Intermediate
Financial Accounting I
Operational Assets:
Utilization and Disposition
Objectives of the Chapter
A. To learn depreciation methods for
financial reporting purposes.
B. To study income tax depreciation
including Accelerated Cost Recovery
System (ACRS) and modified ACRS.
C. To discuss the accounting issues
related to asset impairments.
Operational Assets: Utilization and Disposition
2
A. Depreciation
(For Financial Reporting Purposes)
1. Time-based methods
a. Straight-Line.
b. Sum-of-the-Years’-Digits (SYD).
c. Declining-Balance.
2. Activity-based method

Unit-of-Production.
3. Special methods
a. Group Depreciation.
b. Composite Depreciation.
c. Retirement and Replacement Methods.
Operational Assets: Utilization and Disposition
3
iGAAP: Depreciation
 iGAAP, as in US GAAP, perceives
depreciation as a cost allocation of an asset
over the asset’s life.
 iGAAP, as in US GAAP, allows
depreciation methods such as straight line,
diminishing-balance, and unit-of-production.
 IFRS requires component depreciation.
GAAP permits component deprecation but is
rarely applied.
Operational Assets: Utilization and Disposition
4
For Financial Reporting Purposes
1. Time-Based Methods

Depreciation Methods based on the
passage of time:
a. Straight-Line Method.
b. Sum-of-the-Years’-Digits (SYD).
c. Declining-Balance.
b and c are called the accelerated
depreciation methods (or the
decreasing charge methods).
Operational Assets: Utilization and Disposition
5
A.1a. Straight-Line Method


Cost is allocated evenly through the life of the
P.P.E.
Example 1: Machine costing $10,000 was
purchased on 1/1/x1. The estimated residual
value of the machine is $2,000 and the
estimated life of the machine is 4 years.
Depreciation Expense per year:
($10,000 - 2,000)/ 4 = $2,000
12/31/x1 Depreciation Expenses
2,000
Accumulated Depreciation
2,000
Operational Assets: Utilization and Disposition
6
1a. Straight-Line Method (Partial Year
Depreciation)

Example 2 :Using the information in example 1,
except that the machine was purchased on
3/11/x1. Companies normally compute depre. on
the basis of nearest full month. Depreciation
Expense of year x1 ==> [($10,000-2,000)/4] x
(10/12) = $1,667
Year
Depr. Exp
Acc. Depr.
x1
1667 (10 months)
1,667
x2
2000 (12 months)
3,667
x3
2000 (12 months)
5,667
x4
2000 12 months)
7,667
x5
333 (2 months)
8,000
Operational Assets: Utilization and Disposition
7
1a. Straight-Line Method
Example 2 (contd.)
(Book value = Cost - Acc. Depr)
B/S (Year x1)
P.P.E.
Machine
Acc. Depr.
Net B/V
$10,000
(1,667)
8,333
B/S (Year x3)
P.P.E
Machine
Acc. Depr.
Net
$10,000
(5,667)
$ 4,333
B/S (Year x2)
P.P.E
Machine
Acc. Depr.
Net
$10,000
(3,667)
$6,337
B/S (Year x4)
P.P.E
Machine
Acc. Depr.
Net
$10,000
(7,667)
2,333
Operational Assets: Utilization and Disposition
8
1b. Sum-of-the-Years’-Digits (SYD)

Example 1: Machine costing $10,000 was
purchased on 1/1/x1 with an estimated residual
value of $2,000 and an estimated life of 4 years.
Depr. **Book Value
Year *Depr. Base Fraction Expense at the end
x1
$8,000
4/10
$3,200
6,800
x2
$8,000
3/10
$2,400
4,400
x3
$8,000
2/10
$1,600
2,800
x4
$8,000
1/10
$800
2,000
* Depr. Base= Cost - Residual Value
** Book Value= Cost - Acc. Depreciation
Operational Assets: Utilization and Disposition
9
1b. S-Y-D (contd.)

Example 2: (Partial Year)
Same information as in example 1 on
page 8 except that the machine was
purchased on 2/21/x1 rather than on
1/1/x1.
The depr. period of Year x1 = 10 months
Operational Assets: Utilization and Disposition
10
1b. S-Y-D
Example 2 (contd.)
Annual Depr.
By S-Y-D
Year
Method Months Computation
1
x1
$3,200
10
2
x2
$2,400
12
3
x3
4
x4
5
x5
Depr.
Exp
10/12x3200= $2,667
2/12x3200+
10/12x2400= $2,533
$1,600
12
2/12x2400+
10/12x1600= $1,733
$800
12
2/12x1600+
10/12x800= $934
Operational
and Disposition
2 Assets: Utilization
2/12x800=
$133 11
1c. Declining-Balance Method

Depreciation Exp.= constant rate  book
value at the beginning of the period
Residual
value is not considered in the
computation.
Assets cannot be depreciated below the
residual value.
The constant rate is expressed as a
function of a straight-line annual
depreciation rate.
Operational Assets: Utilization and Disposition
12
1c. Declining-Balance Method
(contd.)

