Chapter 11

Time-Based Depreciation Methods

Straight-Line Methods Accelerated Methods

Activity-Based Depreciation Methods

Activity-based depreciation methods estimate service life in terms of some *measure of productivity* -Units-Of-Production Method

Intangible Assets Subject to Amortization

*(1) Useful life* -Legal, regulatory, or contractual provisions often limit the useful life of an intangible asset. -On the other hand, useful life might sometimes be less than the asset's legal or contractual life. -For example, the useful life of a patent would be considerably less than its legal life of 20 years if obsolescence were expected to limit the longevity of a protected product. *(2) Residual value* -The expected residual value of an intangible asset usually is *zero*. - This might not be the case, though, if at the end of its useful life to the reporting entity the asset will benefit another entity. -For example, if Quadra Corp. has a commitment from another company to purchase one of Quadra's patents at the end of its useful life at a determinable price, we use that price as the patent's residual value. *(3) Allocation method* -The method of amortization should reflect the pattern of use of the asset in generating benefits. -Most companies use the *straight-line method*

Estimates

-*Undiscounted* estimates of cash flows are used to determine whether an impairment loss has occurred -*Discounted* estimates of cash flows often are used to estimate fair value to determine the amount of the loss -A disclosure note is needed to describe the impairment loss. The note should include: 1. Description of the impaired asset or asset group 2. The facts and circumstances leading to the impairment 3. The amount of the loss if not separately disclosed on the face of the income statement 4. The method used to determine fair value

Intangible Assets Not Subject to Amortization

-An intangible asset that is determined to have an *indefinite useful life* is not subject to periodic amortization. -Useful life is considered indefinite if there is *no foreseeable limit on the period of time over which the asset is expected to contribute* to the cash flows of the entity. -Indefinite does not necessarily mean permanent (trademarked company going out of business) -Intangible assets with indefinite useful lives are subject to impairment -Examples of indefinite-life intangibles assets: Goodwill, Trademarks, and Tradenames

Changes in Estimates

-Changes in estimates are accounted for *prospectively*. -When a company revises a previous estimate based on new information, *prior financial statements are not restated*. -Instead, the company merely incorporates the new estimate in any related accounting determinations *from then on*. -So, it usually will affect some aspects of both the balance sheet and the income statement in the *current and future periods*. -A disclosure note should describe the effect of a change in estimate on *net income* and *related per share amounts* for the current period.

Impairment of Value

-Depreciation, depletion, and amortization reflect a *gradual consumption of the benefits inherent in property, plant, and equipment and intangible assets*. -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 potentials.* Example: -Building destroyed by fire before the asset is fully depreciated. -The remaining book value of the asset in that case should be written off as a loss. -Sometimes, though, the impairment of future value is more subtle. -The way we recognize and measure an impairment loss differs depending on whether the *assets are to be held and used or are being held to be sold*. -Accounting is different, too, for assets with finite lives and those with indefinite lives.

Cost allocation known as

1. *Depreciation* -For plant and equipment *we DO NOT depreciate land* 2. *Depletion* -For natural resources 3. *Amortization* -For intangibles assets

Error Correction

-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. Here is a summary of the treatment of material errors occurring in a previous year: (1) Previous years' financial statements are *retrospectively restated*. (2) Account balances are corrected. (3) If retained earnings requires correction, the correction is reported as a *prior period adjustment*. (4) A note describes the nature of the error and the impact of the correction on income.

Impairment of Value: Property, Plant, and Equipment and Finite-life Intangible Assets

-GAAP provide guidelines for when to recognize and how to measure impairment losses of long-lived tangible assets and intangible assets with *finite useful lives.* -For purposes of this recognition and measurement, assets are grouped at the *lowest level* for which identifiable cash flows are largely independent of the cash flows of other assets. -When to Test for Impairment: Tested for impairment only when events or changes in circumstances indicate that the *book value of the asset may not be recoverable*

Accelerated Depreciation

-In some situations it might be more appropriate to assume that the asset will provide *greater benefits in the early years of its life than in the later years*: (1): In these cases, a more appropriate matching of depreciation with revenues is achieved with a *declining pattern of depreciation*, with *higher depreciation in the early years* of the asset's life and *lower depreciation in later years*. (2): An accelerated depreciation method also would be appropriate when benefits derived from the asset are approximately equal over the asset's life, but *repair and maintenance costs increase significantly in later years.* -The *early years incur higher depreciation and lower repairs and maintenance expense*, while the *later years have lower depreciation and higher repairs and maintenance*. -Two ways to achieve such a declining pattern are the *sum-of-the-years'-digits method* and *declining balance methods*.

