Chapter 6: Long-Term Assets
- 1 Learning Objectives
- 2 Fundamental Theory of Long-Term Assets and Depreciation
- 3 Initial Recognition
- 4 Repairs, and Asset Improvements
- 5 Depreciation
- 6 Straight-Line Method
- 7 Double-Declining Balance Method
- 8 Units-of-Production Method
- 9 Sum-of-the-Years-Digits Method
- 10 Comparison of Depreciation Methods
- 11 Accounting for Changes in Depreciation Estimates
- 12 Long-Term Asset Sales and Disposal
- 13 Long-Term Asset Impairment
- 14 Depletion (Natural Resources)
- Learn how to record long-term assets for initial recognition
- Learn how to account for repairs and asset improvements
- Learn how to account for depreciation for long-term assets
- Learn how to calculate and apply the straight-line method of depreciation
- Learn how to calculate and apply the double-declining balance method of depreciation
- Learn how to calculate and apply the units-of-production method of depreciation
- Learn how to calculate and apply the sum-of-the-years method of depreciation
- Learn how to handle changes in depreciation estimates
- Learn how to account for long-term asset sales
- Learn how to account for long-term asset impairments
- Learn how to account for depletion of natural resources
Fundamental Theory of Long-Term Assets and Depreciation
Long-term assets are also referred to as fixed assets, property, plant and equipment or long-lived assets. A long-term asset is any asset that does not meet the definition of being a current asset (12 months or the operating cycle, whichever is longer). They are used in the primary operations of the business to generate revenue and are not sold in the ordinary course of business. Examples of long-term assets are land, buildings, machinery, cars, and furniture. It is important to note that if the purchase is not used in the primary operations of the business then it should be classified as an investment. Investments are assets that a company has purchased with the future intent of reselling those assets. An investment can be reclassified as a fixed asset if the asset was converted to use in the company's primary operations. For example, undeveloped land that was originally intended to be resold at a later date but ultimately had a retail store placed on it. Assets that are less than 12 months in duration should be classified as a current asset and expensed as incurred. Long-term assets are reported on the balance sheet.
The two most significant concepts for long-term assets is that the asset is recorded at historical cost. Historical cost means the long-term asset is initially recorded at the cost to purchase the long-term asset and place it in service. If the long-term asset was purchased for $50,000 and $5,000 was spent to setup the asset then $55,000 becomes the amount it is initially recorded at on the balance sheet. The second significant concept is using depreciation to allocate the cost of the long-term asset to expense over its useful life. Depreciation is the process of recognizing the loss in usefulness of the asset overs its useful life. We never use fair value to adjust the amounts in the balance sheet. We simply record it at the purchase price and then depreciate it until the long-term asset is either scrapped or sold.
The first step in learning about long-term assets is to learn about how the long-term asset gets recognized in the financial statements. The initial recognition begins with the purchase of the asset. As mentioned above, we use the historical cost principle which means we recognize the cost to purchase the asset plus all necessary expenses to place the asset in service. This means we would recognize installation expenses, freight expenses, and any other expenses needed to place the asset in service. Depending on the asset, a variety of expenses could be incurred that are required to be included in the initial cost recognition for the asset. The following asset classes have these typical expenses:
Buildings: Building permits, architect services, construction related expenses (interest, insurance, etc.), repairs, and modifications.
Equipment: Freight expenses, insurance, sales tax, installation, setup charges, and modifications.
Land: Land title, permits, clearing of the land, sales tax, and real estate tax (if required to pay delinquent back taxes).
Important to note is that only direct costs used in preparing the asset for use are included. Costs that are not directly related to the asset are expensed. For example, the following expenses would not be included: cost to dispose old equipment, reorganization costs if not directly related to the asset, and uninsured losses.
When expenses are included with the purchase price of the asset they are called being capitalized which means they are reported on the balance sheet and depreciated. The expenses are not reported separately from the asset, they are all lumped together.
Example purchase of a fixed asset:
Hope corporation purchases a new machine for $5,000 plus $225 sales tax. The company hires an electrician to setup the machine for $500. The company sold the old equipment for $1,000. The following entry is used to record this transaction:
We debit equipment for $5,725 because it consists of $5,000 for the equipment, $225 for sales tax and $500 for the electrician's labor.