Example of constant rate:
Life
S-L
of
Depr.
Asset Rate
4yrs
5yrs
10yrs
25%
20%
10%
DoubleDecliningBalance
Depr. Rate
50%
40%
20%
150%
DecliningBalance
Depr. Rate
37.5%
30%
15%
Operational Assets: Utilization and Disposition
13
1. Time-Based Methods
Double Declining-Balance Method

Example 1: Machine costing $10,000
purchased on 1/1/x1, with a residual
value of $2,000 and an estimated life of
4 years. A double declining-balance
method is used to depreciate the
machine. Thus, the constant rate is
twice of the S-L Depr. Rate (2 x 25% =
50%).
Operational Assets: Utilization and Disposition
14
Double Declining-Balance Method
Example 1 (contd.)
Book Value
of Asset
at Beg. of Constant Depr. Book Value
Year
the Year
Rate
Exp. At the End
x1
$10,000
50%
$5,000
$5,000
x2
$5,000
50%
2,500
2,500
x3
$2,500
50%
500*
2,000*
x4
2,000
50%
0
2,000
*Assets cannot be depreciated below the residual value.
Operational Assets: Utilization and Disposition
15
Double Declining-Balance Method
Example 2 (partial year)

Use the same information as the
example on page 13, except that the
machine was purchased on 3/10/x1.

The depreciation period of Year x1 = 10
months.

Two alternative treatments for the partial
year depreciation of the decliningbalance method are available as follows:
Operational Assets: Utilization and Disposition
16
Double Declining-Balance Method
Example 2 (contd.) - Alternative I
Annual Depr.
Using the
Recognized
D-D-B MonthsComputations Depr. Exp.
1 x1 $5,000 10
10/12x5000= $4,167
2 x2 $2,500
12
3 x3
$500
12
4 x4
5 x5
0
0
12
2
2/12x5000+
10/12x2500=
2/12x2500+
10/12x500=
2/12x500=
-
Operational Assets: Utilization and Disposition
$2,916
$834
$83
17
Double Declining-Balance Method
Example 2 (contd.) - Alternative II
Book
Value
Year at Beg.
Rate
x1 $10,000 50%
x2
$5,833
50%
x3
x4
$2,916
$2,000
50%
50%
Depr. Exp.
10/12x(10,000
x50%)= 4,167
12/12x(5,833
x50%)= 2,917
916
0
Book
Value
At the End
$5,833
2,916
2,0001
2,000
1.Assets cannot be depreciated below the residual value.
Operational Assets: Utilization and Disposition
18
1. Time-Based Methods
A Comparison of Depreciation Methods
Assuming expected life = 4 years
1. Straight-Line Method
2. S-Y-D Method
3. Declining-Balance Method
Depreciation
Expense
1
3
2
Year
Operational Assets: Utilization and Disposition
19
Changes In Depreciation Method
(i.e., Change from D-D-B to S-L)

Accounting treatment (SFAS No. 154: Accounting
Changes and Error Corrections, effective 1/1/2006):

Treated as an accounting estimate change
that is achieved by change in accounting
principle.
Method: Prospective method.
 The accounting for depreciation method
change is an example of revising US GAAP
to converge to iGAAP.

Operational Assets: Utilization and Disposition
20
1. Time-Based Methods
Changes In Depreciation Estimate

Accounting treatment: no retroactive
effect and make no adjustment for the
past years’ misstatement. Spread the
remaining undepreciated balance (i.e.,
the book value) less the revised (new)
residual value over the revised (new)
estimate of the remaining life of the
assets.
Operational Assets: Utilization and Disposition
21
Example: (S-L Depr. Method)

Machine costing $10,000 acquired on
1/1/x1.
Estimates Estimates
on 1/1/x1
on 1/1/x3
Residual value $2,000
$1,000
Life
4 years
5 years
Operational Assets: Utilization and Disposition
22
Example: (Contd.)
Year Depr. Exp Acc. Depr Book Value
x1
$2,0001
2,000
8,000
x2
$2,0002
4,000
6,000
x3
$1,667
5,666.7
4,333.3
x4
$1,667
7,333.4
2,666.6
x5
$1,667
9,000.1
1,000
1. (10,000-2,000)/4 = $2,000
2. (6,000-1,000)/(5-2) =1666.7
Operational Assets: Utilization and Disposition
23
For Financial Reporting Purposes
2. Activity-Based Method

Depreciation based on the usage of
assets. Depreciation bases -- hours of
usage or production units.
Method:
Units-of-Production
Method:
depreciation based on the usage of
the asset
Operational Assets: Utilization and Disposition
24
2. Activity-Based Method
Example

Machine costing $10,000 was purchased
on 5/20/20x1 with an estimated residual
value of $2,000 and an estimated service
hours of 8,000 hours.
Depreciation expense per hour
= ($10,000 - 2,000)/8,000 hours
= $1 per hour
Operational Assets: Utilization and Disposition
25
2. Activity-Based Method
Example (contd.)

During 20x1, the machine was used for
1,000 hours, the depreciation expense of
20x1:
$1 x 1,000 = $1,000
J. E.
12/31/x1
Depreciation Expense
1,000
Accumulated Depreciation
1,000
Operational Assets: Utilization and Disposition
26
For Financial Reporting Purposes
3. Special Methods
a. Group Depreciation (Group-Rate
Method).
b. Composite Depreciation (CompositeRate Method).
c. Retirement and Replacement Methods
(used by special Industries--public
utilities and railroads).
Operational Assets: Utilization and Disposition
27
3a.&b.
Group and Composite Methods

One depreciation rate is applied to
multiple assets (i.e., telephone poles,
switch boards, etc).

Group Method: Used when assets
have similar economic lives and other
attributes.

Composite Method: Used when
assets are physically dissimilar (i.e., a
group of heterogeneous assets).
Operational Assets: Utilization and Disposition
28
Group and Composite Methods
(contd.)


