chapter 11

Kun Yu, Intermediate Accounting I 11-1

AF310- Intermediate Accounting I

Chapter 11 Depreciation, Impairments,

and Depletion


Cost Allocation The goal is to provide a reasonable and consistent matching

of revenue and expense over the asset’s estimated useful life.

PPE: Depreciation Depreciation is the accounting process of allocating the cost of

tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset.

Natural Resources: Depletion Intangible assets: Amortization

Cost

Allocation

(Unused)

Balance Sheet

(Used)

Income Statement

ExpenseAcquisition

Cost


How to Determine Depreciation Expense?

Determine depreciation base Depreciable cost = Acquisition cost -

Residual value Residual value: is the estimated amount to

be recovered at the end of the estimated useful life of the asset (also called terminal value, disposal value, salvage value or scrap value).

Determine useful life Determine the cost allocation method


Cost Allocation – Journal Entry

Recording depreciation expense (impacts the I/S):

Dr. Cr.Depreciation Expense (+E, -SE) XX

Accumulated Depreciation (+XA, -A) XX

The total amount of depreciation expense for an asset reduces the carrying value of the asset in the B/S

Asset Cost- Accumulated Depreciation

Book Value of Asset

BV Assets ≠ Market Value Assets. E.g. Chrysler building. Accumulated Depreciation – it is a contra-asset account. This is done regardless of the method used for depreciation

expense.


Allocation Methods Straight-line depreciation

Constant decline in dollar amounts with time

Units-of-production depreciation Proportional to annual production and usage

Accelerated depreciation Sum of the years’ digits Declining balance depreciation

Constant % decline with time Usually double-declining-balance (DDB).

Modified accelerated cost recovery system (Tax purposes)


2007 Survey of 600 major U.S. Companies

Straight-line 592 Units of production 23 Sum of the years’ digits 5 Declining balance 16 Accelerated-unspecified 27


Example

Delta Airlines Acquisition cost of repair truck :$62,500

(purchased on Jan. 1, 1996) Est. Useful life (years) : 3 Est. residual value :$2,500 Est. life in units (miles) :100,000 miles

Actual miles driven in:first year: 30,000 milessecond year: 50,000 milesthird year: 20,000 miles


Straight-Line DepreciationAnnual Depreciation Expense =

(acquisition cost-residual value)/useful life

Depreciation expense for 1996:

Journal Entry:

($62,500-2,500)/3=$20,000

Dr. Cr. . Depreciation expense (+E,-SE) $20,000

Accumulated depreciation (+XA, -A) $20,000


Straight-Line Depreciation

End of Period End of Period Year Bal. of Truck

asset account Annual

Depreciation Exp

Accumulated Depreciation

Book Value of Asset

1

2

3

$62,500

$62,500

$62,500

$20,000$20,000$20,000

$20,000$40,000$60,000

$42,500$22,500

$2,500


Units-of-ProductionAnnual Depreciation Expense =

Annual units of production (or usage)* Depreciation rate per unit

Depreciation rate per unit = (Acquisition cost – Salvage value) / Estimated total units of production (or usage)

Depreciation rate per unit in the example is:($62,500-2,500)/100,000=$0.60


Units-of-Production


asset account Annual Depreciation Exp


Book Value of Asset

1

2

3

$62,500

$62,500

$62,500

$18,000$30,000$12,000

$18,000$48,000$60,000

$44,500$14,500

$2,500

Depreciation expense: 1st yr—30,000*$0.6 =$18,0002nd yr—50,000*$0.6=$30,0003rd yr—20,000* $0.6=$12,000


Sum of the Years’ Digits Depreciation Expense =Depreciation Base* Number of

Years Remaining/Sum of Years Depreciation Base = Acquisition Cost – Residual Value


Sum of the Years’ Digits




Book Value of Asset

1

2

3

$62,500

$62,500

$62,500

$30,000$20,000$10,000

$30,000$50,000$60,000

$32,500$12,500

$2,500

Depreciation expense: 1st yr—60,000*3/6 =$30,0002nd yr—60,000*2/6=$20,0003rd yr—60,000* 1/6=$10,000


Declining Balance

AnnualDepreciation

expense

NetBook

Value at Year

Beginning( )Useful Life in Years

2= ×

Cost – Accumulated Depreciation

Declining balance rate of 2 isdouble-declining-balance (DDB) rate.

Annual computation ignores residual value.Annual computation ignores residual value.


Double-Declining-Balance




Book Value of Asset

1

2

3

$62,500

$62,500

$62,500

$41,667$13,889$4,444

$41,667$55,556$60,000

$20,833$6,944

$2,500Depr exp: 1st yr--- $62,500*(2/3)=$41,667

Depr exp: 2nd yr--- ($62,500 - $41,667)*(2/3)=$20,833*(2/3)=$13,889Depr exp: 3rd yr--- $6,944*(2/3)=$4,629. But then the book value of asset would have been $2,315 < salvage value. Need to set depreciation expense to $4,444 to bring the net book value of the asset to $2,500.


How do Managers choose? Method that best matches the use of the asset to

revenues it generates.

Accelerated Methods – Assets are more efficient (produce more revenues) in early years (thus need to match to more expenses).

Companies can use different depreciation methods for different assets. Note disclosure for depreciation methods used

and estimated useful lives selected is required. When a depreciation method is chosen for an

asset, it should be consistently applied.


Modified Accelerated Cost Recovery System (MACRS).

The method used for tax purposes. Different from GAAP methods.

Tax laws mandate the lives and depreciation rates to be used. MACRS delays the payment of income taxes, as it allocates more of the depreciable cost in the early years of an asset.

Theoretically, this delay will reverse in the later years of an asset; however, as long as a company continues to purchase new assets, the tax will continue to be delayed.


Tax and Timing Effects Companies generally must maintain two sets of

accounting records. For financial reporting according to GAAP. For Income tax purposes according to IRC.

Why? Why would a firm prefer accelerated

depreciation for tax purposes? Why does the government allow this?

Why not use the tax method for financial reporting?Provide economic information about the business so that decision makers can make future cash flows predictions.

Driven by the government's focus to secure revenues. Taxpayers want to pay the smallest amount of tax at the latest possible date.

To save on taxes.

Income tax and Financial reporting serve different purposes.


Extra Problem on PPEHaley Company has the following account balances for the year ended December 31, 2002.

12/31/02 12/31/01Equipment $900,000 $650,000Accumulated depreciation -equipment 360,000 306,000Gain on sale of equipment 22,000

During 2002, Haley sold for $88,000 a piece of equipment that originally cost $140,000, and purchased several pieces of equipment. Based on the above information, what is the

(i) depreciation expense for 2002?(ii) amount of equipment purchased during 2002?


Extra Problem on PPE (cont.)

Solution :

Haley Company: Gain (Loss) on Sale = [Selling price – BV]If Selling Price= $88 and Gain on Sale = $22 then BV= 66

Now, we know that BV = Cost of Equipment – A/D (accumulated depreciation)If Cost of Equip. sold = $140 and BV = $66 then A/D on Equip. Sold = $74

PPE BB 650 BB 306

Purchase of Equip 140390 Sale of PPE 140 A/D on Equip. sold 74 Dep. Expense 128

EB 900 EB 360

A/D (Acc. Depreciation)


Change of Estimates Acquisition cost of an aircraft $60 million Est. useful life 20 years Est. residual value $3 million SL depreciation method is used. At the start of the 7th year, est. useful

life changed to 16 years, residual value changed to $900,000.

What is the depreciation expense for years 1 thru 6?

Depreciation expense for years 1-6 ($60-3)/20=$2.85 M


Change of Estimates Depreciation expense for the 7th year

onward:

Changes are applied to current and future periods. Changes in depreciation estimates can be caused by

change in asset life or residual value. Waste Management overstated NI in the amount of $1.43

billion by increasing salvage value of assets among other things…

Acquisition cost $60Less: A/D end of year 6 17.1 = (60-3)/20*6Undepreciated balance/BV 42.9

Less: New residual value 0.9 New depreciable amount 42.0 remaining useful life: 10 years New depr exp each year=$42/10=$4.2M

Dr. CrDepreciation exp $4.2 Accum. depreciation $4.2


Change of Estimates New Depreciation Expense:

(Net Book Value – New residual value) (Remaining Life of asset)


What if in the previous example, the firm had spent 1 million in cash to maintain and improve efficiency of the aircraft (major replacement) at the end of year 6? How do we account for the improvement?

Change of Estimates (Cont.)

Capitalize the cost.

New Depreciation Expense for year 7

Dr. CrPPE 1

Cash 1

New book value = 42.9 + 1 =43.9

Depreciation Expense = (43.9-0.9)/10


Depreciation and Partial Periods

Disposal of Assets Cost of equipment acquired on Jan 1, Yr 2001 =$10 million Straight line depreciation method used. Useful life is 3 years

and residual value is $1 million. The firm sold the equipment for $2 million in cash on July 1,

Yr 2003. Calculate the gain or loss on the sale

Make the journal entry.

Straight line depreciation/year = (10-1)/3=3BV equipment at the time of sale = 10-(3+3+1.5) = 2.5 Price - BV equipment = 2 – 2.5 = loss = -0.5

Dr. Cr.Cash (+A) 2Acc. Depr. (Equipment) (-XA, +A) 7.5Loss (-SE) 0.5

Equipment (-A) 10


Asset impairment The value of tangible and intangible assets

must be reviewed for possible impairment.

Two-step test: If estimated future cash flows < book value Impairment loss = Market value (or fair value of

assets) – book value.

Example: Asset (building) acquisition cost=$10 million Accumulated depreciation=$4 million Estimated future cash flows =$5 million Fair value of asset=$4 million


Asset impairment Previous example continued:

Is the asset impaired?

If yes, what’s the impairment loss?

What should be the journal entry?

Yes. Future CF=$5 <BV =$6

Impairment loss=Fair value - BV =$4-$6=-$2

Account Dr. Cr.Loss on Impairment $2

Accumulated Depr $2


E11-16 (Impairment): Presented below is information related to equipment owned by Pujols Company at December 31, 2010. Assume that Pujols will continue to use this asset in the future. As of December 31, 2010, the equipment has a remaining useful life of 4 years.

Instructions:

(a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2010.

(b) Prepare the journal entry to record depreciation expense for 2011.

(c) The fair value of the equipment at December 31, 2011, is $5,100,000. Prepare the journal entry (if any) necessary to record this increase in fair value.

Cost 9,000,000$ Accumulated depreciation to date 1,000,000 Expected future net cash flows 7,000,000 Fair value 4,400,000

Another Example: Asset Impairment


Loss on impairment 3,600,000

Accumulated depreciation 3,600,000

Cost $9,000,000


Carrying amount 8,000,000

Fair value 4,400,000

Loss on impairment $3,600,000

(a).(a).

12/31/10


Depreciation expense 1,100,000


Net carrying amount $4,400,000

Useful life 4 years

Depreciation per year $1,100,000

(b).(b).

(c).(c). Restoration of any impairment loss is not permitted.

12/31/11


Depletion of Natural Resources

Annual Depletion Expense = Annual units of production* Depletion

Cost per unit

Depletion Cost per Unit = (Total cost – Salvage value) /

Estimated total units Available


An Example: Depletion Apex Mining acquired a tract of land

containing ore deposits. Total costs of acquisition and development were $1,000,000 and Apex estimates the land contained 40,000 tons of ore. During the first year of operations Apex extracted and sold 13,000 tons of ore.


Step 2: Depletion Expense

= $25 per ton × 13,000 units = $325,000

Step 1:DepletionPer Unit

= $1,000,000 - $0 40,000 tons

= $25 per ton

Depletion Expense

8-33


Journal Entries to Record Depletion

Record Depletion expense: Dr. Depletion expense 325,000 Cr. Accumulated depletion 325,000

What if the company sold the 13,000 units next year?

Record Depletion:

Dr. Inventory 325,000 Cr. Accumulated Depletion 325,000

When they are sold in the next year

Dr. Depletion expense/Cogs 325,000 Cr. Inventory 325,000

chapter 11

Documents

depreciation depreciation

recording depreciation

balance depreciation

se accumulated depreciation

usage depreciation rate

expense net book value

acquisition cost salvage

disposal value