Chapter 13 117 CHAPTER 13 QUESTIONS Depreciation refers to the cost allocation of tangible long-term assets; depletion refers to the cost allocation of natural resources; and amortization refers to the cost allocation of intangible assets All three terms have similar underlying principles governing their use based on productive output or service hours In theory, the use-factor methods provide a much better matching of costs against revenues than time-factor methods However, because use-factor methods require more extensive accounting records, they are not as common as the time-factor methods Four separate factors must be considered in determining the periodic depreciation charges that should be made for a company’s assets They are (1) asset cost, (2) residual or salvage value, (3) useful life, and (4) pattern of use These factors, when considered together, help determine which of the common methods is most appropriate for the circumstances With group depreciation, periodic depreciation expense is computed on a whole group of assets as if the group were one single asset The weighted-average life of the group is used to determine how much of the aggregate asset cost should be depreciated each year No gains or losses are recognized at the time of the retirement of individual assets; accumulated depreciation is reduced for the difference between the asset cost and the cash retirement proceeds Residual or salvage value is included in the formulas for all time-factor depreciation methods except for the declining-balance methods In practice, residual value is often ignored if it is the practice of a company to retain assets for most of their useful lives In the case of declining-balance methods, although residual value is not included in the formulas, it is considered when an asset is near the end of its useful life Generally, the book value should not be reduced below its expected residual value The amount of an asset retirement obligation is added to the cost of the associated asset Accordingly, the asset retirement obligation increases periodic depreciation In addition, the amount of the asset retirement obligation itself increases each year as the time until the obligation must be satisfied decreases However, this increase, which conceptually is exactly the same as interest expense, is not accounted for as interest expense Instead, it is called accretion expense Functional factors include inadequacy and obsolescence that reduce the usefulness of the asset Physical factors include wear and tear, deterioration and decay, and damage or destruction reducing the usefulness of the asset When a useful-life estimate is changed, the remaining book value of the asset is depreciated over the revised remaining useful life In other words, the estimate impacts only the current and future periods No attempt is made to go back and “fix” the depreciation amount recognized in prior periods Time-factor methods of depreciation base cost allocation on time according to either straight-line or accelerated depreciation In theory, the pattern selected should be related to the pattern of benefits expected from the asset Because the pattern of benefits is very subjective, the selection of a specific time-factor method is usually an arbitrary decision Use-factor methods of depreciation base cost allocation on some measure that relates more directly to the use of the asset Most commonly, the allocation is When new estimates of recoverable natural resources are obtained, a new depletion cost per basic unit is computed from the beginning of the period in which the new estimate is made No adjustment is made to prior periods It is a change in 118 Chapter 13 estimate and therefore prospective in nature 10 A company should recognize an impairment loss when the undiscounted sum of expected future cash flows from the asset is less than the recorded book value of the asset The impairment loss is measured as the difference between the book value of the asset and the asset’s fair value Fair value can be estimated as the discounted sum of expected future cash flows 11 IFRS 36 differs from U.S GAAP in that the discounted sum of future cash flows, rather than the undiscounted sum, is used to determine whether an impairment loss exists 12 If a non-U.S company chooses to revalue a long-term operating asset upward in accordance with IFRS 16, the unrealized “gain” on the revaluation is recognized as a revaluation equity reserve This equity reserve increases the reported amount of equity but is not shown as a gain in the income statement 13 For accounting purposes, recorded intangible assets come in three varieties: a Intangible assets that are amortized The impairment test for these intangibles is the same as the twostep test used for tangible long-term operating assets b Intangible assets that are not amortized The impairment test for these intangibles involves a simple one-step comparison of the book value to the fair value c Goodwill, which is not amortized The goodwill impairment test is a two-step process that first involves estimating the fair value of the entire reporting unit to which the goodwill is allocated 14 a Compute the fair value of each reporting unit to which goodwill has been assigned b If the fair value of the reporting unit exceeds the net book value of the assets and liabilities of the reporting unit, the goodwill is assumed to not be impaired and no impairment loss is recognized c If the fair value of the reporting unit is less than the net book value of the assets and liabilities of the reporting unit, a new fair value of goodwill is computed The goodwill value is the amount of fair value of a reporting unit that is left over after the values of all identifiable assets and liabilities of the reporting unit have been considered d If the implied amount of goodwill computed in (c) is less than the amount initially recorded, a goodwill impairment loss is recognized for the difference 15 a No depreciation is to be recognized b The asset is to be reported at the lower of its book value or its fair value (less the estimated cost to sell) 16 A gain or loss is recognized whenever an exchange of assets takes place unless the following four conditions exist: (a) the assets are similar in nature, (b) the parties to the transaction are in the same line of business, (c) a gain is indicated in the transaction, and (d) if cash is involved, it is less than 25% of the fair value of the exchange The APB concluded that if these conditions exist, any indicated gain should be deferred and recognized over the life of the new asset If less than 25% cash is received as part of the consideration in the exchange, a portion of any indicated gain may be recognized even if all four conditions exist An indicated loss is always recognized 17 ‡ Depreciation is an estimate, and the effort necessary to compute depreciation expense for the exact number of days an asset is owned usually exceeds any benefit derived For companies that acquire and dispose of many assets during a year, detailed tracking of daily depreciation is almost impossible A variety of simplifying assumptions are used, including rounding to the nearest whole month and the half-year convention in which one-half of a year’s depreciation is taken on any asset acquired or disposed of during the year 18.