Long-lived Assets

15.511 Corporate
Accounting Summer 2004

Professor SP Kothari
Sloan School of Management
Massachusetts Institute of Technology

June 29, 2004

1
 Changes in Depreciation
Estimates
„ Caused by change in asset life or Salvage Value
„ Apply the change prospectively, i.e., to future years
(no restatement of past years’ results)
„ Example: Cost = $100K, SV = 0, Initial UL estimate of 5
years. After 2nd year, spend $30K on improvement that
extends UL by 3 years (i.e., to total of 8).
„ What is annual depreciation expense for each of the first
two years?
„ What is book value at the end of 2nd year?
„ How do we account for the improvement?
„ What is annual depreciation expense for years 3 and beyond?
2
 Changes in
Depreciation Estimates
„ Example: Cost = $100K, SV = 0, Initial UL estimate of 5 years. After 2nd
year, spend $30K on improvement that extends UL by 3 years (i.e., to
total of 8).
„ What is annual depreciation expense for each of the first two years?
„ $(100 – 0)/5 = $20K

„ What is book value at the end of 2nd year?

„ $[100 – (20*2)] K = $60k
„ How do we account for the improvement?
Capitalize the improvement costs. BV increases to $ (60+30) = 90K „
„

What is annual depreciation expense for years 3 and beyond?

„ Years left = (5-2) + 3 = 6
„ Therefore, depreciation expense = $90K/6 = $15
3
 Changes in Depreciation
Estimates
Cash PP&E – Acc. =L Ret.
Depr Earn
Acquire
PP&E
Yr 1
Depr.
Yr 2
Depr
Improve
ment
Year 3
4
Depr.
 Changes in
Depreciation Estimates
Cash PP&E – Acc. =L Ret.
Depr Earn
Acquire –100 100
PP&E
Yr 1
Depr.
Yr 2
Depr
Improve
ment
Year 3
5
Depr.
 Changes in
Depreciation Estimates
Cash PP&E – Acc. =L Ret.
Depr Earn
Acquire –100 100
PP&E
Yr 1 20 –20
Depr.
Yr 2 20 –20
Depr
Improve
ment
Year 3
6
Depr.
 Changes in
Depreciation Estimates
Cash PP&E – Acc. =L Ret.
Depr Earn
Acquire –100 100
PP&E
Yr 1 20 –20
Depr.
Yr 2 20 –20
Depr
Improve –30 +30
ment
Year 3
7
Depr.
 Changes in
Depreciation Estimates
Cash PP&E – Acc. =L Ret. Earn
Depr
Acquire –100 100
PP&E
Yr 1 20 –20
Depr.
Yr 2 20 –20
Depr
Improve –30 +30
ment
Year 3 15 –15
8
Depr.
 Disposal (retirement):
Gain or Loss
„ Computation:
„ Gain (Loss) = Proceeds from selling the asset - book value,
„ where BV = Acquisition cost - Accumulated
Depreciation associated with the asset
„ Bookkeeping: Remove asset’s historical cost and
accumulated depreciation from the balance sheet
and record Gain (Loss).
„ Example: At end of 7th year, when BV is $15K, sell Asset
from last example for scrap value of $2K.

Cash + PP&E - Acc. Dep. + OA = L + CC + RE

BB . 130K 115K . . . .
Sale
EB
9
 Disposal (retirement):
Gain or Loss
„ Computation:
„ Gain (Loss) = Proceeds from selling the asset - book value,
„ where BV = Acquisition cost - Accumulated
Depreciation associated with the asset
„ Bookkeeping: Remove asset’s historical cost and
accumulated depreciation from the balance sheet
and record Gain (Loss).
„ Example: At end of 7th year, when BV is $15K, sell Asset
from last example for scrap value of $2K.

Cash + PP&E - Acc. Dep. + OA = L + CC + RE

BB . 130K 115K . . . .
Sale 2K (130K) (115K) (13)
10
EB 0 0
 Disposal
Gross PP&E Acc. Deprecn. Book value at time of sale = 15
Sale value =2
115 115 Book value after sale =0
130 130

Cash Loss on sale (RE)

13k

2k

11
Gain/loss on sale of asset
– book keeping
Dr Cash 002k
Dr Loss on sale of asset 013k
Dr Acc. Deprecn. 115k
Cr PP&E 130k

12
 A brief review of the SCF

„ Cash From (Used by) Investing Activities:

„ Report Cash Used to Purchase PP&E
„ Report Cash Rec’d (if any) from Disposing off PP&E

„ Cash From (Used by) Financing Activities:

„ What if PP&E is purchased using borrowed funds?

„ Cash From (Used by) Operating Activities:

„ Under the Indirect Method, firms start with Reported Net Income
and remove non-cash effects
„ What non-cash effects of PP&E bookkeeping are embedded in
Net Income?
13
 An Application: Inferring PP&E
Events
Following are from Nike’s financial statements

Balance Sheet 1998 1997

Property, plant and equipment,net (Note 3) 1,153.1 922.4
Identifiable intangible assets (Notes 1 and 6) 435.8 464.2
Statement of Cash Flows -- Operations 1998

Net Income $399.6

Depreciation 184.5
Amortization and other 49.0
Statement of Cash Flows -- Investing

Additions to property, plant and equipment (505.9)

Disposals of property 16.8
- Data source: Nike, Inc. Fiscal Year 1998 Annual Report. 1999.

14
 An Application: Inferring
PP&E Events

Property, plant and equipment includes:

1998 1997
Land $93.0 $90.8
Buildings 337.3 241.1
Machinery and equipment 887.4 735.7
Construction in process 248.2 151.6
1,819.6 1,425.8
Less accumulated depreciation 666.5 503.4
$1,153.1 $922.4
“Capitalized interest expense was $6.5 MM, $2.8 MM, and $0.9
MM for the fiscal years ended May 31, 1998, 1997 and 1996
respectively.”
- Data source: Nike, Inc. Fiscal Year 1998 Annual Report. 1999.
15
 An Application: Inferring
PP&E Events

The change in Nike’s Accumulated Depreciation account

is $666.5 - $503.4 = $163.1MM.
What 1998 events probably accounted for this change?

The change in Nike’s gross PP&E account

is $1,819.6 - $1,425.8 = $393.8 MM.
What 1998 events probably accounted for this change?

16
 An Application: Inferring PP&E
Events
PP&E (A)
Beg Balance

Additions
Disposals

Ending balance

Accumulated depreciation (XA)

Beg Balance
Depreciation expense
Acc Dep of disposed off
assets

Ending balance

17
 An Application: Inferring
PP&E Events
PP&E (A)
Beg Balance 1425.8

Additions 505.9
112.1 Disposals

Ending balance 1819.6

Accumulated depreciation (XA)

503.4 Beg Balance

184.5 Depreciation expense

Acc Dep of disposed off 21.4

assets

666.5 Ending balance

18
 An Application: Inferring
PP&E Events

Investing CF from disposals of property = $16.8

But the PP&E account shows disposals = $112.1 and Acc

Dep associated with disposals = $21.4

Hence, BV of disposals = $112.1 - $21.4 = $90.7

Loss on disposals = $90.7 - $16.8 = $73.9

19
 Tax and Timing Effects

„ Tax Depreciation
„ Accelerated depreciation
„ No judgment in determining depreciation expense
„ Tax Reporting ≠ Financial Reporting ==>
timing differences in measurement of income
„ Why would a firm prefer accelerated depreciation for
tax purposes?
„ Why does government allow this?
„ Why not use the tax method for financial reporting?
„ Different depreciation for tax and financial
reporting gives rise to Deferred Taxes
20
 Tax and Timing Effects

Cambridge Innovations bought a $90,000 asset

at the beginning of 2001.
Financial reporting Tax reporting
Asset life 3 years 2 years
Depreciation rate Straight line MACRS: 60%, 40%
Residual value $0 Schedule of $0
depreciation
Year Financial Tax Depreciation Accumulated
reporting reporting difference difference,
depreciation depreciation end of the year
2001 30,000 54,000 24,000 24,000
2002 30,000 36,000 6,000 30,000
2003 30,000 - (30,000) 0
21
 Accounting for Timing
Differences: 2001
„ In Year 1, income before depreciation is $80,000 for both financial and tax reporting. The tax rate is
30% with no anticipated change.
Financial reporting Tax reporting
NI before Depr 80,000 80,000
– Depreciation 30,000 –54,000
= NI before taxes 50,000 26,000
× 30% × 30%
Tax Payable 7,800
Tax Expense 15,000

Tax Expense = Tax Payable + ???

22
??? = $7,200 is “Deferred Tax Expense”
 Deferred Taxes over Time

Deferred taxes caused by timing differences are

temporary; they reverse over time.
Year Financial Tax Depreciation Deferred Acc. Depr Def Tax
reporting reporting difference Tax Difference, Liability
Year depreciation depreciation Expense (EB) (EB)
2001 30,000 54,000 24,000 7,200 24,000 7,200
2002 30,000 36,000 6,000 1,800 30,000 9,000
2003 30,000 - (30,000) (9,000) 0 0

„ Timing differences that create / increase deferred taxes are

called originating differences
„ Timing differences that remove / decrease deferred taxes are called
reversing differences
23
 Summary
„ Depreciation is the systematic allocation of
capital expenditures over the revenue-producing
period of a long-lived asset (matching principle).
„ Depreciation is a function of acquisition
cost, economic life, depreciation rate, and
salvage value.
„ Depreciation does not involve cash. Only
the acquisition and disposal of long-lived
assets involve cash.
„ Deferred taxes arise due to differences in
book (GAAP) and tax depreciation.
24