Depreciation

Method changes the pattern

Depreciation Methods:
SLM
DDB- Does not use SV, Check CFA
Comparison of methods and profitability

Refer Notes pg-44.

Estimation of life and salvage value gives
management ability to manage earnings.
Depreciation is allocated between COGS and
SG&A. This may affect operating margins.
 How can management manage

Suppose we have a lease that has an implicit rate of 12

percent and has $15,000 of annual payments on
January 1 of each year for four years with a residual
value of $15,000 at the end of the four-year lease
term. The fair value is $60,560, for the
lessor expects to receive the residual value, and
includes the residual value in its computation of the
present value.
To the lessee, however, there is a major difference
between what happens if the residual is guaranteed
or not. If guaranteed, then the present value equals
$60,560, which is 100 percent of the fair value, so
the lease is capitalized.
If unguaranteed, then the present value is $51,027,
which is only 84 percent of the fair value. The lease is
not capitalized. By not guaranteeing the residual
value, the lessee unearths yet another way to avoid
capitalization and not disclose the financial
commitment to investors and creditors
 Another trick

Think of a firm that leases floor space in a mall

and that has average sales of $1 million per
month.
Given the nature of the business, the sales are
relatively stable from month to month.
The lessor wants to charge $50,000 per month
for use of the store, but the lessee wants
to avoid capitalization of the lease and offers
the following counterproposal.
The lease will require payment of $10,000 per
month plus 4 percent of the sales. According to
the accounting rules, contingent rental fees are
excluded from the minimum lease payments,
so this clause would reduce the minimum lease
payment per month from $50,000 to $10,000
and substantially reduce the present value of
this stream of cash flows. In this way managers
of this business enterprise can avoid reporting
its financial commitments from leasing
activities.
There are other ways to avoid lease
capitalization, but the simple ones are
managing the incremental borrowing rate, not
guaranteeing the residual value, and employing
contingent rental fees.
 Impairment

IFRS, test for impairment at least once in a

year.
Impairment when Book value > Recoverable
value.
Recoverable value is higher of Fair Value less
selling expense or value in use.
Value in use is present value of future cash
flow
Impairment loss is transferred to Income
statement
USGAAP tested for impairment only when
circumstances indicate
Apply recoverability test
Book value > Undiscounted cash flow
Once the loss is detected asset value is
determined with either the fair value or
discounted expected future cash flow.
Question
 analysis

Firm may overstate an impairment loss in the

current period to increases earnings in future.
Future earnings increase as the depreciation in
future would be lower.
Overstatement of losses happen in recessions
or when a new management takes over as they
wish to clean the slate and prove that earnings
were higher after the took over.
 Upward revaluation

USGAAP- upward revaluation allowed only

for long lived asset for sale, upward
revaluation is prohibited for long lived assets.
IFRS – long lived assets at Fair value and so
there can be some class of assets with
depreciated cost and some assets at fair value.
Revaluation gain beyond the revaluation loss
recognized earlier would bypass the income
statement and recognized in other
comprehensive income.
If the initial revaluation resulted in a loss
(decrease in carrying value), the initial loss
would be recognized in the income statement
and a subsequent gain would be recognized in
the income statement to the extent of the loss.
Revaluation gains beyond the initial loss
would bypass the income statement and be
recognized in other comprehensive income
(shareholders’ equity).
 Age of assets

Exercise:
Ingersoll-Rand India Annual report
 Age calculation

Average age= accumulated depreciation

annual depreciation expense

Average depreciable life=

Ending gross investment
Annual depreciation expense

Remaining useful life=ending net investment

annual depreciation expense
 Accounting for finance lease capitalization

Question- Affordable Leasing Company leases a machine for

its own use for four years with annual payments of $10,000.
At the end of the lease, the machine is returned to the lessor,
who will sell it for its scrap value. The appropriate interest
rate is 6%.
Calculate the impact of the lease on Affordable Leasing’s
balance sheet and income statement for each of the four
years, including the immediate impact. Affordable Leasing
depreciates all assets on a straight-line basis. Assume the
lease payments are made at the end of the year
 Accounting for finance lease capitalization

PV of 10K @6%= 34651.

depreciation will be $34,651 / 4 = $8,663 per
year.
Finance lease
Ratio Impact
Lease capitalization
Other methods of lease capitalization

Solve question on lease analysis

Lease analysis.xls

Lease capitalization- GAP.xls

 Lessor

From the lessor’s perspective, the capital lease

is treated as either a sales-type lease or a
direct financing lease.
IFRS does not distinguish between a sales-type
lease and a direct financing lease.
A sales-type lease is treated as if the lessor sold
the asset and provided the financing to
the buyer.
At the inception of the lease, the lessor will
recognize a sale equal to the present value of
the lease payments, and cost of goods sold
equal to the carrying value of the asset. Just as
with a normal sales transaction, the difference
between the sales price and cost of goods
sold is gross profit.
Asset is removed from the balance sheet and a
lease receivable
In a direct financing lease, no gross profit is
recognized by the lessor at the inception of
the lease. The lessor is simply providing a
financing function to the lessee.
Assume Johnson Company purchases an asset
for $69,302 to lease to Carver, Inc. for
four years with an annual lease payment of
$20,000 at the end of each year. At the end
of the lease, Carver will own the asset for no
additional payment. The implied interest
rate in the lease is 6% (N = 4, PV = –69,302,
PMT = 20,000, FV = 0, CPT I/Y → 6).
 Lessor books if it is operating lease

If the lease is treated as an operating lease, the

lessor simply recognizes the lease
payment as rental income. In addition, the
lessor will keep the leased asset on its balance
sheet and recognize depreciation expense over
the asset’s useful life.
Johnson treats the lease as an operating lease, $20,000 of
rental income is recognized each year. In addition,
depreciation expense of $17,325.50
($69,302 / 4 years) is also recognized.