Depreciation, Impairments, and Depletion Intermediate Accounting, 10th Edition Kieso, Weygandt, and Warfield Chapter 11: Depreciation, Impairments, and Depletion Prepared by Krish Ranganathan, Angelo State University San Angelo, Texas 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Methods of Depreciation Part 1: Methods of Depreciation 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Depreciation - Concept Depreciation is a means of cost allocation. It is not a method of valuation. Depreciation involves: allocating the cost of tangible assets to expense in a systematic and rational manner to periods expected to benefit from use of assets 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Factors in the Depreciation Process Questions to be answered: What is the depreciable base of the asset? What is the asset’s useful life? What method of cost apportionment is best for the asset in question? 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.) Depreciable Base Depreciable base is the amount subject to depreciation. It is determined as: Original cost of the asset less Estimated salvage or disposal value 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Estimated Service Lives An asset’s service life and physical life are not the same. Assets are retired (from productive life) due to: physical factors (such as casualty), or economic factors (such as obsolescence) Economic factors in turn include Inadequacy (asset can not meet current demand) Supercession (by a better asset) Obsolescence (other factors) 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.) Depreciation Methods Depreciation methods can be classified as follows: Tax depreciation methods Financial accounting Depreciation methods Financial accounting methods are: straight-line accelerated methods, or special methods 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Depreciation Methods: Overview Financial Accounting Depreciation Methods Tax Depreciation Straight-line method Activity method Accelerated methods Special methods 1. Declining Balance 2. Sum-of-the-years’ digits 1. Composite method 2. Hybrid methods 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Depreciation Methods: Example Amber corporation buys a truck on January 1, 2000. Information relating to the truck is as follows: Cost, $34,000 Estimated service life, 5 years (or 60,000 miles) Salvage value end of five years or use, $4,000 Actual miles driven: 20,000 miles (in 2000); 15,000 miles (in 2001) 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.) Straight-line method 1. Depreciable base = $34,000 less $4,000 = $30,000 2. Annual depreciation = $30,000 / 5 years = $6,000 3. Depreciation Schedule: (years 1 and 2) Year Book Depreciation Accumulated Book value (beg) Depreciation end of year 1 $34,000 $6,000 $6,000 $28,000 2 $28,000 $6,000 $12,000 $22,000 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Activity method (unit = mile) 1. Depreciable base = $34,000 less $4,000 = $30,000 2. Depreciation per mile = $30,000 / 60,000 = $0.50 3. Depreciation (2000) = $0.50 * 20,000 miles = $10,000 4. Depreciation Schedule: (years 1 and 2) Year Book Depreciation Accumulated Book value (beg) Depreciation end of year 1 $34,000 $10,000 $10,000 $24,000 2 $24,000 $ 7,500 $17,500 $16,500 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Sum-of-the-years’-digits (SYD) method 1. Depreciable base = $34,000 less $4,000 = $30,000 2. SYD fraction = (1+2+3+4+5) = 15 3. Depreciation (2000) = $30,000 * (5/15) = $10,000 Depreciation (2001) = $30,000 * (4/15) = $ 8,000 Depreciation (2002) = $30,000 * (3/15) = $ 6,000 Depreciation (2003) = $30,000 * (2/15) = $ 4,000 Depreciation (2004) = $30,000 * (1/15) = $ 2,000 Decreasing Fractions 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Sum-of-the-years’-digits (SYD) method 4. Depreciation Schedule Year Book Depreciation Accumulated Book value (beg) Depreciation end of year 1 $34,000 $10,000 $10,000 $24,000 2 $24,000 $ 8,000 $18,000 $16,000 3 $16,000 $ 6,000 $ 24,000 $10,000 4 $10,000 $ 4,000 $ 28,000 $ 6,000 5 $ 6,000 $ 2,000 $ 30,000 $ 4,000 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Double Declining balance method 1. Rate of depreciation = 2 * (1/5) = 0.40 2. Depreciation (2000) = $34,000 * 0.40 = $ 13,600 Depreciation (2001) = $20,400 * 0.40 = $ 8,160 Depreciation (2002) = $12,240 * 0.40 = $ 4,896 Depreciation (2003) = $ 7,344 * 0.40 = $ 3,344 Depreciation (2004) = none Total depreciation taken = $ 30,000 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Double declining balance method 3. Depreciation Schedule Year Book Depreciation Accumulated Book value (beg) Depreciation end of year 1 $34,000 $13,600 $13,600 $20,400 2 $20,400 $ 8,160 $21,760 $12,240 3 $12,240 $ 4,896 $ 26,656 $ 7,344 4 $ 7,344 $ 3,344 $ 30,000 $ 4,000 5 $ 4,000 $ none $ 30,000 $ 4,000 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Group and Composite Depreciation Methods The group method is applied to a collection of assets similar in nature. The composite method is applied to a collection of assets dissimilar in nature. The composite depreciation rate is determined as follows: total of annual depreciation for all assets total cost of all assets 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Composite Depreciation Method: Example Given the following information relating to fixed assets, A and B: Asset Cost Annual depreciation A $20,000 $ 4,000 B $36,000 $10,000 $56,000 $14,000 Composite depreciation rate is: $14,000 / $56,000 = 25% 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Partial year depreciation When an asset is bought sometime during the year, a partial depreciation charge is required. The procedure is: determine depreciation for a full year, and allocate the amount between the two periods affected (see example ==> ) 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Partial year depreciation: Example Amber corporation buys a truck on July 1, 2000. Information relating to the truck is as follows: Cost, $10,000 Estimated service life, 5 years Salvage value end of five years, none. Determine depreciation expense under the double declining balance method. 