Difficulty: Intermediate | Prerequisites: Depreciation Methods study notes (Part 1 of Ch. 11), Chapter 10
This is the second half of Chapter 11. It picks up where the depreciation methods left off, covering the cost allocation mechanics for natural resources and intangible assets, the rules for partial-period depreciation, how to handle changes in estimates, and the impairment framework for long-lived assets and goodwill. Impairment testing is a favourite exam topic, and the two-step process for held-and-used assets versus the one-step approach for held-for-sale assets trips students up regularly.
Depletion works like units-of-production depreciation but for natural resources. Intangible assets with finite lives are amortised; those with indefinite lives (goodwill, certain trademarks) are not amortised but are tested for impairment instead. When an asset's book value may not be recoverable, you run an impairment test, and any loss recognised becomes the new cost basis going forward.
Depletion
The cost allocation process for natural resources (oil, gas, timber, minerals). The resource is physically consumed through extraction, and its cost is expensed proportionally to how much is removed.
Depletion base
Cost of the natural resource minus its residual value. Same concept as the depreciable base for PP&E.
Amortisation (of intangibles)
The systematic allocation of an intangible asset's cost over its useful life. Applies only to intangibles with a finite useful life.
Indefinite-life intangible asset
An intangible asset for which there is no foreseeable limit on how long it will generate cash flows. These are not amortised but are tested for impairment at least annually. Think of a well-known trademark that has no expiry date.
Goodwill
A unique intangible asset that arises in a business combination when the purchase price exceeds the fair value of the acquired company's identifiable net assets. Unlike other intangibles, goodwill is not separable from the company as a whole.
Partial period depreciation
Depreciation recorded for less than a full year because the asset was acquired or disposed of partway through the fiscal year. You prorate the annual amount to the months (or fraction of the year) the asset was in use.
Half-year convention
A simplifying rule that records exactly one half of a full year's depreciation in the year of acquisition and one half in the year of disposal, regardless of the actual purchase or sale date.
Change in estimate
A revision to a previously used accounting estimate (useful life, residual value). Accounted for prospectively: the remaining book value is allocated over the revised remaining useful life. No restatement of prior periods.
Impairment
A significant, unexpected decline in the service potential or benefits of a long-lived asset. When book value exceeds what the asset can recover, the difference is written off as an impairment loss.
Recoverability test
The first step of impairment testing for assets held and used. Compare the asset's book value to the undiscounted sum of its expected future cash flows. If book value exceeds that sum, the asset is impaired.
Fair value
The amount at which an asset could be bought or sold in a current transaction between willing parties. When not directly observable, fair value is often estimated as the present value (discounted) of expected future cash flows.
Assets held for sale
Assets that management is actively committed to selling in their present condition and for which a sale is probable. These are not depreciated; they are reported separately on the balance sheet.
Reporting unit
The level at which goodwill impairment is tested. A reporting unit is an operating segment or one level below.
Depletion follows the same logic as the units-of-production depreciation method. The asset (an oil field, a mine, a timber tract) is consumed through extraction rather than through time.
Service life is expressed as the estimated total quantity to be extracted (barrels of oil, tonnes of ore, board feet of timber).
Depletion base = cost of the natural resource - residual value
Depletion per unit = depletion base / estimated extractable units
Periodic depletion = depletion per unit x units actually extracted in the period
When depletion is recorded:
Debit: Depletion Expense (or an inventory account, if the resource will be sold later)
Credit: Accumulated Depletion (or the natural resource asset account directly)
The amount debited equals depletion rate per unit multiplied by units extracted during the period.
Intangible assets with a finite useful life (patents, copyrights, franchises with expiry dates) are amortised over that life.
Useful life is often limited by legal, regulatory, or contractual provisions. A patent's legal life is 20 years, but the company may expect only 10 years of economic benefit.
Residual value is usually zero. The exception: when another entity will take over the asset at the end of the reporting entity's useful life, meaning there is still value to someone else.
Allocation method should reflect the pattern in which the asset's benefits are consumed. If no clear pattern exists, straight-line is the default.
An intangible asset has an indefinite useful life when there is no foreseeable limit on the period over which it will contribute to cash flows.
These assets are not amortised.
Instead, they are subject to impairment testing at least annually (or more frequently if triggering events occur).
Common examples: goodwill, certain trademarks, trade names.
