depreciation and depletion c hapter 11 copyright © 2010 south-western/cengage learning intermediate...

Depreciation and Depletion

Chapter11

COPYRIGHT © 2010 South-Western/Cengage Learning

Intermediate Accounting 11th editionIntermediate Accounting 11th edition

Nikolai Bazley JonesNikolai Bazley Jones

An electronic presentationAn electronic presentationBy Norman SundermanBy Norman Sundermanand Kenneth Buchananand Kenneth BuchananAngelo State University

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1. Identify the factors involved in depreciation.

2. Explain the alternative methods of cost allocation, including time-based and activity-based methods.

3. Record depreciation.

4. Explain the conceptual issues regarding depreciation methods.

5. Understand the disclosure of depreciation.

6. Understand additional depreciation methods, including group and composite methods.

Objectives

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7. Compute depreciation for partial periods.

8. Explain the impairment of property, plant, and equipment.

9. Understand depreciation for income tax purposes.

10. Explain changes and corrections of depreciation.

11. Understand and record depletion.

Objectives

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Depreciation

Depreciation is the process of allocating the cost of an asset in a

systematic and rational manner over the periods benefited.

Depreciation is the process of allocating the cost of an asset in a

systematic and rational manner over the periods benefited.

Land is not depreciated because it generally does not have a limited life.

Land is not depreciated because it generally does not have a limited life.

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Factors Involved in Depreciation

Asset cost Service life Residual value Method of cost

allocation

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Asset CostAsset Cost

The cost of an asset includes all the acquisition costs a company incurs

to obtain the benefits from the asset.

The cost of an asset includes all the acquisition costs a company incurs

to obtain the benefits from the asset.


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Service LifeService Life

The service life of an asset is the measure of the service units expected

from the asset before its disposal.

The service life of an asset is the measure of the service units expected

from the asset before its disposal.


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Service LifeService Life

The factors that limit the service life of an asset can be divided into

two general categories:

The factors that limit the service life of an asset can be divided into

two general categories:

Physical causes Functional causes


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Residual ValueResidual Value

Residual, or salvage, value is the net amount that can be expected to be obtained when the asset is disposed at the end of its service

life.

Residual, or salvage, value is the net amount that can be expected to be obtained when the asset is disposed at the end of its service

life.


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Methods of Cost Allocation

Time-based methodsa. Straight-line

b. Accelerated (declining charge)1) Sum-of-the-years’-digits

2) Declining balance

Activity (or use) methods

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Depreciation

Problem Information

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Depreciation Rate =Cost – Residual Value

Service Life

= $120,000 – $20,000

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Time-Based Method: Straight LineTime-Based Method: Straight Line


= $20,000 per year

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Time-Based Method: Sum of the Years’ DigitsTime-Based Method: Sum of the Years’ Digits

Years of service Years of service Year Year remainingremaining atat

Number beginning of yearNumber beginning of year 11 5 5

22 4 4 3 3 3 3 4 4 2 2 5 5 1 1

Sum of the Years’ Digits = Sum of the Years’ Digits = 15 15

Years of service Years of service Year Year remainingremaining atat

Number beginning of yearNumber beginning of year 11 5 5

22 4 4 3 3 3 3 4 4 2 2 5 5 1 1

Sum of the Years’ Digits = Sum of the Years’ Digits = 15 15


n(n + 1) 30 2 2

n(n + 1) 30 2 2

= = 15

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Depreciation Book Value at Year Base Fraction Depreciation Year-End

2009 $100,000 5/15 $ 33,333 $86,6672010 100,000 4/15 26,667 60,0002011 100,000 3/15 20,000 40,0002012 100,000 2/15 13,333 26,6672013 100,000 1/15 6,667 20,000

$100,000

Residual Residual ValueValue



Time-Based Method: Sum of the Years’ DigitsTime-Based Method: Sum of the Years’ Digits

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Time-Based Method: Declining-BalanceTime-Based Method: Declining-Balance

Book Value at Book Value atYear Beginning of Year Rate Depreciation Year-End

2009 $120,000 40% $ 48,000 $72,0002010 72,000 40% 28,800 43,2002011 43,200 40% 17,280 25,9202012 25,920 — 5,920 20,0002013 20,000 — — 20,000

$100,000

Time-Based Method: Double-Declining BalanceTime-Based Method: Double-Declining Balance




PlugPlugPlugPlug

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Time-Based Method: Declining-BalanceTime-Based Method: Declining-Balance




Book Value at Book Value atYear Beginning of Year Rate Depreciation Year-End

2009 $120,000 30% $ 36,000 $84,0002010 84,000 30% 25,200 58,8002011 58,800 30% 17,640 41,1602012 41,160 30% 12,348 28,8122013 28,812 — 8,812 20,000

$100,000

Time-Based Method: 150%-Declining BalanceTime-Based Method: 150%-Declining Balance

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Activity MethodActivity Method

Assume the asset is used for 2,100 hours.

Depreciation = $21,000 (2,100 hours × $10)Depreciation = $21,000 (2,100 hours × $10)


Depreciation Rate =Cost – Residual Value

Total Lifetime Activity Level

= $120,000 – $20,000

10,000 hours

= $10 per hour

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The credit entry to record depreciation is to a contra-asset

account usually called Accumulated Depreciation or Allowance for Depreciation.

The credit entry to record depreciation is to a contra-asset

account usually called Accumulated Depreciation or Allowance for Depreciation.

Recording Depreciation

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Depreciation Expense

$

2009 2010 2011 2012 2013

During Year

Straight-Line

Sum-of-the-Years’-Digits

Double-Declining-Balance

Conceptual Evaluation of Depreciation Methods

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Book Value

$

2009 2010 2011 2012 2013

At End of Year

Straight-Line

Sum-of-the-Years’-Digits

Double-Declining-Balance


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If a company expects that repair and maintenance costs and the total

economic benefits of the asset will remain similar each period,…

If a company expects that repair and maintenance costs and the total

economic benefits of the asset will remain similar each period,…


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…a similar total cost each period can be achieved through straight-line

depreciation and the similar repair and maintenance costs.

…a similar total cost each period can be achieved through straight-line

depreciation and the similar repair and maintenance costs.


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If the company expects that benefits of having the asset will decline each year for the life of

the asset,…

If the company expects that benefits of having the asset will decline each year for the life of

the asset,…


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…and repairs and maintenance costs are constant each period, a declining total cost will be achieved by using

accelerated depreciation.

…and repairs and maintenance costs are constant each period, a declining total cost will be achieved by using

accelerated depreciation.


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Selection of Depreciation Method

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Effect of Depreciation on Rate of Return

Book Value of Asset Rate of Year Net Income at Beginning of Year Return

2009 $12,000 $120,000 10%2010 12,000 100,000 12 2011 12,000 80,000 152012 12,000 60,000 202013 12,000 40,000 30

2009 $12,000 $120,000 10%2010 12,000 100,000 12 2011 12,000 80,000 152012 12,000 60,000 202013 12,000 40,000 30

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Disclosure of Depreciation

Depreciation expense for the period Balance of major classes of depreciable assets,

by nature or function, at the balance sheet date Accumulated depreciation, either by major

classes of depreciable assets or in total, at the balance sheet date

A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets

GAAP requires the following:

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Disclosure of Depreciation

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IFRS vs. U.S. GAAP

IFRS require that depreciation be “systematic,” rather than “systematic and rational.”

IFRS also require that the estimated useful lives and residual values, and the depreciation method, be reviewed at least once a year. U.S. GAAP only requires this review when events or circumstances indicate that the estimate has changed.

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IFRS vs. U.S. GAAP

IFRS also require that companies disclose the accumulated depreciation for each class of asset, not just the total amount as allowed by U.S. GAAP.

IFRS require that when an operating asset is made up of individual components that are significant with respect to the total cost of the item (e.g., an airplane and its engines) that the initial cost be allocated to the significant components and each component be depreciated separately.

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IFRS vs. U.S. GAAP

U.S. GAAP neither requires nor prohibits a company from depreciating components.

IFRS allow a company to write up the value of its property, plant, and equipment assets to fair value. Such a write-up would affect the amount of depreciation that the company records each period.

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A company purchased 10

cars for $20,000 each, and the

average expected service

life is 3 years with a residual value of $5,000

each.

Group Depreciation

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To record the purchase:To record the purchase:

Cars 200,000 Cash 200,000

To record the first year’s depreciation expense:To record the first year’s depreciation expense:

Depreciation Expense 50,000 Accumulated Depreciation 50,000

This same depreciation entry would be made at the end of the second year.

This same depreciation entry would be made at the end of the second year.

$$200,000 200,000 –– $50,000 $50,00033

Group Depreciation

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To record the disposal of three cars at the end of the second year for $8,000 each:

To record the disposal of three cars at the end of the second year for $8,000 each:

Cash 24,000Accumulated Depreciation 36,000 Cars 60,000

To record the third year’s depreciation expense:To record the third year’s depreciation expense:


25% ($200,000 25% ($200,000 –– $60,000) $60,000)

Group Depreciation

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To record the disposal of five cars at the end of the third year for $6,000 each:

To record the disposal of five cars at the end of the third year for $6,000 each:

Cash 30,000Accumulated Depreciation 70,000 Cars 100,000

To record the fourth year’s depreciation expense:To record the fourth year’s depreciation expense:


To reduce the $11,000 book To reduce the $11,000 book value to the estimated residual value to the estimated residual

value.value.

Group Depreciation

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The final two cars were sold for $4,800 each.The final two cars were sold for $4,800 each.

Cash 9,600Accumulated Depreciation 30,000Loss on Disposal 400 Cars 40,000

To record the disposal of two cars at the end of the fourth year for $4,000 each, and the net gain

or loss of the entire group:

To record the disposal of two cars at the end of the fourth year for $4,000 each, and the net gain

or loss of the entire group:

Cash received Cash received $ 9,600 $ 9,600Book value Book value 10,000 10,000

LossLoss $ (400)$ (400)

Group Depreciation

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Residual Annual Asset Cost Value Life Depreciation

A $25,000 $5,000 10 years $2,000B 13,000 1,000 6 2,000C 12,000 — 4 3,000

$50,000 $6,000 $7,000

Depreciation Rate = = 14%7,000

$50,000

Composite Depreciation

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A company purchases a $6,000 asset with a three-year life and no residual value on August 18. The firm uses the double-declining-balance

method.

A company purchases a $6,000 asset with a three-year life and no residual value on August 18. The firm uses the double-declining-balance

method.

Depreciation for Partial Periods

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Declining-Balance-MethodDeclining-Balance-Method

Depreciation for Partial Periods

Year Computation Annual Depreciation

1 4/12 × $4,000$1,333

2 0.667 × ($6,000 – $1,333)3,113

3 0.667 × ($4,667 – $3,113)1,037

4 Remaining balance 517

$6,000

Two times straight-line rate = 2 × 1/3

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Impairment of Property, Plant, and Equipment

GAAP requires a company to review its property, plant, and equipment

for impairment.

GAAP requires a company to review its property, plant, and equipment

for impairment.

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Impairment occurs whenever events or changes in circumstances indicate that the book value of the property,

plant, and equipment may not be recoverable.

Impairment occurs whenever events or changes in circumstances indicate that the book value of the property,

plant, and equipment may not be recoverable.


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Impairment Test

If the total expected cash flows (undiscounted) are less than the book value of

the asset, an impairment loss is recognized.

Impairment Test

If the total expected cash flows (undiscounted) are less than the book value of

the asset, an impairment loss is recognized.

Measurement of the Loss

The loss is measured as the difference between the book value of the asset and the

present value of future cash flows.

Measurement of the Loss

The loss is measured as the difference between the book value of the asset and the

present value of future cash flows.


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On January 1, 2007, the Hall Company purchased a factory for $1 million (20-year life)

and machinery for $3 million (10-year life).

On January 1, 2007, the Hall Company purchased a factory for $1 million (20-year life)

and machinery for $3 million (10-year life).

Late in 2010, the company believes that its asset(s) may be impaired and the remaining

useful life is five years. The company estimates that the asset will produce cash inflows of

$700,000 and will incur cash outflow of $300,000 each year for the next five years.

Late in 2010, the company believes that its asset(s) may be impaired and the remaining

useful life is five years. The company estimates that the asset will produce cash inflows of

$700,000 and will incur cash outflow of $300,000 each year for the next five years.


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December 31, 2010Factory cost $ 1,000,000 Less: Accumulated depreciation

(4 years × $50,000) (200,000)Book value $ 800,000Machinery cost $ 3,000,000 Less: Accumulated depreciation

(4 years × $300,000) (1,200,000)Book value 1,800,000Total Book Value $2,600,000

Impairment TestImpairment Test


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= 5 × $400,000

= $2,000,000

Undiscounted expected net cash flows = 5 × ($700,000 – $300,000)

Years Years Cash Inflows

Cash Inflows

Cash Outflows

Cash Outflows

Because $2,000,000 is less than $2,600,000 (the book value), an

impairment loss must be recognized.

Because $2,000,000 is less than $2,600,000 (the book value), an

impairment loss must be recognized.

Impairment TestImpairment Test


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Measurement of the LossMeasurement of the Loss

Present value of the expectednet cash flows (fair value) = $400,000 × 3.274294

= $1,309,718 (rounded)

n = 5, i = 0.16 from

Table 4 in the Time Value of Money Module

n = 5, i = 0.16 from

Table 4 in the Time Value of Money Module

Fair value $(1,309,718) Book value 2,600,000Impairment loss $(1,290,282)


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GAAP does not specify how to record the write-down. It does indicate that the

reduced book value is to be accounted for as the new cost.

GAAP does not specify how to record the write-down. It does indicate that the

reduced book value is to be accounted for as the new cost.


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Loss from Impairment 1,290,282Accumulated Depreciation: Factory 200,000Accumulated Depreciation: Machinery 1,200,000Factory (new cost) 327,429Machinery (new cost) 982,289 Factory (old cost)

1,000,000 Machinery (old cost)

3,000,000$1,309,718 $1,309,718 ×× [$1,000,000 ÷ ($3,000,000 + $1,000,000)] [$1,000,000 ÷ ($3,000,000 + $1,000,000)]$1,309,718 $1,309,718 ×× [$1,000,000 ÷ ($3,000,000 + $1,000,000)] [$1,000,000 ÷ ($3,000,000 + $1,000,000)]

$1,309,718 $1,309,718 ×× [$3,000,000 ÷ ($3,000,000 + $1,000,000)] [$3,000,000 ÷ ($3,000,000 + $1,000,000)]$1,309,718 $1,309,718 ×× [$3,000,000 ÷ ($3,000,000 + $1,000,000)] [$3,000,000 ÷ ($3,000,000 + $1,000,000)]


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The recognition of an impairment loss is intended to enhance the usefulness of a

company’s financial statements.

The recognition of an impairment loss is intended to enhance the usefulness of a

company’s financial statements.

All these issues could result in earnings management. For example, management

might prefer to recognize as large a loss as possible, thereby reducing the book value to

the lowest possible amount. This would result in lower depreciation expense and

higher net income in the future.

All these issues could result in earnings management. For example, management

might prefer to recognize as large a loss as possible, thereby reducing the book value to

the lowest possible amount. This would result in lower depreciation expense and

higher net income in the future.

Conceptual Evaluation of Asset Impairment

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IFRS vs. U.S. GAAP

IFRS use a “trigger” value, which is the (1) higher of the asset’s fair value (less costs to sell), or (2) its usage value to determine if an asset is impaired. U.S. GAAP uses undiscounted cash flows.

