What choices are managers making to allocate acquisition costs to the periods benefited?

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Cost allocation includes the processes of depreciation (for tangible fixed assets), amortization
(for limited-life intangible assets), and depletion (for natural resources). When allocating acquisition costs to the periods benefited, managers must: (1) choose an allocation method, (2) estimate useful life, and (3) estimate salvage value. Also, throughout the life of a long-lived asset, the book value must be tested for reasonableness relative to economic values, which may result in revaluing the asset downward for impairment (U.S. GAAP and IFRS) or upward for appreciation (an option under IFRS). Such assessments often require a significant amount of judgment and estimation. Given the magnitude of long-lived assets on most balance sheets and the importance of understanding accounting judgments available to managers, the following subsections discuss these choices and estimates to help you answer the following questions:

•  Are useful lives and salvage values reasonable given the economic service and value of the assets? • Are they in line with competitors? • Can changes in average useful life estimates be explained by strategy or economic reality, or do the useful life changes appear to be opportunistic?
•  Are depreciation methods consistent with the expected economic lives of the assets? • Are they similar to useful lives used by competitors with similar assets? • Are methods frequently changed?

Useful Life for Long-Lived Tangible and Limited-Life Intangible Assets
Physical wear and tear and technological obsolescence affect the projection of the total useful life and salvage value. Managers have an opportunity to convey information to the firm’s stakeholders about their expectations of the future usefulness of long-lived assets. However, the estimation process also provides an opportunity to introduce bias into reported earnings. For example, a manager wanting to report higher earnings could bias the estimated useful lives or salvage values of assets upward, which would result in lower annual depreciation expense

Unfortunately, the disclosures that firms make about depreciable lives are usually not very helpful in assessing a firm’s aggressiveness in lengthening or shortening depreciable lives to manage earnings. The problems include the aggregated nature of the disclosures, the fact that firms usually disclose broad ranges of useful lives for asset categories, and the rare disclosure of expected salvage values. For example, we demonstrate the process of estimating average lives for long-lived assets from note disclosures using PepsiCo’s financial disclosures. PepsiCo’s Note 4, ‘‘Property, Plant and Equipment and Intangible Assets’’ (Appendix A), reports average useful lives of depreciable and amortizable assets, as follows:

Because most U.S. firms use the straight-line depreciation method for financial reporting purposes, you can estimate the average useful life of depreciable (and amortizable) assets by dividing average depreciable cost (gross, assuming zero salvage value) by  depreciation expense for the year. The calculations for PepsiCo for 2007–2012 are presented in Exhibit 8.1.

In 2012, the average useful life estimates are 13.6 years for property, plant, and equipment and almost 27.0 years for amortizable intangible assets. Comparing these estimates to the estimates calculated for 2007 (14.3 and 28.5 years, respectively) shows that PepsiCo’s total useful lives used in depreciation and amortization computations have decreased over the five-year period. If PepsiCo had used 14.3 years life for the depreciation computation in 2012, depreciation expense would have been $2,368.5 million {[($34,425 þ $33,314) 3 0.5]/14.3 years} instead of $2,489 million reported in 2012. The $120.5 million pretax difference is 1.45% of the $8,304 million pretax income in 2012 (slightly less than 1% of net income assuming a 35% tax rate). This might be considered material, but it represents a lower reported net income. Generally, estimate changes on long-lived assets leading to lower reported earnings are of less concern unless the firm in question regularly disposes of the assets (which PepsiCo does not, as evidenced by rare disclosure of material gains or losses from asset sales over time). You should however be concerned when firms increase depreciation rates over time and also engage in frequent long-lived asset sales resulting in gains. This is an example of creating ‘‘cookie jar’’ reserves  and using them later to manage earnings.


Even with such aggregated data, you can gain insight by comparing the average useful life of depreciable assets across firms. Firms with similar asset composition (such as direct competitors) should have similar useful lives; if not, you should assess why they differ. Possibly one firm’s strategy causes a particular asset to have a shorter useful life. For example, an airline choosing a shorter useful life (e.g., Singapore Airlines) might do so because its strategy requires it to fly newer planes, and thus, its aircraft have shorter useful lives. You also need to question firms that report dramatic changes in the useful lives of depreciable assets over time.Is the change because of assumption


changes in the useful lives of the assets, has the composition of the firm’s assets changed over time, or has the firm made the strategic decision to use assets differently? The change over time in the depreciation rates for PepsiCo is not unexpected given the substantial acquisition activity of PepsiCo during this period and the likely change in the composition of both tangible and intangible assets. Firms choosing useful lives that accurately (and consistently) represent the period of time they expect to be able to use the assets report the highest-quality accounting data for depreciable assets. Both U.S. GAAP and IFRS allow managers to classify certain intangible assets  as having an indefinite life; therefore, they are not amortized. These nonamortizable intangibles are assessed for impairment

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