Chapter 9 Reporting and Analyzing Long-lived Assets Flashcards
1
Q
Amortizable amount
A
The cost of a finite-life intangible asset (for example, patent, copyright) less its residual value, if any.
2
Q
Amortization
A
The systematic allocation of the amortizable cost of a finite-life intangible asset over the shorter of the asset’s legal or useful life.
3
Q
Asset retirement costs
A
The amount added to the cost of a long-lived asset that relates to obligations to dismantle, remove, or restore an asset when it is retired.
4
Q
Asset turnover
A
A measure of how efficiently a company uses its total assets to generate sales.
Asset turnover = net sales / average total assets
Average total assets = (beginning + ending total assets) / 2
Profit margin × asset turnover = return on assets
5
Q
Capital expenditures vs. operating expenditures
A
Capital expenditures are expenditures that benefit future periods. They are recorded (capitalized) as long-lived assets.
Operating expenditures are expenditures that benefit only the current period. They are immediately charged against revenues as an expense.
6
Q
Copyright
A
An exclusive right granted by the federal government allowing the owner to reproduce and sell an artistic or published work for a period extending over the life of the creator plus 50 years.
A copyright’s useful life is generally significantly shorter than its legal life, and the copyright is therefore amortized over its useful life.
The cost of the copyright consists of the cost of acquiring and defending it. The cost may be quite low and be composed of only the cost to acquire and register the copyright, or it may amount to a great deal more if a copyright infringement suit is involved.
7
Q
Cost model
A
A model for accounting for a long-lived asset that carries the asset at its cost less any accumulated depreciation or amortization.
8
Q
Depreciable amount
A
The cost of a depreciable asset (e.g., property, plant, and equipment) less its residual value.
9
Q
Cost model
A
A model for accounting for a long-lived asset that carries the asset at its cost less any accumulated depreciation or amortization.
10
Q
Depreciable amount
A
The cost of a depreciable asset (e.g., property, plant, and equipment) less its residual value.
11
Q
Derecognization
A
The removal of a long-lived asset from the accounts upon its disposal or when it no longer provides any future benefits.
12
Q
Development costs
A
Expenditures related to the application of research to a plan or design for a new or improved product or process for commercial use. These costs are recorded (capitalized) as long-lived assets.
13
Q
Diminishing-balance method
A
A depreciation method in which depreciation expense is calculated by multiplying the carrying amount of an asset by a depreciation rate (the straight-line rate, which is 100% divided by the useful life, adjusted for any multiplier effect). This method produces a decreasing periodic depreciation expense over the asset’s useful life.
Depreciation rate = single/double/triple (per specification) the straight-line depreciation rate (e.g., double-diminishing-balance method means the depreciation rate is double the straight-line rate)
Annual depreciation expense = carrying amount at beginning of year × depreciation rate
Carrying amount for the 1st year = cost
Carrying amount for the subsequent years = cost - accumulated depreciation at the beginning of the year
Residual value is not used in determining the amount that the diminishing-balance rate is applied to. Depreciation stops when the asset’s carrying amount equals its expected residual value, so the depreciation expense for the last year is adjusted so that end-of-year carrying amount will equal the residual value.
14
Q
Finance lease (also known as a capital lease)
A
A long-term agreement allowing one party (the lessee) to use the asset of an- other party (the lessor). The arrangement is accounted for as a purchase because the risks and rewards of owning the asset have been transferred to the lessee.
15
Q
Franchise
A
A contractual arrangement under which the franchisor grants the franchisee the right to sell certain products, to render specific services, or to use certain trademarks or trade names, usually within a designated geographic area.
16
Q
Goodwill
A
The value of favourable, unidentifiable attributes (e.g., exceptional management, a desirable location, good customer relations, skilled employees, high-quality products, fair pricing policies, and harmonious relations with labour unions, etc.) related to a company as a whole.
Internally generated goodwill is not recognized as an asset because to determine the value of goodwill items would be difficult and subjective.
It therefore can only be measured objectively when one business acquires another, by comparing the purchase price with the fair value of its net identifiable assets (assets -liabilities).
If the amount paid to acquire the business is greater than its net identifiable assets, then a transaction has occurred and the cost of the purchased goodwill can be measured and recorded as an asset.
Goodwill has an indefinite life and therefore is not amortized. However, it must be tested for impairment.
