7.2: Use, Impairment and Disposal of Property, plant and equipment

Question 1

What is depreciation in accounting, and how does it differ from determining an asset’s current market value?

Answer 1

Depreciation in accounting is the process of allocating the acquisition cost of buildings and equipment over their productive lives.

It is a cost allocation concept, not a method for determining an asset’s current market value.

Depreciation represents the distribution of the acquisition cost over the periods in which the asset generates revenue.

The amount of depreciation expense is subtracted from the asset’s cost to calculate its carrying amount or net book value.

Question 2

How is depreciation expense recorded, and what is its purpose in financial statements?

Answer 2

Depreciation expense is recorded on the statement of earnings and represents the cost allocated for the use of property, plant, and equipment during a specific period.

It reduces the carrying amount of the asset and reflects the wear and tear or obsolescence of the asset over time.

Depreciation is crucial for accurate financial reporting as it ensures that the cost of assets is appropriately distributed over the periods in which they are used to generate revenue.

Question 3

What is the carrying amount of an asset, and how is it calculated?

Answer 3

The carrying amount, also known as the net book value, is the acquisition cost of an asset minus accumulated depreciation and any write-downs in asset value.

It represents the remaining value of the asset after accounting for depreciation.

The carrying amount is reported on the statement of financial position and is essential for evaluating the net value of a company’s assets.

Question 4

How do financial statements disclose information about depreciation and the carrying amount of assets?

Answer 4

Financial statements typically disclose depreciation expense on the statement of earnings, accumulated depreciation on the statement of financial position, and the carrying amount of assets.

Companies provide detailed information about each class of property and equipment, including their acquisition cost and accumulated depreciation, in the notes to the financial statements.

These disclosures offer transparency and enable stakeholders to assess the value and depreciation history of a company’s long-lived assets.

Question 5

How can analysts use the carrying amount of assets to approximate their remaining life, and what does it indicate?

Answer 5

Analysts can compare the carrying amount of assets to their original cost to approximate their remaining life.

If an asset’s carrying amount is 100 percent of its cost, it is new; if it’s 25 percent of its cost, it has about 25 percent of its useful life remaining.

For example, if a company’s property and equipment have a carrying amount of 51 percent of their original cost, it suggests that these assets have approximately 51 percent of their useful life remaining.

However, this method is a rough approximation and can be influenced by factors like the company’s depreciation policies

Question 6

What are the three amounts required for calculating depreciation expense for a depreciable asset?

Answer 6

1. Acquisition cost,
2. Estimated useful life to the company,
3. Estimated residual (or salvage) value at the end of the asset’s useful life to the company

Question 7

Why is depreciation expense considered an estimate?

Answer 7

Depreciation expense involves estimates because two of the three required amounts (estimated useful life and estimated residual value) are based on management’s predictions

Question 8

How should estimated useful life be determined for an asset?

Answer 8

Estimated useful life should be based on evidence and represent management’s estimate of the asset’s useful economic life to the company, not its economic life to all potential users.

Question 9

What factors can influence the differences in estimated lives within a single industry?

Answer 9

Differences in estimated lives within a single industry can be due to factors such as the type of aircraft used, equipment replacement plans, operational differences, and management policies.

Question 10

What is componentization of assets?

Answer 10

Componentization of assets refers to the practice of allocating specific costs to different significant parts of an asset (such as airframe, engines, and landing gear in an aircraft) and depreciating them separately over their useful lives.

Question 11

Why is componentization important in accounting for property, plant, and equipment?

Answer 11

Componentization is important because individual items of property, plant, and equipment may have various significant parts with different useful lives, and IFRS requires that companies allocate acquisition costs to each component and depreciate them separately.

Question 12

How can differences in estimated lives and residual values impact the comparison of companies within the same industry?

Answer 12

Differences in estimated lives and residual values can significantly impact the comparison of profitability among companies.

Analysts need to identify the causes for these differences to make accurate comparisons.

Question 13

Why is there no single best method of depreciation, and what do managers consider when choosing a method?

Answer 13

There is no single best method of depreciation due to differences among companies and their assets.

Managers choose from acceptable methods based on the anticipated reduction in future cash flow from wear and tear.

They consider the nature of the asset’s usage over time

Question 14

What are the three most common depreciation methods, and how do they differ?

Answer 14

Straight line: Used when an asset’s usage is the same each period.

Units of production: Used when an asset’s usage varies based on activity or productivity.

Declining balance: Used when an asset is more efficient in its early years but less efficient over time.*

Question 15

Explain the straight-line depreciation method formula and its application.

Answer 15

(Cost−Residualvalue)× 1/Usefullife = Depreciationexpense.

This method results in a constant annual depreciation amount.

Question 16

How does the straight-line method affect the financial statements over time?

Answer 16

With the straight-line method, depreciation expense remains constant each year, accumulated depreciation increases steadily, and the carrying amount decreases annually until it equals the estimated residual value.

Question 17

Is the reported depreciation expense on the statement of earnings for a 12-month period equal to the accumulated depreciation on the statement of financial position?

Answer 17

No, the reported depreciation expense on the statement of earnings covers a 12-month period.

