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CHAPTER 11
DEPRECIATION, IMPAIRMENTS, AND DEPLETION
Part 1: Read Chapter 11; answer the questions below; and work BE 7, 8 and 9; EX 9.
Part 2: Work EX 2, 4, 5, and 6.
“Depreciation is not a matter of valuation but a means of cost allocation.” What does this mean?
The costs of all long-lived assets (except land and intangible assets with indefinite lives) are written off over the asset’s useful life.
Depreciation = tangible plant assets.
Depletion = natural resources.
Amortization = intangible assets.
The amount of depreciation expense for a period depends on three things:
1. depreciable base = ________________________________________
2. estimated useful life
3. method of cost apportionment (depreciation) used
Book value = ______________________________________________-
Methods of depreciation:
1. Activity method – depreciation is based on how much the asset is used or how much it produces. Depreciation per unit = (cost – salvage) / total estimated units. Depreciation per period = depreciation per unit * actual units.
2. Straight-line method – depreciation is based on passage of time. Depreciation per year = (cost – salvage) / total estimated useful life in years.
3. Sum-of-the-years’-digits method (accelerated method). Depreciation per year = (cost – salvage) * # of years of EUL remaining from beginning of year
sum of the years’ digits
4. Declining balance method at twice the straight line rate (accelerated method). Depreciation per year = book value * 2 / EUL.
5. Group/composite method – see below.
GROUP/COMPOSITE METHOD – used to depreciate multiple assets using one rate. Group = similar assets. Composite = dissimilar assets. There is no difference in the application of the method to group or composite assets.
Calculation of depreciation under group/composite method:
1. Compute the annual straight-line depreciation for each asset and total this.
2. Find the group/composite depreciation rate = annual total depreciation
total cost
3. Compute annual depreciation for asset group = depreciation rate * total cost of assets
Sale of asset from group:
We do not recognize any gain or loss on sale of asset. Because individual assets are not being depreciated, it is not possible to know the amount of accumulated depreciation associated with the asset being sold. Therefore, accumulated depreciation is a plug (difference between proceeds and original cost) and no gain or loss is recognized.
Work EX 9
REVISION OF DEPRECIATION RATES:
Depreciation is based on estimated useful life and estimated salvage value. When it becomes apparent that either or both of these estimates is incorrect, we have a change in estimate. A change in estimate is handled prospectively. This means
1. do not restate prior periods’ financial statements or make any adjustments to amount previously reported.
2. compute depreciation for the current and future periods using the new estimates. (That is, we stop and start over.)
Revised depreciation = book value – new salvage value
remaining estimated useful life
Work BE 7
IMPAIRMENTS – long-lived assets are reported at original cost minus accumulated depreciation unless the asset has suffered a permanent impairment (loss in value).
When an impairment is suspected,
1. apply a recoverability test by estimating the future net cash flows expected from the use of the asset and its disposition. If the sum of future net cash flows (undiscounted) < book value, the asset is impaired.
2. if recoverability test indicates an impairment has occurred, compute the loss. Loss = book value – fair value. Where fair value =
a. market value, if an active market exists for the asset or
b. the present value of the expected future net cash flows from the asset (use the company’s market rate of interest as discount rate).
3. Record Loss on Impairment as follows:
LOSS on IMPAIRMENT XX
ACCUMULATED DEPRECIATION XX
Impairment loss is reported as a component of income from continuing operations.
Once an impairment loss has been recorded, the reduced book value of the impaired asset held for use becomes its new cost basis. A new depreciation rate must be calculated the same as for a change in depreciation estimate.
If the asset is held for sale, it is reported at the lower of cost or net realizable value. NRV = ______________________________________________________________________.
No depreciation is recorded on the asset and the loss may be recovered if the NRV increases (but can never exceed original cost).
Work BE 8
DEPLETION OF NATURAL RESOURCES:
Two main characteristics of natural resources are the complete removal of the asset and replacement of the asset only by act of nature.
Depletion base = acquisition cost + intangible development costs + restoration costs – salvage
Costs:
1. Acquisition cost = price paid to obtain the property right to search and find an undiscovered natural resource or the price paid for an already discovered resource
2. Exploration costs = costs to find the resource. Usually expensed as incurred.
3. Development costs =
a. Tangible equipment needed to extract the resource and get it ready for production or shipment. Recorded in separate asset account and depreciated. This depreciation is a part of the cost of the natural resource inventory.
b. Intangible development costs are drilling costs, tunnels, shafts, and wells which have no physical characteristics but are needed for the production of the natural resource. These costs are part of the depletion base.
4. Restoration costs = costs to restore land to its natural state after extraction.
Depletion is computed using the units of production method (activity method). If the resource is not sold, it is reported as inventory on the balance sheet. If the resource is sold, it is reported as COGS on the income statement.
Work BE 9.
CLASS EXAMPLE 1
DEPRECIATION METHODS
On January 1, 2001, the Smith Company purchased equipment for $160,000. The equipment is expected to be useful to the company for 3 years at the end of which the company estimates that it can sell the equipment for $10,000.
What is the estimated cost of using the equipment for 3 years? _________________
This is called the depreciable base (depreciable cost or depreciable value). This is the total amount of expense the company should recognize over the periods in which the asset is used.
What is the estimated useful life of the equipment? __________ years
What is the residual or salvage value of the equipment? ______________________
ACTIVITY METHOD:
Compute the depreciation for 2001, 2002 and 2003 for the machine using the activity method. The machine is expected to produce 150,000 units over its useful life. The machine actually produced 40,000 units in 2001; 60,000 in 2002; and 50,000 in 2003.
Step 1: Compute the amount of depreciation per unit
Depreciation per unit = Cost – Salvage = ______________________
Total estimated units
Step 2: Compute the depreciation for the period (year):
Depreciation per period = depreciation per unit * actual units produced
Depreciation for 2001 =
Depreciation for 2002 =
Depreciation for 2003 =
What is the book value of the machine at the end of:
2001? _________________________________________________________
2002? _________________________________________________________
2003? _________________________________________________________
STRAIGHT-LINE METHOD:
Compute the depreciation for 2001, 2002 and 2003 for the equipment using the straight-line method.
Depreciation per year = Cost – Salvage
Estimated useful life
Depreciation for 2001 =
Depreciation for 2002 =
Depreciation for 2003 =
What is the book value of the machine at the end of:
2001? _________________________________________________________
2002? _________________________________________________________
2003? _________________________________________________________
SUM-OF-THE-YEARS’ DIGITS METHOD:
Compute the depreciation for 2001, 2002 and 2003 for the equipment using the sum-of-the-years’ digits method.
SYD = sum of the years’ digits = 1 + 2 + 3 + … + n where n = estimated useful life.
SYD = n (n + 1)
2
Depreciation/year = (cost – salvage) * # of years of EUL remaining from beg. of year
Sum of the years’ digits (SYD)
Depreciation for 2001 =
Depreciation for 2002 =
Depreciation for 2003 =
What is the book value of the machine at the end of:
2001? _________________________________________________________
2002? _________________________________________________________
2003? _________________________________________________________
DECLINING BALANCE METHOD:
Compute depreciation for 2001, 2002, and 2003 for the equipment using the declining balance method at twice the straight-line rate (called double-declining balance or DDB). Other rates such as 150% may also be used.
Depreciation per year = Book Value * 2 / EUL (Note: do not subtract salvage.)
Depreciation for 2001 =
Depreciation for 2002 =
Depreciation for 2003 =
What is the book value of the machine at the end of:
2001? _________________________________________________________
2002? _________________________________________________________
2003? _________________________________________________________
CLASS EXAMPLE 2
PARTIAL YEAR DEPRECIATION
Use the same information as in example 1: Equipment purchased at cost of $160,000, salvage value of $10,000 and EUL of 3 years. Assume instead that the equipment was purchased on March 1, 2001.
Compute depreciation for 2001, 2002, 2003 and 2004 using the straight-line method.
Depreciation = (Cost – Salvage) * portion of year used
EUL
Depreciation for 2001:
Depreciation for 2002:
Depreciation for 2003:
Depreciation for 2004:
Compute the depreciation for each year using the sum-of-the-years’ digits method. Use the amounts calculated in example 1 and allocate to the proper years.
Depreciation for 2001: $75,000 * 10/12 = $62,500
Depreciation for 2002: ($75,000 * 2/12) + ($50,000 * 10/12) = $12,500 + $41,667 = $54,167
Depreciation for 2003:
Depreciation for 2004:
Compute depreciation for each year using the double-declining balance method. Use the amounts computed in example 1 and allocate to the proper years.
Depreciation for 2001: $106,667 * 10/12 = $88,889
Depreciation for 2002: ($106,667 * 2/12) + ($35,555 * 10/12) = $17,778 + $29,629 = $47,407
Depreciation for 2003:
Depreciation for 2004:
CLASS EXAMPLE 3
ALTERNATIVE PARTIAL YEAR METHODS
Many companies choose an alternative method for partial year depreciation where all assets acquired during the year are depreciated the same portion of a year. This is acceptable as long as it is consistently applied.
Assume straight-line depreciation and compute the depreciation for the equipment (cost of $160,000, salvage of $10,000 and EUL of 3) purchased on March 1, 2001 under the following three independent assumptions. (Note, that it does not matter what day in 2001 the equipment was purchased under these methods.)
Method 1: A half-year of depreciation in the period of acquisition and half-year in period of disposal.
Depreciation for 2001:
Depreciation for 2002:
Depreciation for 2003:
Depreciation for 2004:
Method 2: A full-year of depreciation in the period of acquisition and none in period of disposal.
Depreciation for 2001:
Depreciation for 2002:
Depreciation for 2003:
Depreciation for 2004:
Method 3: No depreciation in the period of acquisition and a full-year in period of disposal.
Depreciation for 2001:
Depreciation for 2002:
Depreciation for 2003:
Depreciation for 2004: