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18. Assets Impairment

When the carrying amount of a long-lived asset (or group of assets as appropriate) is not recoverable from its expected future cash flows, it is deemed to be "impaired." That is to say, the owner of the asset no longer expects to be able to generate returns of cash from the asset sufficient to recapture its recorded net book value. When this scenario occurs, a loss must be recognized for the amount needed to reduce the asset to its fair value (i.e., debit loss and credit the asset). The downward revised carrying value will then be depreciated over its remaining estimated life. Like other changes in estimates, this is a "prospective change," and no prior periods are restated.

Obviously, the measurements of impairment involve subjective components and require quite a bit of judgment. When the Financial Accounting Standards Board came up with these rules, they gave some guidance. Factors such as the following should be taken into account in considering whether an impairment exits: there has been a significant decrease in market value of an asset, the physical condition of the asset has declined unexpectedly, the asset is no longer being used as intended, legal or regulatory issues have impeded the asset, cost overruns are associated with the asset's acquisition, the overall business seems threatened by unsuccessful performance, or the asset is now expected to be disposed of ahead of schedule.

18.1. Taking a "Big Bath"

This terminology is sometimes used to characterize significant one-time impairment losses. You may see this occur when a business has gone through a significant down-period and is struggling to regain its footing. Coincident with the restructuring, numerous assets may be deemed impaired and their carrying value reduced. Management has some degree of incentive to engage in this "bath." Why? Given that the write down will produce a loss, isn't this something that management might wish to avoid? Well, the logic goes like this - things are already bad, so where is the harm? And, more to the point, future periods' income will be buoyed by this action because the write-off will leave less assets that will need to be depreciated in the future. The reduction in future expenses increases the chances of painting a return to profitability. Memories are short, and management may hope the bath will be forgotten once profitability is restored.

19. Natural Resources

Oil and gas reserves, mineral deposits, thermal energy sources, and standing timber are just a few examples of natural resource assets that a firm may own. There are many industry-specific accounting measurements attributable to such assets. As a general rule, natural resources are initially entered in the accounting records at their direct cost plus logically related items like legal fees, surveying costs, and exploration and development costs. Once the cost basis is properly established, it must be allocated over the periods benefited through a process known as "depletion." Think of it this way: depletion is to a natural resource as depreciation is to property, plant, and equipment.

19.1. Depletion Calculations

The cost of a natural resource (less any expected residual value) must be divided by the estimated units in the resource deposit; the resulting amount is depletion per unit. If all of the resources extracted during a period are sold, then depletion expense equals depletion per unit times the number of units extracted and sold. If a portion of the extracted resources are unsold resources, then the cost of those units (i.e., number of units times depletion per unit) should be carried on the balance sheet as inventory.

To illustrate, assume that a mine site is purchased for $9,000,000, and another $3,000,000 is spent on developing the site for production. Assume the site is estimated to contain 5,000,000 tons of the targeted ore. At completion of the operation, the site will be water flooded and sold as a recreational lake site for an estimated $2,000,000. The depletion rate is $2 per ton, with the calculations shown at right:

Initial cost

$9 000 000

Development cost


Less: Estimated residual value


Delectable base

$ 10,000,000

Divided by estimated units


Depletion per ton

If 1,000,000 tons of ore are extracted in a particular year, the assigned cost would obviously be $2,000,000. But where does that cost go? If 750,000 tons are sold and the other 250,000 tons are simply held in inventory of extracted material, then $1,500,000 would go to Cost of Goods Sold and the other $500,000 would go to the balance sheet as inventory. A representative entry follows:




Cost of Goods Sold


Natural Resource (or accumulated depletion)


To record annual depletion charge reflecting assignment of depletion cost to inventory (250,000 X $2) and cost of goods sold (750,000 X $2)

19.2. Equipment Used to Extract Natural Resources

Property, plant, and equipment used to extract natural resources must be depreciated over its useful life. Sometimes the useful life of such PP&E is tied directly to the natural resource life, even though its actual physical life is much longer. For example, if a train track is built into a mine, the track is of no use once the mine closes (even though it could theoretically still carry a train for a much longer period). As a result, the track would be depreciated over the life of the mine. Conversely, the train that runs on the track can be relocated and used elsewhere; as such it would likely be depreciated over the life of the train rather than the life of the mine.

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