PART II ANALYSIS OF DEPRECIATION AND IMPAIRMENT
LOS 37.e: Discuss accounting requirements .related to remedying environmental damage caused by operating assets and explain the financial
requirements.
Companies ofren own and operate assets that cause,environmeneal damage, including suip mines, nuclear power planes, offshore oil platforms. and production planes that produce (Oxic waste as a by-producL Governmenes @'ften require the company (0 clean up rhe sireafter the companyceases using theasset, and res(Ore the asset or land (0 its original condition. Prior to the issuance of SFAS 143, companies (Ook differene approaches to the accouneing for this asset retirement obligation (ARO).
SFAS 143 requires a consistenr treatment of theAROresulting from obligations related to remedying environmental damage causedby a company. The following rules apply:
• SFAS 143 applies to all companies and all legal and contractual obligations, including leased assets 'Illd legally enforceable coneracts.
• The fair value of theARO (liability) must be recognized. Fair value is either the liability's market value or, ifmarket value is not available. the present value of the expected cash flows nt:cessar!to retire the liability (return the asset to the
Page 190 ©2008Sch\Ve~t:r
:-",.1,.Session ') Cross-ReferencetoCFA lnsrinJlc Assigned R,'"ding #37 - Anal)'sis of l.ong-Liwd AS.\cts: Part II-An;ll)'sis of Depreciation and Impairment
condition required). An equal amounr must be added to the clrr~'ingvalue of rhe asset.
The compan~'must recognize accretion of rhe liability on the income sratement as pan of inrerest expense. The liability on the balance sheer increases each year.
Prior-period amounrs are nor adiusred for changes in the estimated amounr of the liability.
The company is required ro disclose the following information:
A description of the ARO and the asset.
A reconciliation of the ARO liability, including specific information on new liabilities incurred, old liabiliries extinguished, accretion expense, and revisions ro the ARO estimate.
The fair value of funds set aside ro retire the ARO obligation.
Most companies will experience the following financial statement effects from the implemenration of SFAS 143:
Fixed assets and liabilities reponed on the balance sheet will increase.
Net income will be lower because of the additional depreciation of the asset and the accretion of the liability. The accretion will increase each year.
In general, the implementation of SFAS 143 will make the financial statements of a firm with an ARO look worse. Figure 5 shows the ratio effects of implementation of SFAS 143.
Figure 5: Ratio Effects of SFAS 143 Ratio
Asset turnover
Liabilities-to- equllY Return on
assets Interest coverage
J'I'umerator
Sales will not change.
Liabilities will increase because of
ARO liability.
Net income will decrease.
EBIT will decrease because of higher
depreciation.
Denominator
Assets will increase because of high er fixed assets.
Equity will decrease because of lower net income.
Assets will increase.
Interest expense will increase because of accretion of ARO
liability.
Effiet on Ratio
Decrease Increase
Decrease
Decrease
©2008 Schwncr Page 191
Stucly Sc.<sion '.J
Cross-ReferencetoCFA Institute Assigned Reading #37 - Analysis of Long-Lived Assets: Pan II-Analysis of Depreciation and Impairment
1. Depreciation methods include straight-line and accelerated methods, unirs of producrion and service hours methods, and the sinking fund method.
Compared to straight-line methods, accelerated methods decrease operating earnings anJ net income in the early years of an asset's life anJ increase them in the later years.
3. The choice of depreciation method on the firm's financial statements does not affect the firm's cash flow, but the use of accelerated depreciation methods for tax reporting lowers taxable income and taxes due, increasing the firm's cash flow by the reduction in taxes.
4. A change in accounting method requires a restatement of prior income and an adjusrment on the income statement for the cumularive after-rax effecr of the change.
5. Longer estimares of useful lives and higher estimares of residual asset values borh reduce depreciation expense and increase reported earnings.
6. Using balance sheet irems, an analysr can esrimate average age and average depreciable asser lives (borh are approximate and affected by asser mix) and can esrimate rhe relarive age of the assets when suaight-line depreciarion is used.
7. Impairment musr be recognized when rhe carrying value of an asset is higher rhan rhe sum of the future cash f1ows~(undiscounted) from rheir use and disposal. Impairmems will cause income, asser value, deferred ta..xes, equity, and furure depreciation (Q decline, resulting in an increase in furure ner income.
