Chapter 11 11-27

11

Investments in Noncurrent Operating Assets—Utilization and Retirement

Overview

Asset utilization really means the expensing of an asset over its useful life. For tangible, fixed assets, this is called depreciation. For most intangible assets, the same thing as depreciation happens, but it is referred to as amortization. Finally, for natural resources, the same process is called depletion.

Assets can also become impaired, which means that they are expensed faster than their previous useful life would have indicated because of some change of events. The calculation and process by which impairment is indicated varies depending on the type of asset.

Assets can also be disposed of, sold, or exchanged. When this happens, the company removes the asset from the book (along with any contra account like Accumulated Depreciation if such an account exists) and records a gain or loss for the difference between the book value and the amount received (if any).

Companies generally keep multiple sets of fixed asset records. This is because the assets frequently have different useful lives, or methods by which they are depreciated, for financial accounting and income tax accounting purposes. One common convention that is usually different for book and income tax purposes is when to begin and finish depreciation. For financial accounting (book) purposes, most companies use a monthly convention. For income tax purposes, most assets must be depreciated using a half-year convention, which means that the asset is depreciated for half a year in the year in which it is purchased and disposed regardless of the actual date.

Learning Objectives

Refer to the Review of Learning Objectives at the end of the chapter. It is crucial that this section of the chapter is second nature to you before you attempt the homework, a quiz, or exam. This important piece of the chapter serves as your CliffsNotes or “cheat sheet” to the basic concepts and principles that must be mastered.
If after reading this section of the chapter you still don’t feel comfortable with all of the Learning Objectives covered, you will need to spend additional time and effort reviewing those concepts that you are struggling with.
The following “Tips, Hints, and Things to Remember” are organized according to the Learning Objectives (LOs) in the chapter and should be gone over after reading each of the LOs in the textbook.

Tips, Hints, and Things to Remember

LO1 – Use straight-line, accelerated, use-factor, and group depreciation methods to compute annual depreciation expense.

How? Students don’t usually have a problem with straight-line depreciation. It is the method they are most familiar with, and it is the easiest to calculate anyway. Since very few companies use the sum-of-the-years’-digits method, professors may not bother testing you on it. Ask your professor before completely skipping the sum-of-the-years’-digits method. The main thing with the sum-of-the-years’-digits method is to realize that it is an accelerated method.

Use-factor methods are pretty intuitive. You probably don’t need to memorize anything with regards to these methods. Just do what makes sense, and you are likely to get use-factor methods right. That leaves declining-balance depreciation methods as the area to focus your learning on.

Declining-balance methods aren’t as popular as the straight-line method for financial accounting purposes, but it is the most widely used method for income tax purposes. Expect to be tested on this method. There are four things to keep in mind with declining-balance methods:

1.  The straight-line rate is doubled with the double-declining-balance method (and multiplied by 1.5 if the 150 percent-declining balance method is used).

2.  The rate is applied to the book value, not the depreciable cost as is the case with most other methods.

3.  Residual values are ignored in the early years. Depreciation essentially stops when the residual value and book value meet.

4.  This is an accelerated method so expect more depreciation in early years and less depreciation in later years when compared to the straight-line method.


LO2 – Apply the productive-output method to the depletion of natural resources.

How? The productive-output method is essentially the same as the use-factor methods discussed in LO1 for fixed assets. Once the quantity of the natural resource is known (or reasonably estimated), the calculation is merely a matter of allocating the total cost to the individual units in the resource and then depleting the resource as it is extracted and sold (mined, harvested, removed, etc.) at that rate. Buy 10 trees for $10 and you have $1 of depletion that each tree harvested. It’s as simple as that.

LO3 – Incorporate changes in estimates and methods into the computation of depreciation for current and future periods.

How? Changes are accounted for in the current and future periods. This is done through a simple two-step process:

Step 1: Calculate the book value of the asset as of the end of the prior period.

Step 2: Calculate the new deprecation with the new facts provided by the change the same way you would for LO1 with a newly acquired asset. Use this new figure for the current period (and for future periods as well if using the straight-line method).

Changes will be gone over in much more detail (and include changes other than depreciation) in Chapter 20. The other key item to note at this point is that changes must be disclosed in the notes to the financial statements.

LO4 – Identify whether an asset is impaired, and measure the amount of the impairment loss using both U.S. GAAP and IASB standards.

How? For those of you who think better with graphics laid out in front of you, here is a pictorial description of how impairment losses are handled.

$ / $$ / $$$ / $$$$ / $$$$$
Book value / Book value / Book value
Discounted future cash flows / Undiscounted future cash flows
Impairment
No Impairment / No Impairment / Write asset down to fair value

Looking at the table, representing five different dollar amounts (three hypothetical book values, discounted future cash flows, and undiscounted future cash flows), will hopefully make things clearer. What it means is that impairment will only exist when the book value of the asset is greater than the undiscounted future cash flows ($$$$ Undiscounted future cash flows < $$$$$ Book value = Impairment). Impairment does not exist when the book value is less than undiscounted future cash flows ($$$ Book value < $$$$ Undiscounted future cash flows ≠ Impairment). However, when book value is more than undiscounted future cash flows, the asset is written down to fair value. Fair value can be approximated using the present value of estimated future cash flows (discounted future cash flows).

LO5 – Discuss the issues impacting proper recognition of amortization or impairment for intangible assets.

