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Chapter 10
Depreciation
and Depletion
An electronic presentation
by Douglas Cloud
Pepperdine University
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Objectives
1. Identify the factors involved in
depreciation.
2. Explain the alternative methods of cost
allocation, including activity and timebased methods.
3. Record depreciation.
4. Explain the conceptual issues regarding
depreciation methods.
5. Understand the disclosure of depreciation.
Continued
3
Objectives
6. Understand additional depreciation methods,
including group and composite methods.
7. Compute depreciation for partial periods.
8. Explain the impairment of noncurrent assets.
9. Understand depreciation for income tax
purposes.
10. Explain changes and corrections of
depreciation.
11. Understand and record depletion.
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Factors Involved in Depreciation
 Asset cost
 Service life
 Residual value
 Method of cost
allocation
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Factors Involved in Depreciation
Service Life
Service life is the measure of the
number of units of service expected
from the asset before its disposal.
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Factors Involved in Depreciation
Service Life
The factors that limit the service life
of an asset can be divided into two
general categories.
 Physical
causes
 Functional causes
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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.
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Methods of Cost Allocation
• Activity (or use) methods
• Time-based methods
a. Straight-line
b. Accelerated (declining charge)
(1) Sum-of-the-years’-digits
(2) Declining balance
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Methods of Cost Allocation
Activity Methods
Depreciation Rate =
=
Cost – Residual Value
Total Lifetime Activity Level
$120,000 – $20,000
10,000 hours
= $10 per hour
Assume the asset
is used
for 2,100
Depreciation
= $2,100
(2,100
hours hours.
x $10)
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Methods of Cost Allocation
Time-Based Method: Straight Line
Depreciation Rate =
=
Cost – Residual Value
Service Life
$120,000 – $20,000
5 Years
= $20,000 per year
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Methods of Cost Allocation
Time-Based Method: Sum-of-the-Years’ Digits
Year
2003
2004
2005
2006
2007
Depreciation
Base
$100,000
100,000
100,000
100,000
100,000
Book Value at
Fraction Depreciation Year-End
5/15
$ 33,333
$86,667
4/15
26,667
60,000
3/15
20,000
40,000
2/15
13,333
26,667
1/15
6,667
20,000
$100,000
Residual
Value
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Methods of Cost Allocation
Double-Declining
Balance
Time-Based
Method: Declining-Balance
Year
2003
2004
2005
2006
2007
Book Value at
Book Value at
Beginning of Year Rate Depreciation Year-End
$120,000
40% $ 48,000
$72,000
72,000
40%
28,800
43,200
43,200
40%
17,280
25,920
25,920
--5,920
20,000
20,000
----20,000
$100,000
Residual
Value
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Methods of Cost Allocation
150%-Declining
Balance
Time-Based
Method: Declining-Balance
Year
2003
2004
2005
2006
2007
Book Value at
Book Value at
Beginning of Year Rate Depreciation Year-End
$120,000
30% $ 36,000
$84,000
84,000
30%
25,200
58,800
58,800
30%
17,640
41,160
41,160
30%
12,348
28,812
28,812
--8,812
20,000
$100,000
Residual
Value
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Recording Depreciation
The credit to depreciation is
usually called Accumulated
Depreciation or Allowance for
Depreciation.
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Recording Depreciation
The account title Reserve for
Depreciation is considered
undesirable because of the
uncertain meaning of “reserve.”
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Conceptual Evaluation of
Depreciation Methods
$
Depreciation
Expense
Sum-of-the-Years-Digits
Straight-Line
Double-Declining-Balance
2003 2004 2005 2006 2007
During Year
17
Conceptual Evaluation of
Depreciation Methods
$
Sum-of-the-Years-Digits
Book Value
Straight-Line
Double-Declining-Balance
2003 2004 2005 2006 2007
At End of Year
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Conceptual Evaluation of
Depreciation Methods
…a
If similar
a company
totalexpects
cost each
thatperiod
repairs
can
and
bemaintenance
achieve through
costsstraight-line
and the total
economic
depreciation
benefits
and the
of similar
the asset
repair
will
remain
and maintenance
similar each period,...
costs.
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Conceptual Evaluation of
Depreciation Methods
…and
If the company
repairs and
expects
maintenance
that costs
are
benefits
constant
of having
each period,
the asset
a declining
will
totaldecline
cost will
each
be year
achieved
for the
by using
life
accelerated
of the asset,
depreciation.
...
