11-1 Prepared by Coby Harmon University of California, Santa Barbara Intermediate Accounting.

11-1

Prepared by Coby Harmon

University of California, Santa Barbara

Intermediate Accounting

11-2

Intermediate Accounting

14th Edition

11Depreciation, Impairments, and Depletion

Kieso, Weygandt, and Warfield

11-3

1. Explain the concept of depreciation.

2. Identify the factors involved in the depreciation process.

3. Compare activity, straight-line, and decreasing-charge methods

of depreciation.

4. Explain special depreciation methods.

5. Explain the accounting issues related to asset impairment.

6. Explain the accounting procedures for depletion of natural

resources.

7. Explain how to report and analyze property, plant, equipment,

and natural resources.

Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

11-4

Depreciation

Factors involved

Methods of

depreciation

Special methods

Special issues

Impairments DepletionPresentation and Analysis

Recognizing

impairments

Measuring

Impairments

Restoration of

loss

Assets to be

disposed of

Presentation

Analysis

Establishing a

base

Write-off of

resource cost

Estimating

reserves

Liquidating

dividends

Continuing

controversy

Depreciation, Impairments, and DepletionDepreciation, Impairments, and DepletionDepreciation, Impairments, and DepletionDepreciation, Impairments, and Depletion

11-5

Allocating costs of long-term assets:

Fixed assets = Depreciation expense

Intangibles = Amortization expense

Natural resources = Depletion expense

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.

Depreciation - Method of Cost AllocationDepreciation - Method of Cost AllocationDepreciation - Method of Cost AllocationDepreciation - Method of Cost Allocation

LO 1 Explain the concept of depreciation.

11-6


LO 2 Identify the factors involved in the depreciation process.

Three basic questions:

Factors Involved in the Depreciation Process

(1) What depreciable base is to be used?

(2) What is the asset’s useful life?

(3) What method of cost allocation is best?

11-7



Depreciable Base


Illustration 11-1

11-8



Estimation of Service Lifes


Service life often differs from physical life.

Companies retire assets for two reasons:

1. Physical factors (casualty or expiration of

physical life).

2. Economic factors (inadequacy, supersession,

and obsolescence).

11-9


LO 3 Compare activity, straight-line, and decreasing-charge methods of depreciation.

The profession requires the method employed be “systematic

and rational.” Examples include:

Methods of Depreciation

(1) Activity method (units of use or production).

(2) Straight-line method.

(3) Sum-of-the-years’-digits.

(4) Declining-balance method.

(5) Group and composite methods.

(6) Hybrid or combination methods.

Accelerated methods

Special methods

11-10


LO 3

Activity MethodIllustration 11-2

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

Stanley Coal Mines Facts

Illustration 11-3

11-11


Straight-Line Method

Illustration: Stanley computes depreciation as follows:


Illustration 11-4

Illustration 11-2

LO 3

11-12


Decreasing-Charge Methods


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.

Illustration 11-2

n(n+1)

2==

5(5+1)

2== 15Alternate sum-of-the-

years’ calculationLO 3

11-13



Sum-of-the-Years’-DigitsIllustration 11-6

11-14


Decreasing-Charge Methods


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.

Illustration 11-2


11-15


Declining-Balance MethodIllustration 11-7


11-16


E11-5 (Depreciation Computations—Four Methods): Maserati

Corporation purchased a new machine for its assembly process on

August 1, 2012. 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. (c) Sum-of-the-years’-digits.

(b) Activity method (d) Double-declining balance.


11-17


Current

Depreciable Annual Partial Year Accum.

Year Base Years Expense Year Expense Deprec.

2012 126,000$ / 5 = 25,200$ x 5/12 = 10,500$ 10,500$

2013 126,000 / 5 = 25,200 25,200 35,700

2014 126,000 / 5 = 25,200 25,200 60,900

2015 126,000 / 5 = 25,200 25,200 86,100

2016 126,000 / 5 = 25,200 25,200 111,300

2017 126,000 / 5 = 25,200 x 7/12 = 14,700 126,000

126,000$

Journal entry:

2012 Depreciation expense 10,500

Accumultated depreciation 10,500

Straight-line Method


11-18

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

Hours Rate per Annual Partial Year Accum.

