Essentials of FA_Chapter_14_Depreciation and Impairment

8/13/2019 Essentials of FA_Chapter_14_Depreciation and Impairment

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CHAPTER 14

DEPRECIATION AND IMPAIRMENT

Chapter Objective

The objective of this chapter is to provide an understanding of the nature of depreciation

and impairment. It also provides an understanding of the principles and methods of

calculating depreciation and impairment loss.

14.1 DEPRECIATION AND AMORTISATION-INTRODUCTION

14.1.1 Depreciatio

Depreciation is a process of allocating cost of an item of PP&E to periods which are

expected to benefit from the use of the asset. It does not measure decline in the economic

value of the asset. More precisel! depreciation is systematic allocation of the depreciable

amount of a depreciable asset over its useful life. "ith certain exceptions such as #uarries

and sites used for landfill! usuall land has an unlimited useful life. Therefore! it is not

considered as a depreciable fixed asset. $ll other items of propert! plant and e#uipment

are depreciable assets.

Depreciation is a measure of the wearing out! consumption or other loss of value of a

depreciable asset arising from use! efflux of time! or obsolescence through technolog

and mar%et changes.

14.1.! A"orti#atio

Amortisation refers to allocation of expenditure, other than depreciable amount of PPE,

over a number of accounting periods, which are expected to benefit from the expenditure.

Therefore depreciation of intangible assets is also called amortisation.

14.1.3 Objectives of Charging Depreciation

The objective of depreciation is allocation of the depreciable amount and not creation of a

fund that will be available to replace the asset after its useful life. The distributable profit


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is determined after charging depreciation and thus! precludes distribution of total profit

before depreciation. 'et us ta%e an example. (or the sa%e of simplicit! let us assume that

the entit follows the cash basis of accounting! except for fixed asset. In the ear )*** it

earned a profit before depreciation of +s. **!***! which represents! net cash flow from

operation. The depreciation for the ear is +s. ,*!***. The net profit is +s. -*!***. Thus!

depreciation precludes distribution of the total +s. **!***. The entit has to retain +s.

,*!*** in the business. owever! unless the entit invests this amount outside the

business and reserves the amount for replacement of fixed assets! it will not be available!

when re#uired. If invested in the business! it gets loc%ed in assorted assets of different

li#uidit and use. entities do not sell an asset for replacing another asset! because that

adversel affects the business. Therefore! depreciation b itself does not ensure

availabilit of funds for replacement of the assets. owever! some enterprises create

replacement fund b investing a part of profit! which ma be more than the amount of

depreciation.

11.! DEPRECIATION-MEASUREMENT

14.!.1 Depreciab$e A"o%t a& Re#i&%a$ 'a$%e

Depreciab$e a"o%t

Depreciable amount is the cost of a depreciable asset or other amount /e.g.! revalued

amount0 substituted for cost in the financial statements! less its residual value. (or

example! if the cost of ac#uisition of e#uipment is +s.!1**!*** and estimated residual

value is +s.1*!***! the depreciable amount is +s. !,1*!*** /!1**!*** 2 1*!***0.

Re#i&%a$ va$%e

+esidual value of an asset is the estimated amount that an entit would currently obtain

from disposal of the asset! after deducting the estimated costs of disposal! if the assets

were alread of the age and in the condition expected at the end of its useful life. Thus,

residual value should not include estimated inflation.

)


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In practice! often the residual value is immaterial and is ignored in calculating the

depreciable amount. If the estimated residual value exceeds the cost of the asset, the

depreciable amount is considered zero.

The residual value should be reviewed at least at each financial ear3end.

I&ia (AAP co"pari#o

Indian 4$$P does not re#uire annual review of the residual value.

11.!.) U#e*%$ +i*e

The useful life of a depreciable fixed asset is the period over which the entit intends to

use the fixed asset. (or example! if! at the time of ac#uisition of a machine! an entit

estimates that the asset will be used for * ears! the useful life of the asset for the

purpose of depreciation is * ears. The depreciable amount of the machine will be

allocated over * accounting ears. $n entit ma measure the useful life of an item of

PPE in terms of the number of production or similar units! which it expects to obtain

from the use of the asset. (or example! if! at the time of ac#uisition of a heav earth

moving e#uipment! an entit engaged in mining activities estimates that the asset remain

productive for *!***!*** hours! the useful life of the machine is *!***!*** hours.

5suall! useful life is expressed in terms of number of ears.

Techica$ ,Ph#ica$ $i*e a& ecoo"ic $i*e

The technical or phsical life is the period over which the asset is expected to produce the

intended result. The manufacturer of the asset estimates the technical life of an asset. It is

specific to the asset.

Economic life is the period over which use of the asset ma%es economic sense. In a wa

this is also specific to the asset. Economic life ma be shorter than the technical life of

the asset.

The useful life ma be shorter than the economic life.

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/actor# that &eter"ie the %#e*%$ $i*e

5seful life is determined b7

/a0 'egal or contractual limits/b0 Extraction or consumption or use of the fixed asset

/c0 Phsical wear and tear which depends on operational factors! repair maintenance

program of the entit and similar other factors

/d0 Technical or commercial obsolescence

Entities estimate the useful life of a fixed asset based on various factors including

experience and corporate strategy.

