Complete presentation of chapter 8 "Analysis of Long-Lived Assets: Analysis of Depreciation & Impairment" from "Analysis and Use of Financial Statement by White & Sondhi Edition 3

1. Analysis of Long Lived
Assets:
Analysis of Depreciation
and Impairment

2. PRESENTED
BY:
Anzalna Jawaid
Mahrukh Zehra
M.Com Final (Finance)

3. LONG-LIVED ASSETS
A long lived asset is any asset that a business expects to retain
for more than one accounting period.
Long lived assets are usually classified into two subcategories:
1) Property, plant & equipment
2) Intangible assets
Once acquired, the cost of a long lived asset is usually depreciated
(for tangible assets) or amortized (for intangible assets) over the
expected useful life of the asset.

4. PROPERTY, PLANT &
EQUIPMENT
Property, plant & equipment are tangible items
that:
a) are held for use in the production or supply
of goods or services, for rental to others, or
for administrative purposes; and
b) are expected to be used during more than
one year.

5. INTANGIBLE ASSETS
An intangible asset is an identifiable non-monetary asset
without physical substance.
An intangible asset shall be recognized if, and only if:
a) it is probable that the expected future economic benefits
that are attributable to the asset will flow to the entity;
and
b) the cost of the asset can be measured reliably.
(IAS-38)

6. DEPRECIATION CONCEPT
• For accountants, depreciation is an allocation
process, not a valuation process.
• For analysts, it is important to differentiate
between accounting depreciation and economic
depreciation.
• The Cash flows generated by an asset over its life
is not considered income until a provision is made
for its replacement.

7. EXAMPLE:
Suppose an asset costs $240 and is expected
to generate net cash flows of $100 for per
year for its 3 years life. Over the life of the
asset, income equals $60 ($300-$240) as
$240 is required to replace the asset (if we
assume that asset is worthless after 3 years
DEPRECIATION CONCEPT

8. DEPRECIATION METHODS
The depreciation method used shall reflect the pattern
in which the asset’s future economic benefits are
expected to be consumed by the entity.
The depreciation method applied to an asset shall be
reviewed at least at each financial year-end and, if
there has been a significant change in the expected
pattern of consumption of the future economic benefits
embodied in the asset, the method shall be changed to
reflect the changed pattern.

9. DEPRECIATION METHODS
A variety of depreciation methods can be used to allocate
the depreciable amount of an asset on a systematic basis
over its useful life. These methods include
• straight-line method,
• the diminishing balance method and
• the units of production method.

10. ANNUITY OR SINKING FUND METHOD
• The annuity method of depreciation is a process used to
calculate depreciation on an asset by calculating its rate
of return as if it was an investment.
• This method requires the determination of the rate of
return on the cash inflows and outflows of the asset.
• the cash flow of the asset being depreciated is constant
over the life of the asset.

11. The asset generates a return of 12% over in 3 years life. To report a 12% return
for each year requires the following pattern of depreciation.
ANNUITY OR SINKING FUND METHOD
YEARS (1)
Opening
Balance Asset
(2)
Cash Flow
(3)
Depreciation
Expense
(4)=(2)-(3)
Net Income
(5)=(4)/(1)
Rate of Return
1 $240 $100 $71 $29 12%
2 $169 $100 $80 $20 12%
3 $89 $100 $89 $11 12%
Totals $300 $240

12. STRAIGHT LINE METHOD
Straight-Line Depreciation with Declining Cash Flows
YEARS (1)
Opening
Balance Asset
(2)
Cash Flow
(3)
Depreciation
Expense
(4)=(2)-(3)
Net Income
(5)=(4)/(1)
Rate of Return
1 $240 $109 $80 $29 12%
2 $160 $99 $80 $19 12%
3 $80 $90 $80 $10 12%
Totals $298 $240 $58

