1. Depreciation and Depletion10
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Depreciation and Depletion
An electronic presentation
by Douglas Cloud
Pepperdine University 1 1 1 1

2. Objectives 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.
Continued 2 2 2 4

3. Objectives
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.

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

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

10. Methods of Cost Allocation
Time-Based Method: Straight Line
Depreciation Rate =
Cost – Residual Value
Service Life =
$120,000 – $20,000
5 Years
= $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 $100,000 5/15 $ 33,333 $86,667
,000 4/15 26,667 60,000
,000 3/15 20,000 40,000
,000 2/15 13,333 26,667
,000 1/ ,667 20,000
$100,000
Residual Value

12. Methods of Cost Allocation
Time-Based Method: Declining-Balance
Double-Declining Balance
Book Value at Book Value at
Year Beginning of Year Rate Depreciation Year-End
2003 $120,000 40% $ 48,000 $72,000
,000 40% 28,800 43,200
,200 40% 17,280 25,920
, ,920 20,000
, ,000
$100,000
Residual Value

13. Methods of Cost Allocation
Time-Based Method: Declining-Balance
150%-Declining Balance
Book Value at Book Value at
Year Beginning of Year Rate Depreciation Year-End
2003 $120,000 30% $ 36,000 $84,000
,000 30% 25,200 58,800
,800 30% 17,640 41,160
,160 30% 12,348 28,812
, ,812 20,000
$100,000
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$
Sum-of-the-Years-Digits
Depreciation Expense
Straight-Line
Double-Declining-Balance
During Year

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

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

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

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 $120,000 10%
, ,000 12
,000 80,000 15
,000 60,000 20
,000 40,000 30

21. Disclosure of Depreciation
APB Opinion No. 12 requires the following disclosure:
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.

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. To record the first year’s depreciation expense.
Group Depreciation
To record the purchase.
Cars 200,000
Cash 200,000
$200,000 – $50,000 3
To record the first year’s depreciation expense.
Depreciation Expense 50,000
Accumulated Depreciation 50,000
This same depreciation entry would be made at in the end of the second year.

25. Group Depreciation Three cars were sold after 2 years for $8,000 each.
Cash 24,000
Accumulated Depreciation 36,000
Cars 60,000
.25 ($200,000 – $60,000)
To record the third year’s depreciation expense.
Depreciation Expense 35,000
Accumulated Depreciation 35,000

26. Group Depreciation Five cars were sold after 3 years for $6,000 each.
Cash 30,000
Accumulated Depreciation 70,000
Cars 100,000
To reduce the $11,000 book value to the salvage value.
To record the fourth year’s depreciation expense.
Depreciation Expense 1,000
Accumulated Depreciation 1,000

27. Group Depreciation Group Depreciation
The final two cars were sold for $4,800 each.
Two cars were sold after 3 years for $4,800 each.
Cash 9,600
Accumulated Depreciation 30,000
Loss on Disposal 400
Cars 40,000
Book value = $10,000
Cash received = 9,600
Loss $

28. Composite Depreciation
Annual
Asset Cost Residual Value Life Depreciation
A $25,000 $5, yrs. $2,000
B 13,000 1, ,000
C 12, ,000
$50,000 $6,000 $7,000
Depreciation Rate = = 14%
7,000
$50,000

29. Depreciation for Partial Periods
Annual
Year Depreciation
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
$1,000 x 8/12 =
$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. Depreciation for Partial Periods
Annual
Year Depreciation
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
$667 x 8/12 =
$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 = $1,333
x ($6,000 – $1,333) = 3,113
x ($4,667 – $3,113) = 1,037
4 Remaining balance =
$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. Impairment of Noncurrent Assets
Impairment Test
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
(4 years x $300,000) (1,200,000 )
Book value 1,800,000
Total Book Value $2,600,000

37. Impairment of Noncurrent Assets
Impairment Test
Undiscounted expected
net cash flows
= 5 x ($700,000 – $300,000)
Years
Cash Inflows
Cash Outflows
= 5 x $400,000
= $2,000,000
Because $2,000,000 is less than $2,600,000 (the book value), an impairment loss must be recognized.

38. Impairment of Noncurrent Assets
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

39. Impairment of Noncurrent Assets
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.

40. Impairment of Noncurrent Assets
Loss from Impairment 1,290,282
Accumulated Depreciation:
Factory 200,000
Machinery 1,200,000
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 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
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:
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.

43. Determine depreciation for 2003-2008.
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 2003.
20%
Determine depreciation for

44. MACRS Principles 2003 $200,000 x 20% = $ 40,000

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 Cost – Residual Value Units Unit Depletion Rate =
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 2003.
Unit Depletion Rate =
$3,000,000 – $200,000
1,000,000 tons

47. Depletion 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

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