Both methods apply a single straight-line
rate based on the average service lives
of the group assets.
Once the group depreciate rate is
determined, it usually is used despite the
addition or disposition of individual assets
in the group.
Operational Assets: Utilization and Disposition
29
Group and Composite Methods (contd.)

When these methods are applied:
1. No partial year depreciation regardless
of when these assets were purchased.
2. No gain or loss can be recognized in
disposition of group assets except for
the disposition of last piece(s) of assets
in the group.
3. Cannot depreciate the remaining assets
to below their residual value.
Operational Assets: Utilization and Disposition
30
Examples (Group Method)

Five machines were purchased on
3/5/x1 at $10,000 each. All machines
were expected to last 4 years with a
residual value of $2,000 each.
Depreciation expense per year
= ($50,000-10,000)/4
= $10,000
Group annual depreciation rate
= $10,000/$50,000 = 20% (of cost)
Operational Assets: Utilization and Disposition
31
3a. Group Method
Example I

Use the information on page 29 (assuming
no early retirement or new purchase within 4
years), the following J.E. would be recorded
at the end of year:
12/31/x1 Depr. Exp
10,000
Acc. Depr.
10,000
12/31/x2 Depr. Exp
10,000
Acc. Depr.
10,000
12/13/x3 Depr. Exp
10,000
Acc. Depr.
10,000
12/31/x4 Depr. Exp
10,000
Acc. Depr.
10,000
Operational Assets: Utilization and Disposition
32
3a. Group Method
Example I (contd.)

Five machines were sold (disposed) on
3/5/x5 for $1,500 each.
J.E. (The Retirement of 5 machines)
3/5/x5 Cash
7,500
Acc. Depr.
40,000
Loss on Disposal
2,500
Machine
50,000
Operational Assets: Utilization and Disposition
33
3a. Group Method
Example II

Use information on page 29 and assume
one machine was sold for $6,000 on 3/10/x3.
Two were sold for $5,000 each on 8/9/x4 and
the last two were discarded on 9/20/x5.
12/31/x1 (Recording the group depreciation
expenses for Year x1)
Depreciation Expenses
10,000
Accumulated Depreciation
10,000
($50,000 x
20%
= $10,000)
(Total Cost) x (Group Rate)
Operational Assets: Utilization and Disposition
34
3a. Group Method
Example II (contd.)
12/31/x2 (Group Depreciation Expenses for Year x2)
Depreciation Expenses
10,000
Accumulated Depreciation
10,000
($50,000 x 20% = $10,000)
3/10/x3 (the disposal of the first machine)
Cash
6,000
Accumulated Depreciation
4,000a
Machine
10,000
a. No gain or loss can be recognized.
Operational Assets: Utilization and Disposition
35
3a. Group Method
Example II (contd.)
12/31/x3 (Group Depreciation Expenses for Year x3)
Depreciation Expenses
8,000
Accumulated Depreciation
8,000
[($50,000 - $10,000) x 20% = $8,000]
Cost for the
Group rate
remaining 4 machines
Machine
50,000 10,000
40,000
Operational Assets: Utilization and Disposition
36
3a. Group Method
Example II (contd.)
8/9/x4 (Sold 2 machines for $5,000 each)
Cash
10,000
Accumulated Depreciation
10,000a
Machine
20,000
a. No gain or loss can be recognized
12/31/x4 (Depreciation Expenses for Year x4)
Depreciation Expenses
2,000b
Accumulated Depreciation
2,000
[($50,000 - $10,000 - 20,000) x 20% = $4,000]
Cost for the remaining 2 machines
Group rate
b. See explanations on page 36.
Operational Assets: Utilization and Disposition
37
3a. Group Method
Example II (contd.)
Accumulated Depreciation (Before 12/31/x4)
Year x3 …4,000
10,000 … Year x1*
Year x4…10,000
10,000 … Year x2
8,000 … Year x3
14,000
**
* Therefore, book value of the last two machines
before depreciation of Year x4 => $20,000 -14,000
= $6,000
** As a result, maximum depreciation expense
allowed for the last 2 machines => (why??) $6,000
- (2,000x2) = $2,000
Operational Assets: Utilization and Disposition
38
3a. Group Method
Example II (contd.)
9/20/x5 (Discard the Last Two Machines)
Accumulated Depreciation (Before 12/31/x5)
x3 ... 4,000
10,000 … x1
x4 ...10,000
10,000 … x2
8,000 … x3
2,000 … x4
16,000
Accumulated Depreciation
Loss on Disposal
Machine
16,000
4,000
Operational Assets: Utilization and Disposition
20,000
39
3a. Group Method
Comments


No gain or loss can be recognized for
the disposal of group assets except for
the last unit(s). (Example, see example
II, Journal Entry for 3/10/x3 and 8/9/x4)
Cannot depreciate group assets to
below their residual value. (Example,
see journal entry of example II on
12/31/x4)
Operational Assets: Utilization and Disposition
40
3a. Group Method
Comments (contd.)