Sum-Of-The-Years'-Digits Method

-It has no logical foundation other than the fact that it accomplishes the objective of *accelerating depreciation in a systematic manner*. -This is achieved by *multiplying the depreciable base by a declining fraction that declines each year and results in depreciation that decreases by the same amount each year.* -The denominator of the fraction remains constant and is the *sum of the digits from one to n*, where n is the *number of years in the asset's service life* -Deprecation = *Depreciation Base x Depreciation Rate Per Year* -Depreciable Base = *Cost - Salvage(Residual) Value* -Depreciation Rate Per Year = *Asset's Life/ Total Life* -Total Life = *(n (n+1)) ÷ 2* (n is the number of years in the asset's service life) -Book Value End of the Year = *Cost - Accumulated Depreciation* OR *Book Value End of Previous Year - Depreciation This Year*

Examples of Impairment of Value: Property, Plant, and Equipment and Finite-life Intangible Assets

-It would be impractical to test all assets or asset groups for impairment at the end of every reporting period. -GAAP requires investigation of possible impairment only if events or changes in circumstances indicate that the book value of the asset or asset group may not be recoverable. -This might happen from: a. A significant decrease in market price. b. A significant adverse change in how the asset is being used or in its physical condition. c. A significant adverse change in legal factors or in the business climate. d. An accumulation of costs significantly higher than the amount originally expected for the acquisition or construction of an asset. e. A current-period loss combined with a history of losses or a projection of continuing losses associated with the asset. f. A realization that the asset will be disposed of significantly before the end of its estimated useful life.

Cost Allocation—an 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 -That is, their costs are *matched with the revenues they help generate.*

Declining Balance Methods

-Rather than multiplying a constant balance by a declining fraction as we do in SYD depreciation, we *multiply a constant fraction by a declining balance each year*. -Specifically, we *multiply a constant percentage rate times the decreasing book value* (cost less accumulated depreciation), sometimes called carrying value or carrying amount, of the asset (not depreciable base) *at the beginning of the year*. -Because the rate remains constant while the book value declines, annual depreciation is less each year. -The rates used are multiples of the straight-line rate. -Depreciation = *Book Value Beginning of the Year x Depreciation Rate Per Year* -Depreciation Rate Per Year = *1 / n* Double Declining Rate Per Year = (*1 / n) x 2* -Book Value End of the Year = *Book Value Beginning of the Year - Depreciation* OR *Cost - Accumulated Deprecation*

Impairment of Value: Assets to Be Held and Used

-Should be written down if there has been a significant impairment of value -A write-down can *provide important information about the future cash flows that a company can generate from using the asset.* -However, in practice, this process is very subjective. -Even if it appears certain that significant impairment of value has occurred, it often is difficult to measure the amount of the required write-down. For assets to be held and used, different guidelines apply to: 1. Property, plant, and equipment and intangible assets with *finite useful lives*(subject to depreciation, depletion, or amortization) 2. Intangible assets with *indefinite useful lives* (not subject to amortization).

Straight-Line Depreciation

-The most easily understood and widely used depreciation method is straight line. -By this approach, an equal amount of depreciable base is allocated 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 *(Cost - Salvage Value) / Useful Life = Annual Depreciation*

Measuring Cost Allocation

-The process of cost allocation requires that three factors be established at the time the asset is put into use. These factors are: (1) *Service life*: The *estimated use* that the company expects to receive from the asset. (2) *Allocation base*: the *value of the usefulness* that is expected to be consumed. (3) *Allocation method*: the *pattern* in which the usefulness is expected to be consumed.

