Chapter 11: Depreciation, Impairments and Depletion Intermediate Accounting, 11th ed. Kieso, Weygandt, and Warfield Chapter 11: Depreciation, Impairments and Depletion 2

Chapter 11: Depreciation, Impairments and Depletion After studying this chapter, you should be able to: Explain the concept of depreciation. Identify the factors involved in the depreciation process. Compare activity, straight-line, and decreasing-charge methods of depreciation. Explain special depreciation methods.

Chapter 11: Depreciation, Impairments and Depletion Explain the accounting issues related to asset impairment. Explain the accounting procedures for depletion of natural resources. Explain how property, plant, equipment, and natural resources are reported and analyzed.

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 its depreciable assets.

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 depreciation is best for the asset in question?

Depreciable Base Depreciable base is the dollar amount subject to depreciation. It is determined as: Original cost of the asset less Estimated salvage or disposal value

Estimated Service Lives An asset’s service life and physical life are not the same. Assets’ service life are affected by: physical factors, and economic factors Economic factors include: Inadequacy (asset can not meet current demand) Supercession (by a better asset) Obsolescence (other factors)

Depreciation Methods: Overview Financial Accounting Depreciation Methods Tax Depreciation Straight- line Activity Decreasing Charge Special methods 1. Composite method 2. Hybrid methods 1. Declining Balance 2. Sum-of-the-years’ digits

Depreciation Methods: Straight-Line Is a function of time rather than usage Results in an equal amount of depreciation expense for a given period Depreciation Expense is computed as: Cost – Salvage Value Estimated Life

Depreciation Methods: Activity Is a function of usage rather than time. Estimated life is in terms of total input/output of asset. Depreciation expense is computed as: Cost – Salvage Value x Input/Output this period Total Estimated Input/Output

Depreciation Methods: Decreasing Charge (Accelerated) These methods result in higher depreciation expense in the earlier years and lower charges in the later years. Two decreasing charge methods are: Declining balance Sum-of-the-years’-digits

Depreciation Methods: Declining Balance Salvage value is not deducted when computing depreciable base. Utilizes a depreciation rate (%) that is some multiple of the SL rate. The depreciation rate is multiplied by the asset’s book value at the beginning of the period to get the depreciation expense for the period. Since the book value decreases over time this results in a decreasing amount of depreciation expense over time. An asset’s book value can never be less than its estimated salvage value.

Depreciation Methods: Sum-of-the-Years’ Digits A fraction is multiplied by the depreciable base to arrive at the depreciation expense per period. The fraction is: Numerator: number of years remaining in the asset’s life as of the beginning of the period. Denominator: sum of the years in the life For example, a 5 year life property would have depreciation expense for the first year as: (Cost – Salvage value) X 5 (years remaining) 15 (computed as 5+4+3+2+1)

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

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

Revision of Depreciation Estimates Determination of depreciation involves initial estimates (e.g., life, salvage value) When these estimates are revised, depreciation must be re-computed: Remaining B.V. – Est. Salvage Value Remaining Est. Life These revised depreciation expenses apply prospectively to the remaining life of asset. These changes do not affect prior periods.

Impairments An impairment of a depreciable asset occurs when: the carrying amount of the asset is not recoverable, and therefore a write-off is needed. The recoverability test determines if an impairment has occurred.

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

Impairments: Measuring Loss 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 Use company’s market rate of interest No

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

Graphic of Accounting for Impairments

Depletion: Terminology Depletion refers to the cost basis write-off of natural resources (e.g., coal, oil, timber) Depletion expense per unit is calculated: Cost – Estimated Salvage Value Total Estimated Units Available This per unit cost is the multiplied by the units extracted during a period to derive the depletion for the period.

Depletion: Special Problems Difficulty of estimating recoverable reserves Problems of discovery value Accounting for liquidating dividends

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