How? Most of this section is the same as, or similar to, issues already raised. Amortization is basically the same thing as straight-line depreciation except that it is applied to intangibles with a finite life instead of tangible assets. Where this section becomes more difficult is with impairment of goodwill or other intangibles with an indefinite life.
Goodwill has an infinite life so it is not amortized for financial accounting purposes. It does, however, need to be tested on an annual basis for impairment (unlike other assets which are tested whenever there has been a material change in the way they are used, a change in the business environment, or if management obtains information suggesting that the market value of an asset has declined).

Goodwill is usually impaired if the fair value of the reporting unit is less than the net book value of the assets and liabilities. The amount of the impairment, if any, is the difference between the amount of goodwill on record and the goodwill currently assignable to the reporting unit (i.e., the difference between the overall fair value of the reporting unit and the reporting unit’s fair value of the net assets).

So if Company A buys Company B for $1,000,000 when Company B’s fair value of their net assets is $900,000, then $100,000 of goodwill is recorded. If the book value drops to $850,000 due to $50,000 in depreciation and what once was Company B can be sold for over $850,000, then there is nothing to worry about. If what once was Company B has declined in value and can now only be sold for $800,000, then goodwill is impaired. The $100,000 of goodwill should be written off.


LO6 – Account for the sale of depreciable assets in exchange for cash and in exchange for other depreciable assets.

How? Students frequently have trouble with the journal entry related to the disposition of depreciable assets. Recall from earlier chapters that you should approach journal entries by filling in the things you know should be there, and then the rest of the entry should come easier. Also, recall that you shouldn’t leave things on the books that are no longer there.

With those two things in mind, assuming cash is received, you know that Cash is going to receive a debit. If the asset has been depreciated, then you have to get the Accumulated Depreciation for that asset off the books with a debit. The other debit you may have would be to a Loss account (assuming there is a loss on the deal). Remember that losses have the same effect as expenses, so they are both increased with a debit.

To remove the asset from the books requires a credit to the asset account. The other credit you may have would be to a Gain account.

First, set up the entry with the five skeleton accounts mentioned above. Then plug in the items you know (Cash, Accumulated Depreciation, and the asset). If you are missing a credit, you have a gain which should be plugged to the gain with a subsequent removal of the loss part of the entry. If you are missing a debit, it is just the opposite with the difference going to the loss and the removal of the gain portion of the journal entry.

How? What if cash isn’t the item received? Things don’t usually change much if something other than cash is received. Instead the item received gets the debit instead of Cash. There are a few exceptions or items that are noteworthy to keep in mind as follows:

·  Sometimes cash is given up in an exchange, and in those cases, Cash receives a credit rather than a debit.

·  In exchanges that lack commercial substance, assets received are recorded at the book value of assets given up and gain is generally not recognized.

·  In exchanges that lack commercial substance, if a small amount of cash is received in the transaction, the company receiving the cash would recognize some of the gain.

·  In exchanges in which large amounts of cash are involved, the indicated gains are recognized.

LO7 – Compute depreciation for partial periods, using both straight-line and accelerated methods.

Why? Conventions such as mid-month, monthly (frequently used for financial accounting purposes), or half-year (usually required for income tax purposes) make depreciation computations simpler in the year of acquisition and disposition. Otherwise, companies would have to compute how many days an asset was in use both during the first and the last year of use. That process can be cumbersome for a company with thousands of acquisitions and dispositions each year.

LO8 – Understand the depreciation methods underlying the MACRS income tax depreciation system.

Why? MACRS is less flexible than financial accounting depreciation. Certain assets are lumped into certain categories and follow a set of fixed procedures for income tax depreciation purposes. Companies that may be depreciating an asset over, say, ten years for financial accounting purposes may be forced to depreciate the same asset over five years for MACRS income tax purposes.

The purposes of this are several: simplicity, tax benefits (to encourage companies to purchase more fixed assets since they can write off the expense quicker and pay less in income taxes sooner), and less wiggle room for companies to choose how they want to take their deductions. Double-declining-balance method is the norm for most assets (other than real estate) under MACRS.

The following sections, featuring various multiple choice questions, matching exercises, and problems, along with solutions and approaches to arriving at the solutions, is intended to develop your problem-solving and critical-thinking abilities. While learning through trial and error can be effective for improving your quiz and exam scores, and it can be a more interesting way to study than merely re-reading a chapter, that is only a secondary objective in presenting this information in this format.

The main goal of the following sections is to get you thinking, “How can I best approach this problem to arrive at the correct solution—even if I don’t know enough at this point to easily arrive at the proper results?” There is not one simple approach that can be applied to all questions to arrive at the right answer. Think of the following approaches as possibilities, as tools that you can place in your problem-solving toolkit—a toolkit that should be consistently added to. Some of the tools have yet to even be created or thought of. Through practice, creative thinking, and an ever-expanding knowledge base, you will be the creator of the additional tools.

Multiple Choice

MC11-1 (LO1) Depreciation of operating assets is an accounting process for the purpose of

a. / reporting declining asset values on the balance sheet.
b. / accounting for costs to reflect the change in general price levels.
c. / allocating asset costs over the periods benefited by use of the assets.
d. / setting aside funds to replace assets when their economic usefulness expires.

MC11-2 (LO1) Which of the following statements is the assumption on which straight-line depreciation is based?