The above example uses cash as the way for the company to acquire the asset. Companies could also finance a purchase, issue stock (equity) for the asset or acquire the asset by building it. All of these methods of acquiring the asset make the accounting for them slightly more complex compared to using cash.
Acquisition by Financing: If the equipment was purchased with a note payable then we would credit the note payable for the amount of the note. Any costs paid with cash would result in the cash account being credited.
Hope corporation purchases a new machine for $5,000 plus $225 sales tax. The company hires an electrician to setup the machine for $500. A note payable was used to finance the equipment purchase while cash was used to pay the electrician The following entry is used to record this transaction:
Acquisition by Equity: The long-term assets could be purposed by not using cash or debt but rather by giving an ownership stake in the company. For corporations, this is done by giving the company's shares for the long-term asset. When the company's shares are used in the exchange then we use the fair market value for those shares as listed on a stock exchange that actively trades the shares. We will credit the stock's stated par value with the rest of the value above the par value being allocated to additional paid in capital.
Hope corporation agreed to purchase the machine. The company hires an electrician to setup the machine for $500. Hope corporation purchased the equipment by issuing 1,000 shares with a stated par value of $1. The shares had a fair market value of $3 at the time of the transaction. The entry would be recorded as follows:
Note that the concepts of common stock and equity will be discussed in detail in chapter 15.
Acquisition by Construction: Long-term assets can also be acquired by the company by simply constructing the asset. For example, the company could buy the raw materials and hire the necessary labor to build the long-term asset. In situations like this the cost of the asset is simply the cost of the materials, labor and other costs incurred to construct the asset. For very costly assets, most companies will finance the construction project. When financing is involved, we will need to capitalize a certain amount of the interest to the asset. The calculation of capitalized interest is a tedious calculation discussed in advanced financial accounting courses.
Hope Corporation constructed a building by using $100,000 in raw materials, $50,000 in labor and $10,000 in interest expense that was incurred directly related to the financing used to construct the building. The following entry is used to record this transaction:
The $160,000 being calculated as $100,000 raw materials + $50,000 labor + $10,000 interest expense
Repairs, and Asset Improvements
Once the asset has been placed into service the asset will need to be repaired if it breaks down while other improvements will increase the useful life of the asset. It is important to distinguish the two types of expenses. A repair does not increase the useful life of the asset. Instead the repair simply returns the asset back to its normal operating function. An improvement will increase the useful life of the asset or provide some other significant improvement to the asset.
The basic rule for repairs is that they are expensed when incurred and should be recorded as an increase to a repair expense account. The journal entry for a repair would be the following:
What about if the repair increases the asset's useful life? In that case we adjust the depreciation account to reflect the increase in the asset's useful life. The following journal entry is used to record repairs that increase the asset's useful life:
An asset is considered improved if additional functionality or useful life increasing improvements have been added to the equipment. These types of improvements are considered capital expenditures and must be capitalized. An example of a capital expenditure would be adding a new engine to a truck to increase the truck's performance. Asset improvements would be recorded using the following journal entry:
Companies should establish a long-term asset capitalization policy that is consistently applied and conforms to reasonable basis with cost versus reward constraint. Furthermore, the policy should be implemented to not mislead financial statement users. For example, a company might have a long-term asset policy where all repairs below $500 are expensed while any repair above $500 is capitalized.
The overall accounting impact is expensing the repairs will result in an immediate decrease in net income and thus lower tax expense. Capitalizing the repair/improvements will result in more assets on the balance sheet and a higher net income, higher tax expense, with tax expense in the future being less due to the asset being depreciated over a number of future years. In all situations, the accountants must always prioritize the informational needs of the financial statement users over business needs.
Depreciation is the process of recognizing a loss in usefulness of an asset as it is used over time. It is a cost allocation method used to match the expense of purchasing the asset against the expected benefit it will provide. We recognize depreciation similar to how we adjust a prepaid asset account. The basic idea of depreciation is to spread the asset's cost over its useful life. Depreciation allows us to make sure the matching principle is not violated for long-term assets. Land holds a unique place in accounting because it normally does not lose its value with the passage of time. Since land does not lose value over time, we do not depreciate land. A asset can be subject to depreciation due to the following factors:
- Functional: When the asset can no longer provide the intended benefits due to obsolescence.
