Depreciation and Depletion C hapter 11 COPYRIGHT © 2010 South-Western/Cengage Learning Intermediate Accounting 11th edition Nikolai Bazley Jones An electronic presentation By Norman Sunderman and Kenneth Buchanan Angelo State University

2 1.Identify the factors involved in depreciation. 2.Explain the alternative methods of cost allocation, including time-based and activity- based methods. 3.Record depreciation. 4.Explain the conceptual issues regarding depreciation methods. 5.Understand the disclosure of depreciation. 6.Understand additional depreciation methods, including group and composite methods. Objectives

3 7.Compute depreciation for partial periods. 8.Explain the impairment of property, plant, and equipment. 9.Understand depreciation for income tax purposes. 10.Explain changes and corrections of depreciation. 11.Understand and record depletion. Objectives

4 Depreciation Depreciation is the process of allocating the cost of an asset in a systematic and rational manner over the periods benefited. Land is not depreciated because it generally does not have a limited life.

5 Factors Involved in Depreciation  Asset cost  Service life  Residual value  Method of cost allocation

6 Asset Cost The cost of an asset includes all the acquisition costs a company incurs to obtain the benefits from the asset. Factors Involved in Depreciation

7 Service Life The service life of an asset is the measure of the service units expected from the asset before its disposal. Factors Involved in Depreciation

8 Service Life The factors that limit the service life of an asset can be divided into two general categories:  Physical causes  Functional causes Factors Involved in Depreciation

9 Residual Value Residual, or salvage, value is the net amount that can be expected to be obtained when the asset is disposed at the end of its service life. Factors Involved in Depreciation

10 Methods of Cost Allocation  Time-based methods a.Straight-line b.Accelerated (declining charge) 1)Sum-of-the-years’-digits 2)Declining balance  Activity (or use) methods

11 Depreciation Problem Information

12 Depreciation Rate = Cost – Residual Value Service Life = $120,000 – $20,000 5 Time-Based Method: Straight Line Methods of Cost Allocation = $20,000 per year

13 Time-Based Method: Sum of the Years’ Digits Years of service Year remainingat Years of service Year remaining at Number beginning of year Number beginning of year Sum of the Years’ Digits = 15 Years of service Year remainingat Years of service Year remaining at Number beginning of year Number beginning of year Sum of the Years’ Digits = 15 Methods of Cost Allocation n(n + 1) n(n + 1) = = 15

14 Depreciation Book Value at Year BaseFractionDepreciationYear-End 2009$100,0005/15$ 33,333$86, ,0004/1526,66760, ,0003/1520,00040, ,0002/1513,33326, ,0001/15 6,66720,000 $100,000 Residual Value Methods of Cost Allocation Time-Based Method: Sum of the Years’ Digits

15 Time-Based Method: Declining-Balance Book Value at Book Value at Year Beginning of Year Rate Depreciation Year-End 2009$120,00040%$ 48,000$72, ,00040%28,80043, ,20040%17,28025, ,920— 5,92020, ,000— — 20,000 $100,000 Time-Based Method: Double-Declining Balance Residual Value Methods of Cost Allocation PlugPlug

16 Time-Based Method: Declining-Balance Residual Value Methods of Cost Allocation Book Value at Book Value at Year Beginning of Year Rate Depreciation Year-End 2009$120,00030%$ 36,000$84, ,00030%25,20058, ,80030%17,64041, ,16030% 12,34828, ,812— 8,812 20,000 $100,000 Time-Based Method: 150%-Declining Balance

17 Activity Method Assume the asset is used for 2,100 hours. Depreciation = $21,000 (2,100 hours × $10) Methods of Cost Allocation Depreciation Rate = Cost – Residual Value Total Lifetime Activity Level = $120,000 – $20,000 10,000 hours = $10 per hour

18 The credit entry to record depreciation is to a contra-asset account usually called Accumulated Depreciation or Allowance for Depreciation. Recording Depreciation

19 Depreciation Expense $ During Year Straight-Line Sum-of-the-Years’-Digits Double-Declining-Balance Conceptual Evaluation of Depreciation Methods

20 Book Value $ At End of Year Straight-Line Sum-of-the-Years’-Digits Double-Declining-Balance Conceptual Evaluation of Depreciation Methods

21 If a company expects that repair and maintenance costs and the total economic benefits of the asset will remain similar each period,… Conceptual Evaluation of Depreciation Methods

22 …a similar total cost each period can be achieved through straight-line depreciation and the similar repair and maintenance costs. Conceptual Evaluation of Depreciation Methods

