Chapter 10

Depreciation and Amortization

 An attempt to recognize the declining future benefit on a systematic rational basis
 Not intended to mimic the decline in market value of an asset, only its general pattern of
declining future benefit
 Nature of depreciation and amortization
o Solely allocations of asset cost to expense
 Conceptual basis of depreciation and amortization
o The decline in utility of long-lived assets is caused by:
 Physical factors, mainly usage
 Obsolescence (the result of new technology)
 Long-lived assets not depreciated or amortized
o Land – not at risk due to obsolescence, nor does it suffer from wear and tear
o Investment property – when the fair value method is used, the property is adjusted
to fair value every reporting date and not depreciated. Any changes in value are
automatically accounted for, since they are reported in earnings each period
o Held-for-sale assets – not being used in the business and therefore does not suffer
from wear and tear
o Biological assets – valued at net realizable value and not depreciated
o Intangible long-lived assets with an indefinite life – if an asset will continue to
provide service over the foreseeable future without its future benefit being
reduced, it has indefinite life
o Goodwill – not amortized but is subject to an annual review for impairment

Accounting Policy – Choice of Method

 The method chosen should be rational and systematic
 It needs to reflect the pattern of consumption of future economic benefits
 Straight line method – based on equal allocation to each time period
o Method is used when the loss of service potential is largely a function of time, or
when the utilization of the asset is expected to be fairly constant over its useful
life
o Based on the assumption that and asset provides equivalent service, or value in
use, each year of its life
o Relates depreciation directly to the passage of time rather than to the assets use,
resulting in a constant amount of depreciation recognized per time period
 Units of production method – based on inputs and outputs
o Used when there is a physical capacity constraint
o Also used when the asset’s utilization is apt to vary significantly from period to
period and its utilization can be measured reliably
o Not logical if obsolescence is a major factor in depreciation, because
obsolescence occurs whether the asset is in use or not
 Declining balance method – accelerated method
o Used for assets that are subject to rapid obsolescence or for assets that will see
heavy use in the earlier years and lighter use in later years
Factors Influencing Choice
 Nature and use of asset – the pattern of consumption of future benefits is evaluated to
establish the most logical depreciation or amortization pattern
o The pattern of usage is often a good indicator of the patter of consumption of
future benefits or patter of revenue generated
 Corporate reporting objectives
 Industry norms – using the same depreciation method helps for comparability
 Parent company preferences – consolidated financial statements are more meaningful is
all constituents follow the same accounting policies, and thus the parent company often
dictates key policies to its subsidiaries
 Simplified reporting
 Accounting information system costs

Estimates Required
 Acquisition cost
 Useful life
o Involves assumptions about potential obsolescence, intensity of use, and adequate
maintenance
o Often shorter than its economic life due to a management practice of replacing
assets after a specified time frame
o The estimate is reviewed at every reporting date and adjusted prospectively
o They change with new information and experience from the use of the asset
 Residual value
o The amount for which the asset will be sold at the end of its useful life with the
company
o Reviewed every reporting date based on current prices

Depreciation or Amortization Period

 Starts when an asset is in its intended condition and location and is available for use
 Stops when the asset is retired
o At this point, the asset is derecognized or classified as a held-for-sale asset
o If the fair value of the asset is less than its carrying value, the asset is written
down to its fair value and a loss is recorded
 Assets should not be depreciated or amortized below residual value
 Depreciation stops when the carrying value is equal to residual value
 Spare parts
o Depreciation does not begin until they are replaced in the asset and being used
o Must be evaluated for impairment caused by poor condition or obsolescence
 Standby equipment
o Depreciated when ready for use, and continued even if the equipment is not used
o The expected pattern of consumption is most logically linked to the piece of
equipment for which it is acting as backup

Component Depreciation
  Any component that is recognized separately is also depreciated separately
 Information required
o Requires that a company obtain specific information and track this information in
its information system
o When a new asset is acquired, the company will need to determine the following
information:
 Identification of significant major parts or components
 For each significant part/component:
 Acquisition cost
 Residual value
 Useful life
 Depreciation method and period
o Components may be grouped together to determine depreciation when they have a
similar useful life and method of depreciation
o If a major part is replaced or an unanticipated overhaul is required, the cost of the
original major part or overhaul, and its accompanying accumulated depreciation,
would be derecognized, or written off
o Rationale: when an asset is viewed as a whole, it does not reflect the pattern of
consumption since some parts/components will be used up faster than others. The
effect is lower depreciation than if the asset was segregated