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Partial year depreciation: Example Before allocating depreciation, determine full year depreciation as follows: First full year (2000) ==> $10,000 * 40% = $4,000 Second full year (2001) ==> $ (10,000 - $4,000) * 40% = $2,400 And so on for the remaining years 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Partial year depreciation: Example Double declining: date of purchase, July 1, 2000 Allocate first full year’s depreciation of $4,000 between 2000 and 2001 $2,000 Allocate second full year’s depreciation of $2,400 between 2001 and 2002 $1,200 2000 2001 2002 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Revision of Depreciation Estimates Determination of depreciation involves initial estimates (life, salvage value.) When these estimates are revised, we re- compute depreciation. These revised depreciation expenses apply prospectively to the remaining life of asset These changes do not affect prior periods. 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Revision of Depreciation Estimates: Example Amber corporation buys a depreciable asset on January 1, 2000 for $95,000. Estimated life was 20 years. Estimated salvage value was $5,000. On January 1, 2006, estimates were revised as follows: salvage value, $2,000 estimated life : 24 years (years 2000 through 2023) Determine depreciation for 2006 based on straight line method of depreciation. 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Revision of Depreciation Estimates: Example Accumulated depreciation to date of revision of estimates: ($95,000 - $5,000) / 20 years = $4,500 dep $4,500 * 6 years = $27,000 accumulated depr. Amount to be depreciated (years 2006 through 2023 = 18 years) ($95,000 - $27,000 - $2,000) / 18 years = $3,667 (rounded) annual depreciation 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.) Part 2: Impairments 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.) Impairments An impairment occurs when: the carrying amount of an asset is not recoverable, and a write-off of the impaired amount is needed To determine the amount of impairment, a recoverability test is used (see next slide) 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Impairments: The Recoverability Test Sum of expected future net cash flows from use and disposal of asset is less than the carrying amount Sum of expected future net cash flows from use and disposal of asset is equal to or more than the carrying amount Impairment has occurred No impairment 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Impairments: The Recoverability Test Impairment has occurred Loss = Carrying amount less Fair value of asset Yes Determine impairment loss Does an active market exist for the asset? Loss = Carrying amount less present value of expected net cash flows No Use company’s market rate of interest 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Impairment: Accounting Impairment has occurred Assets are held for use Assets are held for sale 1. Loss = Carrying value less Fair value 2. Depreciate new cost basis 3. Restoration of impairment loss is NOT permitted 1. Loss = Carrying value less Fair Value less cost of disposal 2. No depreciation is taken 3. Restoration of impairment loss is permitted 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.) Part 3: Depletion 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Depletion: Terminology Depletion refers to the cost basis write-off of natural resources Natural resources are characterized by: complete removal of the asset, and replacement of the asset only by an act of nature 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Determining the Depletion Base: Factors Types of Costs What they are Acquisition cost Exploration costs Development costs (Tangible costs): not part of depletion base Development costs (Intangible costs) Restoration costs Price paid to search for and find deposit of the natural resource Costs incurred to find the natural resource Costs of heavy equipment for extracting and shipping natural resource. Drilling costs, tunnels, and shafts To restore after extraction 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Accounting for Exploration Costs Exploration costs are usually expensed as incurred These costs are capitalized when: they are substantial, and uncertainty exists regarding finding the natural resource Two competing approaches are employed in practice to account for exploration costs (next slide) 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Accounting for Exploration Costs The two approaches are: Successful efforts approach, and Full cost approach Under the successful efforts concept, only exploration costs of successful projects are capitalized. Under the full cost concept, all costs are capitalized. Either approach is currently acceptable. 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.) Special Problems Difficulty of estimating recoverable reserves Problems of discovery value Accounting for liquidating dividends 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.) Part 4: Tax Depreciation 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Overview of Depreciation Financial Accounting depreciation Tax Depreciation methods Depreciation Methods Up to 1980-end, same as financial methods. Beginning with 1981, tax methods changed. 1. Straight line 2. Double declining bal 3. Sum of the years 4. Units of production

