Lecture 11: PPE

Question 1

What are long-term assets?

Answer 1

Property, plant and equipment (PP&E), also referred to as fixed assets, are all non-current assets that
* have physical substance and
* are used in operations (i.e., not held as an investment or for resale).

Intangible assets are all non-current assets that
* do not have physical substance and
* are not financial assets.

Question 2

What is included under PPE?

Answer 2

Buildings, equipment, land, natural resources?

Question 3

What is included under intangible assets?

Answer 3

Identifiable intangibles, goodwill

Question 4

What are the rules for capitalization of costs related to tangible assets?

Answer 4

The key question in determining what costs can be capitalized is:
Does the cost incurred improve the asset’s ability to generate revenue, i.e., increase its useful life, capacity, or efficiency?

Yes: The cost is capitalized as an asset and depreciated over time.

No: The cost is recognized as an expense (income statement) as incurred.

Question 5

What are the cost items for tangible assets eligible for capitalization?

Answer 5

The cost items eligible for capitalization depend on the nature of the asset.

• Land: purchase price, commissions, survey and legal costs, removal of old buildings.
• Land improvements: fencing, paving, security systems, lighting.
• Buildings: purchase price, commissions, sales and other taxes, repairs and renovation for intended use.
• Machinery and equipment: purchase price, insurance in transit, freight cost, sales taxes, installation.

Question 6

What are the rules for capitalization of costs related to intangible assets?

Answer 6

Rules are more stringent for intangible assets because their future economic benefits are generally difficult to estimate reliably.

We distinguish between

• identifiable intangible assets, which are intangibles that either arise from a legal or contractual right or are separately salable; and
• goodwill, which is a blanket term for all intangibles that cannot be identified and listed separately on the balance sheet.

Question 7

What are the type sof intengible assets most often capitalized?

Answer 7

With few exceptions, most costs incurred in developing intangible assets internally, such as marketing or research and development costs, are not capitalized.
IFRS: Development costs may be capitalized only once ‘technical and commercial feasibility’ has been established.
US GAAP: All research and development costs are expensed as incurred.

As a result, most intangibles shown on the balance sheet are assets purchased from an outside party.

The most common event that gives rise to the recognition of intangible assets on the balance sheet is a business combination (i.e., mergers and acquisitions).

In a business combination, the purchase price paid by the acquirer is first allocated to the fair market value of the target company’s identifiable tangible and intangible assets and liabilities.

Any unallocated residual is capitalized as goodwill.

Question 8

How do we treat intangible assets that we have started using?

Answer 8

Long-term assets generate revenue over multiple periods. The matching principle dictates that the capitalized cost of these assets must be expensed over time in proportion to these revenues.

The expensing of long-term assets is called depreciation for PP&E, amortization for intangibles, and depletion for natural resources.

Question 9

What cost is ppe carried at?

Answer 9

PPE is carried at historical cost

Question 10

What is the useful life in depreciation?

Answer 10

The period over which an asset is depreciated is called the useful life.

Question 11

What is the depreciable basis?

Answer 11

The total amount of capitalized cost to be expensed over the useful life is referred to as the depreciable basis.

If the asset is expected to have a resale value (or salvage value) at the end of its useful life, the depreciable basis is modified to
depreciable basis = capitalized cost – salvage value

Question 12

How do we deal with amortization of intangibles with an indefinite life?

Answer 12

Some intangible assets, including goodwill, are deemed to have an ‘indefinite’ life and are not amortized.

Question 13

How to record depreciation?

Answer 13

Depreciation is not deducted directly from the asset account. Instead, depreciation charges are booked to a contra-asset account called accumulated depreciation.

The journal entry to record depreciation is therefore:

DR depreciation expense xxx
CR accumulated depreciation xxx

Question 14

What is acquisition cost in depreciation?

Answer 14

The cost at which the asset was purchased, including any capitalized ancillary costs

Question 15

What is depreciation/amortization/depletion?

Answer 15

The periodic expense that reduces the depreciable basis

Question 16

What is accumulated depreciation?

Answer 16

The sum of all depreciation charges to date

Question 17

What is the net book value (or net carrying amount) in depreciation?

Answer 17

acquisition cost less accumulated depreciation

Question 18

What are the standard depreciation methods?

Answer 18

1. Straight line
2. Units-of-production
3. Sum-of-the-years’ digits
4. Declining balance

Question 19

What is straight-line depreciation?

Answer 19

Costs are allocated evenly over the useful life.

Depreciation expense formula:
[depreciable basis] ÷ [useful life]

Question 20

What is units-of-production depreciation?

Answer 20

Depreciation expense follows from the asset’s current output (or usage) as a percentage of its expected total output (or usage) over its entire useful life.

Depreciation expense formula:
[current output] ÷ [total output] × [depreciable basis]

Question 21

What is sum-of-the-years’ digits depreciation?

Answer 21

Depreciation is a fraction of the depreciable basis. The fraction is the remaining useful life at the beginning of the period divided by the sum of the remaining useful lives at the beginning of all periods (the ‘sum-of-the-years’-digits’).