23 If the company expects that benefits of having the asset will decline each year for the life of the asset,… Conceptual Evaluation of Depreciation Methods

24 …and repairs and maintenance costs are constant each period, a declining total cost will be achieved by using accelerated depreciation. Conceptual Evaluation of Depreciation Methods

25 Selection of Depreciation Method

26 Effect of Depreciation on Rate of Return Book Value of Asset Rate of Year Net Income at Beginning of Year Return 2009$12,000$120,00010% ,000100, ,00080, ,00060, ,00040, $12,000$120,00010% ,000100, ,00080, ,00060, ,00040,00030

27 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 GAAP requires the following:

28 Disclosure of Depreciation

29 IFRS vs. U.S. GAAP  IFRS require that depreciation be “systematic,” rather than “systematic and rational.”  IFRS also require that the estimated useful lives and residual values, and the depreciation method, be reviewed at least once a year. U.S. GAAP only requires this review when events or circumstances indicate that the estimate has changed.

30 IFRS vs. U.S. GAAP  IFRS also require that companies disclose the accumulated depreciation for each class of asset, not just the total amount as allowed by U.S. GAAP.  IFRS require that when an operating asset is made up of individual components that are significant with respect to the total cost of the item (e.g., an airplane and its engines) that the initial cost be allocated to the significant components and each component be depreciated separately.

31 IFRS vs. U.S. GAAP  U.S. GAAP neither requires nor prohibits a company from depreciating components.  IFRS allow a company to write up the value of its property, plant, and equipment assets to fair value. Such a write-up would affect the amount of depreciation that the company records each period.

32 A company purchased 10 cars for $20,000 each, and the average expected service life is 3 years with a residual value of $5,000 each. Group Depreciation

33 To record the purchase: Cars200,000 Cash200,000 To record the first year’s depreciation expense: Depreciation Expense50,000 Accumulated Depreciation50,000 This same depreciation entry would be made at the end of the second year. $200,000 – $50,000 3 Group Depreciation

34 To record the disposal of three cars at the end of the second year for $8,000 each: Cash24,000 Accumulated Depreciation36,000 Cars60,000 To record the third year’s depreciation expense: Depreciation Expense35,000 Accumulated Depreciation35,000 25% ($200,000 – $60,000) Group Depreciation

35 To record the disposal of five cars at the end of the third year for $6,000 each: Cash30,000 Accumulated Depreciation70,000 Cars100,000 To record the fourth year’s depreciation expense: Depreciation Expense1,000 Accumulated Depreciation1,000 To reduce the $11,000 book value to the estimated residual value. Group Depreciation

36 The final two cars were sold for $4,800 each. Cash9,600 Accumulated Depreciation30,000 Loss on Disposal400 Cars40,000 To record the disposal of two cars at the end of the fourth year for $4,000 each, and the net gain or loss of the entire group: Cash received $ 9,600 Book value 10,000 Loss$ (400) Group Depreciation

37 Residual Annual Asset Cost Value Life Depreciation A$25,000$5,00010 years$2,000 B13,0001,000 62,000 C 12,000 — 4 3,000 $50,000$6,000$7,000 Depreciation Rate = = 14% 7,000 $50,000 Composite Depreciation

38 A company purchases a $6,000 asset with a three- year life and no residual value on August 18. The firm uses the double-declining-balance method. Depreciation for Partial Periods

39 Declining-Balance-Method Depreciation for Partial Periods Year ComputationAnnual Depreciation 14/12 × $4,000$1, × ($6,000 – $1,333)3, × ($4,667 – $3,113)1,037 4Remaining balance 517 $6,000 Two times straight-line rate = 2 × 1/3

40 Impairment of Property, Plant, and Equipment GAAP requires a company to review its property, plant, and equipment for impairment.

