1 Depreciation and Depletion C hapter 10

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

3 6.Understand additional depreciation methods, including group and composite methods. 7.Compute depreciation for partial periods. 8.Explain the impairment of noncurrent assets. 9.Understand depreciation for income tax purposes. 10. Explain changes and corrections of depreciation. 11.Understand and record depletion. Objectives

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

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

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

7 Factors Involved in Depreciation 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.

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

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

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

11 Methods of Cost Allocation Time-Based Method: Sum-of-the-Years’ Digits Depreciation Book Value at Year Base Fraction Depreciation Year-End 2003$100,0005/15$ 33,333$86, ,0004/1526,66760, ,0003/1520,00040, ,0002/1513,33326, ,0001/15 6,66720,000 $100,000 Residual Value

12 Methods of Cost Allocation Time-Based Method: Declining-Balance Book Value at Book Value at Year Beginning of Year Rate Depreciation Year-End 2003$120,00040%$ 48,000$72, ,00040%28,80043, ,20040%17,28025, , ,92020, , ,000 $100,000 Double-Declining Balance Residual Value

13 Methods of Cost Allocation Time-Based Method: Declining-Balance Book Value at Book Value at Year Beginning of Year Rate Depreciation Year-End 2003$120,00030%$ 36,000$84, ,00030%25,20058, ,80030%17,64041, ,16030%12,34828, , ,81220,000 $100, %-Declining Balance Residual Value

14 Recording Depreciation The credit to depreciation is usually called Accumulated Depreciation or Allowance for Depreciation.

15 Recording Depreciation The account title Reserve for Depreciation is considered undesirable because of the uncertain meaning of “reserve.”

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

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

18 Conceptual Evaluation of Depreciation Methods If a company expects that repairs and maintenance costs and the total economic benefits of the asset will remain similar each period,... …a similar total cost each period can be achieve through straight-line depreciation and the similar repair and maintenance costs.

19 Conceptual Evaluation of Depreciation Methods If the company expects that benefits of having the asset will decline each year for the life of the asset,... …and repairs and maintenance costs are constant each period, a declining total cost will be achieved by using accelerated depreciation.

20 Effect of Depreciation on Rate of Return Book Value of Asset Rate of Year Net Income at Beginning of Year Return 2003$12,000$120,00010% ,000100, ,00080, ,00060, ,00040,00030

21 Disclosure of Depreciation  Depreciation expense for the period.  Balances 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. APB Opinion No. 12 requires the following disclosure:

22 Disclosure of Depreciation Number of Companies Straight-line……...… Declining-balance.… Sum-of-the-years- digits……………… Accelerated method, not specified……… Units-of-production…

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

24 Group Depreciation 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 in the end of the second year. $200,000 – $50,000 3

25 Group Depreciation Three cars were sold after 2 years for $8,000 each. Cash24,000 Accumulated Depreciation36,000 Cars60,000 To record the third year’s depreciation expense. Depreciation Expense35,000 Accumulated Depreciation35, ($200,000 – $60,000)

26 Group Depreciation Five cars were sold after 3 years 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 salvage value.

27 Group Depreciation The final two cars were sold for $4,800 each. Cash9,600 Accumulated Depreciation30,000 Loss on Disposal400 Cars40,000 Group Depreciation Two cars were sold after 3 years for $4,800 each. Book value = $10,000 Cash received = 9,600 Loss$ 400 Loss$ 400

28 Composite Depreciation Annual Asset Cost Residual Value Life Depreciation A$25,000$5,00010 yrs.$2,000 B13,0001,000 62,000 C 12, ,000 $50,000$6,000$7,000 Depreciation Rate = = 14% 7,000 $50,000

29 Annual Year Depreciation Depreciation for Partial Periods 1 3/6 x $6,000 = $3,000 x 4/12 = $1,000 2$3,000 x 8/12 2/6 x $6,000 = $2,000 x 4/12= 2,667 3$2,000 x 8/12 1/6 x $6,000 = $1,000 x 4/12= 1,667 4 $1,000 x 8/12= 666 $6,000 A company purchases a $6,000 asset with a 3-year life and no residual value on August 18. The firm uses the sums- of-the-years’-digits method.

30 Annual Year Depreciation Depreciation for Partial Periods 1 2/3 x $6,000 = $4,000 x 4/12 = $1,333 2$4,000 x 8/12 2/3 x $2,000 = $1,333 x 4/12= 3,111 3 $1,333 x 8/12 $667 x 4/12= 1,111 4 $667 x 8/12= 445 $6,000 A company purchases a $6,000 asset with a 3-year life and no residual value on August 18. The firm uses the double-declining-balance method. OR

31 Depreciation for Partial Periods Annual Year Depreciation 1 4/12 x $4,000 = $1, x ($6,000 – $1,333)= 3, x ($4,667 – $3,113)= 1,037 4 Remaining balance= 517 $6,000 Declining-Balance-Method

32 Impairment of Noncurrent Assets The FASB issued FASB Statement No. 144 which requires a company to review its property, plant, and equipment for impairment.

33 Impairment of Noncurrent Assets Impairment occurs whenever events or changes in circumstances indicate that the book value of a noncurrent asset may not be recoverable.

34 Impairment of Noncurrent Assets An impairment loss involves the following steps: Events or Changes in Circumstances Occurs Impairment Test (Undiscounted Cash Flows < Book Value of Asset) Measurement of Loss (Loss = Fair Value – Book Value)

35 Impairment of Noncurrent Assets On January 1, 2001, the Hall Company purchased a factory for $1 million (20-year life) and machinery for $3 million (10-year life). Late in 2004, the company believes that its asset(s) may be impaired and the remaining useful life is 5 years. The company estimates that the asset will produce cash inflows of $700,000 and incur cash outflow of $300,000 each year for the next 5 years.

36 December 31, 2004 Factory cost$1,000,000 Less: Accumulated depreciation (4 years x $50,000) (200,000) Book value$ 800,000 Machinery cost$3,000,000 Less: Accumulated depreciation (4 years x $300,000)(1,200,000) Book value 1,800,000 Total Book Value$2,600,000 Impairment Test Impairment of Noncurrent Assets

37 = 5 x $400,000 = $2,000,000 Impairment Test Undiscounted expected net cash flows = 5 x ($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 of Noncurrent Assets

38 Measurement of the Loss Present value of the expected cash flows (fair value) = $400,000 x = $1,309,718 (rounded) n= 5, i = 0.16 from Table 4 in Appendix Book value$2,600,000 Fair value(1,309,718) Impairment loss$1,290,282 Impairment of Noncurrent Assets

39 The Statement 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 Noncurrent Assets

40 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 Impairment of Noncurrent Assets $1,309,718 x [$1,000,000 ÷ ($3,000,000 ÷ $1,000,000)]$1,309,718 x [$3,000,000 ÷ ($3,000,000 ÷ $1,000,000)]

41 Conceptual Evaluation of Asset Impairment Although FASB Statement No. 121 has been replaced by FASB Statement No. 144, the principles it established have only changed slightly. Although the Statement narrows GAAP, it still allows for significant management flexibility.

42 MACRS Principles 1.A mandated tax life, which is usually shorter than the economic life. 2.The acceleration of the cost recovery (except for buildings). 3.The elimination of residual value. 1.A mandated tax life, which is usually shorter than the economic life. 2.The acceleration of the cost recovery (except for buildings). 3.The elimination of residual value. For an asset purchased in 1987 and later, a company’s computation of depreciation for income tax and financial reporting differ in three major respects:

43 MACRS Principles On January 1, 2003 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 Exhibit l0-12 to determine the annual depreciation rate for % Determine depreciation for

44 MACRS Principles 2003$200,000 x 20% = $ 40, $200,000 x 32%= 64, $200,000 x 19.20%= 38, $200,000 x 11.52%= 23, $200,000 x 11.52%= 23, $200,000 x 5.76%= 11,520 $200,000

45 Changes and Corrections of Depreciation A change in the depreciation method for currently owned assets is accounted for by a cumulative- effect change. Adoption of a new depreciation method for newly acquired assets does not require any adjustment to the accounts. A change in an estimate of the residual value or the service life of a currently owned asset is accounted for prospectively. Correction of an error in depreciation is treated as prior period adjustment.

46 Depletion Unit Depletion Rate = Cost – Residual Value Units A 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 Unit Depletion Rate = $3,000,000 – $200,000 1,000,000 tons

47 Depletion 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 x 80,000 = $224,000

48 C hapter 10 The End

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