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Effect of Depreciation
on Rate of Return
Year
2003
2004
2005
2006
2007
Net Income
$12,000
12,000
12,000
12,000
12,000
Book Value of Asset Rate of
at Beginning of Year Return
$120,000
100,000
80,000
60,000
40,000
10%
12
15
20
30
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Disclosure of Depreciation
APB Opinion No. 12 requires the following disclosure:

Depreciation expense for the period.
 Balances of major classes of depreciable assets, by
nature or function, at the balance sheet date.
 Accumulated depreciation, either by major classes
of depreciable assets or in total, at the balance
sheet date.
 A general description of the method or methods
used in computing depreciation with respect to
major classes of depreciable assets.
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Disclosure of Depreciation
Number of Companies
2000 1997 1994 1990 1986 1982
Straight-line ……...…. 576
Declining-balance. ….. 22
Sum-of-the-yearsdigits ………………. 7
Accelerated method,
not specified……….. 53
Units-of-production…. 34
578 573 560 561
26 27 38 49
562
57
10
9
11
14
20
50
39
49
49
69
50
77
48
69
62
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Group Depreciation
A company
purchased ten
cars for $20,000
each, and the
average expected
life is 3 years
with a residual
value of $5,000
each.
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Group Depreciation
To record the purchase.
Cars
Cash
200,000
$200,000
– $50,000
200,000
3
To record the first year’s depreciation expense.
Depreciation Expense
Accumulated Depreciation
50,000
50,000
This same depreciation entry would be
made at in the end of the second year.
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Group Depreciation
Three cars were sold after 2 years for $8,000 each.
Cash
24,000
Accumulated Depreciation
36,000
Cars
60,000
.25 ($200,000 – $60,000)
To record the third year’s depreciation expense.
Depreciation Expense
Accumulated Depreciation
35,000
35,000
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Group Depreciation
Five cars were sold after 3 years for $6,000 each.
Cash
30,000
Accumulated Depreciation
70,000
Cars
100,000
To reduce the $11,000
book
value to the salvage value.
To record the fourth year’s depreciation expense.
Depreciation Expense
Accumulated Depreciation
1,000
1,000
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Group Depreciation
Two
Thecars
finalwere
twosold
cars after
were3sold
years
forfor$4,800
$4,800each.
each.
Cash
Accumulated Depreciation
Loss on Disposal
Cars
9,600
30,000
400
Book value =
Cash received =
Loss
40,000
$10,000
9,600
$ 400
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Composite Depreciation
Asset
Cost
A
B
C
$25,000
13,000
12,000
$50,000
Annual
Residual Value Life Depreciation
$5,000
1,000
----$6,000
10 yrs.
6
4
$2,000
2,000
3,000
$7,000
7,000
Depreciation Rate =
= 14%
$50,000
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Depreciation for Partial Periods
Year
1
2
3
4
Annual
Depreciation
3/6 x $6,000 = $3,000 x 4/12
= $1,000
A company purchases
$6,000 asset
$3,000 x a8/12
with
a 3-year=life
and no
residual=value
2/6
x $6,000
$2,000
x 4/12
2,667
on August 18. $2,000
The firm
uses the sumsx 8/12
of-the-years’-digits method.
1/6 x $6,000 = $1,000 x 4/12
= 1,667
$1,000 x 8/12 =
666
$6,000
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Depreciation for Partial Periods
Annual
Depreciation
= $1,333
Year
1 2/3 x $6,000 = $4,000 x 4/12
x 8/12
A2company purchases$4,000
a $6,000
asset with a 3-year
2/3no
x $2,000
$1,333
4/12 18.
= The
3,111
life and
residual= value
onxAugust
firm
method.
3 uses the double-declining-balance
$1,333 x 8/12
$667 x 4/12
= 1,111
4
$667 x 8/12 =
445
$6,000
OR
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Depreciation for Partial Periods
Year
1
2
3
4
Annual
Depreciation
4/12 x $4,000
= $1,333
0.667 x ($6,000 – $1,333) = 3,113
0.667 x ($4,667 – $3,113) = 1,037
Remaining balance
=
517
$6,000
Declining-Balance-Method
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Impairment of
Noncurrent Assets
The FASB issued FASB
Statement No. 144 which requires
a company to review its property,
plant, and equipment for
impairment.
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Impairment of
Noncurrent Assets
Impairment occurs whenever
events or changes in circumstances
indicate that the book value of a
noncurrent asset may not be
recoverable.