Measurement of Impairment of Value: Property, Plant, and Equipment and Finite-life Intangible Assets

-Two steps involved in determining whether an impairment loss has occurred and recording the loss: 1. *Recoverability Test*: An impairment loss is required only when the *undiscounted sum of estimated future cash flows from an asset is less than the asset's book value* 2. *Measurement of Impairment Loss*: The *difference between the asset's book value and its fair value* Fair value: -The amount at which the asset could be bought or sold in a current transaction between willing parties -Quoted market prices could be used if they're available. -If fair value is not determinable, it must be estimated. -Fair value often is estimated as the *present value* of future cash flows -If an impairment loss is recognized, the *written-down book value becomes the new cost base for future cost allocation* -Later recovery of an impairment loss is prohibited.

Additional Issues Related to Cost Allocation: Partial Period Depreciation

-When acquisition and disposal occur at times other than the beginning or end of a company's fiscal year, a company theoretically must determine how much depreciation, depletion, and amortization to record for the part of the year that each asset actually is used. -Partial year depreciation presents a problem only when time-based depreciation methods are used. -In an activity-based method, the rate per unit of output simply is multiplied by the actual output for the period, regardless of the length of that period. -Another common convention is to record one-half of a full year's depreciation in the year of acquisition and another half year in the year of disposal. This is known as the *half-year convention.*

Differences between IFRS and U.S. GAAP of Impairment of Value: Property, Plant, and Equipment and Finite-life Intangible Assets

1. *When to Test*: *US GAAP*: When events or changes in circumstances indicate that book value may not be recoverable, it should be tested. *IFRS*: Assets must be assessed for indicators of impairment at the end of each reporting period. Indicators of impairment are similar to U.S. GAAP. 2. *Recoverability*: *US GAAP*: An impairment loss is required when an asset's book value exceeds the undiscounted sum of the asset's estimated future cash flows. *IFRS*: There is no equivalent recoverability test. An impairment loss is required when an asset's book value exceeds the higher of the asset's value-in-use (present value of estimated future cash flows) and fair value less costs to sell. 3. *Measurement*: *US GAAP*: The impairment loss is the difference between book value and fair value. *IFRS*: The impairment loss is the difference between book value and the "recoverable amount" (the higher of the asset's value-in-use and fair value less costs to sell). 4. *Subsequent Reversal of Loss*: *US GAAP*: It is prohibited. *IFRS*: It is required if the circumstances that caused the impairment are resolved.

Amortization in a Nutshell

Amortization Expense = *Cost / Useful Life* "Amortization Expense" is a Debit

Change in Accounting Estimate

Original Cost -Depreciation to Date (Cost - Salvage Value)/Original Useful Life x n years until revision = New Book Value - Revised Residual Value = Revised Depreciable Base /Estimated Remaining Life = New Annual Depreciation Depreciation Expense - Debit Accumulated Depreciation - Credit

Units-Of-Production Method

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.* -The measure of output used is the estimated number of units (pounds, items, barrels, etc.) to be produced by the machine. -We could also use a measure of input such as the number of hours the machine is expected to operate. -By the units-of-production method, we first *compute the average depreciation rate per unit* by *dividing the depreciable base by the number of units expected to be produced. * -This per unit rate is then multiplied by the number of units produced each period. -Depreciation = *Units Produced x Depreciation Rate Per Unit* -Depreciation Rate Per Unit = *(Cost - Salvage Value) / Expected Units* -Book Value End of the Year = *Cost - Accumulated Depreciation* OR *Book Value End of Previous Year - Depreciation This Year*

Valuation of Intangible Assets - Differences between IFRS and U.S. GAAP

U.S. GAAP: Prohibits revaluation of any intangible asset. IFRS: -Allows a company to value an intangible asset subsequent to initial valuation at: (1) cost less accumulated amortization or (2) fair value, if fair value can be determined by reference to an active market. -Goodwill, however, cannot be revalued.