Depreciation, Estimates, Impairment, and Subsequent Expenditures

Change in Estimates and Re-starting Depreciation

• When an asset’s estimate changes (useful life, residual value, or other factors), treat it as a change in estimate, not as if you’re rewriting history.

• For a change in estimate, you do not adjust prior depreciation; you recalculate depreciation going forward using the new values as of the date of the change.

• Conceptual idea in the video: it can feel like starting over, but you’re really continuing from the current book value with a new remaining life and a new residual value.

• Key variables:

  • Current book value (BV)

  • New residual value (RV)

  • Remaining useful life (n)

• Calculation for the next period under straight-line depreciation after a change in estimate:
  ext{Dep}{ ext{next}} = rac{BV{ ext{now}} - RV}{n}

• If you switch from a two-year-old estimate to six years remaining, you recalculate the depreciable base and the annual depreciation from that point forward; past depreciation remains unchanged.

• Example framing (from the transcript):

  • First two years depreciation was higher (e.g., $42{,}000 per year).

  • After re-estimate, future depreciation drops (e.g., $24{,}000 per year) for six years.

  • New book value to depreciate over the remaining life is treated as the new basis.

• Sum-of-years-digits (SYD) and declining balance are also affected by a change in estimate; you recompute the remaining depreciable base and apply the chosen method for the remaining life. The calculation depends on the method you continue to use.

• Sum-up: if estimate changes, disclose the nature of the change, the effect on the asset’s life and residual value, and the effect on depreciation going forward.

Change in Depreciation Method and Disclosures

• A change in depreciation method is more significant than a change in estimate and requires a compelling justification.

• You effectively treat the asset as a new baseline for the remaining life when you change the method.

• Process described in the transcript:

  • Identify current BV and RV, and the remaining life under the new method.

  • Compute depreciation under the new method using the current BV and RV for the remaining life.

  • Do not retroactively adjust past depreciation; disclose the rationale for the switch.

• Example scenario from transcript:

  • Change from double-declining balance to straight-line (or vice versa) for the asset’s remaining life.

  • Start with the current book value (e.g., $106{,}000 or similar) and residual value, then apply the new method over the remaining years.

• Disclosure: you must disclose the reason for the change in method, as it is a material accounting policy change.

• If a change in method occurs, you still consider the asset to be a new life from the point of change; past results remain recorded as they were.

Error Corrections (Corrections of Mistakes in Past Financial Statements)

• When an error from a prior period is discovered, you correct it retrospectively and adjust the effect on retained earnings (and accumulated depreciation) for the earliest period presented.

• Rationale: if depreciation was wrong, income was wrong, which affects retained earnings.

• Example narrative from transcript (simplified):

  • A company recorded $300,000 of legal expenses in 2025 that should have been capitalized as an asset; only $6,000 of expense would have been recognized in 2025 (and $6,000 in 2026).

  • The error caused income to be overstated or understated depending on the year; the net effect across the two years is an adjustment to retained earnings.

  • Tax effect is considered (40% in the example).

• General approach:

  • Restate prior-period financials for material errors.

  • Adjust the opening balance of retained earnings for the earliest period presented (as of the beginning of the earliest year shown).

  • Apply the tax effect to determine net adjustments to retained earnings.

  • Provide retroactive disclosures in the notes.

• Conceptual takeaway: corrections affect retained earnings rather than the current period’s income alone; the entire correction is reflected in the year of discovery as a prior-period adjustment, with tax effects accounted for.

Subsequent Expenditures After Asset Acquisition

• Expenditures after an asset is placed in service are classified as either capital expenditures (capitalized) or operating expenditures (expensed) based on their effect on the asset.

• Core rule: ordinary repairs and maintenance that preserve the asset in its current condition are expensed. If the work significantly extends life, improves efficiency, or adds capability, capitalize.