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Impairment of
Noncurrent Assets
An impairment loss involves the following steps:
Events or Changes in Circumstances Occurs
Impairment Test
(Undiscounted Cash Flows < Book Value of Asset)
Measurement of Loss
(Loss = Fair Value – Book Value)
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Impairment of
Noncurrent Assets
On January 1, 2001, the Hall Company
purchased a factory for $1 million (20-year life)
and machinery for $3 million (10-year life).
Late in 2004, the company believes that its
asset(s) may be impaired and the remaining
useful life is 5 years. The company estimates
that the asset will produce cash inflows of
$700,000 and incur cash outflow of $300,000
each year for the next 5 years.
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Impairment of
Noncurrent Assets
December 31, 2004
Factory cost
Less: Accumulated depreciation
(4 years x $50,000)
Book value
Machinery cost
Less: Accumulated depreciation
(4 years x $300,000)
Book value
Total Book Value
Impairment Test
$1,000,000
(200,000 )
$ 800,000
$3,000,000
(1,200,000 )
1,800,000
$2,600,000
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Impairment of
Noncurrent Assets
Impairment Test
Undiscounted expected
= 5 x ($700,000 – $300,000)
net cash flows
=
5
x
$400,000
Years Cash
= $2,000,000
Inflows
Cash
Outflows
Because $2,000,000 is less than
$2,600,000 (the book value), an
impairment loss must be recognized.
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Impairment of
Noncurrent Assets
Measurement of the Loss
Present value of the expected
= $400,000 x 3.274294
cash flows (fair value)
= $1,309,718 (rounded)
Book value
Fair value
Impairment loss
$2,600,000 n= 5, i = 0.16
(1,309,718 ) from Table 4
$1,290,282 in Appendix
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Impairment of
Noncurrent Assets
The Statement does not specify how to
record the write-down. It does indicate that
the reduced book value is to be accounted
for as the new cost.
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Impairment of
Noncurrent Assets
Loss from Impairment
1,290,282
Accumulated Depreciation:
Factory
200,000
Accumulated Depreciation:
Machinery
1,200,000
Factory (new cost)
327,429
Machinery (new cost)
982,289
Factory (old
cost)
$1,309,718
x [$1,000,000
÷ ($3,000,000 ÷1,000,000
$1,000,000)]
Machinery x(old
cost)
$1,309,718
[$3,000,000
÷ ($3,000,000 ÷3,000,000
$1,000,000)]
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Conceptual Evaluation of
Asset Impairment
Although FASB Statement No. 121 has been
replaced by FASB Statement No. 144, the principles
it established have only changed slightly.
Although the Statement narrows GAAP, it still
allows for significant management flexibility.
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MACRS Principles
For an asset purchased in 1987 and later, a company’s
computation of depreciation for income tax and financial
reporting differ in three major respects:
1. A mandated tax life, which is usually
shorter than the economic life.
2. The acceleration of the cost recovery
(except for buildings).
3. The elimination of residual value.
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MACRS Principles
On January 1, 2003 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 Exhibit l0-12 to determine the
annual depreciation rate for 2003.
20%
Determine depreciation for 2003-2008.
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MACRS Principles
2003
2004
2005
2006
2007
2008
$200,000 x 20%
$200,000 x 32%
$200,000 x 19.20%
$200,000 x 11.52%
$200,000 x 11.52%
$200,000 x 5.76%
= $ 40,000
= 64,000
= 38,400
= 23,040
= 23,040
= 11,520
$200,000
Changes and Corrections
of Depreciation

A change in the depreciation method for currently
owned assets is accounted for by a cumulativeeffect change.
 Adoption of a new depreciation method for newly
acquired assets does not require any adjustment to
the accounts.
 A change in an estimate of the residual value or
the service life of a currently owned asset is
accounted for prospectively.
 Correction of an error in depreciation is treated as
prior period adjustment.
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Depletion
Cost – Residual Value
Unit Depletion Rate =
Units
A company purchases land for $3,000,000 from which it
expects to extract 1,000,000 tons of coal, the estimated
residual value is $200,000, and it mines 80,000 tons of
coal in 2003.
$3,000,000 – $200,000
Unit Depletion Rate =
1,000,000 tons
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Depletion
Cost – Residual Value
Unit Depletion Rate =
Units
$3,000,000 – $200,000
Unit Depletion Rate =
1,000,000 tons
Unit Depletion Rate = $2.80 per ton
Depletion for Year = $2.80 x 80,000 = $224,000
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Chapter 10
The End
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