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Depreciation, Impairment and Disposition

KIESO: Ch. 11

Depreciation, Impairment and Disposition

Depreciation Depreciation A Method of Allocation Factors considered Methods of allocation Other depreciation issues Impairment Indicators of impairment Impairment recognition and measurement models Asset groups and cashgenerating units Held for Sale and Derecognition Long-lived assets to be disposed of by sale Derecognition Presentation, Disclosure, and Analysis Presentation and disclosure Analysis IFRS/Private Entity GAAP Comparison Comparison of IFRS and private entity GAAP Looking ahead

Depreciation Concept
Depreciation (also known as amortization) is a means of cost allocation It is not a method of valuation Depreciation involves:
allocating the depreciable amount of property, plant, and equipment over the periods expected to benefit from the use of the assets

This allocation is generally recognized as Depreciation Expense


Factors in the Depreciation Process

Questions to be answered to determine the amount of depreciation expense:
1. What asset components are depreciated separately? 2. What is the asset s depreciable amount? 3. Over what period is the asset depreciated? 4. What pattern best reflects how the asset s economic benefits are used up?

Components Depreciated Separately

Each significant part of a PP&E asset should be identified and depreciated as a separate component Multiple components may be grouped for calculating depreciation if they have same useful lives and depreciation methods Parts of each PP&E asset that are not individually significant can be grouped and depreciated as a single component Application of components for the purpose of depreciation is required by both private entity GAAP and IFRS. However, IFRS is more detailed and strict.

Depreciable Amount
Depreciable amount is initially calculated as:

Original cost of the asset less estimated residual value (or salvage value) IFRS does not permit the use of salvage value Residual value is the net amount expected to be received for the asset today if it were of the age and in the condition expected at the end of its useful life Salvage value is the asset s estimated net realizable value at the end of the asset s life Residual value should be reviewed regularly (at least annually under IFRS) Depreciation continues as long as residual value is lower than asset s carrying amount

Depreciation Period
Depreciation begins when the asset is available for use Depreciation ends when the asset is derecognized or classified as held for sale. An asset s useful life and physical life are not the same (expressed in time or units) Useful life is sometimes referred to as the economic life the period of time over which the asset will produce revenue for the company Factors affecting useful life are:

economic factors (e.g. obsolescence) physical factors (e.g. wear and tear) legal life (e.g. expiration of contract)

Choice of Depreciation Method

Depreciation method determines the systematic allocation of

the depreciable amount over the asset s useful life Depreciation should reflect the pattern of benefits expected from the use of the asset Additional considerations for choosing a particular depreciation method include simplicity, cost, as well as perceived economic consequences Depreciation method affects:
The balance sheet The income statement The ratios (e.g. return on assets, etc)

Depreciation Methods: Overview

Depreciation Methods Financial Accounting Depreciation Methods Tax Depreciation

Straight-Line Decreasing Charge Method Method

Activity Method

Increasing Charge Methods

Special methods

Comparison of Methods
Straight-Line Method
Simple to use Based on two broad assumptions:
Constant usage Other costs same each year

Decreasing Charge Method Best match of some assets productivity to cost More depreciation in earlier years when asset has greatest benefit

Distorts rate of return analysis

Activity Method
Only appropriate where usage is not a function of time Difficult to estimate total number of units over life of asset

Depreciation Methods: Example

Crane Ltd. buys a crane at the beginning of the current fiscal year. Information relating to the crane follows:

Cost: $500,000 Estimated useful life: five years (or 30,000 hours) Residual value end of five years of use: $50,000 Actual hours used during the current year: 4,000 hours and assume 4,700 in next year

Based on this information, calculate the amortization for the current year using: straight-line, decreasing charge, and activity methods

Straight-Line Method
1. Depreciable amount = $500,000 $50,000 = $450,000 2. Annual Depreciation = $450,000 / 5 years = $90,000 3. Depreciation Schedule: Book Depreciation Accumulated Book value Year Value Expense Depreciation End of year 1 $500,000 $90,000 $ 90,000 $410,000 2 $410,000 $90,000 $180,000 $320,000 Note that the depreciation expense is the same each year


Decreasing Charge Method: DoubleAssets Declining-Balance Methodis residual value not

1. Rate of Depreciation = 2 (1/5) = 40%
deducted Last year is = $500,000 0.40 = $ 200,000 2. Depreciation (current)rounded. Rate= (100% z Book value cannot be Depreciation (next) = ($500,000 - $200,000)Life) x 2 0.40 Useful less than residual = $120,000 value.

