Chapter 11
OPERATIONAL ASSETS:
UTILIZATION AND
IMPAIRMENT
McGraw-Hill /Irwin
© 2009 The McGraw-Hill Companies, Inc.
Slide 2
Cost Allocation – An Overview
The matching principle requires that part of the
acquisition cost of operational assets be expensed in
periods when the future revenues are earned.
Depreciation, depletion, and amortization are
cost allocation processes used to help meet the
matching principle requirements.
Some of the cost is expensed each period.
Acquisition
Cost
(Balance Sheet)
Expense
(Income Statement)
11-2
Slide 3
Cost Allocation – An Overview
Operational
Asset
Debit
Property, Plant, &
Equipment
Depreciation
Natural Resource
Depletion
Intangible
Amortization
Account Credited
Accumulated
Depreciation
Natural Resource
Asset
Intangible Asset
Caution! Depreciation, depletion, and amortization
are processes of cost allocation, not valuation!
Depreciation
on the
Balance
Sheet
11-3
Slide 4
Measuring Cost Allocation
Cost allocation requires three pieces of
information for each asset:
Service
Life
Allocation
Base
The estimated expected
use from an asset.
Allocation
Method
The systematic approach
used for allocation.
Total amount of cost to be allocated.
Cost - Residual Value (at end of useful life)
11-4
Slide 5
Depreciation of Operational Assets
Time-based Methods
Straight-line (SL)
Accelerated Methods
Sum-of-the-years’ digits (SYD)
Declining Balance (DB)
Group and
composite
methods
Tax
depreciation
Activity-based methods
Units-of-production method (UOP).
11-5
Slide 6
Straight-Line
The most widely
used and most easily
understood method.
Results in the same
amount of depreciation in
each year of the asset’s
service life.
On January 1, we purchase equipment for $50,000 cash.
The equipment has an estimated service life of 5 years
and estimated residual value of $5,000.
What is the annual straight-line depreciation?
11-6
Slide 7
Straight-Line
Annual
Straight-line
=
$
– $
50,000
5,000
5
Depreciation
= $
Year
1
2
3
4
5
9,000
Depreciation
(debit)
Accumulated
Depreciation
(credit)
Accumulated
Depreciation
Balance
$
$
$
$
9,000
9,000
9,000
9,000
9,000
45,000
$
9,000
9,000
9,000
9,000
9,000
45,000
9,000
18,000
27,000
36,000
45,000
BV = Residual Value at the
end of the asset’s useful life.
Undepreciated
Balance
(book value)
$
50,000
41,000
32,000
23,000
14,000
5,000
Residual Value
11-7
Slide 8
Accelerated Methods
Accelerated methods result in more depreciation
in the early years of an asset’s useful life and less
depreciation in later years of an asset’s useful life.
Note that total depreciation over the asset’s useful
life is the same as the Straight-line Method.
SYD depreciation is computed as follows:
SYD
= ( Cost
Depreciation
–
Residual
) ×
Value
Remaining Years
of Useful Life
Sum-of-the-Years
Digits*
11-8
Slide 9
Sum-of-the-Years’ Digits (SYD)
Sum-oftheYears'Digits
(SYD)
= (
Useful
Life
× [
Useful
Life
+ 1 ] )
2
On January 1, we purchase equipment for $50,000 cash.
The equipment has a service life of 5 years and an
estimated residual value of $5,000. Using SYD
depreciation, compute depreciation for the first two years.