Indefinite does not mean infinite. The classification is reviewed each period. If circumstances change and a life becomes determinable, the asset is amortised prospectively from that point.
When an asset is acquired or disposed of at a time other than the start or end of the fiscal year, depreciation is recorded only for the portion of the year the asset was actually in service.
If a company purchases equipment on 1 April and the fiscal year ends 31 December, it records 9/12 of a full year's depreciation for that first year.
A widely used simplifying approach:
Record one half of a full year's depreciation in the year of acquisition.
Record one half of a full year's depreciation in the year of disposal.
This avoids the need to track exact acquisition dates for every asset. It applies regardless of whether the asset was bought on 2 January or 30 November.
A company may revise its estimate of an asset's useful life or residual value at any point. These revisions are accounted for prospectively, meaning they affect the current and future periods only. Prior-period financial statements are not restated.
The mechanics:
Determine the remaining book value (cost minus accumulated depreciation to date).
Subtract the revised residual value to get the new depreciable base.
Divide by the revised remaining useful life to get the new annual depreciation.
A disclosure note is required, describing the effect of the change on net income and earnings per share for the current period.
Switching from one depreciation method to another (e.g. from DDB to straight-line) is treated as a change in accounting estimate that is achieved by a change in accounting principle.
Despite involving a principle change, it is still accounted for prospectively, the same way as any other change in estimate. The company must provide a clear justification for why the new method is preferable.
The calculation follows the same pattern as a change in estimate:
Take the current book value (cost minus depreciation recorded to date).
Subtract the residual value to get the remaining depreciable base.
Apply the new method over the remaining useful life.
Impairment arises when events or changes in circumstances suggest that an asset's book value may not be fully recoverable. The rules differ depending on whether the asset is held for sale or held and used, and whether it has a finite or indefinite life.
For PP&E and finite-life intangibles, impairment testing is triggered only when events or circumstances indicate that the book value may not be recoverable. You do not test every year unless there is a reason to.
For indefinite-life intangibles and goodwill, testing is required at least annually, and more frequently if triggering events arise.
These are assets that management is actively committed to selling immediately in their present condition, and for which a sale is probable.
They are not depreciated or amortised once classified as held for sale.
They are reported separately on the balance sheet.
Impairment test (one step): if book value exceeds fair value less cost to sell, recognise the difference as an impairment loss.
Two steps are involved.
Step 1, Recoverability test: compare the asset's book value to the undiscounted sum of its estimated future cash flows. If the undiscounted cash flows exceed book value, there is no impairment and you stop here. If book value exceeds undiscounted cash flows, the asset fails the test and you move to Step 2.
Step 2, Measurement: the impairment loss equals book value minus fair value. Fair value is the amount the asset could be bought or sold for between willing parties. If fair value is not directly observable, estimate it as the present value (discounted) of expected future cash flows.
After recording the loss, the written-down book value becomes the new cost basis. Future depreciation is calculated from this lower figure. A disclosure note is required.
Debit: Loss on Impairment (the difference between book value and fair value)
Debit: Accumulated Depreciation (to close out the existing balance)
Credit: Asset account (reduced to fair value, i.e. the difference between original cost and fair value)
For intangible assets with indefinite useful lives, the impairment test is simpler.
There is no recoverability test (no Step 1).
Compare book value directly to fair value. If book value exceeds fair value, recognise the difference as an impairment loss.
The written-down amount becomes the new cost basis.
Goodwill is unique because it is not separable from the company as a whole, so it cannot be tested on its own the way a patent or a machine can.
Testing occurs at the reporting unit level.
The two-step process:
Step 1: Compare the fair value of the reporting unit to its book value (including goodwill). If fair value exceeds book value, goodwill is not impaired and you stop.
Step 2: If book value exceeds fair value, the impairment loss equals the excess of goodwill's book value over its "implied" fair value. The implied fair value of goodwill is the residual: fair value of the reporting unit minus the fair value of all its identifiable net assets.
If an impairment loss is recognised, the written-down goodwill becomes the new cost basis for future testing.
"Indefinite life means the asset lasts forever." Indefinite simply means there is no foreseeable limit right now. The classification is reassessed each period. If a limit becomes apparent, the asset starts being amortised from that point.
