Chapter 11 Depreciation and Depletion Intermediate Accounting 11

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Chapter 11 Depreciation and Depletion Intermediate Accounting 11 th edition Nikolai Bazley Jones An

Chapter 11 Depreciation and Depletion Intermediate Accounting 11 th edition Nikolai Bazley Jones An electronic presentation By Norman Sunderman and Kenneth Buchanan Angelo State University COPYRIGHT © 2010 South-Western/Cengage Learning

2 Depreciation is the process of allocating the cost of an asset in a

2 Depreciation is the process of allocating the cost of an asset in a systematic and rational manner over the periods benefited. Land is not depreciated because it generally does not have a limited life.

3 Factors Involved in Depreciation Asset Cost The cost of an asset includes all

3 Factors Involved in Depreciation Asset Cost The cost of an asset includes all the acquisition costs a company incurs to obtain the benefits from the asset.

4 Factors Involved in Depreciation Service Life The service life of an asset is

4 Factors Involved in Depreciation Service Life The service life of an asset is the measure of the service units expected from the asset before its disposal.

5 Factors Involved in Depreciation Service Life The factors that limit the service life

5 Factors Involved in Depreciation Service Life The factors that limit the service life of an asset can be divided into two general categories: v Physical causes v Functional causes

6 Factors Involved in Depreciation Residual Value Residual, or salvage, value is the net

6 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.

7 Methods of Cost Allocation v Time-based methods a. Straight-line b. Accelerated (declining charge)

7 Methods of Cost Allocation v Time-based methods a. Straight-line b. Accelerated (declining charge) 1) Sum-of-the-years’-digits 2) Declining balance v Activity (or use) methods

8 Depreciation Problem Information

8 Depreciation Problem Information

9 Methods of Cost Allocation Time-Based Method: Straight Line Depreciation Rate = = =

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

10 Methods of Cost Allocation Time-Based Method: Sum of the Years’ Digits Year Number

10 Methods of Cost Allocation Time-Based Method: Sum of the Years’ Digits Year Number 1 2 3 4 5 Sum of the Years’ Digits = = = 15 Years of service remaining at beginning of year 5 4 3 2 1 15

11 Methods of Cost Allocation Time-Based Method: Sum of the Years’ Digits Year 2009

11 Methods of Cost Allocation Time-Based Method: Sum of the Years’ Digits Year 2009 2010 2011 2012 2013 Depreciation Book Value at Base Fraction Depreciation Year-End $100, 000 5/15 $ 33, 333 $86, 667 100, 000 4/15 26, 667 60, 000 100, 000 3/15 20, 000 40, 000 100, 000 2/15 13, 333 26, 667 100, 000 1/15 6, 667 20, 000 $100, 000 Residual Value

12 Methods of Cost Allocation Time-Based Method: Double-Declining Time-Based Method: Declining-Balance Year 2009 2010

12 Methods of Cost Allocation Time-Based Method: Double-Declining Time-Based Method: Declining-Balance Year 2009 2010 2011 2012 2013 Book Value at Beginning of Year $120, 000 72, 000 43, 200 25, 920 20, 000 Book Value at Rate Depreciation Year-End 40% $ 48, 000 $72, 000 40% 28, 800 43, 200 40% 17, 280 25, 920 — 5, 920 20, 000 — — 20, 000 g $100, 000 Plu Residual Value

13 Methods of Cost Allocation Time-Based Method: 150%-Declining Balance Time-Based Method: Declining-Balance Year 2009

13 Methods of Cost Allocation Time-Based Method: 150%-Declining Balance Time-Based Method: Declining-Balance Year 2009 2010 2011 2012 2013 Book Value at Beginning of Year Rate Depreciation Year-End $120, 000 30% $ 36, 000 $84, 000 30% 25, 200 58, 800 30% 17, 640 41, 160 30% 12, 348 28, 812 — 8, 812 20, 000 $100, 000 Residual Value

14 Methods of Cost Allocation Activity Method Depreciation Rate = = = Cost –

14 Methods of Cost Allocation Activity Method Depreciation Rate = = = Cost – Residual Value Total Lifetime Activity Level $120, 000 – $20, 000 10, 000 hours $10 per hour Depreciation = $21, 000 (2, 100 hours × $10) Assume the asset is used for 2, 100 hours.

15 Recording Depreciation The credit entry to record depreciation is to a contra-asset account

15 Recording Depreciation The credit entry to record depreciation is to a contra-asset account usually called Accumulated Depreciation or Allowance for Depreciation.

