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Chapter 11

Chapter 11. Depreciation, Impairments, and Depletion. 1. Theory of Depreciation. Definition the systematic and rational allocation of the cost of a fixed asset Depreciation is an allocation method – not a valuation method Justification matching

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Chapter 11

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  1. Chapter 11 Depreciation, Impairments, and Depletion

  2. 1. Theory of Depreciation • Definition • the systematic and rational allocation of the cost of a fixed asset • Depreciation is an allocation method – not a valuation method • Justification • matching • fluctuations in market value too difficult to determine

  3. 2. Depreciation Factors • Cost – covered in Chapter 10 • Salvage value – estimated • Useful life • useful life vs. physical life • functional factors • changes in environment, asset inadequate for intended purpose, obsolescence, supersession • physical factors • routine wear and tear, deterioration, effects of continual usage, etc.

  4. 3. Selecting Appropriate Method • Factors • expected use, expected obsolescence, expected pattern of decline in usefulness of asset, expected contribution of asset to revenue, etc. • Conceptually • method that most clearly reflects net income • Practically • method that minimizes bookkeeping expenses • method that reports highest net income • Consistency

  5. 4. Depreciation Methods • Activity method • can be based on output (e.g., units produced) • can be based on inputs (e.g., operating hours or miles) Depr = Cost – Salvage x Productive ServiceExp Life in Units

  6. 4. Depreciation Methods

  7. 4. Depreciation Methods

  8. 4. Depreciation Methods • Straight Line • most commonly used method • easy to use

  9. 4. Depreciation Methods

  10. 4. Depreciation Methods • Sum-of-the-years’ digits • (cost – savage) x declining fraction • numerator of fraction • years in life of asset in reverse order • denominator of fraction • sum of the years • compute denominator of fraction asn (n + 1) 2

  11. 4. Depreciation Methods

  12. 4. Depreciation Methods • Declining balance • remaining BV x fixed rate • rate is a multiple of the straight line rate • compute straight line rate as: 100% / life in years • rates commonly used: 125%, 150%, 200%

  13. 4. Depreciation Methods

  14. 4. Depreciation Methods • Group and Composite methods • assets grouped by common characteristics • average depreciation rate used as if a single unit • depreciation expense = group cost x average rate • Composite • refers to collection of dissimilar assets • Group • refers to collection of similar assets • Use straight line depreciation method • No gain or loss recorded on disposals until entire group disposed of • debit accumulated depreciation for difference between asset’s cost and the proceeds • Example BE 11-6

  15. 4. Depreciation Methods BRIEF EXERCISE 11-6 AssetDepreciation Expense A ($70,000 – $7,000) / 10 = $ 6,300 B ($50,000– $5,000)/5= 9,000 C ($82,000 – $4,000) / 12 = 6,500 $202,000 $16,000 $21,800 Composite rate = $21,800/$202,000 = 10.8% Composite life = ($202,000 – 16,000) / $21,800 = 8.53 years

  16. 4. Depreciation Methods • BRIEF EXERCISE 11-6 Extension Asset A was sold for $60,000 on the first day of year 2. Prepare entry to record sale. Cash 60,000 Accumulated Depreciation 10,000 Equipment 70,000

  17. 4. Depreciation Methods • BRIEF EXERCISE 11-6 Extension Calculate depreciation expense for year 2 for the group. 132,000 x 10.8% = 14,256 Depreciation Expense 14,256 Accumulated Depreciation 14,256

  18. 4. Depreciation Methods • Other methods • Inventory method • sometimes used for large numbers of low cost assets • Retirement and Replacement methods • sometimes used if have large number of similar assets replaced on constant schedule • Retirement method • FIFO approach • Replacement method • LIFO approach • Examples

  19. 4. Depreciation Methods • Partial years • conventions – must be used consistently • half year in first and last year • full year in first year and none in last year • none in first year and full year in last year • nearest month • SYD • prorate 12-month blocks of depreciation between years • DB • use partial year fraction in first year only • Example

  20. 5. Changes in Depreciation • Change in accounting estimate • method, salvage, or life • Depreciate remaining BV over remaining life • Example • Cost = $11,000 • Salvage = $1,000 • Life = 5 years • Date Acquired = January 1, 2012

  21. 5. Changes in Depreciation • SL depreciation: 11,000 – 1,000 / 5 = 2,000 • During 2015, changed life from 5 years to 7 • New depreciation used for 2015 and forward

  22. 6. Depletion • Depreciable assets retain their physical characteristics as used • Natural resources (coal, gas, oil) are used up • as natural resources used up • cost of natural resources allocated to units extracted • Use the units-of-production method • determine depletion base (acquisition cost, development cost, carrying cost) • estimate recoverable units • calculate depletion rate:Cost of Natural Resource – Residual Value Estimated Recoverable Units

  23. 6. Depletion • Example • ABC Mining acquired a tract of land containing ore deposits. Total costs of acquisition and development were $1,100,000. ABC estimated the land contained 40,000 tons of ore, and that the land will be sold for $100,000 after the coal is mined. What is ABC’s depletion rate?

  24. 6. Depletion • Solution Depletion rate = 1,000,000 ÷ 40,000 Tons = $25 Per Ton Assume ABC mined 13,000 tons this year. What is the total amount of depletion for the year? Depletion = 13,000 tons × $25per ton = $325,000 What is the amount of CGS for the year?

  25. 7. Impairments • An impairment occurs when expected future net cash flows (undiscounted) of an asset are less than the asset’s carrying amount

  26. 7. Impairments • Test for impairment • review events for possible impairment • apply recoverability testto determine if impairment has occurred • impairment occurs if sum of expected future net cash flows (undiscounted) is less than asset’s carrying amount • if impairment has occurred • recognize impairment loss for amount by which the carrying amount of the asset exceeds fair value of asset • fair value is market price if active market exists • if no market, use present value of expected future net cash flows

  27. 7. Impairments • if impaired asset is held for use • new cost basis of asset is the reduced carrying amount • depreciation is taken on new cost basis over asset’s remaining useful life • write-ups of asset’s value are not allowed • if impaired asset is intended to be disposed of • reported at the lower-of cost-or-net realizable value • recovery of impairment loss is allowed but write-up cannot exceed carrying amount of asset before impairment

  28. 7. Impairments

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