INTERMEDIATE ACCOUNTING Seventh Canadian Edition KIESO, WEYGANDT, WARFIELD, YOUNG, WIECEK Prepared by: Gabriela H. Schneider, CMA Northern Alberta Institute of Technology CHAPTER 12 Amortization, Impairment, and Disposition Learning Objectives 1. Explain the concept of amortization. 2. Identify and describe the factors that must be considered when determining amortization charges. 3. Determine amortization charges using the activity, straight-line, and decreasing charge methods and compare the methods. 4. Explain the accounting procedures for depletion of natural resources. Learning Objectives 5. Explain special amortization methods. 6. Identify and understand reasons why amortization methods are selected. 7. Explain the accounting procedures for a change in the amortization rate. 8. Explain the accounting issues related to asset impairment. Learning Objectives 9. Explain the accounting standards for longlived assets to be disposed of. 10.Describe the accounting treatment for the disposal of property, plant and equipment. 11.Explain how property, plant and equipment are reported and analysed. Amortization, Impairment and Disposition Amortization Factors involved Methods of cost allocation Depletion Special methods Selecting an amortization method Other amortization issues Impairments Recognizing impairments Measuring impairments Subsequent measurement Disposition Property, plant, and equipment to be disposed of Sales of property, plant and equipment Involuntary conversion Other issues Presentation and Analysis Presentation and disclosure Perspectives Appendix 12A Amortization and Income Tax Capital cost allowance method Amortization – Concept • Amortization is a means of cost allocation • It is not a method of valuation • Amortization involves: – Allocating the cost of capital assets to expense (matching principle) in a systematic and rational manner to periods expected to benefit from use of assets • The terms amortization and depreciation are used interchangeably Factors in the Amortization Process Questions to be answered: 1. What amount of the asset’s cost is to be amortized? 2. What is the asset’s useful life? 3. What pattern and method of cost apportionment is best for this asset? Which amortization method best matches the way this asset is used/consumed? Amount to Be Amortized • Amortizable amount is the amount to be amortized • It is determined as: – Original cost of the asset less – Estimated residual (salvage or disposal) value Useful Life of an Asset • 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 Useful Life of an Asset • Assets are retired (from productive life) due to: – physical factors (such as casualty) – economic factors (such as obsolescence) • Economic factors in turn include: – inadequacy (asset cannot meet current demand) – supercession (by a better asset) – obsolescence (other factors) Amortization Methods: Overview Amortization Methods Financial Accounting Amortization Methods Activity method Tax Amortization Increasing Straight-line Decreasing Charge charge method Methods methods 1. Declining-balance 2. Sum-of-the-years’-digits (not widely used in Canada) Special methods 1. Group and Composite 2. Hybrid methods Amortization 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: 4,000 hours and assume 4,700 in next year Based on this information, calculate the amortization for the current year using: activity, straight-line, and decreasing charge methods Activity Method (unit = hour) This same 1. Depreciable base = $500,000 – $50,000 = $450,000 rate is used each year 2. Amortization per hour = $450,000 / 30,000 = $15.00 3. Amortization (current) = $15.00 X 4,000 hours = $60,000 Amortization (next) = $15.00 X 4,700 hours = $70,500 4. Amortization Schedule: Book Amortization Year Value Expense 1 $500,000 $60,000 2 $440,000 $70,500 Accumulated Amortization $ 60,000 $130,500 Book value End of year $440,000 $369,500 Straight-Line Method 1. Depreciable base = $500,000 – $50,000 = $450,000 Note that 2. Annual Amortization = $450,000 / 5the years = $90,000 amortization expense is 3. Amortization Schedule: the same each year Book Amortization Accumulated Book value Year Value Expense Amortization End of year 1 $500,000 $90,000 $ 90,000 $410,000 2 $410,000 $90,000 $180,000 $320,000 Decreasing Charge Method: Declining-Balance Method 1. Rate of Amortization = 2 x (1/5) = 40% 2. Amortization (current) = $500,000 x 0.40 = $ 200,000 Rate= (100% Amortization (next) = ($500,000 - $200,000) x 0.40 Useful Life) x 2 = $120,000 3. Amortization Schedule: Book Amortization Accumulated Book value Last year is End of year Year Value Expense Amortization rounded. Book $300,000 1 $500,000 $200,000 $200,000 value cannot be$180,000 2 $300,000 $120,000 $320,000 less than residual 3 $180,000 $ 72,000 $392,000 $108,000 value. 4 $108,000 $ 43,200 $435,200 $ 64,800 5 $ 64,800 $ 14,800 $450,000 $ 50,000 Comparison of Methods Activity Method Straight-Line Method • Best matches revenues and expenses • Only appropriate where usage not a function of time • Difficult to estimate total number of units over life of asset • Simple to use • Based on two broad assumptions – Constant usage – Other costs same each year • Does not match always revenues and expenses Decreasing Charge Method • Best match of some assets’ productivity to cost • Less variable total asset expense over asset life Depletion: Terminology • Depletion refers to the cost basis write off of natural resources • Natural resources are characterized by: – complete removal of the asset – replacement of the asset only by an act of nature Determining the Depletion Base: Factors What they Are Types of Costs • Acquisition cost • • Exploration costs • • Development costs (Tangible costs): not part of depletion base • • • Development costs (Intangible costs) • Restoration costs • Price paid to search for and find deposit of the natural resource Costs incurred to find the natural resource Costs of heavy equipment for extracting and shipping natural resources Drilling costs, tunnels, and shafts To restore after extraction Depletion of Resource Cost • Depletion calculated using an activity