Prepared by: Gabriela H. Schneider, CMA Northern Alberta Institute of Technology INTERMEDIATE ACCOUNTING Seventh Canadian Edition KIESO, WEYGANDT, WARFIELD, YOUNG, WIECEK

C H A P T E R 12 Amortization, Impairment, and Disposition

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 long- lived 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. Learning Objectives

Amortization, Impairment and Disposition Amortization Factors involved Methods of cost allocation Depletion Special methods Selecting an amortization method Other amortization issues Disposition Property, plant, and equipment to be disposed of Sales of property, plant and equipment Involuntary conversion Other issues Impairments Recognizing impairments Measuring impairments Subsequent measurement 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 allocationAmortization is a means of cost allocation It is not a method of valuationIt is not a method of valuation Amortization involves: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 interchangeablyThe 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 Amortizable amount is the amount to be amortized It is determined as: 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)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 companyUseful 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:Assets are retired (from productive life) due to: –physical factors (such as casualty) –economic factors (such as obsolescence) Economic factors in turn include:Economic factors in turn include: –inadequacy (asset cannot meet current demand) –supercession (by a better asset) –obsolescence (other factors)

Amortization Methods: Overview AmortizationMethods Financial Accounting Amortization Methods TaxAmortization Activitymethod Straight-linemethod Decreasingchargemethods 1. Declining-balance 2. Sum-of-the-years’-digits (not widely used in Canada) Specialmethods 1. Group and Composite 2. Hybrid methods IncreasingChargeMethods

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 Cost: $500,000 Estimated useful life: five years (or 30,000 hours) Estimated useful life: five years (or 30,000 hours) Residual value end of five years of use: $50,000 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 yearActual 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) 1. Depreciable base = $500,000 – $50,000 = $450, Amortization per hour = $450,000 / 30,000 = $ Amortization (current) = $15.00 X 4,000 hours = $60,000 Amortization (next) = $15.00 X 4,700 hours = $70,500 Amortization (next) = $15.00 X 4,700 hours = $70, Amortization Schedule: Book Amortization Accumulated Book value Year Value Expense Amortization End of year 1 $500,000 $60,000 $ 60,000 $440,000 2 $440,000 $70,500 $130,500 $369,500 This same rate is used each year

Straight-Line Method 2. Annual Amortization = $450,000 / 5 years = $90, Depreciable base = $500,000 – $50,000 = $450,000. Amortization Schedule: 3. Amortization Schedule: Book Amortization Accumulated Book value YearValue Expense Amortization End of year 1 $500,000 $90,000 $ 90,000 $410,000 2 $410,000 $90,000 $180,000 $320,000 Note that the amortization expense is the same each year

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 Amortization (next) = ($500,000 - $200,000) x 0.40 Amortization (next) = ($500,000 - $200,000) x 0.40 = $120,000 = $120, Amortization Schedule: Book Amortization Accumulated Book value Year Value Expense Amortization End of year 1 $500,000 $200,000 $200,000 $300,000 2$300,000 $120,000 $320,000 $180,000 3$180,000 $ 72,000 $392,000 $108,000 4$108,000 $ 43,200 $435,200 $ 64,800 5$ 64,800 $ 14,800 $450,000 $ 50,000 Rate= (100%  Useful Life) x 2 Last year is rounded. Book value cannot be less than residual value.

Comparison of Methods Activity Method Best matches revenues and expensesBest matches revenues and expenses Only appropriate where usage not a function of timeOnly appropriate where usage not a function of time Difficult to estimate total number of units over life of assetDifficult to estimate total number of units over life of asset Straight-Line Method Simple to useSimple to use Based on two broad assumptionsBased on two broad assumptions –Constant usage –Other costs same each year Does not match always revenues and expensesDoes not match always revenues and expenses Decreasing Charge Method Best match of some assets’ productivity to costBest match of some assets’ productivity to cost Less variable total asset expense over asset lifeLess variable total asset expense over asset life

Depletion: Terminology Depletion refers to the cost basis write off of natural resources Depletion refers to the cost basis write off of natural resources Natural resources are characterized by: 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 Types of Costs Acquisition cost Acquisition cost Exploration costs Exploration costs Development costs (Tangible costs): not part of depletion base Development costs (Tangible costs): not part of depletion base Development costs (Intangible costs) Development costs (Intangible costs) Restoration costs Restoration costs What they Are Price paid to search for and find deposit of the natural resource Price paid to search for and find deposit of the natural resource Costs incurred to find the natural resource Costs incurred to find the natural resource Costs of heavy equipment for extracting and shipping natural resources Costs of heavy equipment for extracting and shipping natural resources Drilling costs, tunnels, and shafts Drilling costs, tunnels, and shafts To restore after extraction To restore after extraction

