Long-Lived Assets

and Depreciation

Revsine/Collins/Johnson/Mittelstaedt: Chapter 10

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, All

 Learning objectives
1. What measurement base is used for long-lived assets.

2. What kinds of costs are capitalized and how joint costs are allocated
among assets.

3. How GAAP measurement rules complicate trend analysis and

comparisons across companies.

4. Why the carrying values of internally developed intangibles often differ

from their real values.

5. What asset “impairment” means and how it is recorded.

RCJM: Chapter 10 © 2009 10-2

 Learning objectives concluded
6. How different depreciation methods work.

7. How analysts can adjust for different depreciation assumptions

and improve comparisons across companies.

8. How long-lived asset accounting and depreciation practices differ

internationally.

RCJM: Chapter 10 © 2009 10-3

 Long-lived operating assets
 An asset generates future economic benefits and is under the
exclusive control of a single entity.

 This chapter concentrates on operating assets expected to yield their

economic benefits (service potential) over a period longer than one
year.

RCJM: Chapter 10 © 2009 10-4

 Measuring the carrying
amount
 There are two ways that long-lived assets could be measured on
balance sheets:

Expected benefit approach: Economic sacrifice approach:

• Discounted present
value • Historical cost
$$ $$
• Net realizable • Replacement cost
value

Estimated value in an Estimated value in an input

output market where market where the asset is
the asset is sold purchased

RCJM: Chapter 10 © 2009 10-5

 Measuring the carrying
amount:
Illustration of four approaches
 Assume a truck originally costing $100,000, is two years old, has a remaining
life of 8 years, is being depreciated on a straight-line basis, and is expected to
have no salvage value.

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 Initial asset measurement
rules
 The initial balance sheet carrying amount of a long-lived asset is
governed by two rules:

1. All costs necessary to acquire the asset and make it ready to use are included in the
asset account (meaning they are capitalized costs). Other costs are “expensed” to
income.

Capitalized Expensed

$$ Price paid for land $$ Monthly equipment rental

Cost to repair damaged
$$ Cost of clearing land $$
equipment
2. Joint costs incurred in acquiring more than one asset are apportioned among
the acquired assets.

$100 Equipment A
$200 delivery
and installation fee
$100 Equipment B

RCJM: Chapter 10 © 2009 10-7

 Initial asset measurement
rules:
Example

Purchase price

Preparation
costs

Joint cost

Construction
Special GAAP costs
rules apply
Joint cost

RCJM: Chapter 10 © 2009 10-8

 Initial asset measurement
rules:
Interest capitalization
 SFAS No. 34 requires capitalization of avoidable interest payments
on self-constructed assets.

 Interest paid to lenders during the construction period is considered

to be a cost necessary to prepare the asset for its intended use.
Follows from initial asset
 Here is Canyon’s calculation of avoidable
measurement rule 1. interest:

Construction
expenditures

If the interest rate is 10%, then Canyon’s avoidable interest is $715,000.

RCJM: Chapter 10 © 2009 10-9

 Initial asset measurement
rules:
Interest capitalization concluded
 SFAS No. 4 limits the amount of interest capitalized.

Case 1: Case 2:
Avoidable interest Avoidable interest

$715,000 $715,000

Actual interest Actual interest

$800,000 $600,000

Interest capitalized Interest capitalized

$715,000 $600,000

RCJM: Chapter 10 © 2009 10-10

 Initial asset measurement
rules:
Tax versus financial reporting incentives
 The way incurred costs are allocated between land and buildings
affects the amount of income that will be reported in future
periods.
Allocation 1: Allocation 2:
• Higher • Lower
depreciation depreciation

$500 • Lower net $500 • Higher net

income income
$100 • Lower taxes $100 • Higher
Land Building Land Building taxes

 For financial reporting and tax purposes, the allocation is guided by

which one (the land or the building) generated the cost.

RCJM: Chapter 10 © 2009 10-11

 Capitalization criteria:
Costs incurred after initial use
 GAAP capitalizes costs incurred after the asset has been placed
in use as long as the expenditure:

 Extends the asset’s useful life

 Increases its productive capacity (e.g. attainable production units)
 Increases its production efficiency (e.g., fewer raw materials)
 Or, increases the asset’s other economic benefits

 If there is no increase in economic benefits (or future service

potential), the expenditure is charged to income as an expense.

RCJM: Chapter 10 © 2009 10-12

 Capitalization runs amok
Impact of Worldcom’s Misapplication of Asset Capitalization Rules

RCJM: Chapter 10 © 2009 10-13

 Financial analysis and fixed
assets:
ROA distortion example

25%

20%
Assume:
15%
 No new capital expenditures.
10%
 Prices rise at 3% per year. 5%

0%
ROA chart shows improving 2005 2006 2007 2008 2009

performance.

