978-1259722660 Chapter 11 Lecture Note Part 1

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CHAPTER 11

PROPERTY, PLANT, AND EQUIPMENT AND INTANGIBLE ASSETS:

UTILIZATION AND DISPOSITION

Overview

This chapter completes our discussion of accounting for property, plant, and equipment and

intangible assets. We address the allocation of the cost of these assets to the periods benefited by

their use.

The usefulness of most of these assets is consumed as the assets are applied to the production of

goods or services. Cost allocation corresponding to this consumption of usefulness is known as

depreciation for plant and equipment, depletion for natural resources, and amortization for

intangibles.

We also consider other issues until final disposal such as impairment of these assets and the

treatment of expenditures incurred subsequent to acquisition.

Learning Objectives

LO11–1 Explain the concept of cost allocation as it pertains to property, plant, and equipment and

intangible assets.

LO11–2 Determine periodic depreciation using both time-based and activity-based methods and

account for dispositions.

LO11–3 Calculate the periodic depletion of a natural resource.

LO11–4 Calculate the periodic amortization of an intangible asset.

LO11–5 Explain the appropriate accounting treatment required when a change is made in the service

life or residual value of property, plant, and equipment and intangible assets.

LO11–6 Explain the appropriate accounting treatment required when a change in depreciation,

amortization, or depletion method is made.

LO11–7 Explain the appropriate treatment required when an error in accounting for property, plant,

and equipment and intangible assets is discovered.

LO11–8 Identify situations that involve a significant impairment of the value of property, plant, and

equipment and intangible assets and describe the required accounting procedures.

LO11–9 Discuss the accounting treatment of repairs and maintenance, additions, improvements, and

rearrangements to property, plant, and equipment and intangible assets.

LO11–10 Discuss the primary differences between U.S. GAAP and IFRS with respect to the

utilization and impairment of property, plant, and equipment and intangible assets.

Lecture Outline

Part A: Depreciation, Depletion, and Amortization

I. Cost Allocation—an Overview

A. Property, plant, and equipment and intangible assets are purchased with the expectation

that they will provide future benefits. Logically, then, the cost of these acquisitions

initially should be recorded as assets, and then these costs should be allocated to expense

over the reporting periods benefited by their use. That is, their costs are reported with the

revenues they help generate.

B. Cost allocation for assets is known as depreciation for plant and equipment, depletion for

natural resources, and amortization for intangibles.

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C. Depreciation, depletion, and amortization are processes of cost allocation, not valuation.

D. Depreciation, depletion, and amortization for an asset used to manufacture a product are

overhead costs included in the cost of inventory.

II. Measuring Cost Allocation

A. The process of cost allocation for an asset requires that three factors be established at the

time the asset is put into use: (1) service life, (2) allocation base, and (3) allocation

method.

B. The service life, or useful life, of an asset is the estimated use that the company expects to

receive from the asset.

1. Service life can be expressed in units of time or in units of activity.

2. Expected obsolescence can shorten service life below physical life.

C. Allocation base is the cost of the asset expected to be consumed during its service life.

The allocation base equals the difference between the cost of the asset and its anticipated

residual value (sometimes called salvage value). For plant and equipment, we commonly

refer to the allocation base as the depreciable base; for the depletion of natural resources,

the depletion base; and for amortization of intangible assets, the amortization base.

D. The allocation method is the pattern in which the allocation base is expected to be

consumed (and typically corresponds to the pattern of asset use).

1. Time-based methods

2. Activity-based methods

III. Depreciation

A. Time-based depreciation methods allocate the depreciable base according to the passage of

time.

1. The straight-line depreciation method allocates an equal amount of depreciable base

to each year of the asset’s service life.

2. Accelerated depreciation methods allocate more depreciable base to the earlier years of

an asset’s life and less to the later years.

a. The sum-of-the-years’-digits method multiplies depreciable base by a declining

fraction whose denominator is the constant sum of the digits from one to n where n

is the number of years in the asset’s service life.

b. Declining balance depreciation methods multiply beginning of year book value,

not depreciable base, by an annual rate that is a multiple of the straight-line rate.

When 200% is used as the multiplier, the method is known as the

double-declining-balance method.

B. It is not uncommon for a company to switch from accelerated to straight-line

approximately halfway through an asset’s life.

C. Activity-based depreciation methods estimate service life in terms of some measure of

productivity.

1. Productivity could be measured in terms of output (for example, the number of units a

machine will produce) or input (for example, the number of hours a machine will

operate).

2. The units-of-production method computes a depreciation rate per measure of output

and then multiplies this rate by actual output to determine periodic depreciation.

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Decision Makers’ Perspective—Selecting a Depreciation Method

A. All methods provide the same total depreciation over an asset’s life.

B. Activity-based methods are theoretically superior to time-based methods but often are

infeasible or too costly to use.

