Discuss the long live fixed assets and it depreciation and impairments.

9-195-264 Harvard Business School Rev. April 23, 2012 Long-lived Fixed Assets A company’s long-lived fixed assets (“fixed assets”) include all of its physical assets with a life of more than one year that are used in operations but are not intended for sale as such in the ordinary course of business. Fixed assets can be classified in three different categories: (1) those subject to depreciation, such as plant and equipment; (2) those subject to depletion, such as natural resources; and (3) those not subject to depreciation or depletion, such as land. Fixed assets are normally carried at their original cost less any accumulated depreciation or depletion. Depreciation is the process of allocating the cost of fixed assets over the useful life of the asset so as to match the cost of an asset with the benefits it creates, and depletion is the process whereby the cost of wasting assets is matched with the revenues generated by the asset. Initially, the note focuses on the measurement of investments in fixed assets. The allocation of the cost of fixed assets to the income statement to determine periodic income is covered later in the note. Fixed assets are shown on the balance sheet as follows: Plant and equipment (original cost) xxxx Less: Allowance for depreciation xxxx Net plant and equipment xxxx Ordinarily, no mention is made of a fixed asset’s market value. Statement users should pay close attention to the fixed asset accounting employed by the companies they analyze. The net book value of plant and equipment is a major determinant of many companies’ book value (assets less liabilities), which is a key value often used in equity valuations and debt covenants. The condition of a company’s plant may determine in large measure its cost structure and ability to improve its capital and employee productivity. The values assigned to fixed assets influence periodic income since they are the basis for future depreciation and depletion charges. Management decisions to capitalize or not capitalize fixedasset-related expenditures can influence current profits. Finally, management can improve or depress current profits by lowering or raising the level of maintenance expenditures required to maintain the company’s fixed assets. Capitalization Criteria Considerable judgment is sometimes required to determine whether or not an expenditure related to fixed assets should be capitalized or expensed as incurred. Generally, those fixed-asset-related expenditures are capitalized whose usefulness is expected to extend Professor David Hawkins prepared this note as the basis for class discussion. Copyright © 1995, 2012 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685 or write Harvard Business School Publishing, Boston, MA 02163. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School. 1 195-264 Long-lived Fixed Assets over several accounting periods, expand the usefulness of a fixed asset, or extend its useful life. Conversely, expenditures should be expensed when they neither extend the useful life of a fixed asset beyond the original estimates nor generate benefits beyond the current accounting period. Companies usually establish minimum cost limits below which all fixed-asset-related expenditures are expensed, even if they might otherwise be properly capitalized. The minimum amount selected should be set at a point which still results in fair financial reporting without placing an unreasonable burden on the accounting system. Cost Basis Unless otherwise indicated, the cost of a purchased fixed asset is the price paid for the asset plus all of the costs incidental to acquisition, installation, and preparation for use. Care must be applied to assure the inclusion of all material identifiable elements of cost, such as purchasing, testing, and similar items. Fixed assets may be acquired by manufacture or by exchange. The cost of assets manufactured for use in the business generally includes the materials, labor, and manufacturing overhead directly related to the construction. How much, if any, of the general factory overhead is included in the construction cost depends on whether or not the plant constructing the asset is operating at or below capacity. When the plant is operating at or near capacity, the use of the scarce productive facilities to construct an asset for internal use reduces the opportunity to produce regular items for sale. Because of this lost profit opportunity, a fair share of general manufacturing overhead is typically charged to an asset construction project, thereby relieving the income statement of costs that, in the absence of the construction, would have generated some offsetting revenue. When below-capacity utilization conditions exist, it is debatable whether a fair portion of general manufacturing overhead should be charged to the cost of assets constructed for a company’s own use. The arguments for charging a portion of general manufacturing overhead include: (a) the current loss from idle capacity will be overstated unless a cost for idle capacity used for construction is capitalized; (b) the construction will have future benefits, so all costs related to acquiring these benefits should be deferred; and (c) the construction project should be treated the same as regular products, which are charged with general manufacturing overhead. The principal arguments opposing this point of view are: (a) the cost of the asset should not include general manufacturing overhead costs that would still have been incurred in the absence of the construction; (b) the general manufacturing overhead was probably not considered as a relevant cost in making the decision to construct the asset for the company’s own use, since the costs would be incurred irrespective of whether or not the asset was constructed; (c) when part of the general manufacturing overhead is capitalized, the resulting increase in current income will be due to construction rather than the production of salable goods; and (d) it is more conservative not to capitalize general manufacturing overhead. Increasingly, the practice of charging general manufacturing overhead to fixed assets constructed for a company’s own use, on the same basis and at the same rate as regular goods produced for sale, is being adopted without regard to the prevailing capacity conditions. This trend reflects a movement away from conservatism for its own sake and a growing concern for proper allocation of costs to reduce distortions of periodic income due to undervaluation of assets. Assets manufactured for a company’s own use may cost less than their purchase price. This saving should not be recorded as profit at the time the asset is completed, since profits result from the use of assets, not their acquisition or construction. The advantage of the saving will accrue to the company over the life of the asset through lower depreciation charges than would have been incurred if the asset had been purchased. This document is authorized for use only by Anas Alkhalufah in HCM513-Spring 2023-2024 taught by Awwad Alnesafi, Other (University not listed) from Feb 2024 to Aug 2024. Long-lived Fixed Assets 195-264 Assets costing more to construct than their purchase price are sometimes recorded at their purchase price equivalent in the interests of conservatism. The difference between construction cost and purchase price is charged to income upon completion of the asset. The cost of a nonmonetary asset, such as a building, acquired in exchange for another nonmonetary asset is the fair value of the asset surrendered to obtain it, and a gain or loss should be recognized on the exchange if the exchange is essentially the culmination of an earnings process. However, if the exchange is not the culmination of an earnings process, the accounting for an exchange of nonmonetary assets between an enterprise and another entity should be based on the book value of the asset relinquished with no gain or loss recognized on the exchange. Trade-in allowances on exchanged assets are often greater than their market value. Consequently, the