Chapter 11: Depreciation and Depletion

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Chapter 11 Depreciation, Impairments, and
Depletion
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Part 1 Methods of Depreciation
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Depreciation - Concept

• 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
  assets

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Factors in the Depreciation Process

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

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Depreciable Base

• Depreciable base is the 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 Lives

• An assets service life and physical life are not
  the same.
• Assets are retired (from productive life) due to
• physical factors (such as casualty), or
• economic factors (such as obsolescence)
• Economic factors in turn include
• Inadequacy (asset can not meet current
  demand)
• Supercession (by a better asset)
• Obsolescence (other factors)

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Depreciation Methods

• Depreciation methods can be classified as
  follows
• Tax depreciation methods
• Financial accounting Depreciation methods
• Financial accounting methods are
• straight-line
• accelerated methods, or
• special methods

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Depreciation Methods Overview
Depreciation Methods
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Depreciation Methods Example

• Amber corporation buys a truck on January 1,
  2000. Information relating to the truck is as
  follows
• Cost, 34,000
• Estimated service life, 5 years (or 60,000
  miles)
• Salvage value end of five years or use, 4,000
• Actual miles driven
• 20,000 miles (in 2000) 15,000 miles (in
  2001)

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Straight-line method
1. Depreciable base 34,000 less 4,000
30,000
2. Annual depreciation 30,000 / 5 years
6,000
3. Depreciation Schedule (years 1 and
2) Year Book Depreciation Accumulated Book
value (beg) Depreciation end of
year 1 34,000 6,000 6,000 28,000 2 28,000
6,000 12,000 22,000
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Activity method (unit mile)
1. Depreciable base 34,000 less 4,000
30,000
2. Depreciation per mile 30,000 / 60,000
0.50
3. Depreciation (2000) 0.50 20,000 miles
10,000
4. Depreciation Schedule (years 1 and
2) Year Book Depreciation Accumulated Book
value (beg) Depreciation end of
year 1 34,000 10,000 10,000 24,000 2 24,000
7,500 17,500 16,500
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Double Declining balance method
1. Rate of depreciation 2 (1/5) 0.40
2. Depreciation (2000) 34,000 0.40
13,600 Depreciation (2001) 20,400 0.40
8,160 Depreciation (2002) 12,240
0.40 4,896 Depreciation (2003)
7,344 0.40 3,344 Depreciation
(2004) none
Total depreciation taken 30,000
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Double declining balance method
3. Depreciation Schedule
Year Book Depreciation Accumulated Book
value (beg) Depreciation end of
year 1 34,000 13,600 13,600 20,400 2 20,4
00 8,160 21,760 12,240 3 12,240
4,896 26,656 7,344 4 7,344 3,344
30,000 4,000 5 4,000 none 30,000
4,000
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Group and Composite Depreciation 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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Composite Depreciation Method Example

• Given the following information relating to fixed
  assets, A and B
• Asset Cost Annual depreciation
• A 20,000 4,000
• B 36,000 10,000 56,000 14,000
• Composite depreciation rate is 14,000 /
  56,000 25

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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 (see example gt )

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Partial year depreciation Example

• Amber corporation buys a truck on July 1, 2000.
  Information relating to the truck is as follows
• Cost, 10,000
• Estimated service life, 5 years
• Salvage value end of five years,
  none.
• Determine depreciation expense under the double
  declining balance method.

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Partial year depreciation Example

• Before allocating depreciation, determine full
  year depreciation as follows
• First full year (2000) gt 10,000 40
  4,000
• Second full year (2001) gt (10,000 -
  4,000) 40 2,400
• And so on for the remaining years

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Partial year depreciation Example
Double declining date of purchase, July 1, 2000
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Revision of Depreciation Estimates

• Determination of depreciation involves initial
  estimates (life, salvage value.)
• When these estimates are revised, we re- compute
  depreciation.
• These revised depreciation expenses apply
  prospectively to the remaining life of asset
• These changes do not affect prior periods.

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Revision of Depreciation Estimates Example

• Amber corporation buys a depreciable asset on
  January 1, 2000 for 95,000.
• Estimated life was 20 years.
• Estimated salvage value was 5,000.
• On January 1, 2006, estimates were revised as
  follows
• salvage value, 2,000
• estimated life 24 years (years 2000 through
  2023)
• Determine depreciation for 2006 based on straight
  line method of depreciation.

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Revision of Depreciation Estimates Example

• Accumulated depreciation to date of revision
  of estimates
• (95,000 - 5,000) / 20 years 4,500 dep
• 4,500 6 years 27,000 accumulated
  depr.
• Amount to be depreciated (years 2006 through 2023
  18 years)
• (95,000 - 27,000 - 2,000) / 18 years
• 3,667 (rounded) annual depreciation

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Part 2 Impairments
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Impairments

• An impairment occurs when
• the carrying amount of an asset is not
  recoverable, and
• a write-off of the impaired amount is needed
• To determine the amount of impairment, a
  recoverability test is used (see next slide)

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Impairments The 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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Impairments The Recoverability Test
Loss Carrying amount less Fair value of asset
Does an active market exist for the asset?
Loss Carrying amount less present value
of expected net cash flows
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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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Part 3 Depletion
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Depletion Terminology

• Depletion refers to the cost basis write-off of
  natural resources
• Natural resources are characterized by
• complete removal of the asset, and
• replacement of the asset only by an act of
  nature

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Determining the Depletion Base Factors
Types of Costs
What they are

• Acquisition cost
• Exploration costs
• Development costs (Tangible costs) not part of
  depletion base
• Development costs (Intangible costs)
• Restoration costs

• Price paid to search for and find deposit of the
  natural resource
• Costs incurred to find the natural resource
• Costs of heavy equipment for extracting and
  shipping natural resource.
• Drilling costs, tunnels, and shafts
• To restore after extraction

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Accounting for Exploration Costs

• Exploration costs are usually expensed as
  incurred
• These costs are capitalized when
• they are substantial, and
• uncertainty exists regarding finding the
  natural resource
• Two competing approaches are employed in practice
  to account for exploration costs (next slide)

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Accounting for Exploration Costs

• The two approaches are
• Successful efforts approach, and
• Full cost approach
• Under the successful efforts concept, only
  exploration costs of successful projects are
  capitalized.
• Under the full cost concept, all costs are
  capitalized.
• Either approach is currently acceptable.

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Special Problem(s)

• Difficulty of estimating recoverable reserves