If a similar asset were purchased and
added to the group, a new group
depreciation rate may be computed as
follows:
(Book value of the old in the group + cost
of the new asset - estimated residual
value of the group) / (weighted average
lives of the assets in the group) (see
example III)
Operational Assets: Utilization and Disposition
41
3a. Group Method
Example III (calculating new group depr. rate)

Use the example on page 29. Additional
information is as follows:
One machine was sold on 4/10/x3 for
$7,000. A similar new machine was
acquired on 8/19/x4 for $12,000 with an
expected life of 4 years and $2,000
residual value. Two machines were sold
on 9/10/x4 for $5,000 each. The last three
machines were sold on 10/5/x5 for
$1,000, $2,000 and $1,500, respectively.
Operational Assets: Utilization and Disposition
42
3a. Group Method
Example III (contd.)
Journal Entries:
3/5/x1 (Purchasing of 5 machines on 3/5/x1)
Machine
50,000
Cash
50,000
12/31/x1 (Recording Depr. Exp. for Year x1)
Depreciation Expense
10,000
Accumulated Depreciation
10,000
12/31/x2 (Depreciation Expenses of Year x2)
Depreciation Expense
10,000
Accumulated Depreciation
10,000
Operational Assets: Utilization and Disposition
43
3a. Group Method
Example III (contd.)
4/10/x3
Cash
Accumulated Depreciation
Machine
7,000
3,000
10,000
12/31/x3
Depreciation Expense
8,000
Accumulated Depreciation
8,000
8/19/x4
Machine
Cash
12,000
12,000
Operational Assets: Utilization and Disposition
44
3a. Group Method
Example III (contd.)-New Group Depreciation Rate
Depreciation Expense
= [($15,000+$12,000)1 - ($2,000x4+2,000)2]/1.6 years3
= $10,625
New Group Depreciation Rate
= $10,625 / ($40,000 + 12,000)4
= 20.43%
1. Book Value of the remaining 4 machines.
2. Residual value of 4 remaining machines and the
new one.
3. The W-A lives of remaining machines and the new
one =>[(4-3) x 4 + 4] / 5 = 1.6 (years)
4. Total cost of 4 remaining machines and the new
one.
Operational Assets: Utilization and Disposition
45
3a. Group Method
Example III (contd.)
Journal Entries:
9/10/x4
Cash
Accumulated Depreciation
Machine
12/31/x4
Depreciation Expense1
Accumulated Depreciation
10,000
10,000
20,000
6,538
6,538
1. (62,000 -30,000) x 20.43% = $6,538
Operational Assets: Utilization and Disposition
46
3a. Group Method
Example III (contd.)
10/5/x5 sold the last 3 machines (update the
depreciation expenses for Year x5 because the
group is not fully depreciated to the residual
value of $6,000)
Depreciation Expenses
Accumulated Depreciation
4,4621
Cash
Accumulated Depreciation
Loss on Disposal
Machine
4,500
26,000
1,500
4,462
32,000
1. See explanation on next page.
Operational Assets: Utilization and Disposition
47
3a. Group Method
Example III (contd.)
Machine
3/x1 50,000
10,000 … 4/x3
8/x4 12,000
20,000 … 9/x3
32,000
Accumulated Depreciation
4/x3… 3,000
10,000 … 12/x1
9/x4…10,000
10,000 … 12/x2
8,000 … 12/x3
6,538 … 12/x4
21,538
Operational Assets: Utilization and Disposition
48
3a. Group Method
Example III (contd.)
* Book value of the last 3 machines on 10/5/x5
before the adjusting entry
= $32,000 - 21,538 = 10,462
Residual Value of the last 3 machines
= $2,000 x 3 = $6,000
==> max. depreciation expenses for Year x5
= 10,462 - 6,000 = $4,462
20.43% x $32,000 = $6,538 > $4,462
==> Depreciation exp. for Year x5 = $4,462
Operational Assets: Utilization and Disposition
49
Special Methods
b. Composite Method
(Apply to a group of dissimilar assets with different
expected lives and different salvage value)
Example:
Asset
Trucks
(All assets were purchased on 2/1/x1)
Acquisition
Depreciable
Cost
Salvage
Cost
Life
$145,000 $25,000 $120,000
3
Depr. Exp
Per Year
$40,000
Cars
$44,000
$4,000
$40,000
4
$10,000
Campers
$35,000
$5,000
$30,000
5
$6,000
$224,000 $34,000
$190,000
Total
Operational Assets: Utilization and Disposition
$56,000
50
3b. Composite Method
Example (contd.)
Composite Rate
= $56,000/ $224,000 = 25%
Composite Life
= $190,000/56,000 = 3.39 (years)
12/31/x1
Depreciation Expense
56,000
Accumulated Depreciation
56,000
Operational Assets: Utilization and Disposition
51
3b. Composite Method
Comments



Apply to a group of dissimilar assets.
No partial year depreciation.
All rules that are applied to the group
depreciation method also are applied to
the composite depreciation method.
No gain or loss can be recognized
when composite assets are retired
except for the last piece (pieces) of
assets being disposed.
Operational Assets: Utilization and Disposition
52
3b. Composite Method
Comments (contd.)


Cannot depreciate assets remained in
the group to below the residual value
If a new asset is purchased, a new
composite rate may be calculated.
Operational Assets: Utilization and Disposition
53
3b. Composite Method
Retirement of Composite Assets
(Similar accounting treatment as for the
retirement of group assets -- no gain or
loss can be recognized except for the
disposal of the last asset(s) in the group).
 i.e.,
Trunk 101 was sold on 3/8/x2 for
$1,000. The cost for truck 101 is
$8,000.
Operational Assets: Utilization and Disposition
54
Retirement of Composite Assets
(contd.)
3/8/x2Cash
Accumulated Depr.
Truck
1,000
7,000
8,000
At the end of the year, the composite rate 25%
would be applied to: ($224,000 - 8,000) = $216,000
$216,000 x 25% = $54,000
12/31/x2 Depreciation Exp.
54,000
Accumulated Depr.
54,000
Operational Assets: Utilization and Disposition
55
Special Methods
c. Retirement and Replacement Methods