17
Q
Impairment loss
A
The amount by which the carrying amount of an asset exceeds its recoverable amount.
18
Q
Licences
A
Operating rights to use property that are granted by a government agency to a company.
Examples are the use of city streets for a bus line or taxi service; the use of public land for telephone, power, and cable television lines; and the use of airwaves for wireless devices, radio, or TV broadcasting.
19
Q
Operating lease
A
An arrangement allowing one party (the lessee) to use the asset of another party (the lessor). The arrangement is accounted for as a rental because the risks and rewards of owning the asset have been retained by the lessor.
20
Q
Patent
A
An exclusive right issued by the federal government that enables the recipient to manufacture, sell, or otherwise control an invention for a period of 20 years from the date of the application.
A patent cannot be renewed, but a patent’s legal life can be extended if the patent holder obtains new patents for improvements or other changes in the basic design.
The initial cost of a patent is the price paid to acquire it. Subsequent to acquisition, costs to register the patent, along with legal costs incurred to successfully defend it in any infringement suit, would also be included in the cost of the patent and amortized over time.
The cost of a patent should be amortized over its 20-year legal life or its useful life, whichever is shorter.
21
Q
Research expenses
A
Expenditures on an original planned investigation that is done to gain new knowledge and understanding. These costs are expensed because criteria for recording them as assets have not been met.
22
Q
Residual value
A
An estimate of the amount that a company would obtain from the disposal of an asset at the end of its useful life.
23
Q
Return on assets
A
A profitability measure that indicates the amount of profit generated by each dollar invested in assets (how efficient the company is at generating profit from its assets).
Return on assets = profit / average total assets = profit margin × asset turnover
Average total assets = (beginning + ending total assets) / 2
Profit margin = profit / net sales
24
Q
Revaluation model
A
A model of accounting for a long-lived asset that carries the asset at its fair value less accumulated depreciation or amortization.
Revaluation model is allowed under IFRS but not ASPE. It’s used on a limited basis—primarily for companies in certain industries, such as investments or real estate companies, where fair values are more relevant than cost.
Under the revaluation model, the carrying amount of PPE is adjusted to reflect its fair value. This model can be applied only to assets whose fair value can be reliably measured. A revaluation is not required each year but must be carried out often enough that the reported carrying amount is not materially different from the asset’s fair value.
25
Straight-line method
A depreciation method in which depreciation expense is calculated by dividing an asset’s depreciable amount by its estimated useful life. This method produces the same periodic depreciation expense over the asset’s useful life.
Depreciable amount = cost – residual value
Straight-line depreciation rate = 100% / useful life (in years)
Annual depreciation expense = depreciable amount / useful life (in years)
Annual depreciation expense = depreciable amount × straight-line depreciation rate
Carrying amount at the end of the useful life = residual value.
26
Trademark (trade name)
A word, phrase, jingle, or symbol that distinguishes or identifies a particular business or product.
A creator or original user may obtain the exclusive legal right to the trademark or trade name by registering it with the Canadian Intellectual Property Office. This registration provides continu- ous protection and may be renewed every 15 years as long as the trademark or trade name is in use. In most cases, companies continuously renew their trademarks or trade names. Consequently, as long as the trademark or trade name continues to be marketable, it will have an indefinite useful life.
If the trademark or trade name is purchased, the cost is the purchase price. If it is developed internally, it cannot be recognized as an intangible asset on the statement of financial position. The reason is that expenditures on internally developed trademarks cannot be distinguished from the cost of developing the business as a whole and consequently cannot be measured.
27
Units-of-production method
A depreciation method in which the useful life is expressed in terms of the total units of produc- tion or total use expected from the asset. Depreciation expense is calculated by multiplying the depreciable amount by actual activity during the year divided by the estimated total activity. The method will produce an expense that will vary each period depending on the amount of activity.
Depreciable amount = cost – residual value
Depreciable amount per unit = total depreciable amount / total units of production
Annual depreciation expense = depreciable amount per unit × units of production during the year
28
Determine the cost of property, plant, and equipment.
The cost of land, land improvements, buildings, and equipment includes all expenditures that are necessary to acquire these assets and make them ready for their intended use. After acquisition, costs incurred that benefit future periods (capital expenditures) are also included in the cost of the asset. When applicable, cost also includes asset retirement costs.
