Operational Assets: Depreciation,
Impairment, and Depletion of
Operational Assets
DEPRECIATION CONCEPTS
 Depreciation - expiration or consumption of the
economic service potential of plant assets.
AN ECONOMIC FACT
 Depreciation accounting - the systematic and
rational allocation of the cost of tangible capital
assets, less salvage, over the estimated useful
life of the asset
AN ACCOUNTING PROCEDURE
– Depreciation accounting is a cost allocation process
and is not related to the “market value” of the asset
DEPRECIATION CONCEPTS
Related Areas
 Depletion accounting - periodic allocation of
the cost of natural resources against revenue
earned.
 Amortization accounting - periodic allocation
of intangible assets against revenue earned.
DEPRECIATION CONCEPTS
Factors Impacting Computed Depreciation
Expense
 Asset cost.
 Estimated residual value.
 Estimated useful life.
 Method of depreciation.
DEPRECIATION METHODS
(1) Straight-line.
(2) Based on inputs and outputs (Activity).
Service hours (SH) method.
Productive output (PO) or units-of-production.
(3) Accelerated methods.
Sum-of-the-years’-digits (SYD).
Declining-balance (normally 200% - DDB).
(4) Tax depreciation.
(5) Depreciation systems.
Group and composite.
Retirement and replacement.
STRAIGHT-LINE (SL)
Annual SL
Depreciation
=
Acquisition cost – Residual value
Estimated useful life in years
SL
ACTIVITY METHODS
Inputs and Outputs
 Depreciation based upon measures of input
or output like. . .
– Service hours
– Productive output (units-of-production)
 No depreciation is taken if the asset is idle.
Service Hours (SH)
Acquisition cost – Residual value
Estimated service life in hours
Depreciation
Per SH
=
Depreciation
Per Period
= Depreciation × Number of hours
Per SH
running time
PRODUCTIVE OUTPUT (PO)
Depreciation rate = Acquisition Cost – Residual Value
per unit of output
Estimated Productive Output in Units
Depreciation
Expense
Depreciation
=
rate per unit
×
Number of units
produced
ACCELERATED DEPRECIATION
Sum-of-the-Years’-Digits
Declining Balance Methods
SUM-OF-YEARS’-DIGITS
Depreciation
=
Fraction
No. of years remaining
in useful life
SYD
Depreciation per = Depreciation x
period
Fraction
(Cost - SV)
DOUBLE-DECLINING-BALANCE
(DDB)
DDB rate = 2 x Straight-line rate
(SL Rate = 1/Useful Life
Depr. base = Book value (Cost - Accum. depr.)
at beginning of the year
Depr. per period = Depr. rate x Depr. base
TAX DEPRECIATION
 For income tax reporting the IRS permits the
use of “modified accelerated cost recovery
system” (MACRS).
 MACRS ignores residual value.
 Depreciation is based upon percentages related
to the “class life” of the asset.
DEPRECIATION POLICY
 If a company expected asset obsolescence,
accelerated methods are appropriate.
 Many companies use SL for financial reporting
and accelerated depreciation for tax
reporting.
 SL depreciation is the most popular method
(about 94% of companies surveyed use SL).
DEPRECIATION POLICY
 Depreciation expense is a tax shield because it
is a noncash expense that is deductible for
income tax purposes.
 By lowering our income taxes, depreciation
improves our cash flows.
FRACTIONAL-YEAR DEPRECIATION
So far we have assumed that the depreciable
asset
was purchased at the beginning of the year.
If the asset is purchased sometime during the
year,
we have to adjust annual depreciation.
DEPRECIATION DISCLOSURES
 Depreciation expense.
 Balances of major classes of depreciable assets.
 Accumulated depreciation by asset or in total.
 General description of depreciation methods
used.
PLANT ASSET IMPAIRMENT
Impairment is the loss of a significant
portion of the utility of an asset through
casualty, obsolescence or lack of
demand for the company’s asset.
When plant assets suffer a permanent
impairment in value, a loss should be
recorded.
IMPAIRMENT OF
LONG-LIVED ASSETS
 Background
 SFAS No. 121
 SFAS No. 144
 Reporting requirements
 Disclosure requirements
IMPAIRMENT OF LONG-LIVED ASSETS
Assets to be Held and Used
 Reviewed when circumstances indicate
the carrying value may not be
recoverable
 Recognition of impairment loss
– Required if sum of expected future net cash
flows is less than carrying value of the asset
– Evaluated on a “component basis”
 Measurement of impairment loss
The amount by which the carrying value
of the asset exceeds the fair value of the
asset
IMPAIRMENT OF LONG-LIVED ASSETS
Assets to be Held and Used - Continued
 Presentation of impairment losses
Shown as a component of income from
continuing operations before taxes
 Restoration of impairment losses
Reduced carrying value is basis for future
accounting and restoration is prohibited
IMPAIRMENT OF LONG-LIVED
ASSETS
Disclosure Requirements

