1

Chapter 10

Depreciation
Depreciation
and
and Depletion
Depletion
An
Anelectronic
electronicpresentation
presentation
by
byDouglas
DouglasCloud
Cloud
Pepperdine
PepperdineUniversity
University
 2

Objectives
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
Continued
 3

Objectives
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
Factors Involved
Involved in
in Depreciation
Depreciation

 Asset cost
 Service life
 Residual value
 Method of cost
allocation
 5

Factors
Factors Involved
Involved in
in Depreciation
Depreciation
Service
Service Life
Life
Service
Service life
life isis the
the measure
measure of of the
the
number
number of of units
units of of service
service expected
expected
from
from the
the asset
asset before
before its
its disposal.
disposal.
 6

Factors
Factors Involved
Involved in
in Depreciation
Depreciation
Service
Service Life
Life

The
The factors
factors that
that limit
limit the
the service
service
life
life of
of an
an asset
asset can
can bebe divided
divided into
into
two
two general
general categories.
categories.

 Physicalcauses
 Functional causes
 7

Factors
Factors Involved
Involved in
in Depreciation
Depreciation
Residual
Residual Value
Value
Residual,
Residual, or or salvage
salvage value,
value, isis the
the net
net
amount
amount that
that can
can bebe expected
expected to to be
be
obtained
obtained when
when the
the asset
asset isis disposed
disposed
at
at the
the end
end ofof its
its service
service life.
life.
 8

Methods
Methods of
of Cost
Cost Allocation
Allocation

•• Activity
Activity (or
(or use)
use) methods
methods
•• Time-based
Time-based methods
methods
a.
a. Straight-line
Straight-line
b.
b. Accelerated
Accelerated (declining
(declining charge)
charge)
(1)
(1) Sum-of-the-years’-digits
Sum-of-the-years’-digits
(2)
(2) Declining
Declining balance
balance
 9

Methods
Methods of
of Cost
Cost Allocation
Allocation
Activity
Activity Methods
Methods

Cost – Residual Value

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

Methods
Methods of
of Cost
Cost Allocation
Allocation
Time-Based
Time-Based Method:
Method: Straight
Straight Line
Line

Cost – Residual Value

Depreciation Rate =
Service Life
$120,000 – $20,000
=
5 Years
= $20,000 per year
 11

Methods
Methods of
of Cost
Cost Allocation
Allocation
Time-Based
Time-Based Method:
Method: Sum-of-the-Years’
Sum-of-the-Years’ Digits
Digits
Depreciation Book Value at
Year Base Fraction Depreciation Year-End
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
Residual
Value
Value
 12

Methods
Methods of
of Cost
Cost Allocation
Allocation
Double-Declining
Time-Based
Time-Based Method: Balance
Method: Declining-Balance
Double-Declining Balance
Declining-Balance
Book Value at Book Value at
Year Beginning of Year Rate Depreciation Year-End
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
Residual
Value
Value
 13

Methods
Methods of
of Cost
Cost Allocation
Allocation
150%-Declining
Time-Based
Time-Based Method: Balance
Method: Declining-Balance
150%-Declining Balance
Declining-Balance
Book Value at Book Value at
Year Beginning of Year Rate Depreciation Year-End
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
Residual
Value
Value
 14

Recording
Recording Depreciation
Depreciation
The
The credit
credit to
to depreciation
depreciation isis
usually
usually called
called Accumulated
Accumulated
Depreciation
Depreciation or or Allowance
Allowance
for
for Depreciation.
Depreciation.
 15

Recording
Recording Depreciation
Depreciation
The
The account
account title
title Reserve
Reserve forfor
Depreciation
Depreciation isis considered
considered
undesirable
undesirable because
because ofof the
the
uncertain
uncertain meaning
meaning of of “reserve.”
“reserve.”
 16

Conceptual
Conceptual Evaluation
Evaluation of
of
Depreciation
Depreciation Methods
Methods
$
Sum-of-the-Years-Digits
Depreciation
Expense
Straight-Line

Double-Declining-Balance
2003 2004 2005 2006 2007
During Year
 17

Conceptual
Conceptual Evaluation
Evaluation of
of
Depreciation
Depreciation Methods
Methods
$ Sum-of-the-Years-Digits

Book Value

Straight-Line

Double-Declining-Balance
2003 2004 2005 2006 2007
At End of Year
 18

Conceptual
Conceptual Evaluation
Evaluation of
of
Depreciation
Depreciation Methods
Methods
…a
If
If aa company
…a similar
similar total
company expects
total cost
cost each
expects that
that repairs
each period
repairs
period
can
and
andbe
can maintenance
be achieve
achieve through
maintenance costs
costs and
through straight-line
and the
the total
straight-line
total
economic
depreciation
economic
depreciation benefits
and
and the
benefits of
ofsimilar
the the
the asset
similar repair
asset will
repair
will
remain
and
and maintenance
remain similar
similar each
maintenanceeach period,...
costs.
period,...
costs.
 19