16 Conceptual Evaluation of Depreciation Methods $ Depreciation Expense Sum-of-the-Years’-Digits Straight-Line Double-Declining-Balance 2009 2010

16 Conceptual Evaluation of Depreciation Methods $ Depreciation Expense Sum-of-the-Years’-Digits Straight-Line Double-Declining-Balance 2009 2010 2011 2012 During Year 2013

17 Conceptual Evaluation of Depreciation Methods $ Sum-of-the-Years’-Digits Book Value Straight-Line Double-Declining-Balance 2009 2010

17 Conceptual Evaluation of Depreciation Methods $ Sum-of-the-Years’-Digits Book Value Straight-Line Double-Declining-Balance 2009 2010 2011 2012 At End of Year 2013

18 Conceptual Evaluation of Depreciation Methods If a company expects that repair and maintenance

18 Conceptual Evaluation of Depreciation Methods If a company expects that repair and maintenance costs and the total economic benefits of the asset will remain similar each period, …

19 Conceptual Evaluation of Depreciation Methods …a similar total cost each period can be

19 Conceptual Evaluation of Depreciation Methods …a similar total cost each period can be achieved through straight-line depreciation and the similar repair and maintenance costs.

20 Conceptual Evaluation of Depreciation Methods If the company expects that benefits of having

20 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, …

21 Conceptual Evaluation of Depreciation Methods …and repairs and maintenance costs are constant each

21 Conceptual Evaluation of Depreciation Methods …and repairs and maintenance costs are constant each period, a declining total cost will be achieved by using accelerated depreciation.

22 Effect of Depreciation on Rate of Return Year Net Income Book Value of

22 Effect of Depreciation on Rate of Return Year Net Income Book Value of Asset at Beginning of Year 2009 2010 2011 2012 2013 $12, 000 12, 000 $120, 000 100, 000 80, 000 60, 000 40, 000 Rate of Return 10% 12 15 20 30

23 Disclosure of Depreciation GAAP requires the following: v Depreciation expense for the period

23 Disclosure of Depreciation GAAP requires the following: v Depreciation expense for the period v Balance of major classes of depreciable assets, by nature or function, at the balance sheet date v Accumulated depreciation, either by major classes of depreciable assets or in total, at the balance sheet date v A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets

24 IFRS vs. U. S. GAAP v IFRS require that depreciation be “systematic, ”

24 IFRS vs. U. S. GAAP v IFRS require that depreciation be “systematic, ” rather than “systematic and rational. ” v IFRS also require that the estimated useful lives and residual values, and the depreciation method, be reviewed at least once a year. U. S. GAAP only requires this review when events or circumstances indicate that the estimate has changed.

25 IFRS vs. U. S. GAAP v IFRS also require that companies disclose the

25 IFRS vs. U. S. GAAP v IFRS also require that companies disclose the accumulated depreciation for each class of asset, not just the total amount as allowed by U. S. GAAP. v IFRS require that when an operating asset is made up of individual components that are significant with respect to the total cost of the item (e. g. , an airplane and its engines) that the initial cost be allocated to the significant components and each component be depreciated separately.

26 IFRS vs. U. S. GAAP v U. S. GAAP neither requires nor prohibits

26 IFRS vs. U. S. GAAP v U. S. GAAP neither requires nor prohibits a company from depreciating components. v IFRS allow a company to write up the value of its property, plant, and equipment assets to fair value. Such a write-up would affect the amount of depreciation that the company records each period.

27 Group Depreciation A company purchased 10 cars for $20, 000 each, and the

27 Group Depreciation A company purchased 10 cars for $20, 000 each, and the average expected service life is 3 years with a residual value of $5, 000 each.

28 Group Depreciation To record the purchase: Cars Cash 200, 000 $200, 000 –

28 Group Depreciation To record the purchase: Cars Cash 200, 000 $200, 000 – $50, 000 3 To record the first year’s depreciation expense: Depreciation Expense Accumulated Depreciation 50, 000 This same depreciation entry would be made at the end of the second year.

29 Group Depreciation To record the disposal of three cars at the end of

29 Group Depreciation To record the disposal of three cars at the end of the second year for $8, 000 each: Cash Accumulated Depreciation Cars 24, 000 36, 000 60, 000 25% ($200, 000 – $60, 000) To record the third year’s depreciation expense: Depreciation Expense Accumulated Depreciation 35, 000

30 Group Depreciation To record the disposal of five cars at the end of

30 Group Depreciation To record the disposal of five cars at the end of the third year for $6, 000 each: Cash 30, 000 the $11, 000 book Accumulated Depreciation To reduce 70, 000 value to the estimated 100, 000 residual Cars value. To record the fourth year’s depreciation expense: Depreciation Expense Accumulated Depreciation 1, 000

31 Group Depreciation To record the disposal of two cars at the end of

31 Group Depreciation To record the disposal of two cars at the end of the. The fourth each, the net gain finalyear two for cars$4, 000 were sold forand $4, 800 each. or loss of the entire group: Cash Accumulated Depreciation Loss on Disposal Cars 9, 600 30, 000 40, 000 Cash received Book value Loss $ 9, 600 10, 000 $ (400)

32 Composite Depreciation Asset A B C Cost $25, 000 13, 000 12, 000

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

33 Depreciation for Partial Periods A company purchases a $6, 000 asset with a

33 Depreciation for Partial Periods A company purchases a $6, 000 asset with a three-year life and no residual value on August 18. The firm uses the double-declining-balance method.

