CHAPTER # 07

Fixed Assets
Fixed assets (also called capital assets or property, plant and equipment (PPE)) are operational
assets that generate economic benefits for a business over a long-term period.

For an asset to be classified as a fixed asset, it must be fundamental to the company’s

operations. For example, an investment in bonds held over long-term can’t be classified as a
fixed asset because it is a non-operating asset. Secondly, the asset must not be expected to be
consumed during one financial year or during one operating cycle. For example, inventories
can’t be classified as fixed assets because they are expected to be converted to receivables and
eventually to cash within one operating cycle. Another consideration in deciding whether an
asset should be classified as a fixed asset is whether it exceeds the business’ capitalization limit.
Businesses form a policy of expensing all items lower than a certain monetary value, say
$100,000, even if they otherwise meet the definition of a fixed asset.

Typical fixed assets include land, buildings, plant and machinery, vehicles, furniture, etc.

Initial Recognition Cost

Fixed assets are recorded at their historical cost which includes all such costs which are
necessary to put the asset to its intended use. Most common components of a fixed asset’s cost
include the invoice amount of the asset, transportation cost to the site of installation, insurance
during transit, installation and commissioning cost, cost of consultants and engineers which
carry out the installation and cost to be incurred on dismantling the asset upon its
decommissioning.

Let’s say your company purchased a fleet of 100 buses, each for $1 million (inclusive of cost,
insurance during transit and freight). $300,000 was paid to handling of the buses at the port and
$1,200,000 for onward delivery to a facility where you company wants to modify the seats and
rebrand them with your company logo and stuff, all costing $50,000 per bus. You financed the
buses with an auto-loan at 10% per annum inclusive of insurance charge of 2% over the useful
life of the buses, which is 8 years. The buses must be driven for at least 2,000 kilometers or 200
hours before putting them in commercial operations. The cost per bus (driver’s salaries, fuel,
etc.) during the trial phase amounts to $10,000 per bus.

The total cost at which the 100 buses should be capitalized works out to $107,500,00
(=$1,000,000 × 100 + $300,000 + $1,200,000 + $50,000 × 200 + $10,000 × 200). We excluded

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the interest expense and insurance over the life of the buses because these expenses are not
required for putting the asset to its intended use.

Depreciation
After initial recognition, fixed assets are depreciated, i.e. their cost is written off as depreciation
expense over the useful life of the asset. This is in accordance with the matching concept of
accounting which requires that revenues must be matched with associated expenses to get a
complete and accurate picture of profit and loss.

Even after they run out of their useful lives, fixed assets have a certain residual value (also called
salvage value or scrap value). Fixed assets are depreciated only to the extent of their depreciable
amount, which equals cost minus the salvage value.

Depreciable Amount = Cost - Salvage Value

The buses in the example about have a useful life of 8 years each and their residual value at the
end of 8th year will be 15% of the CIF value i.e. $150,000 (=$1,000,000 × 15%). Salvage value of
100 buses will be $15,000,000. Depreciable amount is hence $92,500,000 (=$107,500,000 -
$15,000,000).

There are different depreciation methods: straight-line method, declining balance method, units
of production, etc. Straight-line method is the simplest in that it charges the cost of a fixed asset
equally over the life of the asset. Declining balance method charges higher depreciation in initial
years of the asset’s useful life and the depreciation expense declines over time. Units of
production method charges depreciation based on the actual usage of the asset.

Under the straight-line depreciation method, the depreciation expense for first year will be
$11,562,500.

Straight-line Depreciation Expense

= ($107,500,000 - $15,000,000)/8 = $11,562,000

The cumulative depreciation charged on an asset since its commissioning is called accumulated

depreciation. It is parked in a contra-account to the relevant asset’s cost account.

The carrying value (also called book value) of an asset on the balance sheet equals its historical
cost minus the accumulated depreciation.

Book Value = Cost - Accumulated Depreciation

In the above case, accumulated depreciation at the end of 3rd year shall be $34,687,500 (= 3 ×
$11,562,500) and the carrying value of the buses on balance sheet shall be $72,812,500
(=$107,500,000 - $35,687,500).

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Tangible Assets
Tangible assets are long-lived assets which have physical existence. They are also referred to as
property, plant and equipment (PPE). They are capitalized on balance sheet and depreciated
over their useful lives.

For an asset to be classified as a tangible asset, it must meet the following conditions:

 It must be tangible, i.e. it must have physical existence,

 It must be non-current, i.e. it must generate economic benefits over a period of more than one
year or more than one operating cycle, and
 It must be operating in nature, i.e. it must be expected to be used in the main operations of the
business.

Tangible assets can also be referred to as non-current operating assets and expenditure incurred
on purchasing or constructing them is called capital expenditure. Typical examples of tangible
assets include land, land improvements, buildings, machinery, office equipment, furniture and
fixtures, etc.

Buildings are intangible assets because (a) they have physical existence, (b) they have a useful
life longer than one year, say 15 years, and (c) they are operating in nature. Copyrights, on the
other hand, are not tangible assets but are intangible assets because even though they are
operating in nature and they have useful life longer than one year, they do not have physical
existence. Long-term investments are not tangible assets because even though they are non-
current they do not have any physical existence, and/or they are not operating in nature.

Accounting for Tangible Assets: Cost Components

Amount expended on acquiring or constructing tangible assets is recorded as an asset on
balance sheet which is periodically charged to income statement. The process through which the
cost of a tangible asset is written off over its useful life is called depreciation. Popular
depreciation methods include straight-line method, declining balance method, modified
accelerated cost recovery system (MACRS) method, etc. ' Depreciation is recorded by debiting
the depreciation and crediting the accumulated depreciation account, which is a contra-account
to the cost account. The carrying value of a tangible asset equals the difference between cost
and the closing balance of the accumulated depreciation.

Some tangible assets such as land have unlimited useful life and hence they are not depreciated.
However, all assets are tested for impairment when there are indications that their carrying value
might be higher than their fair value (recoverable value in case of IFRS).

The amount at which the asset is recognized includes all such costs which are necessary to bring
the asset to its intended use. Typical costs which form part of the cost of a tangible asset include

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invoice amount, any irrecoverable taxes, transportation costs, insurance in transit, installation
costs, testing costs (minus any proceeds from test run production), etc.

Cost of Land
Land is a tangible asset with unlimited useful life, hence it is not depreciated but is tested for
impairment.

Cost of land includes:

 Purchase price
 Transaction costs such as commissions, legal fees, etc.
 Cost of removal of existing structures
 Amounts paid to third parties such as government in relation to the development of the area such
as construction of roads, development of electricity, gas, water, sewerage systems, etc. only if the
third party or the government is responsible for maintenance of such systems.