Return on assets

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 Financial analysis and fixed
assets
Why ROA appears to increase

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 Financial analysis and fixed
assets:
Rizzo Corporation

Same as CHEN

25%
Assume: ROA no longer
20% increases over time.
 Long-lived asset age of 4.5
15%
years.
10%
 Capital expenditures replace 5%
10% of long-lived assets 0%
each year. 2005 2006 2007 2008 2009

 Prices rise at 3% per year.

Return on assets

RCJM: Chapter 10 © 2009 10-16

 Financial analysis and fixed
assets
Why Rizzo’s ROA is flat

RCJM: Chapter 10 © 2009 10-17

 Intangible assets:
Overview
 Intangible assets convey future benefits to their owners.

Patent Trademark

 The accounting for acquired intangible assets is straight-forward:

 The asset is first recorded at the arm’s length transaction price.
 Then amortized (think “depreciation”) over its expected useful life.

 Difficult financial reporting issues arise when the intangible asset

is developed internally instead of being purchased.

RCJM: Chapter 10 © 2009 10-18

 Intangible assets:
Research and development (R&D)
 Recoverability of R&D expenditures (i.e., the future benefit) is highly
uncertain at the start of a project.

 So, SFAS No. 2 requires virtually all R&D expenditures to be

expensed as incurred.

 The FASB justified expensing all R&D for three reasons:

1. The future benefits are highly uncertain and difficult to predict.
2. A causal relationship between current R&D and future revenue (the
benefit) has not been demonstrated.
3. Whatever benefits may arise cannot be objectively measured.

RCJM: Chapter 10 © 2009 10-19

 Intangible assets:
Software development
SFAS No. 86 extends the accounting treatment for R&D to internal expenditures for software development.


Expensed as Technological feasibility established Capitalized

incurred and amortized

Development Development
expenditures $$ expenditures $$

Before After
Software project time line

RCJM: Chapter 10 © 2009 10-20

 Intangible assets:
Purchased in-process R&D
 When one firm buys another firm, the total purchase price must be
apportioned among the individual assets acquired.

In-process R&D (no Immediately

$500 alternative future use) written off

$950 $200 Other in-process R&D

$250 Tangible assets

Price paid for Allocation of

company purchase price
 Managers have a strong incentive to allocate a large portion of the
purchase price to purchased in-process R&D.

RCJM: Chapter 10 © 2009 10-21

 Intangible assets:
Accounting in the United Kingdom
 Marketing and advertising expenditures are treated as period
costs. R&D accounting also similar to U.S. GAAP.

 However, UK accounting rules allow companies to write long-

lived assets up to a new higher carrying value when market value
exceeds historical cost.

 One firm decided to put a balance sheet value of $1.2 billion on

its 60 trademarks (called “brands” in the UK).

RCJM: Chapter 10 © 2009 10-22

 Ambiguities in capitalization
criteria:
Oil and gas exploration costs

 Two different approaches to determining the cost of the producing well have emerged:

Full cost: Successful efforts:

$50 for the field

$10 for drilling costs
$250
$190
$0 $60
Capitalized Expensed Capitalized Expensed
(1 well) (19 wells) (1 well) (19 wells)

RCJM: Chapter 10 © 2009 10-23

 Asset impairment:
SFAS No. 144 guidelines

RCJM: Chapter 10 © 2009 10-24

 Asset impairment:
Example

Solomon Corporation manufactures a variety of consumer electronics products. The

growing popularity of DVD players is expected to reduce the demand for Solomon’s
videocassettes. The videocassettes are produced on an assembly line consisting of five
special purpose assets with a carrying amount (net book value) of $2,000,000.
Solomon’s management believes that this change in the business climate threatens the
recoverability of these assets’ carrying amount

a. Impairment possible? Yes! Expected net operating cash flows:

2008 $800,000
2009 400,000
b. Undiscounted net 2010 200,000
cash flows expected
$1,500,000
Expected salvage value 100,000
Total undiscounted
cash flows $1,500,000
Are cash flows lower Yes!
c.
than carrying amount?

d. Impairment loss $500,000

RCJM: Chapter 10 © 2009 10-25

 Obligations arising from
retiring long-lived assets
(SFAS No. 143)

 Kali records the asset retirement obligation when the asset is

placed into service:
DR Drilling rig (asset retirement cost) $8,167,000
CR ARO liability $8,167,000

 This results in additional depreciation expense:

DR Depreciation expense $1,633,400
CR Accumulated depreciation-drilling rig $1,633,400

RCJM: Chapter 10 © 2009 10-26

 Assets held for sale
 When firms actively try to sell assets they own, the asset groups should be classified on the
balance sheet as “held for sale”.
Table from middle
 When assets are held for sale, they are of page 531
reported at the lower of book value or fair market value
minus costs to sell.

$2,304,000

$2,500,000
$2,350,000
$46,000

Book value Fair value Expected

cost to sell
 So, these assets would be shown on the balance sheet at
$2,304,000.