approach (units of production) • Depletion charge initially debited to Inventory • Inventory credited when the resource is sold – Follows matching principle – Becomes Cost of Goods Sold • Where useful life is clearly linked to the resource, tangible assets are amortized using units of production method Depletion of Resource Cost 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 Depletion of Resource Cost Depletion Rate = Total Costs – Residual value Total estimated units Depletion Rate = 1,000,000 – 0 = $10 per ounce 100,000 Entry to record 25,000 ounces mined: Inventory 250,000 Accumulated depletion 250,000 Group and Composite Amortization Methods • The group method is applied to a collection of assets similar in nature • The composite method is applied to a collection of assets dissimilar in nature • The composite amortization rate is determined as follows: Total of Annual Amortization for All Assets Total Cost of All Assets Composite Amortization Method: Example Given the following information relating to Cars, Trucks, and Campers: Asset Cars Trucks Campers Cost $145,000 Amortizable Cost Annual Amortization $120,000 $ 40,000 44,000 40,000 10,000 5,000 30,000 $ 6,000 $224,000 $190,000 $56,000 Composite amortization rate is: $ 56,000 = 25% $224,000 Group and Composite Amortization Methods • When an asset is sold, or otherwise disposed of, under group/composite amortization: – no gain or loss on disposal is recorded – the difference between cost and sale proceeds is debited to Accumulated Amortization Selecting an Amortization Method • Three main factors or motivations for method of selection: 1. Matching 2. Simplicity 3. Perceived economic consequences • Where possible, matching is the best motivation for method selection Partial Year Amortization • • When an asset is bought sometime during the year, a partial amortization charge is required The procedure is: 1. determine amortization for a full year, and 2. allocate the amount between the two periods affected (See upcoming example) Amortization and Partial Periods Units of Production/Use Method • No special calculations required • Calculate the usage rate and apply to actual for the period • Same rate used in subsequent years 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 Partial Year Amortization: Example • Asset purchased on July 1, 2004. Information relating to the asset is: • Cost: $10,000 • Estimated service life: five years • Residual value end of five years: None • Determine amortization expense under the declining balance method Determine full year amortization as follows: First full year (2004) = $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 Amortization: Example Double-declining: date of purchase, July 1, 2004 Allocate first full year’s amortization of $4,000 between 2004 and 2005 $2,000 2004 Allocate second full year’s amortization of $2,400 between 2005 and 2006 $2,000 $1,200 $1,200 2005 2006 Revision of Amortization Estimates • • • • • Determination of amortization involves initial estimates (life, residual value) When these estimates are revised, amortization is recalculated These revised amortization expenses apply prospectively to the remaining life of asset The changes do not affect prior periods CICA Handbook, Section 1506 Revision of Amortization Estimates: Example • Depreciable asset purchased for $90,000 – Estimated life was 20 years – Estimated residual value: None • In Year 11, estimates were revised as follows: – Estimated life : Total of 30 years • Determine amortization for 11th year based on the straight-line method of amortization Revision of Amortization Estimates: Example • Accumulated Amortization to date of revision of estimates: – ($90,000 – $0) / 20 years = $4,500 per year – $4,500 x 10 years = $45,000 Accumulated Amortization – Book Value: $90,000 – $45,000 = $45,000 • Amount to be amortized (11th to 30th year = 20 years) – ($45,000 – $0) / 20 years = $2,250 each year Impairments • An impairment occurs when: – the carrying amount of an asset is not recoverable, and – a write-off of the impaired amount is needed • To determine the amount of impairment, a recoverability test is used Impairments: The Recoverability Test Impairment? Sum of expected future net cash flows from use and disposal of asset is less than the carrying amount Impairment has occurred Sum of expected future net cash flows from use and disposal of asset is equal to or more than the carrying amount No impairment Impairments: The Recoverability Test Impairment has occurred Determine impairment loss Loss equals difference between carrying amount and fair value of asset based on a method that discounts the future flows to their present value Impairment: Accounting Impairment has occurred Assets held for use or to be disposed of other than by sale 1. Loss equals carrying value less fair value 2. Amortize new cost basis 3. Restoration of impairment loss is not permitted Assets are held for sale 1. Loss equals carrying value less fair value less cost of disposal 2. No amortization is taken 3. Restoration of impairment loss is permitted Dispositions of PP&E • Plant assets may be: – retired voluntarily, or – disposed of by sale, exchange, involuntary conversion • Depreciation is recorded up to the date of disposal before determining gain or loss • Gains or losses from involuntary conversion are often reported as extraordinary items Long-Lived Assets to be Disposed of By Sale Classify As Balance Sheet Classification Measurement Held for sale Separate classification of long-term assets At lower of carrying amount and NRV Other than by Sale Held and used Property, Plant, & Equipment Test for impairment under CICA Handbook Section 3063 Analysis of Property, Plant, and Equipment Asset Utilization: Total Asset Turnover = Net Revenue Average Total Assets Cost Control: Profit Margin = Net Income Net Revenue Analysis of Property, Plant, and Equipment Profitability or Return on Assets: = Asset Turnover x Profit Margin = Net Revenue x Average Total Assets Net Income Net Revenue COPYRIGHT Copyright © 2005 John Wiley & Sons Canada, Ltd. 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