978-0324651140 Chapter 9 Lecture Note

9-1 Notes

CHAPTER 9

LONG-LIVED TANGIBLE AND INTANGIBLE ASSETS:

I. Learning Objectives

1. Understand the concepts distinguishing expenditures on long-lived assets

that qualify for asset recognition from expenditures that firms treat as

expenses in the period incurred.

2. Understand the concepts underlying the measurement of acquisition cost.

3. Understand the distinction between finite-lived and indefinite-lived assets

and the implications for depreciation or amortization.

4. Develop the skills to compute depreciation based on initial estimates of

useful life and residual value and to adjust depreciation for changes in

those estimates over time.

5. Develop the skills to compute an impairment loss on long-lived assets.

6. Develop the skills to record the disposal of assets at various selling prices.

II. Organization of Class Sessions

The coverage of the various topics in this chapter depends on the total

amount of class time that we devote to this chapter. When we devote one hour

of class time, we emphasize the accounting for depreciable assets, including

measurement of acquisition cost, depreciation, and disposal. When we devote

two hours of class time, we consider the accounting for intangible assets. A

third hour of class time permits us to explore in greater depth issues in

capitalizing versus expensing expenditures on depreciable assets, revisions of

depreciable lives, and impairment losses. The application of these concepts to

depreciable and intangible assets, however, is more difficult than for

inventories.

Notes 9-2

III. Lecture Outline

1. Understand the concepts distinguishing expenditures on long–

lived assets that qualify for asset recognition from expenditures

that firms treat as expenses in the period incurred.

2. Understand the concepts underlying the measurement of

acquisition cost.

Begin by reviewing the definition of an asset: a resource that provides

a firm with future benefits. Then review the concept that accountants

measure these benefits using the acquisition cost of the assets. This

does not fully settle the accounting problem; we must address the

question as to which expenditures on an asset accountants should

include in acquisition cost. The general concept is that acquisition cost

should include all costs necessary to prepare an asset for its intended

use. Application of this concept to purchased depreciable assets is

straightforward, but we must remember to include freight charges and

installation costs. For self-constructed assets, the problem is more

difficult. Many costs are easily traceable to the self-constructed asset

and clearly are a component of acquisition cost. Many expenditures are

more indirect, such as the salaries of administrative personnel

overseeing the construction. Some expenditures are relatively small and

firms immediately expense them. Similar issues arise when

distinguishing repairs and maintenance expenditures (expensed when

incurred) and betterments (capitalized and amortized). We work

Exercise 9.15 to illustrate the difficulties accountants often encounter in

applying the broad concepts of acquisition cost accounting to depreciable

assets. Students need to see that accounting is not as clear-cut as they

probably think.

3. Understand the distinction between finite-lived and indefinite-

lived assets and the implications for depreciation or amortization.

We begin by explaining the students that finite life is when the asset

services over time are recognized as expense each period. When the

length of benefit for an asset cannot be estimated it is said to have

indefinite life. Important distinction between the two should be made.

We attempt to get students to see that inventories and depreciable

assets are similar in one important respect: they both provide future

benefits to a firm. An inventory item provides all of its future benefit in

a single accounting period (that is, when it is sold). A depreciable asset,

on the other hand, provides its future benefits over several accounting

periods. Accounting allocates the acquisition cost of an inventory item to

9-3 Notes

the period of sale as an expense. Accounting allocates the acquisition

cost of a depreciable asset to the periods of its use. Thus, the concepts

are similar. The difficulties arise in deciding how much of the

acquisition cost the accountant should allocate to each accounting

period. The analogy breaks down somewhat when accounting applies the

lower of cost or market method to inventories, because both valuation

and cost allocation enter the picture.

4. Develop the skills to compute depreciation based on initial

estimates of useful life and residual value and to adjust

depreciation for changes in those estimates over time

Depreciation accounting requires the following information:

(1) The acquisition cost of a depreciable asset,

(2) An estimate of the number of periods during which the firm expects to

receive benefits from the asset, and

(3) The pattern of benefits received. Issues in measuring acquisition cost

were discussed under the first and second learning objectives.

