Depreciation, Impairments and Depletion

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Depreciation, Impairments and Depletion

• Chapter 11

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Depreciation Conceptual

• Depreciation is a means of cost allocation.
• It is not a method of valuation.
• Depreciation involves
• allocating the cost of tangible assets to
  expense in a systematic and rational manner to
  periods expected to benefit from use of its
  depreciable assets.

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Factors in Depreciation

• Questions to be answered
• What is the depreciable base of the asset?
• What is the assets useful life?
• What method of depreciation is best for the
  asset in question?

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Depreciable Base

• Depreciable base is the dollar amount subject to
  depreciation.
• It is determined as
• Original cost of the asset less
• Estimated salvage or disposal value

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Estimated Service Life

• An assets service life and physical life are not
  the same.
• Assets service life are affected by
• physical factors, and economic factors
• Economic factors include
• Inadequacy (asset can not meet current demand)
• Supercession (by a better asset)
• Obsolescence (other factors)

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Depreciation Methods
Depreciation Methods
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Depreciation Methods - Straight Line

• Is a function of time rather than usage
• Results in an equal amount of depreciation
  expense for a given period
• Depreciation Expense is computed as
• Cost Salvage Value
• Estimated Life

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Depreciation Methods - Activity

• Is a function of usage rather than time.
• Estimated life is in terms of total input/output
  of asset.
• Depreciation expense is computed as
• (Cost Salvage Value) x Input/Output this
  period
• Total Estimated Input/Output

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Depreciation Methods - Decreasing Charge

• These methods result in higher depreciation
  expense in the earlier years and lower charges in
  the later years.
• Two decreasing charge methods are
• Declining balance
• Sum-of-the-years-digits

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Declining Balance Method

• Salvage value is not deducted when computing
  depreciable base.
• Utilizes a depreciation rate () that is some
  multiple of the SL rate.
• The depreciation rate is multiplied by the
  assets book value at the beginning of the period
  to get the depreciation expense for the period.
• Since the book value decreases over time this
  results in a decreasing amount of depreciation
  expense over time.
• An assets book value can never be less than its
  estimated salvage value.
• Often switches to straight-line at some point.

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Sum-of-Years Method

• A fraction is multiplied by the depreciable base
  to arrive at the depreciation expense per period.
• The fraction is
• Numerator number of years remaining in the
  assets life as of the beginning of the period.
• Denominator sum of the years in the life

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Diamond Company 2003

• Diamond Company purchased a new machine on
  1/1/05. The following date applies to this
  machine

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• During the first year what was the depreciation
  assuming
• The activity method is used and the machine was
  operated 6,800 hours.
• The straight-line method is used.
• The double declining balance method is used.
• The sum-of-year digits method is used.

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Group and Composite Methods

• The group method is applied to a collection of
  assets similar in nature.
• The composite method is applied to a collection
  of assets dissimilar in nature.
• The composite depreciation rate is determined as
  follows
• total of annual depreciation for all assets
• total cost of all assets

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Diamond 2004

• Diamond uses the composite method of
  depreciation. Given the following data determine
  the annual depreciation charge.

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Partial Year Depreciation

• When an asset is bought sometime during the year,
  a partial depreciation charge is required.
• The procedure is
• determine depreciation for a full year, and
  allocate the amount between the two periods
  affected

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Revision of Depreciation Estimates

• Determination of depreciation involves initial
  estimates (e.g., life, salvage value)
• When these estimates are revised, depreciation
  must be re-computed
• Remaining B.V. Est. Salvage Value
• Remaining Est. Life
• These revised depreciation expenses apply
  prospectively to the remaining life of asset.
• These changes do not affect prior periods.

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Impairments

• An impairment of a depreciable asset occurs when
• the carrying amount of the asset is not
  recoverable, and therefore a write-off is needed.

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Impairment Recoverability Test
Impairment?
Sum of expected future net cash flows from use
and disposal of asset is less than the carrying
amount
Sum of expected future net cash flows from use
and disposal of asset is equal to or more than
the carrying amount
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Measuring the Impairment Loss
Loss Carrying amount less Fair value of asset
Does an active market exist for the asset?
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Impairment Accounting
Impairment has occurred
1. Loss Carrying value less Fair value 2.
Depreciate new cost basis 3. Restoration of
impairment loss is NOT permitted
1. Loss Carrying value less Fair Value
less cost of disposal 2. No depreciation
is taken 3. Restoration of impairment loss is
permitted
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Diamond 2005

• Diamond purchased a fitness center in 2000 for
  600,000. The building had a 20 year life and no
  residual value (st. line depr.). At the end of
  2005 Diamond estimates the building has a useful
  life of 15 years remaing, a fair value of
  230,000, and will generate 25,000/year of cash
  flow.
• Determine if an impairment is required and record
  the entry if it is.

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Depletion Terminology

• Depletion refers to the cost basis write-off of
  natural resources (e.g., coal, oil, timber)
• Depletion expense per unit is calculated
• Cost Estimated Salvage Value
• Total Estimated Units Available
• This per unit cost is the multiplied by the units
  extracted during a period to derive the depletion
  for the period.

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Problems with Depletion

• Difficulty of estimating recoverable reserves
• Problems of discovery value
• Accounting for liquidating dividends

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Diamond 2006

• Diamond purchases a coal mine for 1,200,000. It
  is estimated that the mine contains 200,000 tons
  of coal. At the end of its life the company will
  need to spend 300,000 to recondition the land.
• In the first year the mine produces 12,000 tons
  of coal.
• In the second year the estimate of coal in the
  mine is increase by 10,000 tons and 18,000 tons
  are mined.