Conceptual
Conceptual Evaluation
Evaluation of
of
Depreciation
Depreciation Methods
Methods
IfIf…and
the
the company
…and repairs
repairsexpects
company and
and maintenance
expects that
maintenance
that
benefits
costs
costs are
benefits of
areofconstant
having
having the
constant each
the
eachasset
period,
period, aa
asset
will
declining
will decline
declining
declinetotal
each
total cost
each year
cost will
year for
willforbethe
be achieved
the
achieved
byby using
life
life of
using ofaccelerated
the
the asset,
asset, ...
accelerated depreciation.
...
depreciation.
 20

Effect
Effect of
of Depreciation
Depreciation
on
on Rate
Rate of
of Return
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
Disclosure of
of Depreciation
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
Disclosure of
of Depreciation
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
Group Depreciation
Depreciation

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.
 24

Group
Group Depreciation
Depreciation
To
To record
record the
the purchase.
purchase.
Cars 200,000
$200,000 – $50,000
Cash 200,000
3
To
To record
record the
the first
first year’s
year’s depreciation
depreciation expense.
expense.

Depreciation Expense 50,000

Accumulated Depreciation 50,000
This
This same
same depreciation
depreciation entry
entry would
would be
be
made
made at
at in
in the
the end
end of
of the
the second
second year.
year.
 25

Group
Group Depreciation
Depreciation
Three
Threecars
cars were
were sold
sold after
after 22 years
years for
for $8,000
$8,000 each.
each.
Cash 24,000
Accumulated Depreciation 36,000
Cars 60,000
.25 ($200,000 – $60,000)
To
To record
record the
the third
third year’s
year’s depreciation
depreciation expense.
expense.

Depreciation Expense 35,000

Accumulated Depreciation 35,000
 26

Group
Group Depreciation
Depreciation
Five
Five cars
cars were
were sold
sold after
after 33 years
years for
for $6,000
$6,000 each.
each.
Cash 30,000
Accumulated Depreciation 70,000
Cars 100,000
To reduce the $11,000 book
value to the salvage value.
To
To record
record the
the fourth
fourth year’s
year’sdepreciation
depreciation expense.
expense.

Depreciation Expense 1,000

Accumulated Depreciation 1,000
 27

Group
Group Depreciation
Depreciation
Two
The
Thecars
Two final
cars were
final two
twosold
were cars
carsafter
sold were
were33sold
after years
sold for
yearsforfor
$4,800
for $4,800
$4,800 each.
$4,800 each.
each.
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

Composite
Composite Depreciation
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

7,000
Depreciation Rate = = 14%
$50,000
 29

Depreciation
Depreciation for
for Partial
Partial Periods
Periods
Annual
Year Depreciation
1 3/6 x $6,000 = $3,000 x 4/12 = $1,000
2 A company purchases
$3,000 x a8/12
$6,000 asset
with
2/6 a 3-year=life
x $6,000 and no
$2,000 residual=value
x 4/12 2,667
3 on August 18. $2,000
The firm uses the sums-
x 8/12
of-the-years’-digits method.
1/6 x $6,000 = $1,000 x 4/12 = 1,667
4 $1,000 x 8/12 = 666
$6,000
 30

Depreciation
Depreciation for
for Partial
Partial Periods
Periods
Annual
Year Depreciation
1 2/3 x $6,000 = $4,000 x 4/12 = $1,333
A2company purchases$4,000 x 8/12
a $6,000 asset with a 3-year
2/3no
life and x $2,000
OR
residual= value
$1,333onxAugust
4/12 18.
3 uses the double-declining-balance
$1,333 x 8/12
= The
3,111
method.
firm

$667 x 4/12 = 1,111

4 $667 x 8/12 = 445
$6,000
 31

Depreciation
Depreciation for
for Partial
Partial Periods
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
Declining-Balance-Method
 32

Impairment
Impairment of
of
Noncurrent
Noncurrent Assets
Assets
The
The FASB
FASB issued
issued FASB
FASB
Statement
Statement No. No. 144
144 which
which
requires
requires aa company
company to to review
review its
its
property,
property, plant,
plant, and
and equipment
equipment
for
for impairment.
impairment.
 33

Impairment
Impairment of
of
Noncurrent
Noncurrent Assets
Assets
Impairment
Impairment occurs
occurs whenever
whenever
events
events or
or changes
changes inin
circumstances
circumstances indicate
indicate that
that the
the
book
book value
value of
of aa noncurrent
noncurrent asset
asset
may
may not
not be
be recoverable.
recoverable.
 34

Impairment
Impairment of
of
Noncurrent
Noncurrent Assets
Assets
An impairment loss involves the following steps:
Events or Changes in Circumstances Occurs

Impairment Test
(Undiscounted Cash Flows < Book Value of Asset)

Measurement of Loss
(Loss = Fair Value – Book Value)
 35

Impairment
Impairment of
of
Noncurrent
Noncurrent Assets
Assets
On
On January
January 1,1, 2001,
2001, the
the Hall
Hall Company
Company
purchased
purchased aa factory
factory for
for $1
$1 million
million (20-year
(20-year life)
life)
and
and machinery
machinery forfor $3
$3 million
million (10-year
(10-year life).
life).