Year Used Hours Expense Year Expense Deprec.

2012 800 x $6 = 4,800$ 4,800$ 4,800$

2013 x =

2014 x =

2015 x =

2016 x =

800 4,800$

Journal entry:




LO 3

Activity Method (Assume 800 hours used in 2012)

11-19


Sum-of-the-Years’-Digits MethodCurrent

Depreciable Annual Partial Year Accum.

Year Base Years Expense Year Expense Deprec.

2012 126,000$ x 5/15 = 42,000 x 5/12 17,500$ 17,500$

2013 126,000 x 4.58/15 = 38,500 38,500 56,000

2014 126,000 x 3.58/15 = 30,100 30,100 86,100

2015 126,000 x 2.58/15 = 21,700 21,700 107,800

2016 126,000 x 1.58/15 = 13,300 13,300 121,100

2017 126,000 x .58/15 = 4,900 4,900 126,000

126,000$

Journal entry:



LO 3

5/12 = .4166677/12 = .583333

11-20


Double-Declining Balance MethodCurrent

Depreciable Rate Annual Partial Year

Year Base per Year Expense Year Expense

2012 150,000$ x 40% = 60,000$ x 5/12 = 25,000$

2013 125,000 x 40% = 50,000 50,000

2014 75,000 x 40% = 30,000 30,000

2015 45,000 x 40% = 18,000 18,000

2016 27,000 x 40% = 10,800 Plug 3,000

126,000$

Journal entry:



LO 3

11-21


LO 4 Explain special depreciation methods.

Choice of method depends on nature of the assets involved:

Special Depreciation Methods

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 asset’s cost in a

systematic and rational manner (Hybrid or Combination Methods).

11-22



(1) How should companies compute depreciation for

partial periods?

(2) Does depreciation provide for the replacement of

assets?

(3) How should companies handle revisions in

depreciation rates?

Special Depreciation Issues

11-23

Accounted for in the period of change and future

periods (Change in Estimate).

Not handled retrospectively.

Not considered errors or extraordinary items.



Change in Depreciation Rate

11-24

Arcadia HS, purchased equipment for $510,000 which was

estimated to have a useful life of 10 years with a residual value

of $10,000 at the end of that time. Depreciation has been

recorded for 7 years on a straight-line basis. In 2012 (year 8), it

is determined that the total estimated life should be 15 years

with a residual 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 2012.

No Entry No Entry RequiredRequired

Change in Estimate ExampleChange in Estimate ExampleChange in Estimate ExampleChange in Estimate Example


11-25

Equipment $510,000Accumulated depreciation 350,000

Net book value (NBV) $160,000

Balance Sheet (Dec. 31, 2011)

Change in Estimate ExampleChange in Estimate ExampleChange in Estimate ExampleChange in Estimate Example After 7 years

Equipment cost $510,000

Salvage value - 10,000

Depreciable base 500,000

Useful life (original) 10 years

Annual depreciation $ 50,000 x 7 years = $350,000

First, establish NBV First, establish NBV at date of change in at date of change in

estimate.estimate.

First, establish NBV First, establish NBV at date of change in at date of change in

estimate.estimate.


11-26

Change in Estimate ExampleChange in Estimate ExampleChange in Estimate ExampleChange in Estimate Example After 7 years

Net book value $160,000

Salvage value (new) 5,000

Depreciable base 155,000

Useful life remaining 8 years

Annual depreciation $ 19,375

Depreciation Expense calculation

for 2012.

Depreciation Expense calculation

for 2012.

Depreciation expense 19,375

Accumulated depreciation 19,375

Journal entry for 2012


11-27

ImpairmentsImpairmentsImpairmentsImpairments

LO 5 Explain the accounting issues related to asset impairment.