Used by public utilities and railroad
companies which own many similar units of
small value (i.e. poles, conductors,
telephones,…).
 Retirement
Method:
Charge the cost of the retired assets (less
salvage) to depreciation expense.
 Replacement Method:
Charge the cost of newly purchased assets
(less the salvage value of the replaced
assets) to depreciation expense.
Operational Assets: Utilization and Disposition
56
Example
3c. Retirement and Replacement Methods
In 20x2, Greenway Co. purchased small tools
costing $10,000. In 20x3, tools originally
costing $3,000 were sold for $100 and
replaced with new tools costing $4,000.
Determine the depreciation expense for the
small tools for the year of 20x3.
Under the retirement method: $2,900
Uner the replacement method:$3,900
Operational Assets: Utilization and Disposition
57
3c. Retirement and Replacement Methods
Example (cont.)
Journal entries (under the retirement method)
20x2 Small Tools
10,000
Cash
10,000
to record the acquisition of small tools
20x3
Small Tools
4,000
Cash
4,000
to record the additional small tool acquisition
Operational Assets: Utilization and Disposition
58
3c. Retirement and Replacement Methods
Example (cont.)
Journal entries (retirement method cont.)
20x3 Cash
100
Depreciation expense
2,900
Small tools
3,000
to record sale/depre. of small tools
Operational Assets: Utilization and Disposition
59
3c. Retirement and Replacement Methods
Example (cont.)
Journal entries (under the replacement method)
20x2 Small Tools
10,000
Cash
10,000
to record the acquisition of small tools
20x3
Small Tools
4,000
Cash
4,000
to record the additional small tool acquisition
Operational Assets: Utilization and Disposition
60
3c. Retirement and Replacement Methods
Example (cont.)
Journal entries (replacement method cont.)
20x3 Cash
100
Depreciation expense
3,900
Small tools
4,000
to record sale/depre. of small tools
Operational Assets: Utilization and Disposition
61
Comments
3c. Retirement and Replacement Methods
1. No depreciation expense recognized
until assets are retired or replaced.
2. For railroad companies, these methods
are rarely used after 1983 due to ICC
required railroads to switch to traditional
depreciation accounting (i.e., S-L
method, SYD…).
Operational Assets: Utilization and Disposition
62
Disclosure of Depreciation
(APB No. 12)
1. Depreciation expense for the period.
2. Balances of major classes of
depreciable assets at the balance
sheet date.
3. Accumulated depreciation, either by
major classes of depreciable assets or
in total, at the balance sheet date.
4. A general description of the method or
methods used with respect to major
classes of depreciable assets.
Operational Assets: Utilization and Disposition
63
The Use of Alternative Depreciation
Methods -- Statistics from a Survey of 600 Companies
Source: Accounting Trends and Techniques1
Method
2010
2007
2001
1998
1991 1990
Straight Line
488
592
576
578 558 560
Declining balance
10
16
22
26
28
38
Sum of the years’ digits
3
5
7
10
8
11
An Accelerated method
(not specified)
17
27
53
50
70
69
Units of production
Group/composite
16
1
23
9
34
39
50
50
1.There are more than 600 responses because many companies use more
than one method of depreciation
.
Operational Assets: Utilization and Disposition
64
Miscellaneous Points Related To
Depreciation



Group method is applied to a group of
homogeneous assets with similar lives and
attributes (may or may not have the same residual value).
Composite method is used when assets are
physically dissimilar but are aggregated for
convenience.
Hybrid of combination methods: GAAP
allows any systematic and rational way to
allocate costs. Steel industry uses a
combination of straight-line and activity based
method (a production variable method).
Operational Assets: Utilization and Disposition
65
Miscellaneous Points Related To
Depreciation (contd.)





Selection of a depreciation method is based
on the goal of the company.
There is no cash flow involved in the
deprecation.
The depreciation method change should not
have an impact on stock price based on the
efficient market hypothesis.
This is supported by some research (Kaplan
& Roll, 1972).
Partial year depreciation is computed on the
basis of the nearest
Operationalfull
Assets:month.
Utilization and Disposition
66
For Income Tax Reporting Purposes
B. Income Tax Depreciation

Tax Depreciation in different periods:
1.GAAP depreciation methods (i.e., S-L, SYD
or DDB): Apply to assets acquired before
1981; cannot be depreciated to below the
residual value. IRS published tables with
estimated lives for depreciable assets .
2.ACRS: Accelerated Cost Recovery System
applies to assets purchased between 1981
- 1986.
3.Modified ACRS: MACRS applies to assets
purchased in 1987 or later.
Operational Assets: Utilization and Disposition
67
Tax Depreciation
ACRS & MACRS vs. GAAP

ACRS and MACRS differ with GAAP
depreciation in the following aspects:
a. a mandated tax life, which is generally
shorter than the economic life;
b. cost recovery on an accelerated basis;
c. an assigned salvage value of zero (i.e.,
salvage = $0);
d. Assume assets acquired in the midyear.
Operational Assets: Utilization and Disposition
68
Tax Depreciation
2. ACRS (Skip)



Classify depreciable assets into five classes
(i.e., 3, 5 ,10, 15 and 18 year classes).
Have a tax rate table for each class.
Examples of classes:
3-year class: cars, light-duty trucks,
equipment..
5-year class: office furniture, heavy duty
truck..
10-year class: depreciable real estate..
15-year class:
18-year class: buildings.
Operational Assets: Utilization and Disposition
69
2. ACRS (contd.) (Skip)
Rate Table for ACRS:
3-year
25%
38%
37%
5-year
15%
22%
21%
21%
21%
10-year
18%
14%
12%
10%
10%
9%
9%
9%
9%
9%
15-year
5%
10%
9%
8%
Operational Assets: Utilization and Disposition
70
Tax Depreciation
3. MACRS