RCJM: Chapter 10 © 2009 10-27

 Depreciation:
Basic concepts
 The costs of productive assets must be apportioned to the periods
in which they provide benefits (matching principle).

• Buildings
Depreciation • Equipment

Amortization • Intangibles
• Mineral deposits
Depletion • Wasting assets

 The cost to be allocated to periods is the asset’s original historical

cost minus its expected salvage value.

 Depreciation is not intended to track the asset’s declining market

value.

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 Depreciation:
Straight-line example

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 Depreciation:
Double-declining balance example

Switch to
straight-line
method

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 Depreciation:
Sum-of-the-years’ digits example

= n(n+1)/2

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 Depreciation:
Alternative patterns
(a)

Alternative
depreciation methods

(a) Annual depreciation charges

Total depreciation expenses
will be the same

(b)

(b) Net book value

Ending book values will be
the same

RCJM: Chapter 10 © 2009 10-32

 International perspective
 In the U.K., companies are permitted to revalue land and
buildings.

 Suppose a building that originally cost ₤20 million and has an

accumulated depreciation balance of ₤10 million is appraised at
₤35 million. The entry to write-up the building is:
DR Building £15,000,000
DR Accumulated depreciation 10,000,000
CR Revaluation reserve £ 25,000,000

 And the new book value becomes:

RCJM: Chapter 10 © 2009 10-33

 Exchanges of Nonmonetary
assets
 Sometimes firms exchange one nonmonetary asset like inventory or
equipment for another nonmonetary asset.

 Unless certain exceptions apply, the recorded cost of the acquired

asset is the fair market value of the asset given up.

DR Store equipment $85,000

DR Accumulated depreciation- delivery truck 20,000
CR Delivery truck $80,000
CR Cash 15,000
CR Gain on exchange 10,000
FMV of truck
plus cash

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 Exchanges of productive
assets:
Recent “capacity swap” abuses
Asia network leased
for $5 million per year

Telecom One Telecom Two

Europe network leased
for $5 million per year

 Each company received cash, which set the stage for potential
revenue recognition abuses.

 Further accounting “games” were played with the acquired asset (a

lease).

 To prevent these abuses, the FASB is formulating new rules that

require companies to record certain exchanges at the existing book
value of the relinquished asset.

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 Exchanges recorded at book
value:
Fair value not determinable

 Because neither crane’s FMV is know, the new crane is recorded

as:

DR Construction crane (new) $640,000

DR Accumulated depreciation-construction crane (old) 100,000
CR Construction crane (old) $700,000
CR Cash 40,000
BV of old crane
plus cash

RCJM: Chapter 10 © 2009 10-36

 Exchanges recorded at book
value:
Fair value is determinable
 Recall the Rohan Department Store example:
DR Store equipment $85,000
DR Accumulated depreciation- delivery truck 20,000
CR Delivery truck $80,000
CR Cash 15,000
CR Gain on exchange 10,000

 The FASB requires that the exchange must possess commercial

substance:
 The firm’s future cash flows are expected to change as a result of the
transaction;
 And, the amount of cash flow is significant relative to the fair value of
the assets exchanged.

 If the exchange lacks commercial substance, then book value

must be used. No gain or loss is recorded.

RCJM: Chapter 10 © 2009 10-37

 Exchanges recorded at book
value:
Exchange transaction to facilitate sale

 Because the exchange does not culminate an earnings process,

the plasma sets are recorded as:

DR Inventory-plasma sets $40,000

CR Inventory-LCDs $40,000

Book value of asset

surrendered with no gain
or loss recorded

RCJM: Chapter 10 © 2009 10-38

 Exchanges recorded at book
value:
Cash received—a special case

Lee also receives $5,778 cash from

Bonnie.
 Because 10% of the proceeds were received in cash, 10% of the
LCD assets are considered sold:
DR Cash $5,778
DR Inventory-plasma sets 36,000
CR Inventory-LCDs $40,000

CR Recognized gain on exchange 1,778

10% of ($52,000 + $5,778 - $40,000) =

RCJM: Chapter 10 © 2009 10-39

 Summary
 The need for reliable and verifiable numbers causes long-lived
assets to be measured using historical cost.

 The balance sheet amounts for intangible assets often differ from
their real value.

 Managers have incentives to deliberately allocate an excessive

portion of the total purchase price of a takeover to in-process
R&D.

 Changes in the amount of capitalized interest from one period to

another can distort earnings trends.

RCJM: Chapter 10 © 2009 10-40

 Summary concluded
 When comparing return on assets (ROA) ratios across firms,
remember that ROA drifts upward as assets age.

 Asset impairment write-downs depend on subjective forecasts

and could be used to manage earnings, especially under IASB
rules.

 Depreciation differences can complicate comparisons across

firms. Footnote details can be used to improve these
comparisons.

 International practices for long-lived assets and depreciation are

sometimes very different from those in the United States.

RCJM: Chapter 10 © 2009 10-41