For example, insurance during transit is part of the cost of obtaining the asset and therefore should be capitalized. Insurance paid to insure the asset against fire or theft after it is situated and in use should be expensed because these costs benefit only the current period. Likewise, any costs incurred to train employees on how to operate the equipment would be expensed and not added to the cost of the equipment because such costs were incurred to get the employees ready and not to get the equipment ready for use.
Subsequent to acquisition of a long-lived asset, the same distinction exists between operating and capital expenditures. Operating expenditures generally benefit only the current period. They are required to maintain an asset in its normal operating condition and often recur, although not always annually. Examples include repainting a building or replacing the tires on a truck. These costs would be debited to an expense account, such as Repairs and Maintenance Expense, rather than being debited to an asset account.
Capital expenditures after acquisition include costs that increase the life of an asset or its productivity or efficiency. In other words, they are anticipated to provide future economic benefits. These costs are normally larger than operating expenditures and occur less frequently. The cost for reconfiguration and upgrading commercial planes should be capitalized because they improve the planes’ service value or extend their useful lives. Other examples for a different type of business might include the cost to replace the roof on a building or to overhaul an engine in a truck.
If a company leases an asset, depending on whether the risks and rewards of ownership are transferred, it may be accounted for as an operating lease or a finance lease. An operating lease results in rent expense on the income statement. A finance lease results in an asset on the statement of financial position, similar to a purchased asset.
29
Account for depreciation
Depreciation is the process of allocating the cost of a long-lived asset over its useful (service) life in a systematic way. It begins when the asset is available for use and ends when it is derecognized (removed from the accounts). The cost of the asset is allocated to depreciation expense over the asset’s useful life so that expenses are properly matched with the expected use of the asset’s future economic benefits.
Depreciation is recorded in an adjusting journal entry that debits Depreciation Expense and credits Accumulated Depreciation. Depreciation Expense is an income statement account; Accumulated Depreciation appears on the statement of financial position as a contra asset account to the relevant property, plant, or equipment account. The resulting balance, cost less accumulated depreciation, is the carrying amount of a depreciable asset.
Companies can choose from two models to account for PPE: the cost model and the revaluation model. The cost model is the most commonly used model under IFRS, and is the only model allowed for use under ASPE.
The cost model records PPE at cost when acquired. Subsequent to acquisition, depreciation is recorded each period and the assets are carried at cost less the accumulated depreciation. Under the cost model, an increase in the asset’s current fair value is not considered relevant, because PPE are not held for resale. As a result, the carrying amount of PPE may be very different from its fair value. In fact, if an asset is fully depreciated, it can have a carrying amount of zero but may still have a large fair value.
Note that depreciation applies to only three of the four classes of PPE: land improvements, buildings, and equipment. Land is not a depreciable asset.
30
Account for the derecognition of PPE
The procedure for accounting for the disposal of PPE through sale or retirement is:
Step 1: Update unrecorded depreciation for any partial period. (If the disposal occurs in the middle of an accounting period, depreciation must be updated for the fraction of the year that has passed since the last time adjusting entries were recorded up to the date of disposal.)
Step 2: Calculate the carrying amount (= cost i updated accumulated depreciation).
Step 3: Calculate any gain or loss on disposal.(gain/loss = proceeds - carrying amount)
Step 4: Record the disposal. Derecognize (remove) the asset and accumulated depreciation accounts related to the sold or retired asset. Record the proceeds received and the gain or loss (if any).
To update depreciation expense and accumulated depreciation if the disposal occurs in the middle of the accounting period:
Depreciation Expense (debit)
Accumulated Deprecation - PPE (credit)
```
To record the sale of PPE:
Cash/Receivable (debit)
Accumulated Depreciation - PPE (debit)
Loss on Disposal (debit)
PPE (credit)
```
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Or:
Cash/Receivable (debit)
Accumulated Depreciation - PPE (debit)
PPE (credit)
Gain on Disposal (credit)
```
```
To record the retirement of PPE (no or few proceeds):
If there's proceeds:
Cash (debit)
Accumulated Depreciation - PPE (debit)
PPE (credit)
```
If no proceeds:
Accumulated Depreciation - PPE (debit)
Loss on Disposal (debit)
PPE (credit)
Note that once an asset is fully depreciated, even if it is still being used, no additional depreciation should be taken. Accumulated depreciation on a piece of property, plant, and equipment can never be more than the asset’s cost.
31
Identify the basic accounting issues for intangible assets and goodwill.
Intangible assets are reported at cost (if the cost model is used), which includes all expenditures that are necessary to prepare the asset for its intended use. An intan- gible asset with a finite life is amortized over the shorter of its useful life or legal life, usually on a straight-line basis. Like property, plant, and equipment, intangible assets with finite lives are tested for impairment only if indicators of impair- ment are present. Intangible assets with indefinite lives are not amortized and must be tested for impairment annually under IFRS but only when indicators of impairment are present under ASPE. Impairment losses can be reversed under IFRS but not under ASPE.
Goodwill, which is the difference between the price paid for a business and the fair value of the identifiable assets less liabilities of the business, is not considered an intangible as- set because it is not separately “identifiable.” Goodwill has an indefinite life and is not amortized. It is tested for impairment annually under IFRS but under ASPE it is only tested if indica- tors of impairment are present. Goodwill impairment losses are never reversed.
32
Illustrate how long-lived assets are reported in the financial statements.
In the statement of financial position, land, land improvements, buildings, and equipment are usually com- bined and shown under the heading “Property, Plant, and Equipment.” Intangible assets with finite and indefinite lives are sometimes combined under the heading “Intangible Assets” or are listed separately. Goodwill must be presented separately.
Either on the statement of financial position or in the notes to the financial statements, the cost of the major classes of long-lived assets is presented. The depreciation and amorti- zation methods and rates must also be described in the notes to the statements. The accumulated depreciation and amorti- zation of depreciable/amortizable assets and carrying amount by major classes is also disclosed, including a reconciliation of the carrying amount at the beginning and end of each period for companies reporting under IFRS. The company’s impair- ment policy and any impairment losses should be described and reported. The company must disclose whether it is using the cost or revaluation model.
Depreciation expense, any gain or loss on disposal, and any impairment losses are reported as operating expenses in the income statement. In the statement of cash flows, any cash flows from the purchase or sale of long-lived assets are reported as investing activities.
Summary:
On IS:
Amortization Expense (operating expense)
Depreciation Expense (operating expense)
Gain on Disposal (operating expense, reduction)
Loss on Disposal (operating expense)
Impairment Loss (operating expense)
Repairs and Maintenance Expense (operating expense)
Research Expenses (operating expense)
Interest Expense (non-operating expenses, under Other Revenue and Expenses)
On SFP:
PPE (Assets under Financial Leases), Intangible Assets (Copyrigts, Patents, Development Costs, Trademarks, Franchises Licenses), Goodwill
Accumulated depreciaiton (contra asset account)
Accumulated amortization (contra asset account)w
33
Descibe the methods for evaluating the use of assets.
The use of assets may be analyzed using the return on assets and asset turnover ratios. Return on assets (profit 4 average total assets) indicates how well assets are used to generate profit. This is really a function of the following two ratios: asset turnover (net sales 4 average total assets), which indicates how efficiently assets are used to generate revenue, and profit margin (profit 4 net sales), which measures the profit made on each sale.s
34
Determine the cost of land
All costs related to the purchase of land, including closing costs such as survey, title search, and legal fees, are added to the Land account.
Costs for additional work required to prepare the land for its intended use, such as clearing, draining, grading, and filling, are also recorded as capital expenditures in the Land account.
If the land has a building on it that must be removed to make the site suitable for construction of a new building, all demolition and removal costs, less any proceeds from salvaged materials, are added to the Land account.
When land has been purchased to construct a building, all costs that are incurred up to the time of excavation for the new building are considered to be part of the costs that are necessary to prepare the land for its intended use.
Once the land is ready for its intended use, recurring costs, such as property tax, are recorded as operating expenditures. In other words, these costs are matched against the revenues that the land helps generate.
35
Determine the cost of land improvements
Land improvements are structural additions made to land, such as driveways, sidewalks, fences, lighting, and parking lots. Land improvements, unlike land, decline in service potential over time and require maintenance and replacement. Because of this, land improvements are recorded sepa- rately from land and are depreciated over their useful lives.
Note that one-time costs that are required for getting the land ready to use are always charged to the Land account, while land improvements are typically made after acquisition and can be separately distinguished from the land itself.