8. SFAS 143 requires capi ralizarion of environmemal remediarion expenses and for mos, firms will lead (Q higher assers, liabiliries. depreciarion expense, and imeresr expense, which will tend (Q decrease net income. ROA, asser rurnover, and interesr coverage rarios will all decrease, and liabiliries-ro-equiry will Increase.
Srud)' Session C) Cr"s.ãR,.[crclll'"toerA1nsriwt" Assi{incd RCOlding #37 - Anal)'sis of Long-Liwd Assets: Part II-Anah-sis of Depreciation and Impairment
1. \X'hich "f rhe following accounrs is /1'11.11 /ikl'Zl' to be aFfected by an 'asset impairmcnt?
A. lm'elltor\,.
B. Fixed assets.
C. Deferred raxes.
D. Stockholders' equiry.
2. \'\!hich of rhe folJowing wiJI femt fikeZl'enable a firm to reporr higher income in rhe future?
A. Changing from sum of rhe years' digirs ro suaighr-line while capiral expenditures are increasing.
B. Declaring an asser impairment.
C. Reserring rhe salvage values of alJ of irs assers ro zero.
D. Increasing rhe depreciable life of all of irs assers.
Use the following data to answer Questions3through 6.
Acquisirion cosr of asser Salvage value
Useful life
Cash flow per year
Expecred ourpur of machine
$25,000
$3,000 4years
$8,000 25.000 unirs
3. Based on rhe suaighr-line (SU merhod, rhe firsr year's depreciation will be:
A. $4,460.
B. $5,500.
C. $6,250.
D. $8,800.
4. Based on rhe sum-of-years' digirs (SYD) merhod, rhe firsr year's depreciarion will be:
A. $4,460.
B. $5,500.
C. $6,250.
D. $8,800.
5. Based on rhe double-declining balance (DO B) method, rhe first year's depreciarion will be:
A. $4,400.
B. $5,500.
C. $8,800.
D. $12,500.
Pagel 93
Study Session 9
Cross-Reference to CFA Institute Assigned Reading #37 - Analysis of Long-Lived Assets: Part II-Analysis of Depreciation and Impairment 6. If the actual usage of theã asset in the first year is 7,200 units, then depreciation
under the units-of-production method will be:
A. $4,400.
B. $5,500.
C. $6,336.
D. $7,200.
7. Compared to firms using the sum-of-years' digits (SYD) method, a firm using straight-line (SL) depreciation will initially report earnings that are:
A. lower.
B. equal.
C. greater.
D. dependent on usage.
Use the following data to answer Questions 8 through 10.
Tofu Products, Inc., has purchased a new soybean processor for $300,000 (shipping and installation included).
The processor has a useful life of 15 years.
The expecred salvage value is $10,000.
Their corporare tax rare is 39%.
They expecr to earn $500,000 before depreciarion and taxes.
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8.
9.
10.
What is rhe depreciation expense for year 3 if the sum-of-years' digirs (SYD) depreciation merhod is used?
A. $19,333.
B. $29,604.
C. $31,417.
D. $36,250.
Whar is the depreciation expense for year 2 if the double-declining balance (DDB) merhod is used?
A. $19,333.
B. $24,242.
C. $34,667.
D. $40,000.
Which of the three methods-SL, SYD, or DDB-will produce the most year-1 net income?
A. Straight-line.
B. Sum-of-years' digits.
C. Double-declining balance.
D. They all will produce rhe same level of net income.
©2008Schweser
Sl'lId~ã St's~i(lll q Cross-Referencc to CFA Inslitutc Assigncd Rcading /1.17 - An,t1ysis of Long-Livcd Assets: Part II-Analysis of Dcpreciation and Impairmcnt
Use the following data to answet Questions 11 through 13.
Gross plant and equipment Depreciation expense Accumulated depreciation The firm uses SL depreciation.
$ L500.000
$22S.1ltH)
$6""'S.000
11. The average depreciable life of plant and equipment is:
A. 3.00years.
B. 3.67vears.
e., 6.67 years.
D. 10.33years.
12. The average age. given as percent. of the plant and equipment is:
A. 40%.
B. 45%.
e. 50%.