Depletion of Resource Cost Depletion calculated using an activity approach (units of production)Depletion calculated using an activity approach (units of production) Depletion charge initially debited to InventoryDepletion charge initially debited to Inventory Inventory credited when the resource is soldInventory 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 methodWhere 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 Total estimated units Depletion Rate = 1,000,000 – 0 = $10 per ounce 100, ,000 Entry to record 25,000 ounces mined: Inventory250,000 Accumulated depletion250,000

Group and Composite Amortization Methods The group method is applied to a collection of assets similar in natureThe group method is applied to a collection of assets similar in nature The composite method is applied to a collection of assets dissimilar in natureThe composite method is applied to a collection of assets dissimilar in nature The composite amortization rate is determined as follows:The composite amortization rate is determined as follows: Total of Annual Amortization for All Assets Total of Annual Amortization for All Assets Total Cost of All Assets Total Cost of All Assets

Composite Amortization Method: Example Given the following information relating to Cars, Trucks, and Campers: AssetCost Amortizable Cost Annual Amortization Cars$145,000$120,000 $ 40,000 Trucks44,00040,00010,000 Campers 5,000 5,000 30,000 30,000 $ 6,000 $ 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: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: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 selectionWhere 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 requiredWhen an asset is bought sometime during the year, a partial amortization charge is required The procedure is: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 requiredNo special calculations required Calculate the usage rate and apply to actual for the periodCalculate the usage rate and apply to actual for the period Same rate used in subsequent yearsSame rate used in subsequent years Straight-Line Method Calculate the amortization for the portion of the yearCalculate the amortization for the portion of the year Generally use the nearest full monthGenerally use the nearest full month Declining-Balance Method More complex calculations involvedMore complex calculations involved

Partial Year Amortization: Example Asset purchased on July 1, Information relating to the asset is:Asset purchased on July 1, Information relating to the asset is: Cost: $10,000Cost: $10,000 Estimated service life: five yearsEstimated service life: five years Residual value end of five years: NoneResidual value end of five years: None Determine amortization expense under the declining balance methodDetermine 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$2,000 Allocate second full year’s amortization of $2,400 between 2005 and 2006 $1,200 $1,

Revision of Amortization Estimates Determination of amortization involves initial estimates (life, residual value) Determination of amortization involves initial estimates (life, residual value) When these estimates are revised, amortization is recalculated When these estimates are revised, amortization is recalculated These revised amortization expenses apply prospectively to the remaining life of asset These revised amortization expenses apply prospectively to the remaining life of asset The changes do not affect prior periods The changes do not affect prior periods CICA Handbook, Section 1506 CICA Handbook, Section 1506

Revision of Amortization Estimates: Example Depreciable asset purchased for $90,000Depreciable asset purchased for $90,000 –Estimated life was 20 years –Estimated residual value: None In Year 11, estimates were revised as follows:In Year 11, estimates were revised as follows: –Estimated life : Total of 30 years Determine amortization for 11 th year based on the straight-line method of amortizationDetermine amortization for 11 th year based on the straight-line method of amortization

Revision of Amortization Estimates: Example Accumulated Amortization to date of revision of estimates: 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 (11 th to 30 th year = 20 years) Amount to be amortized (11 th to 30 th year = 20 years) –($45,000 – $0) / 20 years = $2,250 each year

Impairments An impairment occurs when: 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 To determine the amount of impairment, a recoverability test is used

Impairments: The Recoverability Test Sum of expected future net cash flows from use and disposal of asset is less than the carrying amount Sum of expected future net cash flows from use and disposal of asset is equal to or more than the carrying amount Impairment? Impairment has occurred 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 1. Loss equals carrying value less fair value 2. Amortize new cost basis 3. Restoration of impairment loss is not permitted loss is not permitted 1. Loss equals carrying value less fair value less cost of disposal cost of disposal 2. No amortization is taken 3. Restoration of impairment loss is permitted loss is permitted Impairment has occurred Assets held for use or to be disposed of other than by sale Assets are held for sale

Dispositions of PP&E Plant assets may be: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 lossDepreciation is recorded up to the date of disposal before determining gain or loss Gains or losses from involuntary conversion are often reported as extraordinary itemsGains or losses from involuntary conversion are often reported as extraordinary items

Long-Lived Assets to be Disposed of By Sale Other than by Sale Classify As Held for sale Held and used BalanceSheetClassificationSeparateclassification of long-term assets Property, Plant, & Equipment Measurement At lower of carrying amount and NRV 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 = Asset Turnoverx Profit Margin = Net Revenue x Net Income Average Total Assets Net Revenue

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