Description of impaired assets

Circumstances leading to impairment

Amount of impairment loss

How fair value was determined

Segment in which the impaired asset group is reported
– SFAS 131
I guess this boat is about
fully depreciated!
Deprec - 24
NATURAL RESOURCES
 Sometimes referred to as wasting
assets.
 Supplied by nature and extracted from
natural environment.
– Gold, oil, timber, coal, and other minerals.
 Presented on the balance sheet as
noncurrent assets.
Deprec - 25
NATURAL RESOURCES
 SFAS No. 19 identifies total costs as including
–
–
–
–
–
acquisition costs
exploration costs
development costs
production costs
support equipment and facilities cost.
 Total cost is allocated over periods benefited by
means of depletion.
Deprec - 26
NATURAL RESOURCES
Depletion
Depletion is calculated using the
units-of-production method.
Unit depletion rate is calculated as follows:
Capitalized Cost of
Natural Resource
–
Residual
Value
Estimated Recoverable Units
The numerator, cost – residual value,
is called the depletion base.
Deprec - 27
NATURAL RESOURCES
Total depletion cost for a period is:
UNIT DEPLETION
RATE
×
NUMBER OF UNITS
EXTRACTED IN PERIOD
The unit depletion rate . . .
•is inventoried with each extracted unit.
•is expensed as a part of cost of goods sold for
each unit sold.
•remains in inventory with each unsold unit.
Deprec - 28
NATURAL RESOURCES
Restoration Costs
 In some cases, the extractor is required
to restore the land to its original state
subsequent to the resources being
extracted.
 The estimated cost of restoration
increases the depletion base.
Deprec - 29
RESTORATION COSTS
Assume mine property has a capitalized cost of $4,000,000,
estimated recoverable ore of 2,000,000 tons, with 300,000
tons produced in Year 1. If the company must restore the
land to its original state after mining at an estimated cost of
$1 million, present the entry for production.
Unit depletion rate = ($4,000,000 + $1,000,000) / 2,000,000 tons
= $2.50 per ton
Entry: Inventory of ore
Accum depletion - Mine property
Estim. Liability for mine restoration
*300,000 tons x $2.50
**300,000 tons x $2,00
***300,000 tons x $.50
750,000*
600,000**
150,000***
Deprec - 30
NATURAL RESOURCES
Change in Estimate
 The unit depletion rate is based on estimated
recoverable units.
 Those estimates may change over time.
 The revised unit depletion rate is computed
for the remaining costs.
 Prior depletion costs are not revised.
Deprec - 31
NATURAL RESOURCES
Income Tax Reporting
 The cost-based depletion method is for
financial reporting purposes.
 The Internal Revenue Code allows the use
of statutory depletion (also called
percentage depletion) for tax purposes.
 Use of different methods for tax and
financial reporting purposes leads to
different incomes.
Deprec - 32
EXPLORATION COSTS
Oil and Gas Industry
 The costs of exploration for the oil and gas
industry are very large.
 An accounting question arises as to how
much of the exploration costs can be
capitalized.
 Two basic methods are allowed when
accounting for those costs:
– Successful-efforts method
– Full-cost method
Deprec - 33
EXPLORATION COSTS
Successful-Efforts Method
 Only the exploration costs associated
with successful wells are capitalized in
the cost of the natural resource.
 The costs associated with unsuccessful
wells are expensed
as incurred.
Deprec - 34
EXPLORATION COSTS
Full-Cost Method
 All exploration costs are capitalized as
part of the cost of the natural resource.
 This method tends to be used by
smaller firms primarily in the
exploration business.