3. Depreciation Schedule: Book Depreciation Accumulated Year Value Expense Depreciation 1 $500,000 $200,000 $200,000 2 $300,000 $120,000 $320,000 3 $180,000 $ 72,000 $392,000 4 $108,000 $ 43,200 $435,200 5 $ 64,800 $ 14,800 $450,000

Book value End of year $300,000 $180,000 $108,000 $ 64,800 $ 50,000


Activity Method (unit = hour)

1. Depreciable amount = $500,000 $50,000 = $450,000 2. Depreciation per hour = $450,000 / 30,000 = $15.00 3. Depreciation (current) = $15.00 4,000 hours = $60,000 Depreciation (next) = $15.00 4,700 hours = $70,500 This same rate 4. Depreciation Schedule: Book Depreciation Accumulated Book value Year Value Expense Depreciation End of year 1 $500,000 $60,000 $ 60,000 $440,000 2 $440,000 $70,500 $130,500 $369,500

is used each year

Depletion of Natural Resources

Natural resources are depleted (depreciated) over

time as they are removed Depletion is calculated using an activity method (such as units-of-production) The depletion charge is initially debited to Inventory When the resource is sold, Inventory is credited and Cost of Goods Sold is debited Where an equipment s useful life is clearly linked to the life of the resource, it is also amortized using the units-of-production method 15

Depletion: Example
Mining Company has right to use land to mine gold: Lease cost: Exploration cost: Development cost: Total capitalized cost: $ 50,000

$ 100,000 $ 850,000 $1,000,000

Estimated production (useful life*) = 100,000 ounces of gold *Note: useful life is the # of units estimated to be in the resource deposit


Depletion: Example
Depletion Rate = Total cost residual value Total estimated units Depletion Rate = $1,000,000 0 = $10 per ounce 100,000 Entry to record 25,000 ounces mined: Inventory (Depletion Expense) 250,000 Accumulated depletion 250,000

Partial Year Depreciation

When an asset is acquired sometime during the year, a partial depreciation charge is sometimes taken The procedure is:
determine depreciation for a full year, and allocate the amount between the two periods affected (See upcoming example)


Depreciation and Partial Periods

Straight-Line Method Calculate the amortization for the portion of the year Generally use the nearest full month Declining-Balance Method More complex calculations involved Units of Production/Use Method
No special calculations required Calculate the usage rate and apply to actual usage for the period Same rate used in subsequent years

Partial Year Depreciation: Example

Asset purchased on July 1, 2011. Information relating to the asset is:

Cost: $10,000 Estimated service life: five years Residual value end of five years: none
Determine depreciation expense under the doubledeclining-balance method
Determine full year depreciation as follows: First full year = $10,000 x 40% = $4,000 Second full year = $6,000 x 40% = $2,400 Third full year = $3,600 x 40% = $1,440

Partial Year Depreciation: Example

Date of purchase, July 1, 2011
Allocate first full years depreciation of $4,000 between 2011 and 2012 Allocate second full years depreciation of $2,400 between 2012 and 2013


$2,000 $1,200





Revision of Depreciation Estimates

Determination of depreciation involves estimates of useful life, residual value, pattern in which asset benefits will be received These estimates need to be reviewed regularly (under IFRS, at least at the end of every fiscal year end) When these estimates are revised, depreciation is recalculated The revised depreciation is applied prospectively to the remaining life of the asset, i.e., it is accounted for in the period of the change and to future periods The changes do not affect prior periods


Revision of Depreciation Estimates: Example

Depreciable asset purchased for $90,000

Estimated life was 20 years Estimated residual value was $10,000 Pattern of benefits received: equal amounts per period
In year 9, estimates were revised as follows:

