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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
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
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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)
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)
Activity Method
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
Activity Method
Only appropriate where usage is not a function of time Difficult to estimate total number of units over life of asset
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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
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
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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
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
Estimated production (useful life*) = 100,000 ounces of gold *Note: useful life is the # of units estimated to be in the resource deposit
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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
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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
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$2,000
$2,000 $1,200
$1,200
2011
2012
2013
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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:
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($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
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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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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
Impairment losses cannot be reversed Applied by private entity and U.S. GAAP
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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 =$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
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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:
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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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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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