Operational Assets: Depreciation, Impairment, and Depletion of Operational Assets

DEPRECIATION CONCEPTS Depreciation - expiration or consumption of the economic service potential of plant assets. AN ECONOMIC FACT Depreciation accounting - the systematic and rational allocation of the cost of tangible capital assets, less salvage, over the estimated useful life of the asset AN ACCOUNTING PROCEDURE Depreciation accounting is a cost allocation process and is not related to the “market value” of the asset

DEPRECIATION CONCEPTS Related Areas Depletion accounting - periodic allocation of the cost of natural resources against revenue earned. Amortization accounting - periodic allocation of intangible assets against revenue earned.

DEPRECIATION CONCEPTS Factors Impacting Computed Depreciation Expense Asset cost. Estimated residual value. Estimated useful life. Method of depreciation.

DEPRECIATION METHODS (1) Straight-line. (2) Based on inputs and outputs (Activity). Service hours (SH) method. Productive output (PO) or units-of-production. (3) Accelerated methods. Sum-of-the-years’-digits (SYD). Declining-balance (normally 200% - DDB). (4) Tax depreciation. (5) Depreciation systems. Group and composite. Retirement and replacement.

STRAIGHT-LINE (SL) = Annual SL Acquisition cost – Residual value Depreciation Acquisition cost – Residual value Estimated useful life in years = SL

ACTIVITY METHODS Inputs and Outputs Depreciation based upon measures of input or output like. . . Service hours Productive output (units-of-production) No depreciation is taken if the asset is idle.

Acquisition cost – Residual value Estimated service life in hours Service Hours (SH) Depreciation Per SH = Acquisition cost – Residual value Estimated service life in hours Depreciation Per Period Depreciation Number of hours Per SH running time × =

PRODUCTIVE OUTPUT (PO) Depreciation rate per unit of output = Acquisition Cost – Residual Value Estimated Productive Output in Units Depreciation Expense Depreciation Number of units rate per unit produced × =

ACCELERATED DEPRECIATION Sum-of-the-Years’-Digits Declining Balance Methods

SUM-OF-YEARS’-DIGITS No. of years remaining in useful life Depreciation Fraction = SYD Depreciation per period Depreciation Fraction = x (Cost - SV)

DOUBLE-DECLINING-BALANCE (DDB) DDB rate = 2 x Straight-line rate (SL Rate = 1/Useful Life Depr. base = Book value (Cost - Accum. depr.) at beginning of the year Depr. per period = Depr. rate x Depr. base

TAX DEPRECIATION For income tax reporting the IRS permits the use of “modified accelerated cost recovery system” (MACRS). MACRS ignores residual value. Depreciation is based upon percentages related to the “class life” of the asset.

DEPRECIATION POLICY If a company expected asset obsolescence, accelerated methods are appropriate. Many companies use SL for financial reporting and accelerated depreciation for tax reporting. SL depreciation is the most popular method (about 94% of companies surveyed use SL).

DEPRECIATION POLICY Depreciation expense is a tax shield because it is a noncash expense that is deductible for income tax purposes. By lowering our income taxes, depreciation improves our cash flows.

FRACTIONAL-YEAR DEPRECIATION So far we have assumed that the depreciable asset was purchased at the beginning of the year. If the asset is purchased sometime during the year, we have to adjust annual depreciation.

DEPRECIATION DISCLOSURES Depreciation expense. Balances of major classes of depreciable assets. Accumulated depreciation by asset or in total. General description of depreciation methods used.

PLANT ASSET IMPAIRMENT Impairment is the loss of a significant portion of the utility of an asset through casualty, obsolescence or lack of demand for the company’s asset. When plant assets suffer a permanent impairment in value, a loss should be recorded.

IMPAIRMENT OF LONG-LIVED ASSETS Background SFAS No. 121 SFAS No. 144 Reporting requirements Disclosure requirements

IMPAIRMENT OF LONG-LIVED ASSETS Assets to be Held and Used Reviewed when circumstances indicate the carrying value may not be recoverable Recognition of impairment loss Required if sum of expected future net cash flows is less than carrying value of the asset Evaluated on a “component basis” Measurement of impairment loss The amount by which the carrying value of the asset exceeds the fair value of the asset

IMPAIRMENT OF LONG-LIVED ASSETS Assets to be Held and Used - Continued Presentation of impairment losses Shown as a component of income from continuing operations before taxes Restoration of impairment losses Reduced carrying value is basis for future accounting and restoration is prohibited

IMPAIRMENT OF LONG-LIVED ASSETS Disclosure Requirements Description of impaired assets Circumstances leading to impairment Amount of impairment loss How fair value was determined Segment in which the impaired asset group is reported – SFAS 131

I guess this boat is about fully depreciated!

NATURAL RESOURCES Sometimes referred to as wasting assets. Supplied by nature and extracted from natural environment. Gold, oil, timber, coal, and other minerals. Presented on the balance sheet as noncurrent assets.

NATURAL RESOURCES SFAS No. 19 identifies total costs as including acquisition costs exploration costs development costs production costs support equipment and facilities cost. Total cost is allocated over periods benefited by means of depletion.

NATURAL RESOURCES Depletion Depletion is calculated using the units-of-production method. Unit depletion rate is calculated as follows: Estimated Recoverable Units Capitalized Cost of Residual Natural Resource Value – The numerator, cost – residual value, is called the depletion base.

Total depletion cost for a period is: NATURAL RESOURCES Total depletion cost for a period is: UNIT DEPLETION RATE NUMBER OF UNITS EXTRACTED IN PERIOD × The unit depletion rate . . . is inventoried with each extracted unit. is expensed as a part of cost of goods sold for each unit sold. remains in inventory with each unsold unit.

NATURAL RESOURCES Restoration Costs In some cases, the extractor is required to restore the land to its original state subsequent to the resources being extracted. The estimated cost of restoration increases the depletion base.

RESTORATION COSTS Assume mine property has a capitalized cost of $4,000,000, estimated recoverable ore of 2,000,000 tons, with 300,000 tons produced in Year 1. If the company must restore the land to its original state after mining at an estimated cost of $1 million, present the entry for production. Unit depletion rate = ($4,000,000 + $1,000,000) / 2,000,000 tons = $2.50 per ton Entry: Inventory of ore 750,000* Accum depletion - Mine property 600,000** Estim. Liability for mine restoration 150,000*** *300,000 tons x $2.50 **300,000 tons x $2,00 ***300,000 tons x $.50

NATURAL RESOURCES Change in Estimate The unit depletion rate is based on estimated recoverable units. Those estimates may change over time. The revised unit depletion rate is computed for the remaining costs. Prior depletion costs are not revised.

NATURAL RESOURCES Income Tax Reporting The cost-based depletion method is for financial reporting purposes. The Internal Revenue Code allows the use of statutory depletion (also called percentage depletion) for tax purposes. Use of different methods for tax and financial reporting purposes leads to different incomes.

EXPLORATION COSTS Oil and Gas Industry The costs of exploration for the oil and gas industry are very large. An accounting question arises as to how much of the exploration costs can be capitalized. Two basic methods are allowed when accounting for those costs: Successful-efforts method Full-cost method

EXPLORATION COSTS Successful-Efforts Method Only the exploration costs associated with successful wells are capitalized in the cost of the natural resource. The costs associated with unsuccessful wells are expensed as incurred.

EXPLORATION COSTS Full-Cost Method All exploration costs are capitalized as part of the cost of the natural resource. This method tends to be used by smaller firms primarily in the exploration business.