking one over the useful life of the asset. Depreciable base (also referred to as depreciable cost) is equal to acquisition cost less estimated scrap value. Depreciation expense is the depreciable base divided by the useful life or the depreciable base multiplied by the straight-line rate. Depreciable Base = Acquisition Cost - Scrap Value Straight-Line Depreciation Expense = Depreciable Base / Useful Life or Straight-line Rate = 1/Useful Life Straight-line Depreciation Expense = Depreciable Base * Straight-Line Rate

2 main differences between US GAAP and IFRS related to the capitalization of interest for specific borrowings

1. IFRS-reporting firms capitalize all borrowing costs related to a loan obtained specifically to acquire or construct the asset because the debt is used directly to finance the construction. Unlike US GAAP, there is no need to use the weighted-average accumulated expenditures to determine interest to capitalize for specific borrowing. The weighted-average accumulated expenditures are only used to determine interest to capitalize for general debt. 2. Income from the temporary investment of specific borrowings reduces capitalized borrowing costs Exhibit 11.1 on pg 586

US GAAP definition of an asset (3 characteristics)

1. It represents probable future economic benefits 2. The firm can obtain the benefit of the asset and can also control others' access to it 3. The transaction or other event giving rise to the entity's right to the benefit or control of the benefit has already occurred. Firms also require reliable measurement methods to record a cost as an asset. Identifying an asset involves differentiating between costs with probable future economic benefits and costs that have expired without the ability to generate revenue in subsequent accounting periods. Firms must also consider the cost-benefit tradeoff and materiality when measuring PPE. (Information is said to be material if omitting it or misstating it could influence decisions that users make on the basis an entity's financial statements.)

PPE Categories

1. Land 2. Land Improvements 3 Machinery and Equipment 4. Buildings Types of PPE include land, plant, equipment, and buildings.

Interest Capitalization

A company constructing a long-term operating asset such as a new manufacturing facility may need to finance the costs of construction. When financing by issuing debt, the company must determine whether to add interest costs to the cost of the asset (that is, to capitalize) or to expense the interest costs as incurred. In other words, accountants must determine if interest is a cost of a constructed plant asset or if it is a financing cost. To properly value the cost of a constructed plant asset, firms capitalize material interest charges incurred in the construction of certain assets. The amount of interest capitalized is the lesser of actual interest incurred and avoidable interest. Avoidable interest is the interest the firm could have avoided if it had not borrowed funds to construct the plant asset. 4 Major Considerations in the application of interest capitalization requirements: 1. Assets that qualify for interest capitalization 2. Expenditures on which the firm should compute interest 3. Rate of interest 4. Period of capitalization Because capitalized interest increases an asset's cost, depreciation expense on the asset will be higher in the future. However, interest expense is lower in the construction period.

Overview of Initial Measurement

A company determines the amount to capitalize as PPE as the costs that are reasonable and necessary to bring the asset to the location and condition required for its intended use. Consequently, costs such as installation, delivery, special wiring, interest from the financing of constructed assets, closing costs, and sales tax are included in the initial measurement of PPE. All fixed assets are not capitalized. In practice, firms develop a capitalization policy for PPE, which typically sets guidelines based on the type and/or the magnitude of the cost of the asset acquired. A materiality threshold for capitalization specifies that the firm immediately expense an asset that falls below a predetermined fixed dollar limit (e.g. $1000) rather than capitalize it as an asset. Ex. Ford Motor Company's 2012 annual report noted that it capitalized new assets it expected to use for more than one year with acquisition costs greater than $2500. Firms typically have several subcategories of PPE.

Depreciation of Tangible Fixed Assets

A company's allocation of the initial cost of the asset to future periods of expected benefit from use of the asset is a critically important aspect of accounting for PPE.

IFRS Interest Capitalization

Accounting for interest capitalization under IFRS is similar to US GAAP for all areas discussed: 1. Assets that qualify for interest capitalization 2. Expenditures on which firms should compute interest 3. Rate of interest 4. Period of capitalization

Subsequent Measurement of Property, Plant and Equipment

Accounting for long-term operating assets extends beyond acquisition. New machinery must be maintained, depreciated over time, or impaired if its value falls. Several events and transactions affect long-term fixed assets after acquisition, including subsequent expenditures related to the fixed assets, depreciation, and impairments. Impairments (Chp.12) , are decreases in an asset's carrying value whenever the asset no longer provides the future benefits expected.

Overview of the Depreciation Process for Property, Plant, and Equipment

Allocating the cost of a fixed asset through depreciation requires that management estimate the asset's useful life and its scrap value, and choose the depreciation method.

Expenditures

As construction occurs, a company records its expenditures in a noncurrent asset account (construction in progress) and computes interest on the weighted average accumulated expenditures for the accounting period in which it is calculating interest capitalization.