36
Determine the cost of buildings
The cost of a building (capitalized to the Buildings account.) includes all costs that are directly related to its purchase or construction.
When a building is purchased, its cost includes: 1) purchase price, 2) costs incurred to close (complete) the transaction (such as legal fees), 3) costs required to make the building ready for its intended use, which can include expenditures for remodelling rooms and offices, and for replacing or repairing the roof, floors, electrical wiring, and plumbing.
When a new building is constructed, its cost includes: 1) contract price plus payments made for architect fees, building permits, and excavation costs, 2) interest costs relating to a loan obtained to finance a construction project up to the date that the asset is ready for use (interest costs in this case are considered as necessary as materials and labour).
If land and a building are purchased together for a single price, as is sometimes the case, the fair (appraised) value of each must be determined and recorded separately.
37
Determine the cost of equipment
The cost of equipment includes the purchase price and all costs that are necessary to get the equipment ready for its intended use, including:
1) freight charges, insurance during transit that is paid by the purchaser;
2) expenditures that are required to assemble, install, and test the equipment;
3) cost incurred for painting and lettering (they are capitalized because they benefit future periods, and are not recorded as separate assets because they are not separate from the equipment).
Because they are recurring expenditures that do not benefit future periods, annual costs such as motor vehicle licences (recorded under the Vehicles Expense account) and ongoing insurance (recorded under the Insurance Expense account) are treated as operating expenditures when they are incurred.
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For example, to record purchase of delivery van and related expenses:
Vehicles
Vehicles Expenses
Prepaid Insurance
Cash
```
38
Buying vs leasing assets
Some advantages of leasing an asset rather than purchasing it include the following:
1. Reduced risk of obsolescence. Obsolescence is the process by which an asset becomes out of date before it physically wears out. Frequently, lease terms allow the lessee to exchange the asset for a more modern or technologically capable asset if it becomes outdated. This is much easier than trying to sell an obsolete asset.
2. 100% financing. If a company borrows to purchase an asset, it is usually required to make a down payment of at least 20%. Leasing an asset does not require any down payment, which helps to conserve cash. In addition, rent payments are often fixed for the term of the lease so they are predictable, unlike other financing, which often has a floating interest rate.
3. Income tax advantages. When a company owns a depreciable asset, it can only deduct a certain amount of depreciation expense (called capital cost allowance for income tax purposes) on its income tax return. If the company has borrowed to purchase an asset, it can also deduct the interest expense on the bor- rowed funds. When a company leases an asset, it simply deducts the rent paid on its income tax return. In some years, this deduction may be greater than the deductions taken if the asset was owned.
4. Off–balance sheet financing. The financial statements for firms leasing asset and firms buying the same asset on bank loans look significantly different (see p444)
Under IFRS, lease transactions must be accounted for according to their economic substance. That is, if the risks and rewards of ownership are transferred to the lessee, then the leased asset must be treated like a purchase financed with a loan provided by the seller of the asset (accounted for as a finance lease and recorded under Assets under Finance Leases account, along with a liability relating to future rent payments recorded under the Finance Lease Liability account).
If the risks and rewards of ownership are not transferred to the lessee, then the lease is account- ed for as an operating lease. Under an operating lease, no asset or liability is recorded; rather, each lease payment is recorded as rent (lease) expense on the income statement.
Companies often incur costs when they renovate leased property. These costs are charged to a separate account called Leasehold Improvements. Since the leasehold improvements are attached to a leased property, they belong to the lessor at the end of the lease. Because the benefits of these im- provements to the lessee will end when the lease expires, they are depreciated over the remaining life of the lease (including any renewal options) or the useful life of the improvements, whichever is shorter.
39
Calculating depreciation for PPE
There are three factors that affect the calculation of depreciation.
1) Cost, which includes the purchase price plus all costs necessary to get the asset ready for use, as well as estimated asset retirement costs, if there are any.
2) Useful life, expressed as (a) the period of time over which an asset is expected to be available for use or (b) the number of units of production or units of output that are expected to be obtained from an asset.
3) Residual value. Residual value is an estimate of the amount that a company would obtain from the disposal of the asset at the end of its useful life. Residual value is not depreciated, since the amount is expected to be recovered at the end of the asset’s useful life. (The difference between a depreciable asset’s cost and its residual value is called the depreciable amount, which is the total amount to be depreciated over the useful life.)