SYD
= (
5
× [
=
30
÷
=
15
5
+ 1] ) ÷ 2
2
11-9
Slide 10
Sum-of-the-Years’ Digits (SYD)
SYD
= (
Depreciation
Cost
Remaining Years
of Useful Life
Residual
–
) ×
Value
Sum-of-the-Years
Digits
5
15
$ 15,000 Depreciation in Year 1
= ( $ 50,000 – $ 5,000 ) ×
=
4
= ( $ 50,000 – $ 5,000 ) ×
15
=
$ 12,000 Depreciation in Year 2
11-10
Slide 11
Sum-of-the-Years’ Digits (SYD)
5/15
4/15
3/15
2/15
1/15
$
$
$
15,000
12,000
9,000
6,000
3,000
45,000
Depreciation
Fraction
Depreciation
(debit)
Accumulated
Depreciation
Balance
15,000
27,000
36,000
42,000
45,000
Undepreciated
Balance
(book value)
$
50,000
35,000
23,000
14,000
8,000
5,000
Residual Value
16000
14000
12000
10000
8000
6000
4000
2000
0
1
2
3
4
Life in Years
5
11-11
Slide 12
Declining-Balance (DB) Methods
DB depreciation


Based on the straight-line rate
multiplied by an acceleration
factor.
Stop depreciating
when:
BV = Residual Value
Computations initially ignore
residual value.
Double-Declining-Balance (DDB) depreciation
is computed as follows:
DDB =
Book
Value
× ( 2 × Straight-line Rate )
Note that the Book Value will get lower each year.
11-12
Slide 13
Double-Declining-Balance (DDB)
On January 1, we purchase equipment for $50,000
cash. The equipment has a service life of 5 years
and an estimated residual value of $5,000.
What is depreciation for the first two years using
double-declining-balance?
DDB =
Book
Value
× ( 2 × Straight-line Rate )
= $ 50,000 × ( 2 × 20% )
= $ 20,000 1st Year Depreciation
= ($50,000 - $20,000) × (2 × 20%)
= $ 12,000 2nd Year Depreciation
11-13
Slide 14
Double-Declining-Balance (DDB)
1
2
3
4
5
$
$
$
20,000
12,000
7,200
4,320
1,480
45,000
Undepreciated
Balance
(book value)
$
50,000
30,000
18,000
10,800
6,480
5,000
20,000
32,000
39,200
43,520
45,000
Depreciation forced so that BV = Residual Value.
Depreciation
Year
Depreciation
(debit)
Accumulated
Depreciation
Balance
20000
18000
16000
14000
12000
10000
8000
6000
4000
2000
0
1
2
3
4
Life in Years
5
11-14
Slide 15
Units-of-Production
Depreciation
rate per unit
of output
=
Acquisition
Cost
Residual
–
Value
Estimated Output in Units
Depreciation
Depreciation =
rate per unit
×
Units of
output
11-15
Slide 16
Units-of-Production
On January 1, we purchased equipment for $50,000 cash.
The equipment is expected to produce 100,000 units during
its life and has an estimated residual value of $5,000.
If 22,000 units were produced this year, what is the amount
of depreciation?
Depreciation
rate per unit
$50,000 – $5,000
=
100,000
Depreciation
=
Depreciation
rate per unit
=
=
$0.45
$9,900
= $0.45
×
Units of
output
×
22,000
11-16
Slide 17
Use of Various Depreciation Methods
11-17
Slide 18
Depreciation Disclosures
Depreciation.
 Balances of major classes of depreciable
assets.
 Accumulated depreciation by asset or in
total.
 General description of
depreciation methods used.

11-18
Slide 19
Group and Composite Methods






Assets are grouped by common characteristics.
An average depreciation rate is used.
Annual depreciation is the average rate × the total
group acquisition cost.
Accumulated depreciation records are not maintained
for individual assets.
If assets in the group are sold, or new assets
added, the composite rate remains the same.
When an asset in the group is sold or retired,
debit accumulated depreciation for the difference
between the asset’s cost and the proceeds.
11-19
Slide 20
Depletion of Natural Resources
As natural resources are “used
up”, or depleted, the cost of the
natural resources must be
allocated to the units extracted.
Cost of Natural
Resource
Depletion rate
=
per unit
Total
Depletion
Cost
The approach is based
on the units-ofproduction method.