MACRS was enacted by Congress in
the Tax Reform Act of 1986. Assets
are classified in 8 property classes
instead of 5 classes as in ACRS. In
addition, a specified GAAP depreciation
method is used in computing the
depreciation expense for all classes.
Operational Assets: Utilization and Disposition
71
MACRS Depreciation Methods
MACRS
Depreciation Method
Property Class
Double-Declining Balance 3,5,7 or 10-year
property
150%
Declining Balance
Straight-Line
15 or 20-year
property
27.5 or 39 year
property
Operational Assets: Utilization and Disposition
72
MACRS Property Classes
3-year property: small tools, horses, assets
used in R&D activities.
5-year property: automobiles, trucks,
computers, peripheral
equipment, office machines.
7-year property: office furniture,equipment.
10-year property: railroad tank cars, mobile
homes.
Operational Assets: Utilization and Disposition
73
MACRS Property Classes (contd.)
15-year property: roads, shrubbery, lowincome housing, sewage
treatment plants.
20-year property: certain real estate.
27.5 -year property: residential rental
property.
39-year property: nonresidential real
property.
Operational Assets: Utilization and Disposition
74
Principles Applied to MACRS
1. No residual value assigned (100%
depreciation for tax purposes). All proceeds
from the disposal of a fully depreciated asset
are fully taxable.
2. Assume acquired in the mid-year (half-year
convention).
3. When applying 150% declining balance(DB)
method or DDB method, the depreciation
method should be switched to S-L method if
S-L method results in a higher depreciation
expense than that of the DB method.
Operational Assets: Utilization and Disposition
75
MACRS
Example
Cost= $200,000 (purchased on 10/2/x1).
 Expected life= 8 years.
 Salvage= $40,000.
 GAAP depr. method= Straight-Line.
 MACRS life = 5 years.
 MACRS method= Double-Declining
Balance Method.
 Disposal proceeds – 1/2/x9 = $22,000

Operational Assets: Utilization and Disposition
76
MACRS
Example (contd.)
Year
Depr. Exp
x1 $200,00040%0.5= 40,000
x2 160,000  40% = 64,000
x3 96,000  40% = 38,400
x4 57,600  40% = 23,040
x5
34,560/ 1.51
= 23,040
x6
11,520
Dep.% BookV
20% 160,000
32% 96,000
19.2% 57,600
11.52% 34,560
11.52% 11,520
5.76%
0
1.DDB depr for year x5 is 34,560  40% = 13,824.
The S-L method results in a higher depr. exp. (i.e.,
$23,040) than that of DDB in year x5. Thus, the depr.
Method should be switched to the S-L method in x5.
Operational Assets: Utilization and Disposition
77
GAAP Depreciation and Gain/Loss
at Disposal
 Annual GAAP depreciation
= ($200,000-40,000)/8 =$20,000
 Accumulated GAAP depre. over 8 years
= $20,000x8= $160,000
 Disposal loss for finanical reporting
= $22,000 - 40,000 = -18,000
 Disposal gain for tax filing= $22,000 – 0 =22,000
Operational Assets: Utilization and Disposition
78
Gain/Loss at Disposal (contd.)
 Total expense recognized for tax filing
= accumulated tax depreciation – disposal gain
= $200,000 -22,000= $178,000
 Total GAAP expense
= accumulated GAAP depreciation + disposal loss
= $160,000+18,000=178,000
 Even though the net effects on income (i.e.,
$178,000 total expense) are the same,
MACRS enables companies to defer income
tax payments to later years.
Operational Assets: Utilization and Disposition
79
Table 11A-3
MACRS DEPR. RATES BY CLASS OF PROPERTY
.
Recovery 3-year 5-year 7-year 10-year 15-year 20-year
Year (200% DB) (200% DB) (200% DB) (200% DB) (150% DB) (150% DB)
1
33.33 20.00
2
44.45 32.00
3 14.81* 19.20
4
7.41 11.52*
5
11.52
6 ………..
5.76
7
8
9
14.29
24.49
17.49
12.49
8.93*
8.92
8.93
4.46
10.00
18.00
14.40
11.52
9.22
7.37
6.55*
6.55
6.56
5.00 3.750
9.50 7.219
8.55 6.677
7.70 6.177
6.93 5.713
6.23 5.285
5.90* 4.888
5.90 4.522
5.91 4.462*
* Switchover to straight-line depreciation.
Operational Assets: Utilization and Disposition
80
Table 11A-3 (contd.)
Recovery 3-year 5-year 7-year 10-year 15-year 20-year
Year (200% DB) (200% DB) (200% DB) (200% DB) (150% DB) (150% DB)
10
11 ………………………………
12
13
14
15
16
17
18
19
20
21
6.55
3.28
5.90
5.91
5.90
5.91
5.90
5.91
2.95
Operational Assets: Utilization and Disposition
4.461
4.462
4.461
4.462
4.461
4.462
4.461
4.462
4.461
4.462
4.461
2.231
81
Tax Versus GAAP Depreciation
 Purpose of tax depreciation: to raise
revenue.
 Purpose of GAAP depreciation: for
financial reporting to fairly reflect the
performance of a company.
 With difference purposes, tax
depreciation is different from GAAP
depreciation.
Operational Assets: Utilization and Disposition
82
C. Asset Impairmentsa


Unlike inventory which is reported at
LCM, PPE and Intangibles are
reported at cost except for impairments.
An impairment occurs when the book
value of an asset is not fully
recoverable.
a. Based on SFAS No. 144: Accounting for the
Impairment or Disposal of Long-Lived Assets and
SFAS No. 142: Goodwill and Other Intangible
Assets
Operational Assets: Utilization and Disposition
83
C. Asset Impairments (all intangibles related
impairments (i.e., C1b and C1c) should be deferred
until chapter 12 is discussed)

C.1: Operational Assets Held for Use
a.
b.
c.


