1. Depreciation and Depletion C hapter 11 An electronic presentation by Norman Sunderman Angelo State University An electronic presentation by Norman Sunderman Angelo State University COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Intermediate Accounting 10th edition Nikolai Bazley Jones

2. 2 Factors Involved in Depreciation Asset cost Service life Residual value Method of cost allocation

3. 3 Service Life Service life is the measure of the number of units of service expected from the asset before its disposal. Factors Involved in Depreciation

4. 4 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

5. 5 Residual Value Residual, or salvage value, is the net amount that can be expected to be obtained when the asset is disposed. Factors Involved in Depreciation

6. 6 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

7. 7 Depreciation Rate = Cost - Residual Value Service Life = $120,000 - $20,000 5 Years Time-Based Method: Straight Line = $20,000 per year Methods of Cost Allocation

8. 8 Time-Based Method: Sum-of-the-Years’ Digits Years of service remaining at beginning of year Years Remaining 1 5 2 4 3 3 42 5 1 Sum-of-the-Years’-Digits = 15 15 Years of service remaining at beginning of year Years Remaining 1 5 2 4 3 3 42 5 1 Sum-of-the-Years’-Digits = 15 15 (n + 1) n = 30 = 15 2 2 (n + 1) n = 30 = 15 2 2 Methods of Cost Allocation

9. 9 Time-Based Method: Sum-of-the-Years’ Digits Depreciation Book Value at Year BaseFractionDepreciationYear-End 2006$100,0005/15$ 33,333$86,667 2007100,0004/1526,66760,000 2008100,0003/1520,00040,000 2009100,0002/1513,33326,667 2010100,0001/15 6,66720,000 $100,000 Residual Value Methods of Cost Allocation

10. 10 Time-Based Method: Declining-Balance Book Value at Book Value at Year Beginning of YearRate Depreciation Year-End 2006$120,00040%$ 48,000$72,000 200772,00040%28,80043,200 200843,20040%17,28025,920 200925,920--- 5,92020,000 201020,000--- --- 20,000 $100,000 Double-Declining Balance Residual Value Methods of Cost Allocation PlugPlug

11. 11 Time-Based Method: Declining-Balance Book Value at Book Value at Year Beginning of Year Rate Depreciation Year-End 2006$120,00030%$ 36,000$84,000 200784,00030%25,20058,800 200858,80030%17,64041,160 200941,16030%12,34828,812 201028,812--- 8,81220,000 $100,000 150%-Declining Balance Residual Value Methods of Cost Allocation

12. 12 Activity Method 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 = $21,000 (2,100 hours x $10) = $10 per hour Methods of Cost Allocation

13. 13 The credit to depreciation is usually called Accumulated Depreciation or Allowance for Depreciation. Recording Depreciation

14. 14 Depreciation Expense $ 2006 2007 2008 2009 2010 During Year Straight-Line Sum-of-the-Years-Digits Double-Declining-Balance Conceptual Evaluation of Depreciation Methods

15. 15 Book Value $ 2006 2007 2008 2009 2010 At End of Year Straight-Line Sum-of-the-Years-Digits Double-Declining-Balance Conceptual Evaluation of Depreciation Methods

16. 16 If a company expects that repairs and maintenance costs and the total economic benefits of the asset will remain similar each period,... Conceptual Evaluation of Depreciation Methods

17. 17 …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

18. 18 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

19. 19 …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

20. 20 Effect of Depreciation on Rate of Return Book Value of Asset Rate of Year Net Income at Beginning of Year Return 2006$12,000$120,00010% 200712,000100,00012 200812,00080,00015 200912,00060,00020 201012,00040,00030 2006$12,000$120,00010% 200712,000100,00012 200812,00080,00015 200912,00060,00020 201012,00040,00030

21. 21 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. APB Opinion No. 12 requires the following:

22. 22 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. Group Depreciation

23. 23 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 Group Depreciation

24. 24 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 Depreciation35,000.25 ($200,000 – $60,000) Group Depreciation

25. 25 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. Group Depreciation

26. 26 The final two cars were sold for $4,800 each. Cash9,600 Accumulated Depreciation30,000 Loss on Disposal400 Cars40,000 Two cars were sold after 3 years for $4,800 each. Book value = $10,000 Cash received = 9,600 Loss$ 400 Loss$ 400 Group Depreciation

27. 27 Annual Asset Cost Residual Value Life Depreciation A$25,000$5,00010 yrs.$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

28. 28 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. Depreciation for Partial Periods

29. 29 1$6,000 x 2/3 x 4/12 = $1,333 2($6,000-$1,333) x 2/3= $3,111 3($4,667-$3,111) x 2/3 = 1,037 4Remaining balance= $ 518 Annual Year Depreciation Declining-Balance-Method Depreciation for Partial Periods

30. 30 Impairment of Noncurrent Assets The FASB issued FASB Statement No. 144 which requires a company to review its property, plant, and equipment for impairment.

31. 31 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.

32. 32 Impairment of a Noncurrent Asset Impairment Test If the total undiscounted cash flows are less than the book value of the asset, an impairment loss is recognized. Impairment Test If the total undiscounted cash flows 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.

33. 33 Impairment of a Noncurrent Asset On January 1, 2004, the Hall Company purchased a factory for $1 million (20-year life) and machinery for $3 million (10-year life). Late in 2007, 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.

34. 34 December 31, 2007 Factory cost$1,000,000 Less: Accumulated depreciation (4 x $50,000) (200,000) Book value$ 800,000 Machinery cost$3,000,000 Less: Accumulated depreciation (4 x $300,000)(1,200,000) Book value1,800,000 Total Book Value$2,600,000 Impairment Test Impairment of a Noncurrent Asset

35. 35 = 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 a Noncurrent Asset

36. 36 Measurement of the Loss Undiscounted annual cash flows Present value of the expected cash flows (fair value) = $400,000 x 3.274294 = $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 a Noncurrent Asset

37. 37 FASB Statement No. 121 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 a Noncurrent Asset

38. 38 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 x [$1,000,000 ÷ ($3,000,000 + $1,000,000)] $1,309,718 x [$3,000,000 ÷ ($3,000,000 + $1,000,000)] Impairment of a Noncurrent Asset

39. 39 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. Conceptual Evaluation of Asset Impairment

40. 40 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, the Modified Accelerated Cost Recovery System (MACRS) is required for tax purposes. A company’s computation of depreciation for income tax and financial reporting differ in three major respects: Depreciation for Tax Purposes

41. 41 On January 1, 2006, 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 l1-3 to determine the annual depreciation rate for 2006. 20% Determine depreciation for 2006-2011. MACRS Principles

42. 42 Changes and Corrections of Depreciation  A change in an estimate of the residual value or the service life of a currently owned asset is accounted for prospectively.  A change in the depreciation method for currently owned assets is accounted for prospectively.  Correction of an error in depreciation is treated as prior period adjustment (restatement).

43. 43 Depletion  Depletion of natural resources is calculated using the units of activity method  Any environmental costs at the end of the project are added to the cost in determining depletion per unit

44. 44 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

45. 45 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 Depletion

46. 46 C hapter 11 Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.