Estimating the service life of a depreciable asset requires information

on the manner in which a firm intends to use the asset. A machine used

24 hours each day will have a shorter life than one used 8 hours a day. A

machine that undergoes regular maintenance will last longer than one

that the firm services only when a problem arises. Service life estimates

also require predictions about new technologies that might hasten the

obsolescence of the asset. We conclude discussion of service life by asking

whether a firm has an incentive to choose a shorter or longer life than the

expected economic life. The response to this question depends on

whether it relates to financial or tax reporting. A firm can delay the

recognition of depreciation by choosing a longer life and thereby

maximize cumulative reported earnings to shareholders. Choosing a

shorter depreciable life for tax purposes maximizes the present value of

tax savings from depreciation deductions. Firms are not required to use

the same depreciable life for financial and tax reporting.

Determining the pattern of depreciation involves answering the

question: How much of the benefit does a firm expect to receive from

using the assets and how much does it expect to receive from disposal of

the asset? The portion of the acquisition cost that the firm expects to

receive from disposal of the asset (that is, the salvage value) gets

allocated to the period of disposal (that is, the salvage value is in effect a

revenue and the allocated portion of the acquisition cost of the asset is in

effect an expense, so no gain or loss arises if the actual salvage value

Notes 9-4

coincides with expectations). The remaining acquisition cost gets

allocated to the periods when the firm uses the asset. We try to get

students to see that a firm cannot observe the pattern by which it uses up

a depreciable asset’s benefits, so any pattern is probably as “accurate” as

any other. After illustrating the calculation of depreciation using various

depreciation methods, we discuss how a firm should choose a depreciation

method for financial reporting. (Exercises 9.19 and 9.20)

5. Develop the skills to compute an impairment loss on long-lived

assets.

The accounting for impairment losses on tangible assets with finite lives

requires a distinction between

(1) Recognition and

(2) Measurement of the loss.

Recognition of Impairment Loss—if Book Value of Assets Exceeds the

Sum of Expected Undiscounted Cash Flows from the Asset.

Measurement of Impairment Loss—equals Book Value of Assets minus

Present Value of Expected Cash Flows from the Asset.

We raise the question: Which of these two approaches best captures

the economic loss that a firm incurs from asset impairment? It is clear

that the second approach, which compares the book value of the assets

to the present value of expected cash flows, best measures the economic

loss. Then ask: Is it possible that a firm would incur an economic loss

but would not recognize the loss under GAAP? The answer is clearly

yes. For this to occur, the undiscounted expected cash flows would

exceed the book value of the asset, but the discounted expected cash

flows would be less than the book value. Finally, ask: Why might the

FASB have imposed a recognition test that uses undiscounted cash

flows? We confess that we see no economic rationale for such a test.

However, in accounting, income is cash in minus cash out, other than

transactions with owners. Thus, if the undiscounted cash flows from an

asset exceed its book value, that asset will not generate an accounting

loss. It can easily generate an economic loss (think invest $1 today to

get back $1.10 in five years, which generates an accounting profit of $5,

even though no sensible person would undertake such a project as it

does not make economic sense). The FASB uses the concept of

recoverability to justify this test. Recoverability means that a firm will

receive cash flows in the future whose sum equals or exceeds the current

book value of the asset, so there is no accounting loss. We use Problem

8.41 to illustrate the recognition and measurement of impairment losses

9-5 Notes

on tangible assets. We tend not to spend much class time on

impairment losses for intangible assets. (Exercises 9.09, 9.10, 9.11, 9.21,

9.24, and 9.25)

6. Develop the skills to record the disposal of assets at various

selling prices.

Chapter 5 discussed the accounting for asset disposals, so the

instructor may not wish to spend class time on this topic at this point.

The one concept we attempt to get across is that gains and losses on

disposal would not occur if the firm predicted correctly the amount of the

salvage value. If the actual salvage is less than the estimated amount,

the firm recognized too little depreciation during the asset’s useful life.

The loss on disposal represents additional “depreciation” recognized in

the period of disposal. Had the firm perfect foresight, it would have

charged more for depreciation and income would have been smaller. The

loss is catch-up depreciation—catch-up relative to perfect foresight. If

the actual salvage value exceeds the estimated amount, then the firm

recognized too much depreciation during the asset’s useful life. The gain

on disposal represents a recapture for that excess depreciation which the

firm recognizes in the period of disposal. The gain is a recovery of

expenses recognized earlier that the firm would not have recognized had

it been omniscient. The other concept to note is that accounting reports

the gain or loss as a net amount (instead of showing the sale proceeds as

a revenue and the unamortized cost of the asset as an expense) because

the sale of depreciable assets is a peripheral activity to the primary

operating activities of most firms.

Notes 9-6

This page is intentionally left blank