Depreciation Process 1. Depreciate by Component: o By useful lives and patterns of consumption group similar o By depreciation method

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1 Depreciation - means of cost allocation to match expense with revenue - not a method of valuation - involves allocating the depreciable amount of property, plant, and equipment over the periods expected to benefit from the use of the assets Depreciation Process 1. Depreciate by Component: o By useful lives and patterns of consumption group similar o By depreciation method 2. Depreciation base: o IFRS: Cost less residual value Residual value - net amount expected to be received for the asset today if it were of the age and in the condition expected at the end of its useful life IFRS requires at least annual review of residual value o ASPE: Higher of cost less residual value or cost less salvage value Salvage value - asset s estimated net realizable value at the end of the asset s life 3. Depreciation period: o begins when the asset is available for use and ends when the asset is derecognized or classified as held for sale o Factors affecting useful life are: economic factors obsolescence physical factors wear and tear, decay legal life end of lease term 4. Depreciation method: o reflect the pattern of benefits expected from the use of the asset o Accounting methods include (not to be confused with tax method): straight-line - Depreciation is a function of the passage of time diminishing balance - Assumes assets deliver higher benefits in earlier years (declining and double declining balance) activity based - depreciate based on actual usage or productivity instead of time Example: Cost of crane $500,000 Estimated useful life 5 years Productive life 30,000 hours Estimated residual value $50,000 Straight-Line Method Depreciation charge = (cost residual value)/estimated useful life (500,000 50,000) / 5 = 90,000 Double Declining Balance Method - residual value not deducted - 100%/estimated useful life x 2

2 Yea r Book value DDB rate Dep expense Accum dep Net book value 1 500,000 40% 200, , , ,000 40% 120, , , ,000 40% 72, , , ,000 40% 43, ,200 64, ,800 40% 14, ,000 50,000 Units of Production (500,000 50,000) / 30,000 hours = $15/hour If used for 4,000 hours during the year, depreciation expense = 15 x 4,000 = 60,000 P11-2 On June 15, 2011, a second-hand machine was purchased for $77,000. Before being put into service, the equipment was overhauled at a cost of $5,200, and additional costs of $400 for direct material and $800 for direct labour were paid in fine-tuning the controls. The machine has an estimated residual value of $5,000 at the end of its five-year useful life. The machine is expected to operate for 100,000 hours before it will be replaced and is expected to produce 1.2 million units in this time. Operating data for the next six fiscal years are provided below. The company has an October 31 fiscal year end. Depreciation expense should be calculated to the nearest half month. Year Hours of Operation Units Produced , , , , , , , , , , , ,000 a) Depreciation in 2011 June 15 Oct 31 (4.5 months) Asset cost = 77, , = 83,400 Depreciation base = 83,400 5,000 = 78,400 Straight-line: 2011 depreciation = (78,400/5)*(4.5/12) = 5, depreciation = 78,400/5 = 15, depreciation = (78,400/5)*(7.5/12) = 9,800 activity method (output): 2011 depreciation = (78,400/1,200,000)*110,000 = 7, depreciation = (78,400/1,200,000)*270,000 = 17, depreciation = (78,400/1,200,000)*264,000 = 17, depreciation = (78,400/1,200,000)*310,000 = 20, depreciation = (78,400/1,200,000)*134,000 = 8, depreciation = (78,400/1,200,000)*112,000 = 7, activity method (input): 2011 depreciation = (78,400/100,000)*10,000 = 7, depreciation = (78,400/100,000)*20,000 = 15,680