- Physical: When the asset becomes physically damaged due to use over time.
The process of depreciation begins by determining which assets will be subject to depreciation. This determination must by made by management and will vary from company to company. Companies will use the cost of the asset, the useful life of the asset, the salvage value and cost vs benefit factors. The accountants or management should never select a depreciation method that will present a false representation of the company. Once the depreciation polices have been established we will record the cost of the asset through a journal entry. Different types of assets will be subject to different methods of depreciation based on how the asset is used.
Before we can calculate depreciation, we need to determine the following depreciation factors for each long-term asset:
- Useful Life: The useful life is simply the amount of time (usually in years) that the company will use the asset in its business. The useful life is influenced by both functional and physical decay over time.
- Depreciation Base: The depreciation base is simply the purchase price of the asset minus salvage value. Salvage value is defined as amount of expected cash the asset will be sold for after the company scraps the asset. If the asset will not be worth anything after being used by the company then the salvage value will simply be zero.
- Ideal Depreciation Method: The ideal depreciation method used must be able to match the value the asset will provide over time to the company. If the asset provides lots of value in the first half of its useful life then a depreciation method should be selected to match. The only criteria required for the depreciation method used is that it must be systematic (applied consistently) and rational (logical reason).
Now that we have the basics covered, let's review the most popular depreciation methods in use.
The first depreciation method we will learn about is called the straight-line method. The straight-line method is the most commonly used depreciation due to its simplicity. The significant aspect of the straight-line method is that it provides an equal amount of expense per month over the asset's depreciable life. We will highlight the high-level of how the straight-line method works.
To use the straight-line method, we need the following information about the asset:
- Acquisition cost: The cost of the asset including all ordinary and necessary expenses to put the asset into service.
- Estimated Useful Life: The company should estimate the asset's useful life using methods that will accurately predict the asset's useful life.
- Salvage Value: The asset's value after it has been depreciated. If salvage value cannot be estimated then it is assume to have no salvage value.
After we have gathered the above information, we can use the straight-line method formula to calculate our annual or monthly depreciation.
Straight-line method = (Acquisition Cost - Salvage Value) / Estimated Useful Life
The amount of depreciation should be similar to the assets placed in service dates. For example, if an asset is placed in service in June then only 6 months of depreciation should be recorded for the year. Often times, depreciation is recorded on a monthly basis. We could use a daily depreciation factor but this is generally use used to the principle of cost versus benefit. Recording daily depreciation does not have significant benefits since financial reports are prepared quarterly and annually.
The best way to explain depreciation is through an example. The first step to starting depreciation is to purchase a long-term asset that will be required to be depreciated over its useful life. In this case, the company purchased a new vehicle for $23,000. We record the purchase as follows:
The next step is to determine the useful life of the vehicle. Based on various factors the management team has determined this asset will have a useful life of 10 years before it will be worth nothing. Once the useful life has been determined we will select the depreciation method. In this case, we will use a method called straight-line depreciation. Straight-line deprecation basically records the same amount of depreciation for each month or year the asset is in service. For the vehicle we know the cost is $23,000 and the useful life is 10 years. Therefore, we calculate the depreciation by using simple division: $23,000/10 = $2,300 per year. If we want to apply depreciation on a monthly basis then we would divide the $2,300 by 12: $2,300/12 = $191.67 per month. We then record the monthly depreciation as follows:
This journal entry will be recorded each month until the asset is either fully depreciated or sold/scrapped. You will notice that we are using a new account called accumulated depreciation. Accumulated depreciation is a special type of account called a contra asset account. The reason it is called a contra asset account is because accumulated depreciation is subtracted from the asset account. This allows the net book value (called the carrying value) of the asset to be determined. For example, assume you purchased a car for $10,000. When you purchase the vehicle you will record it on the balance sheet at the purchase price of $10,000. At anytime after the initial purchase date, you can determine the book value of the asset by subtracting the accumulated depreciation from the $10,000. If you recorded $2,000 of depreciation then your net book value for your asset would be $8,000. The original cost of the long-term asset remains unchanged. Depreciation does not reflect the asset's current market value.