Tangible assets and intangible assets
with finite life (i.e., patens, copyrights).
Intangible assets with indefinite life other
than goodwill (i.e., trade names).
Goodwill
C.2: Operational Assets Held for Sale
C.3: Operational Assets Held to be
Disposed of other than by Sale
Operational Assets: Utilization and Disposition
84
C.1a Operational Assets Held for Use –
Tangible Assets and Finite-Life Intangibles (Patents,
etc)


SFAS No. 144 (effective 2002) requires
test for impairment only when events
or changes in circumstances indicate
that the book value of this asset (or
asset group) may not be recoverable.
For the purpose of this test, assets are
grouped at the lowest level in which the
cash flows of each group are
independent.
Operational Assets: Utilization and Disposition
85
Events or Changes in Circumstances
Which May Lead to an Impairment
The following are examples of such events or
changes in circumstances:
1. A significant decrease in the market price of
the asset (asset group).
2. A significant adverse change in how the
asset is being used or in its physical
condition.
3. A significant adverse change in legal factors
or in the business climate that affects the
value of the asset.
Operational Assets: Utilization and Disposition
86
Events or Changes in Circumstances
Which May Lead to an Impairment (Cont.)
4. An accumulation of costs significantly in
excess of the amount originally expected
for the acquisition or construction of an
asset.
5. A current-period loss combined with a
history of losses or a projection of
continuing losses associated with an
asset.
6. A realization that the asset will be
disposed of significantly before the end
of its estimated life. (not in SFAS 121)
Operational Assets: Utilization and Disposition
87
The Accounting Treatment for Impairment
(for Held for Use Tangible and finite-Life Intangibles)
Steps:
1. Conduct the Recoverability Test.
2. Compute the Impaired Amount.
Operational Assets: Utilization and Disposition
88
Step 1: Conduct the Recoverability
Test

Compare the book value (BV) of the
asset with the undiscounted expected
future cash flows (EFCF) of the asset
(asset group).
If BV > Undiscounted EFCF, the
impairment has occurred and the
impaired amount should be written off.
Operational Assets: Utilization and Disposition
89
Step 2: Compute The Impaired
Amount


Impaired amount
= Book value - fair value
(if the fair value is available) or
Impaired amount
= Book value – estimated fair value1
(if fair value is not available)
1. discounted present value of the future cash flows
of the asset can be the estimated fair value
Operational Assets: Utilization and Disposition
90
Write Off the Impaired Amount

Recognition of Impairment Loss:
Loss on Impairment1
$$$$$
Accumulated Depre.
$$$$$
1. Reported as part of income from continuing
operations, not extraordinary losses.
Operational Assets: Utilization and Disposition
91
Impairment (contd.)


After the write off, the fair value (or the
estimated fair value if fair value is not
available) becomes the new cost base
for depreciation.
No restoration of impaired loss is
allowed for tangibles and finite-life
intangibles assets held for use.
Operational Assets: Utilization and Disposition
92
iGAAP –Assets Impairments



iGAAP, as in US GAAP, allows
reporting impairments on PPE.
iGAAP, as in GAAP, use fair value test
to measure the impairments.
In determining the impairment loss,
iGAAP compares the book value with
the fair value (thus, iGAAP is more
strict than US GAAP in this test).
Operational Assets: Utilization and Disposition
93
iGAAP – PPE Valuation and
Impairment (contd.)

iGAAP, unlike GAAP, permits write-ups
for subsequent recoveries of
impairment losses back to the amount
before the impairments (i.e., the
reversals of impairment losses).
Operational Assets: Utilization and Disposition
94
Impairment (contd.)

Disclosure Requirements of impairment
loss:
1. A description of the impaired asset or
asset group.
2. The facts and circumstances leading to
the impairment.
3.The amount of the loss.
4.The method used to determined the fair
value.
Operational Assets: Utilization and Disposition
95
C.1.b. Intangibles with indefinite life Other
than Goodwill – (Held-for-Use)

For indefinite life intangibles (i.e., trade
names) held for use, impairment test
should be conducted at least annually
or more often if events or changes in
circumstances indicate an impairment.

Test of Impairment: one-step test =>

Compare book value with the fair value.
Operational Assets: Utilization and Disposition
96
C.1.b. (contd.)




If book value > fair value, impairment loss
exits and should be recognized.
The fair value becomes the new cost
base.
A recovery of the impairment loss is
prohibited.
Disclosure requirements are similar to
those of tangible and finite-life intangibles.
Operational Assets: Utilization and Disposition
97
C.1.c. Impairment for Goodwill (SFAS
142)


The cost of goodwill cannot be directly
associated with any specific identifiable
right.
Also, goodwill cannot be separated from
the company (or a reporting unit)a as a
whole.
a. An operating segment of a company or a
component of an operating segment for which
discrete financial information is available and
segment management regularly review the
operating results of that component.
Operational Assets: Utilization and Disposition
98
C.1.c. Impairment for Goodwill
(cont.)