use of trade-in allowances to value a newly acquired asset may lead to misleading results, through an overstatement of cost and subsequent depreciation charges. Caution must be exercised in trade-in situations, since assets acquired through exchanges should not be recorded at a price greater than would have been paid in the absence of a trade-in. The interest cost on funds financing construction of long-lived assets must be capitalized as part of the fixed asset cost. Examples of the types of assets covered include assets intended for the enterprise’s own use (such as facilities) or assets intended for sale or lease that are constructed as discrete projects (such as ships or real estate projects). This relevant standard states: To qualify for interest capitalization, assets must require a period of time to get them ready for their intended use. . . . Interest cannot be capitalized for inventories that are routinely manufactured or otherwise produced in large quantities on a repetitive basis. The interest cost eligible for capitalization shall be the interest cost recognized on borrowings and other obligations. The amount capitalized is to be an allocation of the interest cost incurred during the period required to complete the asset. The interest rate for capitalization purposes is to be based on the rates of the enterprise’s outstanding borrowings. If the enterprise associates a specific new borrowing with the asset, it may apply the rate on the borrowings to the appropriate portion of the expenditures for the asset. A weighted average of the rates on other borrowings is to be applied to expenditures not covered by specific new borrowings. Judgment is required in identifying the borrowings on which the average rate is based. Donated assets should be recorded at their fair market value. Expenditures Subsequent to Acquisition and Use After a fixed asset is acquired and put into use, a number of expenditures related to its subsequent utilization may be incurred. The manager must decide whether or not these expenditures should be capitalized as part of the asset cost or expensed as incurred. The general practice is to capitalize those expenditures that will generate future benefits beyond those originally estimated at the time the asset was acquired. However, if there is substantial uncertainty as to whether the benefits will ever be realized, such expenditures are charged to current income. Also, all expenditures related to fixed assets that are necessary to realize the benefits originally projected are expensed. 3 195-264 Long-lived Fixed Assets Maintenance and Repairs Maintenance and repair costs are incurred to maintain assets in a satisfactory operating condition. When these expenditures are ordinary and recurring, they are expensed. Significant expenditures made for repairs which lead to an increase in the asset’s economic life or its efficiency beyond the original estimates should be charged to the allowance for depreciation. This effectively raises the asset’s book value. In addition, the asset’s depreciation rate should also be changed to reflect the new use, life, and residual value expectations. Extraordinary expenditures for repairs that do not prolong an asset’s economic life or improve its efficiency probably represent the cost of neglected upkeep of the asset, and as such should be charged to income as incurred. Repairs made to restore assets damaged by fire, flood, or similar events should be charged to loss from casualty up to the amount needed to restore the asset to its condition before the damage. Expenditures beyond this amount should be treated like any other expenditure that prolongs the economic life of an asset. When some assets are acquired, it is anticipated that unusually heavy maintenance costs, such as repainting, may be incurred at different points during their lives. In these situations, some managers establish an Allowance for Repairs and Maintenance account to avoid unusually large charges against income. This practice, which is permissible, charges income with a predetermined periodic maintenance expense based upon management’s estimate of the total ordinary and unusual maintenance costs over the asset’s life. The credit entry is to the liability account, Repairs and Maintenance Allowance. When the actual expenditures for the anticipated maintenance are incurred, the allowance account is charged with this amount. Since the allowance represents a future charge to current assets, it is sometimes treated as a current liability. In other cases, it is reported as a contra account to fixed assets, along with the allowance for depreciation account. Credit balances are deducted from original cost in determining book value. Debit balances are regarded as temporary additions, and as such increase book value. For income tax purposes, only the actual expenditures for maintenance are deductible. Therefore, the establishment of an allowance usually has deferred tax accounting implications also. Betterments, Improvements, and Additions Expenditures for betterments and improvements, such as replacing wooden beams with steel girders, usually result in an increase in an asset’s economic life or usefulness. As such, these expenditures are properly capitalized and subsequently charged to the related asset’s allowance for depreciation. Also, the asset’s depreciation rate should be redetermined to reflect the economic consequences of the expenditure. Minor expenditures for betterments and improvements are typically expensed as incurred. Additions to existing assets, such as a new wing to a plant, represent capital expenditures and as such should be recorded at their full acquisition cost and accounted for just like an original investment in fixed assets. Land Land is a nondepreciable asset. Its life is assumed to be indefinitely long. Land should be shown separately on the balance sheet. The cost of land includes the purchase price, all costs incidental to the purchase, and the costs of permanent improvements, such as clearing and draining. Expenditures made for This document is authorized for use only by Anas Alkhalufah in HCM513-Spring 2023-2024 taught by Awwad Alnesafi, Other (University not listed) from Feb 2024 to Aug 2024. Long-lived Fixed Assets 195-264 improvements with a limited life, such as sidewalks and fencing, should be recorded in a separate account, Land Improvements, and written off over their useful lives. If land is held for speculative purposes, it should be captioned appropriately and reported separately from the land used for productive facilities. The carrying costs of such land can be capitalized, since the land is producing no income and the eventual gain or loss on the sale of the land is the difference between the selling price and the purchase price plus carrying charges. Wasting Assets Mineral deposits and other natural resources that are physically exhausted through extraction and are irreplaceable are called “wasting assets.” Until extracted, such assets are classified as fixed assets. The cost of land containing wasting assets should be allocated between the residual value of the land and the depletable natural resource. If the natural resource is discovered after the purchase of the land, it is acceptable to reallocate the original cost in a similar way. Companies in the business of exploiting wasting assets on a continuing basis incur exploration costs to replace their exhausted assets. These exploration costs can be either expensed or capitalized. Because of the great uncertainty associated with exploration in the extractive industries, the typical practice is to capitalize only those costs identifiable with the discovery and development of productive properties and expense the rest as incurred. There are two basic approaches to the capitalization of discovery and development costs. These are commonly called the “full cost” and “field cost,” or “successful efforts,” methods. In practice, these methods are applied in a variety of different ways. The field cost method assigns the costs of discovery and development to specific fields of wasting assets, such