CHAPTER

11

DEPRECIATION, IMPAIRMENTS, AND DEPLETION

Chapter 11-1

Depreciation - Method of Cost Allocation

Depreciation is the accounting process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset.
Allocating costs of long-term assets:
Fixed assets = Depreciation expense Intangibles = Amortization expense

Natural resources = Depletion expense

Chapter 11-2

Depreciation - Method of Cost Allocation

Factors Involved in the Depreciation Process
Three basic questions:
(1) What depreciable base is to be used? (2) What is the assets useful life? (3) What method of cost allocation is best?

Chapter 11-3

Depreciation - Method of Cost Allocation

Factors Involved in the Depreciation Process
Depreciable Base
Illustration 11-1

Chapter 11-4

Depreciation - Method of Cost Allocation

Factors Involved in the Depreciation Process
Estimation of Service Lifes
Service life of an asset often differs from its physical life. Companies retire assets for two reasons: physical factors (such as casualty or

expiration of physical life) and

economic factors (obsolescence).
Chapter 11-5

Depreciation - Method of Cost Allocation

Methods of Depreciation
The profession requires the method employed be systematic and rational. Examples include:
(1) Activity method (units of use or production).

(2) Straight-line method.

(3) Sum-of-the-years-digits. (4) Declining-balance method. Accelerated methods Special methods

(5) Group and composite methods.

(6) Hybrid or combination methods.
Chapter 11-6

Depreciation - Method of Cost Allocation

Activity Method
Illustration 11-2

Stanley Coal Mines Facts

Illustration: If Stanley uses the crane for 4,000 hours the first year, the depreciation charge is:
Illustration 11-3

Chapter 11-7

Depreciation - Method of Cost Allocation

Straight-Line Method
Illustration 11-2

Stanley Coal Mines Facts

Illustration: Stanley computes depreciation as follows:
Illustration 11-4

Chapter 11-8

Depreciation - Method of Cost Allocation

Decreasing-Charge Methods
Illustration 11-2

Stanley Coal Mines Facts

Sum-of-the-Years-Digits. Each fraction uses the sum of

the years as a denominator (5 + 4 + 3 + 2 + 1 = 15). The

numerator is the number of years of estimated life

remaining as of the beginning of the year.
Chapter 11-9

Depreciation - Method of Cost Allocation

Sum-of-the-Years-Digits
Illustration 11-6

Chapter 11-10

Depreciation - Method of Cost Allocation

Decreasing-Charge Methods
Illustration 11-2

Stanley Coal Mines Facts

Declining-Balance Method.
Utilizes a depreciation rate (percentage) that is some multiple of the straight-line method. Does not deduct the salvage value in computing the depreciation base.
Chapter 11-11

Depreciation - Method of Cost Allocation

Declining-Balance Method
Illustration 11-7

Chapter 11-12

Depreciation - Method of Cost Allocation

E11-5 (Depreciation ComputationsFour Methods): KC Corporation purchased a new machine for its assembly process on August 1, 2010. The cost of this machine was $150,000. The company estimated that the machine would have a salvage value of $24,000 at the end of its service life. Its life is estimated at 5 years and its working hours are estimated at 21,000 hours. Year-end is December 31. Instructions: Compute the depreciation expense under the following methods.

(a) Straight-line depreciation.

(b) Activity method
Chapter 11-13

(c) Sum-of-the-years-digits.
(d) Double-declining balance.

Depreciation - Method of Cost Allocation

Straight-line Method
Year 2010 2011 2012 2013 2014 2015 Depreciable Base $ 126,000 126,000 126,000 126,000 126,000 126,000 / / / / / / Years 5 5 5 5 5 5 = = = = = = Annual Expense $ 25,200 25,200 25,200 25,200 25,200 25,200 x 7/12 = x Partial Year 5/12 = Current Year Expense $ 10,500 25,200 25,200 25,200 25,200 14,700 $ 126,000 Accum. Deprec. $ 10,500 35,700 60,900 86,100 111,300 126,000

Journal entry: 2010 Depreciation expense Accumultated depreciation

Chapter 11-14

10,500 10,500

Depreciation - Method of Cost Allocation

Activity Method
(Given) Hours Used 800 x x x x x 800 Journal entry: 2010 Depreciation expense Accumultated depreciation
Chapter 11-15

(Assume 800 hours used in 2010)

Current Year Expense $ 4,800

($126,000 / 21,000 hours = $6 per hour)

Rate per Hours $6 = = = = = $ 4,800 Annual Expense $ 4,800 Partial Year Accum. Deprec. $ 4,800

Year 2010 2011 2012 2013 2014

4,800 4,800

LO 3

Depreciation - Method of Cost Allocation

Sum-of-the-Years-Digits Method
Year 2010 2011 2012 2013 2014 2015 Depreciable Base $ 126,000 126,000 126,000 126,000 126,000 126,000 x x x x x x Years 5/15 = Annual Expense 42,000 38,500 30,100 21,700 13,300 4,900 x Partial Year 5/12

5/12 = .416667 7/12 = .583333

Current Year Expense $ 17,500 38,500 30,100 21,700 13,300 4,900 $ 126,000 Accum. Deprec. $ 17,500 56,000 86,100 107,800 121,100 126,000

4.58/15 = 3.58/15 = 2.58/15 = 1.58/15 = .58/15 =

Journal entry: 2010

Chapter 11-16

Depreciation expense Accumultated depreciation

17,500 17,500

LO 3

Depreciation - Method of Cost Allocation

Double-Declining Balance Method
Year 2010 2011 2012 2013 2014 Depreciable Base $ 150,000 x 125,000 x 75,000 x 45,000 x 27,000 x Rate per Year 40% 40% 40% 40% 40% = = = = = Annual Expense $ 60,000 x 50,000 30,000 18,000 10,800 Plug Partial Year 5/12 Current Year Expense = $ 25,000 50,000 30,000 18,000 3,000 $ 126,000

Journal entry: 2010

Chapter 11-17

Depreciation expense Accumultated depreciation

25,000 25,000
LO 3

Depreciation - Method of Cost Allocation

Special Depreciation Methods
The choice of method depends on the nature of the assets involved:
Group method used when the assets are similar in nature and have approximately the same useful lives. Composite approach used when the assets are dissimilar and have different lives. Companies are also free to develop tailor-made depreciation methods, provided the method results in the allocation of an assets cost in a systematic and rational manner (Hybrid or Combination Methods).
Chapter 11-18

Depreciation - Method of Cost Allocation

Special Depreciation Issues
(1) How should companies compute depreciation for partial periods?
Companies normally compute depreciation on the basis of the nearest full month.

(2) Does depreciation provide for the replacement of assets?

Funds for the replacement of the assets come from the revenues

(3) How should companies handle revisions in depreciation rates?

Chapter 11-19

Depreciation - Method of Cost Allocation

Changes in Depreciation Rate
Accounted for in the period of change and future periods (Change in Estimate) Not handled retrospectively Not considered errors or extraordinary items

Chapter 11-20

Change in Estimate Example

Arcadia HS, purchased equipment for $510,000 which was estimated to have a useful life of 10 years with a salvage value of $10,000 at the end of that time. Depreciation has been recorded for 7 years on a straight-line basis. In 2010 (year 8), it is determined that the total estimated life should be 15 years with a salvage value of $5,000 at the end of that time. Questions: What is the journal entry to correct the prior years depreciation? Calculate the depreciation expense for 2010.
Chapter 11-21

No Entry Required

Change in Estimate Example

Equipment cost Salvage value Depreciable base Useful life (original) Annual depreciation

After 7 years

$510,000 First, establish - 10,000 NBV at date of change in estimate. 500,000 10 years $ 50,000 x 7 years = $350,000

Balance Sheet (Dec. 31, 2009) Fixed Assets: Equipment Accumulated depreciation Net book value (NBV)
Chapter 11-22

$510,000 350,000 $160,000

Change in Estimate Example

Net book value Salvage value (new) Depreciable base Useful life remaining Annual depreciation $160,000 5,000 155,000 8 years $ 19,375

After 7 years
Depreciation Expense calculation for 2010.

Journal entry for 2010

Depreciation expense
Accumulated depreciation
Chapter 11-23

19,375
19,375

Impairments
When the carrying amount of an asset is not recoverable, a company records a write-off referred to as an impairment.
Events leading to an impairment:
a. c. Decrease in the market value of an asset. Adverse change in legal factors or in the business climate. b. Change in the manner in which an asset is used. d. An accumulation of costs in excess of the amount originally expected to acquire or construct an asset. e. A projection or forecast that demonstrates continuing losses associated with an asset.

Chapter 11-24

Impairments
Measuring Impairments
1. Review events for possible impairment.
2. If the review indicates impairment, apply the recoverability test. If the sum of the expected future net cash flows from the long-lived asset is less than the carrying amount of the asset, an impairment has occurred. 3. Assuming an impairment, the impairment loss is the amount by which the carrying amount of the asset exceeds the fair value of the asset. The fair value is the market value or the present value of expected future net cash flows.
Chapter 11-25

Impairments
E11-16 (Impairment): Presented below is information related to equipment owned by Pujols Company at December 31, 2010. Assume that Pujols will continue to use this asset in the future. As of December 31, 2010, the equipment has a remaining useful life of 4 years.
Cost Accumulated depreciation to date Expected future net cash flows Fair value $ 9,000,000 1,000,000 7,000,000 4,400,000

Instructions:

(a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2010. (b) Prepare the journal entry to record depreciation expense for 2011. (c) The fair value of the equipment at December 31, 2011, is $5,100,000. Prepare the journal entry (if any) necessary to record this increase in fair value.
Chapter 11-26

Impairments
(a).
Cost Accumulated depreciation Carrying amount Fair value Loss on impairment $9,000,000 1,000,000 8,000,000 4,400,000 $3,600,000

12/31/10

Loss on impairment
Accumulated depreciation
Chapter 11-27

3,600,000
3,600,000

Impairments
(b).

Net carrying amount Useful life Depreciation per year

12/31/11

$4,400,000 4 years $1,100,000

Depreciation expense
Accumulated depreciation

1,100,000
1,100,000

(c). Restoration of any impairment loss is not permitted.

Chapter 11-28

Depletion
Natural resources, often called wasting assets, include petroleum, minerals, and timber. They have two main features:
1. complete removal (consumption) of the asset, and 2. replacement of the asset only by an act of nature. Depletion is the process of allocating the cost of natural resources.

Chapter 11-29

Depletion
Establishing a Depletion Base
Computation of the depletion base involves four factors: (1) Acquisition cost of the deposit, (2) Exploration costs, (3) Development costs, and (4) Restoration costs.

Chapter 11-30

Depletion
Write-off of Resource Cost
Normally, companies compute depletion on a units-ofproduction method (an activity approach). Thus, depletion is a function of the number of units extracted during the period. Calculation:
Total cost Salvage value

Total estimated units available

Units extracted x Cost per unit
Chapter 11-31

= Depletion cost per unit = Depletion

Depletion
E11-19 (Depletion ComputationsTimber): Hernandez Timber Company owns 9,000 acres of timberland purchased in 1999 at a cost of $1,400 per acre. At the time of purchase the land without the timber was valued at $400 per acre. In 2000, Hernandez built fire lanes and roads, with a life of 30 years, at a cost of $87,000. Every year Hernandez sprays to prevent disease at a cost of $3,000 per year and spends $7,000 to maintain the fire lanes and roads. During 2001, Hernandez selectively logged and sold 700,000 board feet of timber, of the estimated 3,000,000 board feet. In 2002, Hernandez planted new seedlings to replace the trees cut at a cost of $100,000.

Instructions:
Determine the depreciation expense and the cost of timber sold related to depletion for 2001.
Chapter 11-32

Depletion
E11-19 (Depletion ComputationsTimber)

Depreciation Expense:
Fire lanes and roads Useful life Depreciation expense per year $ 87,000 30 $ 2,900

Chapter 11-33

Depletion
E11-19 (Depletion ComputationsTimber)

Depletion:
Cost of timberland per acre Cost of land per acre Cost of timber only per acre Total acres Value of timber Estimated total board feet Cost per board foot Board feet of timber sold Cost of timber sold related to depletion
Chapter 11-34

$ $ $ $ $

1,400 (400) 1,000 9,000 9,000,000 3,000,000 3.00 700,000 2,100,000

Depletion
Estimating Recoverable Reserves
Same as accounting for changes in estimates.
Revise the depletion rate on a prospective basis. Divides the remaining cost by the new estimate of the recoverable reserves.

Chapter 11-35

Depletion
Liquidating Dividends Dividends greater than the amount of accumulated net income. Illustration: Callahan Mining had a retained earnings balance of $1,650,000 and paid-in capital in excess of par of $5,435,493. Callahans board declared a dividend of $3 a share on the 1,000,000 shares outstanding. It records the $3,000,000 cash dividend as follows.

Retained Earnings
Paid-in Capital in Excess of Par Cash
Chapter 11-36

1,650,000
1,350,000 3,000,000

Depletion
Continuing Controversy
Oil and Gas Industry:
Full cost concept Successful efforts concept

Chapter 11-37

Presentation and Analysis

Presentation of Property, Plant, Equipment, and Natural Resources
Depreciating assets, use Accumulated Depreciation. Depleting assets may include use of Accumulated Depletion account, or the direct reduction of asset.
Basis of valuation (cost) Pledges, liens, and other commitments Depreciation expense for the period. Balances of major classes of depreciable assets. Accumulated depreciation. A description of the depreciation methods used.

Disclosures

Chapter 11-38

Presentation and Analysis

The assets turnover is a measure of a firms ability to generate sales from a particular investment in assets.

Illustration 11-20

Chapter 11-39

Presentation and Analysis

The profit margin on sales is a measure of the ability to generate operating income from a particular level of sales.

Illustration 11-21

Chapter 11-40

Presentation and Analysis

Rate of Return on Assets measures a firms success in using assets to generate earnings.

Illustration 11-22

Chapter 11-41

Presentation and Analysis

The analyst obtains further insight into the behavior of ROA by disaggregating it into components of profit margin on sales and asset turnover as follows:
Rate of Return on Assets Net Income Average Total Assets = Profit Margin on Sales Net Income Net Sales x Asset Turnover Net Sales Average Total Assets

Chapter 11-42

Presentation and Analysis

The analyst obtains further insight into the behavior of ROA by disaggregating it into components of profit margin on sales and asset turnover as follows:
Rate of Return on Assets $64.2 ($811.8 + 665.3) / 2 8.7%
Chapter 11-43

Profit Margin on Sales $64.2 $420.1

Asset Turnover $420.1 ($811.8 + 665.3) / 2

15.28%

.569