There are three commonly used depreciation methods: straight-line, diminishing-balance, and units-of-production.
It's appropriate to use the straight-line method when the asset is used uniformly and the decline in usefulness is likely constant throughout its useful life.
Note that a) the total depreciation expense, b) the accumulated deprecation for the last year, and c) the carrying amount for the last year, which equals the residual value, is the same no matter which method is used.
But in the early years, diminishing-balance method will result in higher depreciation expense than the straight-line method. Methods such as the diminishing-balance method that produce higher depreciation expense in the early years than in the later years are known as accelerated depreciation methods.
The depreciable amount is the same (cost less residual value) when using straight-line and units-of-production method; the depreciable amount equals the cost when using diminishing-balance method.
The diminishing-balance, or another accelerated method, is appropriate if the asset has a higher revenue-producing ability in its early years, or if the asset is expected to become less useful over time. Some assets require higher repair and maintenance costs in later periods to maintain production capacity, in which case an advantage of the diminishing-balance method is that it will result in a fairly constant total expense (for depreciation plus repairs and maintenance).
The units-of-production method works well for machinery where production can be measured in terms of units produced or for vehicles where usage can be measured in terms of kilometres driven. It's useful for long-lived assets whose productivity varies significantly from one period to another. In this situation, the units-of-production method results in depreciation amounts that match the benefits consumed as the asset is used. One area where the units-of-production method is commonly used is in the natural resources industry, which includes oil and gas and mineral deposits. When natural resources are depreciated, the term depletion is used instead of depreciation. The units-of-production method is generally not suitable for such assets as buildings or furniture, because activity levels are less relevant and difficult to measure for these types of assets.
Comparing calculation of the annual deprecation expense for each of the three methods:
Straight-line (remain constant):
= (Cost - RV) / Useful life
Diminishing-balance (decline):
= (Cost -Accumulated Depreciation) × Depreciation rate
Units-of-production (depends on the units of production for the given year):
= (Cost - RV) × Actual units of activity during year / Total estimated units of activity
The impact of depreciation policy on financial statements:
Effects on income statement and the statement of financial position. In the early years, straight- line depreciation results in a lower amount of depreciation expense and higher profit on the income statement than the diminishing-balance method. It also results in higher total assets and higher shareholders’ equity on the statement of financial position. The opposite is true in the later years. Results under the units-of-production method will vary. There is no impact on total expense over the life of the asset or cash flow regardless of method used.
40
Other depreciation issues: significant components
When an item of PPE includes individual components that have different useful lives, the cost of the item should be allocated to each of the asset’s significant components. This allows each component to be depreciated separately over different useful lives or even using different depreciation methods if they deliver different patterns of economic benefits.
41
Other depreciation issues: depreciation and income tax
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For accounting purposes, management determines the method of depreciation to use and estimates the useful life and residual value of assets. The Canada Revenue Agency (CRA) requires that, for income tax purposes, depreciation amounts should be determined not by using management estimates but by using tax regulations. For this reason, when preparing a tax return and determining taxable income, companies cannot deduct the depreciation expense used in the income statement. They must deduct the income tax version of depreciation, which is known as capital cost allowance (CCA). In determining CCA, only the diminishing-balance method of depreciation is permitted. In addition, assets are grouped into various classes and the depreciation rates for each asset class are specified for income tax purposes.
Impairments.
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42
Other depreciation issues: impairments
The carrying amount of PPE is rarely the same as its fair value. The cost model assumes that fair value is not relevant since PPE are not purchased for resale, but rather for use in operations over the long term. While it is accepted that long-lived assets such as PPE may be undervalued on the statement of financial position by reporting a carrying amount lower than fair value, it is not appropriate if assets are overvalued (impaired).
Companies are required to determine if there are indicators of impairment on a regular basis. If there are no indicators, it is not necessary to test the asset for impairment. However, if indicators are present, an impairment test must be done. For example, if a machine has become obsolete, or if the market for a product made by a machine has declined, there is a likelihood that an impairment loss exists. Management is then required to perform an impairment test and this involves determining an estimate of the machine’s recoverable amount. The recoverable amount can be determined by observing the fair value less selling costs of similar assets in an active market. If this information is not available, the value in use of the asset, which is based on its future cash flows, can be used.