3. Select Depreciation Method

Management also decides which depreciation method to use for the company's fixed assets. The goal is to select a depreciation method reflecting the pattern that most closely articulates with the revenue generated from the use of the asset. The conceptual framework direct that firms should recognize expenses when they consume benefits in revenue-generating activities.

1. Estimate Useful Life

Management consider a number of different factors in estimating the productive life of a fixed asset. Ex. managers may consider experience using this type of asset in prior years, relevant industry practice, maintenance policy, specific firm usage versus normal usage, and the possibility of obsolescence. Useful life varies by type of asset. Ex. AT&T depreciates its buildings and improvements over 10 to 44 years, office equipment over 3 to 10 years, and cable, wiring, and conduits over 15 to 50 years

Depreciation Guidelines

Depreciation Expense is an end-of-period adjustment that firms include on the income statement in the computation of operating income. Firms generally report depreciation expense as part of selling, general, and administrative expenses. On the balance sheet, firms reduce the tangible fixed asset by increasing accumulated depreciation, a contra-asset account that represents the total depreciation taken over the life of the asset. Firms subtract accumulated depreciation from the original cost of the fixed asset and report net book value (NBV), also referred to as net fixed assets (NFA), in the noncurrent asset section of the balance sheet. Initially the most objective information regarding a fixed asset's value is its cost. As a result, the accountant preserves the record of historical cost and records the estimated depreciation in the separate accumulated depreciation account. For financial statement purposes, firms report the net book value as a single line item.

Initial Measurement with Deferred Payment Arrangements

Firms can acquire PPE by making an immediate cash payment, financing the acquisition by issuing a note payable, or some combination of the two. The payment method used impacts the amount of PPE the firm records.

Period of Capitalization

Firms capitalize interest from the time of the initial expenditure to the time the asset is ready for its intended use. When construction is completed but the asset is held idle - envision protestors blocking the operating of a nuclear power plant - the firm must charge interest incurred after the completion of construction to expense.

Land Improvements

Firms capitalize land improvements - which include landscaping costs, lighting, fence installations, lawn sprinkler systems, and driveway construction - in a separate land improvements account. A separate account is needed because land improvements are subject to depreciation, whereas land is not.

Computation of Capitalized Interest

Firms compute the amount of avoidable interest as the weighted-average accumulated expenditures times the appropriate interest rate. If the computed avoidable interest exceeds the actual interest for the year, the firm only capitalizes the actual interest incurred. (in other words, it capitalizes the lesser of the actual interest or the avoidable interest) Companies often invest excess borrowed funds, particularly at the beginning of a construction project, in short-term interest-bearing investments that earn interest revenue. Companies report interest revenue separately, rather than netting this interest revenue with their interest costs.

Subsequent Expenditures

Firms either capitalize or expense expenditures made after acquisition of a fixed asset. Again, the decision to capitalize or expense these costs depends on the definition of an asset. Firms expense noncapital expenditures immediately, such as ordinary repairs, which are expenditures to maintain the operating efficiency of an asset that do not extend its original useful life. Many ordinary repairs are relatively small expenditures that recur on a regular basis, such as a periodic oil change for a vehicle. An oil change does not increase the life of an asset beyond the original estimate and it does not enhance its output. If an expenditure provides future economic benefit and therefore, qualifies as an asset (i.e. it is a capital expenditure), the firm capitalizes the costs by adding the cost of the expenditure to the carrying value of the long-term fixed asset. Examples of capital expenditures are major overhauls of existing property, plant and equipment, extraordinary repairs, and plant expansion. Adding an additional floor to a factory building or installing a refrigeration system in a delivery van would qualify as a capital expenditure.

Property, Plant, and Equipment Measurement

Firms measure PPE by determining the amounts to record as an asset or to expense immediately.

Qualifying Assets

Firms should capitalize interest for assets constructed or otherwise produced for the firm's own use (ex. a self-constructed power plant by a public utility). Qualifying assets include assets constructed by others for the firm's use where deposits and progress payments have been made. The manufacture of inventory or other routine production are not qualifying assets. Firms should also capitalize interest on assets intended for sale or lease that they construct or otherwise produce as discrete projects (for example, office buildings and land purchased for development)

Rate of Interest

Firms use two separate interest rates to determine the amount of interest to capitalize. 1. The interest rate incurred on specific borrowings applies to the portion of the weighted-average accumulated expenditures that is less than or equal to the amount borrowed specifically to finance the construction of the asset. 2. The weighted average interest rate on all other general outstanding debt during the period applies to the amount of the weighted-average accumulated expenditures that is greater than the amount borrowed specifically to finance the construction of the asset.