34 Depreciation for Partial Periods Year 1 2 3 4 Computation 4/12 × $4,

34 Depreciation for Partial Periods Year 1 2 3 4 Computation 4/12 × $4, 000 0. 667 × ($6, 000 – $1, 333) 0. 667 × ($4, 667 – $3, 113) Remaining balance Two times straight-line rate = 2 × 1/3 Annual Depreciation $1, 333 3, 113 1, 037 517 $6, 000 Declining-Balance-Method

35 Impairment of Property, Plant, and Equipment GAAP requires a company to review its

35 Impairment of Property, Plant, and Equipment GAAP requires a company to review its property, plant, and equipment for impairment.

36 Impairment of Property, Plant, and Equipment Impairment occurs whenever events or changes in

36 Impairment of Property, Plant, and Equipment Impairment occurs whenever events or changes in circumstances indicate that the book value of the property, plant, and equipment may not be recoverable.

37 Impairment of Property, Plant, and Equipment Impairment Test If the total expected cash

37 Impairment of Property, Plant, and Equipment Impairment Test If the total expected cash flows (undiscounted) are less than the book value of the asset, an impairment loss is recognized. Measurement of the Loss The loss is measured as the difference between the book value of the asset and the present value of future cash flows.

38 Conceptual Evaluation of Asset Impairment The recognition of an impairment loss is intended

38 Conceptual Evaluation of Asset Impairment The recognition of an impairment loss is intended to enhance the usefulness of a company’s financial statements. All these issues could result in earnings management. For example, management might prefer to recognize as large a loss as possible, thereby reducing the book value to the lowest possible amount. This would result in lower depreciation expense and higher net income in the future.

39 IFRS vs. U. S. GAAP v IFRS use a “trigger” value, which is

39 IFRS vs. U. S. GAAP v IFRS use a “trigger” value, which is the (1) higher of the asset’s fair value (less costs to sell), or (2) its usage value to determine if an asset is impaired. U. S. GAAP uses undiscounted cash flows. v Typically, this should mean that international companies will recognize impairment losses earlier than U. S. companies. Under IFRS, the impairment loss is the difference between the book value and the “trigger” value defined above. v IFRS allow an impairment loss to be reversed if the value is recovered, which is not allowed under GAAP.

40 Depreciation for Tax Purposes For assets purchased in 1987 and later, the Modified

40 Depreciation for Tax Purposes For assets purchased in 1987 and later, the Modified Accelerated Cost Recovery System (MACRS) is required for tax purposes. A company’s computations of depreciation for income tax purposes and financial reporting purposes differ in three major respects: 1. A mandated tax life, which is usually shorter than the economic life 2. Acceleration of the cost recovery (except for buildings) 3. Elimination of the residual value

41 MACRS Principles On January 1, 2009, Melville Company purchased an asset for $200,

41 MACRS Principles On January 1, 2009, 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 the next slide to determine the annual depreciation rates for 2009 through 2014

42 MACRS Percentages Determine depreciation for 2009– 2014.

42 MACRS Percentages Determine depreciation for 2009– 2014.

43 MACRS Principles Year 2009 2010 2011 2012 2013 2014 Cost $200, 000 $200,

43 MACRS Principles Year 2009 2010 2011 2012 2013 2014 Cost $200, 000 $200, 000 × × × MACRS % 20% 32% 19. 20% 11. 52% 5. 76% = = = Annual Tax Depreciation $ 40, 000 $ 64, 000 $ 38, 400 $ 23, 040 $ 11, 520 $200, 000

44 Changes and Corrections of Depreciation 1. A change in an estimate of the

44 Changes and Corrections of Depreciation 1. A change in an estimate of the residual value or the service life of a currently owned asset is accounted for prospectively. 2. A change in the depreciation method for currently owned assets is also accounted for prospectively. 3. A correction of an error in depreciation is accounted for as a prior period adjustment (restatement).

45 Depletion v Depletion of natural resources is calculated using an activity method. v

45 Depletion v Depletion of natural resources is calculated using an activity method. v Any environmental costs at the end of the project are added to the cost in determining depletion per unit.

46 Chapter 11 Task Force Image Gallery clip art included in this electronic presentation

46 Chapter 11 Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.