‡ The original reasons for the development of the ACRS income tax depreciation method were simplification of the tax depreciation computations and acceleration of tax depreciation deductions to reduce income taxes and Chapter 13 119 stimulate investment Simplification comes through the grouping of assets in just a few classes and through the ignoring of salvage values Acceleration of tax depreciation deductions comes through shortened asset lives and use of accelerated depreciation methods like double-declining balance ‡ Relates to Expanded Material PRACTICE EXERCISES PRACTICE 13−1 RECORDING DEPRECIATION EXPENSE Depreciation Expense Accumulated Depreciation PRACTICE 13−2 1,000 1,000 COMPUTING STRAIGHT-LINE DEPRECIATION ($80,000 − $10,000)/4 years = $17,500 annual depreciation expense Depreciation Expense Accumulated Depreciation 17,500 17,500 Book value: $80,000 − $17,500 = $62,500 PRACTICE 13−3 COMPUTING SUM-OF-THE-YEARS’-DIGITS DEPRECIATION and Year Computation ($80,000 − $10,000) ($80,000 − $10,000) ($80,000 − $10,000) ($80,000 − $10,000) PRACTICE 13−4 × × × × Depreciation Accumulated Amount Depreciation (4/10) $28,000 $28,000 (3/10) 21,000 49,000 (2/10) 14,000 63,000 (1/10) 7,000 70,000 Book Value $52,000 31,000 17,000 10,000 COMPUTING DOUBLE-DECLINING-BALANCE DEPRECIATION and Double-declining-balance percentage: (100%/4 years) × = 50% Depreciation Accumulated Year Computation Amount Depreciation $100,000 × 0.50 $50,000 $50,000 $50,000 × 0.50 25,000 75,000 $25,000 × 0.50 12,500 87,500 $12,500 − $10,000 2,500 90,000 Book Value $50,000 25,000 12,500 10,000 The depreciation amount in the final year is the amount that reduces the machine’s book value to equal the estimated residual value PRACTICE 13−5 COMPUTING SERVICE-HOURS DEPRECIATION and Rate per service hour: [($60,000 − $10,000)/10,000 hours] = $5 per hour Year Computation 2,000 hours × $5 per 5,000 hours × $5 per 2,000 hours × $5 per 1,000 hours × $5 per PRACTICE 13−6 Depreciation Accumulated Amount Depreciation hour $10,000 $10,000 hour 25,000 35,000 hour 10,000 45,000 hour 5,000 50,000 Book Value $50,000 25,000 15,000 10,000 COMPUTING PRODUCTIVE-OUTPUT DEPRECIATION and Rate per unit: [($70,000 − $5,000)/13,000 units)] = $5 per unit Year Computation 3,000 units × $5 per 5,000 units × $5 per 2,000 units × $5 per 3,000 units × $5 per PRACTICE 13−7 unit unit unit unit Depreciation Accumulated Amount Depreciation $15,000 $15,000 25,000 40,000 10,000 50,000 15,000 65,000 Book Value $55,000 30,000 20,000 5,000 COMPUTING GROUP DEPRECIATION Asset Asset Asset Asset Totals Acquisition Cost $ 64,000 90,000 42,000 30,000 $226,000 Salvage Value $ 4,000 10,000 6,000 Useful Life years 10 Expense $10,000 8,000 4,000 6,000 $28,000 $28,000/$226,000 = 0.12389 This percentage is applied to the total original cost of all assets in the group in order to compute total annual depreciation expense PRACTICE 13−8 GROUP DEPRECIATION: RECORDING ASSET SALES With group depreciation, gains and losses are typically not recognized on the sale of individual assets Cash Accumulated Depreciation Asset 22,000 20,000 42,000 Accumulated Depreciation is the plug figure in this entry We assume that the overall depreciation policy is accurate, so no gains or losses are recorded when disposing of group assets The group rate percentage is normally left the same unless there is persuasive evidence for the need of a change ($64,000 + $90,000 + $30,000 + $50,000) × 0.12389 = $28,990 PRACTICE 13−9 ASSET RETIREMENT OBLIGATION The present value of the asset retirement obligation is computed as follows: FV = $200,000; I = 10%; N = 10 years → $77,109 The total cost of the landfill site is $477,109 = $400,000 + $77,109 Depreciation expense: $477,109/10 years = $47,711 Accretion expense: $77,109 × 0.10 = $7,711 PRACTICE 13−10 COMPUTING DEPLETION EXPENSE Depletion rate = (January cost – Residual value)/January tons ($100,000 − $20,000)/5,000 tons = $16.00 per ton 900 tons × $16.00 per ton = $14,400 depletion expense Depletion Expense Accumulated Depletion (or Mine) 14,400 14,400 PRACTICE 13−11 CHANGE IN ESTIMATED LIFE Annual depreciation using the original estimates: ($60,000 − $5,000)/11 years = $5,000 annual depreciation expense Total accumulated depreciation after two years: $5,000 annual depreciation expense × years = $10,000 Remaining useful life after two years: New estimate of years – years already elapsed = years remaining Annual depreciation using the revised estimates in the third year: [($60,000 − $10,000 accumulated depreciation) − $12,000]/6 years = $6,333 annual depreciation expense PRACTICE 13−12 CHANGE IN ESTIMATED UNITS OF PRODUCTION Depletion rate for Year = January cost/January tons $150,000/2,000 tons = $75.00 per ton 900 tons × $75.00 per ton = $67,500 depletion expense Depletion rate for Year = January cost/January tons ($150,000 − $67,500 + $60,000)/(600 tons + 700 tons) = $109.62 per ton 600 tons × $109.62 per ton = $65,772 PRACTICE 13−13 DETERMINING WHETHER A TANGIBLE ASSET IS IMPAIRED The equipment is not impaired The relevant comparison is the book value of the asset to the sum of the expected future cash flows Sum of future cash flows ($65,000 × 14 years)$910,000 Book value ($1,500,000 − $600,000) 900,000 Because the sum of future cash inflows is more than the book value of the asset, no impairment has occurred In testing for impairment, the current value of the asset is not used Therefore, the equipment should continue to be reported in Fredo’s books at its net book value of $900,000 PRACTICE 13−14 RECORDING A TANGIBLE ASSET IMPAIRMENT The building is impaired The relevant comparison is the book value of the building to the sum of the expected future cash flows Sum of future cash flows ($15,000 × 30 years)$450,000 Book value ($500,000 − $40,000) 460,000 Because the sum of future cash inflows is less than the book value of the asset, the building is impaired Accumulated Depreciation 40,000 Loss on Impairment ($460,000 − $120,000)340,000 Building 380,000 PRACTICE 13−15 RECORDING UPWARD ASSET REVALUATIONS Building ($730,000 − $500,000) Accumulated Depreciation Revaluation Equity Reserve 230,000 40,000 270,000 PRACTICE 13−16 RECORDING AMORTIZATION EXPENSE Amortization Expense Accumulated Amortization 60,000 60,000 $300,000/5 years = $60,000 annual amortization expense (Note: Straight-line amortization is used unless there is compelling evidence for using another method.) PRACTICE 13−17 GOODWILL IMPAIRMENT Estimated fair value of the Manufacturing reporting unit: Present value of $350 per year for 10 years at 10% = $2,151 With a business calculator: Make sure to toggle so that the payments are assumed to occur at the end (END) of the period PMT=$350; N=10; I=10% → PV = $2,151 Net book value of the assets and liabilities of the Manufacturing reporting unit: Assets ($3,500 + $1,000) – Liabilities ($2,000) = $2,500 Because the estimated fair value of the reporting unit ($2,151) is less than the net book value of the reporting unit ($2,500), further computations are needed to determine the amount of a goodwill impairment loss, if any Implied fair value of goodwill as of December 31: Fair value of identifiable assets + Fair value of goodwill – Fair value of liabilities = Total fair value $4,000 + Fair value of goodwill − $2,000 = $2,151 Fair value of goodwill = $151 Journal entry necessary to recognize the goodwill impairment loss: Goodwill Impairment Loss Goodwill ($1,000 − $151) 849 849 PRACTICE 13−18 EXCHANGE OF DISSIMILAR ASSETS Land 400,000 Accumulated Depreciation 340,000 Gain on Exchange ($400,000 − $360,000) 40,000 Building 700,000 Land 200,000 Accumulated Depreciation 340,000 Loss on Exchange ($360,000 − $200,000)160,000 Building 700,000 PRACTICE 13−19 CLASSIFYING AN ASSET AS HELD FOR SALE BuildingHeld for Sale ($40,000 − $6,000)34,000 Loss on Held-for-Sale Classification 11,000 Accumulated DepreciationBuilding 155,000 Building 200,000 Building Held for Sale 11,000 Gain on Recovery of ValueHeld for Sale 11,000 Computation of gain: ($60,000 − $6,000) − $34,000 = $20,000; maximum gain that can be recognized is the amount of the initial loss recognized upon classification as held for sale = $11,000 PRACTICE 13−20 EXCHANGE OF SIMILAR ASSETS New Asset Accumulated Depreciation (old asset) Old Asset 150 850 Cash New Asset Accumulated Depreciation (old asset) Gain on Exchange ($400 − $150 book value) Old Asset 300 100 850 1,000 250 1,000 [Note: This transaction is considered to be a monetary exchange because the cash exchanged is more than 25% of the value of the deal ($300/$400 = 75% > 25%).] Cash New Asset Accumulated Depreciation (old asset) Gain on Exchange Old Asset Recognized gain 80 120 850 50 1,000 = Indicated gain × Cash received as a percentage of the total value of the deal = ($400 − $150 book value) × ($80/$400) = $50 Discussion Case 13–75 The first year of a new management is a unique opportunity for making asset write-offs and restructuring charges because the negative impact on earnings will be blamed on the previous management Managements are typically replaced because of dissatisfaction with their performance Accordingly, restructuring and reevaluations of the assets are expected In calculating these charges, the new management has no incentive to understate their magnitude When faced with a difficult decision of whether or not to write off an asset, new management would always have an incentive to write it off in the first year when old management will be blamed rather than waiting until subsequent years when the new management will be held responsible for poor earnings Discussion Case 13–76 An increase in estimated useful life would decrease depreciation expense for the year, increase net income, and increase the book value of the asset (above what it would have been without the change in useful life) The effects on net income can be quite significant The most theoretically correct reason for increasing the estimated useful life of an asset is that new technology has made it possible to prolong the life of the asset, or new engineering studies reveal that the previous estimate understated the life of the asset For example, on July 1, 1986, Delta Air Lines changed the depreciation period for its flight equipment from 10 years to 15 years This change had the effect of decreasing Delta’s depreciation expense for the year ended June 30, 1987, by $130 million and increasing Delta’s net income for the year by $69 million—a 35% increase In practice, a reason often given for increasing an estimated useful life is that the change will bring the firm’s accounting practices more in line with other firms in the industry For example, in 1987 General Motors increased the estimated service lives of its plant, equipment, and special tools, bringing GM’s estimates more in line with Chrysler and Ford The increases reduced depreciation expense for 1987 by $1.2 billion, resulting in an increase in operating income of 93% Clearly, these useful-life changes can have an enormous impact on earnings Accordingly, it is natural to suspect that at least some of these changes are motivated by management’s desire to improve reported earnings Discussion Case 13–77 ‡ The issue of the impact of tax legislation on financial accounting is a complex one and is becoming increasingly important As indicated throughout the text, the objectives of taxing authorities in defining income are not the same as those used by accounting standard-setting bodies concerned with financial reporting However, because both groups identify something called income, attempts are often made to use the tax legislation in financial reporting This case demonstrates how changeable tax legislation can be as economic conditions change Chapter 16 text explores in more detail the issue of accounting for income taxes in financial reporting This case can be used to explore current developments in the area of tax legislation Students should be aware of the potential impact tax regulations can have on financial reporting Many accountants believe that accounting standards should ignore tax regulations These accountants feel that the conceptual framework should be used to determine desirable accounting practice for areas such as noncurrent operating assets Differences between tax accounting and accounting standards should be identified and disclosed Other accountants, especially those working for smaller business enterprises, feel that financial reporting would be simpler if the tax regulations were followed for reporting purposes The cost of maintaining two sets of accounting records is unjustified Class discussion of this case should provide good opportunities for student interaction in discussing the economic consequences of different reporting conventions ‡ Relates to Expanded Material SOLUTIONS TO STOP & THINK 170 Chapter 13 Stop & Think (p 789): Imagine that at the beginning of 2005, Schuss Boom had five different machines: one brand new, and the others one year, two years, three years, and four years old Which depreciation method—straight line, sum-of-the-years’ digits, or double-declining balance—would give the highest total depreciation expense in 2005? Total depreciation expense for the five assets is computed here ( Note: With double-declining balance, the depreciation for the 4-year-old asset is the amount that reduces the book value to the residual value of $5,000.) Age of Asset Brand new One year old Two years old Three years old Four years old Total depreciation Straight Line $19,000 19,000 19,000 19,000 19,000 $95,000 Sum-of-theYears’ Digits $31,667 25,333 19,000 12,667 6,333 $95,000 DoubleDeclining Balance $40,000 24,000 14,400 8,640 7,960 $95,000 For each depreciation method, total annual depreciation expense for the five assets is the same: $95,000 For a company with a stable base of assets, all depreciation methods yield the same total depreciation expense If a company is growing and thus has more new assets than old assets, the accelerated methods yield higher total depreciation expense than does the straight-line method Stop & Think (p 799): Why you think the FASB designated the undiscounted sum of future cash flows rather than the fair value as the threshold for determining whether an asset is impaired? This is a very controversial question The theoretical argument in favor of the undiscounted threshold is that an asset is impaired only if expected future cash flows are not sufficient to recover the recorded book value of the asset Of course, this ignores the time value of money The practical impact of the undiscounted threshold, which is higher than a fair value threshold, is that the frequency of required recognition of impairment losses is reduced It has been suggested that the undiscounted threshold represents a compromise between a theoretically correct fair value threshold and the desire in the business community to never be required to recognize an impairment loss Stop & Think (p 805): Why wouldn’t the regular two-step impairment test (using the undiscounted sum of future cash flows) work for intangible assets that are not amortized? For an intangible asset with indefinite life, there is no foreseeable end to the future cash flows to be generated by the asset Accordingly, the undiscounted sum of future cash flows will always be infinite and, using the two-step impairment test, no impairment loss would ever be recognized This is an unreasonable outcome, so a separate impairment test, using the discounted present value of the future cash flows, is used Stop & Think (p 807): It has been suggested that the goodwill impairment test is a costly one to apply in practice Which one of the four procedures of the impairment test you think is the most costly to perform? Procedure is the most costly to perform In many cases, procedure can be performed using simple earnings or revenue multiples to estimate the fair value of the reporting unit Procedure is a simple calculation using the estimated fair value and the reported amounts of assets and liabilities for the reporting unit Once procedure is completed, procedure simply involves the comparison of two numbers However, procedure requires the estimation of the fair values of all of the assets and liabilities of the reporting unit Because of the difficulty of performing procedure 3, SFAS No 142 allows a company to use the same detailed asset and liability valuations from one year to the next if the economic situation of the reporting unit has not changed much, if the composition of the assets and liabilities has not changed much, and if the previous impairment test threshold was exceeded by a substantial margin Stop & Think (p 813): How is it possible for both companies on opposite sides of the deal to show a gain on the same transaction? Gains are computed based on a comparison between the fair value of the asset given up and the book value of that same asset Reported gains are not a reflection of which company in a transaction has negotiated a better deal Accordingly, it is entirely possible for both companies to recognize a gain or for both to recognize a loss 172 Chapter 13 SOLUTIONS TO STOP & RESEARCH Stop & Research (p 794): One company that is likely to have a large amount recorded for “asset retirement obligation” is ExxonMobil Access a copy of ExxonMobil’s most recent annual report and determine how much the company has recognized as asset retirement obligation In its 2001 financial statements, ExxonMobil described the required accounting for asset retirement obligations under SFAS No 143 However, the company had not yet applied the new standard, which was required beginning in the company’s 2002 financial statement ExxonMobil described the accounting policy it followed in 2001 as follows: “In August 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No 143 (FAS 143), ‘Accounting for Asset Retirement Obligations’ FAS 143 is required to be adopted by the corporation no later than January 1, 2003 and its primary impact will be to change the method of accruing for upstream site restoration costs These costs are currently accrued ratably over the productive lives of the assets At the end of 2001 the cumulative amount accrued under this policy was approximately $3.2 billion Under FAS 143, the fair value of asset retirement obligations will be recorded as liabilities when they are incurred, which are typically at the time the assets are installed Amounts recorded for the related assets will be increased by the amount of these obligations Over time the liabilities will be accrued for the change in their present value and the initial capitalized costs will be depreciated over the useful lives of the related assets The corporation is evaluating the impact of adopting FAS 143.” Stop & Research (p 807): The standard eliminating the immediate write-off of goodwill in the United Kingdom is FRS 10, “Goodwill and Intangible Assets.” Go to the Web site of the Accounting Standards Board (ASB) in the United Kingdom (http:// www.asb.org.uk), access the publicly available summary of FRS 10, and determine what the ASB has to say about whether goodwill is an asset The ASB makes the following comment with respect to the recording of goodwill as an “asset” in the balance sheet (emphasis added): “The standard takes the view that goodwill arising on an acquisition (i.e., the cost of acquisition less the aggregate of the fair value of the purchased entity's identifiable assets and liabilities) is neither an asset like other assets nor an immediate loss in value Rather, it forms a bridge between the cost of an investment shown as an asset in the acquirer's own financial statements and the values attributed to the acquired assets and liabilities in the consolidated financial statements Although purchased goodwill is not in itself an asset, its inclusion amongst the assets of the reporting entity, rather than as a deduction from shareholders' equity, recognizes that goodwill is part of a larger asset, the investment, for which management remains accountable.” SOLUTIONS TO NET WORK EXERCISES Net Work Exercise (p 784): One of the authors owns a 1989 Jeep Comanche pickup truck According to the Kelley Blue Book, the truck (which is not exactly in perfect condition) has a retail value of $685 (as of September 2002) The author bought the truck in 1998 for $3,000 Most of the “depreciation” has been caused by his two teenage sons Net Work Exercise (p 816): The following comes from the IRS Web site information on Topic 704 regarding the tests that must be met in order to depreciate tangible property The kinds of property that you can depreciate include machinery, equipment, buildings, vehicles, and furniture You cannot claim depreciation on property held for personal purposes If you use property, such as a car, for both business or investment and personal purposes, only the business or investment-use portion may be depreciated You may depreciate property that meets all five of the following tests: • • • • • It must be property you own; It must be used in a business or other income-producing activity; It must have a determinable useful life; It must be expected to last more than one year; and It must not be excepted property Excepted property includes certain intangible property and term interests and property placed in service and disposed of in the same year The following comes from the IRS Web site information on Topic 704 regarding when it is necessary to use MACRS depreciation Generally, if you are depreciating property you placed in service after 1980 and before 1987, you must use the accelerated cost recovery system (ACRS) For property placed in service after 1986, you generally must use the modified accelerated cost recovery system (MACRS) For property placed in service before 1981, you must continue to use the same method you have used in the past 174 Chapter 13 SOLUTIONS TO BOXED ITEMS College Depreciation: FASB vs GASB (pp 792–793) Failing to report depreciation results in a substantial understatement of the cost of operating a college or university In addition, the depreciation charge is an explicit recognition that an organization must generate sufficient funds to cover the cost of replacing capital assets as they wear out in order to maintain its capacity to continue to provide services in the long term As an argument against the requirement, colleges and universities point out that their operating funds and capital funds typically are acquired from different sources We all have been (or will be) approached by our alma maters to contribute to a "capital campaign," a fund-raising drive intended specifically to acquire funds for expansion and replacement of depreciable assets Adherence to FASB and GASB pronouncements is strictly voluntary The worst that can happen to firms refusing to comply is that their audit opinions will be qualified However, if the community of users loses faith in the FASB and GASB standards, qualifications of this sort may not be seen as being serious The announcement by bond-rating agencies that they would not penalize colleges and universities that refuse to comply with the depreciation requirement was very disturbing When major users ignore accounting principles, it is questionable whether those principles can still be called "generally accepted." The major concern with all disputes in accounting standard setting is that the SEC or Congress will "settle" the dispute by taking the standard-setting authority away from the private sector In the college depreciation controversy, one college president said that if the rule were not changed, he was "quite prepared to go to Congress to get it overturned." A college or university might want to recognize depreciation in order to accurately reflect the cost of operations In particular, recognition of depreciation makes any budget deficit look worse and therefore makes pleas to potential contributors seem more convincing Baseball Accounting (pp 802–803) The initial roster asset is described as representing the value of the team over and above the value of the individual players This description sounds very much like goodwill Recorded goodwill is the excess amount paid for a company over the fair market value of the company's identifiable net assets There are several possible ways to make the financial statements of a team that has never been sold more comparable to those of a team that has recently changed hands (a) Don't revalue team assets when the team is purchased by a new owner Instead, preserve the book values that existed before the change in ownership This is similar to the pooling-of-interests method of accounting for a business combination This approach has the disadvantage of ignoring the information contained in the acquisition price paid by the new owner (b) Don’t record an initial roster asset for the excess amount paid over the fair value of the identifiable assets of the team This approach is often used in Great Britain to avoid recording goodwill; instead of recording an intangible asset, a direct reduction to equity is made (c) Require all balance sheet amounts for all teams to be based on current market values Baseball team owners have many incentives to understate profits Team profits are used in salary negotiations with players to indicate whether the teams can afford to increase players’ salaries Clearly, owners want the reported profits to be as low as possible In addition, owners frequently seek aid from municipal governments in the form of tax relief or the building of a new stadium Owners’ pleas sound more convincing if they can produce financial statements showing large losses Did Goodwill Accounting Put U.S Firms at a Disadvantage? (pp 806–807) An international standard-setting group, the International Accounting Standards Board (IASB), has been established to provide a forum for dealing with differences among the accounting standards of different countries This board meets regularly and issues standards that address issues such as goodwill (the topic discussed in this scenario) Countries vary in their laws, cultures, traditions, and objectives of accounting information This has made it more difficult to bring harmonization into the accounting standards However, the need for investors and creditors to evaluate financial statements