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CHAPTER 11 Depreciation, Impairment, and Disposition

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1 CHAPTER 11 Depreciation, Impairment, and Disposition

2 Copyright John Wiley & Sons Canada, Ltd.
11: Depreciation, Impairment, and Disposition After Studying this chapter you should be able to: Understand the importance of depreciation, impairment, and disposition from a business perspective. Explain the concept of depreciation and identify the factors to consider when determining depreciation charges. Identify how depreciation methods are selected. Calculate depreciation using the straight-line, decreasing charge, and activity methods and recognize the effects of using each. Explain the accounting issues for depletion of mineral resources. Explain and apply the accounting procedures for partial periods and a change in depreciation rate. Copyright John Wiley & Sons Canada, Ltd.

3 Copyright John Wiley & Sons Canada, Ltd.
11: Depreciation, Impairment, and Disposition After studying this chapter you should be able to (continued): Explain the issues and apply the accounting standards for capital asset impairment under both IFRS and ASPE. Explain and apply the accounting standards for long-lived assets that are held for sale. Account for derecognition of property, plant, and equipment. Describe the types of disclosures required for property, plant, and equipment. Analyze a company’s investment in assets. Identify differences in accounting between ASPE and IFRS, and what changes are expected in the near future. Calculate capital cost allowance in straightforward situations. Copyright John Wiley & Sons Canada, Ltd.

4 Depreciation, Impairment and Disposition
Depreciation– A Method of Allocation Factors considered Methods of allocation Depreciation – methods of calculation Depletion of mineral resources Other depreciation issues Impairment Indicators of impairment Impairment – recognition and measurement models Asset groups and cash-generating 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/ASPE Comparison Comparison of IFRS and ASPE Looking ahead Copyright John Wiley & Sons Canada, Ltd.

5 Depreciation – Concept
Depreciation (and amortization more broadly) 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 Copyright John Wiley & Sons Canada, Ltd.

6 Factors in the Depreciation Process
Questions to be answered to determine the amount of depreciation expense: What asset components are depreciated separately? What is the asset’s depreciable amount? Over what period is the asset depreciated? What pattern best reflects how the asset’s economic benefits are used up? Copyright John Wiley & Sons Canada, Ltd.

7 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 ASPE and IFRS. However, IFRS is more detailed and strict. Copyright John Wiley & Sons Canada, Ltd.

8 Copyright John Wiley & Sons Canada, Ltd.
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 Copyright John Wiley & Sons Canada, Ltd.

9 Copyright John Wiley & Sons Canada, Ltd.
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) Copyright John Wiley & Sons Canada, Ltd.

10 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) Copyright John Wiley & Sons Canada, Ltd.

11 Depreciation Methods: Overview
Financial Accounting Depreciation Methods Tax Depreciation Straight-Line Method Diminishing Balance Special methods Activity Copyright John Wiley & Sons Canada, Ltd.

12 Copyright John Wiley & Sons Canada, Ltd.
Comparison of Methods Straight-Line Method Simple to use Based on two broad assumptions: Constant usage Other costs same each year Distorts rate of return analysis Diminishing Balance Method Best match of some assets’ productivity to cost More depreciation in earlier years when asset has greatest benefit Activity Method Only appropriate where usage is not a function of time Difficult to estimate total number of units over life of asset Copyright John Wiley & Sons Canada, Ltd.

13 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, 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 Copyright John Wiley & Sons Canada, Ltd.

14 Copyright John Wiley & Sons Canada, Ltd.
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, $410,000 2 $410,000 $90,000 $180, $320,000 Note that the depreciation expense is the same each year Copyright John Wiley & Sons Canada, Ltd.