–
Residual
Value
Estimated Recoverable Units
=
Unit Depletion
Rate
×
Units
Extracted
11-20
Slide 21
Depletion of Natural Resources
ABC Mining acquired a tract of land containing ore
deposits. Total costs of acquisition and development were
$1,100,000. ABC estimated the land contained 40,000
tons of ore, and that the land will be sold for $100,000 after
the coal is mined.
What is ABC’s unit depletion rate?
a. $40 per ton
b. $50 per ton
c. $25 per ton
d. $20 per ton
Cost / Units
$1,000,000 / 40,000 Tons
= $25 Per Ton
11-21
Slide 22
Depletion of Natural Resources
For the year ABC mined 13,000 tons. What is the
total amount of depletion for the year?
a.
b.
c.
d.
$325,000
$315,000
$275,000
$225,000
Depletion = 13,000 x $25 = $325,000
11-22
Slide 23
Amortization of Intangible Assets
The amortization process uses the straight-line
method, but usually assumes residual value = 0.
Amortization period is the shorter of
economic life or legal life.
The amortization entry is:
GENERAL JOURNAL
Date
Description
Amortization Expense
Intangible Asset
Page 42
PR
Debit
Credit
$$$
$$$
Note that the amortization process does not
use a contra-asset account.
11-23
Slide 24
Amortization of Intangible Assets
Torch, Inc. has developed a new device. Patent
registration costs consisted of $2,000 in attorney fees and
$1,000 in federal registration fees. The device has a
useful life of 5 years. The legal life is 20 years.
For year 1, what is Torch’s amortization expense?
Use the shorter of economic life (5 years)
or legal life (20 years).
Amortization
= Cost
÷ Economic life
= $3,000 ÷ 5 years
= $ 600 per year
GENERAL JOURNAL
Date
Description
Amortization Expense
Patent
Page 42
PR
Debit
Credit
600
600
11-24
Slide 25
Intangible Assets Not Subject
to Amortization
Goodwill
Not amortized.
Subject to assessment
for impairment
value and may be
written down.
11-25
Slide 26
Partial-Period Depreciation
Pro-rating the depreciation based on the
date of acquisition is time-consuming
and costly. A commonly used alternative
is the . . .
Half-Year Convention
Take ½ of a year of depreciation in the
year of acquisition, and the other ½ in
the year of disposal.
11-26
Slide 27
Changes in Estimates
Depreciation Expense is based on . . .
ESTIMATED
service life
ESTIMATED
residual value
If the estimates change, the book value less any
residual value at the date of change is depreciated
over the remaining useful life.
On January 1, equipment was purchased that cost $30,000, has
a useful life of 10 years and no salvage value. At the beginning
of the fourth year, it was decided that there were only 5 years
remaining, instead of 7 years.
Calculate depreciation expense for the fourth
year using the straight-line method.
11-27
Slide 28
Changes in Estimates
Asset cost
Accumulated depreciation
($3,000 per year × 3 years)
Remaining book value
Divide by remaining life
Revised annual depreciation
$ 30,000
9,000
21,000
÷ 5
$ 4,200
What happens if we change
depreciation methods?
11-28
Slide 29
Change in Depreciation Method
A change in depreciation, amortization, or depletion
method is considered a change in accounting estimate
that is achieved by a change in accounting principle.
We account for these changes prospectively,
exactly as we would any other change in estimate.
On January 1, 2007, Matrix, Inc., purchased equipment for
$400,000. Matrix expected a residual value $40,000, and a
service life of 5 years. Matrix uses the double-decliningbalance method to depreciate this type of asset. During
2009, the company switched from double-declining balance
to straight-line depreciation. Let’s determine the amount of
depreciation to be recorded at the end of 2009.
11-29
Slide 30
Change in Depreciation Method
Depreciation - 2007 $
Depreciation - 2008
Total Depreciation $
160,000 ($400,000 × 40%)
96,000 [($400,000 - $160,000) × 40%]
256,000
Cost of asset
Accumulated depreciation
Undepreciated balance
Remaining service life
Annual depreciation
$
÷
$
400,000
(256,000)
144,000
3
48,000
General Journal
2009
Depreciation
Description
Debit
Depreciation expense
Accumulated depreciation
48,000
Credit
48,000
11-30
Slide 31
Error Correction
Errors found in a subsequent
accounting period are corrected by . . .