PPE are considered impaired if the asset’s carrying amount exceeds its recoverable amount and an impairment loss is recorded:
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Impairment Loss (debit)
Accumulated Depreciation (credit)
```
Impairment cost = carrying amount - recoverable amount
Impairment cost is reported on the income statement as an operating expense
Impairment losses can create problems for users of financial statements. Some companies attempt to record asset impairments in bad years, when they are going to report poor results anyway. This practice is sometimes referred to as “taking a big bath.” While asset writedowns must be justified, impairments do involve professional judgement and management can usually provide a reasonable justification for the loss, particularly if the company is not performing well. Critics of such losses note that after a company writes down assets, its depreciation expense will be lower in subsequent periods. When the company later recovers, its results look even better because of lower depreciation expense.
43
Other depreciation issues: revising periodic depreciation
There are several reasons why periodic depreciation may need to be revised during an asset’s useful life. These include:
1. Capital expenditures during the asset’s useful life. While an asset is being used, additional costs relating to it may be incurred. The criteria to determine whether such costs are operating or capital expenditures remain unchanged even if they were not incurred at the acquisition date. If a cost, such as ordinary repairs and maintenance, benefits the company only in the current period, the cost is an operating expenditure and is recorded as an expense in the income statement. If the cost, such as an addition to a building, will benefit future periods, then it is a capital expenditure and is added to the asset’s cost. As capital expenditures during the asset’s useful life increase the cost of a long-lived asset, the depreciation calculations from that point onward will have to be revised.
2. Impairment losses. As described earlier in the chapter, an impairment loss will result in the reduction of the asset’s carrying amount. Since the carrying amount is reduced, the future depreciation calculations will also be reduced because the depreciable amount is now lower.
3. Changes in the estimated useful life or residual value. Management must review its estimates of useful life and residual value each year. For example, wear and tear or obsolescence might indicate that annual depreciation is not enough. Capital expenditures may increase the asset’s useful life and/or its residual value. Impairment losses might signal a reduction in useful life and/or residual value. Regardless of the reason for the change, a change in estimated useful life or residual value will cause a revision to the depreciation calculations.
4. Changes in the pattern in which the asset’s economic benefits are consumed. Management must review the choice of depreciation method for a long-lived asset at least annually. If the pattern in which the future benefits will be consumed is expected to change, the depreciation method must change as well. A change in methods will obviously result in a revision to depreciation calculations.
Revising depreciation is known as a change in estimate. Changes in estimates are made in current and future years but not to prior periods. Thus, when a change in depreciation is made, (1) there is no correction of previously recorded depreciation expense, and (2) only depreciation expense for current and future years is revised. The rationale for this treatment is that the original calculations were based on the best information known at the time when the asset was purchased. The revision is based on new information that should only affect future periods as that information was not available in the past.
To determine revised depreciation expense, first calculate the asset’s carrying amount at the time of the change in estimate (=original cost - accumulated depreciation to date + any capital expenditures). The asset’s residual value (either the original amount or a revised amount if appropriate) is deducted from the carrying amount at the time of the change in estimate and the result divided by the remaining estimated useful life.
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Research and Development costs
R&D costs are not intangible assets on their own, but may lead to patents, copyrights, or other intangible assets.
When a company develops intangible assets internally rather than acquiring them from another party, two accounting problems arise: (1) It is sometimes difficult to determine the costs related to a specific project; and (2) it is hard to know if future benefits will be generated, and if so, when. To help resolve these issues, accounting distinguishes between a research phase and a development phase.
During the research phase, expenditures are made but it is not yet known if these costs will have any future benefit. Consequently, they are expensed and recorded in the account Research Expenses.
The development phase begins when certain criteria are met that indicate that the project being developed will have future benefit. All of the following criteria must be met:
1) The project is technically feasible;
2) The company has a desire to complete development;
3) The company is able to complete development; and
4) A market exists for the product.
Once all of the above conditions are met, future expenditures on the project that specifically relate to its development will be capitalized and recorded in the asset account Development Costs. During the development phase, if expenditures incurred relate to another specific asset such as equipment or a patent, then those costs are recorded in their respective accounts rather than in Development Costs. After development is complete, such as when commercial production begins, development costs would be amortized over the useful life of the product or process developed.