Example: The useful life is 4 years. The sum-of-the-years’-digits is thus 4 + 3 + 2 + 1 = 10.

Depreciation expense formula:

[remaining useful life] ÷ [sum-of-the-years’-digits] × [depreciable basis]

Question 22

What is declining balance depreciation?

Answer 22

Depreciation is a fraction (the depreciation rate) of the net carrying amount at the beginning of the period. The rate is a multiple (also called the accelerator) of 1 / [useful life].

Note 1: The depreciation method is typically switched to straight-line once the straight-line method yields a higher depreciation expense than the declining balance factor.

Note 2: Salvage values are ignored in the calculation of the depreciation expense before the switch.

Note 3: Depreciation can never reduce the net carrying amount below the salvage value, so the last depreciation charge may be a plug number.

Note 4: Under the declining balance method, the final depreciation charge may occur before the end of the asset’s useful life.

Question 23

What are the formulas for declining balance depreciation?

Answer 23

Depreciation expense formula (initial):
[net carrying amount] × [depreciation factor]

Depreciation expense formula (after switch):
[remaining depreciable basis at time of switch] ÷ [remaining useful life at time of switch]

Depreciation expense formula (final period):
[net carrying amount] - [salvage value]

Question 24

What is meant by accelerated (front-loaded) depreciation methods?

Answer 24

The declining balance and sum-of-the-years’-digits methods are examples of accelerated (front-loaded) depreciation schedules.

Question 25

What happens when a depreciated asset is sold?

Answer 25

1. First, we need to recognize depreciation on the asset through the disposal date. (This may require partial-period depreciation if the asset is not sold at year-end.)
2. Second, we remove the asset from the balance sheet and recognize any gain or loss incurred as a result of the disposal. In particular, we

• reduce the balances of the acquisition cost and accumulated depreciation accounts to zero;
• record the proceeds (payment) received from the buyer (if applicable); and
• compute and record any gain or loss on the sale ( income statement), equal to the net carrying amount of the asset less any sale proceeds.

Question 26

What are asset impairments?

Answer 26

In principle, PP&E and intangibles are accounted for at (depreciated or amortized) historical cost.

An exception arises when the fair value (US GAAP) or recoverable amount (IFRS) of the asset falls below its current net carrying amount.
If it does, the asset is considered impaired and must be written down to this fair value (recoverable amount).

(The requirement to recognize impairment losses is yet another example of conservatism in accounting.)

Question 27

How are asset impairments recorded?

Answer 27

Indefinite-lived intangibles, including goodwill, must be tested for impairment annually. Other long-term assets must be tested if there are indicators of an impairment.

Effectively, impairments are like one-off depreciation expenses and are also recorded like depreciation:

DR impairment loss xxx
CR accumulated impairments xxx

After an impairment, the company will likely need to adjust the depreciation or amortization schedule of the asset.

Question 28

What is fair value/recoverable amount?

Answer 28

(IFRS) The recoverable amount of an asset is the higher of:

• the asset’s fair value, such as a recent transaction or market price (i.e., the value to an outside buyer), less any costs to sell the asset; and
• the asset’s value-in-use, i.e., the present value of the future cash flows the asset is expected to generate for the company when used internally.

(US GAAP) The fair value of an asset is

• the market price of the asset or of similar assets (default option); or
• the present value of future cash flows generated by the asset (if no observable market prices exist).

Question 29

How to identify impairmetns?

Answer 29

The impairment test for identifiable (non-goodwill) assets works like this:

• (IFRS) Determine whether the asset’s carrying amount exceeds its recoverable amount. If it does, recognize an impairment loss equal to the difference. Impairments may be reversed at later dates if the asset value recovers.

(US GAAP) Impairments may never be reversed at later dates.

• For finite-lived assets (including all PP&E), determine whether the carrying amount exceeds the sum of all future undiscounted cash flows the asset is expected to generate. If it does, recognize an impairment loss that reduces the asset’s carrying amount to its fair value.
• For indefinite-lived assets, determine whether the asset’s carrying amount exceeds its fair value. If it does, recognize an impairment loss equal to the difference.

Question 30

How do we test for goodwill impairments?

Answer 30

To test goodwill for impairment:

1. allocate goodwill and other assets to subdivisions (or business units) of the firm, called ‘cash-generating units’ (IFRS) or ‘reporting units’ (US GAAP);
2. determine the fair value of the business unit, i.e., what an outside buyer would pay to acquire it (estimates and judgment again).
3. If the business unit’s fair value is below the carrying amount of its total assets, recognize an impairment in goodwill (and, where necessary, possibly in other assets as well) equal to the difference.

Question 31

What is the revaluation options?

Answer 31

Under IFRS ONLY, companies may elect to carry their long-term assets at fair value, recognizing both increases and decreases in value.

• Revaluations may be performed annually or less frequently, depending on the volatility of the asset’s value.
• Upward revaluations above the cost basis are recognized in OCI.
• Revalued assets’ accumulated depreciation/amortization may either be scaled proportionately or reset by eliminating it against the gross value.