Cost of land doesn’t include costs incurred in development of internal infrastructure such as
fences, pavements, etc. whose maintenance is responsibility of the land-owner.

Land Improvements
Land improvements represent items which improve the usability of land such as landscaping,
pavements, fencing, etc. Cost of land improvements include costs incurred on items whose
maintenance is responsibility of the land-owner.

Because land improvements must be maintained by the land-owner, they must be redone after
a period of time and hence they have limited useful life, hence they are depreciated.

Buildings
Buildings are structures erected on land. Unlike land, they are depreciable and when land and
buildings are acquired together, the basket purchase cost must be allocated to land and
building based on their fair values.

Cost of acquired building include purchase price, transaction fees such as commissions, legal
fees, etc. plus any costs incurred on adjustments and alterations necessary to put the building to
its intended use.

Cost of self-constructed buildings include:

 Cost incurred to obtain the necessary approval to commence construction such as municipal fees,
regulatory clearance fees, etc.
 Costs incurred on designing the building i.e. architect’s fee, consultant’s fee, etc.
 Cost incurred on construction including materials, labor and overheads.
 Capitalized interest

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Equipment, Machinery, etc.
Cost of equipment, machinery, furniture, etc. include purchase price, irrecoverable taxes,
transaction costs, transportation costs, insurance in transit, installation and testing costs, etc

Purchase of Fixed Assets

When a fixed asset is purchased, it is recognized as an asset on balance sheet by debiting the
asset account and crediting cash or accounts payable or notes payable depending on whether it
is a cash purchase, credit purchase or deferred payment.

The expenditure incurred on purchase of fixed assets is called capital expenditure which is
recorded as an asset initially and charged to income statement over the useful life of the asset
through the process of depreciation.

The amount at which a fixed asset is recognized broadly includes all such costs which are
necessary so as to put the asset to its intended use. Cost of acquisition includes the purchase
price, taxes, transaction costs (commissions, legal fees, etc.), transportation costs, installation
costs, cost of test run (minus income from test run production), decommissioning costs (i.e.
costs to be incurred in future to remove the asset), etc. Costs which are not included in the
acquisition cost of a fixed asset include the ongoing insurance costs, periodic repair and
maintenance costs i.e. such maintenance costs which do not result in improvement in the
usefulness of the asset, etc.

When a fixed asset is purchased through deferred payment and the purchase price equals the
current cash price of the asset, the asset is recorded at the stated purchase price and the
periodic interest is recognized as an expense when it is accrued. However, if the deferred
payment purchase of fixed asset is such that no purchase price is mentioned, the asset is
recorded at the fair value and the difference between total payments (i.e. the sum of purchase
price paid in installments) and the fair value is amortized over the life of the asset.

Example
Aqua, Inc. purchased the following assets during the first quarter of 2018:

 Asset A: land at a price of $10 million, half of which is required to be paid right away and
the rest is to be paid after 1-year subject to a 10% interest rate
 Asset B: a building with a fair value of $40 million requiring a down payment of $10
million and eight quarterly payment of $4.5 million
 Asset C: machinery with a purchase price of $10 million, custom duties of $1 million,
transportation costs of $0.2 million, installation costs of $1.8 million, present value of
decommissioning costs (i.e. asset retirement obligation) of $0.7 million, net testing and
commissioning costs of $0.5 million, first-year insurance of $0.2 million.

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Asset A must be recorded at the given purchase price using the following journal entry:

Land $10 million

$5
Cash
million
$5
Notes payable
million
After one year, the remaining payment and associated add-on interest shall be recognized as
follows:

Notes payable $5 million

Interest expense ($5 million × 10%) $0.5 million
$5.5
Cash
million
Asset B must be recorded at its fair value as follows and the difference between the total
payment required and the fair value must be recognized as discount on notes payable:

Buildings $40 million

Discount on notes payable $6 million
$36
Notes payable ($4.5 million × 8)
million
$10
Cash
million
The discount on notes payable is amortized using the effective interest rate method.

Asset C must be recorded at a cost of $14.2 million by debiting equipment account and
crediting accounts payable.

Purchase price $10 million

Custom duties 1 million
Transportation costs 0.2 million
Installation costs 1.8 million
Decommissioning costs 0.7 million
Net testing and commissioning
0.5 million
costs
Total acquisition cost 14.2 million
The first year insurance cost is not included in the acquisition cost because it is an on-going
revenue expenditure

Basket Purchase
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A basket purchase is a transaction in which multiple fixed assets are purchased together. If the
cost can’t be assigned, it is allocated to the assets based on their appraised value.

One reason for basket purchase is when the price quoted in basket purchase is lower than the
price charged for individual assets. In many cases, buildings are purchased together with land
without agreeing on the cost of land and cost of building separately. Other instances involving
basket purchase include acquisition of a whole division or manufacturing facility of one
company by another.

The following steps are involved in accounting for a basket purchase:

 Identify the consideration paid for the basket purchase.

 Identify the assets being acquired and their quantities.
 Assign the costs which can directly assigned to specific assets.
 Find out the appraised values of whose cost is not specifically identified in the
transaction
 Allocated the remaining payment to the remaining assets in proportion of their
appraised values.

Example
Karakorum, Inc., a manufacturer of sports equipment, is in financial distress and has decided to
sell off its golf division to Himalaya, Inc. for $40 million. The following table lists the division’s
assets:

Assets Appraisal Value

Land $10 million
Buildings $5 million
Machinery $22 million
Office equipment $2 million
Furniture and
$1 million
fittings
Intangible assets $7 million
Himalaya, Inc. paid the fair value for intangible assets but due to the forced sale nature of the
transaction, it was able to pay a lower price for other assets.

Because the cost paid for intangible asset is $7 million which is exactly equal to its fair value, this
cost is directly assigned to intangible assets and the remaining purchase consideration paid is
allocated to the remaining assets in proportion of their appraisal value.

The following table shows the assignment and allocation of cost:

USD in million Fair Value Direct Allocation Percentage Cost Allocated

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 Land 10 25% 8.25
Buildings 5 13% 4.125
Machinery 22 55% 18.15
Office equipment 2 5% 1.65
Furniture and
1 3% 0.825
fittings
Sub-total 40 33 100% 33
Intangible assets 7 7 7
Total 47 40 40
The following journal entry needs to be passed to record the basket purchase:

$8.25
Land
million
4.125
Buildings
million
18.15
Machinery
million
Office equipment 1.65 million
0.825
Furniture and fittings
million
Intangible assets 7 million
$40
Cash
million

Depreciation
Depreciation is the process through which the cost of a tangible asset i.e. property, plant and
equipment is charged as an expense on income statement. Popular depreciation methods
include straight-line method, declining balance method, units of production method and
MACRS.

