depreciation and depletion c hapter 11 an electronic presentation by norman sunderman angelo state...

Depreciation and Depletion

Chapter11

An electronic presentation by Norman Sunderman Angelo State University

An electronic presentation by Norman Sunderman Angelo State University

COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Intermediate AccountingIntermediate Accounting 10th edition 10th edition

Nikolai Bazley JonesNikolai Bazley Jones

2

Factors Involved in Depreciation

Asset costService lifeResidual valueMethod of cost

allocation

3

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.


4

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


5

Residual ValueResidual Value

Residual, or salvage value, is the net amount that can be

expected to be obtained when the asset is disposed.

Residual, or salvage value, is the net amount that can be

expected to be obtained when the asset is disposed.


6

Methods of Cost Allocation

Activity (or use) methodsTime-based methods

a. Straight-lineb. Accelerated (declining charge)

(1) Sum-of-the-years’-digits (2) Declining balance

7

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


8

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


Years of service remaining at beginning of year Years Years of service remaining at beginning of year Years RemainingRemaining

11 5 522 4 433 3 344 2255 11

Sum-of-the-Years’-Digits = Sum-of-the-Years’-Digits = 1515 15 15

Years of service remaining at beginning of year Years Years of service remaining at beginning of year Years RemainingRemaining

11 5 522 4 433 3 344 2255 11

Sum-of-the-Years’-Digits = Sum-of-the-Years’-Digits = 1515 15 15

(n + 1) n = 30 = 15

2 2

(n + 1) n = 30 = 15

2 2


9



Depreciation Book Value at Year Base Fraction Depreciation Year-End

2006 $100,000 5/15 $ 33,333 $86,6672007 100,000 4/15 26,667 60,0002008 100,000 3/15 20,000 40,0002009 100,000 2/15 13,333 26,6672010 100,000 1/15 6,667 20,000

$100,000

Residual Residual ValueValue



10

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

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

2006 $120,000 40% $ 48,000 $72,0002007 72,000 40% 28,800 43,2002008 43,200 40% 17,280 25,9202009 25,920 --- 5,920 20,0002010 20,000 --- --- 20,000

$100,000

Double-Declining BalanceDouble-Declining Balance




PlugPlugPlugPlug

11

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

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

2006 $120,000 30% $ 36,000 $84,0002007 84,000 30% 25,200 58,8002008 58,800 30% 17,640 41,1602009 41,160 30% 12,348 28,8122010 28,812 --- 8,812 20,000

$100,000

150%-Declining Balance150%-Declining Balance




12

Activity MethodActivity Method

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

= $10 per hour


13

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.

Recording Depreciation

14

Depreciation Expense

$

2006 2007 2008 2009 2010

During Year

Straight-Line

Sum-of-the-Years-Digits

Double-Declining-Balance

Conceptual Evaluation of Depreciation Methods

15

Book Value

$

2006 2007 2008 2009 2010

At End of Year

Straight-Line

Sum-of-the-Years-Digits

Double-Declining-Balance


16

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,...


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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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Effect of Depreciation on Rate of Return

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

2006 $12,000 $120,000 10%2007 12,000 100,000 12 2008 12,000 80,000 152009 12,000 60,000 202010 12,000 40,000 30

2006 $12,000 $120,000 10%2007 12,000 100,000 12 2008 12,000 80,000 152009 12,000 60,000 202010 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.

APB Opinion No. 12 requires the following:

22

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.

Group Depreciation

23

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.

$$200,000 200,000 –– $50,000 $50,000

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Group Depreciation

24

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.


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

Group Depreciation

25

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.


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

Group Depreciation

26

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

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

Group Depreciation

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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

Composite Depreciation

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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.

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.

Depreciation for Partial Periods

29

1 $6,000 x 2/3 x 4/12 = $1,3332 ($6,000-$1,333) x 2/3 = $3,111

3 ($4,667-$3,111) x 2/3 = 1,037

4 Remaining balance = $ 518

Annual Year Depreciation

Declining-Balance-MethodDeclining-Balance-Method

Depreciation for Partial Periods

30

Impairment of Noncurrent Assets

The 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.

31

Impairment of Noncurrent Assets

Impairment 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.

32

Impairment of a Noncurrent Asset

Impairment Test

If the total undiscounted cash flows are less than the book value of the asset, an

impairment loss is recognized.

Impairment Test

If the total undiscounted cash flows 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.

33


On January 1, 2004, the Hall Company purchased a factory for $1 million (20-year life) and machinery for $3 million (10-year

life).

On January 1, 2004, the Hall Company purchased a factory for $1 million (20-year life) and machinery for $3 million (10-year

life).

Late in 2007, 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 2007, 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.

34

December 31, 2007Factory cost $1,000,000 Less: Accumulated depreciation(4 x $50,000) (200,000)Book value $ 800,000Machinery cost $3,000,000 Less: Accumulated depreciation(4 x $300,000) (1,200,000)Book value 1,800,000Total Book Value $2,600,000

Impairment TestImpairment Test


35

= 5 x $400,000

= $2,000,000

Impairment TestImpairment TestUndiscounted 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.


36

Measurement of the LossMeasurement of the Loss

Undiscounted annual cash flowsPresent 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


37

FASB Statement No. 121 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.

FASB Statement No. 121 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.


38

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


39

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.

Conceptual Evaluation of Asset Impairment

40

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

Depreciation for Tax Purposes

41

On January 1, 2006, 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, 2006, 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 l1-3 to determine the annual depreciation rate for 2006.

Examine Exhibit l1-3 to determine the annual depreciation rate for 2006.

20%20%Determine depreciation for 2006-2011.Determine depreciation for 2006-2011.

MACRS Principles

42

Changes and Corrections of Depreciation

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

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

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

43

Depletion

Depletion of natural resources is calculated using the units of activity method

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

44

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

45

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

Depletion

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Chapter11

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depreciation and depletion c hapter 11 an electronic presentation by norman sunderman angelo state...

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