71 Lesson 2: Depreciation and Amortization of Long-Lived Assets, and the Revaluation Model

What is the fundamental concept behind both depreciation and amortization, and how do they differ in practice?

Depreciation and amortization both involve allocating the costs of assets, with depreciation applying to tangible assets and amortization to intangible assets with finite useful lives.

What is the cost model, and under which accounting standards is it required or permitted?

The cost model allocates the cost of long-lived tangible assets (except land) and intangible assets with finite useful lives over their useful lives. It is required under U.S. GAAP and permitted under IFRS.

What is the revaluation model, and under which accounting standards is it permitted?

The revaluation model is permitted under IFRS but not under U.S. GAAP. It involves reporting long-lived assets at their fair value rather than historical cost minus accumulated depreciation/amortization.

What are some common depreciation methods used to allocate the cost of tangible assets?

Common depreciation methods include the Straight-Line Method, Accelerated Methods, and Units-of-Production Method.

What is the key characteristic of straight-line depreciation, and how is the depreciation expense calculated using this method?

Straight-line depreciation evenly allocates the cost of an asset across its estimated useful life. The depreciation expense is calculated as (Original cost - Salvage value) / Depreciable life.

How does accelerated depreciation differ from straight-line depreciation, and what is a common method of accelerated depreciation?

Accelerated depreciation allocates more depreciable cost in the early years of asset use. A common method of accelerated depreciation is the declining balance method, where depreciation expense for a period is a percentage of the carrying amount at the beginning of the period.

What is the formula for double declining balance depreciation, and how is it calculated?

Double declining balance depreciation is calculated as (2 / Depreciable life) × Beginning book value. It allows for a faster depreciation of assets in the earlier years of their useful life. → consider to only depreciate the asset until its salvage value.

What is the units-of-production method, and how is the depreciation expense calculated using this method?

The units-of-production method calculates depreciation expense based on the asset's production in the period relative to the total estimated productive capacity over its useful life.

The depreciation expense per unit is determined as (Beginning Book Value - Salvage Value) / Estimated productive capacity over the asset's life, and this is multiplied by the production to obtain the depreciation expense for the period.

What should we consider for depreciation regardless of the method used?

Carrying amount not reduced below estimated residual value.

How does the choice between straight-line and accelerated depreciation methods affect the Asset Turnover Ratio, Operating Profit Margin, and Operating Return on Assets (ROA) in the early years of an asset's life?

In the early years, straight-line depreciation results in a lower Asset Turnover Ratio and higher Operating Profit Margin and Operating ROA due to a lower depreciation charge, which leads to higher net assets.

How does accelerated depreciation influence the reported trends of asset turnover ratio, operating profit margin, and ROA over time?

Accelerated depreciation leads to an improving asset turnover ratio, operating profit margin, and ROA over time, as more depreciation expense is recognized in the early years.

What balance sheet disclosures related to depreciation and amortization are typically provided by companies, and where can these details be found?

Companies typically provide balance sheet disclosures related to depreciation and amortization, including acquisition costs, depreciation and amortization expenses, accumulated depreciation and amortization, depreciation and amortization methods used, and information on assumptions used for depreciating and amortizing long-lived assets. These details can be found in the notes to the financial statements.

How do longer useful life and higher expected residual value affect the annual depreciation expense, and what opportunities do these assumptions create for management?

Longer useful life and higher expected residual value result in lower annual depreciation expense.

These assumptions allow management to manipulate earnings, such as writing down the long-lived asset value to recognize a significant charge against net income in the current period.

What earnings manipulation strategies related to depreciation can management employ, and how do they impact financial statements?

Management can employ strategies like writing down long-lived asset value to depress current-year earnings but lower annual depreciation expense going forward.

They can also overstate the useful life and salvage value initially to show impressive profits and recognize a significant loss when the asset is retired.

What additional assumptions are needed to allocate depreciation expense between Cost of Goods Sold (COGS) and Selling, General, and Administrative Expenses (SG&A), and how does this allocation impact financial statements?