With the above example, the asset did not have any salvage value. Salvage value is the value of the asset if it was sold after its useful life. For example, instead of scrapping the car, the company could sell the car to a recycler that might pay $500 for the car due to the value of the metal in the car. The $500 is called the salvage value. When the asset has salvage value it is important to subtract the salvage value from the depreciable base. For example, if the asset is worth $10,000 and has a $500 salvage value then we would calculate the depreciable base as $9,500. We will then divide that amount by the useful life of the asset.
Double-Declining Balance Method
The double-declining balance method uses the straight-line method's rate of depreciation and doubles it. However, the application of the double-declining balance method is slightly tricky since the amount of depreciation recorded will change from year to year or month to month. Double-declining method should be used for assets that depreciate significantly during their initial use and then the depreciation slows down in the later years. When the rate is double the straight line rate then it is quoted as 200%. We can also use one and half times the straight line rate which is quoted as the 150% method. The following steps will allow you to use the double-declining balance method:
For this example lets assume we have a long-term asset with an acquisition cost of $100,000, $10,000 salvage value and 10 year useful life.
Step 1: Calculate the straight-line depreciation percentage: To use the double-declining balance method we must use double the straight-line percentage rate. If we have an asset with a useful life of 10 years then the percentage rate will be 10% which is calculated as 100%/10 = 10%. We will double this rate for our double-declining balance rate to get 20%.
Step 2: Multiply the double-declining balance rate by the net book value of the asset: The net book value of the asset is the acquisition cost minus the accumulated depreciation to date. In our calculations the salvage value of the asset is ignored and the asset should not be depreciated below the salvage value.
The best way to show this is by showing the calculation.
|Year||Acquisition Cost||Accumulated Depreciation||Net Book Value (Beginning of Year)||Declining-Balance Rate||Depreciation||Net Book Value (End of Year)|
As you can see, our ending net book value is $10,000.00. If our salvage value was $15,000 then we would not depreciate below that amount. In the final year the depreciation should be increased to fully depreciate the asset to its salvage value. Also take note that we began the first year's net book value at the amount of $100,000 which ignores the asset's salvage value. The reason we ignore salvage value is because double-declining balance method is an accelerated depreciation method. Each column is calculated as follows:
- Acquisition Cost: Acquisition cost does not change from year to year.
- Accumulated Depreciation: This is the amount of all previous year's depreciation. It is calculated as the prior year's accumulated depreciation plus the year's worth of depreciation.
- Net Book Value (Beginning of Year): This amount is the same as the net book value for the prior year.
- Declining-Balance Rate: This amount is double the straight-line percentage which in this case is 20%.
- Depreciation: This is the amount of depreciation for the year. It is calculated by taking the net book value at the beginning of the year and multiplying it by the declining-balance rate. The depreciation for the year cannot put the asset's net book value at the end of the year below the salvage value. In this case, we are calculating yearly depreciation. If we were recording monthly depreciation journal entries then our depreciation would need to be prorated to monthly figures. You will have to factor in when the asset was placed in service by month and prorate the depreciation accordingly.
- Net Book Value (End of Year): This is the net book value at the end of the year and it is calculated as taking the net book value at the beginning of the year and subtracting the depreciation for the year. The net book value in this column should never fall below the salvage value.
The units-of-production method is different from the straight-line and double-declining balance methods due to the fact that this method factors in the asset's production. The units-of-production method is called an activity depreciation method because it uses the amount of production to determine the rate of depreciation. This method is useful for assets that degrade as they are used. For example, a company might have a company policy where they own their trucks for 1,000,000 miles and then salvage the truck for a newer model. The units-of-production method is a good depreciation methods for such assets. We use the following formula to calculate units-of-production depreciation:
Units-of-Production Method = (Acquisition Cost - Salvage Value) / Total Units of Production
This formula gives us the amount of depreciation per unit of production. We then multiply that factor by the amount of production in the period.