Additional Depreciation/Amortization Issues

Fractional-Year Depreciation or Amortization
 Two ways to adjust for fractional periods
o Compute the exact amount of depreciation for each fractional period
o Apply an accounting policy convention (standardized shortcut)
 Exact calculation approach
o The ‘exact’ approach usually means that amortization/depreciation is calculated
only to the nearest month
o The units of production method automatically adjust for fractions of a year
 The number of hours/units product in the partial-year period is applied to
the depreciation rate in the normal manner
 The number of hours used is lower because the asset is used for a shorter
period
o Else rule:
 If purchased in first 15 days of month, include full month of depreciation
 If purchased after the first 25 days, do not include the months depreciation
 Accounting policy convention approach
o May be applied only if the difference between an exact calculation and one of the
convention is immaterial
o If a convention is chosen, it should be used materially
o Examples include:
 Half-year convention – a half-years depreciation is charged on all assets
acquired or disposed of during the year
  Full-first-year convention – a full years depreciation is charged to all
assets that exist at the end of the year, including those acquired throughout
the year. No depreciation or amortization is taken on assets disposed of
during the year
 Final-year convention – annual depreciation is determined solely on the
basis of the balance in the long-lived asset accounts at the beginning of the
period
 Assets disposed of during a period are depreciated or amortized for
a full period, and assets purchased during a period are not
depreciated for the period
 Depreciation expense is based solely on the opening balances in
the asset accounts

Group Depreciation
 The group method is appropriate only when the assets are small, have no significant
components, and have a short useful life
 Works on the principle of averaging
o As long as the estimates are correct on average, the depreciation will be correct
 No gains or losses are recorded on the routine disposal of assets
o Group methods offset the gains and losses within the asset group account, thereby
eliminating any possibility of earnings manipulation through managements timing
of disposals
 In the accounting records, there is one control account for each group of assets and one
accumulated depreciation account is maintained. To apply this method:
o Debit the asset control account for each asset when it is purchased
o Record annual depreciation based on the group rate
o Credit the asset control account for the original cost of the item when it is sold,
debit cash for the amount received, and debit accumulated depreciation to balance
the entry

Impairment of Long-Lived Assets

 Asset reported at NBV if it depreciates over its limited life, or at cost, if it has an infinite
life
 An asset may not be overvalued therefore, it is important to critically examine long-lived
assets and ask if they have an impairment
 A basic assumption underlying impairment tests is that the asset is intended to be used in
the company’s operations, through which its cost will be recoverable
o If the cost is not recoverable through operations, the asset does not meet the
definition of an asset and therefore must be written off
 An impairment test is the process of comparing the carrying value of an asset with its
recoverable amount
 Reversal of impairment losses is allowed when the recoverable amount goes up
(permitted for all long-lived assets except goodwill)
 Key definitions:
 o Impairment loss – the amount by which the carrying amount of an asset or cash
generating unit exceeds its recovering amount
o Cash generating unit (CGU) – the smallest group of assets that will generate cash
inflows. These cash inflows must be largely independent of the cash flows of
other assets or groups of assets
o Recoverable amount – the higher of fair value less costs to sell and value in use
o Fair value less costs to sell – the amount that could be received from the sale of
the asset between two knowledgeable, willing parties less the cost incurred for
disposal
o Value in use – the discounted cash flows derived from the use of the asset and
eventual disposal

Steps
1. Identification of an asset or cash-generating units
2. Review of external and internal impairment indicators
o Intangible assets with indefinite lives and intangible assets not yet avaialb le for
use must be tested for impairment annually
o For all other long-lived asset, both the internal and external impairment indicators
must be assessed each reporting date. These assets are only tested for impairment
if there are indicators
3. If required, annual impairment testing, which involves the measurement of the
recoverable amount
o Fair value less costs to sell may be obtained from prices in an active market for
the long-lived assets
o Value in use calculated a value for the CGU using a valuation model
o It is the expected present value
4. If impaired, record the impairment loss and allocate the impairment loss to individual
assets
o If the loss related to a specific asset, the carrying amount of the individual asset is
reduced to the recoverable amount
o The write-down must reduce the carrying value
o Loss can be recorded in two ways:
o Crediting the asset account
o Crediting accumulated deprecation
o In practice, crediting accumulated depreciation is often used to preserve historical
cost of the asset
o If the loss related to a group of assets, then the loss is allocated first to goodwill,
and then to the remaining component assets on a pro-rate basis
o The allocation of an impairment loss should not reduce the carrying
amount of an asset below the higher of:
 The separate fair value less costs to sell, or its separable value in
use, if either value can be readily determined
 Zero

Asset Impairment (Class notes)

 1. Determine the asset or cash generating unit
 Can use individual asset if it has an independent cash flow
o The cash flow is caused by that asset and that asset only
o Example of individual assets: vending machine, parking metre, airplane
2. Is it an indefinite life intangible asset or good will?
a. If yes  test for impairment annually
b. If no  is there an indication of impairment? Completed at the end of every year
i. If yes  continue to step 3
ii. If no do nothing
3. Calculate the current value and determine the recoverable amount
 Higher of:
a. Fair value less cost to sell
b. Value in use – discounted cash inflow that is expected to receive over the
remaining estimated useful life
4. Is current value greater than or less than the recoverable amount?
a. If CV > RA  the asset is impaired (overstated on balance sheet), continue to
step 5
b. If CV < RA  do nothing
5. Write-down asset and depreciation from new value
Using cost model:
Dr Loss
Cr Accumulated Depreciation