Late
Late inin 2004,
2004, the the company
company believes
believes that
that its
its
asset(s)
asset(s) maymay be be impaired
impaired andand the
the remaining
remaining
useful
useful life
life isis 55 years.
years. TheThe company
company estimates
estimates
that
that the
the asset
asset willwill produce
produce cash
cash inflows
inflows of of
$700,000
$700,000 and and incur
incur cash
cash outflow
outflow ofof $300,000
$300,000
each
each year year for
for the
the next
next 55 years.
years.
 36

Impairment
Impairment of
of
Noncurrent
Noncurrent Assets
Assets
Impairment Test
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
Impairment of
of
Noncurrent
Noncurrent Assets
Assets
Impairment Test
Impairment Test

Undiscounted expected
net cash flows = 5 x ($700,000 – $300,000)
= 5 x $400,000
Years
Years Cash Cash Cash
Cash
= $2,000,000
Inflows
Inflows Outflows
Outflows
Because
Because $2,000,000
$2,000,000 isis less
less than
than
$2,600,000
$2,600,000 (the
(the book
book value),
value), anan
impairment
impairment loss
loss must
must be
be recognized.
recognized.
 38

Impairment
Impairment of
of
Noncurrent
Noncurrent Assets
Assets
Measurement of
Measurement of the
the Loss
Loss

Present value of the expected

= $400,000 x 3.274294
cash flows (fair value)
= $1,309,718 (rounded)

Book value $2,600,000 n= n=5,5, ii == 0.16

0.16
Fair value (1,309,718 ) from
from Table
Table 44
Impairment loss $1,290,282 in in Appendix
Appendix
 39

Impairment
Impairment of
of
Noncurrent
Noncurrent Assets
Assets
The
The Statement
Statement doesdoes not
not specify
specify howhow toto
record
record thethe write-down.
write-down. ItIt does
does indicate
indicate
that
that the
the reduced
reduced book
book value
value isis to
to be
be
accounted
accounted for for as
as the
the new
new cost.
cost.
 40

Impairment
Impairment of
of
Noncurrent
Noncurrent Assets
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
$1,309,718 cost)
x [$1,000,000 ÷ ($3,000,000 ÷1,000,000
$1,000,000)]
Machinery (old cost) 3,000,000
$1,309,718 x [$3,000,000 ÷ ($3,000,000 ÷ $1,000,000)]
 41

Conceptual
Conceptual Evaluation
Evaluation of
of
Asset
Asset Impairment
Impairment
Although
Although FASBFASB Statement
Statement No.
No. 121
121 has
has been
been
replaced
replaced by by FASB
FASBStatement
Statement No.
No. 144,
144, the
the
principles
principles itit established
established have
have only
only changed
changed slightly.
slightly.

Although
Although the
the Statement
Statement narrows
narrows GAAP,
GAAP, itit still
still
allows
allows for
for significant
significant management
management flexibility.
flexibility.
 42

MACRS
MACRS Principles
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.
1. AA mandated
mandated tax tax life,
life, which
which isis usually
usually
shorter
shorter than
than the
the economic
economic life.
life.
2.
2. The
The acceleration
acceleration of of the
the cost
cost recovery
recovery
(except
(except for
for buildings).
buildings).
3.
3. The
The elimination
elimination of of residual
residual value.
value.
 43

MACRS
MACRS Principles
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.

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

Determine
Determine depreciation
depreciation for
for 2003-2008.
2003-2008.
 44

MACRS
MACRS Principles
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
Changes and
and Corrections
Corrections
of
of Depreciation
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

Depletion
Depletion
Cost – Residual Value
Unit Depletion Rate =
Units

A
A company
company purchases
purchases land
land for
for $3,000,000
$3,000,000 from
from which
which
itit expects
expects to
to extract
extract 1,000,000
1,000,000 tons
tons of
of coal,
coal, the
the
estimated
estimated residual
residual value
valueisis $200,000,
$200,000, andand itit mines
mines
80,000
80,000 tons
tons of
of coal
coal in
in 2003.
2003.
$3,000,000 – $200,000
Unit Depletion Rate =
1,000,000 tons
 47

Depletion
Depletion

Cost – Residual Value

Unit Depletion Rate =
Units
$3,000,000 – $200,000
Unit Depletion Rate =
1,000,000 tons

Unit Depletion Rate = $2.80 per ton

Depletion for Year = $2.80 x 80,000 = $224,000

 48

Chapter 10

The
The End
End
49