3 2013 depreciation = (78,400/100,000)*20,000 = 15, depreciation = (78,400/100,000)*20,000 = 15, depreciation = (78,400/100,000)*18,000 = 14, depreciation = (78,400/100,000)*12,000 = 9,408 double-declining balance: DDB rate = (100%/5)*2 = 40% 2011 depreciation = 83,400*40%*(4.5/12) = 12,510 carrying amount = 83,400 12,510 = 70, depreciation = 70,890*40% = 28,356 carrying amount = 70,890 28,356 = 42, depreciation = 42,534*40% = 17, carrying amount = 42,534 17, = 25, depreciation = 25,520.40*40% = 10, carrying amount = 25, , = 15, depreciation = 15,312.24*40% = 6, carrying amount = 15, , = 9, depreciation = 9, ,000 = 4, carrying amount = 5,000 (residual value) b) carrying amount at Oct. 31, 2014: straight-line $ 30, activity (output) $ 21, activity (input) $ 28, double-declining $ 15, Depletion of Natural Resources Natural resources are depleted (amortized) over time as they are removed (timber, oil and gas, mining) Depletion is calculated using an activity method (such as units-of-production) The depletion charge is initially debited to Inventory When the resource is sold, Inventory is credited and Cost of Goods Sold is debited Example: assume a mining company acquired the right to use 1,000 hectares of land in the Northwest Territories to mine for gold. The lease cost is $50,000, the related exploration and evaluation costs are $100,000, and development costs incurred in opening the mine are $3,850,000, all of which have been capitalized. The company estimates that the mine will provide approximately 10,000 ounces of gold. Cost of mine = 50, , ,850,000 = 4,000,000 Depletion cost per unit = 4,000,000 / 10,000 = $400/ounce 2,500 ounces extracted during the year = 400 x 2,500 = $1,000,000 Inventory 1,000,000 Accumulated depletion 1,000,000 E11-11 Rachel Timber Inc., a small private company that follows Canadian ASPE, owns 9,000 hectares of timberland purchased in 2001 at a cost of $1,400 per hectare. At the time of purchase, the land without the timber was valued at $420 per hectare. In 2002, Rachel built fire lanes and roads, with a

4 physical life of 30 years, at a cost of $84,000 and separately capitalized these costs. Every year, Rachel sprays to prevent disease at a cost of $3,000 per year and spends $7,000 to maintain the fire lanes and roads. During 2003, Rachel selectively logged and sold 700,000 cubic metres of the estimated 3.5 million cubic metres of timber. In 2004, Rachel planted new seedlings to replace the cut trees at a cost of $100,000. a) Cost of land = 9,000 x $420 = $3,780,000 Cost of timber = 9,000 x ($1,400 - $420) = $8,820,000 Cost of fire lanes and roads = $84,000 depletion charge = $8,820,000/3,500,000 cubic metres = $2.52/cubic metre 2003 accumulated depletion = $2.52 x 700,000 cubic metres = $1,764,000 Inventory 1,764,000 Accumulated depletion 1,764,000 Cost of goods sold 1,764,000 Inventory 1,764,000 b) Rachel has not logged since Assume that Rachel logged and sold 900,000 cubic metres of timber in 2014 and the timber cruiser (the appraiser) had estimated a total resource of 5 million cubic metres. Determine the cost of timber sold that relates to the depletion for Carrying amount of timber in 2014 = (8,820,000 1,764,000) + 100,000 = 7,156,000 depletion charge = $7,156,000/5,000,000 cubic metres = $1.4312/cubic metre 2014 accumulated depletion = $ x 900,000 cubic metres = $1,288,080 Inventory 1,288,080 Accumulated depletion 1,288,080 Cost of goods sold 1,288,080 Inventory 1,288,080 Liquidating Dividend - dividend greater than the amount of accumulated net income = accumulated net income (after depletion) + depletion charged Example: r/e = 1,650,000 accum. Depletion = 2,100,000 common shares = 5,400,000 Dividends paid = $3 per share on 1,000,000 shares outstanding = 3,000,000 Retained earnings 1,650,000 Common shares 1,350,000 Cash 3,000,000 $3 dividend per share represents a $1.65 (1,650,000/1,000,000) per share return on investment and a $1.35 (1,350,000/1,000,000) per share liquidating dividend, or return of capital. PPE bought/sold during the year may be depreciated: Prorate by months or even days. Full year depreciation in the acquisition year and none in the final year (or vice versa) As long as policy is consistent, usually difference is not material.

5 Example: (straight-line) automated drill machine with a five-year life is purchased for $45,000 (no residual value) on June 10, The company's fiscal year ends December 31. Depreciation allocated over 5-year life (Jun 10, ) Fractional-year policy Nearest fraction of a year (6-2/3) 5,000 9,000 9,000 9,000 9,000 4,000 Nearest full month (7) 5,250 9,000 9,000 9,000 9,000 3,750 Half year in acquisition and disposal 4,500 9,000 9,000 9,000 9,000 4,500 Full year in acquisition, none in 9,000 9,000 9,000 9,000 9,000 0 disposal None in acquisition, full year in disposal 0 9,000 9,000 9,000 9,000 9,000 Example: (double-declining) asset purchased for $10,000 on October 1, 2014 useful life = 5 years DDB rate 100/5 x 2 = 40% depreciation for 2014 (3 months) (3/12) x (10,000 x 40%) 1,000 asset carrying amount = 10,000 1,000 = 9,000 depreciation for ,000 x 40% 3,600 asset carrying amount = 9,000 3,600 = 5,400 depreciation for ,400 x 40% 2,160 asset carrying amount = 5,400 2,160 = 3,240 Revision of depreciation rates, useful lives, residual value: Recalculate depreciation expense prospectively (period of change and in the future) Example: machinery that cost $90,000 was estimated originally to have a 20-year life and a $10,000 residual value. It has already been depreciated for eight years using the straight-line method. In year nine, the asset's total life is now expected to be 30 years with a residual value of only $2,000. Depreciation expense from years 1-8 (90,000 10,000)/20 4,000 Cost of machine 90,000 Less: accumulated depreciation (4,000 x 8) (32,000) Depreciation base for the next 22 years 58,000 Depreciation expense for the next 22 years (58,000 2,000)/22 2,545 Depreciation expense 2,545 Accumulated depreciation Machinery 2,545 Impairment IFRS o o ASPE annual impairment test required (look for indications of impairment) Rational Entity Impairment Model

6 o o carry out recoverability test only when there are trigger events that indicate an asset s carrying amount may not be recoverable. Cost Recovery Impairment Model Rational entity impairment model: Impairment if carrying amount is greater than the recoverable amount, defined as the higher of: o Value in use o Fair value less costs of disposal Reversal of loss allowed. Example 1: As a result of its annual assessment of property, plant, and equipment for indications of impairment, an entity determines that equipment with a carrying amount of $45,000 (cost of $60,000; accumulated depreciation of $15,000) may be impaired due to technological obsolescence. The entity calculates the asset's recoverable amount to be $47,500. This is the higher of its value in use of $47,500 and its fair value less costs of disposal of $40,000. Recoverable amount of 47,500 > carrying amount of 45,000 no impairment Example 2: Assume the same facts as in Example 1 above, except that the asset's value in use is determined to be $37,500 and its fair value less costs of disposal (of $2,000) is $40,000. In addition, the expected future undiscounted net cash flows from the use of the asset and its later disposal are estimated to be $43,000. Compare the accounting for impairment under ASPE versus IFRS. ASPE: Carrying amount of 45,000 > undiscounted net cash flows of 43,000 Loss on Impairment (45,000 42,000) 3,000 Accumulated Impairment Losses - Equipment 3,000 Losses - Equipment IFRS: Recoverable amount = higher of value in use 37,500 and fair value less costs of disposal (2,000) 40,000 Carrying amount of 45,000 > recoverable amount of 40,000 Loss on Impairment (45,000 40,000) 5,000 Accumulated Impairment Losses - Equipment 5,000 Losses - Equipment Cost recovery impairment model: Pre-screening test to determine whether asset is impaired Recoverability test: Impairment if carrying amount is greater than the undiscounted future cash flows. If fails the recoverability test: write down to fair value No reversal of loss allowed. Example 1: asset's carrying amount is $600,000 ($800,000 cost less $200,000 accumulated depreciation). The expected future undiscounted net cash flows from the use of the asset and its later disposal are estimated to be $650,000, and the asset's fair value is $525,000.

7 Recoverability test: carrying amount of 600,000 < undiscounted net cash flows of 650,000 No impairment Example 2: same facts as in Example 1 above, except that the expected future net cash flows from the equipment are $580,000 instead of $650,000 Recoverability test: carrying amount of 600,000 > undiscounted net cash flows of 580,000 Loss on Impairment (600, ,000) 75,000 Accumulated Impairment Losses - Equipment 75,000 Losses - Equipment Asset Groups and Cash-generating Units Many assets do not generate cash flows independently, so impairment analysis cannot be done at the level of the individual asset (or component) These assets are identified with an asset group or cash-generating unit (CGU) o i.e. smallest identifiable group of assets that generates cash inflows that are largely independent of the cash flows from other assets or groups of assets (IAS 36.6) Any impairment losses are then allocated to individual assets (or component) on a pro-rata basis No individual asset should be reduced below its fair value (under cost recovery model) or recoverable amount (under rational entity model) if these amounts are known Example 1: Uni Corp. (UC) is a manufacturer that produces parts for residential telephone sets. Recent indications are that the market for this product is likely to decline significantly and UC is testing equipment used in the production process for impairment. The following assets are used only in the manufacture of these parts. The tools and dies and specialized equipment cannot be used elsewhere and have no resale value, while the general equipment could be sold today for $1,500. UC plans to continue producing the parts for two more years to fill a commitment to its customer. The net future cash flows from the next two years' production of these parts and the disposal of the equipment are estimated to be $3,200, and the present value of these cash flows is $2,600. Cost accumulated depreciation carrying amount Tools and dies 1, Specialized equipment 5,000 3,500 1,500 General equipment 3,000 1,800 1,200 9,000 5,900 3,100 tools and dies and specialized equipment cannot be used elsewhere and have no resale value one CGU cost recovery: carrying cost 3,100 < future cash flows 3,200 no impairment rational entity: recoverable amount: higher of value in use 2,600 and FV less costs to sell 1,500 carrying cost 3,100 > recoverable amount 2,600 impairment carrying amount proportion loss allocation Tools and dies 400 4/ Specialized equipment 1,500 15/19 395

8 1, Loss on Impairment (3,100 2,600) 500 Accumulated Impairment Losses - Tools and dies 105 Accumulated Impairment Losses - Specialized equipment 395 E11-19 Green Thumb Landscaping Limited has determined that its lawn maintenance division is a cashgenerating unit under IFRS. The carrying amounts of the division's assets at December 31, 2014, are as follows: Land 25,000 Building 50,000 Equipment 30,000 Trucks 15, ,000 The lawn maintenance division has been assessed for impairment and it is determined that the division's value in use is $108,000, fair value less costs to sell is $75,000, and undiscounted future net cash flows is $144,000. a) IFRS rational entity; recoverable amount = higher of value in use 108,000 and FV cost to sell 75,000 Carrying amount 120,000 > recoverable amount 108,000 impairment loss of (120, ,000) Land 25,000 5/24 2,500 Building 50,000 10/24 5,000 Equipment 30,000 6/24 3,000 Trucks 15,000 3/24 1, ,000 12,000 Loss on Impairment 12,000 Accumulated Impairment Losses Land 2,500 Accumulated Impairment Losses Building 5,000 Accumulated Impairment Losses Equipment 3,000 Accumulated Impairment Losses Trucks 1,500 b) ASPE cost recovery; carrying amount 120,000 < future net cash flows 144,000 no impairment c) Building = max loss allowed 4,000; divide remaining loss of 8,000 among: Land 25,000 5/14 2,857 Equipment 30,000 6/14 3,429 Trucks 15,000 3/14 1,714 70,000 8,000 Loss on Impairment 12,000 Accumulated Impairment Losses Land 2,857 Accumulated Impairment Losses Building 4,000 Accumulated Impairment Losses Equipment 3,429 Accumulated Impairment Losses Trucks 1,714

9 Asset Held for Sale (review Chapter 4) Reported separately on balance sheet No depreciation is taken while held for sale Measured at lower of carrying cost or fair value less cost to sell. Derecognition (sale, exchanged, retired etc.): Depreciation is recorded up to the date of disposal before determining gain or loss Gains or losses from disposal are normally shown with Other revenues and expenses in the income statement Ratios Efficiency in using assets to generate revenues/earnings: Total asset turnover = net revenue / average total assets Return on assets = net income / average total assets In class exercises Depreciation methods: o P11-2, E11-23 (b) Natural resources: o E11-11 Change in estimates: o E11-14 Impairment: o E11-19 Disposal of PPE: o E11-25 Recommended Practice Problems Depreciation methods: E11-23 (a) and (b) P11-5, P11-7 Natural resources: E11-12 Impairment: E11-21 Change in estimates: E11-15 Comprehensive: P11-15