Amount expended on purchase of fixed assets is a capital expenditure i.e. it is expected to

generate revenues and/or cost savings over a period of more than one year. A capital
expenditure is recorded as an asset on balance sheet and a portion of it is transferred to income
statement each period reflecting the use of the asset in the operations of the business. The
amount at which the asset is recorded on a balance sheet is called its cost and it is a measure of
the present value of total economic benefits which the asset holds.

When an asset is used, its usefulness decreases due to wear and tear, obsolescence, etc. Hence,
it makes sense to reduce the cost of the asset through depreciation to reflect the drop in
productivity of the asset. The depreciation process reduces the cost of the asset by the amount
of depreciation expense each period. When an asset gets older, its productivity declines till it
reaches a point when it is no longer feasible to continue using the asset. Most assets still have

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some value even at the end of their useful life, for example third parties might be interested in
purchasing it so they can overhaul or refurbish it and use it their own operations or the asset
can also be sold just to recover the recyclable material, etc. The amount at which a fixed
asset can be disposed off at the end of its useful life is called salvage value (or residual value or
scrap value).

Because some portion of an asset’s cost is recoverable in the form of salvage value, not all of the
cost is written off as depreciation. The cost of an asset which shall be charged to income
statement as depreciation in all periods of its useful life is called its depreciable amount (also
called depreciable cost) and it equals the historical cost minus the salvage value.

Depreciation expense is the amount subtracted from revenue each period on account of the use
of the fixed asset. The total depreciation expense charged on an asset since its acquisition is
called accumulated depreciation.

Each asset is an hour glass and depreciation is the flow of time which reduces the amount of
sand in the upper half (represented by the carrying value) and increases the amount of sand in
lower half (which is equivalent to accumulated depreciation).

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10
Popular depreciation methods include the straight-line method, declining balance method, units
of production method. Under the straight-line method, equal depreciation expense is charged in
each period of the asset’s useful life but in the declining balance method, higher depreciation
expense is charged in earlier periods. The units of production depreciation method charges
depreciation based on the actual usage of the asset. The total depreciation expense charged
over the life of the asset is the same regardless of the method used. The different depreciation
methods differ just in the inter-period allocation of cost. The depreciation method selected must
correspond to the manner in which the asset is expected to be used. If the asset is expected to
be more productive in earlier years, the declining balance method is appropriate.

Component Depreciation
Component depreciation is a procedure in which the cost of an large item of property, plant and
equipment is allocated to different components of the asset and each component is depreciated
separately.

IAS 16 Property, Plant and Equipment is the IFRS accounting standard that deals with fixed
assets and depreciation. It requires that each significant component of an item of property, plant
and equipment (also referred to as tangible fixed assets) must be depreciated separately.
Because different components of a very large asset may have different useful lives and different
salvage values, applying a composite rate of depreciation to the whole asset might not correctly
reflect the periodic allocation of the asset’s cost to different periods. Hence, it is appropriate to
break down the asset cost to different components as far as practical and treat each component
as a sub-asset with its own depreciation estimates.

Component depreciation is different from unit depreciation which is a procedure that calculates
depreciation by applying a single rate to each tangible fixed asset. It also differs from group
depreciation (or composite depreciation) which involves applying a weighted-average rate of
depreciation to a class of similar (or dissimilar) fixed assets.

One advantage of the component depreciation is that it is the most accurate. Further, treating
each component as a sub-asset allows precise accounting if the component is replaced before
the ‘main’ asset is retired. One potential drawback is that significant calculations are needed
both at the time of acquisition of an asset (in allocating the cost to different components) and at
the end of each reporting period. However, due to availability of powerful accounting and ERP
software, applying component depreciation was never easier.

Example
Alwataki Air operates a fleet of 10 aircrafts, the most recent of which is Boeing 777 acquired 3
years back for $300 million (including $70 for the two engines). Each aircraft is a different variant

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which was acquired over a period of time since the company’s inception. The engines have a
useful life of 20 years and the overall aircraft has a useful life of 30 years. Assume the engine’s
residual value is 10% and other component’s composite residual value is 15%. Calculate annual
depreciation under unit depreciation and component depreciation approaches.

Because each aircraft is different and because each was acquired at different times, each must
be individually depreciated. In fact, because different components such as engines, landing gear,
software, cabin fittings, etc. have different characteristics, say useful lives and salvage values,
hence each should be depreciated separately. In this particular case, we depreciate engines
separately and club all other components together.

The following table shows the calculation:

Componen Residual Depreciable Useful Depreciation

Cost
t Value Amount Life Expense
Engines $70.00 $7.00 $63.00 $20.00 $3.15
$230.0
Others $34.50 $195.50 $30.00 $6.52
0
$300.0
Total $9.67
0
If instead of depreciation each significant component separately, we lump all the components
together and apply an average rate of depreciation to the total cost of the aircraft, we won’t
exactly match revenues with expenses.

Group Depreciation
Group depreciation is an approach to calculation of depreciation expense which lumps together
a number of related assets and depreciate them using a weighted average useful life.

Group depreciation is easier to apply as compared to more refined depreciation calculation

approaches such as component depreciation or unit depreciation. It is because under this
approach, you don’t need to keep track of date of acquisition, accumulated depreciation,
remaining useful life, etc. of each individual asset. Group depreciation makes most sense in case
of a large number of very similar low-value assets.

Group depreciation is not very appropriate for high-value assets due to a number of reasons:

 Due to averaging-out, it is not exactly in line with the matching concept because it
doesn’t correctly allocate depreciation expense between different periods.
 Because separate accumulated depreciation and carrying amount are not available for
each asset, no gain or loss on disposal of assets can be accurately determined.

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  Because the number of high-value assets is low, adopting group depreciation doesn’t
make sense from the perspective of cost-benefit and materiality more so in an
increasingly computerized accounting environment.

Accounting standards show clear preference (an in most cases, requirement) for adopting unit
depreciation or even component depreciation. Unit depreciation is a depreciation approach
which works out depreciation expense for each asset separately and component depreciation is
a depreciation method which involves breaking an asset to ‘sub-asset’ components if they have
significantly different residual values and useful lives and charging depreciation on each
component.

No gain or loss is recognized on retirement of fixed assets accounted for under the group
depreciation because carrying values for individual assets can't be worked out. Retirement of an
asset contained in a group of assets which are depreciated together is recorded by debiting the
cash received, crediting the whole cost of the asset and debiting accumulated depreciation for
the difference.