C. One possible motivation for the predominant use of straight-line is its positive effect on

reported income.

D. A company does not have to use the same depreciation method for both financial reporting

and income tax purposes nor does it have to use the same depreciation method for

different classes of assets.

E. IFRS requires that each component of an item of property, plant, and equipment be

depreciated separately if its cost is significant in relation to the total cost of the item.

IV. Dispositions

A. When a depreciable asset is sold, a gain or loss is recognized for the difference between

the consideration received and the book value of the asset sold.

1. A gain occurs when an asset is sold for more than its book value (there is a net increase

in book value of total assets).

2. A loss occurs when an asset is sold for less than its book value (there is a net decrease in

book value of total assets).

B. Sometimes management plans to sell property, plant, and equipment or an intangible asset,

but that sale hasn’t yet happened. In this case, the asset is classified as “held for sale” in

the period in which certain criteria are met.

1. An asset that is classified as held for sale is no longer depreciated or amortized. This

type of asset is reported at the lower of its current book value or its fair value less any

cost to sell.

2. If the fair value less cost to sell is below book value, we recognize a loss in the current

period.

C. Sometimes instead of selling a used asset, a company will retire (or abandon) the asset.

1. At the time of retirement, the asset accounts are removed from the books and a loss

equal to the remaining book value of the asset is recorded because there will be no

monetary consideration received.

Decision Makers’ Perspective—Understanding Gains and Losses

A. Gains and losses on the sale of a depreciable asset are sometimes misinterpreted as “good”

and “bad” news.

B. A gain on the sale of a depreciable asset simply means the asset was sold for more than its

book value. The net increase in the book value of total assets is an accounting gain (not

necessarily an economic gain).

C. The same is true for losses. A loss signifies that the cash received is less than the book

value of the asset being sold; there is a net decrease in the book value of total assets.

V. Group and Composite Depreciation Methods

A. Group and composite depreciation methods aggregate assets in order to reduce the

recordkeeping costs of determining periodic depreciation.

B. The group depreciation method defines the collection of assets as depreciable assets that

share similar service lives and other attributes.

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1. The group depreciation rate is determined by dividing the depreciation per year by the

total cost of the group.

2. The group’s average service life is calculated by dividing the depreciable base by the

depreciation per year.

3. The depreciation rate is applied to the total cost of the group.

4. No gain or loss is recorded when a group asset is retired or sold.

C. The composite depreciation method is used when assets are physically dissimilar but are

aggregated anyway to gain the convenience of group depreciation.

D. IFRS allows a company to report property, plant, and equipment at cost less accumulated

depreciation (book value), or, alternatively, at fair value (revaluation).

VI. Depletion of Natural Resources

A. Depletion of the cost of natural resources usually is determined using the

units-of-production method.

B. Depletion is a product cost and is included in the cost of inventory.

C. The units-of-production method often is used to determine depreciation on assets used in

the extraction of natural resources.

D. Under IFRS, biological assets are valued at fair value less costs to sell.

VII. Amortization of Intangible Assets

A. The cost of an intangible asset with a finite useful life is amortized.

1. Most intangibles have a legal, regulatory, or contractual life that limits useful life.

2. Intangibles typically have no residual value, so the amortization base is simply cost.

3. The cost of an intangible asset usually is amortized by the straight-line method.

B. The cost of an intangible asset with an indefinite useful life is not amortized. Goodwill is

the most common intangible asset with an indefinite useful life.

C. Similar to depreciation, whether amortization is a product cost or a period cost depends on

the use of the asset.

D. IFRS allows a company to report intangible assets at cost less accumulated amortization

(book value), or, alternatively, at fair value (revaluation).

VIII. Partial Periods

A. Depreciation, depletion, and amortization in the year of acquisition and year of disposal

should be determined only for the part of the year that the asset is actually used.

Partial-year depreciation presents a problem only for time-based methods.

B. Most companies adopt a simplifying assumption, or convention, for computing

partial-year depreciation. A common convention, known as the half-year convention,

records one-half of a full year’s depreciation in the year of acquisition and another

half-year in the year of disposal.

Part B: Additional Issues

I. Changes in Estimates

A. Changes in estimates are reflected in the financial statements of the current period and

future periods.

B. Prior years’ financial statements are not restated.

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C. A disclosure note describes the change in estimate and the effect of the change on income

before extraordinary items, net income, and related per-share amounts.

II. Change in Depreciation, Amortization, or Depletion Method

A. Changes in depreciation, amortization, or depletion method are accounted for the same

way as a change in accounting estimate.

B. A disclosure note is required to provide justification for the change and to report the effect

of the change on the current year’s income.

III. Error Correction

A. For material errors occurring in a previous year, previous years’ financial statements are

retrospectively restated.