D. 55%.
13. The average age in years of plant and equipment is:
A. 2.67years.
B. 3,00 years.
C. 3.67 years.
D. 6.67years.
14. Which of the following statements about depreciation methods is Least Like6' correct?
A. Sinking fund depreciation is a common depreciation method in the U.S.
B. The COSt of plant and equipment includes all necessary expenditures made prior to placing the asset in to service.
e. \X'Then using the DDB method, depreciation is ended when book value is reduced to salvage value.
D. Accelerating deductions byusing SYD for tax purposes and SL for financial reponing will result in the creation of a deferred tax liability.
15. Which of the following statements is LeastLike~y correct? Assuming the firm continues to invest in new assets, firms that choose accelerated depreciation over straight-line (SL) depreciation will tend to have lower:
A. equity.
B. net income.
C. return on assets.
D. depreciation expense.
16. Which of the following statements is most Likerycorrect? When a company changes the salvage values of an asset:
A. past earnings must be ,restated.
B. the company must repon a change in accounting principles.
e. current and future income will be slightly affected ..
D. an impairment is declared.
©2008Schwescr Page195
Study Session 9
Cross-Reference toCPAInstitute Assigned Reading #37 - Analysis of Long-Lived Assets: Part II-Analysis of Depreciation and Impairment
17. Which of the following statements about how inflation affects the
measurement of economic depreciation is LeaH LikeLycorrect? In an inflationary period:
A. reported ROAs and ROEs will be too low.
B. reported income will be toO high.
C. depreciation based on historical cosrs will not be sufficient to replace the asset.
D. depreciation based on the current cOSt of the asser (rather than historical costs) will create superior future ner income esrimates.
18. A change in depreciarion merhod is:
A. not allowed under GAAP.
B. considered a change in accounting estimares.
C. considered a change in accounting principles.
D. required when an asset is judged to be impaired.
19. An asset is impaired when:
A. accumulated depreciation exceeds acquisition cOSts.
B. rhe firm can no longer fully recover the carrying amoum of the asset through operations.
C. accumulared depreciarion plus salvage value exceeds acquisirion cosrs.
D. rhe presenr value of future cash flows exceeds rhe carrying amoum of rhe asset.
20. Which of rhe following starements is Least LikeLy correcr? During rhe year of a writedown, the loss from impairment will decrease:
A. cash flows.
B. asser values.
C. rerained earnings.
D. income from conrinuing operations.
21. Which of the foJlowing choices describes a oenefitof calculating average age of assers?
A. Firms with low average age of assets typicallv are ineftlcient.
B. An analyst can use the data to help forecast future capital expenditures.
C. Average age multiplied by asset turnover wilJ be equal to rhe DuPont ROE.
D. Risk arbirrage analysts view companies wirh low average age as takeover candidares.
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22. To derermine wherher an asset is impaired, a~ analyst should use:
A. discounted cash Hows and should use discounred cash t10ws to calculare the amount of the impairment.
B. discounted cash Haws and should use undiscounted cash Hows ro caleulare rhe amoum of the impairment.
C. undiscounted cash flows :lnd should use discoulHed cash Hows [0 c:dculate the amount of the impairment.
D. undiscounred cash Hows and should use undiscounted (ash Hows to calculate the amount of the impairment.
Srulhã Session ') Cross-Referencl' to CFA Institute Assigned Readin!,: #37 - Anah'sis of Long-Lived Assets: Part II-Anal)'sis of Depreciation and IIttl'airment
23. Which of the following statements about SFAS 143 on environmental remediation is LeaJf LikcZl'correct?
A. Implement:1tion of SFAS 143 inf]ate~.,depreciationexpense.
B. Ratio impacts include lower asset, turnover and higher debt-to-equity ratIOs.
C. The periodic interest accretion increases expenses and decreases cash flow from operations.
D. The asset and liability are recorded at the time of asset acquisition and include the costS to return the land to the condition required.
24. Which depreciation metho~will Least LikeZJI lead to an increasing return on investment when net asset cash flows are level over the asset's life?
A. Sum-of-year's-digirs.
B. Straight line.
C. Double-declining balance.
D. Sinking fund.
©2008Schweser Page 197
Srudy Session 9
Cross-Reference to CFA Institute Assigned Reading#37 - Analysis of Long-Lived Assets: Part I1-Analysi., of Depreciation and Impairment
1. A Invenrory will not be affected.
2. C Decreasing salvage values ro zero would result in higher depreciation expense and, thus, decreased income. To increase income, the company would needto increase salvage values. The otha choices would result in less depreciarion expense and, rhus, higher lncome.