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. Significant decrease in the fair value of an asset.

b. Significant change in the manner in which an asset is used.

c. Adverse change in legal factors or in the business climate.

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.

11-28


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.

Measuring Impairments


11-29 LO 5

Illustration 11-16Graphic of Accounting for Impairments


11-30

E11-16 (Impairment): Presented below is information related to equipment owned by Pujols Company at December 31, 2012. Assume that Pujols will continue to use this asset in the future. As of December 31, 2012, the equipment has a remaining useful life of 4 years.

Instructions:

(a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2012.

(b) Prepare the journal entry to record depreciation expense for 2013.

(c) The fair value of the equipment at December 31, 2013, is $5,100,000. Prepare the journal entry (if any) necessary to record this increase in fair value.

Cost 9,000,000$

Accumulated depreciation to date 1,000,000

Expected future net cash flows 7,000,000

Fair value 4,400,000


LO 5

11-31

Loss on impairment 3,600,000

Accumulated depreciation 3,600,000


Cost $ 9,000,000


Carrying amount 8,000,000

Fair value 4,400,000

Loss on impairment $ 3,600,000

(a).

12/31/12


11-32


Net carrying amount $ 4,400,000

Useful life 4 years

Depreciation per year $ 1,100,000

(b).


Depreciation expense 1,100,000


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

12/31/11

11-33

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.

DepletionDepletionDepletionDepletion

LO 6 Explain the accounting procedures for depletion of natural resources.

Depletion is the process of allocating the cost of natural resources.

11-34

Establishing a Depletion Base



Computation of the depletion base involves four factors:

(1) Acquisition cost.

(2) Exploration costs.

(3) Development costs.

(4) Restoration costs.

11-35

Write-off of Resource Cost

Normally, companies compute depletion on a units-of-

production method (activity approach). Depletion is a function

of the number of units extracted during the period.

Calculation:

Total cost – Residual value

Total estimated units available= Depletion cost per unit

Units extracted x Cost per unit = Depletion



11-36

Illustration: MaClede Co. acquired the right to use 1,000

acres of land in Alaska to mine for silver. The lease cost is

$50,000, and the related exploration costs on the property are

$100,000. Intangible development costs incurred in opening

the mine are $850,000. MaClede estimates that the mine will

provide approximately 100,000 ounces of silver. Illustration 11-17



11-37

If MaClede extracts 25,000 ounces in the first year, then the

depletion for the year is $250,000 (25,000 ounces x $10).

LO 6

Inventory 250,000

Accumulated Depletion 250,000

MaClede’s statement of financial position:

Depletion cost related to inventory sold is part of cost of goods sold.


Illustration 11-18

11-38

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.



11-39

Liquidating Dividends - Dividends greater than the amount of accumulated net income.

Illustration: Callahan Mining had a retained earnings balance

of $1,650,000, accumulated depletion on mineral properties of

$2,100,000, and share premium of $5,435,493. Callahan’s 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 1,650,000

Paid-in Capital in Excess of Par 1,350,000

Cash

3,000,000



11-40

Oil and Gas Industry:

Full cost concept

Successful efforts concept



Continuing Controversy

11-41

Presentation of Property, Plant, Equipment, and Natural Resources

Presentation and AnalysisPresentation and AnalysisPresentation and AnalysisPresentation and Analysis

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.

Depreciating assets, use Accumulated Depreciation.

Depleting assets may include use of Accumulated Depletion

account, or the direct reduction of asset.

Disclosures

LO 7 Explain how to report and analyze property, plant, equipment, and natural resources.

11-42

Measure of a firm’s ability to generate

sales from a particular investment

in assets.

Illustration 11-20

LO 7

Analysis of Property, Plant, and Equipment

Asset Turnover Ratio


11-43

Measure of the ability to generate operating

income from a particular level of

sales.

Illustration 11-21

LO 7

Profit Margin on Sales



11-44

Measures a firm’s success in using

assets to generate earnings.