Depreciation Methods

Rather than requiring a particular method of depreciation, U.S. GAAP simply states that the method of depreciation should result in a systematic allocation of the cost of the asset. Thus, firms employ a number of different depreciation methods in practice. 3 most common allocation methods: 1. Straight-line method 2. Units-of-output method 3. Double-declining balance approach

Land

The cost of land generally includes the purchase price, development costs, legal fees, closing costs,delinquent property taxes, the costs of grading and clearing the land, and a portion of the interest costs incurred during the development process. In addition, firms consider the costs to remove an old structure, net of any proceeds on the sale of scrap materials, as part of the land's acquisition cost, because these costs are required to bring the land to the condition necessary for its intended use.

Buildings

The costs of buildings includes any acquisition or construction costs, as well as legal and closing costs similar to those incurred in the acquisition of land. In addition, firms may capitalize interest on financing employed during the construction period as part of the building under construction.

Full-cost accounting

The firm allocates a proportionate share of all indirect cost incurred by the company to the construction project.

2. Estimate Scrap Value

The scrap value (also referred to as residual or salvage value) is the amount the firm expects to realize on disposal of the fixed asset at the end of its productive service to the firm. The scrap value reduces the depreciable base of the asset, so that the firm only depreciates the cost less scrap value over the life of the asset. Scrap values are designed to minimize or avoid any gain or loss on disposal. Ex. A company sells its fleet of service vans every 5 years. If the dealership allows a trade-in value equal to 10% of the original cost, then there is a 10% residual value. If the company depreciates the vans using a 10% residual value, there would never be a gain or loss on the disposal. Management estimates scrap values based on their experience or relevant industry practice. For example, management teams that estimated residual values for fixed assets used in high-tech industries typically assume a zero scrap value due to rapid advances in technology causing a minimal residual value in a short period of time. As a result, the cost of eliminating scrap values is not worth the benefit.

Initial measurement of Basket Purchases

The valuation of assets acquired in a basket purchase includes both homogenous assets (assets that are the same), and heterogenous assets (assets that are dissimilar from one another).

Constructed Assets and Overhead Costs

When a company constructs an asset, it may contribute certain portions of the labor and material toward the completion of the project. Ex. a company incurs costs to pay the builders and buy the concrete and steel needed to construct a new headquarters. Firms capitalize direct materials used and direct labor hours expended on the project as part of the acquisition cost of the asset. Indirect overhead costs (ex. general supervisory salaries and depreciation) are generally accounted for using full-cost accounting.

Basket Purchase: Homogenous Assets

When a firm acquires homogeneous assets, it records the PPE at cost and includes it on the balance sheet, assigning an equal amount to each asset. Ex. If a firm acquires five identical laptop computers at a total cost of $5,250, it would value each laptop at $1,050 (5250/5) and report the total cost of $5250 in the office equipment account on the balance sheet

Asset Valuation: Determinable Market Value

When the face amount of a note does not reasonably represent the present value of the consideration give or received in the exchange (today's cash price), the accountant must then determine the proper valuation of the asset. Ex. notes payable are sometimes issued with a zero interest rate stated or at a stated rate that is significantly below the market rate of interest. If the asset's fair value is readily determinable or if the note is traded, the firm records the acquired asset at the fair value of the consideration given (the note) or the fair value of the consideration received (the asset), whichever value is more clearly evident. The difference between the face amount of the note and the fair value of the property (or the note) is called the discount, and represents the amount of interest to be deferred over the loan term. The discount on notes payable, (a contra liability) reduces the face value of the note payable to its present value. The firm reports the note payable's carrying value (its par or face value less the balance of the unamortized discount) - on the balance sheet

Asset Valuation: Nondeterminable Market Value

When the fair values of the asset or the note are not clearly evident, the firm must compute the present value of the note as an estimate of the asset's fair value. The firm computes the fair value of the asset by discounting the note payable at an implied or imputed rate of interest reflecting the market rate of interest that a borrower would incur today under similar terms and conditions. After determining the present value of the note payable, the firm allocates the face value of the note between the asset's acquisition cost (which equals the present value of the note payable) and the discount, which represents the deferred interest expense (i.e. finance charges) When using the effective interest rate method of amortization, the carrying value of the note payable will always the equal the present value of the remaining cash flows discounted at the historical market rate. Separating the asset value from the finance charges is critical for proper expense classification on the income statement. Depreciation affects operating income, while interest expense is a non-operating expense. Ignoring taxes, combining the finance charge with the acquisition cost overstates the asset's carrying value on the balance sheet. Improper management of the asset's cost and the finance charge will also overstate depreciation expense and interest expense on the income statement. pg. 576

Nonmonetary exchange

a company acquires an asset by exchanging another set with the seller rather than paying cash. Non monetary exchanges are an infrequent way to acquire PPE and are discussed in Appendix A.