Estimated life : total of 30 years Estimated residual value: $2,000

Determine amortization for 9th year based on the straight-line method of depreciation


Revision of Depreciation Estimates: Example

Book value of the asset at the date of revision of estimates:

($90,000 $10,000) / 20 years = $4,000 per year $4,000 8 years = $32,000 of Accumulated Depreciation Book value: $90,000 $32,000 = $58,000

Amount to be depreciated (9th to 30th year = 22 years remaining)

($58,000 $2,000) / 22 years = $2,545 each year


Impairment: Overview
Impairment occurs when the carrying amount of the long-lived

asset (such as PP&E) is greater than its future economic benefit to the company There are many external and internal indicators that provide evidence of possible impairment Management needs to regularly evaluate assets for these indicators of impairment IFRS requires this at the end of each reporting period If there is an indicator of possible impairment, then the asset must be tested for impairment Two main approaches to measuring impairment losses are: Cost recovery impairment model Rational entity impairment model

Cost Recovery Impairment Model

Under this model, an asset is impaired only if carrying

amount cannot be recovered from using and eventually disposing of the asset (recoverability test)
i.e. impaired if carrying amount > undiscounted future net

cash flows
Impairment loss is then measured as asset s carrying amount less fair value Fair value of the asset is best measured by quoted market

prices in active markets

It is by its nature a present value or discounted measure

Impairment losses cannot be reversed Applied by private entity and U.S. GAAP

Rational Entity Impairment Model

Impairment loss is measured by comparing the asset s carrying

amount and recoverable amount Recoverable amount is measured as higher of

1. 2.

Value in use, and

(present value of future net cash flows)

Fair value less cost to sell

If carrying amount < recoverable amount, then there is no

impairment loss If carrying amount > recoverable amount, then impairment loss is difference between two values Impairment losses may be reversed Applied under IFRS

Intl Inc. owns a piece of machinery with the following values at year end: CA=$40K Discounted future net CF s =$37K FV=$37K Undiscounted future net CF s=$42K Cost to sell=1K Recoverable Amount =higher of [FV(37K)-cost to sell (1K); value in use (37K)]=$37K IFRS Impairment=$40K-$37K=$3K

Asset Groups and Cash-Generating Units (CGU)

Many assets do not generate cash flows independently, so impairment analysis cannot be done at the level of the individual asset These assets are identified with an asset group or cash-generating unit (CGU) i.e. smallest identifiable group of assets that generates cash inflows that are largely independent of the cash flows from other assets or groups of assets (IAS 36.6) Both cost recovery and the rational entity impairment models are then applied to the groups of assets, instead of the individual asset Any impairment losses are then allocated to individual assets on a pro-rata basis No individual asset should be reduced below its fair value (under cost recovery model) or recoverable amount (under rational entity model) if these amounts are known

Plant assets may be:

retired voluntarily, or disposed of by sale, exchange, involuntary conversion, donation

Depreciation is recorded up to the date of disposal before determining gain or loss Gains or losses from disposal are normally shown with Other revenues and expenses in the income statement


Presentation and Disclosure

There are many significant disclosures required for property, plant, and equipment Types of disclosures include the following:

cost and the accumulated depreciation depreciation method and rate or period assumptions surrounding fair-value-related measurements carry amounts of assets held for sale outstanding contingencies

Specific standards under IFRS generally have more extensive disclosure requirements compared to private entity GAAP

Analysis of Property, Plant, and Equipment

1. Activity analysis (efficiency in using assets to generate revenues)
Total Asset Turnover = Net Revenue Average Total Assets

2. Profitability analysis (net income earned from each sales dollar):

Profit Margin = Net Income Net Revenue

Analysis of Property, Plant, and Equipment

Return on Assets (effect long-lived assets have on profitability):
= Asset Turnover Profit Margin Net Income Net Revenue

= Net Revenue Average Total Assets

= Net Income Average Total Assets


IFRS and Private Entity GAAP

Private entity GAAP and IFRS are consistent in many areas of accounting for depreciation and disposition Most significant difference between the two standards relates to measurement of impairment losses There are no major changes expected in this area