Long-lived Assets 15.501/516 Accounting Spring 2004 Professor S. Roychowdhury Sloan School of Management Massachusetts Institute of Technology March 17, 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? 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 2 3Changes in Depreciation Estimates – Acc.Cash PP&E = L Ret. Depr Earn Acquire PP&E Yr 1 Depr. Yr 2 Depr Improve ment Year 3 Depr. Changes in Depreciation Estimates – Acc.Cash PP&E = L Ret. Acquire PP&E Yr 1 Depr. Yr 2 Depr Improve ment Year 3 Depr. Depr Earn –100 100 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 Depr. 4 5 6Changes in Depreciation Estimates Cash PP&E – Acc. = L Ret. Depr Earn Acquire –100 100 PP&E Yr 1 20 –20 Depr. Yr 2 –20 Depr Improve 20 –30 +30 ment Year 3 Depr. 8 Changes in Depreciation Estimates –1515 Depr. +30–30 –2020 Depr –2020 Depr. –PP&E = L– Acc. Depr PP&ECash Year 3 Improve ment Yr 2 Yr 1 100 100 Acquire Ret. Earn Disposal (retirement):  :  )Gain or Loss ComputationGain (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 7 9Disposal (retirement):  :  ) iti ion i iGain or Loss ComputationGain (Loss = Proceeds from selling the asset - book value, where BV = Acquis on cost - Accumulated Depreciatassoc ated w th 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) EB 0 0 Disposal Book value at time of sale = 15 Gross PP&E Acc. Deprecn. Sale value = 2 Book value after sale = 0 115115130 130 Loss on sale (RE) Cash 13k 2k 11 Gain/loss on sale of asset – book keeping 002kDr Cash Dr Loss on sale of asset 013k Dr Acc. Deprecn. 115k Cr PP&E 130k 10 12A 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? An Application: Inferring PP&E Events Following are excerpts 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 An Application: Inferring PP&E Events Note 3 - PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment includes the following: 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. 13 14 15 Courtesy of U.S. Securities and Exchange Commission. Used with permission.Courtesy of U.S. Securities and Exchange Commission. Used with permission.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? 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 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 21.4assets 666.5 Ending balance 16 17 18An 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 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