1. Prepared by: Gabriela H. Schneider, CMA; Grant MacEwan College INTERMEDIATE ACCOUNTING INTERMEDIATE ACCOUNTING Sixth Canadian Edition KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK

2. C H A P T E R 12 Amortization, Impairments, and Depletion

3. 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 special amortization methods.

4. Learning Objectives 5.Identify and understand reasons why amortization methods are selected. 6.Explain the accounting issues related to asset impairment. 7.Explain the accounting procedures for depletion of natural resources. 8.Explain how tangible capital assets, including natural resources are reported and analysed.

5. Amortization, Impairments, and Depletion Amortization Factors involved Methods of cost allocation Special methods Selecting a method Special issues Depletion Establishing a base Depletion of resource cost Oil and gas accounting Special problems Impairments Recognizing impairments Measuring impairments Restoration of loss Assets to be disposed of Presentation and Analysis Presentation Analysis

6. Amortization - Concept Depreciation (Amortization) is a means of cost allocation It is not a method of valuation Depreciation 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

7. 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?

8. Amount to Be Amortized Depreciable base is the amount subject todepreciation It is determined as: original cost of the asset less estimated salvage or disposal value

9. 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 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 can not meet current demand) supercession (by a better asset) obsolescence (other factors)

10. Amortization Methods: Overview Amortization Methods Financial Accounting Amortization Methods Tax Amortization Activity method Straight-line method Accelerated methods 1. Declining-balance 2. Sum-of-the-years’-digits Special methods 1. Group and Composite 2. Hybrid methods Increasing Charge Methods

11. Amortization Methods: Example Crane Ltd. buys a crane on January 1, 2000. Information relating to the crane is as follows: Cost: $500,000 Estimated useful life, 5 years (or 30,000 hours) Salvage value end of five years or use, $50,000 Actual hours used during the year: 4,000 hours – 2000 and assume 4,700 in 2001 Based on this information, calculate the amortization for the year 2000 using: units of use, straight-line and the accelerated methods

12. Activity Method (unit = hour) 1. Depreciable base = $500,000 - $50,000 = $450,000 2. Amortization per hour = $450,000 / 30,000 = $15.00 3. Amortization (2000) = $15.00 X 4,000 hours = $60,000 Amortization (2001) = $15.00 X 4,700 hours = $70,500 4. Amortization Schedule: YearBook Amortization Accumulated Book value 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

13. Straight-Line Method 2. Annual Amortization = $450,000 / 5 years = $90,000 1. Depreciable base = $500,000 - $50,000 = $450,000 3. Amortization Schedule: YearBook Amortization Accumulated Book value Value 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 depreciation expense is the same each year!

14. Declining Balance Method 1. Rate of Amortization = 2 X (1/5) = 40% 2. Amortization (2000) = $500,000 X 0.40 = $ 200,000 Amortization (2001) = ($500,000 - $200,000) X 0.40 = $120,000 Rate= (100%  Useful Life) X 2 3. Amortization Schedule: YearBook Amortization Accumulated Book value 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 Last year is rounded. Book value cannot be less than salvage value

15. Sum-of-the-Years’-Digits Method 1. Depreciable base = $500,000 less $50,000 = $450,000 2. SYD fraction = (1+2+3+4+5) = 15 3. Amortization (2000) = $500,000 X (5/15) = $166,667 Amortization (2001) = $500,000 X (4/15) = $133,333 Decreasing Fractions 3. Amortization Schedule: YearBook Amortization Accumulated Book value Value Expense Amortization End of year 1 $500,000 $166,667 $166,667 $333,333 2$333,333 $133,333 $300,000 $200,000 3$200,000 $100,000 $400,000 $100,000 4$100,000 $ 50,000 $450,000 $ 50,000 5$ 50,000 $ -0- $450,000 $ 50,000 Do not depreciate below salvage value

16. 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

17. Composite Amortization Method: Example Given the following information relating to fixed assets, A and B: Asset Cost Annual amortization A$20,000$ 4,000 B$36,000$10,000 $56,000$14,000 Composite amortization rate is: $14,000 = 25% $56,000

18. 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

19. Partial Year Amortization When an asset is bought sometime during the year, a partial amortization charge is required The procedure is: determine amortization for a full year, and allocate the amount between the two periods affected (see example ==> )

20. 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

21. 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 More complex calculations involved

22. Partial Year Amortization: Example Amber Ltd. buys a truck on July 1, 2000. Information relating to the truck is as follows: Cost: $10,000 Estimated service life: 5 years Salvage value end of five years: none. Determine amortization expense under the declining balance method. Determine full year amortization as follows: First full year (2000) =$10,000 X 40% = $4,000 Second full year = $6,000 X 40% = $2,400 Third full year = $3,600 X 40% = $1,440

23. Partial Year Amortization: Example Double declining: date of purchase, July 1, 2000 Allocate first full year’s amortization of $4,000 between 2000 and 2001 $2,000 Allocate second full year’s amortization of $2,400 between 2001 and 2002 $1,200 200020012002

24. Revision of Amortization Estimates Determination of amortization involves initial estimates (life, salvage 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

25. Revision of Amortization Estimates: Example ABC Ltd. buys a depreciable asset on January 1, 2000 for $95,000. Estimated life was 20 years. Estimated salvage value was $5,000. On January 1, 2006, estimates were revised as follows: Salvage value, $2,000 Estimated life : 24 years (years 2000 through 2023) Determine amortization for 2006 based on the straight-line method of amortization

26. Revision of Amortization Estimates: Example Accumulated Amortization to date of revision of estimates: ($95,000 - $5,000) / 20 years = $4,500 per year $4,500 X 6 years = $27,000 Accumulated Amortization Book Value: $95,000 - $27,000 = $68,000 Amount to be amortized (years 2006 through2023 = 18 years) ($68,000 - $2,000) / 18 years = $3,667 (rounded) annual amortization

27. 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 (see next slide)

28. 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

29. Impairments: The Recoverability Test Impairment has occurred Determine impairment loss Does an active market exist for the asset? Loss = Carrying amount less Fair value of asset Yes Loss = Carrying amount less present value of expected net cash flows No Use company’s market rate of interest

30. Impairment: Accounting 1. Loss = carrying value less fair value 2. Amortize new cost basis 3. Restoration of impairment loss is not permitted 1. Loss = carrying value less fair value less cost of disposal 2. No amortization is taken 3. Restoration of impairment loss is permitted Impairment has occurred Assets are held for use Assets are held for sale

31. 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

32. Determining the Depletion Base: Factors Types of Costs Acquisition cost Exploration costs Development costs (Tangible costs): not part of depletion base Development costs (Intangible costs) Restoration costs What they Are 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

33. Accounting for Exploration Costs Two competing approaches are employed in practice to account for exploration costs – Successful efforts approach only exploration costs of successful projects are capitalized – Full-cost approach all costs are capitalized Both approaches are currently practised in Canada

34. Depletion of Resource Cost Depletion calculated using an activity approach (units of production) Depletion charge initially debited to Inventory Credited when the resource is sold –Follows matching principle Where useful life clearly linked to the resource, tangible assets are amortized using units of production method

35. Special Problems Difficulty of Estimating Recoverable Reserves Revise depletion rate on a prospective basis Future Removal and Site Restoration Costs Costs should be recognized if they can be reasonably measured, otherwise a contingent liability should be disclosed Accounting for Liquidating Dividends Reduce the respective Share Capital account for the related portion

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