• Four main pathways discussed in the transcript:
  1) Capitalize the cost (add to the asset’s basis) when it significantly changes the asset or extends its life or increases future benefits.
  2) Additions: add a new component to the asset that either improves or extends it; capitalize the cost and depreciate over the remaining life of the asset or the life of the addition, whichever is less.
  3) Improvements: more complex; three accounting methods exist (see below).
  4) Rearrangements: reorganizations to improve efficiency; capitalize and depreciate over the remaining life of the asset.

• Additions (example logic): add a new component (e.g., refrigeration unit to a building).

  • Capitalize the cost from the point of addition.

  • Depreciate over the shorter of the remaining life of the original asset or the life of the addition.

• Improvements (three methods): overhauls or upgrades that enhance value or performance.

  • Method 1: Substitution (the old asset is essentially replaced). Treat as selling the old asset and acquiring a new asset; record a gain/loss on disposal; record the new cost.

  • Method 2: Capitalization (increase the original asset’s book value and then depreciate the increased base).

  • Method 3: Reducing accumulated depreciation (increase the current book value by reducing accumulated depreciation; this increases the net book value without increasing the original cost; this method often yields odd-looking depreciation patterns).

• Rearrangements: changes that do not add a new component but improve efficiency; capitalize and depreciate over the remaining life of the asset.

• Practical note: gray areas exist in repairs vs. capitalization, and tax authorities sometimes have differing interpretations; judgments can be material.

• Tax note: MACRS (for tax purposes) is separate from this accounting framework and is not the same as GAAP/IFRS depreciation methods.

Impairment of Value

• Impairment occurs when the asset has suffered a significant decline in value; the asset’s carrying amount may not be recoverable.

• Key idea: under GAAP, impairment testing has two steps for long-lived assets (PG&E-type items) and finite-life intangibles:
  1) Recoverability test (undiscounted cash flows): Is the carrying amount recoverable? If the sum of undiscounted future cash flows is less than the carrying amount, proceed to impairment measurement.
  2) Measurement of impairment: impairment loss = carrying amount − fair value (if impaired).

• Important concept: You compare three figures to determine impairment:

  • Book value (BV) of the asset.

  • Undiscounted future cash flows (recoverability test).

  • Fair value or market value (or discounted cash flows if there’s no active market).

• If undiscounted cash flows are less than BV, impairment is recorded; impairment is the difference between BV and the asset’s fair value (or discounted cash flows).

• After impairment, you write down the asset to its new fair value and begin depreciation from that new base.

• Example structure from transcript (illustrative):

  • Cost = $200; BV = $110; undiscounted cash flows over the asset’s life = $120; since $120 > $110, no impairment despite fair value being $99 (illustrative) — no impairment because recoverability test uses undiscounted cash flows.

  • If undiscounted cash flows were $100 (less than BV), impairment would be required; impairment amount would be BV − FairValue (e.g., $110 − $82.80 = $27.20 under a discounted-value scenario).

  • After impairment, reset BV to the new fair value (e.g., $82.80) and begin depreciation anew from that base with no prior accumulated depreciation carrying forward as applicable.

• IFRS vs GAAP differences in impairment testing:

  • IFRS uses a one-step approach for impairment of assets, and impairment losses can be reversed in future periods if the recoverable amount later increases (except goodwill).

  • GAAP employs a two-step approach for long-lived assets: recoverability test first, then impairment measurement; goodwill impairment under GAAP is not reversed; IFRS allows some reversals in certain asset categories but not for goodwill.

  • For indefinite-life assets (except goodwill), impairment testing under GAAP is typically annual or when indicators exist; IFRS uses a more qualitative approach with annual tests and a “value in use” concept.

• Held-for-sale assets:

  • When an asset is classified as held-for-sale, it is measured at the lower of carrying amount or fair value less costs to sell; depreciation and amortization cease.

  • If the asset is sold at a loss after impairment, the loss is recognized in the period of sale.

• Goodwill impairment (special case):

  • Goodwill is tested at the reporting unit (or cash-generating unit) level, not asset-by-asset.

  • Step 1: Compare the carrying amount of the reporting unit (including goodwill) with its fair value; if fair value is less, proceed to Step 2.