 Under IFRS, if the asset recovers, we can write the asset back up to the amount it would
have had if it was never impaired in the first place

Asset Impairment – ASPE (Class Notes)

1. Determine the asset or asset group
 Can use individual asset if it has an independent cash flow
o The cash flow is caused by that asset and that asset only
o Example of individual assets: vending machine, parking metre, airplane
2. Is it an indefinite life intangible asset or good will?
a. If yes  test for impairment annually
b. If no  has an indication of impairment become evident?
i. If yes  continue to step 3
ii. If no do nothing
3. Calculate the current value and determine the recoverable amount
c. Recoverable amount is the undiscounted value in use
4. Is current value greater than or less than the recoverable amount?
a. If CV > RA  step 5
b. If CV < RA  do nothing
5. Write-down asset to fair value
Using cost model:
Dr Loss
Cr Accumulated Depreciation
Reversal of Impairment Losses
 Recorded if the fair value of the asset has been recovered
 Allowed for all impairments except goodwill
 The reversal must result from an increase in the value in use of the asset or fair value less
costs to sell
 Allocating the reversal
o The carrying amount of the individual asset is written up, but cannot go higher
than the carrying value the asset would have reflected without the impairment
 The carrying amount if no impairment loss had been previously
recognized
o If the reversal related to all the assets of a CGU, the reversal is allocated to the
assets in proportion to their carrying values
 The carrying value of any particular asset may not be increased higher
than the recoverable amount of that asset

Goodwill Impairments
 Must be tested for impairment annually
 Assigned to the CGU to which it relates
 Cannot be reversed

Revaluation Model (Appendix 2)

 Alternative to the cost model for PPE under IFRS
 Use is permitted but not required
 Highlights:
o Uses fair value as the basis of measurement
o Revaluations are done regularly, but not annually – must be performed often
enough that fair value is not materially out of date
o Applied by class of assets – cannot be applied to only one asset in a class
o Depreciation is recorded annually
o In between revaluations, the asset is carried at its revaluated amount less
subsequent accumulated depreciation and subsequent accumulated impairment
losses
o When a revaluation occurs, either accumulated depreciation is eliminated, and the
asset is restated to fair value, or the asset and accumulated depreciation are
grossed up so that the net book value reflects fair value
o Increases in fair value (gains and gain reversals) are recorded as a component of
other comprehensive income
o Decreases in fair value greater than gains to date (losses and loss reversals) are
recorded in earnings

How is Fair Value Determined

 The company might be able to reference an active market for long-lived assets to
determine a reference price, or it might depend on discounted cash flow models
 Range of valuation methods or choices in estimating fair value
 Some alternatives:
 o Appraisals
o An estimate based on the PV of future cash flows
o An estimate based on depreciated replacement cost
Frequency of Revaluations
 Depends on the volatility of the fair value of the asset
 If the asset value changes frequently, revaluation may be completed every year
 The period must be consistent unless the volatility of the fair value of the asset has
changed

Depreciation and Elimination of Accumulated Depreciation

 Recorded each year
 If the asset is revalued for the year, depreciation is recorded prior to the revaluation
o Then, the fair value is compared to the NBV after the current-year depreciation
 Accumulated depreciation is eliminated or revised on revaluation. There are two
methods:
o Elimination method – the cost of the asset is restated to the fair value and the
accumulated depreciation is eliminated. More common method in practice
o Proportionate method – the original cost of the asset and the accumulated
depreciation are restated proportionately so the net carrying amount after
revaluation equals fair value

Changes in Fair Value

 Debits and credits caused by revaluation may be recorded to other comprehensive income
or earnings
 Classification depends on the direction of the change and the accumulated revaluation
changes to date

OCI Revaluation Surplus

 The accumulated revaluation surplus is transferred to retained earnings when the asset is
sold, or as the asset is used

Note Disclosure
 The date of the revaluation
 Whether or not an appraiser was used, and if so, the name and qualifications
 The methods used to determine fair value
 The amount of the revaluation surplus
 For each class, the carrying amount of the asset if the cost model had been used

Comparison to the Fair-Value Model

 The fair value model requires an annual assessment of fair value, while the revaluation
model requires less frequent revaluation
 There is no depreciation using the fair value model but the revaluation model record
depreciation in any year where fair values are not re-estimated
 All changes in fair value are part of earnings in the fair-value model, but the revaluation
model uses OCI for gains and gain reversals. Losses and loss reversal are part of earnings
in the revaluation model
 The fair-value model is applicable to investment properties, but the revaluation model
can be applied to any class of long-lived asset that meets certain criteria