Acct 3311 - Class 21 Chapter 11 DEPRECIATION, IMPAIRMENTS, AND DEPLETION Sommers – ACCT 3311 Chapter 1: Environment and Theoretical Structure of Financial Accounting.

Is Accounting Helpful for Valuation? Conceptual Framework (FASB) Purpose of Accounting: “financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise.” Caveat: Accounting information “may help those who desire to estimate the value of a business enterprise, but financial accounting is not designed to measure directly the value of an enterprise.”

Discussion Questions Q11–1 Distinguish among depreciation, depletion, and amortization.

Cost Allocation 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. Allocating costs of long-term assets: Fixed assets = Depreciation expense Intangibles = Amortization expense Natural resources = Depletion expense

Cost Allocation – An Overview The matching principle requires that part of the acquisition cost of operational assets be expensed in periods when the future revenues are earned. Depreciation, depletion, and amortization are cost allocation processes used to help meet the matching principle requirements. Some of the cost is expensed each period. Part I. The matching principle requires that part of the acquisition cost of an operational asset be expensed in periods when the future revenues are earned. A portion of an asset’s cost is moved from the balance sheet to the income statement each period. Part II. Depreciation, depletion, and amortization are cost allocation processes. We allocate the cost of the asset to expense over its useful life in some rational and systematic manner. The unused portion of the asset’s cost appears on the balance sheet. We allocate a portion of the cost to expense on the income statement each accounting period. Accumulated depreciation represents the depreciation taken on the asset since its purchase, and is deducted from the asset’s cost on the balance sheet. Expense Acquisition Cost (Balance Sheet) (Income Statement)

Cost Allocation – An Overview Caution! Depreciation, depletion, and amortization are processes of cost allocation, not valuation! Part I. Depreciation is term used for the cost allocation process for operational assets in the property plant and equipment category. Land is not depreciated. Depletion is the cost allocation process for natural resource operational assets, and amortization refers to the allocation of intangible asset costs. Depreciation, depletion, and amortization are processes of cost allocation, not for valuation. We do not want to confuse asset valuation, an economic concept, with allocation of acquisition costs to periods benefited by the use of operational assets. Part II. Here you see an example of the property, plant and equipment section of a balance sheet showing the assets at cost less the accumulated depreciation. Accumulated depreciation is a contra-asset account and is subtracted from the assets’ cost to determine book value. Net property, plant & equipment is the undepreciated cost (book value) of plant assets. Book value is not equal to market value. Depreciation on the Balance Sheet

Discussion Questions Q11–7 What basic questions must be answered before the amount of the depreciation charge can be computed?

Measuring Cost Allocation Cost allocation requires three pieces of information for each asset: Service Life Depreciable Base Allocation Method The estimated expected use from an asset. Total amount of cost to be allocated. Cost - Residual Value (at end of useful life) The systematic approach used for allocation. Regardless of the method used to calculate depreciation expense, we must have three items of information: (1) the estimated useful life of the asset; (2) the allocation base which is the cost of the asset less its estimated residual value at the end of its useful life, and (3) the allocation method.

Estimation of Service Life Service life often differs from physical life. Companies retire assets for two reasons: Physical factors (casualty or expiration of physical life). Economic factors (inadequacy, supersession, and obsolescence).

Depreciable Base How much is value going to decrease while company owns it? This amount has to be transferred to expense during the period that the company is using the item.

Methods of Depreciation The profession requires the method employed be “systematic and rational.” Examples include: Activity method (units of use or production). Straight-line method. Sum-of-the-years’-digits. Declining-balance method. Group and composite methods. Hybrid or combination methods. Accelerated methods Special methods

Straight-Line Time: Activity: Part I. The straight-line method is the most widely used and the most easily understood method of depreciation. It results in an equal amount of depreciation in each year of an asset’s useful life. The annual depreciation is determined by dividing the asset’s cost less its estimated residual value by the asset’s estimated useful life in years. Part II. Consider the following example. On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of five years and an estimated residual value of $5,000. What is the annual straight-line depreciation?

Example 1a: Straight Line Depreciation On January 1, 2011, the Excel Delivery Company purchased a delivery van for $33,000. At the end of its five-year service life, it is estimated that the van will be worth $3,000. During the five- year period, the company expects to drive the van 100,000 miles. Calculate annual depreciation for the five-year life of the van using: Straight line

Example 1b: Activity Based Depreciation On January 1, 2011, the Excel Delivery Company purchased a delivery van for $33,000. At the end of its five-year service life, it is estimated that the van will be worth $3,000. During the five- year period, the company expects to drive the van 100,000 miles. Calculate annual depreciation for the five-year life of the van using: Units of production using miles driven as a measure of output, and the following actual mileage: ($33,000 – $3,000) / 100,000 miles = $0.30 / mile deprec rate Year Miles Depreciation 2011 22,000 2012 24,000 2013 15,000 2014 20,000 2015 21,000

Declining-Balance Method Sometimes called a Decreasing-Charge Method or an Accelerated Method Declining-Balance Method. Utilizes a depreciation rate (percentage) that is some multiple of the straight-line method. Does not deduct the salvage value in computing the depreciation base.

