CHAPTER 11

DEPRECIATION, IMPAIRMENTS, AND DEPLETION

Sommers – ACCT 3311

Is Accounting Helpful for Valuation?

• Conceptual Framework (FASB)– Purpose of Accounting: “financial reporting should

provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise.”

– Caveat: Accounting information “may help those who desire to estimate the value of a business enterprise, but financial accounting is not designed to measure directly the value of an enterprise.”

Discussion Questions

Q11–1 Distinguish among depreciation, depletion, and amortization.

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.

Cost Allocation

Some of the cost is expensed each period.Some of the cost is expensed each period.

Cost Allocation – An Overview

• The matching principle requires that part of the acquisition cost of operational assets be expensed in periods when the future revenues are earned.

• Depreciation, depletion, and amortization are cost allocation processes used to help meet the matching principle requirements.

ExpenseExpenseAcquisitionCost

AcquisitionCost

(Balance Sheet) (Income Statement)

OperationalAsset Debit

Intangible Amortization Intangible Asset

Account Credited

Accumulated Depreciation

Property, Plant, & Equipment

Depreciation

Natural Resource DepletionNatural Resource

Asset

Caution! Depreciation, depletion, and amortizationare processes of cost allocation, not valuation!

Cost Allocation – An Overview

Property, plant, and equipment: Land and buildings 150,000$ Machinery and equipment 200,000 Office furniture and equipment 175,000 Land improvements 50,000 Total 575,000$ Less Accumulated depreciation (122,000) Net property, plant and equipment 453,000$

Depreciation on the

Balance Sheet

Discussion Questions

Q11–7 What basic questions must be answered before the amount of the depreciation charge can be computed?

Cost allocation requires three pieces of information for each asset:

The estimated expected use from an asset.

The estimated expected use from an asset.

Total amount of cost to be allocated.

Cost - Residual Value (at end of useful life)

Total amount of cost to be allocated.

Cost - Residual Value (at end of useful life)

The systematic approach used for allocation.

The systematic approach used for allocation.

Depreciable Base

Depreciable Base

Service Life

Service Life

Allocation Method

Allocation Method

Measuring Cost Allocation

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).

Estimation of Service Life

Depreciable Base

• How much is value going to decrease while company owns it?

• This amount has to be transferred to expense during the period that the company is using the item.

The profession requires the method employed be “systematic

and rational.” Examples include:

(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

Methods of Depreciation

Straight-Line

Time:

Activity:

Acquisition Cost

–Residual

ValueEstimated Service Life in

Years

Annual Straight-line Depreciation

=

Acquisition Cost

–Residual

Value

Estimated Output in Units

Depreciation rate per unit

of output =

Depreciation =Depreciation rate per unit

×Units of output

Example 1a: Straight Line Depreciation

On January 1, 2011, the Excel Delivery Company purchased a delivery van for $33,000. At the end of its five-year service life, it is estimated that the van will be worth $3,000. During the five- year period, the company expects to drive the van 100,000 miles. Calculate annual depreciation for the five-year life of the van using:• Straight line

Example 1b: Activity Based Depreciation

On January 1, 2011, the Excel Delivery Company purchased a delivery van for $33,000. At the end of its five-year service life, it is estimated that the van will be worth $3,000. During the five- year period, the company expects to drive the van 100,000 miles. Calculate annual depreciation for the five-year life of the van using:• Units of production using miles driven as a measure of output,

and the following actual mileage: ($33,000 – $3,000) / 100,000 miles

= $0.30 / mile deprec rate

Year Miles Depreciation2011 22,0002012 24,0002013 15,0002014 20,0002015 21,000

Sometimes called a Decreasing-Charge Method or an Accelerated Method

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.

Declining-Balance Method

Accelerated Methods

• Accelerated methods result in more depreciation in the early years of an asset’s useful life and less depreciation in later years of an asset’s useful life

• Note that total depreciation over the asset’s useful life is the same as the Straight-line Method

Declining-Balance depreciation –• Based on the straight-line rate multiplied by an acceleration

factor• Computations initially ignore residual value• Stop depreciating when BV = Residual Value

• Note that the Book Value will get lower each year

DDB =Book Value

× ( 2 × Straight-line Rate )

Acceleration Factor

Example 1c: Double-Declining Balance

On January 1, 2011, the Excel Delivery Company purchased a delivery van for $33,000. At the end of its five-year service life, it is estimated that the van will be worth $3,000. During the five- year period, the company expects to drive the van 100,000 miles. Calculate annual depreciation for the five-year life of the van using:• Double-declining balance

 Year

Book Value Beg of Year X

Rate per Year =

  Depreciation

Book ValueEnd of Year

2011 $33,0002012201320142015

Use of Various Depreciation Methods

Example 2: DDB to Straight Line

On January 2, 2011, the Jackson Company purchased equipment to be used in its manufacturing process. The equipment has an estimated life of eight years and an estimated residual value of $30,625. The expenditures made to acquire the asset were as follows:

Purchase price $154,000

Freight charges 2,000

Installation charges 4,000

Jackson’s policy is to use the double-declining-balance (DDB) method of depreciation in the early years of the equipment’s life and then switch to straight line halfway through the equipment’s life. Calculate depreciation for each year of the asset’s eight-year life.

  Year

Book ValueBeg of Year

 X

DepreciationRate per Year

 =

 Depreciation

Book ValueEnd of Year

2011201220132014

Example 2: Continued

  Year

Book ValueBeg of Year

 X

DepreciationRate per Year

 =

 Depreciation

Book ValueEnd of Year

2011 $160,000   2 / 8   $  40,000 $120,0002012201320142015201620172018Total

* Switch to straight-line in 2015: 

Partial-Period Depreciation

Pro-rating the depreciation based on the date of acquisition is time-consuming and costly. A commonly used alternative is the . . .

Half-Year Convention• Take ½ of a year of depreciation in the year of

acquisition, and the other ½ in the year of disposal

That said, unless told otherwise for class you calculate based on months!

Example 3: Partial-Period

On October 1, 2011, the Allegheny Corporation purchased machinery for $115,000. The estimated service life of the machinery is 10 years and the estimated residual value is $5,000. The machine is expected to produce 220,000 units during its life. Calculate depreciation for 2011 and 2012 using each of the following methods. Partial-year depreciation is calculated based on the number of months the asset is in service.

1. Straight line.

2. Double-declining balance.

3. One hundred fifty percent declining balance.

4. Units of production (units produced in 2011, 10,000; units produced in 2012, 25,000).

Example 3: Continued

Straight-line:

 

Example 3: Continued

Units-of-production:

 

E11-6

Muggsy Bogues Company purchased equipment for $212,000 on October 1, 2014. It is estimated that the equipment will have a useful life of 8 years and a salvage value of $12,000. Estimated production is 40,000 units and estimated working hours are 20,000. During 2014, Bogues uses the equipment for 525 hours and the equipment produces 1,000 units. Compute depreciation expense under each of the following methods. Bogues is on a calendar-year basis ending December 31.

a. Straight-line method for 2014.

b. Activity method (units of output) for 2014.

c. Activity method (working hours) for 2014.

d. Sum-of-the-years’-digits method for 2016.

e. Double-declining-balance method for 2015.

E11-6: Continued

E11-6: Continued