as a specific oil or gas field in Oklahoma. If the exploration and development activities related to that field are unsuccessful, the costs are expensed. If the field proves to be successful, the costs are capitalized and written off against the production of the field on a units-of-production basis. If the costs exceed the value of the field’s reserves, the costs are capitalized only to the extent they can be recovered from the sale of the reserves. Should a field be abandoned, any capitalized costs are written off immediately. The full cost method assigns costs of discovery and development to regions of activity, such as the North American continent. These regions may include one or more fields in which the company is active. The full cost method follows the same capitalization-expense rules as the field method. However, since the area for measuring reserves is now a larger region, the costs of discovery and development in unsuccessful fields can be lumped together with the costs of successful efforts and written off against the total region’s production. Alternative Measurement Proposals Historical cost is the only accepted base for measuring plant and equipment and related depreciation charges in published financial statements. A number of other approaches have been proposed by accounting authors. These include: making the carrying value of assets more responsive to their current market values, adjusting the historical cost base to reflect general price level changes, and the use of replacement costs as the basis for calculating annual depreciation charges. Those who oppose the use of historical costs to value fixed assets do so principally on the ground that it does not, in their opinion, lead to useful financial statements. For many years, 5 195-264 Long-lived Fixed Assets supporters of alternative approaches to the historical cost convention did not challenge the objectivity and feasibility of historical costs in comparison with other, alternative methods for measurement of fixed assets. In recent years, however, these two qualities have been increasingly questioned. The proponents of historical cost argue that it is a useful basis and part of the discipline of management in that it holds managers responsible for the funds invested in fixed assets. Also, the users of financial reports are fully aware that historical costs do not represent value but merely unexpired costs. The weight of convention, experience, and acceptance is clearly on the side of historical costs; therefore, it is argued, the burden of proving any alternative basis more useful rests with those who oppose the use of historical costs to measure assets. The essence of the price-level and market value approaches often proposed as alternatives to the historical cost method can be illustrated as follows. A farmer’s sole asset is land purchased 15 years ago for $8,000. The current appraisal of the land’s market value is $300,000. During the 15 years the farmer held the land, general price levels doubled. A historical cost based balance sheet for this farmer would show assets of $8,000 and net worth of $8,000 (other items excluded). If price-level adjustments were made, the statement would show assets of $16,000 and a similar amount for net worth. The $16,000 is the current purchasing power equivalent of the original $8,000 × 200% inflation. If market values were used, the statements would show assets at $300,000 and net worth at $300,000, which would consist of $8,000 original investment and $292,000 appreciation by reason of holding the land in a rising market. If the price-level and market value approaches were combined, the assets would remain the same, but net worth would now consist of the $8,000 original investment, the $8,000 price-level gain, and the $284,000 appreciation in the market value of the land after adjusting for general price-level changes. General price-level adjustment (constant dollar accounting) attempts to state historical costs incurred in different years in terms of a common monetary unit of equivalent purchasing power. It is not a valuation method. It simply adjusts nominal dollars spent or received in different periods to a common purchasing power equivalent. In countries with rapidly rising price levels, it is common practice to adjust the historical acquisition costs of fixed assets for general price-level changes. This results in a measurement of fixed assets and their related depreciation charges in terms of the general purchasing power invested and expiring. Under conditions of rapid inflation, few question the wisdom of this practice. However, for many years, it was argued that the annual rate of inflation in the United States had not been high enough to justify converting the historical costs invested in assets during prior years to equivalent dollars having the same purchasing power. In 1979, the FASB, after a period of above-average inflation, decided that general-price-level-adjusted statements may be more meaningful than historical-cost-based statements and required certain larger companies to provide supplemental disclosure of their price-level-adjusted data. Later, in 1985, the FASB rescinded this requirement to publish data adjusted for changes in the general price level. Price change accounting and recent developments in this area are covered in greater detail in another note. The case for the market value approach to asset valuation is expressed as follows. Assets are recorded at cost initially, because this is the economic measure of their potential service value. After acquisition, the accounting goal should continue to be to express the economic value of this service potential. This is difficult to measure directly, but the current market price others are willing to pay for similar assets approximates this value in most cases. Therefore, to the extent that market values are available, they should be used to measure fixed asset carrying values and their subsequent consumption in the production of goods and services. Property values are more useful than historical costs to managers and stockholders because market values determine the collateral value of property for borrowing purposes, fix liability for property taxes, establish the basis for insurance, and reflect the amount an owner might expect to realize upon sale of the property. This document is authorized for use only by Anas Alkhalufah in HCM513-Spring 2023-2024 taught by Awwad Alnesafi, Other (University not listed) from Feb 2024 to Aug 2024. Long-lived Fixed Assets 195-264 The principal objection to market value is that it is often difficult to determine objectively. The proponents of market value answer this argument by indicating that the notion of market value has some important qualifications. For example, market values should be recognized only when the disparity between market value and cost is likely to prevail for a fairly long period. Furthermore, the market value of an asset should be recognized only on the basis of reliable evidence. The notion of market value probably has little relevance to nonstandardized equipment or special fixed assets for which no readily available market exists. Historical costs must suffice in these cases. The market value approach has significant implications for the income statement. Market value advocates claim that management continually faces the alternative of using or disposing of assets. Income statements based on historical cost do not show how well management has appraised this alternative since in no way is the “cost” of the alternative forgone included in the statements. In a case where the market value of an asset is greater than its historical cost, historical-cost-based depreciation leads to an overstatement of the incremental benefit gained by using rather than selling, since the book depreciation basis is understated. The reverse is true when the market value is less than the book value. It is claimed that marketvalue-based depreciation would overcome this weakness. The incremental benefit of continuing to use the asset would be determined after a depreciation charge based on the “cost” of the income forgone by not disposing of the asset. There is a difference of opinion among market value supporters as to how changes in the carrying value of the assets should be recorded. Some would treat the increases or decreases in stockholders’ equity in much the same way as appraisal adjustments are recorded. Others propose including the changes as part of a comprehensive income determination. The replacement cost approach advocates carrying assets at the cost of reproducing equivalent property, not identical property (as some critics of replacement cost assume). This approach is based on a concept of income which does not recognize profit until depreciation charges have provided adequately for the eventual cost of replacing the capacity represented in existing assets with an asset of more modern design. Based on this theory, traditional depreciation, which recovers original cost from revenues, fails to provide adequately for future replacement in periods of rising replacement costs, and so leads to an overstatement of distributable profits. As a result, excessive dividends, wages, and income taxes may be paid, to the detriment of the company’s ability to maintain its current level of productive capacity. The replacement cost approach is usually implemented by multiplying an asset’s original cost by a price index specifically related to the changing cost of the asset involved. Sometimes a further adjustment is made to this figure to reflect technological changes since the date of the original asset’s acquisition. The result approximates the replacement cost of an asset’s equivalent capacity derived through an appraisal. Such price indexes are available and widely accepted for specific categories of assets. The replacement cost proponents argue that their method has the advantage of the objectivity associated with recording the original cost of the asset at acquisition, as well as minimizing the role of judgment in subsequent revaluations. Thus, the net result of their approach, they argue, is a more useful income figure without any sacrifice in objectivity. The FASB provided guidance to companies working to report the current cost of their property, plant, and equipment. This valuation approach is similar in many respects to the replacement cost concept. The FASB defined current cost as “the current cost of acquiring the same service potential (indicated by operating costs and physical output capacity) as embodied by the asset owned.” The service potential (or future economic benefit) of an asset is its capacity to provide services or benefits to the company using the asset. 7 195-264 Long-lived Fixed Assets Depreciation The term depreciation, as used in accounting, refers to the process of allocating the cost of a depreciable tangible fixed asset to the accounting periods covered during its expected useful life. Some of the difficulties encountered by financial statement users in connection with depreciation result from failure to recognize the meaning of the term in this accounting sense. Outside the area of accounting, depreciation is generally used to denote a reduction in the value of property; misunderstandings are caused by attempts to substitute this concept for the more specialized accounting definition. Depreciation was defined by the American Institute of Certified Public Accountants in its Accounting Terminology Bulletin No. 1: Depreciation accounting is a system of accounting which aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. It is a process of allocation, not of valuation. Depreciation for the year is the portion of the total charge under such a system that is allocated to the year. Depreciation can be distinguished from other terms with specialized meanings used by accountants to describe asset cost allocation procedures. Depreciation is concerned with charging the cost of manmade fixed assets to operations (and not with determination of asset values for the balance sheet). Depletion refers to cost allocations for natural resources such as oil and mineral deposits. Amortization relates to cost allocations for intangible assets such as patents and leaseholds. The use of the term depreciation should also be avoided in connection with valuation procedures for securities and inventories. A good grasp of the nature of depreciation is important to statement users since depreciation enters into a number of common financial analysis ratios and techniques. For example: This document is authorized for use only by Anas Alkhalufah in HCM513-Spring 2023-2024 taught by Awwad Alnesafi, Other (University not listed) from Feb 2024 to Aug 2024. 1. Depreciation is added back along with other noncash items to net income to derive cash flow from operations. 2. Capital expenditures are related to historical cost and current cost depreciation to judge the adequacy of a company’s capital expenditure program. 3. The gross depreciable asset original cost balance is divided by the annual depreciation expense to determine the average depreciable life of a firm’s plant and equipment. 4. The accumulated depreciation account is divided by the annual depreciation expense to estimate the average age of a company’s plant and equipment. 5. Depreciation is an element of both the cost of goods sold and the general, administration and selling expense items; as such it influences gross margin and operating costs and profit percentages. 6. A company’s book and tax depreciation accounting choices influence its deferred tax balances, tax payments, and earnings quality. Long-lived Fixed Assets 195-264 Computing Depreciation Depreciation expense for a period of operations can be determined by a variety of means, all of which satisfy the general requirements of consistency and reasonableness. Depreciation accounting requires the application of judgment in four areas: (1) determination of the cost of the asset depreciated, (2) estimation of the useful life of the asset, (3) estimation of the residual value at the end of expected useful life, and (4) selection of a method of computing periodic depreciation charges. Estimating the Useful Life of Fixed Assets The estimated useful life of most fixed assets is expressed in terms of a period of calendar time. For example, a time basis for determining depreciation charges is suitable for general-purpose assets such as buildings. The useful life of an asset might be expressed in units other than time, however. For instance, the life of a motor vehicle could be estimated as 100,000 miles, while the life of a unit of specialized machinery could be estimated as 200,000 units of output or as 5,000 operating hours. The estimated life of an asset should be the period during which it is of use to the business. Thus, the estimate should take into account such factors as the use of the asset, anticipated obsolescence, planned maintenance, and replacement policy. The period of useful life may be less than the entire physical life of the asset. For example, machinery with an expected physical life of 10 years under normal conditions will have a useful life for depreciation purposes of six years if company policy is to trade or dispose of such assets after six years or if technological improvements are expected to make the machine obsolete in six years. Residual Value Residual (or salvage) value of fixed assets represents estimated realizable value at the end of this useful life. This may be the scrap or junk proceeds, cash sale proceeds, or trade-in value, depending upon the company’s disposition and replacement policies. Depreciable cost is determined by subtracting residual value from the cost of the fixed asset. This depreciable cost is the amount allocated to the operating periods over the asset’s useful life. Depreciation Methods Any depreciation method which results in a logical, systematic, and consistent allocation of depreciable cost is acceptable for financial accounting purposes. The procedures most commonly used are based upon straight-line, declining-balance, sum-of-the-years’-digits, and units-of-production (or service-life) depreciation methods. The commonly used