THEORY OF ACCOUNTS

MR. EDMAN P. FLORES, CPA

TOA 011: DEPRECIATION, DEPLETION, REVALUATION AND IMPAIRMENT I. DEPRECIATION Depreciation is the accounting process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset. Allocating costs of long-term assets: Long-lived assets = Depreciation expense Intangibles = Amortization expense Mineral resources = Depletion expense Factors Involved in the Depreciation Process 1. Depreciable Base Original Cost Residual/Salvage Value Depreciable Cost

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2. Estimation of Service Lives Service life often differs from physical life. Companies retire assets for two reasons: a. Physical factors (casualty or expiration of physical life) b. Economic factors (inadequacy, supersession, and obsolescence). 3. Methods of Depreciation The profession requires the method employed be systematic and rational. Examples include: a. Activity method (units of use or production). b. Straight-line method. c. Diminishing (accelerated)-charge methods: i. Sum-of-the-years-digits. ii. Declining-balance method. Change in Useful Life The useful life of an item of PPE shall be reviewed at least at each financial year-end and if expectations are significantly different from previous estimate, the change shall be accounted for as a change in accounting estimate. Therefore, the depreciation charge for the current and future periods shall be adjusted. Change in Depreciation Method The depreciation method shall be reviewed at least at each financial year-end and if there has been significant change in the expected pattern of economic benefits embodied in the asset, the method shall be changed to reflect the new pattern. The change in depreciation method shall be accounted for as a change in accounting estimate, and the depreciation charge for the current and future periods shall be adjusted. II. DEPLETION Depletion is the process of allocating the cost of mineral resources. Cost of Wasting Asset Acquisition cost is the price paid to obtain the property containing the natural resource. Exploration cost is the cost incurred in an attempt to locate the natural resource that can economically be extracted or exploited. It may be accounted for using: Successful effort method only the exploration cost directly related to the discovery of commercially producible natural resource is capitalized as cost of the resource property. The

exploration cost related to dry wells or unsuccessful discovery is expensed in the period incurred. Full cost method all exploration costs, whether successful or not, are capitalized as part of the cost of successful resource discovery. Development cost is the cost incurred to exploit or extract the natural resource that has been located through successful exploration. It can be in the form of: Tangible equipment not capitalized as cost of natural resource. Intangible development cost capitalized as cost of the natural resource. Restoration cost cost necessary to bring the property to its original state after the extraction of the natural resources. It can be added to the cost of the resource property or netted against the expected residual value of the resource property.

Computation of Depletion Normally, companies compute depletion on a units-of-production method (activity approach). Depletion is a function of the number of units extracted during the period.

Depreciation of mining property The depreciation of equipment used in mining operations is based on the life of the equipment or life of the wasting asset, whichever is shorter. If the life of the equipment is shorter, the straight-line method of depreciation is normally used. If the life of the wasting asset is shorter, the output method of depreciation is used. If the mining equipment is movable and can be used in future extractive project, the equipment is depreciated over its useful life using the straight-line method. Shutdown Depreciation in the year of shutdown is based on the remaining life of the equipment following the straight-line method. In other words, the remaining book value of the equipment is divided by the remaining life of the equipment to arrive at the depreciation in the year of shutdown. Wasting Asset Doctrine A wasting asset corporation can pay dividend not only to the extent of retained earnings but also to the extent of accumulated depletion. The amount paid in excess of retained earnings is accounted for as liquidating dividend or return of capital. The formula in determining the maximum dividend that can be declared and paid by a wasting asset corporation is: Retained earnings xxx Add: Accumulated depletion xxx Total xxx Less: Capital liquidated in prior years xxx Unrealized depletion in ending inventory xxx xxx Maximum dividend xxx III. REVALUATION After recognition, an entity shall choose either the cost model or the revaluation model as its accounting policy and shall apply that policy to the entire class of PPE. Cost Model An item of PPE shall be carried at cost less any accumulated depreciation and accumulated impairment losses. Revaluation Model

An item of PPE shall be carried at revalued amount less any subsequent accumulated depreciation and subsequent accumulated impairment losses. Basis of Revaluation Fair value this value is determined by appraisal normally undertaken by professional qualified appraisers. Depreciated replacement cost if the fair value is not available, depreciated replacement cost may be used. Computation of revaluation surplus If fair value is available: Fair value Less: Book value Revaluation surplus If fair value is not available: Depreciated replacement cost Less: Book value Revaluation surplus

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Treatment of revaluation surplus Revaluation surplus is a component of other comprehensive income. It is transferred to retained earnings when realized. If the asset is non-depreciable, it may be realized on the retirement or disposal of the asset. If the asset is depreciable, it is realized over the remaining life of the asset. pGeneral Rules for Revaluation 1. When a company revalues its PPE above historical cost, it reports revaluation surplus that increases other comprehensive income. Thus, the revaluation surplus bypasses net income, increases other comprehensive income, and increases accumulated other comprehensive income. 2. If a company experiences a loss on impairment (decrease of value below historical cost), the loss reduces income and retained earnings. Thus, gains on revaluation increase equity but not net income, whereas losses decrease income and retained earnings (and therefore equity). 3. If a revaluation increase reverses a decrease that was previously reported as an impairment loss, a company credits the revaluation increase to income using the account Recovery of Impairment Loss up to the amount of the prior loss. Any additional valuation increase above historical cost increases other comprehensive income and is credited to Revaluation Surplus. 4. If a revaluation decrease reverses an increase that was reported as a revaluation surplus, a company first reduces other comprehensive income by eliminating the revaluation surplus. Any additional valuation decrease reduces net income and is reported as a loss on impairment. IV. IMPAIRMENT Impairment is a fall in the market value of an asset so that its recoverable amount is now less than its carrying amount in the statement of financial position. An entity shall write down the carrying amount of an asset to its recoverable amount if the carrying amount is not recoverable in full. The amount of write down is recorded as an impairment loss. Recognizing Impairments A long-lived tangible asset is impaired when a company is not able to recover the assets carrying amount either through using it or by selling it. On an annual basis, companies review the asset for indicators of impairmentsthat is, a decline in the assets cash-generating ability through use or sale.

If impairment indicators are present, then an impairment test must be conducted.

Impairment Indicators External sources 1. Significant decrease or decline in the market value of the asset as a result of passage of time or normal use or a new competitor entering the market. 2. Significant change in the technological, market, legal or economic environment of the business which the asset is employed. 3. An increase in interest rate or market rate of return on investment which will likely affect the discount rate used in calculating the value in use. Internal sources 1. Evidence of obsolescence or physical change of an asset. 2. Significant change in the manner or extent in which the asset is used with an adverse effect on the entity. 3. Evidence that the economic performance of an asset will be worse than expected.

Measurement of recoverable amount The recoverable amount of an asset is its fair value less cost to sell or value in use, whichever is higher. Fair value less cost to sell is simply the net selling price of the asset. Value in use is the present value or discounted value of future net cash flows expected to be derived from an asset. In determining the value in use, the entity must use pretax cash flows and pretax discount rate. Cash-Generating Units When it is not possible to assess a single asset for impairment because the single asset generates cash flows only in combination with other assets, companies identify the smallest group of assets that can be identified that generate cash flows independently of the cash flows from other assets. Impairment of Assets to Be Disposed Of Report the impaired asset at the lower-of-cost-or-net realizable value (fair value less costs to sell). No depreciation or amortization is taken on assets held for disposal during the period they are held. Can write up or down an asset held for disposal in future periods, as long as the carrying amount after the write up never exceeds the carrying amount of the asset before the impairment

Summary on Accounting for Impairment