Calculating Group Depreciation Rate

The annual group depreciation rate equals total annual depreciation expense divided by total
cost of the group of assets which are depreciated. Total annual depreciation is calculated by
dividing the cost of each asset in the group by its useful life and summing annual depreciation
expense of all assets in the group.

The weighted-average useful life of the group of assets can be calculated as 1 divided by the
group depreciation rate.

Example
You work for King Fort Transit Commission as a financial accountant. You must come up with
depreciation policy for the access control and revenue collection system.

The following table shows the assets that form an integral part of the system, their residual
values, useful lives and annual depreciation:

Residual Depreciable Useful

Asset Cost Depreciation
Value Cost Life
Turnstiles $1,000 $200.00 $800 10 $80
Ticket vending
$5,000 $500.00 $4,500 5 $900
machines
Ticket validators $500 $- $500 3 $167
Initialization $10,00
$- $10,000 5 $2,000
machines 0

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 $16,50
Total $3,147
0
The group depreciation rate is 19.07% ($3,147/$16,500). The average useful life is 5.24
(1/19.07%). This is the rate that can be applied to each asset that is added to the system to work
out its depreciation.

Let's say an asset costing $20,000 is sold for $8,000, it would be recorded using the following
journal entry:

Cash 8000
Accumulated depreciation 12000
Cost 20000

Accelerated Depreciation
Accelerated depreciation is an accounting term referring to various depreciation methods in
which the periodic depreciation expense charged to an asset reduces gradually as the asset
becomes older. In other words, there is negative acceleration in depreciation expense of a given
asset provided other things remain constant. It is interesting to note that this definition does not
include positively accelerated depreciation. This is because there are no common depreciation
methods in which depreciation charge increases as the asset becomes older.

The logic behind charging higher depreciation in early life and lower in later life of an asset is
that when assets are newer they are more productive therefore charging higher depreciation
during the beginning of useful life of an asset results in more accurate accounting information.
Accelerated depreciation methods generally follow the matching principle of accounting better
than straight-line method.

Examples
There are various techniques for depreciating assets with acceleration most common of which
are declining-balance (also known as reducing-balance) and double-declining-balance
depreciation methods. In declining-balance method, depreciation is calculated as the product
of: predetermined acceleration factor, straight-line depreciation rate and asset's carrying value.
Since the carrying value declines in each accounting period, there is negative acceleration in
depreciation expense. Double-declining balance method is a type of declining-balance method
in which the acceleration factor used is 2. Sum-of-the-years-digits and MACRS are other
examples of accelerated depreciation method but these are not so common. MACRS is used for
tax purposes

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Depreciation Methods
A depreciation method is the systematic manner in which the cost of a tangible asset is expensed
out to income statement. Popular depreciation methods include straight-line method, declining
balance method, units of production method, sum of year digits method. For tax, MACRS is the
relevant depreciation method.

Amount spent on acquisition of an asset is initially recorded as an asset on balance sheet and
charged to income statement over the useful life of the asset. The purpose of depreciation is to
match revenues with expenses, hence the depreciation method must replicate the manner in
which a particular asset is expected to generate revenues or cost savings.

Depreciation methods can be broadly classified into two types: the time-factor methods and
the usage-factor-methods. The time factor methods (straight-line method and declining
balance method) works out depreciation based on passage of time and usage-factor methods
work out depreciation based on actual usage of the asset.

Straight-Line Method
Under the straight-line method, equal depreciation expense is charged in each period of the
asset’s useful life. Straight-line method is appropriate for assets which are expected to be
equally productive in all periods of its useful life.

Depreciation expense under the straight-line method is calculated by dividing the depreciable

amount by the total useful life of the asset. Depreciable amount equals historical cost minus
salvage value.

Straight-Line Depreciation Expense Cost − Salvage Value

=
Useful Life of the Asset

Straight-line depreciation can also be calculated using Microsoft Excel SLN function.

Depreciation rate under the straight-line method equals 1/y. If an asset is used only for a
fraction of the period, the depreciation expense is worked out by multiplying the whole-period
depreciation expense with the proportion of the period in which the asset was used.

Straight-line method is the most popular depreciation method due to the ease with which
depreciation expense can be worked out using it. It may be the most appropriate method to
depreciate to a plan whose production is constant in all years of its useful life.

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Example of Straight-Line Method
Parvaz Air, Inc. purchased an airplane for $200 million. It is expected to last 70,000
decompression cycles or 10 years. Let’s work out straight-line depreciation if the the plane’s
salvage value is equal to 20% of the cost.

Depreciation in each year under the straight-line method equals $16 million (($200 million -
$200 million × 20%)/10). It remains the same for all years i.e. the same for Year 1 and Year 10.

Declining Balance Method

Under the declining balance method, depreciation expense charged in the first year is the
highest and it decreases as the asset gets older. Since higher depreciation expense is charged in
initial years, it is called accelerated depreciation method.

There are many variants of the declining balance depreciation method: 150%-declining balance
method, 200%-declining balance method (also called double-declining balance method).

The depreciation expense under the declining balance method is calculated by multiplying the
beginning carrying value of the asset with the depreciation rate. The depreciation rate under the
declining balance depreciation method equals 1 divided by the total useful life of the asset
multiplied by a factor (which is 1.5 in case of 150%-method and 2 in case of double-declining
method).

The following is a direct formula for calculating declining balance depreciation:

DBD = A 1
× (C - AD)
×
Useful Life

Where DBD is the declining-balance depreciation expense for the period, A is the accelerator, C
is the cost and AD is the accumulated depreciation.

Declining balance depreciation can also be calculated using Excel DB function and DDB function.

Example of Declining Balance Method

Let’s continue with the example above assuming a 200%-declining balance method. The
following process is used to calculate declining balance depreciation:

 Step 1: Find out the cost of the asset, its salvage and total useful life. In case of the airplane in the
example, it is $200 million, $40 million and 10 years respectively.
 Step 2: work out depreciation rate which equals 1/y multiplied by the declining factor. For the
airplane in question, it works out to 0.2 (=1/10× 2).
 Step 3: for the first year, calculate depreciation expense by multiplying the depreciation rate (i.e.
0.2 calculated above) with the cost of the asset i.e. $200 million (remember, it’s not depreciable
amount). The first-year depreciation works out to $40 million.

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  Step 4: work out the carrying value at the end of the year (i.e. cost minus depreciation expense).
In this example, it is $160 million (i.e. $200 million - $40 million).
 Step 5: for each next period, calculate depreciation expense by applying the depreciation rate
worked out in Step 2 to the opening carrying value; For the second year, depreciation expense is
$32 million (=0.2 × $160 million).
 Step 6: continue charging depreciation unless the carrying value equals salvage value.