depreciation methods are illustrated and discussed separately below. Several rarely used and comparatively complex depreciation methods which take into account the imputed earning power of investments in fixed assets will not be discussed. This group includes the annuity and sinking fund methods. Straight-Line Depreciation The most simple method of computing depreciation is the straight-line method. For purposes of illustration, a machine with a cost of $6,000 and estimated salvage value of $1,000 at the end of its expected five-year useful life is assumed. Depreciation expense for each year is computed thus: 9 195-264 Long-lived Fixed Assets Cost of machinery Less: Estimated residual value $6,000 1,000 Depreciable cost $5,000 Depreciable Cost  Depreciation Expense Estimated Life $5,000  $1,000 per Year 5 years Until accelerated The straight-line method’s strongest appeal is its simplicity. depreciation methods were permitted for income tax purposes, this method was used almost universally. Objections to the straight-line method center on the allocation of equal amounts of depreciation to each period of useful life. Identical amounts are charged in the first year for use of a new and efficient machine and in the later years as the worn machine nears the salvage market. Accelerated Depreciation Accelerated depreciation methods provide relatively larger depreciation charges in the early years of an asset’s estimated life and diminishing charges in later years. The doubledeclining-balance method and the sum-of-the-years’-digits methods are the two best-known methods. Double-declining-balance depreciation for each year is computed by multiplying the asset cost less accumulated depreciation by twice the straight-line rate expressed as a decimal fraction. Using the earlier examplemachinery with a cost of $6,000 and a five-year estimated useful life, which is equal to 20% per yeardepreciation is computed as follows: First year: Second year: Third year: Fourth year: Fifth year: Total $6,000 × 0.40 ($6,000 – $2,400) × 0.40 ($6,000 – $3,840) × 0.40 ($6,000 – $4,704) × 0.40 ($6,000 – $5,222) × 0.40 $2,400 1,440 864 518 311 $5,533 Note that estimated residual value is not used directly in these computations, even though the asset has salvage value. Since the double-declining-balance procedure will not depreciate the asset to zero cost at the end of the estimated useful life, the residual balance provides an amount in lieu of scrap or salvage value. Ordinarily, however, depreciation is not continued beyond the point where net depreciated cost equals a reasonable salvage value. Also, it is common practice to switch from double-declining-balance depreciation to straight-line depreciation over the remaining life of an asset when the annual depreciation charge falls below what the charge would have been if straight-line depreciation had been used on the remaining cost of the asset. Sum-of-the-years’-digits depreciation for the year is computed by multiplying the depreciable cost of the asset by a fraction based upon the years’ digits. The years’ digits are added to obtain the denominator (1 + 2 + 3 + 4 + 5 = 15), and the numerator for each successive year is the number of the year in reverse order. 10 Long-lived Fixed Assets 195-264 The formula for determining the sum-of-the-years’ digits is:  n + 1 SY D  n    2  Again using the facts for the illustration of straight-line depreciation, annual depreciation computed by the sum-of-the-years’-digits method would be: First year: $5,000 × 5/15 $1,667 Second year: $5,000 × 4/15 1,333 Third year: $5,000 × 3/15 1,000 Fourth year: $5,000 × 2/15 667 Fifth year: $5,000 × 1/15 333 Total $5,000 Accelerated depreciation methods provide larger depreciation charges against operations during the early years of asset life, when the asset’s new efficient condition contributes to greater earnings capacity. Further, the increasing maintenance and repair costs in the later years of asset use tend to complement the reducing depreciation charges, thereby equalizing the total cost of machine usage. Therefore, it is claimed that accelerated depreciation methods more properly match income and expense than does the straight-line method. Units-of-Production Depreciation The units-of-production depreciation method is based upon an estimated useful life in terms of units of output, instead of a calendar time period. Units-of-production (or service-life) methods are appropriate in those cases where the useful life of the depreciable asset can be directly related to its productive activity. Under the units-of-production method, depreciation is determined by multiplying the actual units of output of the fixed asset for the operating period by a computed unit depreciation rate. This rate is calculated by dividing the depreciable cost by the total estimated life of the asset expressed in units of output. A $6,000 machine is estimated to have a $1,000 salvage value after producing 100,000 units of output. The depreciation rate for the machine is: $5,000  $0.05 per unit 100,000 units And, the depreciation charge for a year in which 25,000 units are produced with this machine is $1,250 (25,000 units × $0.05 per unit). The units-of-production depreciation method relates fixed asset cost directly to usage. It is argued this method best matches depreciation costs and revenues. However, the life of an asset is not necessarily more accurately estimated in units of output than in terms of time. Further, this depreciation method requires a record of the output of individual assets, which may not be readily available without significant additional effort and cost. A hybrid straight-line and production method is sometimes used by companies in cyclical businesses. The straight-line portion is treated as a period cost and is the minimum depreciation charge. In addition, when production increases beyond a “normal” operating level, an additional depreciation charge is made to reflect the use of assets which are idle at normal production levels. 11 195-264 Long-lived Fixed Assets Accounting for Depreciation Regardless of the method chosen for computing depreciation, the accounting entry required to record depreciation applicable to a period of operation is: Dr. Depreciation Expense XXX Cr. Accumulated Depreciation XXX In addition, both account titles should indicate the type of fixed assets involved, that is, buildings, machinery, office equipment, and so on. This aids in proper handling of the accounts in the financial statements. Depreciation expense can be listed in the income statement as a single item or according to the nature of the fixed asset giving rise to the depreciation. Depreciation expense on factory machinery can be included in factory overhead, while depreciation on office equipment can be included among the administrative expenses. Accumulated Depreciation (sometimes called Allowance for Depreciation) is deducted from the related fixed asset account on the balance sheet. This account’s credit balance increases as assets are depreciated in successive accounting periods. Of course, the allocation of fixed asset cost could be accomplished by crediting the amount of depreciation directly to the fixed asset accounts. This procedure is not recommended because it merges the cost of the fixed asset with estimated depreciation charges, and the users of financial statements would be denied information about fixed asset investment and depreciation policies. Depreciation charges are continued systematically until the asset is disposed of or until the asset is depreciated to its salvage value. Fully depreciated assets remaining in service are carried in the accounts until disposition. From time to time, significant changes in a company’s circumstances may require a switch from one depreciation method to another. Group Depreciation Depreciation is frequently computed for a group of assets owned by a business. In preceding illustrations, it was assumed that depreciation was calculated separately for each fixed asset; such procedures are called unit methods. If the asset units can be grouped together in some general category, such as machinery, delivery equipment, or office equipment, it may be desirable to compute depreciation for the total of each group. This practice minimizes detailed analyses and computations. Also, errors in estimates of useful life and salvage value tend to balance out for the group. Estimated useful life is established for the entire group of assets, and depreciation is computed on the basis of weighted-average or composite rates. Both unit and group methods will theoretically achieve the same results of charging fixed asset costs to operations during the period of expected useful life. Depreciation and Federal Income Tax Federal income tax laws recognize depreciation as an expense in the computation of taxable income. There is no requirement that the same depreciation methods be used for both tax and financial reporting purposes. It is not uncommon for a business to adopt an accelerated depreciation method for tax purposes while using the straight-line depreciation method for financial reporting. Material differences in annual depreciation charges under this procedure will require appropriate deferred tax accounting in the financial statements. 