Accumulated depreciation on the statement of financial position is the sum of all depreciation expenses for all property, plant, and equipment since their acquisition dates.

Question 18

What is the declining-balance depreciation method, and why might managers choose this method?

Answer 18

The declining-balance method is an accelerated depreciation method where an asset’s economic benefits decrease more sharply in its earlier years.

Managers choose this method to reflect the decline in economic benefits over time, especially when assets are more productive in their initial years, leading to accelerated depreciation.

Question 19

What is the formula for calculating depreciation expense under the double declining-balance method?

Answer 19

Question 19

How is the double declining-balance rate calculated, and what is a typical rate used?

Answer 19

The double declining-balance rate is often double (two times) the straight-line rate.

For example, if the straight-line rate is 10 percent, the double declining-balance rate would be 20 percent (2 times 10 percent).

Other typical acceleration rates include 1.5 times and 1.75 times.

Question 20

What are the key differences between the declining-balance method and other depreciation methods?

Answer 20

The declining-balance method includes accumulated depreciation in the formula, which results in a decline in depreciation expense over time.

Also, the carrying amount should not be depreciated below the residual value.

Adjustments are made to ensure the carrying amount does not drop below the residual value.

Question 21

Why is it important for analysts to consider the depreciation method when comparing financial results of companies?

Answer 21

The depreciation method selected by a company informs users of the company’s expectation of the pattern of economic benefits from using an asset.

Different methods can result in different estimates for an asset’s remaining useful life, impacting financial analysis.

Analysts need to understand the chosen method to make accurate comparisons.

Question 22

Table: Three methods of calculating Depreciation

Answer 22

Question 23

When comparing companies using accelerated (declining balance) and straight-line depreciation methods, which method results in lower net earnings during the early years of an asset’s life?

Answer 23

Accelerated (declining balance) depreciation methods result in lower net earnings during the early years of an asset’s life compared to the straight-line method.

Question 24

How does the impact of depreciation methods on net earnings change in later years of an asset’s life?

Answer 24

In later years, the impact reverses. Companies using accelerated depreciation report lower depreciation expense and higher net earnings during the later years of an asset’s life compared to those using the straight-line method.

Question 25

Why is it tricky to determine which company’s net earnings would be higher without considering specific details?

Answer 25

It is tricky because differences in depreciation methods, rather than real economic differences, can cause significant variations in reported net earnings. The choice of method affects net earnings at different stages of the asset’s life.

Question 26

What is essential for users of financial statements to understand regarding the impact of alternative depreciation methods?

Answer 26

Users of financial statements must understand the impact of alternative depreciation methods used over time.

Differences in depreciation methods can cause variations in reported net earnings, influencing financial analysis and comparisons between companies.

Question 27

What are the two estimates on which depreciation is based, and when might these estimates need to be revised?

Answer 27

Depreciation is based on useful life and residual value estimates.

These estimates may need to be revised if experience with the asset accumulates, or if improvements extend the asset’s useful life, to more accurately represent the economic effect of using the asset.

Question 28

What is a change in estimate in the context of depreciation, and how is it computed for the straight-line method?

Answer 28

A change in estimate occurs when either the useful life or residual value of a depreciable asset is revised.

To compute the new depreciation expense for the straight-line method, substitute the carrying amount for the original acquisition cost, the new residual value, and the estimated remaining useful life for the original estimates.

Question 29

Can companies change depreciation methods, and what is the significance of such a change?

Answer 29

Companies can change depreciation methods, but such changes require more disclosure due to the compromised comparability of information over time.

Changes in accounting estimates and methods should only be made if the new estimate or method “better measures” the periodic net earnings of the business.

Question 30

What factors influence managers’ selection of a depreciation method for financial reporting purposes?

Answer 30

Managers select a depreciation method based on the best matching of revenues and expenses for a given asset.

If the benefits of the asset are expected to be even over time, the straight-line method is preferred.

If assets are more efficient and produce more revenue in their early years, managers choose accelerated methods.

Repair costs may also influence the choice, aiming for a nearly constant total expense over periods.

Question 31

Why is the straight-line method the most common depreciation method for financial reporting purposes?

Answer 31

The straight-line method is the most common because it reports higher net earnings during the early years of an asset’s life, making it a preferred choice if no other method provides improved faithful representation.

It is also easy to use and explain, providing a consistent allocation of expenses.

Question 32

What challenges do managers face when deciding whether to revalue property, plant, and equipment to their fair value at the end of the fiscal year?

Answer 32

Managers face the challenge of objectivity when estimating an asset’s fair value. While revaluation addresses the impact of inflation, it lacks objectivity in estimation.

The historical cost method, adjusted for depreciation, is favored for its objectivity, with most companies using this method for financial reporting purposes.

Question 33

Why do most Canadian public companies prepare two sets of reports, one under IFRS for shareholders and another for tax authorities?

Answer 33

Canadian public companies prepare two sets of reports because financial reporting (under IFRS) and tax reporting (under the Income Tax Act) have different objectives.