The following table shows the depreciation schedule for the whole life of the airplane:

Yea Opening Carrying Depreciation Accumulated Closing Carrying

r Value Expense Depreciation Value

0 200,000,000 - - 200,000,000

1 200,000,000 40,000,000 40,000,000 160,000,000

2 160,000,000 32,000,000 72,000,000 128,000,000

3 128,000,000 25,600,000 97,600,000 102,400,000

4 102,400,000 20,480,000 118,080,000 81,920,000

5 81,920,000 16,384,000 134,464,000 65,536,000

6 65,536,000 13,107,200 147,571,200 52,428,800

7 52,428,800 10,485,760 158,056,960 41,943,040

8 41,943,040 1,943,040 160,000,000 40,000,000

9 40,000,000 - 160,000,000 40,000,000

10 40,000,000 - 160,000,000 40,000,000

In Year 8, depreciation of only $1,943,040 is charged because the carrying value can’t be lower
than the salvage value. The company seizes to depreciate the airplane in Year 8.

Units of Production Method

Units of production method is a depreciation method in which depreciation expense in a period
equals the depreciable amount divided by total number of units the asset is expected to
produce multiplied by the total number of units produced in the period.

For example, airplanes useful life is measured in number of decompression cycle i.e. the number
of time a plane takes off and is exposed to pressure. The units of production method might be
very relevant to depreciation of the fuselage and cabin of the plane.

The following formula can be used to calculate units of production depreciation expense:

17
Units of Production Depreciation x
× (C - S)
=
y

Where x is the total number of units produced int eh period, y is the total number of units the
asset can produce, C is the cost and S is the salvage value.

Example of Units of Production Method

Continuing with the example above, let’s assume that instead of using the straight-line method
or the double-declining balance method, the company wants to depreciate the airplane based
on the flights it takes in each year. The following schedule shows the flights taken each year and
the relevant depreciation expense.

Accumulated
Year Flights Depreciation Expense Closing Carrying Value
Depreciation

0 200,000,000

1 11,000 25,142,857 25,142,857 174,857,143

2 9,500 21,714,286 46,857,143 153,142,857

3 10,000 22,857,143 69,714,286 130,285,714

4 10,200 23,314,286 93,028,571 106,971,429

5 8,000 18,285,714 111,314,286 88,685,714

6 6,500 14,857,143 126,171,429 73,828,571

7 6,000 13,714,286 139,885,714 60,114,286

8 3,500 8,000,000 147,885,714 52,114,286

9 2,500 5,714,286 153,600,000 46,400,000

10 2,800 6,400,000 160,000,000 40,000,000

Tota
70,000 160,000,000
l

For illustration, the 4th year depreciation expense is calculated using the following formula:

Units of Production Depreciation 10,200

× (200,000,000 - 40,000,000) = $23,314,286
=
70,000

Carrying Value
18
Carrying value of a fixed asset (also called book value) is the amount at which a fixed asset is
appears on a balance sheet. It equals the original cost or revalued amount of the asset minus
accumulated depreciation and accumulated impairment loss, if any.

When a fixed asset (i.e. an item of property, plant and equipment) is acquired, it is recognized at
its historical cost which includes the invoice amount, transportation costs, installation and
testing costs, etc. and all such costs which are necessary to get the asset ready for its intended
use. Because an asset generates economic benefits over more than one accounting periods, its
cost is expensed out through the process of depreciation. The accumulated depreciation is the
amount of total depreciation expense that has been charged on the asset since its acquisition.

Formula
Carrying value = C – AD – AI

Where C is the historical cost or revalued amount (if revaluation is allowed, as in IFRS), AD is the
accumulated depreciation (or adjusted accumulated depreciation, as in the IFRS revaluation
model) and AA is accumulated impairment.

A fixed asset is presented on a balance sheet at its carrying value. The accumulated depreciation
and accumulated impairment are contra-accounts to the fixed asst cost account.

Example
Aaahan, Inc. purchased machinery with invoice value of $30 million. The cost of transportation
and insurance in transit is $0.5 million and $0.2 million. The cost of installation is $5 million. Test
production will cost $1 million, $0.5 of which will be recovered by selling the production during
testing phase. The machinery has a residual value of 10% of the original cost and useful life of
10 years.

Find out the carrying value at the end of third year under the straight-line depreciation method.
The machinery shall be recorded at a total cost of $ as determined below:

Invoice amount $30 million

Plus: transportation cost $0.5 million
Plus: insurance-in-transit $0.2 million
Plus: installation cost $5 million
Plus: testing cost $1 million
Less: proceeds from test production ($0.5 million)
Cost of machinery $36.2 million
The depreciable cost is $32.58 million (=$36.2 million minus residual value of $3.62 million
($36.2 million × 0.1)). Annual depreciation under the straight-line method would be $3.258
million (=$32.58 million divided by 10). At the end of third year, accumulated depreciation

19
would be $9.774 million (=$3.258 million × 3). The carrying value works out to $26.426 million
($36.2 million - $9.774 million).

Machinery – historical cost $36.2 million

Less: accumulated
($9.774 million)
depreciation
Machinery - carrying value $26.426 million

Exchange of Fixed Assets

When a company exchanges a fixed asset with another and the transaction has commercial
substance, it records the asset acquired at its fair value or the fair value of assets given up,
whichever is readily available.

In most cases, fixed assets are acquired through exchange of monetary assets, such as cash.
However, there are instances where two companies engage in barter transactions of fixed assets.
In accounting for such exchanges of non-monetary assets, we need to find out if the transaction
has commercial substance. In plain English, it means whether the exchange would change the
cash flows of the business to a significant extent. If the cash flow pattern changes, the
transaction is said to have commercial substance and if doesn’t, it has no commercial substance.

When commercial substance exists, the asset acquired must be recognized at fair value and if it
doesn’t, the asset must be recognized at the book value of the asset given up. Materiality is an
important consideration in determining whether commercial substance exists.

Where no commercial substance exists, the asset swap has effectively no accounting
implications because there is no (or insignificant change) However, where an asset transfer
results in a loss, the loss is recognized. If transfer of cash is involved, a gain may be recognized
by the party which receives cash only to the extent of cash transfer as illustrated below.

Example 1: Exchange involving Commercial Substance

Gomal Ltd. and Tochi Ltd. are companies engaged in construction of large infrastructure. Their
project life cycle is such that Gomal needs 200 dumper trucks in initial two years of its project
and Tochi needs 100 concrete mixers. At the end of second year, Gomal exchanges 200 dumper
trucks for 100 concrete mixers. The total fair value of dumper trucks is $20 million, and the fair
value of concrete mixers is $22 million but the fair value of dumper trucks is more reliable
because an active market exists for them. If the dumper truck’s fleet costed $30 million and the
concrete mixers costed $35 million and useful life of each item is 10 years, find out how both
companies should account for the transaction.

