What is Depreciation in Accounting?

Time and again we have been confused about the three very important accountancy concepts that are the depreciation, amortization, and impairment. Depreciation is the book adjustment of reduction in the value of tangible assets, which are attributed to the use and normal wear and tear of such assets. The wear and tear have been apportioned to, as depreciation and charged to the value of assets. Amortization and impairment, however, are both reductions in the value of intangible assets. Intangible assets are reduced in value on the basis of their estimated lifespan (Melville, 2013). This reduction is intrinsically depreciation of the asset but is done as an equal charge over its estimated lifespan.

Impairment, however, is the reduction in the recoverable value of fixed assets, including goodwill, below its book value. The main difference between amortization and impairment, which look alike and are often misunderstood for each other, amortization is a gradual and constant and common decrease in the value of an asset, impairment is a sudden and irreversible decrease in the recoverable value of the asset (Melville, 2013).

Cash generating units are the smallest group of assets clubbed together which can independently generate cash flows. The Cash Generating Units are formed when certain assets cannot generate cash independently. We can also club the entire assets into one group, but as the definition of CGUs or Cash Generating Units suggests, the CGU should be the smallest group of asset individually generating cash flows.

Goodwill is the intangible asset which is a result of the reputation which the company earns over a period of time-based on its activities. The goodwill of the company is its brand value, which is non-physical. The goodwill of a company helps it realize profits, and sustain in a competitive market. In order to understand the concept in common terms, if a company is sold today, the amount the company gets, over and above the difference of its assets and liabilities, is goodwill (Parrino et. al, 2012). It can be negative or positive.

The basic reason as to why we depreciate an asset is very logical and simple. It is to ensure that a company cannot carry its assets in its financial statements below its recoverable amount. To impairment, we need to first understand recoverable amount. The recoverable amount is the value the asset would fetch if it was sold as on today (Leo, 2011). To arrive at this value of recoverable amount, we compare two values:

1.       Asset’s fair value as reduced by its cost of disposal
2.       Value in use

Understanding Amortization and Impairment

Before conducting this calculation and testing for impairment, first, it is mandatory to check whether the indications for impairment exist. Theories on this concept suggest many internal as well as external indicators for impairment. Once the existence of an impairment is confirmed, the assets are tested and computed for impairment. Goodwill cannot be separated from other assets which are acquired by the parent company. Also, goodwill which is impaired is always acquired or purchased as a part of an acquisition plan. Self-generated goodwill can never be impaired. Hence, going forward in the write-up, any goodwill addressed to, will be acquired goodwill only (Needles & Powers, 2013).

Goodwill is always grossed up for the parent if the goodwill is computed on a proportionate basis. Any impairment loss so computed is allocated towards the sum of recognized and unrecognized goodwill in the profit and loss sharing ratio of the parent and subsidiary (Petty et. al, 2012). The amount which is written off against the notional goodwill will not affect the consolidated financial statements. It also does not affect the non-controlling interest of the parent company. However, any portion of recognized goodwill so written off will be attributed to only the parent company. It will, however, not affect the non-controlling interests (Marsh, 2009).

Any excess of impairment loss over the recognized goodwill will be attributed to other assets on a proportionate basis. This will be absorbed by the parent company and the non-controlling interest in the profit and loss sharing ratio (Merchant, 2012).

However, when the goodwill is already grossed up in nature, the impairment loss is simply shared between the parent and the non-controlling interest in the normal profit and loss sharing ratio. 

The above scenario exists when there is a goodwill in the balance sheet of a financial statement. For a company with no goodwill, the computation of impairment for a CGU is the same as that for any individual asset (Porter & Norton, 2014).

It’s better to analyze both the situations with the help of an example.

Assuming the following scenario:

The assets of a 70% owned subsidiary are being tested for impairment.  The carrying amount of the net assets (assets-liabilities) was $420 million. Parent’s goodwill was computed to be $400 million. The recoverable amount if the subsidiary was $800 million.

The proportionate goodwill = Goodwill of parent*100/Percentage of holdings in subsidiary

                                                       = $420 million *100/70

                                                       = $600 million

Carrying value of assets plus goodwill= $400 million+ $600 million

                                                                         = $1000 million

Impairment loss= Carrying amount – the recoverable amount

                       = $1000 million – $800 million

                       = $200 million

Impairment loss has been computed because the recoverable amount is less than the carrying amount. Has the situation been opposite, there would have been an impairment profit?

Since the total of the impairment loss is less than the total recognized and unrecognized goodwill, only goodwill is impaired. This will not impact the non-controlling interest. 70%*0 million comes to $140 million will be charged to the profits of the parent company.

Had the situation been the other one where goodwill was grossed, and say 0 million was attributable to the non-controlling interests, the calculation would have been as under:

Carrying amount= Net Assets+ Goodwill

                                 = $ 420 million + $ 400 million

                                 = $ 820 million

Recoverable amount= $ 800 million

Thus impairment loss = Carrying amount- recoverable amount

                                             = $ 820 million- $800 million

                                             = $ 20 million

Hence the goodwill will now appear in the bools at $ (400-20) million, which is $ 380 million.

The loss will be shared by the parent and the NCI ( Non-controlling interest) in the ratio of 70%: 30%. 

References

Leo, K. J. (2011). Company Accounting. Boston:McGraw Hill

Marsh, C. (2009) Mastering financial management. Harlow: Financial Times Prentice Hall.

Melville, A. (2013) International Financial Reporting – A Practical Guide. 4th edition. Pearson, Education Limited, UK

Merchant, K. A. (2012) Making Management Accounting Research More Useful. Pacific Accounting  Review. [online]. 24(3), 1-34. Available from

Needles, B.E & Powers, M. (2013) Principles of Financial Accounting. Financial Accounting Series: Cengage Learning.

Needles, B.E. and Powers, M. (2013) Principles of Financial Accounting. Financial Accounting Series: Cengage Learning.

Parrino, R, Kidwell, D. & Bates, T. (2012) Fundamentals of corporate finance. Hoboken,

Petty, J. W, Titman, S., Keown, A. J., Martin, J. D., Burrow, M. and Nguyen, H. (2012) Financial Management: Principles and Applications, 6th ed. Australia: Pearson Education Australia.

Porter, G. and  Norton, C. (2014) Financial Accounting: The Impact on Decision Maker. Texas: Cengage Learning