from all over the world will inexorably exert pressure on accounting standard setters to develop a common body of accounting standards The rationale for immediately writing off goodwill against equity reserves is consistency; since homegrown goodwill is not recognized as an asset, purchased goodwill should not be recognized either This sounds like a “two wrongs make a right” argument Goodwill should be recognized as an asset when it can be reliably measured Goodwill purchased as part of an acquisition can be reliably measured, so it should be recognized Historically, in the United Kingdom, goodwill was not recorded as an asset and was not amortized against earnings At the same time, U.S companies were required to amortize goodwill If identical U.S and U.K firms were bidding to acquire the same company, the British company would have an advantage, the argument went, because it would have been able to show higher annual earnings after the acquisition Firms care about reported annual earnings for several reasons: (a) Managers' bonuses are frequently based on reported earnings (b) Loan covenants are often written in terms of reported earnings (c) Some investors seem to rely on the naive use of reported earnings in picking stocks However, it has never been established that stock prices are systematically influenced by differing accounting methods 176 Chapter 13 COMPETENCY ENHANCEMENT OPPORTUNITIES Deciphering 13–1 (The Walt Disney Company) The following information was extracted from the notes to Disney’s 2001 financial statements: Parks, resorts and other property are carried at cost Depreciation is computed on the straightline method based upon estimated useful lives ranging from three to fifty years Film and television production and participation costs are expensed based on the ratio of the current period's gross revenues to estimated total gross revenues from all sources on an individual production basis Estimates of total gross revenues can change significantly due to a variety of factors, including the level of market acceptance of film and television products, advertising rates and subscriber fees Accordingly, revenue estimates are reviewed periodically and amortization is adjusted, if necessary In order to find out Disney’s total depreciation and amortization expense for 2001, one has to look at the statement of cash flows Depreciation is $987 million, and amortization is $767 million, making a total of $1,754 million (Note: The amortization amount is reported separately on the face of the income statement.) The following comes from Note on Film and Television Costs: Based on management's total gross revenue estimates as of September 30, 2001, approximately 54% of completed and unamortized film, television costs and television broadcast rights (excluding amounts allocated to acquired film libraries) are expected to be amortized during fiscal 2002, and approximately 80% during the next three years The difference between the $19.0 billion and the $14.073 billion does not stem from amortization because Disney lists the accumulated amortization separately in Note 10 The actual reason for the difference is that since the ABC acquisition, Disney has disposed of some of the business segments of ABC For example, in 1997 Disney disposed of most of the publishing businesses owned by ABC Goodwill from the initial ABC acquisition is allocated to these business segments when they are sold; that is, this portion of the ABC goodwill is removed from Disney’s books upon the disposition Deciphering 13–2 (Delta Air Lines) Depreciable cost for 1998 was as follows: Flight equipment held all of 1998 Acquired during year [($11,180 – $9,619) × 1/2] Total depreciable cost for 1998 $ 9,619.00 780 50 $10,399 50 Estimated depreciation expense for 1998: [$10,399.5 – $10,399.5(0.05)] ÷ 20 years = $494 [$10,399.5 – $10,399.5(0.05)] ÷ 25 years = $395 The assumption of no disposals during 1998 is not reasonable The change in accumulated depreciation during the year is $385 ($3,895 – $3,510) Because this is significantly less than the estimated depreciation expense for the year ($494), it appears that there have been some disposals Deciphering 13–3 (Ford Motor Company) T-accounts will be used to estimate the book value of assets disposed of during 2001: 12/31/00 01 Purchases 12/31/01 Property and Equipment 51,302 6,357 01 Disposals 51,833 ???? From the T-account data, the indicated historical cost of 2001 disposals is $5,826 01 Disposals Accumulated Depreciation 12/31/00 ???? 01 Depreciation 12/31/01 24,327 8,565 27,510 From the T-account data, the indicated accumulated depreciation on items disposed of in 2001 is $5,382 Estimated book value of property and equipment is $444 ($5,826 – $5,382) Total property and equipment, December 31, 2000 Less: Land Non-land property and equipment, December 31, 2000 Non-land disposals during 2001 [$5,826 – ($639 – $583)] Property and equipment held all of 2001 $51,302 639 $50,663 5,770 $44,893 Depreciable base for 2001 was as follows (ignoring residual values): Property and equipment held all of 2001 Disposed during year ($5,770 × 1/2) Acquired during year ($6,357 × 1/2) Total depreciable base for 2001 $44,893 2,885 3,179 $50,957 $50,957/$8,565 = 5.95 years average life Accumulated depreciation, December 31, 2001 Non-land property and equipment ($51,833 – $583) $27,510/$51,250 = 53.7% proportion of cost depreciated $27,510 $51,250 5.95 years × 0.537 ≅ 3.20 years average age (Note: This estimation ignores residual values.) Deciphering 13–4 (AT&T Corporation) 1998 Operating income/ Total revenues 14.1% 1.5% 10.6% 2.2% Net income (loss)/ Total revenues 12.0 5.2 0.3 Net income (loss)/ Common equity 37.7 1997 13.3% 9.4% 1996 1995 1994 1993 1992 1991 16.9 1.0 17.2% 9.8% 8.6 11.4 0.2 6.3 (8.5) 23.3 33.4 0.8 26.3 (44.2) 178 Chapter 13 Revised numbers, after adding back the effects of the special charges (numbers are in millions), are shown in the following table The net income effect is added to year-end common shareowners’ equity, and the effects on shareowners’ equity are cumulative ($2,700 increase in 1991, another $9,600 increase in 1993, a further $4,680 increase in 1995, and a final $1,500 increase in 1998) 1998 1997 1996 1995 1994 1993 1992 1991 Total revenues $53,223 $51,577 $50,688 $79,609 $75,094 Operating income (loss) $9,987 $6,836 $8,709 $9,015 $7,949 Net income (loss) $7,898 $4,415 $5,793 $4,819 $4,710 Common shareowners' equity $35,429 $35,890 $34,300 $34,254 $30,221 Operating income/ Total revenues Net income (loss)/ Total revenues Net income (loss)/ Common equity $69,351 $66,647 $64,455 $6,498 $3,694 $6,529 $3,442 $5,928 $2,871 $25,674 $23,013 $20,673 18.8% 13.3% 17.2% 11.3% 10.6% 9.4% 9.8% 9.2% 