15 Diminishing Balance Method: Double-Declining-Balance Method
Asset’s residual value is not deducted 1. Rate of Depreciation = 2 × (1/5) = 40% 2. Depreciation (current) = $500,000 × = $ 200,000 Depreciation (next) = ($500,000 - $200,000) × 0.40 = $120,000 Last year is rounded. Book value cannot be less than residual value. Rate= (100%  Useful Life) x 2 3. Depreciation Schedule: Book Depreciation Accumulated Book value Year Value Expense Depreciation End of year 1 $500,000 $200,000 $200, $300,000 2 $300,000 $120,000 $320, $180,000 3 $180,000 $ 72,000 $392, $108,000 4 $108,000 $ 43,200 $435, $ 64,800 5 $ 64,800 $ 14,800 $450, $ 50,000 Copyright John Wiley & Sons Canada, Ltd.

16 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 is used each year 4. Depreciation Schedule: Book Depreciation Accumulated Book value Year Value Expense Depreciation End of year 1 $500,000 $60,000 $ 60, $440,000 2 $440,000 $70,500 $130, $369,500 Copyright John Wiley & Sons Canada, Ltd.

17 Depletion of Natural Resources
Natural resources are depleted (amortized) 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 Copyright John Wiley & Sons Canada, Ltd.

18 Copyright John Wiley & Sons Canada, Ltd.
Depletion: Example 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, ounces of gold *Note: useful life is the # of units estimated to be in the resource deposit Copyright John Wiley & Sons Canada, Ltd.

19 Copyright John Wiley & Sons Canada, Ltd.
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 ,000 Accumulated depletion ,000 Copyright John Wiley & Sons Canada, Ltd.

20 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) Copyright John Wiley & Sons Canada, Ltd.

21 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 Copyright John Wiley & Sons Canada, Ltd.

22 Partial Year Depreciation: Example
Asset purchased on July 1, 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 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 Copyright John Wiley & Sons Canada, Ltd.

23 Partial Year Depreciation: Example
Date of purchase, July 1, 2014 Allocate first full year’s depreciation of $4,000 between 2014 and 2015 $2,000 Allocate second full year’s depreciation of $2,400 between 2015 and 2016 $1,200 2014 2015 2016 Copyright John Wiley & Sons Canada, Ltd.

24 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 Copyright John Wiley & Sons Canada, Ltd.

25 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 Copyright John Wiley & Sons Canada, Ltd.

26 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 Copyright John Wiley & Sons Canada, Ltd.

27 Copyright John Wiley & Sons Canada, Ltd.
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 Copyright John Wiley & Sons Canada, Ltd.

28 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 ASPE Copyright John Wiley & Sons Canada, Ltd.

29 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 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 Copyright John Wiley & Sons Canada, Ltd.

30 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 Copyright John Wiley & Sons Canada, Ltd.

31 Copyright John Wiley & Sons Canada, Ltd.
Held for Sale Long-lived asset is classified as held for sale if the company intends on disposing the asset by sale and meets strict criteria (described in Ch. 4) Held for sale assets are Reported separately on the balance sheet Not depreciated Measured at the lower of Carrying amount, and Fair value less costs to sell Subsequent increases in net realizable value may be recognized as gains, but only to the extent they offset previously recognized losses Copyright John Wiley & Sons Canada, Ltd.

32 Copyright John Wiley & Sons Canada, Ltd.
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 Copyright John Wiley & Sons Canada, Ltd.

33 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 ASPE Copyright John Wiley & Sons Canada, Ltd.

34 Analysis of Property, Plant, and Equipment
1. Activity analysis (efficiency in using assets to generate revenues) Average Total Assets Net Revenue Total Asset Turnover = Net Income Profit Margin = Net Revenue 2. Profitability analysis (net income earned from each sales dollar): Copyright John Wiley & Sons Canada, Ltd.

35 Analysis of Property, Plant, and Equipment
Net Revenue Average Total Assets × Return on Assets (effect long-lived assets have on profitability): Net Income = Net Revenue = Net Income Profit Margin = Asset Turnover Copyright John Wiley & Sons Canada, Ltd.

36 Copyright John Wiley & Sons Canada, Ltd.
IFRS and ASPE ASPE 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 Copyright John Wiley & Sons Canada, Ltd.

37 COPYRIGHT Copyright © 2013 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.


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