12 Long-lived Fixed Assets 195-264 Depreciation Schedule Revisions Depreciation schedules are based upon management’s best estimate of the future utilization of an asset at the time it is acquired. During the life of the asset, these estimates may prove to be improper due to circumstances that indicate the asset’s useful life or the disposal value, or both, should be revised. Under these conditions, the approach specified in Opinion No. 20 is to leave the book value as it is and alter the rate of future depreciation charges. The changes are made prospectively, not retroactively. For example, assume a company depreciating an $11,000 asset on a straight-line basis over 10 years decided after five years that the asset’s remaining useful life was only going to be two years, rather than five. In addition, the previous $1,000 estimate of the salvage value was now thought to be erroneous. The new salvage value was estimated to be zero. The prior depreciation schedule was $1,000 per year ([$11,000 – $1,000]  10). Therefore, after five years the book value of the asset would be $6,000 ($11,000 – [5 × $1,000]). Before the change in the estimated life and salvage value, the annual depreciation charge over each of the next five years would have been $1,000. Now, based on the revised estimates, the annual depreciation charge over the next two years will be $3,000 per year ([$6,000 – $0]  2). Depreciation Method Changes In recent years a number of companies have changed their depreciation method. Typically, the shift has been from an accelerated to a straight-line depreciation method. A company may adopt the new accounting method for depreciable assets bought after a specific date, usually the beginning of the fiscal year in which the accounting change is initiated, or for all of its existing depreciable assets. The FASB recommends that when a company changes its depreciation accounting policy for all of its depreciable assets, the change should be recognized by including in the net income for the period of the change the cumulative effect, based on a retroactive computation, of changing to the new depreciation principle. Additions For depreciation purposes, an addition to fixed assets should be depreciated over its own economic life or that of the original asset, whichever is shorter. Donated Assets Fixed assets donated to a company on a conditional basis raise a difficult issue: Should income be charged with depreciation on such assets before full title is obtained? Since the company does not own the asset, it can be argued that depreciation should not be charged. On the other hand, the economic life of an asset is not dependent on who owns it. Therefore, if depreciation is not charged until title is obtained, the full depreciation charge must be applied to the economic life of the asset remaining after this event. This practice, which relates depreciation to ownership rather than the period of use, results in a misleading variation of income charges during two similar operating periods. Therefore, it is argued, the depreciation for such assets should be charged to operations during the full period of use. Asset Write-Downs Should it become clear to a company that it cannot recover through sale or productive use its remaining investment in a fixed asset, the asset should be written down to its net realizable value and current income charged with the write-down amount. Written-Up Assets The writing up of assets is not a generally acceptable practice. However, it may happen under certain circumstances in the accounts of foreign subsidiaries. When appreciation is 13 195-264 Long-lived Fixed Assets entered on the books, the company is obliged to make periodic depreciation charges that are consistent with the increased valuation rather than the historical cost basis. Accounting for Retirements The accounting for asset retirement is fairly straightforward. At the time an asset is retired, its original cost is credited to the appropriate asset account and the related accumulated depreciation is charged to the accumulated depreciation account. Any gain or loss on the retirement after adjusting for the cost of removal and disposition should be recognized. To illustrate, assume the Cleveland Company purchased a piece of equipment for $100,000. After two years, the company sold the equipment for $50,000. At the time of the sale the asset’s book value was $60,000 and the related accumulated depreciation was $40,000. The entries to record the purchase are: Dr. Machinery Cr. Cash 100,000 100,000 The entries to record the subsequent sale are: Dr. Cash Accumulated Depreciation Loss of Sale of Machinery Cr. Machinery 50,000 40,000 10,000 100,000 If the group method of depreciation had been in use, there would have been no loss and Accumulated Depreciation would have been reduced by $50,000. Capital Investment Decisions Some fault current depreciation accounting on the ground that it does not lead to a measurement of return on investment which matches the economic concept of return on investment used by many companies in making asset investment decisions. To illustrate, assume a company approves a proposed investment of $1,000, which is estimated to earn $250 cash per year after taxes for five years and therefore is expected to earn 8% on the amount, at risk, as indicated by Illustration A. The economic return on this investment is 8%, since the investor’s principal is recovered over the life of the investment and each year the investor receives an 8% return on the principal balance outstanding. Illustration A Year Total Earnings (a) Return at 8% on Investment Outstanding (b) Balance Capital Recovery (c) = (a) – (b) Investment Outstanding End of Year (d) 0 – – – $1,000 1 $250 $80 $170 830 2 250 66 184 646 3 250 52 198 448 4 250 36 214 234 5 250 19 231 3 a a Due to rounding. Assuming a straight-line depreciation method, this investment will be reported for financial accounting purposes as shown in Illustration B. From this illustration it is clear that 14 Long-lived Fixed Assets 195-264 the financial reports in no year show a return of 8%. This problem is eliminated if the periodic cost-based depreciation of an asset is shown as the difference between the present value of the related future service benefits at the beginning and end of the accounting period discounted by the internal rate of return calculated in the purchase decision analysis.1 In practice, it is difficult to measure the future service benefits accurately enough to apply this approach with confidence, so managers resort to using the various depreciation methods discussed above. Illustration B Netb Income Year Gross Assets Average Net Assetsa Computed Return On Gross On Net 1 $1,000 $900 $50 5% 5.5% 2 1,000 700 50 5 7.1 3 1,000 500 50 5 10.0 4 1,000 300 50 5 16.7 5 1,000 100 50 5 50.0 a Beginning and ending book values divided by 2. Cash earnings, $250, minus depreciation, $200. Income taxes are included in the calculation of net