Chapter 7 Cash and Receivables - School of Business Administration

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• Administrative
  • Quiz #4 due Wednesday 3/4
• Ch. 10: wrap up
• Ch. 11: Depreciation, Impairments and
           Depreciation: Concept
• Depreciation is a means of cost allocation
• It is not a method of valuation
  • What does this mean? It means that we will see
    Book Value = Fair Value only by coincidence
    (except for at the time when the asset is
• Depreciation involves:
  • allocating the cost of tangible assets to expense
    in a systematic and rational manner to periods
    expected to benefit from use of its depreciable
     •   à Matching
    Factors in the Depreciation Process

Questions to be answered:

•      What is the depreciable base of the asset?
     •    Depreciable base is the dollar amount subject to
          depreciation. It is determined as:
     Original cost of the asset less
     Estimated salvage or disposal value
     ·      (however note that for declining balance methods, we use
            original cost (and ignore salvage value) in the calculation, and
            only check that our deprecation does not cause the carrying
            value of the asset to drop below salvage value)
•        What is the asset’s useful life?
•        What method of depreciation is best for the asset in
      Depreciation Methods: Overview


Financial Accounting                     Tax
Depreciation Methods                 Depreciation

 Activity   Straight-   Decreasing     Special
               line      Charge        methods

1. Declining Balance            1. Composite method
2. Sum-of-the-years’ digits     2. Hybrid methods
Depreciation Methods: Straight-Line

• S/L is a function of time rather than usage
   • most commonly used method
• Results in an equal amount of depreciation
  expense for a given period
• Depreciation Expense is computed as:
             Cost – Salvage Value
              Estimated Life
  Example – Depreciation Methods

Jose Inc. bought a new printing press for
$1,000,000 on June 30, 2005. The press has an
estimated useful life of 15 years, and a salvage
value of $50,000. It is estimated that the
machine will provide 200,000 hours of use.
From its purchase to Jose’s year end of
December 31, 2005, the press ran for 7,000
hours. Calculate depreciation expense for the
machine for using the following methods:
straight-line, Activity, and Double Declining
Balance (2x SL rate).

           Straight Line Method

Jose Inc.’s 2005 depreciation (S/L Method):
• Depreciable Base:
      1,000,000 – 50,000 = 950,000

• Rate per year: 950,000 / 15 = $63,333

• 6 months from July 1 to Dec 31: $31,666
  • Note: unless told otherwise, assume that firms using SL
    depreciation; go by month for part-year problems

  Depreciation Methods: Activity Based

• This method is a function of usage
 rather than time
  • requires more effort in recording asset use
    (e.g., must read + record odometer readings,
    or install hourly usage meters, etc.)
• Estimated life for this method is in
  terms of total input/output of asset.
• Depreciation expense is computed as:
 (Cost – Salvage Value) x Input or Output in period
            Total Estimated Input or Output
       Activity Based Method

Jose Inc.’s 2005 depreciation (Activity-
  Based Method):
• Part-year? Doesn’t impact calculation

• $950,000 / 200,000 hrs = $4.75 / hr

• 7,000 x $4.75 = $33,250 Dep’n for 2005
    Depreciation Methods: Decreasing
          Charge (Accelerated)
     These methods result in higher
     depreciation expense in the earlier years
     and lower charges in the later years.

     Two accelerated methods are:
•    Declining balance
•    Sum-of-the-years’-digits
    Depreciation Methods: Declining
•       Salvage value is not deducted when computing depreciable
        base for declining balance
•       Often utilizes a depreciation rate (%) that is some multiple
        of the SL rate
•       The depreciation rate is multiplied by the asset’s book
        value at the beginning of the period to get the depreciation
        expense for the period.
•       Since the book value decreases over time this results in a
        decreasing amount of depreciation expense over time.
•       An asset’s book value can never be less than its estimated
        salvage value.
    •      You must check this “manually” after calculating the
           depreciation expense for the year – and cut back on
           depreciation that would drop carrying value below salvage
 Double Declining Balance Method

Jose Inc.’s 2005 depreciation (DDB method):
• Ignores Salvage Value
• Calculate full- year depreciation:
  • 1,000,000 x [2/15] = $133,333
• Since only half-year:
  133,333 x [6/12] = $66,667
• What about next year in 2006?
  • Take the NBV at the beginning of the period
    (1,000,000 – 66,667) = 933,333 X [2/15] =

