depreciation and depletion

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Depreciation Depreciation and Depletionand DepletionDepreciation Depreciation and Depletionand Depletion

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1. Identify the factors involved in depreciation.

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

3. Record depreciation.4. Explain the conceptual issues regarding

depreciation methods.5. Understand the disclosure of depreciation.

ObjectivesObjectives

ContinuedContinuedContinuedContinued

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

7. Compute depreciation for partial periods.

8. Explain the impairment of noncurrent assets.

9. Understand depreciation for income tax purposes.

10. Explain changes and corrections of depreciation.

11. Understand and record depletion.

ObjectivesObjectives

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Factors Involved in DepreciationFactors Involved in Depreciation

Asset costService lifeResidual valueMethod of cost

allocation

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Factors Involved in DepreciationFactors Involved in Depreciation

Service LifeService Life

Service life is the measure of the number of units of service expected from the asset before its disposal.

Service life is the measure of the number of units of service expected from the asset before its disposal.

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Factors Involved in DepreciationFactors Involved in Depreciation

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 causesFunctional causes

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Factors Involved in DepreciationFactors Involved in Depreciation

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 AllocationMethods of Cost Allocation

• Activity (or use) methods

• Time-based methodsa. Straight-line

b. Accelerated (declining charge)(1) Sum-of-the-years’-digits (2) Declining balance

• Activity (or use) methods

• Time-based methodsa. Straight-line

b. Accelerated (declining charge)(1) Sum-of-the-years’-digits (2) Declining balance

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Methods of Cost AllocationMethods of Cost Allocation

Activity MethodsActivity Methods

Depreciation Rate =Cost – Residual Value

Total Lifetime Activity Level

= $120,000 – $20,000

10,000 hours

Assume the asset is used for 2,100 hours.Depreciation = $2,100 (2,100 hours x $10)

= $10 per hour

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Methods of Cost AllocationMethods of Cost Allocation

Depreciation Rate =Cost – Residual Value

Service Life

= $120,000 – $20,000

5 Years

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

= $20,000 per year

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Methods of Cost AllocationMethods of Cost Allocation

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

Depreciation Book Value atYear Base Fraction Depreciation Year-End

2003 $100,000 5/15 $ 33,333 $86,6672004 100,000 4/15 26,667 60,0002005 100,000 3/15 20,000 40,0002006 100,000 2/15 13,333 26,6672007 100,000 1/15 6,667 20,000

$100,000

Residual Residual ValueValue

Residual Residual ValueValue

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Methods of Cost AllocationMethods of Cost Allocation

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

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

2003 $120,000 40% $ 48,000 $72,0002004 72,000 40% 28,800 43,2002005 43,200 40% 17,280 25,9202006 25,920 --- 5,920 20,0002007 20,000 --- --- 20,000

$100,000

Double-Declining BalanceDouble-Declining Balance

Residual Residual ValueValue

Residual Residual ValueValue

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Methods of Cost AllocationMethods of Cost Allocation

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

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

2003 $120,000 30% $ 36,000 $84,0002004 84,000 30% 25,200 58,8002005 58,800 30% 17,640 41,1602006 41,160 30% 12,348 28,8122007 28,812 --- 8,812 20,000

$100,000

150%-Declining Balance150%-Declining Balance

Residual Residual ValueValue

Residual Residual ValueValue

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Recording DepreciationRecording Depreciation

The credit to depreciation is usually called Accumulated Depreciation or Allowance

for Depreciation.

The credit to depreciation is usually called Accumulated Depreciation or Allowance

for Depreciation.

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Recording DepreciationRecording Depreciation

The account title Reserve for Depreciation is considered undesirable because of the

uncertain meaning of “reserve.”

The account title Reserve for Depreciation is considered undesirable because of the

uncertain meaning of “reserve.”

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Conceptual Evaluation of Depreciation Methods

Conceptual Evaluation of Depreciation Methods

Depreciation Expense

$

2003 2004 2005 2006 2007

During Year

Straight-Line

Sum-of-the-Years-Digits

Double-Declining-Balance

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Conceptual Evaluation of Depreciation Methods

Conceptual Evaluation of Depreciation Methods

Book Value

$

2003 2004 2005 2006 2007

At End of Year

Straight-Line

Sum-of-the-Years-Digits

Double-Declining-Balance

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Conceptual Evaluation of Depreciation Methods

Conceptual Evaluation of Depreciation Methods

If a company expects that repairs and maintenance costs and the total economic benefits of the asset will

remain similar each period,...

If a company expects that repairs and maintenance costs and the total economic benefits of the asset will

remain similar each period,...

…a similar total cost each period can be achieve through straight-line depreciation and the similar repair

and maintenance costs.

…a similar total cost each period can be achieve through straight-line depreciation and the similar repair

and maintenance costs.

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Conceptual Evaluation of Depreciation Methods

Conceptual Evaluation of Depreciation Methods

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, ...

…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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Effect of Depreciation on Rate of Return

Effect of Depreciation on Rate of Return

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

2003 $12,000 $120,000 10%2004 12,000 100,000 12 2005 12,000 80,000 152006 12,000 60,000 202007 12,000 40,000 30

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Disclosure of DepreciationDisclosure of Depreciation

Depreciation expense for the period. Balances 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.

APB Opinion No. 12 requires the following disclosure:

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Disclosure of DepreciationDisclosure of Depreciation

Number of Companies

2000 1997 1994 1990 1986 1982

Straight-line ……...….576 578 573 560 561 562Declining-balance.….. 22 26 27 38 49 57Sum-of-the-years- digits ………………. 7 10 9 11 14 20Accelerated method, not specified……….. 53 50 49 69 77 69Units-of-production…. 34 39 49 50 48 62

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Group DepreciationGroup Depreciation

A company purchased ten

cars for $20,000 each, and the

average expected life is 3 years

with a residual value of $5,000

each.

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Group DepreciationGroup Depreciation

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 in the end of the second year.

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

$200,000 – $50,000$200,000 – $50,000

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Group DepreciationGroup Depreciation

Three cars were sold after 2 years for $8,000 each.Three cars were sold after 2 years 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.

Depreciation Expense 35,000 Accumulated Depreciation 35,000

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

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Group DepreciationGroup Depreciation

Five cars were sold after 3 years for $6,000 each.Five cars were sold after 3 years 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.

Depreciation Expense 1,000 Accumulated Depreciation 1,000

To reduce the $11,000 book To reduce the $11,000 book value to the salvage value.value to the salvage value.

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Group DepreciationGroup Depreciation

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

Group DepreciationGroup Depreciation

Two cars were sold after 3 years for $4,800 each.Two cars were sold after 3 years for $4,800 each.

Book value = Book value = $10,000$10,000Cash received =Cash received = 9,600 9,600 LossLoss $ 400$ 400

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Composite DepreciationComposite Depreciation

AnnualAsset Cost Residual Value Life Depreciation

A $25,000 $5,000 10 yrs. $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

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Annual Year Depreciation

Depreciation for Partial PeriodsDepreciation for Partial Periods

1 3/6 x $6,000 = $3,000 x 4/12 = $1,000 2 $3,000 x 8/12 2/6 x $6,000 = $2,000 x 4/12 = 2,667 3 $2,000 x 8/12 1/6 x $6,000 = $1,000 x 4/12 = 1,667 4 $1,000 x 8/12 = 666

$6,000

A company purchases a $6,000 asset with a 3-year life and no residual value on August 18. The firm uses the sums-

of-the-years’-digits method.

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Annual Year Depreciation

Depreciation for Partial PeriodsDepreciation for Partial Periods

1 2/3 x $6,000 = $4,000 x 4/12 = $1,333 2 $4,000 x 8/12 2/3 x $2,000 = $1,333 x 4/12 = 3,111 3 $1,333 x 8/12

$667 x 4/12 = 1,111 4 $667 x 8/12 = 445

$6,000

A company purchases a $6,000 asset with a 3-year life and no residual value on August 18. The firm

uses the double-declining-balance method.OROR

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Depreciation for Partial PeriodsDepreciation for Partial Periods

Annual Year Depreciation

1 4/12 x $4,000 = $1,333 2 0.667 x ($6,000 – $1,333) = 3,113 3 0.667 x ($4,667 – $3,113) = 1,037 4 Remaining balance = 517

$6,000

Declining-Balance-MethodDeclining-Balance-Method

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Impairment of Noncurrent AssetsImpairment of

Noncurrent AssetsThe FASB issued FASB Statement No. 144 which

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

for impairment.

The FASB issued FASB Statement No. 144 which

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

for impairment.

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Impairment of Noncurrent AssetsImpairment of

Noncurrent AssetsImpairment occurs whenever

events or changes in circumstances indicate that the

book value of a noncurrent asset may not be recoverable.

Impairment occurs whenever events or changes in

circumstances indicate that the book value of a noncurrent asset

may not be recoverable.

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Impairment of Noncurrent AssetsImpairment of

Noncurrent Assets

An impairment loss involves the following steps:

Events or Changes in Circumstances Occurs

Impairment Test

(Undiscounted Cash Flows < Book Value of Asset)

Measurement of Loss

(Loss = Fair Value – Book Value)

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Impairment of Noncurrent AssetsImpairment of

Noncurrent Assets

On January 1, 2001, the Hall Company purchased a factory for $1 million (20-year life)

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

On January 1, 2001, the Hall Company purchased a factory for $1 million (20-year life)

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

Late in 2004, the company believes that its asset(s) may be impaired and the remaining

useful life is 5 years. The company estimates that the asset will produce cash inflows of

$700,000 and incur cash outflow of $300,000 each year for the next 5 years.

Late in 2004, the company believes that its asset(s) may be impaired and the remaining

useful life is 5 years. The company estimates that the asset will produce cash inflows of

$700,000 and incur cash outflow of $300,000 each year for the next 5 years.

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December 31, 2004Factory cost $1,000,000 Less: Accumulated depreciation

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

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

Impairment TestImpairment Test

Impairment of Noncurrent AssetsImpairment of

Noncurrent Assets

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= 5 x $400,000

= $2,000,000

Impairment TestImpairment Test

Undiscounted expected net cash flows = 5 x ($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 of Noncurrent AssetsImpairment of

Noncurrent Assets

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Measurement of the LossMeasurement of the Loss

Present value of the expectedcash flows (fair value)

= $400,000 x 3.274294

= $1,309,718 (rounded)

n= 5, i = 0.16 from Table 4 in Appendix

n= 5, i = 0.16 from Table 4 in Appendix

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

Impairment of Noncurrent AssetsImpairment of

Noncurrent Assets

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The Statement 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.

The Statement 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.

Impairment of Noncurrent AssetsImpairment of

Noncurrent Assets

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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

Impairment of Noncurrent AssetsImpairment of

Noncurrent Assets

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

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Conceptual Evaluation of Asset Impairment

Conceptual Evaluation of Asset Impairment

Although FASB Statement No. 121 has been replaced by FASB Statement No. 144, the

principles it established have only changed slightly.

Although FASB Statement No. 121 has been replaced by FASB Statement No. 144, the

principles it established have only changed slightly.

Although the Statement narrows GAAP, it still allows for significant management flexibility.

Although the Statement narrows GAAP, it still allows for significant management flexibility.

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MACRS PrinciplesMACRS Principles

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

2. The acceleration of the cost recovery (except for buildings).

3. The elimination of residual value.

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

2. The acceleration of the cost recovery (except for buildings).

3. The elimination of residual value.

For an asset purchased in 1987 and later, a company’s computation of depreciation for income tax and financial reporting differ in three major respects:

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MACRS PrinciplesMACRS Principles

On January 1, 2003 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, 2003 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 Exhibit l0-12 to determine the annual depreciation rate for 2003.

Examine Exhibit l0-12 to determine the annual depreciation rate for 2003. 20%20%

Determine depreciation for 2003-2008.Determine depreciation for 2003-2008.

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MACRS PrinciplesMACRS Principles

2003 $200,000 x 20% = $ 40,0002004 $200,000 x 32% = 64,0002005 $200,000 x 19.20% = 38,4002006 $200,000 x 11.52% = 23,0402007 $200,000 x 11.52% = 23,0402008 $200,000 x 5.76% = 11,520

$200,000

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Changes and Corrections of Depreciation

Changes and Corrections of Depreciation

A change in the depreciation method for currently owned assets is accounted for by a cumulative-effect change.

Adoption of a new depreciation method for newly acquired assets does not require any adjustment to the accounts.

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

Correction of an error in depreciation is treated as prior period adjustment.

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DepletionDepletion

Unit Depletion Rate =Cost – Residual Value

Units

A 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 2003.

A 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 2003.

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

1,000,000 tons

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DepletionDepletion

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 x 80,000 = $224,000

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Chapter10

The EndThe EndThe EndThe End

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