Financial reporting aims to provide useful information to investors, lenders, and creditors, while tax reporting’s objective is to raise sufficient revenues for government expenditures and encourage certain behaviors.

Question 34

What economic principle explains the reason behind preparing two sets of reports, known as the “least and the latest” rule?

Answer 34

The “least and the latest” rule states that taxpayers aim to pay the lowest amount of tax legally permitted at the latest possible date.

This principle allows taxpayers to invest the saved money for an extra year, earning a return on the investment.

Question 35

Why do corporations have deferred tax obligations, and what contributes to the deferral of income tax payments?

Answer 35

Corporations have deferred tax obligations due to differences between the depreciation methods used for financial reporting and tax reporting.

Compliance with the Income Tax Act allows corporations to defer (delay) paying significant amounts of income taxes.

This deferral is often due to variations between financial reporting methods and tax regulations.

Question 36

What is the purpose of capital cost allowance (CCA) in Canadian taxation, and how does it differ from regular depreciation methods?

Answer 36

Capital cost allowance (CCA) is used in Canadian taxation to calculate the maximum annual expense for tangible assets based on schedules provided by tax authorities.

Unlike regular depreciation methods, CCA does not aim to match the cost of an asset with its revenue over its useful life.

Instead, CCA provides accelerated depreciation, allowing for greater deductions in the early years of the asset, reducing taxable income and income tax payable.

Question 37

How does the CCA deduction for an asset, such as an aircraft, differ from the straight-line depreciation expense?

Answer 37

The CCA deduction is based on an accelerated method and reduces taxable income significantly more in the early years of a long-lived asset compared to straight-line depreciation.

For instance, while the straight-line depreciation expense for an aircraft might be $1,100,000, the corresponding CCA deduction could be $7,000,000 (calculated as $28,000,000 x 25 percent), with half of this amount deductible in the first year of acquisition.

The difference between the CCA deduction and the straight-line depreciation expense results in reduced taxable income and income tax payable, providing the company with more available cash for financing its growth.

Question 38

What is the effect of asset impairment on financial statements?

Answer 38

Asset impairment occurs when events or changed circumstances cause the carrying amount of assets to exceed their recoverable amount.

If carrying amount > recoverable amount, the asset is impaired, and a loss is recognized for the difference between the carrying amount and recoverable amount.

Question 39

How is recoverable amount determined for impaired assets?

Answer 39

Recoverable amount is the higher of the asset’s value in use (present value of future cash flows) and its fair value less costs to sell.

If carrying amount > recoverable amount, the asset is impaired, and impairment loss is calculated as Carrying amount - Recoverable amount.

Question 40

What factors trigger impairment of assets?

Answer 40

Assets should be assessed for impairment if there are adverse changes to future benefits caused by events such as economic downturn, war, decreased market price, operating cash flow losses, or technological obsolescence.

Question 41

How are fair values determined for impaired assets?

Answer 41

Fair values can be based on quoted market prices, prices of similar assets from recent transactions, arm’s-length appraisal, or specific valuation techniques if no current market price is available.

Question 42

Can an impairment loss recognized in a prior period be reversed?

Answer 42

Yes, an impairment loss recognized in a prior period can be reversed in the future if there has been a change in estimates used to determine the asset’s recoverable amount.

However, the increased carrying amount cannot exceed what it would have been without the prior impairment loss.

Question 43

What disclosures are required for impairment losses in financial statements?

Answer 43

Companies recognizing impairment losses or reversal of prior impairment losses must disclose specific details in their financial statement notes, including the nature of the asset, events leading to the impairment, the amount of the impairment loss, and methods used to determine the recoverable amount.

Question 44

What are the reasons for the disposal of long-lived assets?

Answer 44

Long-lived assets might be disposed of voluntarily due to product discontinuation, equipment obsolescence, or replacement needs.

Involuntary disposals can occur due to events like storms, fires, theft, or accidents.

Question 45

What journal entries are required for the disposal of a depreciable asset?

Answer 45

Disposal of a depreciable asset involves an adjusting entry to update depreciation accounts and another entry to record the disposal.

The cost and accumulated depreciation of the asset at the disposal date are removed from the accounts.

The difference between cash received (or fair value) and carrying amount results in a gain or loss on disposal, reported in the statement of earnings.

Question 46

How is the gain or loss on disposal calculated?

Answer 46

The gain or loss on disposal is calculated as the difference between the cash received (or fair value) and the carrying amount of the asset at the date of disposal.

It occurs due to differences between estimated depreciation and actual experience, and because depreciation is based on original cost, not fair value.

Question 47

What are the journal entry and effects of a trade-in transaction?

Answer 47

In a trade-in transaction, the old asset’s carrying amount is compared to the fair value of the new asset.

The old asset’s carrying amount is reduced, and the new asset is recorded at its fair value.

If there is a cash payment, it covers the difference between the old asset’s carrying amount and the new asset’s fair value.

Question 48

How is retirement of an asset accounted for, and what is the financial impact?

Answer 48

The retirement of an asset results in a loss equal to the asset’s carrying amount.

The journal entry is similar to a sale or trade-in, but the cash account is not affected.

The loss is recognized, reducing the company’s earnings.