                Depreciation Methods:
               Sum-of-the-Years’ Digits
•       A fraction is multiplied by the depreciable base to
        arrive at the depreciation expense per period.
•       The fraction is:
    •     Numerator: number of years remaining in the
          asset’s life as of the beginning of the period.
    •     Denominator: sum of the years in the life
    •     For example, a 5 year life property would have
          depreciation expense for the first year as:
    •     (Cost – Salvage value) X 5 (years remaining)
                                      15 (computed as
                       SYD Method
Jose Inc.’s 2005 depreciation (SYD Method):
• Calculate full- year depreciation:
   • (Cost – SV) X (# years remaining at beg of period/sum of years)
   • 950,000 x [15/120] = $118,750
• Since only half-year:
  118,750 x [6/12] = $59,375
• What about next year in 2006?
   • The remaining $59,375 is attributable to the first 6 months of
   • Then calculate depreciation for the next 12 months: 950,000 x
     [14/120] = $110,833
   • Then allocate 6 months of the $ 110,833 to the last six months of
       $ 110,833 X 6/12 = 55,417
   • 2006 depreciation: 59,375 + 55,417 = 114,792

          Depreciation Methods: Summary
•       Straight-Line
                   Cost – Salvage Value
                       Estimated Life

•     Activity Method
    •    Depreciation expense is computed as:
                  (Cost – Salvage Value) x Input or Output in period
                             Total Estimated Input or Output
•       DDB:
    •      Salvage value is not deducted when computing depreciable base.
    •      The rate is double the SL rate
    •      The depreciation rate is multiplied by the asset’s book value at the
           beginning of the period to get the depreciation expense for the

•       SYD:
        (Cost – Salvage value) X     5 (years remaining)
                                     15 (computed as 5+4+3+2+1)
         Partial Year Depreciation

• When an asset is bought sometime during the year,
  follow the company’s policy for treatment
   • In some cases, a partial depreciation charge is required
   • In other cases, the firm may choose to take a full year’s
     depreciation in the year purchased, and none in the year
     of disposal (or even ½ year when purchased and ½ year
     when disposed)
• If the firm allocates proportionately based on
  months owned, determine depreciation for a full
  year, and allocate the amount between the two
  periods affected
    Revision of Depreciation Estimates

•   Determination of depreciation involves
    initial estimates (e.g., life, salvage value)
•   When these estimates are revised,
    depreciation must be re-computed:
        Remaining B.V. – Est. Salvage Value
               Remaining Est. Life
•   These revised depreciation expenses apply
    prospectively to the remaining life of asset.
•   No Adjustment to prior periods
               Revision Example
Kennedy Floatation Devices Inc. (KFD) bought a plastic
foam manufacturing machine on November 1, 2005. At
that time, KFD assumed the machine would last for 10
years, and would have a salvage value of $1,000. The
machine cost $50,000.

On July 1, 2007, KFD installed a new part on the machine
at a cost of $15,000. The new part extended the life of
the machine for an additional 15 years, although at that
date it would have a salvage value of only $500.

Calculate the depreciation expense for the machine for
the 2007 fiscal year (ended December 31).
Book value on July 1, 2007, before new part:

2005 depreciation = (50,000 – 1,000)/10 = 4,900 x 2/12 = 817
2006 depreciation = 4,900
2007 depreciation (up to July 1) = 4,900 x 6/12 = 2,450
Total Accum. Depn.: 817 + 4900 + 2450 = 8,167
Book Value before new part = 50,000 – 8,167 = 41,833
BV after new part: 41,833 + 15,000 = 56,833
Remaining Life: 15 years
New Depreciation per year = (56,833 – 500) / 15 = 3,756 per year

Total Depreciation for 2007: 2,450 + 3,756 X (6/12) = 4,328


  An impairment of a depreciable asset
  occurs when:
• The carrying amount of the asset (or
  asset group) is not recoverable, and
  therefore a write-off is needed.
• The recoverability test determines if
  an impairment has occurred.

A Recoverability test should be performed
when circumstances change indicating a
carrying amount may not be recoverable:
• Significant decrease in market price
• Significant change in use or physical condition
• Significant change in legal factors or in business climate
  that could affect asset’s value
• Accumulation of cost significantly greater than amount
  originally expected to acquire or construct a long-lived
• Expectation that entity will sell or otherwise dispose of
  long-lived asset significantly before the end of its
  previously estimated useful life
Impairments: The Recoverability Test


    Sum of expected              Sum of expected
 future net cash flows         future net cash flows
   (NO DISCOUNTING)           from use and disposal
from use and disposal                of asset is
   of asset is less than      equal to or more than
  the carrying amount           the carrying amount

Impairment has occurred             No impairment
   Impairments: Measuring Loss
Impairment has occurred                Loss =
                                  Carrying amount
    Determine              Yes           less
  impairment loss                Fair value of asset

Does an active market
                                       Loss =
 exist for the asset?
                                  Carrying amount
                           No     present value of
                                 expected net cash
    Use company’s market               flows
       rate of interest
              Impairment: Accounting
                     Impairment has occurred

           Assets are held         Assets are held
               for use             for disposal
1. Loss = Carrying value         1. Loss = Carrying value
   less Fair value                  less Fair Value less
2. Depreciate new cost basis
   • i.e., this is a change in      cost of disposal
     estimate                    2. No depreciation is taken
3. Restoration of impairment     3. Restoration of impairment
   loss is NOT permitted            loss is permitted
             Graphic of Accounting for

               Impairment Example

Rocky Inc. manufactured a pet rock making machine. Raw materials and
direct labor costs totaled $100,000, plus another $5,000 of allocated
overhead and $3,000 of capitalized interest. On January 1, 2003, the
machine was put into use. On that date, Rocky estimated that it would
have a useful life of 10 years and no scrap value. In 2004, another
$3,000 was spent on overhauling the machine. This did not extend the
life or output of the machine, and was part of its regular maintenance.

After sales declined in early 2006, Rocky’s controller assessed whether
the machine’s value was impaired. He estimated that the machine
would generate net cash flows of $14,000 per year for the next 4 years
(including 2006), but would not generate any future cash flows after
that. No market existed for the machine. Rocky’s discount rate is 10%.
Rocky intends to continue to use the machine to make pet rocks.

Show any journal entries that might be required for 2006 with respect to
the machine.

We need the Book Value as of January 1, 2006:
108,000 / 10 = 10,800 x 3 years (2003 to 2005) = 32,400
BV: 108,000 – 32,400 = 75,600
(note: the $3000 expenditure in 2004 is regular maintenance, and was
charged to expense in 2003)

Total future net cash flows: 14,000 x 4 = 56,000

Because 56,000 < 75,600, there is an impairment (move to stage 2)

No market exists for the machine, so use PV à i=10%, n=4, pmt=14,000
à PV = $44,378

Dr. Impairment Loss (75,600 – 44,378)      31,222
Cr.     AD – machine                                31,222

Dr. Depreciation Expense (44,378 / 4)      11,095
Cr.     AD – machine                                11,095

                         What if…
• What if the market improved in 2007, and expected future
  cash flows increased?
   • We would do nothing, unless the expected useful life of the
     machine also increased. In that case, we would revise our
     depreciation rate from 3 years remaining to some new number
• What if a market existed for the machine in 2006, and its fair
  value was $50,000?
   • We would have written the machine down to 50,000 instead of
• What if Rocky had decided to sell the machine instead of
  continue to use it?
   • We would write the machine down to its present value less any
     estimated disposal costs (e.g., fees paid to an auction)
   • No more depreciation!
   • If a market existed, and its market value increased in the future,
     we could recognize a recovery of the loss we recognized in 2006
     (but we could not increase its book value above the original

                      IFRS vs. US GAAP
Step 1: Recoverability test
•US GAAP compares carrying value to future undiscounted cashflows
•IFRS compares carrying value to the recoverable amount.
    • The recoverable amount is the greater of:
         • Net selling price (market value of the asset less disposal costs)
         • Value in use (Discounted future cashflows)
Step 2: Measurement of loss
•US GAAP: Carrying value less:
    • Fair value (if there is a market for assets) – or – if not market:
    • Future discounted cashflows
•IFRS: Carrying value less the recoverable amount

Write-ups for subsequent recoveries:
•Under US GAAP, allowed only if asset is held for disposal, up to carrying
value at time of original write-down
•Under IFRS, allowed
    • If using cost model, up to carrying value at time of original write-down
    • If using the revaluation model, no ceiling

         Depletion: Terminology

  Depletion refers to the cost basis write-off
  of natural resources (e.g., coal, oil, timber)
  • Note that cost here includes (future)
    restoration costs (e.g., replanting logged areas)
Depletion expense per unit is calculated:
            Cost – Estimated Salvage Value
           Total Estimated Units Available
  The per unit cost is multiplied by the units
  extracted during a period to derive the depletion for
  the period.
     Oil and Gas – A Special Case

• How to you treat “dry” well costs?
  • There are no future benefits from dry wells – so
    you could write off all related expenses
    (successful efforts method)
  • However, there will always be dry wells dug in
    the process of finding good wells
     • So perhaps the cost of dry wells could be capitalized
       and added to the depletion base of good wells (full cost
  • Currently, both methods are acceptable


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