RSM220

Depreciation, Impairment and DispositionKIESO: Ch. 11

Depreciation, Impairment and Disposition

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Depreciation– Depreciation– A Method of A Method of AllocationAllocation

•Factors considered

•Methods of allocation

•Other depreciation issues

Held for Sale Held for Sale and and DerecognitionDerecognition

•Long-lived assets to be disposed of by sale

•Derecognition

ImpairmentImpairment

•Indicators of impairment

•Impairment – recognition and measurement models

•Asset groups and cash-generating units

Presentation, Presentation, Disclosure, Disclosure, and Analysisand Analysis

•Presentation and disclosure

•Analysis

IFRS/Private IFRS/Private Entity GAAP Entity GAAP ComparisonComparison

•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

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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?

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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.

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Depreciable Amount • Depreciable amount is initially calculated as:

Original cost of the assetless 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

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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)

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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)

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Depreciation Methods: Overview

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DepreciationMethods

Financial AccountingDepreciation Methods

TaxDepreciation

Straight-LineMethod

DecreasingChargeMethod

Specialmethods

IncreasingCharge

Methods

Activity Method

Comparison of Methods

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

Straight-Line Method• Simple to use• Based on two broad

assumptions:– Constant usage– Other costs same each

year• Distorts rate of return

analysis

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Decreasing Charge Method• Best match of some assets’

productivity to cost• More depreciation in earlier

years when asset has greatest benefit

Depreciation Methods: ExampleCrane 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

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Straight-Line Method

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2. Annual Depreciation = $450,000 / 5 years = $90,000

1. Depreciable amount = $500,000 – $50,000 = $450,000

3. Depreciation Schedule: Book Depreciation Accumulated Book value

Year Value Expense Depreciation End of year1 $500,000 $90,000 $ 90,000 $410,0002 $410,000 $90,000 $180,000 $320,000

Note that the depreciation expense is the same each year

Decreasing Charge Method: Double-Declining-Balance Method

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1. Rate of Depreciation = 2 × (1/5) = 40%

2. Depreciation (current) = $500,000 × 0.40 = $ 200,000 Depreciation (next) = ($500,000 - $200,000) × 0.40

= $120,000

3. Depreciation Schedule: Book Depreciation Accumulated Book value

Year Value Expense Depreciation End of year1 $500,000 $200,000 $200,000 $300,0002 $300,000 $120,000 $320,000 $180,0003 $180,000 $ 72,000 $392,000 $108,0004 $108,000 $ 43,200 $435,200 $ 64,8005 $ 64,800 $ 14,800 $450,000 $ 50,000

Rate= (100% Useful Life) x 2

Last year is rounded. Book value cannot be less than residual value.

Asset’s residual value is not deducted

Activity Method (unit = hour)

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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

4. Depreciation Schedule: Book Depreciation Accumulated Book value

Year Value Expense Depreciation End of year1 $500,000 $60,000 $ 60,000 $440,0002 $440,000 $70,500 $130,500 $369,500

This same rate 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

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Mining Company has right to use land to mine gold:

Lease cost: $ 50,000

Exploration cost: $ 100,000

Development cost: $ 850,000

Total capitalized cost: $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

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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)

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Depreciation and Partial PeriodsStraight-Line Method• Calculate the amortization for the portion of

the year• Generally use the nearest full monthDeclining-Balance Method• More complex calculations involvedUnits 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

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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 double-declining-balance method

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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

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Date of purchase, July 1, 2011

Allocate first full year’sdepreciation of $4,000

between 2011 and 2012

$2,000 $2,000

Allocate second full year’s depreciation of $2,400

between 2012 and 2013

$1,200 $1,200

2011 2012 2013

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

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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

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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

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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

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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

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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. Value in use, and(present value of future net cash flows)

2. 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

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Example

Intl Inc. owns a piece of machinery with the following values at year end:

CA=$40K Discounted future net CF’s =$37KFV=$37K Undiscounted future net CF’s=$42KCost to sell=1KRecoverable Amount

=higher of [FV(37K)-cost to sell (1K); value in use (37K)]=$37K

IFRS Impairment=$40K-$37K=$3K

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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

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Derecognition• 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

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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

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Analysis of Property, Plant, and Equipment

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1. Activity analysis

(efficiency in using assets to generate revenues)

Average Total Assets

Net RevenueTotal Asset Turnover =

Net IncomeProfit Margin =

Net Revenue

2. Profitability analysis

(net income earned from each sales dollar):

Analysis of Property, Plant, and Equipment

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Net RevenueAverage Total Assets

×

×

Return on Assets

(effect long-lived assets have on profitability):

Net Income= Net Revenue

= Net Income

Average Total Assets

Profit Margin= Asset Turnover

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

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