"The recoverability test uses discounted cash flows." For assets held and used, Step 1 (recoverability) uses undiscounted cash flows. Discounting only comes in at Step 2 when measuring the loss (if fair value must be estimated). This is one of the most common exam mistakes.
"Once an asset is impaired, you can write it back up if conditions improve." Under US GAAP, reversal of impairment losses on long-lived assets held and used is prohibited. The written-down value sticks. (IFRS does allow reversal for assets other than goodwill.)
"Goodwill impairment works the same way as impairment of other intangibles." It does not. Goodwill is tested at the reporting unit level and uses a two-step process (fair value of the unit vs book value, then implied fair value of goodwill). Other indefinite-life intangibles are simply compared to their own fair value in a one-step test.
⚠️ The recoverability test (undiscounted cash flows) vs measurement of the loss (fair value, often discounted) distinction is tested heavily. Do not confuse the two.
⚠️ Know the difference between held-for-sale impairment (one step: BV vs FV less cost to sell) and held-and-used impairment (two steps: recoverability, then measurement).
⚠️ Goodwill impairment's two-step process at the reporting unit level is a favourite exam topic. Be ready to calculate implied fair value of goodwill.
⚠️ Changes in estimate are prospective. Expect a problem where you must recalculate depreciation after a revision to useful life or residual value, starting from the current book value.
⚠️ Under US GAAP, impairment losses on long-lived assets are not reversible. Under IFRS, they are reversible for all assets except goodwill.
True or false: Depletion uses a time-based approach, spreading cost equally over each year.
False. Depletion uses an activity-based (units-of-production) approach tied to extraction volume.
Fill in the blank: Intangible assets with ______ useful lives are tested for impairment at least annually rather than being amortised.
Indefinite.
True or false: The recoverability test for held-and-used assets compares book value to discounted future cash flows.
False. It compares book value to undiscounted future cash flows.
Fill in the blank: For assets held for sale, an impairment loss is recognised when book value exceeds ______ less ______.
Fair value less cost to sell.
True or false: A change in depreciation method is accounted for retroactively by restating prior periods.
False. It is accounted for prospectively, like a change in estimate.
Q: A mining company acquires mineral rights for $2,000,000. The estimated residual value is $200,000, and the estimated recoverable ore is 900,000 tonnes. In Year 1, the company extracts 120,000 tonnes. What is Year 1 depletion?
A: Depletion base = $2,000,000 - $200,000 = $1,800,000. Rate = $1,800,000 / 900,000 = $2.00 per tonne. Year 1 depletion = 120,000 x $2.00 = $240,000.
Q: A company owns equipment with a book value of $500,000. Due to a decline in market demand, management estimates that the equipment's undiscounted future cash flows total $450,000. The equipment's fair value is $380,000. What impairment loss, if any, should be recognised?
A: Step 1 (recoverability): book value ($500,000) exceeds undiscounted cash flows ($450,000), so the asset is impaired. Step 2 (measurement): impairment loss = $500,000 - $380,000 = $120,000.
Q: A company purchased a patent for $100,000 with a legal life of 20 years but an expected useful life of 10 years. What is the annual amortisation?
A: Useful life governs (the shorter of legal and expected economic life). Annual amortisation = $100,000 / 10 = $10,000 per year (assuming zero residual value).
Q: Equipment with an original cost of $200,000 and accumulated depreciation of $80,000 has a remaining useful life revised from 8 years to 5 years. Residual value remains $10,000. What is the new annual depreciation under straight-line?
A: Remaining book value = $200,000 - $80,000 = $120,000. New depreciable base = $120,000 - $10,000 = $110,000. New annual depreciation = $110,000 / 5 = $22,000.
Q: A company classifies a building as held for sale. Its book value is $600,000. Fair value is $550,000, and estimated cost to sell is $20,000. What is the impairment loss?
A: Fair value less cost to sell = $550,000 - $20,000 = $530,000. Impairment loss = $600,000 - $530,000 = $70,000.
Impairment testing ties directly to fair value measurement concepts you will encounter in later chapters on investments and financial instruments. Goodwill impairment connects to business combinations (Chapter 12 in many textbooks), where goodwill arises from acquisitions. Changes in estimates are part of the broader topic of accounting changes (Chapter 20), which also covers changes in accounting principles and error corrections. Depletion connects to inventory accounting when extracted resources are held as inventory before sale.
Related Terms / Search Tags
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