20
Because the fair value of dumper trucks is determined with greater accuracy, Gomal would
record the transaction by (a) debiting Concrete Mixers account by $20 million, (b) debiting the
accumulated depreciation by the amount of depreciation already charged on dumper trucks i.e.
$6 million ($30 million divided by 10 multiplied by 2), (c) crediting the Dumper Trucks account at
their cost i.e. $30 million and (d) recording the difference as gain or loss.

Concrete Mixers 20 million

Accumulated Depreciation – Dumper Trucks 6 million
Loss on exchange of machinery 4 million
30
Cost – Dumper Trucks
million
Sometimes exchange of cash takes place between the parties exchanging assets because there
is a difference between the market value of the assets being exchanged.

Example 2: Exchange involving no Commercial Substance

Company T and Company W are two telecommunication operators. They agree that Company T
will transfer one of its telecom tower installed at Palo to Company W in exchange of W’s tower
installed at Alto. Company T will pay Company W an amount of $10,000. The cost, accumulated
depreciation and fair value of Company T’s tower is $400,000, $180,000 and $240,000 and the
corresponding values for Company W’s tower are $380,000, $160,000 and $250,000.

Company T must recognize the transaction using the following journal entry:

Telecom tower - Alto 230,000

Accumulated depreciation – Palo 180,000
Cost – Palo 400,000
Cash 10,000
Since the fair value of the Company W’s tower is higher than its book value by $30,000 (i.e. fair
value of $250,000 minus book value of tower of $220,000 (=$380,000 - $160,000)), Company W
can recognize only such gain on exchange which is realized in cash i.e. $1,2000
(=$10,000/$250,000 × $30,000).

Cash 10,000
Telecom tower - Palo 211,200
Accumulated depreciation - Alto 160,000
Cost - Alto 380,000
Gain on exchange 1,200

Held for Sale Assets

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Held for sale assets are long -lived assets for which a company has a concrete plan to dispose of
the asset by sale. They are carried on balance sheet at the lower of carrying value or fair value
and no depreciation is charged on them.

Many long-lived assets which a company owns are specialized in nature and they can’t be sold
over-night. In many cases, it takes months since the date the company decides to sell the asset
till the date a contract for sale is executed. During this period, the asset is not being used in the
operations and hence not depreciation expense need to be charged on the asset.

IFRS 5 contains the international accounting rules related to held-for-sale assets which is
broadly in compliance with the requirements of the US GAAP.

The asset which a company want to classify as held-for-sale must meet the following conditions:

Management must have a concrete plan to sell the asset at a price which is reasonable in
relation to its fair value, The asset must be immediately available for disposal if a sale is finalized,
The management is actively searching for a buyer (by advertising, engaging third-parties, etc.),
and It is probable that a buyer will be found in near future i.e. within 12 months and any change
to the disposal plan is unlikely.

In many cases, a company decides to sell a group of assets in a single transaction. Such a group
of assets is called disposal group.

Accounting Adjustment
Before classifying an asset or a disposal group as held-for-sale, a company works out its carrying
value. An asset’s carrying value equals its cost minus accumulated depreciation and accumulated
amortization. Once the conditions mentioned above are met, the asset is classified as a held-for-
sale and its carrying value is reduced if the fair value less cost to sell is lower and the difference
is charged to income statement as a loss on held-for-sale assets. If the fair value less costs to sell
is higher than the carrying value, no adjustment is needed, and the classification only results in
additional disclosure.

Because IFRS allows a revaluation model for long-lived asset, it also allows companies to net off
any impairment loss arising on held-for-sale assets against any positive revaluation surplus
balance.

Example
On 1 January 2018, JKR, Inc. decided to replace its existing machinery which it had acquired on 1
January 2015 for $40 million and initiated process for acquisition of new machinery.
Simultaneously, it also initiated efforts to sell of the old machinery. The new machinery was
commissioned on 30 March 2018. The company depreciates machinery assuming a zero residual
value and 5-year total useful life. The carrying value of old machinery as at 1 January 2018

22
worked out to $16 million. If the fair value of the old machinery is $12 million and it would cost
10% of the sale proceeds to close the deal, find out when the company should classify the
machinery as held-for-sale.

Because the new machinery wasn’t commissioned until 30 March 2018, it is the date when the
old machinery can be reclassified as held for sale. The accumulated depreciation on the old
machinery as at 30 March 2018 works out to $26 million resulting in a carrying value of $14
million.

Before reclassifying the old machinery as held for sale, JK must recognize the depreciation
expense to update the carrying value:

Depreciation expense (3/60 × 40 million) $2 million

Accumulated depreciation – old $2
machinery million
As at 30 March 2018, JK must pass the following journal entry:

Old machinery – held for sale (12 million × (1 – $10.8

0.1)) million
Accumulated depreciation – old machinery $26 million
Loss on held for sale assets $3.2 million
$40
Old machinery - cost
million

Impairment Test
Impairment test is an accounting procedure carried out to find out if an asset is impaired, i.e.
whether the economic benefits that the asset embodies have dropped drastically. Under US
GAAP, if the carrying value of an asset exceeds the sum of undiscounted expected cash flows of
an asset, the asset is impaired.

An asset’s carrying value reflects its worth. Conceptually, the value should equal its fair value and
whenever the carrying value is different from its fair value, the carrying value must be reduced
by the amount of difference by recognizing an expense called impairment expense in
the income statement. The impairment expense is different from depreciation and amortization.
It represents a non-continuous adjustment made as and when required.

Indicators of Impairment
Impairment review is required each year to assess whether there are indications that impairment
might have occurred. These include:

23
  obsolescence due to new technological changes,
 decline in performance i.e. net cash flows of the asset or CGU,
 decline in market value of the asset,
 changes in economy such as an increase in labor cost, raw materials, etc. that would
shrink the net cash flows of the asset
 physical damage to the asset such as fire or other accident
 major restructuring i.e. reshuffling of products, segments, acquisition of new assets, etc.

Steps in Impairment Test

Under US GAAP, ASC 360-10 offers accounting guidance related to impairment testing. US
GAAP impairment test has two steps:

 Step 1: compare the sum of all undiscounted net cash flows that the asset is expected to
generate with the carrying value of the asset. If the carrying value is lower than the sum
of cash flow, it indicates impairment and vice versa.
 Step 2: once it is established that impairment has occurred, the amount of impairment
expense is determined as the difference between the carrying value of the asset and its
fair value.