B. Any account balances that are incorrect as a result of the error are corrected.

C. If retained earnings requires correction, the correction is reported as a prior period

adjustment.

D. A disclosure note is needed to describe the nature of the error and the impact of its

correction on income before extraordinary items, net income, and earnings per share.

IV. Impairment of Value

A. An asset held for use should be written down if there has been a significant impairment of

value.

B. Property, plant, and equipment and finite-life intangible assets are tested for impairment

only when events or changes in circumstances indicate that book value, sometimes called

carrying value or carrying amount, may not be recoverable.

C. For property, plant, and equipment and finite-life intangible assets, determining whether to

record an impairment loss and actually recording the loss is a two-step process.

1. Step 1 – An impairment loss is required only when the undiscounted sum of future

cash flows is less than book value.

2. Step 2 – The impairment loss is the excess of book value over fair value. The present

value of future cash flows often is used as a measure of fair value.

D. There are important differences in accounting for impairment of value of property, plant,

and equipment and finite-life intangible assets between U.S. GAAP and international

financial reporting standards.

E. Intangible assets with indefinite useful lives, other than goodwill, should be tested for

impairment at least annually and more frequently if events or changes in circumstances

indicate that it is more likely than not that the asset is impaired. A company has the option

of first undertaking a qualitative assessment. Companies selecting this option will evaluate

relevant events and circumstances to determine whether it is “more likely than not” (a

likelihood of more than 50 percent) that the fair value of the asset is less than its book

value. Only if that’s determined to be the case will the company perform the quantitative

impairment test. If book value exceeds fair value, an impairment loss is recognized. There

are differences between U.S. GAAP and IFRS in the measurement of an impairment loss

for intangible assets with indefinite useful lives.

F. GAAP provides guidelines for the recognition and measurement of goodwill impairment.

1. Step 1 – A goodwill impairment loss is indicated when the fair value of the reporting

unit is less than its book value.

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2. Step 2 – A goodwill impairment loss is measured as the excess of the book value of

the goodwill over its “implied” fair value.

3. The implied fair value of goodwill is calculated in the same way that goodwill is

determined in a business combination. That is, it’s a residual amount measured by

subtracting the fair value of all identifiable net assets from the consideration

exchanged (purchase price) using the unit’s previously determined fair value as the

consideration exchanged. Similar to other intangible assets with indefinite useful lives,

goodwill should be tested for impairment on an annual basis and in between annual

test dates if events or circumstances indicate that the fair value of the reporting unit is

below its book value. Companies have the option to perform a qualitative assessment

to determine whether Step 1 of the goodwill impairment test is necessary.

G. There are important differences in accounting for impairment of value of goodwill

between U.S. GAAP and international financial reporting standards.

H. For assets held for sale, if book value exceeds fair value, an impairment loss is recognized

for the difference.

Part C: Subsequent Expenditures

I. Expenditures Subsequent to Acquisition

A. Expenditures that are expected to produce future benefits beyond the current year are

capitalized. Expenditures that simply maintain a given level of benefits are expensed in the

period they are incurred.

B. Many companies do not capitalize any expenditure unless it exceeds a predetermined

amount that is considered material.

C. Expenditures for repairs and maintenance generally are expensed when incurred.

D. Additions involve adding a new major component to an existing asset and should be

capitalized because future benefits are increased.

E. Improvements involve the replacement of a major component of an asset and usually are

capitalized.

1. By the substitution method, both the disposition of the old component and the

acquisition of the new component are recorded.

2. The cost of the improvement sometimes is recorded without removing the original cost

and accumulated depreciation of the original component.

3. Another way to record improvements is to reduce accumulated depreciation.

F. The cost of material rearrangements should be capitalized if they clearly increase future

benefits.

G. The costs incurred to successfully defend an intangible right should be capitalized. The

costs incurred to unsuccessfully defend an intangible right should be expensed. Under

IFRS, litigation costs are expensed, except in rare situations when an expenditure

increases future benefits.

Appendix 11A: Comparison with MACRS (Tax Depreciation)

A. The federal tax code allows taxpayers to compute depreciation for their tax returns on

assets acquired after 1986 using the modified accelerated cost recovery system (MACRS).

B Under MACRS, each asset is placed within a recovery period category, which determines

the fixed-rate depreciation schedule.

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C. MACRS depreciation is equivalent to applying the double-declining-balance (DDB)

method with a switch to straight-line in the year straight-line yields an equal or higher

deduction than DDB and a half-year convention.

D. Companies have the option to use the straight-line method.

Appendix 11B: Retirement and Replacement Methods of Depreciation

A. The retirement depreciation method records depreciation when assets are disposed of and

measures depreciation as the difference between the proceeds received and cost.

B. By the replacement method, depreciation is recorded when assets are replaced.

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