Additional assumptions are needed to allocate depreciation expense between COGS and SG&A. A higher proportion in COGS lowers gross profit margin and operating expenses but doesn't affect the net profit margin (after depreciation).

Why should companies periodically review their depreciation estimates, and what is the requirement for annual review under IFRS?

Companies should periodically review their depreciation estimates to ensure reasonability. IFRS requires an annual review of estimates to maintain their accuracy.

Are there significant differences between IFRS and U.S. GAAP in the definition of depreciation and acceptable methods?

There are no significant differences between IFRS and U.S. GAAP in the definition of depreciation and acceptable methods. However, IFRS requires the component method of depreciation, which allows for the depreciation of different asset components separately using estimates. This method is allowed in U.S. GAAP but is not widely used.

How are intangible assets with finite useful lives treated in terms of amortization?

Intangible assets with finite useful lives are amortized over those useful lives to align the cost of these assets with the benefits they provide.

What are some examples of intangible assets that are amortized?

Examples of intangible assets that are amortized include acquired patents or copyrights with specific expiration dates, customer lists, acquired licenses with specific expiration dates and no renewal rights, and acquired trademarks for products to be phased out over specific years.

How are assets with indefinite useful life treated in terms of amortization?

Assets with indefinite useful life are not amortized. They are considered indefinite when there's "no foreseeable limit to the period over which the asset is expected to generate net cash inflows."

What are the acceptable amortization methods for intangible assets?

The acceptable amortization methods for intangible assets are the same as the acceptable depreciation methods.

What estimates are needed to calculate the yearly amortization expense for intangible assets?

To calculate the yearly amortization expense for intangible assets, you need to consider the original value of the intangible asset, its residual value at the end of its useful life, and the length of its useful life.

What does the revaluation model allow for the reporting of carrying amounts of noncurrent assets on the balance sheet?

The revaluation model allows for the reporting of carrying amounts at fair value, reflecting the asset's fair value as long as it can be measured reliably.

What is a key difference between the revaluation model and the cost model?

The key difference is that the revaluation model can result in reported values higher than historical cost, while the cost model ensures the reported value never exceeds historical cost.

In the revaluation model under IFRS, how is the initial decrease in carrying amount of an asset recognized?

The initial decrease in carrying amount is recognized as a loss on the income statement.

How is an increase in the carrying amount of an asset's class recognized in the revaluation model?

An increase in the carrying amount of an asset's class is recognized as a gain on the income statement to the extent that it reverses a revaluation loss.

What happens to any increase beyond the reversal amount in the revaluation surplus account?

Any increase beyond the reversal amount is adjusted directly to equity through the revaluation surplus account.

What is the treatment of the revaluation surplus when an asset is sold or disposed of?

The revaluation surplus associated with the asset is transferred to retained earnings when the asset is sold or disposed of.

What are the effects of an increase in carrying value due to asset revaluations on total assets and shareholders' equity?

An increase in carrying value increases both total assets and shareholders' equity.

How does an increase in carrying value due to asset revaluations affect reported leverage (financial leverage ratio)?

An increase in carrying value reduces reported leverage, making the company appear less leveraged.

Why might companies choose to revalue assets upward, especially when seeking new capital or nearing leverage limits set by financial covenants?

Companies may revalue assets upward to present favorable solvency levels when seeking new capital or approaching leverage limits set by financial covenants.

What are the effects of a decrease in asset value due to revaluations on net income, return on assets (ROA), and return on equity (ROE)?

A decrease in asset value due to revaluations decreases net income in the year of revaluation and reduces ROA and ROE in the same year. In future years, lower asset and equity values may result in higher ROA and ROE.

How can reversals of downward revaluations be timed to manage earnings and increase income?

Reversals of downward revaluations can be timed to manage earnings and increase income by recognizing them when needed to improve financial performance.

What impact does an increased carrying value have on annual depreciation expense and future performance measures like ROA and ROE?

An increased carrying value leads to higher annual depreciation expense, potentially resulting in lower future ROA and ROE, even if asset improvement is associated with upward revaluations.