Under IFRS, IAS 36 offers impairment guidance. IFRS impairment test is more comprehensive. It
involves comparing carrying value of the asset with its recoverable amount, which is the higher
of the asset or cash-generating unit’s fair value less cost and value in use. Value in use is
the present value of net incremental cash flows that a company generates by using the asset in
its operations.

Example
Your company owns a fleet of 200 articulated diesel buses. Environmentalists are pressing the
government to require public transit companies to switch to hybrid buses. You expect to earn
$12 million from the buses each year for next 5 years. There is a 50% chance that the new laws
will be passed which will reduce your revenues from the fleet by 30%. The carrying value of your
fleet is $55 million and your company’s cost of capital is 12%. Find out if there is any impairment
loss, if you company follows US GAAP.

In the first step of the impairment test, you need to compare the sum of expected undiscounted
cash flows with the carrying value of the fleet. Expected cash flows per year is $10.2 million (=0.5
× $12 million + 0.5 × 12 million × (1 – 0.3)). Total expected undiscounted cash flows over the
remaining useful life of the asset are $51 million ($10.2 million × 5). Because the carrying value is
higher than the sum of cash flows, the asset is impairment.

In the second step, you need to find out the actual amount of the impairment expense which
equals the difference between the fair value of the asset and its carrying value. The present

24
value of expected cash flows, which in this case works out to $36.77 million, is a good indicator
of fair value. Impairment loss that must be recognized equals $18.33 million (=$55 million -
$36.77 million).

Recoverable Amount
Recoverable amount is the higher of fair value less costs to sell (FVLCTS) and value in use. The
carrying value of a fixed asset is compared with recoverable amount to find out impairment loss,
if any.

Recoverable amount is the concept introduced by IAS 36 Impairment of Assets. The US GAAP
impairment guidance doesn't mentions recoverable amount.

The carrying amount (i.e. book value) of a fixed asset represents the economic benefits i.e. future
cash flows that the asset embodies. These cash flows can come in two forms: either through sale
of the asset in open market or through continued use in the operations of the business.

Fair Value Less Cost to Sell (FVLCTS)

Fair value less cost to sell is the measure of value of ‘net’ economic benefits embedded in a fixed
asset that can be unlocked in event of the sale of the asset. As the name shows, it equals the fair
value minus the costs that the company will incur in selling the asset such as transaction costs,
irrecoverable taxes, delivery and transportation costs, etc. The fair value of the asset is the
amount at which it can be sold to a knowledgeable and willing buyer in an arm’s length
transaction.

Value in Use
The value in use is the present value of the expected future net cash flows generated by the
asset. It is calculated by finding out probability-weighted future cash flows of the asset (or the
cash-generating unit containing the asset, if no cash flows can be identified for the asset itself)
and discounting those cash flows using a discount rate that reflects the risk of the cash flows.
Both the cash flows and the discount rate are pre-tax inputs.

Example
Pankaj, Inc. operates a hotel facility in a hot tourist destination. The facility was constructed at a
cost of $30 million 5 years back and it is depreciated on a straight-line basis (total useful life of
15 years and residual value of 20%). There are indications that the property is not performing as
expected due to (a) opening of a competing hotel nearby, (b) a significant drop in number of
tourists to the area, etc.

25
There is a 40% probability that the property will generate net cash flows of $4 million per annum
over the next 10 year and 60% probability that the cash flows would only be $2 million per
annum.

The property’s net operating income (NOI) is $3 million and the appropriate capitalization

rate based on past transactions of similar nature is 15%. 5% of the proceeds from sale would be
expended in closing the deal.

Assuming that the asset has zero residual value and the appropriate discount rate is 10%, find
out the recoverable amount and see if the property is impaired.

First, we need to work out the carrying value of the property. The depreciable cost is $24 million
(=$30 million × (1 – 0.2), which results in annual depreciation expense of $1.6 million (=$24
million divided by 15). The 5-year accumulated depreciation works out to $8 million ($1.6 million
× 5). The carrying amount/value at the end of 5th year is $22 million (=$30 million - $8 million).

Next, we need to work out both the fair value less cost to sell (FVLCTS) and value in use. Because
no readily available market data exist to find out the value of the property, the direct
capitalization method is used to work out the fair value of property. Under the direct
capitalization method, value of property equals net operating income divided by a capitalization
rate (which reflects comparable transactions). In this case, property value is $20 million ($3
million divided by 15%). After incorporating the disposal costs, the FVLCTS works out to $19
million (=$20 million × (1 – 0.05)).

Even though FVLCTS calculated above is lower than the property’s carrying value, we can’t
conclude, as yet, that the property is impaired. We must work the present value of net cash
flows of the property over the next 10 years. Expected cash flow each year over the next 10 years
works out to $2.8 million (= 0.4× $4 million + 0.6 × $2 million). Discounting them at 10% gives
us a value in use of $17.2 million (worked out using Excel PV function PV(10%,10,-2.8)).

Recoverable amount is $19 million, i.e. the higher of the fair value less cost to sell (which is $19
million) and the value in use (which is $17.2 million). Comparing this with the carrying value of
the property (which is $22 million) shows that an impairment loss of $3 million (=$22 million -
$19 million) must be recognized.

Value in Use
Value in use equals the present value of the cash flows generated by an asset or a cash
generating unit. Impairment loss, if any, under IFRS is determined by comparing the carrying
amount of an asset of CGU to the higher of the fair value less cost to sell or the value in use of
the asset.

26
A company can recover economic benefits from an asset or a cash-generating unit by either
selling the asset at its fair value or continuing to use it in its operations. When an asset is sold,
the net proceeds equal the fair value less cost of sell. It forms one leg of the asset or CGU’s
worth. When the asset or CGU is not sold but is instead used by the company in its continuing
operations, its value comes from the revenue it earns in future net of any associated costs or any
savings which the asset causes. This leg of asset’s value to a company is called value in use and
it is estimated by discounting the net incremental cash flows of the asset to the impairment test
date.

Formula
The value in use must be determined for each individual asset. However, if it is not practical,
value in use most be worked out for the cash-generating unit containing the asset. A cash-
generating unit is the smallest group of assets for which net cash flows can be identified.

The estimation of expected cash flows must consider the probability and timing of cash flows.
The present value must be determined using a discount rate which reflects the current risk-free
interest rate plus any risk premia which are relevant to the asset such as liquidity risk, currency
risk, etc. The cash flows and the discount rate must both be consistent i.e. real discount rate to
be used with real cash flows and nominal discount rate with nominal cash flows. They both
should be on a pretax basis.

The discount rate most appropriate to work out value in use is the rate that would prevail in the
market to finance an asset with identical cash flow and risk pattern. If no such rate is available,
the company’s pretax cost of capital, incremental borrowing rate, etc. can be used.