Entries that
restate the
incorrect
account
balances to the
correct amount.
Restating the
prior period’s
financial
statements.
Reporting the
correction as a
prior period
adjustment to
Beginning R/E.
11-31
Slide 32
Impairment of Value
Test for impairment of value
when considered for sale.
Accounting treatment differs.
Operational assets
to be held and used
Tangible and
intangible
with finite
useful lives
Intangible
with
indefinite
useful lives
Operational assets
held to be sold
Goodwill
Test for impairment of
value at least annually.
Test for impairment of value when it is suspected
that book value may not be recoverable
11-32
Slide 33
Tangible and Finite-Life Intangibles
Measurement – Step 1
An asset is impaired when . . .
The undiscounted
sum of its estimated
future cash flows
<
Its
book
value
11-33
Slide 34
Tangible and Finite-Life Intangibles
Measurement – Step 2
Impairment
loss
=
Reported as part
of income from
continuing operations.
$0
Book
value
Market value, price of similar assets,
or PV of future net cash inflows.
Fair Value
$125
Case 1: $50 book value.
No loss recognized
–
Fair
value
Undiscounted future
cash flows
$250
Case 3: $275 book value.
Loss = $275 - $125
Case 2: $150 book value. No loss recognized
11-34
Slide 35
Impairment of Value –
Indefinite Life Intangibles
Goodwill
Step 1 If BV of business
unit > FV, impairment
indicated.
Step 2 Loss = BV of
goodwill less implied value
of goodwill.
Other Indefinite
Life Intangibles
One-step Process
If BV of asset >
FV, recognize
impairment loss.
11-35
Slide 36
Impairment of Value –
Operational Assets to be Sold
Operational assets to be sold
includes assets that management
has committed to sell immediately in
their present condition and
for which sale is probable.
Impairment
loss
=
Book
value
Fair value less
– cost to sell
11-36
Slide 37
Expenditures Subsequent to Acquisition
Type of
Expenditure
Repairs and
Maintenance
Additions
Definition
Expenditures to maintain
a given level of benefits
Usual Accounting Treatment
Expense in the period incurred
The addition of a new major Capitalize and depreciate over the
component to an existing asset remaining useful life of the original
asset, or over the useful life of the
addition, whichever is shorter
Improvements
The replacement of
a major component
Capitalize and depreciate over the
useful life of the improved asset
Rearrangements
Expenditures to restructure
an asset without addition,
replacement, or improvement
If expenditures are material and
clearly increase future benefits,
capitalize and depreciate over
the future periods benefited
11-37
Slide 38
Appendix 11A ─ Comparison With
MACRS (Tax Depreciation)
Most corporations use the Modified
Accelerated Cost Recovery System
(MACRS) for tax purposes.
Provides
for rapid
write-off
Ignores
residual
value
Rates based
on asset
“class lives”
11-38
Appendix 11B ─ Retirement and
Replacement Methods of Depreciation
Slide 39
Used for groups of similar, low-valued
assets with short service lives.
Retirement Method
Acquisitions:
• Record initial acquisitions
of assets at cost in the
asset account.
• Record subsequent
acquisitions of assets at
cost in the asset account
Dispositions:
• Credit the asset account
for cost.
• Debit depreciation expense
for cost less the proceeds
received.
Replacement Method
Acquisitions:
• Record initial acquisitions of
assets at cost in the asset
account.
• Record subsequent
acquisitions with a debit to
depreciation expense.
Dispositions:
• Credit depreciation expense
for the proceeds received.
11-39
End of Chapter 11
McGraw-Hill /Irwin
© 2009 The McGraw-Hill Companies, Inc.