I&ia (AAP co"pari#o

Indian 4$$P considers that the depreciation calculated at the rates and methods

stipulated in schedule 8I9 of the :ompanies $ct! ;1- is the minimum depreciation that

a compan should charge against an item of propert! plant and e#uipment.

I$$%#tratio 14.1

$lex 'imited /$'0 purchases e#uipment that has phsical life of )* ears! the period

over which it will produce the intended result. Its economic life is 1 ears! because it

will produce economic benefit for 1 ears onl. owever! $' decides to dispose the

asset after ten ears and to go for new generation e#uipment for better productivit and

flexibilit.

Re0%ire&

Determine the useful life of the e#uipment.

So$%tio

The useful life of an item of PP&E is the period for which the entit intends to use the

item. Therefore! the useful life of the e#uipment is * ears.

,


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14.) ACCOUNTIN( PRINCIP+ES /OR DEPRECIATION

14.).1 (eera$ Pricip$e

The depreciation method should be selected based on the expected pattern ofconsumption of the future economic benefits embodied in the fixed asset. owever! in

practice! it is difficult to select a method that exactl matches the depreciation with the

expected pattern of consumption of economic benefits. Entities generall follow the

straight3line method of depreciation.


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method for vehicles. ol%ata.

14.).! Depreciatio o Reva$%e& PPE

"here the depreciable fixed asset is revalued! depreciation should be provided based on7

/a0 The revalued amount

/b0 The estimate of the remaining useful life of the fixed asset

$n amount calculated b multipling the revaluation reserve b the ratio of depreciation

for the ear3to3the revised depreciable amount at the date of revaluation! should be

transferred from the revaluation reserve to the general reserve ever ear over theremaining useful life of the asset.

I$$%#tratio 14.!

The carring amount of e#uipment as at ?anuar ! )** was +s. 1**!***. The entit

revalued the asset on that date at +s. !***!*** and recognises revaluation reserve at +s.

1**!*** /!***!*** 2 1**!***0. The entit follows the straight line method of

depreciation. The residual value of the asset is estimated to be @ero. The remaining usefullife of the asset is five ears.

Re0%ire&

/a0 :alculate the amount of depreciation to be recognised in the profit and loss account

for the ear )** and four subse#uent ears.

/b0 :alculate the amount to be transferred each ear from the revaluation reserve to the

general reserve.

So$%tio

/a0 The entit should charge depreciation of +s. )**!*** /!***!***A10 or for the ear

)** and subse#uent four ears.

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/b0 It should transfer +s. **!*** /1**!***A10 from the revaluation reserve to the general

reserve for next five ears starting from the ear )**.

14.).) Depreciatio %&er the Ico"e Ta2 +a3

The tax law provides depreciation rates and the method to be used in computing

depreciation that is allowable as an expense in computing the taxable income. $ll

assesses /including companies0 are re#uired to use the same rates and the same method in

computing depreciation irrespective of their own technical estimate of the useful life and

the residual value of assets. Tax law is often used as a fiscal instrument to encourage

investment in a particular tpe of asset. (or example! tax law ma allow **B

depreciation on pollution control e#uipment or on assets ac#uired for use in research and

development.

In India the tax law re#uires use of the reducing balance method of depreciation.

14.).4 Co""ece"et a& Ce##atio o* Depreciatio

Depreciation arises from man factors including efflux of time. Therefore! depreciation

should be charged from the date when the asset is available for use! even if the entit

decides to use it later. $n asset is available for use when it is in the location and condition

necessar for it to be capable of operating in the manner intended b management.

Depreciation should be provided on assets! which were not in use during the financial

ear. Idleness of a fixed asset might increase its useful life. This might result in charging

lower depreciation in subse#uent ears.

Co depreciation should be charged on assets that are classified as capital wor%3in3

progress=. (or example! no depreciation should be charged on e#uipment! which could

not be installed because the site civil wor% was not complete.

I$


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I&ia (AAP co"pari#o

Indian 4$$P re#uires that depreciation should be charged on all items of propert! plant

and e#uipment including those which are classified as held for sale=.

I$$%#tratio 14.)

Pramod 'imited /P'0 has two warehouses for stoc%ing its finished goods. It decides to

retire one warehouse from active use! due to lac% of demand of its product. owever! it

expects that the demand will pic% up with the recover of the industr and it will use both

the warehouses in future.

Re0%ire&

Explain whether P' should charge depreciation on the warehouse that is retired from

operation temporaril.

So$%tio

Depreciation on a depreciable asset should be charged from the date it is available for

use. Co depreciation should be charged onl when the asset is derecognised or it is

classified as held for sale. Therefore! P' should continue to provide depreciation on the

warehouse! which has been retired from operation temporaril.

14.). Cha5e# i Carri5 A"o%t6 Re#i&%a$ 'a$%e6 U#e*%$ +i*e a& Depreciatio

Metho&

Cha5e i carri5 a"o%t

The carring amount of a depreciable asset ma undergo a change due to price

adjustments! and changes in duties or similar factors. In India the historical cost of a

depreciable asset ma undergo a change also due to adjustment of exchange difference.

In that situation! the depreciation on the revised unamortised depreciable amount should

be provided prospectively over the remaining useful life of the asset.

F


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Revi#io o* the e#ti"ate& re#i&%a$ va$%e

The revision of the residual value should be considered as a change in estimate.

Therefore! where there is a revision of the estimated residual value! the revised

unamortised depreciable amount should be allocated over the remaining useful life.

Revi#io o* the e#ti"ate& %#e*%$ $i*e

+evision of the useful life should be considered as a change in estimate. Therefore! where

there is a revision of the estimated useful life! the unamortised depreciable amount should

be allocated over the revised remaining useful life. In other words! the amount of

depreciation should be revised prospectively.

I$$%#tratio 14.4

The following are the details of a machine ac#uired b $ 'td. in )**7

$c#uisition cost +s. *!***

Estimated useful life * ears

Estimated residual value +s. *!***

$ 'td. uses the straight3line method of depreciation.

In the ear )** it reviewed and revised the estimated useful life and the estimated

residual value to 1 ears and +s. ,*!***! respectivel. The amount of depreciation that $

'td. should charge p.a. over the remaining useful life of the machine should be calculated

as follows7

:ost of ac#uisition +s. *!***

Less: Estimated residual value +s. ,*!***

$mount of depreciation to be allocated over the useful life of

1 ears +s. *!***

Less: Depreciation alread charged in the initial 6 ears +s. 6*!***

$mount of depreciation to be allocated over the remaining useful

life of ) ears +s. ,*!***

;


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Therefore! $ 'td. should charge +s. )*!*** in the profit and loss account for the ear

)** towards depreciation. The same amount should be charged in the profit and loss

account for the ear )*.

Cha5e i the &epreciatio "etho&

I$


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with the depreciation charged under the straight3line method7 the difference is the

deficienc or surplus.

"ear #epreciation under straight$line #epreciation under reducing

method /+s.0 balance method /+s.0

)** *!*** )6!,6*

)**F *!*** F!,6;

)**; *!*** ,!1)

6*!***

Deficienc )-!6F

1-!6F 1-!6F

The deficienc of +s. )-!6F should be charged to the profit and loss account for the ear

)**! and it should be shown as a separate line item. In addition! it should charge +s.

!,) towards depreciation for the ear )**.

14.).7 Depreciatio o A&&itio or E2te#io o* the A##et

$n addition or extension to an existing fixed asset which is of a capital nature and which

becomes an integral part of the existing fixed asset is depreciated over the remaining

useful life of that fixed asset. If an addition or extension of the asset is recognised

separatel! depreciation should be provided based on an estimate of its own useful life.


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(reehold land usuall does not have a limited useful life and! therefore! should not be

depreciated. In conse#uence! the cost incurred in purchasing freehold propert should be

allocated between freehold land and buildings. The amount allocated to the building

should be depreciated over its estimated useful life.

+ea#eho$& propertie#

'easehold properties should be depreciated over the unexpired period of the lease! or the

useful life of the assets! if shorter. Provision should be made for the estimated cost of

contractual obligation to ma%e good an dilapidation over the period of the lease! using

the latest estimate of the cost of repairs at current prices. It is normal to use straight3line

method of depreciation.

/reeho$& b%i$&i5#

Guildings have limited useful lives and! therefore! should be depreciated. 5suall the

straight3line method of depreciation is most appropriate in depreciating freehold

buildings.

P$at a& "achier

4enerall! the straight3line method of depreciation is used for depreciating plant and

machiner. owever! in certain circumstances! the reducing balance and unit of

production method are more appropriate. $ssets of ver short effective lives such as

loose tools! jigs and patterns are depreciated using revaluation method or an other more

satisfactor method of depreciation.

Ship# a& vehic$e#

The straight3line method of depreciation is commonl used for depreciating ships and

vehicles.

A##et# o* a 3a#ti5 character

)


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$ssets of a wasting character such as mines! oil wells and #uarries are depreciated on the

basis of estimated exhaustion of the asset concerned. Provision should include the

estimated cost of an liabilit for environmental reinstatement.

14. DEPRECIATION METHODS

The depreciation method used should reflect the pattern in which the economic benefits

of the assets are consumed b the enterprise. owever! in view of the difficulties in

establishing a clear pattern of the flow of benefits and setting up a depreciation method

that matches the pattern of benefits! if established! most enterprise follows the straight3

line method of depreciation.

The accepted methods of depreciation are listed in exhibit ,. below7

E2hibit 14.18 Depreciatio "etho

5nder accelerated depreciation method depreciation charges become progressivel

smaller each period.

14..1 Strai5ht +ie Ti"e Metho&

Depreciation methods


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The straight line time method divides the depreciable amount b the number of ears of

useful life! to calculate annual depreciation.

I$$%#tratio 14.7

The following are the details of a machine ac#uired in )**7

$c#uisition cost +s. *!***

Estimated useful life * ears

Estimated residual value +s. *!***

Co. of units estimated to be produced over the useful life **!*** units

The entit uses the straight line time method of depreciation.

Re0%ire&

:alculate the depreciation rate and the amount of depreciation per annum.

So$%tio

Depreciation should be charged H *B per annum to allocate the cost reduced b the

estimated residual value over the useful life of the machine! which is * ears. The

amount of depreciation to be charged uniforml over the useful life of the asset7

/+s. *!*** +s. *!***0 J *! that is! +s. *!***

14..! Strai5ht +ie U#e Metho&

This method allocates the depreciable amount of the fixed asset over its useful life in

terms of the number of units estimated to be produced! or machine hours estimated to be

used in relation to total units estimated to be produced during the asset=s useful life. This

method is superior to the straight3line or reducing balance methods! because it matches

costs with revenue more accuratel. %o&ever, the precision depends on the accuracy

&ith &hich the total output during the useful life of the asset can be estimated.

,


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5nder this method a rate per unit is calculated b dividing the depreciable amount b the

estimated number of units expected to be produced over the estimated useful life of the

asset. Depreciation for a particular period is calculated b multipling the actual number

of units produced b the depreciation rate per unit.

I$$%#tratio 14.9

$ssume the information provided in illustration ,.- above. The production for the ear

)** was ;!*** units.

Re0%ire&

:alculate the depreciation rate if the entit uses the straight line use method ofdepreciation.

So$%tio

Depreciation per unit of production7

/+s. *!*** +s. *!***0 J +s. **!***! that is! +e. per unit

Depreciation to be charged in each ear would be calculated b multipling number of

units produced during the ear b the rate per unit. Depreciation for the ear )** would

be ;!*** K +e. that is +s. ;!***.

14..) Re&%ci5 :a$ace Metho&

5nder the reducing balance method! the amount of depreciation reduces over the ears.

5nder this method! a fixed percentage is applied on the reducing balance! popularl

%nown as "ritten3Down 9alue /"D90. The formula for calculating that fixed rate can be

derived as follows7

'et r be the rate of depreciation. If ' represents cost of ac#uisition! ( represents the

residual value and n represents the useful life. Then7

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') / r 0n L (

or

(1 )n R

r C

− =

or

1 n R

r C

− =

or

1 n R

r C

= −


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10

1

10,0001 1 0.787 0.213

1,10,000

Rr n

C = −

= − = − =

Thus! the rate of depreciation is ).6B against the straight3line method of *B.

"ear *ritten$do&n value /+s.0 (ate /B0 #epreciation /+s.0

)** *!*** ).6 )6!,6*

)* F-!1* ).6 F!,6;

)*) -F!6 ).6 ,!1)

)*6 16!-; ).6 !,)

)*, ,)!;F ).6 F!;FF

)*1 66!)* ).6 !*,

)*- )-!6- ).6 1!1-

)* )*!1-; ).6 ,!6F

)*F -!FF ).6 6!,,F

)*; )!,* ).6 )!,*

**!***

The amount of depreciation for the ear )*; is calculated as the difference between

"D9 at the beginning of the ear and the residual value7 ).6B of +s. )!,* is +s.

)!,. The difference of +s. )- has arisen due to accumulation of rounding off errors.

5nder the reducing balance method +s. -!-)) or -FB of the depreciable amount will be

written off in the first four ears. 5nder the straight3line method onl ,*B will be written

off in the first four ears.

It ma be noted that the rate of depreciation under reducing balance method depends on

the estimated residual value. (or example! if the residual value is estimated at *.****B

of the cost! the rate will be7

r L *.)** L *.F*

Thus! if residual value is estimate at close to @ero! F*B of the cost will be written off in

the ver first ear.


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If the residual value is estimated at 1B of cost! the rate of depreciation will be

r L *., L *.)1;

The :ompanies $ct! ;1- provides rate of depreciation based on the assumption that the

residual value will be 1B of the ac#uisition cost.

14..4 S%"-o*-the-ear#< &i5it# Metho&

5nder sum3of3the3ears= digits method! the amount of depreciation is calculated b

multipling the depreciable amount b the factor /+ A s0. If n be the estimated useful life of

the asset! then + for ear is n! /n 0 for the ear )! /n )0 for the ear 6! and so on.

Thus! for the nth ear + is . is the sum of the numbers to n. Thus! if the useful life is

estimated at * ears! is e#ual to 11. Thus! /+ A s0 for the ear is /*A110. If the

depreciable amount is +s. **!***! depreciation for the first ear is +s. !**!*** K

/*A110 or +s. F!F). Depreciation for the *th ear is +s. **!*** K /A110 or +s.

!FF.

14.6 DEPRECIATION UNDER THE COMPANIES ACT

5nder the :ompanies $ct! ;1-! depreciation should normall be provided at the rates

provided in


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be calculated on pro rata basis

up to the date on which such asset has been sold! discarded! demolished or destroed.

Depreciation should be charged from the date of commissioning of the asset even if the

enterprise started using it at a later date.

I$$%#tratio 14.=

$ 'td.! having two manufacturing units! both non3seasonal! has adopted the straight3line

method= of depreciation. The details of machiner installed b the compan as on 6

March )** are given as7

-nits capitalised -nits capitalised

during the during

current year previous years

///01/2/0

Plant $ Plant G Plant $

. Date of commissioning )- $pril )**; )* Dec. )**; C$

). :ost +s. **!*** +s. )**!*** +s. !***!***

6. Cumber of das wor%ed for each shift

/a0


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:alculate the amount of depreciation to be charged in the profit and loss account for the

ear )**;3*.

So$%tio

$mount of depreciation to be charged in the profit and loss account for the ear )**;3

)**

. 5nits commissioned during the ear

$. Plant $

/a0


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;1- should be considered as the minimum amount of depreciation to be provided b a

limited compan. The view has been supported b the Department of :ompan $ffairs of

the union government.

14.9 INTAN(I:+E ASSETS - AMORTISATION

14.9.1 C$a##i*icatio o* Ita5ib$e A##et#

I$


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situation it is appropriate to sa that there is no foreseeable limit to the period over which

the asset is expected to generate net cash inflows to the enterprise. $ccordingl the

license should be classified as an intangible asset with indefinite useful life. Nn the other

hand! if the government distributes the license through auction! the license has a finite

useful life! which is five ears.

Nther examples of intangible assets with indefinite useful life are patent or brand

ac#uired from another enterprise and trade mar%.

If the useful life is finite! the enterprise should assess the useful life in terms of length of

ears or number of production or similar units. $ssets with indefinite useful life is not

amortised! it is tested for impairment annuall.

I&ia (AAP co"pari#o

Indian 4$$P /$


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If control over an intangible asset is achieved through legal rights that have been granted

for a finite period! the useful life should not exceed the period of the legal rights unless7

/a0 The legal rights are renewable.

/b0 +enewal is virtuall certain.

In practice! the useful life ma be considered longer than the period or legal right! if the

legal right is renewable at a nominal cost and experiences of others show that there is no

hurdle in renewing the legal right.

Re#i&%a$ va$%e

+esidual value of an intangible asset is usuall assumed to be @ero. Nnl rarel! theresidual value of an intangible asset is estimated at more than @ero.

Metho& o* a"orti#atio


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$ fundamental accounting principle is that an asset that should not be carried at an

amount higher than its recoverable amount or fair value. There is an implicit assumption

that the enterprise will recover at least the carring amount of assets either b use or

through sale.

+ecoverable amount is the higher of the amount that the enterprise expects to recover b

using the asset and the amount the enterprise expects to recover b selling the same.

Therefore! if at an time the recoverable amount of an asset falls below its carring

amount! the asset is written down to its recoverable amount and an impairment loss is

recognised. The accounting principle of recognising impairment loss presents an

application of the principle of prudence! which re#uires recognition of an estimated loss

immediatel it is identified.

$n entit ac#uires an asset onl if it expects to recover the ac#uisition cost of the asset

and the cost of financing the same. It is rare that estimated recoverable amount of an asset

at the ac#uisition date is lower than its ac#uisition cost. owever! subse#uent events

might adversel affect the service potential of the asset causing its recoverable amount

falling below the carring amount. This results in impairment of the asset. Therefore!

when an entit identifies events that indicate impairment of an asset! it should test the

same for impairment. This ensures that no asset is carried at an amount higher than its

recoverable amount! which is higher of its value in use and 3air value less costs to sell4 .

I&ia (AAP co"pari#o

I$


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If there is an indication that an asset might have been impaired! the following should be

reviewed7

/a0 Estimated remaining useful life

/b0 Depreciation method

/c0 +esidual value for the asset

The enterprise should revie& the above irrespective of &hether impairment loss is

recognised or not.

I$$%#tratio 14.1>

Ghavi%a 'imited /G'0 is in the business of manufacturing jute products. The externalenvironment /changes in the mar%et conditions0 indicates that assets in the balance sheet

of G' might have been impaired. The enterprise estimates an impairment loss at +s.

1**!***. owever! due to strategic reasons! G' decides to continue the business and to

use those assets over their originall estimated useful life of ten ears.

Re0%ire&

Explain how G' should account for the impairment loss.

So$%tio

G' should recognise the impairment loss and reduces the carring amount of the assets

b +s. 1**!***. G' should depreciate the carring amount! adjusted for the impairment

loss! over the remaining useful life of the e#uipment.

14.;.) Mea#%re"et o* I"pair"et +o##

$n asset is impaired when its carring amount exceeds its recoverable amount.

Impairment loss is the amount b which the carring amount of an asset exceeds its

recoverable amount.

)1


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+ecoverable amount is the higher of an asset=s fair value less costs to sell= and its value

in use.

9alue in use of an asset is the present value of estimated future cash flows expected to

arise from the continuing use of the asset in its present condition and from its disposal at

the end of its useful life.

I$$%#tratio 14.11

Mauri 'imited /M'0 is in the business of carpet manufacturing.


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The following is the list of external sources of information7

/a0 During the period! there is significant decline in an asset=s mar%et value as compared

to what would be expected as a result of the passage of time or normal use.

/b0


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/b0 $ctual net cash flows or operating profit or loss arising from the asset are

significantl worse than those budgeted.

/c0 $ significant decline in budgeted net cash flows or operating profit! or a significant

increase in budgeted loss arising from the asset.

/d0 Nperating losses or net cash outflows for the asset! when current period figures are

aggregated with budgeted figures for the future.

Except otherwise re#uired b another accounting standard! an entit is not re#uired to test

assets for impairment. Nnl if an of the indicators is identified the enterprise in respect

of an asset or a group of assets! it should test the asset or the group of asset for

impairment.

14.;. Ca#h (eerati5 Uit ,C(U

$n item of long3lived assets /e.g. fixed assets0 seldom produces cash flows independent

of cash flows produced b other assets. In most situations it is almost impossible to

determine the recoverable amount of an individual asset. Therefore! grouping of assets is

essential to appl the accounting principles for determination of the impairment loss. The

concept of cash generating unit /:450 incorporates this principle.

$ :45 is the smallest identifiable group of assets that generates cash flows from

continuing use that are largely independent of the cash flows from other assets or group

of assets.

Identification of CGU is a matter of judgement. Determination of CGU at a higher level

might camouflage the impairment loss of certain assets. On the other hand, endeavour to

identify CGU at a very low level of the organisation might result in recognition of

impairment loss which does not exist.

'ertica$$ ite5rate& or5ai#atio

)F


29/44

If an active mar%et exists for the output produced b an asset or group of assets! that asset

or group of assets is identified as a :45! even if some or all of the output is used

internall.

I$$%#tratio 14.1!

The government has issued a license to an International airline to operate in India! subject

to fulfillment of certain conditions. The conditions include providing minimum services

to specified sectors. The compan has allocated aircraft and other resources to each

sector.

Re0%ire&

Explain whether the entit should designate each sector in India as a :45.

So$%tio

The :45 is the India operations as a whole! because the airline cannot close down

operations in unprofitable sectors and continue its operations onl in other sectors. It is

inappropriate to conclude that each sector in India generates cash flows independentl of

cash flows being generated b other sectors.

I$$%#tratio 14.1)

$ retail stores chain has large number of retail stores in different locations in India. Each

retail store serves a particular local mar%et. owever! the purchase activit is located

centrall at its head#uarter in Mumbai. Each retail store has to follow the pricing polic

decided centrall b the corporate office.

Re0%ire&

Explain whether the entit should designate each retail store as a :45.

So$%tio

);


30/44

Each retail store is a :45! because it generates cash flows independentl from cash

flows being generated b other stores! although purchases and pricing polic are decided

centrall.

I$$%#tratio 14.14

$ compan manufactures small agricultural pumps in its three factories located in ?o%a!

Thane and Coida. These three factories serve the demand across the countr and supports

execution of export orders. The compan receives orders centrall and allocates them to

three manufacturing units depending on their capacit and bac%log of orders.

Re0%ire&

Explain whether the entit should designate each factor as a :45.

So$%tio

The capacit utilisation of factories depends on the allocation of orders b the corporate

office! and therefore! each factor individuall is not generating cash flows independentl

from other cash flows in the compan. Therefore! the compan as a whole is the :45!

and each factor is a part of the same.

14.;.7 /air 'a$%e +e## Co#t# to Se$$

(air value less costs to sell is the amount obtainable from the sale of an asset in an arm=s

length transaction between %nowledgeable and willing parties! less the costs of disposal.

The best evidence of an asset=s net selling price is a price in a binding sale agreement in

an arm=s length transaction! reduced b costs of disposal. If there is no binding sale

agreement! the net selling price is the asset=s mar%et price /current bid price0 in an active

mar%et! reduced b costs of disposal. In case current bid prices are unavailable! the price

of the most recent transaction should be used to estimate the net selling price. owever!

the same should be adjusted for significant changes in the economic circumstances

between the transaction date and the date at which the estimate is made.

6*


31/44

There might be situations where neither a binding sale agreement nor an active mar%et for

an asset is available. In such a situation! the net selling price should be based on the best

information available to reflect the amount that the entit could obtain! at the balance

sheet date! for the disposal of the asset. 5utcome of recent transactions for similar assets

&ithin the same industry should be used as the basis for estimating the amount .

5suall! an entit does not sell a going concern piecemeal. In most situations it

determines the net selling price of a :45! for which no active mar%et exists. Therefore!

in absence of bid price in an active mar%et or recent transactions involving similar assets!

established valuation models ma be used to determine the fair value less costs to sell!

unless there is a binding sale agreement. owever! use of valuation models ma result in

an estimate that is close to the value in use= unless additional benefits that are expectedto accrue to the buer are incorporated in the model. 5suall! buers agree to pa a price

higher than the value in use. It expects higher cash flows than the estimated cash flows

from the present use of the asset b the present owner due to snerg or higher mar%et

share or some other economic benefits.

Apprai#a$ "etho&

$n enterprise ma determine the realisable value of its assets b using appraisal method .9alue determined through the appraisal method ma be used as a surrogate measure of

the net selling price.

14.;.9 'a$%e i U#e

9alue in use= is the present value of estimated future cash flows expected to arise from

the continuous use of the asset in its present condition for the remaining useful life and

from its eventual disposition.

$s the asset is tested for impairment in its present condition! effect of proposed

restructuring! if an! should not be considered unless the enterprise is committed to the

same. $n enterprise is deemed to have committed to a restructuring proposal onl if it is

so close to implementation that the enterprise has practicall no option to withdraw the

6


32/44

proposal. Inclusion of the restructuring plan in the corporate plan does not provide

ade#uate evidence of enterprise=s commitment to the plan.


33/44

second stage! it discounts the forecasted cash flows using a discount rate appropriate for

that currenc. (inall! it translates the present value using the exchange rate at the

balance sheet date.

Ca#h *$o3 o* a C(U6 3hich &oe# ot #e$$ o%tp%t

In case the production of a :45 is being used internall b the entit! management=s best

estimate of future price that could be achieved in arm=s length transactions shall be used

in estimating

/a0 The value in use of the :45 when estimating the future cash inflows that relate to the

internal use of the output

/b0 The value in use of the other :45 when estimating the future cash outflows that

relate to the internal use of the output

Di#co%t rate

Pre3tax discount rate should be used to determine the value in use. Determination of the

discounting rate should be consistent with the projection of cash flows. If the projected

cash flow is the expected cash flow= /as the term is used in statistics0! which representsris%3free e#uivalent cash flow=! ris%3free rate should be used to discount that cash flow.

If the cash flow is not the expected cash flow! the discounting rate should incorporate the

time value of mone and also the ris%s surrounding the cash flow.

The discount rate should reflect the mar+et assessment of the time value of mone and

the ris% that the future cash flows will differ in amount or timing from estimates.

The "eighted $verage :ost of :apital /"$::0 is the appropriate discount rate! onl ifthe ris% to the :45 under consideration is the average ris% of the entit. In case the ris%

to which the :45 is exposed is significantl different from the average ris% of the entit!

a discount rate separate from "$:: should be used.

Illustration 14.15

66


34/44

Sudeshna Limited (SL) has two divisions. Division 1 produces part Y and Division 2

produces part Z and assembles parts Y, Z and other components. Although part Y has

active markets, the total production is consumed internally.

Required

Explain whether SL should designate each division as a separate CGU.

Solution

Division 1 and Division 2 are separate CGUs. In estimating cash flows for Division 1 and

Division 2, the transfer price of Y should be ignored. Management’s best estimate of

future market prices should be used to estimate future cash inflows of Division 1 andfuture cash outflows of Division 2.

14.;.; I"pair"et o* (oo&3i$$

A$$ocate 5oo&3i$$ to C(U#

Internall generated goodwill is not recognised in financial statements. $n entit

recognises goodwill! if the purchase consideration paid in an ac#uisition exceeds the fair

value of identifiable assets and liabilities ac#uired in the transaction. Therefore! goodwill

recognised in financial statements must relate to one or more businesses ac#uired prior to

the balance sheet date! which is the date at which the :45 is being tested for impairment.

(or the purpose of impairment test! an entit should allocate goodwill ac#uired in a

business combination! from the ac#uisition date! to each of the :45 /or group of :45s0

that is expected to benefit from the snergies of the combination. It is not necessary that

good&ill shall be allocated to the 'G- to &hich other assets and liabilities in thebusiness combination are allocated.

No rea#oab$e ba#i# *or a$$ocatio o* 5oo&3i$$

6,


35/44

In certain situations an entit ma not be able to allocate goodwill to :45s except

arbitraril. In those situations the entit does not allocate the goodwill to each :45.

"hen goodwill relates to a :45 but has not been allocated to that unit! the :45 should

be tested for impairment whenever there is an indication that it might have been

impaired. $n entit compares the carring amount! excluding an goodwill! with

recoverable amount to test the :45 for impairment. The impairment loss is allocated to

individual assets! other than goodwill.

Te#t *or i"pair"et at $ea#t a%a$$

$ :45 to which goodwill has been allocated should be tested for impairment at least

annuall. It should also be tested for impairment whenever there is an indication that it

might have been impaired.

The "etho& to te#t i"pair"et

$n entit compares the carring amount! including an goodwill! with recoverable

amount to test the :45 for impairment. The impairment loss! if an is first allocated to

goodwill to reduce its carring amount and then to other assets.

$t the time of impairment testing of a :45 to which goodwill is allocated! there might

be an indication that an asset or a :45 within the :45 being tested for impairment has

been impaired. In such circumstances! that particular asset or :45 should be tested for

impairment before impairment testing of the :45 to which goodwill has been allocated.

$n entit should recognise the impairment loss associated with that particular asset or

:45 before determining the carring amount of the :45 to which goodwill has been

allocated for the purpose of impairment testing.

I$$%#tratio 14.17

Nn ?anuar )**! ?essica 'imited /?'0 ac#uires


36/44

garments= division. ?' pas +s. !*** million /+s. ** crores0 to the share holders of


37/44

/b0 If! in performing the bottom up test the entit could not allocate the carring amount

of goodwill on a reasonable and consistent basis to the :45 under review! the entit

should also perform a top3down test.

Bottom-up test

The entit evaluates whether the carring amount of the goodwill can be allocated on a

reasonable and consistent basis to the :45 under review. In case it is able to allocate the

goodwill to the :45! the carring amount of the :45 should include the allocated

amount of goodwill. The :45 is tested for impairment b comparing the recoverable

amount and the carring amount! including the carring amount of the goodwill.

The bottom up test should be carried out to test the impairment of a :45 even if

goodwill cannot be allocated to it. owever! if goodwill cannot be allocated! the entit

will perform the top3down test to estimate the impairment of goodwill.

Top-down test

The top3down test involves identification of a larger :45! which includes the :45

under review. The carring amount of the larger :45! including the carring amount of

allocated goodwill! is compared with the recoverable amount of the larger :45. The

excess of the carring amount over the recoverable amount is the impairment loss. The

impairment loss is adjusted against goodwill. The carring amount of the :45 under

consideration that is included in the carring amount of the larger :45 is the carringamount adjusted for impairment loss determined in the bottom3up test=.

The method stipulated in the Indian 4$$P gives the result which is same as that would

be obtained b the method stipulated in I$< 6-.