13. Straight-Line Depreciation with Constant Cash Flows
STRAIGHT LINE METHOD
YEARS (1)
Opening
Balance Asset
(2)
Cash Flow
(3)
Depreciation
Expense
(4)=(2)-(3)
Net Income
(5)=(4)/(1)
Rate of Return
1 $240 $100 $80 $20 8.3%
2 $160 $100 $80 $20 12.5%
3 $80 $100 $80 $20 25%
Totals $300 $240 $60

14. ACCELERATED DEPRECIATION METHODS
The matching principle can also justify accelerated depreciation patterns,
with higher depreciation charges in early years and smaller amounts in
later years. There are two arguments:
1. Benefits (revenues) from an asset may be higher in early years,
declining in later years as efficiency falls (the asset wears out). The
matching process suggests that depreciation should decline with
benefits.
2. Even if revenues are constant over time, an asset requires
maintenance and repairs over time, costs that tend to increase as the
asset ages. Accelerated depreciation methods compensate for the

15. The two most common accelerated methods are the sum-of-years’ digits (SYD)
method and the family of declining-balance methods.
1. SUM–OF-YEARS’ DIGIT: The sum of years’ digits method is a form of
accelerated depreciation that is based on the assumption that the
productivity of the asset decreases with the passage of time.
2. DECLINING BALANCE METHODS: The declining balance method, also
known as the reducing balance method, is an accelerated depreciation
method that records larger depreciation expenses during the earlier years of
an asset’s useful life, and smaller ones in later years.
ACCELERATED DEPRECIATION METHODS

16. SUM OF YEARS’ DIGIT METHOD
Cost of the machine: $250,000, Expected useful life of machine: 5
years, Salvage value: $25,000

17. DOUBLE DECLINING BALANCE METHOD
The double declining balance depreciation (DDB) method is one of two
common methods a business uses to account for the expense of a long-lived
asset.

18. UNITS-OF-PRODUCTION & SERVICE
HOURS METHOD
• This method depreciate assets in proportion to their actual
use rather than as function of the passage ,thus more
depreciation is recognized in years of higher production.
• These methods make depreciation expense a variable rather
than a fixed cost, decreasing the volatility of reported
earnings as compared to straight line or accelerated
methods.
• Formula: Total number of units of output OR services

19. DRAWBACK OF UNITS-OF-PRODUCTION
& SERVICE HOURS METHOD
A significant drawback of these two methods accurs when
the firm’s productive capacity becomes obsolete as it loses
business to more efficient competitors. The units-of-
production and service hours methods decrease
depreciation expense during periods of low production

20. GROUP & COMPOSITE
DEPRECIATION METHOD
• This method of depreciation allocate the cost of similar (dissimilar)
assets using depreciation rates based on a weighted average of
the service lives of assets.
• Gain or losses on the disposable of assets depreciated using
group or composite method are either.
-Recognized in reported income,
-Reported instead as a component of accumulated
depreciation

21. DEPLETION
Depletion is an accrual accounting technique used to
allocate the cost of extracting natural resources such as
timber, minerals and oil from the earth. Unlike depreciation
and amortization, which mainly describe the deduction of
expenses due to the aging of equipment and property,
depletion is the actual physical depletion of natural
resources by companies.

22. AMORTIZATION
• Amortization is an accounting term that refers to the process of
allocating the cost of an intangible asset over a period of time.
• Amortization of intangible assets may be based on useful lives or
may be depreciated over the period during which the firm expects
to receive benefits.
• Companies use either straight line or units-of-production methods.

23. DEPRECIATION METHODS
DISCLOSURES
• Disclosure of depreciation method used is required and
can usually be found in the footnote listing accounting
policies.
• More than 90% American Firms use straight line
depreciation, but accelerated methods are widely used in
other countries.