LO 7

Rate of Return on Assets


Illustration 11-22


11-45

Analyst obtains further insight into the behavior of ROA by disaggregating it into components of profit margin on sales and asset turnover as follows:

Net Income

Average Total Assets


=

Net Income

Net Sales


=

Net Sales

Asset Turnover x

x

Average Total Assets



11-46

$53.5

($838.2 + $813.5) / 2


=

$53.5

$495.5


=

$495.5

Asset Turnover x

x

6.5% 10.5% =

x .60

($838.2 + $813.5) / 2

Analyst obtains further insight into the behavior of ROA by disaggregating it into components of profit margin on sales and asset turnover as follows:



11-47 LO 8 Describe income tax methods of depreciation.

Modified Accelerated Cost Recovery System

MACRS differs from GAAP in three respects:

1. a mandated tax life, which is generally shorter than the

economic life;

2. cost recovery on an accelerated basis; and

3. an assigned salvage value of zero.

APPENDIXAPPENDIX 11A INCOME TAX DEPRECIATION



Tax Lives (Recovery Periods)Illustration 11A-1




Tax Depreciation Methods


Illustration 11A-2



Illustration: Computer and peripheral equipment purchased by Denise Rode Company on January 1, 2011.




Illustration 11A-3


Illustration:

11-52 LO 8


Illustration: Using the rates from the MACRS depreciation rate schedule for a 5-year class of property, Rode computes depreciation as follows

Illustration 11A-4

Illustration 11A-5




Additional Issues

Optional straight-line method.

Tax versus book depreciation.


11-54

RELEVANT FACTS

The definition of property, plant, and equipment is essentially the same under GAAP and IFRS.

Under both GAAP and IFRS, changes in depreciation method and changes in useful life are treated in the current and future periods. Prior periods are not affected. GAAP recently conformed to IFRS in this area.

The accounting for plant asset disposals is the same under GAAP and IFRS.

The accounting for the initial costs to acquire natural resources is similar under GAAP and IFRS.

11-55

RELEVANT FACTS

Under both GAAP and IFRS, interest costs incurred during construction must be capitalized. Recently, IFRS converged to GAAP.

The accounting for exchanges of nonmonetary assets has recently converged between IFRS and GAAP. GAAP now requires that gains on exchanges of nonmonetary assets be recognized if the exchange has commercial substance. This is the same framework used in IFRS.

GAAP also views depreciation as allocation of cost over an asset’s life. GAAP permits the same depreciation methods (straight-line, diminishing-balance, units-of-production) as IFRS.

11-56

RELEVANT FACTS

IFRS requires component depreciation. Under GAAP, component depreciation is permitted but is rarely used.

Under IFRS, companies can use either the historical cost model or the revaluation model. GAAP does not permit revaluations of property, plant, and equipment or mineral resources.

In testing for impairments of long-lived assets, GAAP uses a two-step model to test for impairments (details of the GAAP impairment test is presented in the About the Numbers discussion). As long as future undiscounted cash flows exceed the carrying amount of the asset, no impairment is recorded. The IFRS impairment test is stricter. However, unlike GAAP, reversals of impairment losses are permitted.

11-57

Which of the following statements is correct?

a. Both IFRS and GAAP permit revaluation of property, plant, and

equipment.

b. IFRS permits revaluation of property, plant, and equipment but

not GAAP.

c. Both IFRS and GAAP do not permit revaluation of property,

plant, and equipment.

d. GAAP permits revaluation of property, plant, and equipment but

not IFRS.

IFRS SELF-TEST QUESTION

11-58

Under IFRS, value-in-use is defined as:

a. net realizable value.

b. fair value.

c. future cash flows discounted to present value.

d. total future undiscounted cash flows.

IFRS SELF-TEST QUESTION

11-59

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11-1 Prepared by Coby Harmon University of California, Santa Barbara Intermediate Accounting.

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Transcript of 11-1 Prepared by Coby Harmon University of California, Santa Barbara Intermediate Accounting.