Typically, this should mean that international companies will recognize impairment losses earlier than U.S. companies. Under IFRS, the impairment loss is the difference between the book value and the “trigger” value defined above.

IFRS allow an impairment loss to be reversed if the value is recovered, which is not allowed under GAAP.

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1. A mandated tax life, which is usually shorter than the economic life

2. Acceleration of the cost recovery (except for buildings)

3. Elimination of the residual value

For assets purchased in 1987 and later, the Modified Accelerated Cost Recovery System (MACRS) is required for tax purposes. A company’s computations of depreciation for income tax purposes and financial reporting purposes differ in three major respects:

Depreciation for Tax Purposes

On January 1, 2009, Melville Company purchased an asset for $200,000. The estimated economic life

and MACRS life are 8 years and 5 years, respectively. The estimated residual value is

$20,000.

On January 1, 2009, Melville Company purchased an asset for $200,000. The estimated economic life

and MACRS life are 8 years and 5 years, respectively. The estimated residual value is

$20,000.

Examine the next slide to determine the annual depreciation rates for 2009

through 2014

Examine the next slide to determine the annual depreciation rates for 2009

through 2014

MACRS Principles

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MACRS Percentages

Determine depreciation for 2009–2014.Determine depreciation for 2009–2014.

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2009 $200,000 × 20% = $ 40,0002010 $200,000 × 32% = $ 64,0002011 $200,000 × 19.20% = $ 38,4002012 $200,000 × 11.52% = $ 23,0402013 $200,000 × 11.52% = $ 23,0402014 $200,000 × 5.76% = $ 11,520

$200,000

MACRS Principles

Annual Tax Year Cost MACRS % Depreciation

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Changes and Corrections of Depreciation

1. A change in an estimate of the residual value or the service life of a currently owned asset is accounted for prospectively.

2. A change in the depreciation method for currently owned assets is also accounted for prospectively.

3. A correction of an error in depreciation is accounted for as a prior period adjustment (restatement).

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Depletion

Depletion of natural resources is calculated using an activity method.

Any environmental costs at the end of the project are added to the cost in determining depletion per unit.

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Depletion

Unit Depletion Rate =Cost – Residual Value

Units

Reggio Company purchases land for $3,000,000 from which it expects to extract 1,000,000 tons of

coal, the estimated residual value is $200,000, and it mines 80,000 tons of coal in the first year.

Reggio Company purchases land for $3,000,000 from which it expects to extract 1,000,000 tons of

coal, the estimated residual value is $200,000, and it mines 80,000 tons of coal in the first year.

Unit Depletion Rate =$3,000,000 – $200,000

1,000,000 tons

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Unit Depletion Rate =Cost – Residual Value

Units

Unit Depletion Rate =$3,000,000 – $200,000

1,000,000 tons

Unit Depletion Rate = $2.80 per ton

Depletion for Year = $2.80 × 80,000 tons = $224,000

Depletion

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Revised Depletion Estimate

Suppose that at the beginning of the second year of operation, a new estimate indicates that the

mine has a capacity to produce another 1,600,000 tons (for a lifetime production of 1,680,000 tons).

What is the new depletion rate?

Suppose that at the beginning of the second year of operation, a new estimate indicates that the

mine has a capacity to produce another 1,600,000 tons (for a lifetime production of 1,680,000 tons).

What is the new depletion rate?

Unit Depletion Rate =($3,000,000 – $224,000) – $200,000

1,600,000 tons

= $1.61 per ton

Unit Depletion Rate =Book Value – Residual Value

Remaining Units

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Chapter 11

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depreciation and depletion c hapter 11 copyright © 2010 south-western/cengage learning intermediate...

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depreciation book value

record depreciation

compute depreciation

corrections of depreciation

disclosure of depreciation

asset costthe cost

service lifethe factors

service lifethe service