For example, just imagine we own a truck that is subject to the 1,000,000 mile company policy. The driver's mileage log reports miles of 100,000 were driven for the month. The truck was purchased for $200,000 and has a salvage value of $5,000. The monthly depreciation would be calculated as follows:
Units-of-Production Method = (200,000 - 5,000) / 1,000,000 = $0.195
100,000 miles X $0.195 = $19,500
As shown above, we would record our depreciation at $19,500 for the month. The monthly depreciation will change from month to month based on how many miles the truck is driven.
The Sum-of-the-Years-Digits Method is an accelerated depreciation method which results in more depreciation being recorded in the first few years the asset is in service. The remaining years result in a decreasing amount of depreciation being recorded. This method is effective if the asset provides lots of value to the company early in its life while declining in the later part of the its life. To implement this method, we follow these steps:
- Establish Depreciation Base: The depreciation base will be the assets purchase price minus the salvage value.
- Establish Depreciation Factor: For this method we will use an example of a 5 year asset. In this case, the denominator will be 15 which is calculated as 1+2+3+4+5. The numerator is the remaining years of service for the asset as of the beginning of the year. For example, in the first year, the numerator would be 5 followed by the second year being 4 and so on.
- Calculate Depreciation: To calculate the depreciation, we simply multiply the depreciation base times the depreciation factor. Remember, the depreciation base does not change from year-to-year.
The chart below illustrates the calculation of depreciation for an asset that was purchased for $100,000 with a salvage value of $10,000 with a remaining useful life of 5 years.
|Years of Service Remaining||Depreciation Base||Depreciation Factor||Depreciation Expense||Book Value (End of Year)|
|1||$90,000||1/15||$6,000||$10,000 (salvage value)|
In rare situations, you will have to place into service an asset that has a very long service life. For example, how would you calculate the depreciation factor for an asset that has a service life of 36 years. In this case the numerator is easy to calculate, simply: 36,35,34,33 and so on but the denominator is a bit more challenging. In essence we would have to manually calculate 1+2+3+4+5+6...and soon until we get to 36. This process is rather tedious. For calculating the the denominator we have a simple formula we can use, as follows:
n(n+1)/2 = denominator for sum-of-the-years digits method.
Using our example, we have the following calculation:
36(36+1)/2 = 666
So our depreciation factors would be 36/666, 35/666, 34/666 and so on.
Comparison of Depreciation Methods
The accounting staff must select the correct accounting method that accurately reflects the rate of depreciation for the assets they are going to depreciate. To do this, the staff must understand how each depreciation method compares. We will summarize the differences between the three depreciation methods below:
|Depreciation Method||Depreciation Life||Depreciation Rate||Depreciation Base||Depreciation Expense|
|Straight-Line||Years||100% / Useful Life||Acquisition Cost - Salvage Value||Fixed|
|Double-Declining Balance||Years||(100% / Useful Life) * 2||Decreasing Net Book Value||Decreasing Net Book Value|
|Units of Production||Production Units||(Cost - Salvage Value) / Total production||Acquisition Cost - Salvage Value||Variable with Production Rate|
|Sum-of-the-Years-Digits||Years||Year over Year Decreasing||Acquisition Cost - Salvage Value||Declines Exponentially|
Using some hypothetical data, we can see how the depreciation expense is different for each method. We will use the following data to illustrate the differences:
Acquisition Cost: $50,000
Salvage Value: $0
Useful Life: 5 years
|Year||Straight-Line||Double-Declining Balance||Units of Production||Sum-of-the-Years-Digits|
The below chart lists the rate of depreciation that each method will report on the financial statements:
Accounting for Changes in Depreciation Estimates
The accounting staff should periodically review their depreciation estimates to make sure that the depreciation methods are reflecting the best possible estimates. During these reviews, it may become aware that a change in the estimates for certain long-term assets will need to be revised either upward or downward. When a change in depreciation estimate is performed they are done for the current year and forward. In other words, changes in estimates are handled prospectively. Changes in depreciation estimates are not considered an accounting error and don't require revising prior depreciation amounts.
When depreciation estimates are revised we will need to recalculate our depreciation rates. We do this by simply determining how much depreciation was recorded in prior periods and recalculating the depreciation using the new estimates.
To illustrate this concept, we will work through an example.