24. IMPACT OF DEPRECIATION METHODS
ON FINANCIAL STATEMENTS
A depreciation expense has a direct effect on the profit that
appears on a company's income statement. The larger the
depreciation expense in a given year, the lower the
company's reported net income – its profit. However,
because depreciation is a non-cash expense, the expense
doesn't change the company's cash flow.

25. ACCELERATED DEPRECIATION
AND TAXES
• The primary reason for accelerated depreciation methods
is their beneficial effect on the firm’s tax burden.
• Depreciation acts as a tax shield.
• Firms are better off using accelerated depreciation
methods to obtain the benefit of increased cash flows
during the earlier years.

26. CHANGES IN DEPRECIATION
METHOD
Companies may change the reported depreciation
of fixed assets in different ways
• Change in method applicable only to newly acquired
assets
• Change in method applicable to all assets
• Changes in assets lives or salvage value

27. IMPAIRMENT OF LONG-LIVED
ASSETS
• Impairment of assets means that some or all the carrying
cost cannot be recovered from expected level of
operation.
• Due to unfavorable conditions, technological
developments, or decline in market demand, firms may
temporarily idle, continue to operate at a significantly
reduced level, sell, or abandon impaired assets.

28. IMPAIRMENT OF ASSETS HELD
FOR SALE
The new standard requires that long lived assets held for sale:
• Be written down to fair value less cost to sell when lower than the
carrying amount. In most cases estimated fair value would be the
present value of expected cash flows, discounted at the credit-
adjusted risk-free rate. Costs to sale exclude cost associated with
the ongoing operations of assets held for sale.
• Cease to be depreciated after reclassification as held for sale.
• Subsequent increase in fair value less cost to sale would be
recognized as gain only to the extent of previously recognized
write-downs.

29. FINANCIAL STATEMENT IMPACT
OF IMPAIRMENTS
• Impairment write downs of long- lived assets have pervasive and
significant effects on financial statements and financial ratios.
The principal balance sheet impacts of the write down are
reductions in the:
• Carrying value of plant, equipment and other production assets
• Deferred tax liabilities
• Stockholder’s equity

30. LIABILITIES FOR ASSET
RETIREMENT OBLIGATIONS
• Government often require that owners of operating assets remedy
the environmental damage caused by operating those assets or
restore land to its preexisting condition. Common examples
include:
• Restoration of strip mines after mining is completed
• Dismantlement of an offshore oil platform after the end of its useful
life
• Removal of toxic wastes raised by production
• Decontamination of site when a nuclear power plant is
decommissioned.

31. PROVISION OF SFAS 143
• This standard changes accounting standards for ARO in the following
ways:
• It applies to all entities and to all legal obligations connected with the
retirement of tangible fixed assets.
• Affected firms must recognize the fair value of an ARO liability in the
period in which it is incurred(normally at acquisition).
• Absent a market value, fair value is the present value of the expected
cash flows required to extinguish the liability.
• As the liability is carried at its present value, the firm must recognize
accretion expense in its income statement each period.

32. PROVISION OF SFAS 143
• Required disclosure include:
• Description of the ARO and associated asset
• Reconciliation of the ARO liability, showing the effect of:
• New liabilities incurred
• Liabilities extinguished
• Accretion expense
• Revision of the estimated AROs
• Fair value of any restricted assets (such as funds) set aside for ARO
obligation.

33. EFFECTS OF SFAS 143
• Implementation of the new standard will result in the following
financial statement effects for most firms.
• Increase in the carrying value of fixed assets.
• Increase in liabilities due to recognition of the ARO.
• Lower net income due to recognition of additional depreciation ( higher fixed
assets) and accretion expense (on the ARO). Due to the nature of the
accretion process, this expense will increase will increase every year.

34. EFFECTS OF SFAS 143
• The following ratio effects will also occur:
• Lower asset turnover (higher asset levels)
• Lower debt to equity ratio as equity is depressed by lower income
• Lower return on assets (income, higher assets)
• Lower interest coverage (lower income due to higher depreciation, higher
interest expense).