I$$%#tratio 14.19

Nn ?anuar )**! ?essica 'imited /?'0 ac#uires


38/44

Nn ?anuar )** ?' recognises goodwill at +s. )** million /+s. )* crores0 on

ac#uisition of


39/44

#ivision A #ivision 6 #ivision '

:arring amount with goodwill ,)* 66* ,1*

+ecoverable amount ,1* ),* ,F*

Impairment loss Cil ;* Cil

It is li%el that there are indications that assets in Division G have been impaired.

Therefore! under $


40/44

In the given situation! both the accounting standards re#uire that at the first stage

Division G should be tested for impairment. This is referred as the bottom up test= in

$ I"pair"et o* Corporate A##et#

,*


41/44

The %e characteristic of corporate assets is that the do not generate cash inflows

independentl from other assets or groups of assets. Examples of corporate assets are

building of the corporate head#uarter! EDP e#uipment and a research centre. The

carring amount of those assets cannot be attributed to a particular :45 under review

except on an arbitrar basis. The recoverable amount of an individual corporate asset

cannot be determined unless management decides to dispose of the asset. Therefore! if

there is an indication that a corporate asset is impaired! recoverable amount is

determined for the :45 to which the corporate asset belongs. It is compared with the

carring amount of the :45 to determine the impairment loss. 5suall the :45 for

corporate assets is the entit as a whole.

14.;.11 A$$ocatio o* I"pair"et +o## o* a C(U

The impairment loss for a :45 should be allocated to reduce the carring amount of

assets of the :45 in the following order7

/a0 (irst! to goodwill! if an! allocated to the :45

/b0 Then! to other assets of the unit on a pro3rata basis based on the carring amount of

each asset in the unit

In allocating an impairment loss! the carring amount of an asset should not be reduced

below the highest of

/a0 Its net selling price /if determinable0

/b0 Its value in use /if determinable0

/c0 Oero

The amount of the impairment loss that would otherwise have been allocated to the asset

should be allocated to other assets of the unit on a pro3rata basis. (or example! if a :45

has a piece of land among other assets and the net selling price of the land is higher than

its carring amount! no part of the impairment loss estimated for the :45 should be

allocated to the piece of land.

,


42/44

14.;.1! Rever#a$ o* I"pair"et

I&icatio# o* rever#a$

$n entit should assess at each balance sheet date whether there is an indication that animpairment loss recognised for an asset in prior accounting periods ma no longer exists

or ma have decreased. If an such indication exists! the entit should estimate the

recoverable amount of that asset.

Acco%ti5 *or rever#a$

$ reversal of an impairment loss should be recognised as income in the profit and loss

account for the period in which the impairment loss is reversed. In case of a revaluedasset! the reversal of the impairment loss should be considered as revaluation increase.

owever! if a portion of the impairment loss recognised in prior period was charged in

the profit and loss account! the reversal to that extent should be recognised as income in

the profit and loss account.

?or o* ca%tio

The increased carrying amount of an asset due to a reversal of an impairment loss shouldnot exceed the carrying amount that would have been determined had no impairment loss

been recognised for the asset in prior accounting periods .

$n impairment loss recognised for an asset in prior accounting periods should be

reversed if there has been a change in the estimates of cash inflo&s, cash outflo&s or

discount rates used to determine the asset=s recoverable amount since the last impairment

loss was recognised.

$n asset=s value in use ma become greater than the assets carring amount simpl

because the P9 of future cash inflows increases as the become closer! although there is

no increase in the service potential of the asset. Impairment loss is not reversed just

because of unwinding of the discount.

,)


43/44

I$$%#tratio 14.1;

$s on 6 December )**! $ar@oo 'imited /$'0 estimated net cash inflows for )* to

)**- were as follows7

)*7 +s. Oero )*)7 +s. **!*** )*67 +s. **!*** )*,7 +s. **!*** )*17 +s.

**!*** )*-7 +s. **!***. The appropriate discount rate was *B. The P9 as at 6

December )** was +s. 666!)). $s at 6 December )*! there is no change in

estimated net cash inflow and the discount rate. The P9 as at 6 December )* is +s.

6*!,6.

Re0%ire&

Explain how $' should account for the increase in P9 of future cash flows.

So$%tio

The increase in P9 is due to the rewinding of the discount rate and not due to increase in

the service potential. Therefore! the #uestion of reversal of the impairment loss does not

arise. The increase in P9 should not be recognised in financial statements.

11.1>.1) Rever#a$ o* a I"pair"et +o## *or (oo&3i$$

I$


44/44

Examples of external events that impaired goodwill are new regulation that prohibits the

use of a particular product or new regulation that imposes a cost for using a product that

is not environment friendl. "ithdrawal of the regulation is the subse#uent event that

reverses the effect of the event that impaired goodwill. :onditions for reversal of

impairment of goodwill are stricter than the conditions for the reversal of impairment of

assets other than goodwill.

5suall! impairment loss related to goodwill is not reversed! because it is difficult to

identif the external event that has caused the impairment of the goodwill and reversal of

the effect of that event.

14.;.14 Rever#a$ o* a I"pair"et +o## *or a C(U

+eversal of an impairment loss for a :45 should be allocated to increase the carring

amount of assets of the :45 in the following order7

/a0 (irst! to assets other than goodwill on a pro3rata basis based on the carring amount of

each asset in the :45.

/b0 Then! to goodwill if the conditions stipulated in $

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Essentials of FA_Chapter_14_Depreciation and Impairment

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