earnings. b Depletion Depletion is the process of allocating the cost of an investment in natural resources through systematic charges to income as the supply of the physical asset is reduced in the course of operations, after making provision for the residual value of the land remaining and any environmental remedial costs after the valuable resource is exhausted. There are two depletion methods: the production method and percentage method. The production method is acceptable for accounting purposes, whereas the percentage method is not. It is used in certain circumstances for computing income tax payments, however. The production method establishes the depletion rate by dividing the cost of the depletable asset by the best available estimate of the number of recoverable units. The unit costs are then charged to income as the units are extracted and sold. The unit can be the marketing unit (ounces of silver) or the extractive unit (tons of ore), although the marketing unit is preferred. It is permissible to adjust the depletion rate when it becomes apparent that the estimate of recoverable units used to compute the unit cost is no longer the best available estimate. To illustrate the cost-based depletion method, assume a coal mine containing an estimated profitable output of 10 million tons of coal is developed to the point of exploitation at a cost of $1 million. Furthermore, during the first year of operations, 500,000 tons of coal are mined and 450,000 tons are sold. The depletion unit charge is the total development cost divided by the estimated profitable output, or 10 cents per ton, that is, $1 million/10 million tons. The total depletion charged to the inventory in the first operating year is $50,000, that is, total production (500,000 tons) times the depletion unit cost ($0.10). The depletion charged to income as cost of goods sold during this period is $45,000, that is, total production sold (450,000 tons) times the depletion unit cost of ($0.10). Consequently, $5,000 of the year’s depletion charge is still lodged in the inventory account. 1 The internal rate of return is the discount rate which reduces the present value of the future benefits to the present value of the investment. 15 195-264 Long-lived Fixed Assets Depletion differs from depreciation in several respects: depletion charges relate to the actual physical exhaustion of an asset, and as such are directly included in inventory costs as production occurs. In contrast, depreciation recognizes the service exhaustion of an asset and is allocated to periodic income, except for depreciation related to manufacturing facilities, which is included in inventory costs on an allocated basis. The percentage or statutory method, which is permissible for some tax purposes, computes depletion as a fixed percentage of the gross income from the property. The percentage varies according to the type of product extracted. The cost method is also permissible for determining income tax payments. Companies are not obliged to use the same depletion method for book and tax purposes. Over the years Congress has eliminated or reduced the use of percentage depletion for tax purposes for many oil- and gas-producing companies. Depreciation Decisions The accounting criteria for choosing one depreciation method rather than another in any particular situation are fuzzy. The decision to use one of the depreciation methods over another should be made on the basis of a close examination of the asset’s characteristics and the way management viewed these characteristics in its investment decision. Empirical and theoretical evidence suggests that most productive assets tend to become less and less valuable over time. Maintenance costs rise and the quality of the asset’s service declines. Also, as technological advances are made, the quality of the existing equipment declines relative to alternative more modern equipment, even though quality does not deteriorate absolutely. Based on this evidence, it is believed by some that productive equipment depreciates on an accelerated basis in most cases, rather than, as was thought for a long time, on a straight-line basis. Similar studies indicate straight-line depreciation is a reasonable approximation of the depreciation rate of buildings and plant structures. When an asset is utilized in a project whose future success is more uncertain than the typical situation, some managements believe it is prudent to use accelerated depreciation. Others object to this practice on the ground that the project is more likely to be viewed as unsuccessful because the high depreciation charges will lower profits in the early years. Thus the action taken to reflect the excessive risk involved would contribute to the worst fears of management being realized. More often than not, depreciation accounting is used as an instrument of management’s financial reporting policy. Management selects the depreciation method or mix of methods that contributes to the desired financial results it hopes to achieve over time. For example, in some cases accelerated depreciation methods have been used to hold earnings down and conserve funds by reducing stockholder pressure to increase dividend distributions. In other situations, straight-line depreciation has been utilized to smooth earnings. In times of depressed profits, some companies have switched from accelerated to straight-line depreciation to boost earnings with the hope that this will maintain the market price of the company’s stock. The choice of service life can be used in a similar way to further the achievement of management’s financial reporting objectives. The different nature of assets argues for retaining the present wide range of permissible depreciation methods. However, the apparent use of depreciation as a tool of financial reporting policy, and the difficulty in practice of determining which method is the most appropriate for any given asset, have led some to conclude that depreciation methods should be standardized for similar categories of assets. 16 Long-lived Fixed Assets 195-264 Asset Impairments The FASB has issued a standard dealing deals with the accounting for impairment of long-lived assets and assets to be disposed of. While the standard should result in more realistic balance sheets, statement users should be wary of this rule. It leaves a lot up to management discretion in the timing of the recognition and in the measurement of impairment losses. The FASB’s fundamental conclusion is that a grouping of long-lived assets including fixed assets, intangible assets, capital leases and related goodwill, if any, is impaired when its book value is not recoverable, as measured by the projected cumulative undiscounted net cash flows (excluding interest) related to the asset. In this situation, the FASB requires that a new cost basis for that asset be established at its fair value. The resulting asset writedown to fair value is charged to income as an impairment loss. If goodwill is included as part of the impaired asset group, the carrying value of the goodwill should be reduced before the other impaired asset carrying values are reduced to fair value. Companies are prohibited from restoring impairment losses if circumstances change. In making the determination as to whether an asset is impaired, assets must be grouped at the lowest level for which there is an identifiable cash flow that is largely independent of the cash flows of other groups of assets. The term “asset” in SFAS 121 refers to a group of assets. The grouping decision is potentially a very subjective one requiring considerable judgment. Varying interpretations of facts and circumstances may justify different groupings. For example, a hotel chain that shared advertising programs and reservation systems could justify a different and more inclusive grouping of its hotels for impairment testing and measurement purposes than one that only owned and operated several autonomous and independent hotels. Alternatively, a bus company with a municipal contract requiring operation of five routes could not test for impairment of the assets