Tax Depreciation Methods The current tax depreciation rules are called Modified Accelerated Cost Recovery System (MACRS) MACRS usually produces greater tax deductions earlier in the asset’s life. Differences between tax and GAAP depreciation deductions produce timing differences for deferred tax purposes Differences between the MACRS and GAAP depreciation amounts are reconciled in the M-1 and M-2 schedules (tax return)

MACRS (1987 and later) MACRS incorporated recovery periods for assets Assets can be either personalty, or realty, or intangible assets For personalty, the recovery periods are: 3 [years], 5, 7, 10, 15, and 20 years For residential and non-residential real estate, recovery periods range from 27.5 to 39 years. For intangibles, the recovery period is fifteen years.

Taking section 179 expensing option Before we compute depreciation, we can take a one-time deduction of $20,000 in 2000 in addition to the annual tax depreciation. The depreciable cost is then reduced by the $20,000 one-time write-off.

Section 179 expensing option for personalty TP can expense up to a maximum of $20,000 per year of cost of assets placed in use in 2000. The election applies to TANGIBLE personalty used in trade or business ONLY. The election does NOT apply to either realty or to property used for the production of income. The limit applies separately for each year.

Section 179 expensing option for personalty The initial write-off ($20,000) is reduced for “excess” assets dollar for dollar. If you place in service assets exceeding a total cost of $200,000, you lose $1 in write-off for every dollar of excess assets. 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Section 179 expensing amounts Tax year Annual Limit 1998 $18,500 1999 $19,000 2000 $20,000 2001 or 2002 $24,000 2003 and thereafter $25,000 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

MACRS (1987 and later): Example Taxpayer buys a computer on July 23, 2000. The cost is $69,000. Determine the tax depreciation deduction for the asset under MACRS. 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)

Example Taxpayer buys a computer on July 23, 2000. The cost is $69,000. Is 5-year property MACRS applies Entire cost is recovered

Taking the expensing option …. Taxpayer buys a computer on July 23, 2000. The cost is $69,000. Original cost = $69,000 less: one-time expensing = ($20,000) ------------- Adjusted basis: = $49,000 subject to tax depreciation -------------

Computing MACRS depreciation …. MACRS: 5-year personalty Year 5-year Depreciation 1 [2000] 20.00% 49,000* 0.20 2 [2001] 32.00% 49,000* 0.32 3 [2002] 19.20% 49,000* 0.192 4 [2003] 11.52%* 49,000* 0.1152 5 [2004] 11.52% 49,000* 0.1152 6 [2005] 5.76% 49,000* 0.0576 100.00% = $49,000 total

Summing up the expensing option and MACRS depreciation …. Depreciation deduction in 2000: (first year) One-time expensing = $ 20,000 MACRS depreciation [1999] = $ 9,800 Total cost recovery = $ 29,800 total

Summing up the expensing option and MACRS depreciation …. Depreciation deduction in 2001: (second year) [no further expensing allowed] (49,000 * 0.32) MACRS depreciation [2001] = $ 15,680

Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.) Copyright Copyright © 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. 11/8/2018 Intermediate Accounting, 10th Edition, Ch. 11 (Kieso et al.)