Depreciation

Amortization
Amortization is the process of gradually writing off the initial cost of an intangible asset over its
useful life. This is similar to depreciation, which applies to tangible assets. The purpose of
amortization is to match the expense of using the asset with the revenue it generates over time.
Here are some key points:
1. Intangible Assets: These include patents, copyrights, trademarks, and goodwill.
2. Useful Life: The period over which the asset is expected to provide economic benefits.
3. Amortization Methods: Common methods include the straight-line method, where the
cost is evenly spread over the useful life, and the units-of-production method, where the
cost is based on usage or production levels.
Impairment
Impairment occurs when the carrying amount of an asset exceeds its recoverable amount. This
means the asset's value has declined, and it is no longer worth its book value. Here are the key
points:
1. Carrying Amount: The value of the asset as recorded on the balance sheet, which is the
initial cost minus accumulated amortization or depreciation.
2. Recoverable Amount: The higher of the asset's fair value less costs to sell and its value
in use (present value of future cash flows).
3. Impairment Loss: The difference between the carrying amount and the recoverable
amount. This loss is recognized in the income statement.
Accounting for Impairment
1. Identification: Determine if there are indicators of impairment, such as significant
changes in market conditions or physical damage to the asset.
2. Measurement: Calculate the recoverable amount and compare it to the carrying amount.
3. Recognition: If the carrying amount exceeds the recoverable amount, recognize an
impairment loss in the income statement.
4. Reversal: Under certain accounting standards, impairment losses can be reversed if the
asset's value recovers, but this is not allowed under U.S. GAAP for intangible assets other
than goodwill.
Depreciation vs. Amortization vs. Impairment
1. Depreciation:
 Definition: The systematic allocation of the cost of a tangible asset over its useful life.
 Assets: Applies to tangible assets like machinery, buildings, and vehicles.
 Methods: Common methods include straight-line, declining balance, and units of
production.
 Purpose: To match the expense of using the asset with the revenue it generates over time.
2. Amortization:
 Definition: The systematic allocation of the cost of an intangible asset over its useful life.
 Assets: Applies to intangible assets like patents, copyrights, and trademarks.
 Methods: Common methods include straight-line and units of production.
 Purpose: Similar to depreciation, it matches the expense of using the asset with the
revenue it generates over time.
Impairment:
 Definition: Occurs when the carrying amount of an asset exceeds its recoverable amount,
indicating that the asset's value has declined.
 Assets: Can apply to both tangible and intangible assets.
 Indicators: Significant changes in market conditions, physical damage, legal changes, or
reduced demand for the asset's products.
 Purpose: To ensure that the asset is not carried at more than its recoverable amount on
the balance sheet.
Indicators of Impairment
 Significant decline in market value.
 Changes in the way the asset is used or its physical condition.
 Adverse changes in legal or economic factors.
 Decrease in expected future cash flows from the asset.
Amortization of Intangible Assets
Intangible assets can have either a limited useful life or an indefinite useful life:
Limited Useful Life:
  Amortization: The cost of the asset is amortized over its useful life using methods like
straight-line or units of production.
 Example: A patent with a 10-year useful life would be amortized over 10 years.
Indefinite Useful Life:
 Amortization: These assets are not amortized but are tested for impairment annually or
whenever there is an indication of impairment.
 Example: Goodwill is an intangible asset with an indefinite useful life and is tested for
impairment rather than amortized.
Net Realizable Value (NRV)
 NRV is the estimated selling price of inventory in the ordinary course of business, minus
any costs necessary to complete the sale, such as completion and disposal costs. It is used
to ensure that inventory is not overstated on the balance sheet.
Calculation of NRV
 To calculate NRV, follow these steps:
 Estimated Selling Price: Determine the price at which the inventory can be sold.
 Costs to Complete: Subtract any costs required to complete the inventory.
 Selling Costs: Subtract any costs necessary to sell the inventory, such as marketing and
distribution costs.
Lower of Cost or NRV
 According to accounting standards, inventory should be reported at the lower of its cost
or NRV. This ensures that inventory is not overstated on the balance sheet and reflects
any potential losses in value.
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