Step 1: The impairment test for goodwill
is to compare the book value of a
reporting unit for goodwill unit with the
fair value of this reporting unit.
Reasons: 1)the value of goodwill is not
associated with any specific cash flows of
any specific asset; 2) goodwill is not
separable from a particular reporting unit
Operational Assets: Utilization and Disposition
99
Impairment for Goodwill (cont.)


If book value exceeds the fair value
for the reporting unit of the goodwill,
an impairment loss exists.
The impairment test should be
conducted at least annually or more
often if impairment indicated.
Operational Assets: Utilization and Disposition
100
Impairment for Goodwill (cont.)

If goodwill is tested for impairment at
the same time as other assets of the
reported unit, the other assets must
be tested first and adjusted for
impairment (if any) prior to testing
goodwill.
Operational Assets: Utilization and Disposition
101
Impairment for Goodwill (cont.)


Step 2: If goodwill impairment exits,
the goodwill impairment loss equals:
Book value of goodwill – implied fair
value of goodwilla
a The implied fair value of goodwill is calculated in
the same way that goodwill is determined in a
business combination.
Operational Assets: Utilization and Disposition
102
Impairment for Goodwill (cont.)
Example of calculating implied goodwill of
a reporting unit:
Determination of Implied goodwill:

Fair value of the reporting unit
Fair value of the reporting unit's
net assets (excluding goodwill)
Implied value of goodwill
$400 million
$330 million
$ 70 million
Operational Assets: Utilization and Disposition
103
Impairment for Goodwill (cont.)
Determination of impairment loss:
Book value of goodwill
Implied fair value of goodwill
Impairment loss
$320 million
70 million
250 million
Operational Assets: Utilization and Disposition
104
C.2 Impairment for Operational
Assets to be Sold (SFAS 144)


If the impaired asset is to be disposed
ofa by sale, the following principles
apply:
1. An impairment test needs to be
conducted when an asset is considered
as held for sale.
2. A one-step test: impairment exists
when book value exceeds fair vale.
a. Assets which managers have actively committed to
sell immediately in their present condition and for
which sale is probable, including assets held
for sale of discontinued operations.
Operational Assets: Utilization and Disposition
105
Impairment for Operational Assets
to be Sold (cont.)
3. The impaired amount = book value (fair value - disposal cost)a,b.
4. No depreciation after the write-down.
a. Fair value – disposal cost = the net realizable
value
b. if the asset is unsold in the subsequent
period, the restoration of the
impairment loss is allowed when the
fair value rebounded in the subsequent
period.
Operational Assets: Utilization and Disposition
106
C.3 Impairment for Operational Assets to
Be Disposed Other Than by Sale


Examples of this type of assets: assets
to be abandoned, exchanged for a
similar assets or distributed to owners in
a spin-off.
SFAS 144 requires these assets to be
treated as assets held for use until they
are disposed of.
Operational Assets: Utilization and Disposition
107
Summary of Asset Impairment:
Assets Held for Use
Asset Type
When to Test
Impair. Test
To be used:
Tangible and
Intangible
Events indicate
BV not
recoverable
Two-Step:
1. BV > EFCF
2. BV - FV
(finite life))
Intangible(inde Annually or
finite, excluding more often
goodwill)
Goodwill
Annually or
more often
One-Step:
BV – FV
1.BV (reporting unit)
> FV
2. BV of goodwill –
implied FV
Operational Assets: Utilization and Disposition
108
Summary of Asset Impairment:
Assets Held to Be Disposed of
Asset Type
When to Test
Impair. Test
To be sold
When
One-Step:
(including assets considered held BV > (FV-disposal
cost)
of discontinued for sale
operations)
To be
disposed of
other than
sale
No depreciation
after write-down
Considered as
held for use
until disposal
Depre. Life needs
to be revised
based on APB 20
Operational Assets: Utilization and Disposition
109
The Impact of SFAS 144 on the Disposal
Loss of Discontinued operations


SFAS 144 applied to assets for both
continuing and discontinued
operations (Par. 41).
Therefore, the assets held for sale of
the discontinued operations are also
reported at the lower of book value or
the (fair value - cost to sell), not at the
net realizable value as prescribed in
APB 30.
Operational Assets: Utilization and Disposition
110
The Impact of SFAS 144 on the Disposal
Loss of Discontinued operations (contd.)

Also, the future operating losses of the
discontinued operations are no longer
recognized before they occur under
SFAS 144.
Operational Assets: Utilization and Disposition
111
The Impact of SFAS 144 on the Disposal
Loss of Discontinued operations (cont.)


The impairment loss (disposal loss) of
the assets held for sale under the
discontinued operations is reported as
a component of the discontinued
operations.
See Chapter 4 notes for detailed
discussion of the reporting of the
operating results and disposal results
for discontinued operations.
Operational Assets: Utilization and Disposition
112
Impairment Losses and Earnings
quality


Similar to the write-down of inventory
and restructuring costs, impairment
losses can have significant adverse
impact on the current year's income
number.
When fair value needs to be
estimated, the estimation of fair value
requires the forecast of future cash
flows generated by the asset.
Operational Assets: Utilization and Disposition
113
Impairment Losses and Earnings
quality (contd.)


Companies can understate future
cash flows to understate the fair value
and overstate the write-down amount.
By writing down large amounts of
operational assets, companies are
able to increase future earnings by
lowering future depreciation, depletion
or amortization.
Operational Assets: Utilization and Disposition
114