14.8% 8.6% 11.4% 6.1% 6.3% 5.3% 5.2% 4.5% 22.3% 12.3% 16.9% 14.1% 15.6% 14.4% 15.0% 13.9% The series of special charges recognized by AT&T makes it impossible to interpret the time series of operating income and net income margins computed in (1) The margin for a given year is dependent on whether a charge was recognized during the year, and it is difficult to get an idea of trends and comparisons The adjusted series in (2) is much easier to interpret The steady increase in profit margins in (2) is misleading A large part of this increase is due to decreased depreciation expense that results from the reduction in depreciable asset base associated with a large restructuring charge With the data available, it is not possible to remove this subsequent-year effect from AT&T’s numbers Sample CPA Exam Questions The correct answer is b The total cost of the mineral mine will include the $2,820,000 spent to acquire the mine and the $360,000 in development costs for a total of $3,180,000 This will be reduced by the estimated recoverable value of the property of $300,000 for a net cost of $2,880,000 Since 1,200,000 tons are expected to be extracted, depletion will be $2,880,000/1,200,000, or $2.40 per ton The depletion on 60,000 tons extracted in 2005 will be 60,000 × $2.40, or $144,000 The correct answer is b Under double-declining-balance depreciation over a 5-year life, depreciation on the $50,000 machine would have been 40% or $20,000 in the first year, and 40% of the remaining $30,000 or $12,000 in the second year, for a total of $32,000 The remaining $18,000 would be depreciated straight-line over the remaining years at the rate of $6,000 per year As a result, after the first years, accumulated depreciation would have been $32,000 + $6,000, or $38,000 Writing Assignment: One depreciation method, please! To: FASB Members From: New Research Staff Member Subject: Depreciation—One Method Only 180 Chapter 13 Recently, a recommendation was received from a financial analysts group urging the FASB to address the area of depreciation accounting with the objective of designating just one method as acceptable Below are reasons for and against adding such a project to the FASB’s agenda For: • • Current GAAP allows companies many choices of depreciation method This diversity impairs the comparability of financial statements Choice of depreciation method gives managers one more way to manipulate the reported financial statement numbers Against: • All assets are not used in the same way Some are used uniformly throughout their useful lives; others are used more heavily in early years GAAP should have the flexibility to allow for this difference in circumstances • FASB resources are limited Depreciation accounting is an area that has been settled and quiet for years The Board should work on more pressing matters • Over 90% of large firms use straight-line depreciation Why worry about the small number who not? Research Project: How old are those assets? The computations needed to estimate the average useful life of long-term depreciable assets and the average age of assets in place are illustrated in the solution to Deciphering 13–3 (Ford Motor Company) Assumptions that are required in making the life and age estimates are: • • Something must be assumed about depreciation on acquisitions and disposals during the year Alternatively, acquisitions and disposals can be ignored, and all calculations can be done using the ending property, plant, and equipment balance Land must be either excluded (because it is not depreciated), or it must be assumed to be insignificant in amount The Debate: The impairment standard is dumb! The FASB Majority • Impairment occurs when the future cash flows from an asset are not expected to be sufficient to recover the undepreciated cost of the asset This is the same recoverability standard that is frequently used in accounting • Impairment losses should not be recognized based on merely temporary declines in fair value The undiscounted cash flow threshold ensures that any impairment losses recognized will be of a permanent nature • The threshold is relatively easy to compute and apply The test is a very practical one • Fair values not exist for many assets, and the lack of reliability of estimated fair values makes it unwise to base the existence of impairment losses on these estimates The Anti-144 Coalition • Let’s use some common sense—an asset is impaired when its fair value is less than its recorded value This is a simple economic test that everyone understands, and it should be the basis of the impairment standard • On the other side, these long-term operating assets are not at all like investment securities—they are intended to be used up in the course of operations Because they will not be sold, the task of the accountant is simple—allocate the historical cost of the asset over its useful life There is no need to worry about impairment at all Ethical Dilemma: Profit manipulation during labor negotiations There are two extreme possible courses of action: Do nothing to the depreciation numbers Present the financial statements, as they are, to the employee committee Some risk is inherent in this strategy because if the employee committee discovers the questionable depreciation calculations, the atmosphere in the negotiations will turn nasty very quickly In addition, doing nothing when you know that the numbers are deceiving is an unethical approach 182 Chapter 13 Insist that your partner revise the financial statements using more realistic depreciation calculations Refuse to cooperate with any attempt to deceive the employee committee Of course, this approach runs the risk of angering your partner and long-time friend, perhaps harming your entire business relationship The dilemma here is that two important relationships of trust must be maintained—your relationship with the employees and your relationship with your partner Neither of the two courses of action described above preserves both of those relationships A possible alternative is to redirect the focus of the negotiations from the reported financial numbers back to the real issue—what is a fair wage for your employees It seems that, in this case, the most relevant information is comparative wage data for employees in other firms in the area who similar work In addition, you and your partner must consider what costs there are in potentially losing a number of your existing employees Focusing on these issues, rather than arguing about financial statement assumptions, would probably be more fruitful for both sides of the negotiation Cumulative Spreadsheet Analysis See Cumulative Spreadsheet Analysis solutions CD-ROM, provided with this manual Internet