  • Step 2: Impairment is measured by the difference between the implied fair value of goodwill and its carrying amount (the goodwill impairment is not to exceed the existing goodwill; if the implied value is less than carrying goodwill, the impairment equals the difference).

  • GAAP prohibits reversals of impairment for goodwill; IFRS allows reversals for some impairments but not for goodwill.

• Practical observations from the lecture:

  • Impairments can be used strategically (a “big bath”) to show a poor performance year, while potentially boosting future years’ results due to lower depreciation expense thereafter.

  • This is a managerial tool that requires careful governance to avoid manipulation of earnings.

Indefinite-Life Assets and Goodwill Impairment

• Indefinite-life assets (other than goodwill) require annual impairment tests or more frequent testing if indicators exist.

• Goodwill impairment testing focuses on reporting units and has both a quantitative (fair value vs. carrying amount) and qualitative components.

• Goodwill impairment is generally non-recoverable; reversals are prohibited under GAAP but IFRS allows certain reversals in other asset categories (not goodwill).

• Value concepts:

  • Value in use (IFRS) vs. fair value (GAAP in certain contexts) influences impairment measurements.

  • For goodwill, impairment is calculated as the difference between the implied fair value of goodwill and the carrying amount of goodwill within the reporting unit.

Assets Held for Sale

• When classified as held for sale, an asset is not depreciated or amortized.

• Measurement is at the lower of carrying amount or fair value less costs to sell.

• If the asset’s value declines after classification, recognize a loss; if it rises, reversals are generally not allowed for asset held for sale under GAAP.

Tax Depreciation vs GAAP/IFRS Depreciation (MACRS)

• MACRS is a tax depreciation method used in the United States for tax reporting, separate from GAAP/IFRS accounting depreciation.

• The accounting depreciation methods (straight-line, SYD, declining balance) are used for financial reporting and may differ from tax depreciation schedules.

Ethics and Management Considerations: Big Bath and Earnings Management

• Impairments and write-downs can be used (intentionally or unintentionally) to manipulate reported earnings.

• A “big bath” involves taking a large impairment in one period to make future periods look better, often to align with new management teams or strategic pivots.

• Ethical implications: impairment judgments require reasonable estimates, robust governance, and transparent disclosures to avoid misleading financial statements.

Quick Reference: Key Formulas (LaTeX)

• Straight-line depreciation (new estimate):
  ext{Dep}_{ ext{SL}} = rac{BV - RV}{n}

• Sum-of-years-digits (SYD) depreciation for remaining life $n$ years, year $t$ (starting at 1):

  • Denominator: S = rac{n(n+1)}{2}

  • Year $t$ depreciation: ext{Dep}_{t} = (BV - RV) imes rac{n - t + 1}{S}

• Declining balance (e.g., double-declining, RB = 2, n = years of useful life):
  ext{Dep}{t} = ext{BV}{t-1} imes rac{2}{n} (adjust to not go below RV or to economically appropriate level)

• Change in estimate (new base after change):

  • New depreciable base: ext{Base}{ ext{new}} = BV{ ext{as of change}} - RV_{ ext{new}}

  • New annual depreciation: ext{Dep}{ ext{new}} = rac{ ext{Base}{ ext{new}}}{n_{ ext{remaining}}}

• Impairment (recoverability test):

  • If undiscounted cash flows $< BV$, impairment exists; impairment amount:
    ext{Impairment} = BV - ext{FairValue}

• Impairment of goodwill (GAAP):

  • Impairment equals the difference between the carrying amount of the reporting unit and the implied fair value of goodwill within the unit; cannot be reversed for goodwill under GAAP.

• Held-for-sale measurement: lower of carrying amount or fair value less costs to sell; no depreciation.

Note

• This note consolidates concepts from the transcript on depreciation changes, method switches, errors and corrections, subsequent expenditures, impairment tests (GAAP vs IFRS), goodwill impairment, assets held for sale, and tax depreciation (MACRS).

• If you need, I can tailor these notes to specific chapters or slides from your course and align them with your professor’s preferred examples and numbers.