Double-Declining Balance Method (DDB)

a decreasing-charge method that applies a constant rate of deprecation against a decline net book book value (defined as cost less accumulated depreciation). The constant rate used in dealing balance methods is a multiple of the straight-line rate. Note that the asset's net book value is the depreciable base for DDB and not the cost less scrap value. Therefore, DDB does not subtract the scrap value from the depreciable base before computing the annual depreciation expense. Firms compute the DDB rate as twice the straight-line rate - hence the term "double" in the title of the method. DDB Rate = 2 * Straight-line Rate or DDB Rate = 2 * 1/Useful Life DDB Depreciation Expense = Net Book Value at Beginning of Period * DDB Rate With the DDB approach, the ending net book value is not always equal to the planned scrap value. In this case, the firm reduces the depreciation expense in the last year to the necessary amount to arrive at an ending book value equal to the scrap value.

Basket purchase

a firm acquires two or more fixed assets together for a single purchase price.

Capitalizing or expensing an expenditure for a fixed asset

affects the financial statements differently. When a firm expenses an item, earnings are reduced for the full amount in the first year. When a firm capitalizes an expenditure, assets increase and earnings are reduced only for the depreciation expense in the first year. Therefore, firms may prefer to capitalize expenditures whenever possible in order to avoid the larger decrease in earnings in the first year. Of course, future earnings will decrease, but by a lower amount than expensing immediately.

Property, plant, and equipment (PPE), also referred to as tangible fixed assets

are assets used in the production of goods and services that the firms sells in order to generate operating income and cash flow. PPE Assets are: 1. tangible in nature 2. expected to be used for more than one year (or more than one operating cycle, whichever is longer) 3. Used in the production and sale of other assets, for rental to others, or for administrative purposes PPE includes land and land improvements; buildings, machinery and equipment; and furniture and fixtures. It also includes natural resources covered in Appendix B.

Decreasing-charge methods

are depreciation methods that take more depreciation in the early years than in the late years of the asset's useful life. Acceleration of depreciation charges is based on the premise that an asset is often most productive in its early years of service. Thus, decreasing charge methods match higher depreciation expense with higher related revenues in the early years of the asset's life and match lower depreciation charges against lower related revenues in the later years. Accelerated depreciation generally results in constant total annual usage costs (depreciation expense and repair and maintenance expense) charged against income over the life of the asset. In the early years of the asset's life, there are high depreciation expenses but low repair and maintenance expenses. When the asset is older. there are high repair and maintenance expenses and low depreciation expenses. Thus, the decreasing-charge methods of depreciation result in a fairly constant level of asset utilization costs over the asset's useful life. (Exhibit 11.2 pg 592)

Notes payable

are formal credit arrangements between a creditor (lender) and a debtor (borrower) requiring the payment of a stated face amount on a specified maturity date. In a straight-forward notes payable issue, the face value of an interest-bearing note is equal to the cash price (i.e. the fair value) of the asset. In this case, for the initial measurement, the firm debits the asset and credits the notes payable for that amount. The firm recognizes interest expense each period on the unpaid balance of the debt and pays the debt in full at maturity.

Weighted-average accumulated expenditures

are the construction expenditures weighted by the portion of the year that the expenditure is outstanding until the project is complete, or the end of the year if the project is not complete.

Long-Term Operating Assets

consist of tangible fired assets (also referred to as property, plant, and equipment), natural resources, and intangible assets. Typically have a significant impact on a firm's financial statements.

Units-of-Output Method

derives a rate of depreciation per unit produced and applies that rate against the actual number of units produced each period. Ex. Number of miles driven could be used to depreciate a delivery truck. Depreciation expense is the depreciable base divided by the estimated total units of output times the actual number of units produced each period. The depreciable base is cost less estimated scrap value. Depreciation Rate per Unit = Depreciable Base/ Estimated Total Units of Output Units-of-output Depreciation Expense = Depreciation Rate per Unit * Actual Units produced or Units-of-output Depreciation Expense = Depreciable Base * (Actual Units of Output/ Estimated Total Units of Output)

Acquisition Cost

includes the costs necessary too bring the asset to the location and condition for its intended use

Capital expenditure

is a cost recorded by a company as an asset rather than an expense.

Capitalization

is the process of recording an expenditure as an asset.

Depreciation

is the systematic and rational allocation of the cost of a long-term plant asset to expense over the asset's expected useful life. As the asset is depreciated, the firm reports depreciation expense on the income statement and reduces the carrying value of the asset on the balance sheet. Depreciation is a process of allocating costs to the periods in which the benefits are consumed. Land is not depreciated because it typically has unlimited life - generally, it is not consumed in operations.

Avoidable interest

the interest the firm could have avoided if it had not borrowed funds to construct the plant asset.