41 Impairment occurs whenever events or changes in circumstances indicate that the book value of the property, plant, and equipment may not be recoverable. Impairment of Property, Plant, and Equipment

42 Impairment Test If the total expected cash flows (undiscounted) are less than the book value of the asset, an impairment loss is recognized. Impairment Test If the total expected cash flows (undiscounted) 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. Impairment of Property, Plant, and Equipment

43 On January 1, 2007, the Hall Company purchased a factory for $1 million (20-year life) and machinery for $3 million (10-year life). Late in 2010, the company believes that its asset(s) may be impaired and the remaining useful life is five years. The company estimates that the asset will produce cash inflows of $700,000 and will incur cash outflow of $300,000 each year for the next five years. Impairment of Property, Plant, and Equipment

44 December 31, 2010 Factory cost$ 1,000,000 Less: Accumulated depreciation (4 years × $50,000) (200,000) Book value$ 800,000 Machinery cost$ 3,000,000 Less: Accumulated depreciation (4 years × $300,000) (1,200,000) Book value 1,800,000 Total Book Value$2,600,000 Impairment Test Impairment of Property, Plant, and Equipment

45 = 5 × $400,000 = $2,000,000 Undiscounted expected net cash flows = 5 × ($700,000 – $300,000) Years Cash Inflows Cash Outflows Because $2,000,000 is less than $2,600,000 (the book value), an impairment loss must be recognized. Impairment Test Impairment of Property, Plant, and Equipment

46 Measurement of the Loss Present value of the expected net cash flows (fair value) = $400,000 × = $1,309,718 (rounded) n = 5, i = 0.16 from Table 4 in the Time Value of Money Module Fair value$(1,309,718) Book value 2,600,000 Impairment loss$(1,290,282) Impairment of Property, Plant, and Equipment

47 GAAP 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. Impairment of Property, Plant, and Equipment

48 Loss from Impairment1,290,282 Accumulated Depreciation: Factory200,000 Accumulated Depreciation: Machinery1,200,000 Factory (new cost)327,429 Machinery (new cost)982,289 Factory (old cost)1,000,000 Machinery (old cost)3,000,000 $1,309,718 × [$1,000,000 ÷ ($3,000,000 + $1,000,000)] $1,309,718 × [$3,000,000 ÷ ($3,000,000 + $1,000,000)] Impairment of Property, Plant, and Equipment

49 The recognition of an impairment loss is intended to enhance the usefulness of a company’s financial statements. All these issues could result in earnings management. For example, management might prefer to recognize as large a loss as possible, thereby reducing the book value to the lowest possible amount. This would result in lower depreciation expense and higher net income in the future. Conceptual Evaluation of Asset Impairment

50 IFRS vs. U.S. GAAP  IFRS use a “trigger” value, which is the (1) higher of the asset’s fair value (less costs to sell), or (2) its usage value to determine if an asset is impaired. U.S. GAAP uses undiscounted cash flows.  Typically, this should mean that international companies will recognize impairment losses earlier than U.S. companies. Under IFRS, the impairment loss is the difference between the book value and the “trigger” value defined above.  IFRS allow an impairment loss to be reversed if the value is recovered, which is not allowed under GAAP.

51 1.A mandated tax life, which is usually shorter than the economic life 2.Acceleration of the cost recovery (except for buildings) 3.Elimination of the residual value For assets purchased in 1987 and later, the Modified Accelerated Cost Recovery System (MACRS) is required for tax purposes. A company’s computations of depreciation for income tax purposes and financial reporting purposes differ in three major respects: Depreciation for Tax Purposes

On January 1, 2009, 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 the next slide to determine the annual depreciation rates for 2009 through 2014 MACRS Principles 52

MACRS Percentages Determine depreciation for 2009–

$200,000 × 20% = $ 40, $200,000 × 32%= $ 64, $200,000 × 19.20%= $ 38, $200,000 × 11.52%= $ 23, $200,000 × 11.52%= $ 23, $200,000 × 5.76%= $ 11,520 $200,000 MACRS Principles Annual Tax Year Cost MACRS % Depreciation

55 Changes and Corrections of Depreciation 1.A change in an estimate of the residual value or the service life of a currently owned asset is accounted for prospectively. 2.A change in the depreciation method for currently owned assets is also accounted for prospectively. 3.A correction of an error in depreciation is accounted for as a prior period adjustment (restatement).

56 Depletion  Depletion of natural resources is calculated using an activity method.  Any environmental costs at the end of the project are added to the cost in determining depletion per unit.

57 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. Unit Depletion Rate = $3,000,000 – $200,000 1,000,000 tons

58 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 × 80,000 tons = $224,000 Depletion

59 Revised Depletion Estimate Suppose that at the beginning of the second year of operation, a new estimate indicates that the mine has a capacity to produce another 1,600,000 tons (for a lifetime production of 1,680,000 tons). What is the new depletion rate? Unit Depletion Rate = ($3,000,000 – $224,000) – $200,000 1,600,000 tons = $1.61 per ton Unit Depletion Rate = Book Value – Residual Value Remaining Units

60 C hapter 11 Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.