Accelerated Methods Accelerated methods result in more depreciation in the early years of an asset’s useful life and less depreciation in later years of an asset’s useful life Note that total depreciation over the asset’s useful life is the same as the Straight-line Method Declining-Balance depreciation – Based on the straight-line rate multiplied by an acceleration factor Computations initially ignore residual value Stop depreciating when BV = Residual Value Note that the Book Value will get lower each year Part I. Accelerated methods result in more depreciation in the early years of an asset’s useful life and less depreciation in later years of an asset’s useful life. The total amount of depreciation over the asset’s useful life is the same as the straight-line method. Part II. Sum-of-the-years’-digits depreciation is calculated by multiplying cost minus residual value times a fraction that declines each year of an asset’s useful life. The numerator of the fraction is a number equal to the remaining useful life of the asset. For an asset with a four-year life, the numerator would be four for the first year, three for the second year, two for the third year and one for the fourth year The denominator of the fraction is constant. It is the sum of the digits in the asset’s life from one to n, where n is the number of years in the asset’s life. For example, if the estimated life is four years, the sum of the digits is 1 plus 2 plus 3 plus 4, a total of 10. Acceleration Factor

Example 1c: Double-Declining Balance On January 1, 2011, the Excel Delivery Company purchased a delivery van for $33,000. At the end of its five-year service life, it is estimated that the van will be worth $3,000. During the five- year period, the company expects to drive the van 100,000 miles. Calculate annual depreciation for the five-year life of the van using: Double-declining balance   Year Book Value Beg of Year X Rate per Year =    Depreciation End of Year 2011 $33,000 2012 2013 2014 2015

Use of Various Depreciation Methods In a recent survey of large publicly traded companies, 592 of the companies indicated that they used the straight-line method of depreciation. The straight-line method is used by the majority of companies because it is the easiest method to understand and to apply.

Example 2: DDB to Straight Line On January 2, 2011, the Jackson Company purchased equipment to be used in its manufacturing process. The equipment has an estimated life of eight years and an estimated residual value of $30,625. The expenditures made to acquire the asset were as follows: Purchase price $154,000 Freight charges 2,000 Installation charges 4,000 Jackson’s policy is to use the double-declining-balance (DDB) method of depreciation in the early years of the equipment’s life and then switch to straight line halfway through the equipment’s life. Calculate depreciation for each year of the asset’s eight-year life.    Year Book Value Beg of Year   X Depreciation Rate per Year = End of Year 2011 2012 2013 2014

Example 2: Continued Year Book Value Beg of Year X Depreciation    Year Book Value Beg of Year   X Depreciation Rate per Year = End of Year 2011 $160,000 2 / 8 $ 40,000 $120,000 2012 2013 2014 2015 2016 2017 2018 Total * Switch to straight-line in 2015:  

Partial-Period Depreciation Pro-rating the depreciation based on the date of acquisition is time-consuming and costly. A commonly used alternative is the . . . Half-Year Convention Take ½ of a year of depreciation in the year of acquisition, and the other ½ in the year of disposal That said, unless told otherwise for class you calculate based on months! To this point we have discussed assets that were purchased at the beginning of a year and depreciated for a full year. Relatively few assets will actually be purchased on January 1. When an operational asset is acquired during the year, depreciation is calculated for the fraction of the year the asset is owned. Pro-rating the depreciation based on the date of acquisition is time-consuming and costly. A commonly used alternative is the half-year convention. Using this convention, a company would record one-half year of depreciation in the year of acquisition, and one-half year of depreciation in the year of disposal.

Example 3: Partial-Period On October 1, 2011, the Allegheny Corporation purchased machinery for $115,000. The estimated service life of the machinery is 10 years and the estimated residual value is $5,000. The machine is expected to produce 220,000 units during its life. Calculate depreciation for 2011 and 2012 using each of the following methods. Partial-year depreciation is calculated based on the number of months the asset is in service. Straight line. Double-declining balance. One hundred fifty percent declining balance. Units of production (units produced in 2011, 10,000; units produced in 2012, 25,000).

Example 3: Continued Straight-line:

Example 3: Continued Units-of-production:

E11-6 Muggsy Bogues Company purchased equipment for $212,000 on October 1, 2014. It is estimated that the equipment will have a useful life of 8 years and a salvage value of $12,000. Estimated production is 40,000 units and estimated working hours are 20,000. During 2014, Bogues uses the equipment for 525 hours and the equipment produces 1,000 units. Compute depreciation expense under each of the following methods. Bogues is on a calendar-year basis ending December 31. Straight-line method for 2014. Activity method (units of output) for 2014. Activity method (working hours) for 2014. Sum-of-the-years’-digits method for 2016. Double-declining-balance method for 2015.

E11-6: Continued

E11-6: Continued