Assume you operate a company and are in charge of depreciating a factory machine. Based on your initial review of the asset in the first year, prior to placing the asset into service you have gathered the following asset information:
Acquisition Cost: $75,000
Salvage Value: $25,000
Useful Life: 5 years
Depreciation Method: Straight-Line Method
The asset was placed in service on January 1st and a full year's depreciation was taken for $10,000 ($50,000/5). At the beginning of the following year you review the asset's depreciation estimates and have discovered that the salvage value is only $15,000 and the useful life is 7 years instead of 5 years. At this point, we need to calculate the asset's net book value and recalculate the depreciation.
Step 1: Calculate net book value: Net book value is calculated as the asset's acquisition cost minus the accumulated depreciation from prior years. We calculate this value as follows:
$75,000 - $10,000 = $65,000
Step 2: Calculate the new straight-line depreciation rate: Using our net book value we calculate the new depreciation rate by taking the net book value and subtracting the revised salvage value:
$65,000 - $15,000 = $50,000
We then divide this amount by the new useful life:
$50,000/6 = $8,333.33
We divide by 6 years since one year of depreciation was already taken. We only have 6 years left of depreciation to take.
The following chart shows the impact of the change in useful life and salvage value:
|Year||Acquisition Cost||Salvage Value Estimate||Useful Life Estimate||Depreciation Expense||Net Book Value (End of Year)|
- An additional 2 cents in depreciation was taken in the final year to account for the impact of rounding.
As you can see we have taken a total of $60,000 in depreciation over the asset's life. We do not need to revise the $10,000 of depreciation that was taken in the prior period.
Long-Term Asset Sales and Disposal
When a company no longer has a useful need for a long-term asset, they are sold or disposed of (scrapped). Fully depreciated assets are not removed from the books when they are fully depreciated. Instead they are kept on the books at a net book value of zero. Long-term assets are only removed from the books when they have been sold or disposed. Depreciation journal entries will continue until the asset is sold or scrapped. For disposal that involve the sale of the asset a gain or loss may result due to depreciation being inaccurate. The gain or loss is recognized to account for the true economic impact of the transaction on net income.
Long-term Asset Disposal
Long-term assets are disposed when they have no salvage value. An asset with no salvage value essentially means the asset is worth nothing to the company. These assets might still have a market value but the company has chosen to not seek that value due to materiality considerations. Instead, the asset is either given away for free or hauled to a scrap yard for disposal.
When a long-term asset is disposed of we must remove the asset account and the related accumulated depreciation account.
Let's assume we have an asset that was purchased for $10,000 and the asset has been fully depreciated. The asset has no salvage value. The following entry would be recorded when the asset is disposed of:
The result of this transaction is that the accumulated depreciation account is removed and the long-term asset is removed as well.
In certain situations, it may become necessary to dispose of an asset that has not been fully depreciated. In that case to balance out the journal entry we would debit the different to a loss account such as loss on long-term asset disposal. This loss would flow to the income statement.
Suppose that we purchased an asset for $10,000 with no salvage value. The asset was depreciated up to $8,000 before it was disposed of. The journal entry to be recorded would be:
Sale of Long-Term Assets
When a long-term asset is sold it can generate gain or loss which is reported on the income statement. In the same journal entry we must also remove the associated accumulated depreciation and the long-term asset account. Any difference between the sales price (cash received) and the net book value (acquisition cost - accumulated depreciation) will be recorded as either a gain or loss. In our example we will show you an example with a gain and another example with a loss.
Our long-term asset will have the following parameters:
Acquisition cost: $15,000
Accumulated depreciation: $10,000
The amount of cash we receive will determine how much gain or loss to book, if any at all.
Step 1: Calculate the net book value of the long-term asset: The net book value is calculated as acquisition cost - accumulated depreciation or $15,000 - $10,000 = $5,000. Therefore, our net book value is $5,000.
Step 2: Calculate the gain or loss, if any: No gain or loss is created if we receive the cash in the amount that is the same as net book value, which in this case would be $5,000. A loss is created if we receive cash that is less than the net book value, in this case, anything less than $5,000. A gain is created if we receive cash that is greater than $5,000.