Example: calculating value in use

ABC, Inc. is a public transit system operator licensed by the government to ply 70,000 kilometers
per bus. The company has a fleet of 150 buses right now whose carrying amount is $30 million
and remaining useful life is 4 years. Recently, the government announced a policy to phase out
the diesel-based buses and introduce a more energy-efficient buses. ABC, Inc. is allowed to run
the buses only for 50,000 kilometers next year and this threshold will decrease by 5,000
kilometers per annum. Each bus generates average revenue of $3 per kilometer and has variable
cost per kilometer of $1.5 and the whole fleet has a fixed cost of $1 million per annum. Find out
the fleet’s value in use if the appropriate discount rate is 10%. And if the fleet’s fair value less
cost to sell is $15 million, find out the amount if impairment loss.

The following schedule shows the calculation of net cash flows and their discounted present
value for the remaining useful life of the fleet:

Year 1 2 3 4
Kilometers 40,000 35,000 30,000 25,000

27
 Contribution margin per kilometer per bus 60,000 52,500 45,000 37,500
Total contribution margin for 500 buses 9,000,000 7,875,000 6,750,000 5,625,000
(1,000,000
Fixed costs (1,000,000) (1,000,000) (1,000,000)
)
Pre-tax cash flows 8,000,000 6,875,000 5,750,000 4,625,000
Present value factor @ 10% 0.9091 0.8264 0.7513 0.6830
Present value of pre-tax cash flows 7,272,727 5,681,818 4,320,060 3,158,937
Value in use (i.e. sum of PV of cash flows) 20,433,543
Because the value in use if higher than the fair value less cost to sell, it is the recoverable
amount. Because the carrying amount exceeds the recoverable amount by $9,566,457, this is the
impairment loss that must be recognized.

Full Cost Method

Full cost method is a method of accounting for oil and gas exploration costs in which all
exploration costs are capitalized when they are incurred, and none are expensed out.

Oil and gas exploration costs include cost of acquiring license to extract, cost of seismic data
acquisition and analysis, cost of drilling wells, etc. Accounting for oil and gas exploration costs is
different than accounting for costs incurred on other long-lived assets because not all
exploration efforts result in discovery of oil, hence companies are not sure even when significant
costs are incurred whether it would be commercially feasible to extract the oil and gas reserves
discovered, if any. There are two methods adopted by the oil and gas industry in accounting for
such costs: the full cost method and the successful cost method

The full cost method is most popular with smaller oil and gas companies because it is argued
that because of the high risk in the oil and gas business, expensing exploration costs depresses
the company’s net income which results in the company’s stock price which in turn impedes the
companies from accessing new capital. The successful efforts method requiring expensing all
exploration costs unless the oil reserves discovered as a result of a particular drilling effort is
commercially feasible. The full cost method and the successful efforts method differs on the
accounting treatment of exploration costs. Development costs i.e. costs incurred on
development of an oil or gas field for extraction of known reserves, are capitalized under both
methods. Further, production costs i.e. costs incurred on extracting the oil or gas, are expensed
out.

Example
Saghay Oil & Gas, Inc. a small company exploring oil and gas off the cost of Baluchistan. It
acquired the offshore oil and gas exploration license for $1 million which entitles it to explore oil
in K Block for two years. During the period, it must drill three wells in the block. It acquired

28
seismic data for $5 million, hired external consultants for analysis of the data and paid them $3
million over the first year period. During the period, it drilled two wells, A and B, costing $20
million and $15 million respectively. At the end of the first year, it has decided to abandon Well
A because it succeeded in hitting oil in Well B. It awarded a contract for oil field services
company for development of the field for $10 million.

If the Saghay Oil and Gas, Inc. has adopted the full cost method, it shall capitalize the whole cost
of $44 million (exploration license fee of $1 million plus seismic data acquisition cost of $5
million, seismic data analysis costs of $3 million and oil drilling costs of $35 million).

Impairment of Intangible Assets

Intangible assets with indefinite useful life (including goodwill) are tested for impairment at least
annually and others are tested when there are indications of impairment such as legal
restrictions, business restructuring, development of new technology, economic changes, etc.

Under US GAAP, impairment test for intangible assets with finite useful life is the same as that
for a tangible fixed asset, i.e. it involves the following steps:

 comparing the carrying value with the sum of undiscounted cash flows and
 where the carrying value exceeds the sum of undiscounted cash flows, recognizing any
excess of carrying value over the fair value of the asset as the impairment loss.

Under IFRS, comparison is made between the carrying amount of the asset and the higher of fair
value (less cost to sell) and value in use and any excess is recognized as impairment.

The impairment test for intangible assets with indefinite useful life is a little different because
the sum of their undiscounted cash flows is theoretically infinite. They are reviewed for
impairment at least annually by comparing their carrying value with their fair value and
recognizing any impairment loss equal to the amount by which carrying value exceeds fair value.

Impairment test for goodwill is more complex. The goodwill is first allocated to different units of
the business and each unit is tested for impairment individually and the whole impairment loss
is then aggregated.

Example
Selai Telecom is a mobile telecom operator that purchased a 4G license for $200 million in 20Y4
which is valid for a 10-year period for a small annual fee. Then it expected that the license will
generate revenues of $50 million per year for the next 8 years. However, after the first year of
operations, the market reception of the new technology proved not to be that encouraging, and

29
the company was forced to revise its estimate of annual cash flows down to $30 million per
annum. Further, due to rapid advancement in the technology standards, it now expects the
existing technology to be replaced by new technology in 5 years thereby eliminating any
economic benefits from the 4G license accruing after 5 years.

The decline in market performance and the technological advancement are an indication of
impairment necessitating an impairment review.

During the first year, the license amortization expense would be $25 million ($200 million
divided by 8). The license’s carrying value at the end of first year works out to $175 million. The
sum of undiscounted cash flows which the license will bring in future is $150 million ($30 million
multiplied by 5). Because the carrying value is higher than the sum of undiscounted cash flows,
the license is impaired. The second step of the test requires the company to work out the
license’s fair value. Since the license is not transferable, the fair value must be estimated based
on the present value of future cash flows. If the appropriate discount rate is 10%, the fair value
of the license works out to $113.72 million. The impairment loss in this case equals $61.28
million i.e. the amount by which the carrying value, which is $175 million, exceeds the fair value,
i.e. $113.72 million.

The impairment loss would be recognized using the following journal entry:

Impairment loss $61.28 M

$61.28
Accumulated impairment loss
M
Under IFRS, the impairment, if any, is worked out by directly comparing the carrying amount
with the higher of the fair value less cost to sell (which is zero in this case) to the value in use
(which is $113.72 million). There is no need to compare the sum of undiscounted cash flows to
the carrying amount.

30