3. B Suaight-line (SL) depreciation is equal for all years.
SL d . . original COSt - salvage value year 1 epreClatiOn= - - " - - - " ' - - -
depreciable life
$25,000 - $3, 000=$5 500
4 '
4. D Sum-of -years' digits (SYD) depreciation for year 1
( . . ) (useful life - year of in rerest+1)
= ongmal COSt - salvage value x -'---'---'- sum of the useful life's digits ($25,000 -$3,000)( 4 -1 -:- 1)
= =$8,800
(4+3+2+1)
5. D Using the double-declining balance method:
") )
year1depreciation= - x original COSt= .::.x$25, 000=$12,500
useful life 4
6.
...,
I .
8.
C
C
C
Using the units of production method, rhe year 1 depreciation= rare per unir x number of units. Rare per unir= (original COSt - salvage value) / expected ourput= (25,000 - 3,000 / 25,000) =0.88. Thus, year1depreciation=0.88 x (7,200) =$6,336.
The sum-of-years' digits (SYD) method will report greater depreciation early on, thus reporting lower earnings. A firm using suaight-line (SL) depreciation will report greater earnings. Neither merhod considers usage.
. . _ . . useful life - year of imerest+1
SYD depreCIation ror Year 3=(ongmal COSt - s'llvage value) x- - - = - - - -
, sum of the useful life's digits
SYD=1+2+ ... + l5=l20
depreciation= (15 - 3 + l)x290.000=$31,417
120 "
")
9. C Depreciation invear 1: -=- x300,000=$40.000.
15
Book value in the beginning of the second year= 300.000 - 40.000= $260,000 . ..,
Depreciation in year 2: -=-x260,000=$3't.667.
11
10. A Because straight-line (SL) depreciation reports the lowest expense. it will report the highest year-l income. The other two methods accelerate depreciation expense.
Page 198 ©2008Schweser
Study Session ') Cross-Reference to CFA Institute Assigned Reading#,~7- Analysis of Long-Lived Assets: Part II-Analysis of Depreciation and Impairment
1I. C d ' bl I'c ending gr,)ss investment Average epreCl<l e lie= ----"'-"'--.-.- - - - - depreCiation expense
1,500,000=.6 67 years.
225,000
12. B
13. B
14. A 15. D
16. C
17, A
18. C
19. B 20. A 21. B
22. C
23. C
24. D
. accum~lateddepreciation Average age as a percentage of plant and eqUlpmenr= . .
endlllg gross Illvesrmenr
= 675,000 =45%
1,500,000
A accumulated depreciation 675,000 00
veraoe aoe= = =3. years
" " depreciation &pense 225,000 Sinking fund depreciation is prohibited in the U.S.
A firm that continues to invesr in new assers will have higher depreciation expense due to the use of accelerated methods.
Changing the salvage value of an asset is considered a change in accounting estimate;
past income does not needto be restated.
Inflation causes ROA and ROE to be too high because the true cost of replacing the asset is not reflected by depreciation.
A change in depreciation method is a change in the method of accounting. The cumulative effect on past income should be noted.
This statemenr correctly describes an impaired asset.
The loss from impairmenr does not affect cash flow.
Average age calculations can be useful because the~'allo",' an anah'st to assess the quality of a company's assets and help the analyst forecaSt when major capital expenditures will be required.
Don't let this confuseyou. In testing for impairment, undiscounted cash flows are used. Once impairment has been detected, it should be measured using discounted cash flows.
Cash flow is nOt decreased by SFAS 143 since the annual accretion is not a cash charge.
The other statements are true. The debt-equity ratio is higher because debt will be higher and equity will be lower. Asset turnover ratios are lower because assets are higher. The present value of the liability added to the asset's balance at the time of purchase is depreciated over the asset's useful life, thus increasing depreciation expense.
Sinking fund depreciation is calculated to produce a constanr return on investment.
©2008 Schweser Page 199
The following is a review of the Financial Statement Analysis principles designed to address the learning outcome statements set forth by CFA Institute®. This topic is also covered in: