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Chapter 11
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  1. Chapter 11

  2. Amortization, Impairment, and Revaluation Chapter 11

  3. Introduction • Significant areas of accounting policy choice: • Amortization Method Companies are relatively free to choose the amortization method that best suits their financial reporting objectives • Impairment in Value Lower of Cost or Market where market is related to a projection of future cash flows: it is subjective at best There is lots of room for the motivations of management to be reflected in the financial statements

  4. Definitions • Capital assets (both tangible and intangible) • produce revenue through use rather than through resale • can be viewed as quantities of economics service potential to be consumed over time in the earning of revenues • Accounting principles call for the matching of costs of all types of operational assets against revenue over their useful lives

  5. Definitions (cont.) • Amortization:allows for the periodic allocation of the cost of capital assets against revenue earned • Amortization is called depreciation when it is associated with tangible capital assets, and depletionwhen associated with natural resources

  6. Definitions (cont.) • The net book value (carrying value) of an asset: the original cost plus any capitalized post-acquisition cost less accumulated amortization to date • Amortizable cost:the total amount of amortization to be recognized over the useful life of the asset---it equals total capitalized asset cost less estimated residual value

  7. Definitions (cont.) • Depreciation (i.e., on tangible capital assets) is recorded in an accumulated depreciation account---a contra account that is deducted from the related asset account for balance sheet presentation • Amortizationof other assets has generally been recorded as a direct credit to the asset account, particularly for intangible capital assets

  8. Nature of Amortization • Amortization is an allocation of capital cost, expensed over the useful life of the asset • Amortization applies to all items of limited life that appear on the balance sheet • Amortization does not • represent cash set aside for replacement of plant assets • measure the decline in market value during the period • Net Book Value does not equal market value

  9. The Conceptual Basis of Amortization • The eventual decline in value and decline in utility of capital assets is caused by: • physical factors, mainly usage (wear and tear from operations, action of time and the elements, and deterioration and decay) • obsolescence (the result of new technology) • Technological change does not automatically render older equipment obsolete • If the older equipment meets the present needs of the company, obsolescence is not a factor

  10. The Requirement to Recognize Amortization Expense • The general requirement for periodic amortization is based firmly on the matching concept and on the underlying assumption that a primary objective of financial reporting is to match the cost of providing services to the revenue generated • Generally, capital assets must be amortized

  11. The Requirement to Recognize Amortization Expense (cont.) • There are three categories that do not have to be amortized • land • intangible capital assets with an indefinite life • goodwill

  12. Accounting Policy Choice • The CICA Handbook requires only that the method of amortization chosen be rational and systematic, and appropriate to the nature of the capital asset and its use [CICA 3061.28] • The choices are • based on equal allocation to each time period (the straight-line SL method) • based on inputs and outputs (variable charge) • service-hours (SH) method • productive output (PO),or units-of-production, method

  13. Accounting Policy Choice (cont.) • accelerated methods (decreasing charge) • declining balance (DB) methods • sum-of-the-years’-digits (SYD) method • sinking fund methods (increasing charge)

  14. Policy Choices in Practice • Financial Reporting in Canada 2000 reports the following about choice of amortization policy: Amortization PolicyNumberProportion Straight-line 180 62% Declining balance 57 20% Units of production 44 15% Sinking fund9 3% 290 100%

  15. Factors Influencing Choice • Nature and use of asset • Corporate reporting objectives • Industry norms • Parent company preferences • Minimize deferred taxes • Accounting information system costs

  16. Estimates Required • All amortization methods require that the following estimates are made: • acquisition cost • estimated residual value • estimated useful life

  17. Exhibit 11-1

  18. Straight Line • The straight-line (SL) method is based on the assumption that a plant asset provides equivalent service, or value in production, each year of its life • The SL method relates amortization directly to the passage of time rather than to the asset's use, resulting in a constant amount of amortization recognized per time period

  19. Straight Line (cont.) • The SL method is logically appealing as well as rational and systematic • The SL method is the most popular method in use, as the CICA’s corporate reporting survey demonstrates • Ease of use partially explains the method’s popularity

  20. Methods Based on Inputs and Outputs • Amortization methods that associate periodic amortization with a measurable attribute of capital assets include the service-hours method and productive output method (also called the units-of-production method) • The input-output methods are rational and systematic and logically match expense and revenue if the asset's utility is measurable in terms of service time or units of output

  21. Methods Based on Inputs and Outputs (cont.) • If obsolescence is a factor, an asset’s utility decreases whether used or not, and these methods will not portray this reality • The service-hours and productive output methods can produce different results, depending on the ratio of machine-hours to units produced

  22. Accelerated Amortization Methods • Accelerated amortization methods recognize greater amounts of amortization early in the useful life of capital assets and lesser amounts later • Accelerated methods are based on the assumption that newer assets produce more benefits per period because they are more productive and require less maintenance and repair • The declining balance method is the accelerated method widely used in Canada

  23. Sinking Fund Amortization • Produces a pattern of increasing amortization---less in the initial years, and more in later years • This amortization method has gained a toehold in real estate companies that hold apartment buildings • These properties are usually highly levered---lots of debt that translates into lots of interest

  24. Additional Amortization Issues • Additional amortization issues include: • a minimum amortization test • fractional-year amortization • site restoration costs • amortization systems

  25. Fractional-Year Amortization • Is necessary when capital asset acquisitions and disposals do not coincide with the fiscal year • Is computed on a whole-year basis • the appropriate fraction of a period is applied to the amortization for the relevant whole year of the asset’s life • Some firms apply an accounting convention and do not record non-material fractional amortization

  26. Site Restoration Costs • Must be accrued over the life of a capital asset so affected • When these are minor, they are netted with residual value • When these are major, such costs are accrued as a liability and separately disclosed

  27. Impairment of Capital Assets and Goodwill • Capital assets are subject to the same sort of “lower of cost or market value” assessment as other assets • Overvaluation of any asset is a major issue in our GAAP model • One has to critically examine capital assets periodically and ask, “Do they still have the ability to generate revenue commensurate with their net book value?”

  28. Impairment of Capital Assets and Goodwill(cont.) • Impairment of value:the loss of a portion of the utility or value in the context of capital assets and goodwill

  29. Revaluation of Capital Assets • Historical cost has long been the generally accepted basis for reporting capital assets in Canada • On rare occasions, however, a company may restate one or more of its capital assets upward, generally by using appraisal values

  30. Comprehensive Revaluation • Comprehensive revaluation of assets and liabilities to market value can occur, but only if there is a change in control resulting from a financial reorganization • Revaluation to market value also occurs in push-down accounting after a business combination

  31. Disclosure of Amortization • CICA Handbook recommends“for each major category of capital assets there should be disclosure of. . .the amortization method used, including the amortization period or rate” [CICA 3060.54] • Other recommended disclosures relating to capital asset amortization are: • the amount of any impairment or write-down during the period • the amount of amortization charged to income for the period

  32. Disclosure of Amortization (cont.) • the accumulated amortization of each major category of capital assets • details about comprehensive revaluations