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Depreciation and Depletion

C. 10. hapter. Depreciation and Depletion. 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.

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Depreciation and Depletion

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  1. C 10 hapter Depreciation and Depletion

  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

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

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

  11. Depreciation Book Value at Year Base Fraction Depreciation Year-End Methods of Cost Allocation Time-Based Method: Sum-of-the-Years’ Digits 2003 $100,000 5/15 $ 33,333 $86,667 2004 100,000 4/15 26,667 60,000 2005 100,000 3/15 20,000 40,000 2006 100,000 2/15 13,333 26,667 2007 100,000 1/15 6,667 20,000 $100,000 Residual Value

  12. Book Value at Book Value at Year Beginning of Year Rate Depreciation Year-End Methods of Cost Allocation Double-Declining Balance Time-Based Method: Declining-Balance 2003 $120,000 40% $ 48,000 $72,000 2004 72,000 40% 28,800 43,200 2005 43,200 40% 17,280 25,920 2006 25,920 --- 5,920 20,000 2007 20,000 --- --- 20,000 $100,000 Residual Value

  13. Book Value at Book Value at Year Beginning of Year Rate Depreciation Year-End Methods of Cost Allocation 150%-Declining Balance Time-Based Method: Declining-Balance 2003 $120,000 30% $ 36,000 $84,000 2004 84,000 30% 25,200 58,800 2005 58,800 30% 17,640 41,160 2006 41,160 30% 12,348 28,812 2007 28,812 --- 8,812 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. Sum-of-the-Years-Digits Straight-Line Double-Declining-Balance Conceptual Evaluation of Depreciation Methods $ Depreciation Expense 2003 2004 2005 2006 2007 During Year

  17. Sum-of-the-Years-Digits Straight-Line Double-Declining-Balance Conceptual Evaluation of Depreciation Methods $ Book Value 2003 2004 2005 2006 2007 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 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 $120,000 10% 2004 12,000 100,000 12 2005 12,000 80,000 15 2006 12,000 60,000 20 2007 12,000 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 2000 1997 1994 1990 1986 1982 Straight-line ……...…. 576 578 573 560 561 562 Declining-balance. ….. 22 26 27 38 49 57 Sum-of-the-years- digits ………………. 7 10 9 11 14 20 Accelerated method, not specified ……….. 53 50 49 69 77 69 Units-of-production …. 34 39 49 50 48 62

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

  24. $200,000 – $50,000 3 Group Depreciation To record the purchase. Cars 200,000 Cash 200,000 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. .25 ($200,000 – $60,000) Group Depreciation Three cars were sold after 2 years for $8,000 each. Cash 24,000 Accumulated Depreciation 36,000 Cars 60,000 To record the third year’s depreciation expense. Depreciation Expense 35,000 Accumulated Depreciation 35,000

  26. To reduce the $11,000 book value to the salvage value. Group Depreciation Five cars were sold after 3 years for $6,000 each. Cash 30,000 Accumulated Depreciation 70,000 Cars 100,000 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 $ 400

  28. 7,000 $50,000 Depreciation Rate = = 14% Composite Depreciation Annual Asset Cost Residual Value Life Depreciation A $25,000 $5,000 10 yrs. $2,000 B 13,000 1,000 6 2,000 C 12,000 ----- 4 3,000 $50,000 $6,000 $7,000

  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. Thefirm uses thesums-of-the-years’-digitsmethod.

  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. Thefirm uses thedouble-declining-balancemethod. OR

  31. Depreciation for Partial Periods Annual Year Depreciation 1 4/12 x $4,000 = $1,333 2 0.667 x ($6,000 – $1,333) = 3,113 3 0.667 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 Test (Undiscounted Cash Flows < Book Value of Asset) Measurement of Loss (Loss = Fair Value – Book Value) Impairment of Noncurrent Assets An impairment loss involves the following steps: Events or Changes in Circumstances Occurs

  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 Less: Accumulated depreciation (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) Cash Inflows Cash Outflows Years = 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. Book value $2,600,000 Fair value (1,309,718 ) Impairment loss $1,290,282 Impairment of Noncurrent Assets Measurement of the Loss 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

  39. Impairment of Noncurrent Assets The Statementdoes 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. $1,309,718 x [$3,000,000 ÷ ($3,000,000 ÷ $1,000,000)] $1,309,718 x [$1,000,000 ÷ ($3,000,000 ÷ $1,000,000)] Impairment of Noncurrent Assets Loss from Impairment 1,290,282 Accumulated Depreciation: Factory 200,000 Accumulated Depreciation: 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

  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. 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. 20% Examine Exhibit l0-12 to determine the annual depreciation rate for 2003. Determine depreciation for 2003-2008.

  44. MACRS Principles 2003 $200,000 x 20% = $ 40,000 2004 $200,000 x 32% = 64,000 2005 $200,000 x 19.20% = 38,400 2006 $200,000 x 11.52% = 23,040 2007 $200,000 x 11.52% = 23,040 2008 $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. $3,000,000 – $200,000 1,000,000 tons Unit Depletion Rate = 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.

  47. Cost – Residual Value Units Unit Depletion Rate = Depletion for Year = $2.80 x 80,000 = $224,000 $3,000,000 – $200,000 1,000,000 tons Unit Depletion Rate = Depletion Unit Depletion Rate = $2.80 per ton

  48. C 10 hapter The End

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