devoted to one route. Since the company was required to operate all routes, the appropriate grouping would be the assets devoted to the contract. In other cases, such as oil and gas producers, the asset grouping may be defined by clear boundaries, such as geography. According to the FASB, fair value is to be determined as follows: Fair value of assets shall be measured by their market value if an active market for them exists. If no active market exists for the assets transferred but exists for similar assets, the selling prices in that market may be helpful in estimating the fair value of the assets transferred. If no market price is available, a forecast of expected cash flows may aid in estimating the fair value of assets transferred, providing the expected cash flows are discounted at a rate commensurate with the risk involved. The estimate of expected future cash flows should give weight to the likelihood of possible outcomes and be based on reasonable and supportable assumptions and projections. The discount rate decision requires management judgment. The FASB suggests that the hurdle rate used for internal capital budgeting decisions might be a useful guide to estimating the discount rate. After impairment is recognized, the new carrying value is charged to income over the asset’s remaining useful life. The FASB has concluded that an impairment loss was not similar to an extraordinary item or a loss from discontinued operations. Therefore, impairment losses are classified as components of earnings (losses) from continuing operations. SFAS require that assets to be disposed of be subjected to a lower of cost or fair value to sell measurement. 17 195-264 Long-lived Fixed Assets Analysis of Fixed Assets Companies usually file with the SEC in their 10-Ks more information on their various fixed asset balances, additions, subtractions, and lives, as well as maintenance costs, than they disclose in annual reports. These SEC filings are essential for a thorough analysis of a company’s fixed assets. With these data, statement users should attempt to appraise the competitive quality of the company’s fixed assets. Indications that a company’s fixed assets may be becoming less competitive are: a. Lengthening of the average age of the company’s plant and equipment, suggested by a drop-off in reported nominal or analyst estimated inflation-adjusted capital expenditures for plant and equipment and an increasing estimate of the plant and equipment’s average age in years, determined by dividing the accumulated depreciation balance by the current year’s depreciation expense. b. Failure to maintain plant and equipment, indicated by a decline in maintenance expenditures relative to gross plant. c. Uncompetitive facilities and equipment, suggested by an excess of analyst estimated annual current cost or constant dollar depreciation over current reported nominal annual capital expenditures. It is difficult to establish absolute standards to evaluate the results of fixed asset studies. The analyst must make judgments on the relative results of fixed asset studies of companies in the same industry, the object company’s own trend data, and management’s description of its business strategy and the role of fixed assets in that strategy. To understand in depth the quality of a company’s earnings, the details of the fixed asset accounts should be analyzed to detect any gains or losses from the disposition of fixed assets. Losses may suggest the company is underdepreciating its assets, with the result that earnings from operations are overstated. A gain on the sale of an asset may appear in the details of the fixed asset accounts but be reported simply as other income in the income statement. The unwary reader relying solely on the income statement presentation might miss this onetime source of income and thus overestimate the company’s income from operations. Depreciation Analytical Considerations Depreciation is a difficult item for analysts to deal with since depreciation accounting practices can vary considerably from company to company, are influenced by management judgments, and can be used to manipulate income. Faced with this situation, some statement analysts would prefer to exclude the distorting effect of depreciation from income when comparing the earnings performance of companies. This is a mistake. Depreciation is a cost of doing business and must be recovered like any other cost in order to earn a profit. Also, many of the differences between company depreciation accounting practices do reflect genuine differences in the nature of the companies’ assets and their economic circumstances which justify, if not demand, different approaches to depreciation accounting. Some financial analysts have claimed in the case of appreciating assets, such as real estate properties, that depreciation should not be charged against income. They argue that these assets are gaining value, not losing value. This point of view misses the cost allocation character of accounting depreciation, which has nothing to do with value. Also, it assumes assets appreciate forever. This is imprudent and does not reflect actual experience, which clearly indicates physical assets have definite lives and are subject to wear, tear, and exhaustion. If the business objective is to generate capital gains for investors through increases in the value of real 18 Long-lived Fixed Assets 195-264 estate, management’s degree of achievement of this objective can be communicated through supplemental disclosures of the appraisal values of properties. Depreciable asset accounting practices should be scrutinized carefully in earnings quality assessments and income source analyses. For example, a switch in depreciation method from accelerated to straight-line usually indicates that a company has trouble maintaining its earnings at a level high enough to support its former conservative approach to depreciation accounting. Another red flag indicating earnings problems and low-quality earnings is the use of unrealistically long depreciation lives. A depreciation red flag that can appear in profit analysis is a declining depreciation to sales ratio. This may indicate management is “milking” the company by not reinvesting in new assets and thereby not maintaining the operating quality of its plants and equipment. This practice is known as “riding down” the depreciation curve because as more assets become fully depreciated the level of depreciation to sales falls at an increasing rate. This usually results in the company becoming uncompetitive. Finally, in profit analysis, the depreciable asset-related maintenance expense should be tracked relative to sales or total product costs (cost of goods sold plus change in inventory). Management may attempt to push profits up by cutting back on maintenance. This is another red flag indicating profitability problems and, if continued, can lead to operating difficulties. Some statement users prefer to measure profits after adjusting depreciation for inflation. This approach to profit measurement and the role of inflation-adjusted depreciation on statement analysis is discussed in a later note. In times of above-average inflation rates, these inflation-adjusted data may produce more meaningful insights into how well a company is coping with inflation than the historical-cost-based depreciation data. 19

Collepals.com Plagiarism Free Papers

Are you looking for custom essay writing service or even dissertation writing services? Just request for our write my paper service, and we'll match you with the best essay writer in your subject! With an exceptional team of professional academic experts in a wide range of subjects, we can guarantee you an unrivaled quality of custom-written papers.

Get ZERO PLAGIARISM, HUMAN WRITTEN ESSAYS

Why Hire Collepals.com writers to do your paper?

Quality- We are experienced and have access to ample research materials.

We write plagiarism Free Content

Confidential- We never share or sell your personal information to third parties.

Support-Chat with us today! We are always waiting to answer all your questions.