Search a In its 2001 annual report, Philip Morris stated the following with respect to its implementation of SFAS No 142: During 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No 141, "Business Combinations" and SFAS No 142, "Goodwill and Other Intangible Assets." Effective January 1, 2002, the Company will no longer be required to amortize indefinite life goodwill and intangible assets as a charge to earnings In addition, the Company will be required to conduct an annual review of goodwill and other intangible assets for potential impairment The Company estimates that net earnings and diluted earnings per share would have been approximately $9,569 million and $4.33, respectively, for the year ended December 31, 2001; $9,096 million and $4.00, respectively, for the year ended December 31, 2000; and $8,252 million and $3.43, respectively, for the year ended December 31, 1999, had the provisions of the new standards been applied in those years The Company does not currently anticipate having to record a charge to earnings for the potential impairment of goodwill or other intangible assets as a result of adoption of these new standards b In its 2001 annual report, AT&T stated the following with respect to its implementation of SFAS No 142: Also in June 2001, the FASB issued SFAS No 142, “Goodwill and Other Intangible Assets" which supercedes APB Opinion No 17 Under SFAS No 142, goodwill and indefinite-lived intangible assets will no longer be amortized, but rather will be tested for impairment upon adoption and at least annually thereafter In addition, the amortization period of intangible assets with finite lives will no longer be limited to 40 years SFAS No 142 is effective for AT&T as of January 1, 2002 In connection with the adoption of this standard, AT&T's unamortized goodwill balance and excess basis related to equity method investments will no longer be amortized, but will continue to be tested for impairment The goodwill balance as of December 31, 2001, was $24.7 billion, and the related amortization in 2001 was $0.9 billion The excess basis balance at December 31, 2001, was $8.8 billion, with related amortization in 2001 of $207 million In addition, we have determined that our franchise costs are indefinite-lived assets, as defined in SFAS No 142, and therefore will not be subject to amortization beginning in 2002 The balance of our franchise costs as of December 31, 2001, was $42.8 billion and the related amortization for 2001 was $1.2 billion The adoption of SFAS No 142 will have a significant impact on our future operating results due to the cessation of goodwill and franchise cost amortization For 2001, the amortization of goodwill, excess basis and franchise costs had an approximate impact of $0.45 per share In accordance with SFAS No 142, goodwill was tested for impairment by comparing the fair value of our reporting units to their carrying values As of January 1, 2002, the fair value of the reporting units' goodwill exceeded their carrying value, and therefore no impairment loss will be recognized upon adoption In accordance with SFAS No 142, the franchise costs were tested for impairment as of January 1, 2002, by comparing the fair value to the carrying value (at market level) An impairment loss of $0.9 billion, net of taxes of $0.5 billion will be recognized as a change in accounting principle in the first quarter of 2002 c In its 2001 annual report, Viacom stated the following with respect to its implementation of SFAS No 142: SFAS 142 supersedes APB Opinion No 17 "Intangible Assets", related to financial accounting and reporting for acquired goodwill and other intangible assets SFAS 142 requires that goodwill and intangible assets with indefinite lives, including such assets recorded in past business combinations, no longer be amortized to earnings, but should instead be tested for impairment on an annual basis and between annual tests if events occur or circumstances change that would more likely than not reduce the fair value below its carrying amount Intangible assets with finite lives will continue to be amortized over their useful lives and reviewed for impairment The Company will adopt SFAS 142 in the first quarter of 2002 The Company has determined that with the exception of Blockbuster, none of the Company's reporting units has an impairment The impairment charge will be determined after the fair value of Blockbuster has been allocated to specific assets and liabilities and will be recognized as a cumulative effect of a change in accounting principle Any potential write-off of Blockbuster's goodwill would represent an insignificant decrease relative to the Company's consolidated intangibles of approximately $71 billion Also, as a result of the new accounting standard, future amortization expense will be significantly lower The Company anticipates a significant reduction in amortization expense from $2.2 billion for 2001 to approximately $110 million for 2002 As of September 2002, the basic provisions of IFRS No 36 were the same as those outlined in the text of Chapter 13 The following summary is taken from the IASB’s Web site: An impairment loss should be recognised whenever the recoverable amount of an asset is less than its carrying amount (sometimes called "book value"): • The recoverable amount of an asset is the higher of its net selling price and its value in use, both based on present value calculations; • Net selling price is the amount obtainable from the sale of an asset in an arm’s length transaction between knowledgeable willing parties, less the costs of disposal; • Value in use is the amount obtainable from the use of an asset until the end of its useful life and from its subsequent disposal Value in use is calculated as the present value of estimated future cash flows The discount rate should be a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the asset Thus, the provisions of IFRS No 36 continue to differ from those of SFAS No 144 in that the IASB uses a present value threshold in deciding whether an impairment has occurred whereas the FASB threshold does not incorporate present values ... increases the reported amount of equity but is not shown as a gain in the income statement 13 For accounting purposes, recorded intangible assets come in three varieties: a Intangible assets that... Building ($1,300,000 – $380,000) 390,000 530,000 920,000 The answer to (1) is unaffected by the fair value of the asset The existence of an impairment loss is determined solely using the... $1,300,000 390,000 $ 910,000 According to IFRS 36, the existence of impairment is determined by comparing the book value of $910,000 to the fair value of $380,000 The fair value is lower, so