The following journal entries show how each situation is recorded:
No gain or loss: If we received $5,000 cash we would book the following entry:
Loss Realized: If we received $3,000 cash we would book the following entry:
Gain Realized: If we received $8,000 cash we would book the following entry:
Remember to always record gains with a credit and losses with a debit. An easy way to remember this is to always remember to take CREDIT for the good stuff.
Long-Term Asset Impairment
As previously learned, when a long-term asset is purchased we record it at its historical cost. The long-term asset could increase in value or it could decrease in value. If the asset increases in value due to an increased amount of cash flows then there is no impact in regards to our accounting. We simply maintain the historical cost and record the required depreciation. In other situations, the value of the long-term asset rapidly degrades to the point where reporting this long-term asset on our balance sheet would result in misleading financial statement users. To eliminate this issue, we record an impairment entry. The goal of the impairment entry is to bring the asset down to a more realistic valuation (net book value) on our balance sheet. To perform an impairment we need to do two things:
1) Determine if the asset is impaired
2) Determine and record how much to write down (decrease) the value of the asset on our books.
Luckily there is a set of tests we can perform to solve each issue.
First, we determine if the asset is impaired. These sets of tests should be performed whenever it becomes apparent that the asset could be impaired. As a baseline, it is recommended to test for impairment at least once per year.
In order to test for impairment, we will perform a recoverability test. To perform this test we will calculate the future cash flows of the asset (undiscounted) and then compare it to the net book value of the asset. If the net book value of the asset is more than the undiscounted future cash flows then the asset is impaired.
A company is testing a long-term asset for impairment by using the recoverability test. They calculate the future undiscounted cash flows to be $550,000. The net book value of the asset is $600,000. Since the net book value is $50,000 more than the undiscounted future cash flows then the asset is impaired.
Once we have determined a long-term asset is impaired, we need to write the asset down to its fair value.The difference between the net book value and the fair value is determined to be the impairment loss.
impairment loss = net book value - fair value
After the impairment loss is recorded then the asset will be reported at its fair value and then depreciated using the remaining useful life. If the value of the asset increases in the future, we do not write the asset up in value, we are only allowed to write the asset down.
A company is performing an asset impairment test. They have gathered the following information on the asset:
Future undiscounted cash flows: $200,000 Net book value of the asset: $250,000 Fair value of the asset: $150,000
Based on the above data, we can see that the asset is impaired because the net book value is more than the future undiscounted cash flows ($250,000 > $200,000). We calculate the impairment loss as the difference between the net book value and fair value:
Impairment loss = $250,000 - $150,000 = $100,000 impairment loss
The following journal entry would be recorded:
Depletion (Natural Resources)
Natural resources are resources that exist in the environment. Examples of natural resources are coal, iron ore and petroleum. Generally these resources are not renewable and only a fixed amount can be extracted from the land before the resource is used up. To account for non-renewable natural resources we use the concept of depletion. When a natural resource has been completely used up then it is called being fully depleted. The accounting for non-renewable natural resources is similar to the units of production depreciation method discussed earlier. The first step in the process is to determine how much of the resource can be extracted. The amount that can be extracted is called our resource base. For example, you might own land that contains oil which is estimated to be able to produce 2,000,000 barrels of oil total. The 2,000,000 barrels is our resource base. The process of recording depletion requires several steps:
Step 1: Determine the acquisition cost of the natural resource: The cost to purchase the natural resources or the cost to develop and discover the natural resource is considered the acquisition cost. In our example we will assume that we purchased the 2,000,000 of oil for $10,000,000.
Step 2: Calculate a per-unit depletion rate: The per-unit depletion rate is calculated by the following formula:
Per-Unit Depletion Rate = Cost to Acquire or Develop the Resource / Total estimated resource base
Using the data from our example, our per-unit depletion rate is calculated as: 10,000,000 / 2,000,000 = $5 per barrel of oil
Step 3: Using the amount of resource that has been extracted during the period, we calculate our depletion expense: Using our per-unit depletion rate and our production for the period, we can calculate our depletion expense. For example, if we produced 100,000 barrels of oil, our depletion expense would be: 100,000 x $5 = $500,000 depletion expense.
Step 4: Record the journal entry: Our journal entry would be recorded as follows:
Accumulated depletion is a balance sheet account which will reduce the long-term asset account associated with the natural resource being extracted.