Chapter 11
Depreciation, Impairments,
and Depletion
1
Depreciation in accounting is not about valuation, but cost allocation.
Depletion is used for natural resources and Amortization for intangibles such as
patents, copyrights
GAAP requires the allocation over the asset’s life in a systematic and rational manner.
Choice of method usually guided by the matching principle
1.
Activity methods (miles, m/c hours, units of production)
– depreciation a function of usage
2. Straight line method – depreciation a function of time
Assumed same usefulness and maintenance expense each year
3. Accelerated methods – reducing expense: higher dep. expense in early years. New
equipment more productive and require less maintenance; a more constant annual cost
a. DDB– rate is a multiple of the st-line rate. SV not factored into calculation
b. Sum of the years digits – rate of dep. = year # in reverse order / Sum of years
c. MACRS – for tax purpose – eqt. class with published associated rates – see p.631
d. Special depreciation methods: group/composite and hybrid (combination)
2
p.637 E11-2 ( Depreciation— Conceptual Understanding)
Hasselback Company acquired a plant asset at the beginning of
Year Straight-Line SYD
DDB
Year 1. The asset has an estimated service life of 5 years. An
1 $ 9,000 $ 15,000
$ 20,000
employee has prepared depreciation schedules for this asset using
2
9,000
12,000
12,000
three different methods to compare the results of using one method
3
9,000
9,000
7,200
with the results of using other methods. You are to assume that the
4
9,000
6,000
4,320
following schedules have been correctly prepared for this asset
5
9,000
3,000
1,480
using (1) the straight-line method, (2) the sum-of the-years’-digits
Total $ 45,000 $ 45,000
$ 45,000
method, and (3) the double-declining-balance method
5 yr m/c: Rate: 20% 5/15 for 1st yr. 40%
Answer the following questions.
a)
What is the cost of the asset being depreciated?
b)
What amount, if any, was used in the depreciation calculations for the salvage value for this asset?
c)
Which method will produce the highest charge to income in Year 1?
d)
Which method will produce the highest charge to income in Year 4?
e)
Which method will produce the highest book value for the asset at the end of Year 3?
f)
If the asset is sold at the end of Year 3, which method would yield the highest gain ( or lowest loss) on
disposal of the asset?
a) For DDB: Cost*rate = dep. Cost = dep./rate = 20,000/40% = $50,000
b) St. line: Depreciable base = total depreciated = 45,000. SV = cost – base = $5,000
c) Highest dep. For year 1 – using the DDB method
d) By observation – straight line method
e) Highest BV => lowest acc. Dep. for year 3: Straight line method
f) Highest gain => lowest BV, hence for year 3: DDB
3
4. Other Depreciation Methods –
intention here is to simplify bookkeeping; averages out errors caused by
under/over estimation of depreciation; recognize no gain/loss on disposal (by
adjusting accumulated depreciation), hence do not distort Income Statement.
a. Group and composite
i)
ii)
Use Group method when assets are similar with approx. the same useful
lives e.g. fleet of delivery trucks–
similar to single-unit cost procedure [No gain/loss if sold – adjust acc. Dep.]
Use Composite method otherwise – see I.11-8 p.612
Rate of dep. = sum of individual asset annual dep. ÷ by total cost of assets
Composite life = Total depreciable amount / annual depreciation
Methods basically capitalizes the total cost of the assets into one account and is treated
as one “asset” for purpose of depreciation.
If one, or some items in the “asset” is sold, the company does not recognize a gain or
loss on that item because the entire “asset” is not retired. The difference between cash
received and item cost is debited to accumulated. Gain/loss recognized when final
item in group is retired.
b. Hybrid or combination – mixture of straight-line and activity method
4
p.636 BE11-6 Dickinson Inc. owns the following assets.
Asset
Cost Salvage Estimated Useful Life
A
$ 70,000
$ 7,000
10 years
B
50,000
5,000
5 years
C
82,000
4,000
12 years
Compute the composite depreciation rate and the composite life of Dickinson’s assets.
Dickinson Inc. owns the following assets
Asset
Cost Salvage Est Life
A 70,000 7,000
10
B 50,000 5,000
5
C 82,000 4,000
12
202,000
Total
Depreciable
Annual Dep
63,000
6,300
45,000
9,000
78,000
6,500
186,000
21,800
Composite rate = total annual depreciation / total equipment cost =
10.79%
Composite life = total depreciable amount / annual dep. = 8.53 years
Note that depreciation expense is computed by multiplying the composite rate
by the cost of the remaining asset value. Note: Cost, not depreciable amount.
5
p.638 E11-9 ( Composite Depreciation) Presented below is information related to Morrow Manufacturing
Corporation.
Machine Cost
Estimated Salvage Value Estimated Life
Depreciable Ann. Dep.
A
$ 40,500
$ 5,500
10
35,000
3,500
B
33,600
4,800
9
28,800
3,200
C
36,000
3,600
8
32,400
4,050
D
19,000
1,500
7
17,500
2,500
E
23,500
2,500
6
21,000
3,500
a)
Compute the rate of depreciation per year to be applied to the machines under the composite method.
b)
Prepare the adjusting entry necessary at the end of the year to record depreciation for the year.
c)
Prepare the entry to record the sale of Machine D for cash of $ 5,000. It was used for 6 years, and
depreciation was entered under the composite method.
a)
Composite rate = total annual depreciation
÷ total “asset” cost = 10.98%
Total “asset” cost = 152,600;
depreciable amount = 134,700
depreciation = 16,750
Composite life = 134,700/16,750 = 8.04 years
b) Depreciation expense
16,750
Accumulated depreciation 16,750
c) For Asset D:
Cash
5,000
Acc. Dep. 14,000
Plant assets
19,000
Note: No gain/loss recognized.
Equipment cost * rate
Note that : equipment cost used and not
depreciable amount – see rate calc. above
What is the depreciation expense for the next
year if no new asset added?
Plant asset remaining cost = 152,600 – 19,000
= 133,600
Depn. expense = 133,600*10.98% = 14,669
6
Depreciation for partial periods
In practice, companies normally depreciate their equipment to the nearest month.
(i.e. if equipment purchased in the first 15 days of a month, count that as a full month).
Other adoption – the half year convention: in the year of acquisition charge half a year of
depreciation. Example: Depreciation periods of a 3 year equipment: ½, 1,1, and ½ year.
Approach similar to one used by MACRS.
Note again that depreciation is about cost allocation.
The cost is allocated over the life of the machine.
Since accounting year is not the same as machine year,
Depreciation expense is made up of portions of machine’s annual cost allocations.
Equipment purchase May 1, 2011
Cost allocation
over life of
Equipment life: 1st Yr.
equipment
Depreciation
recognize over
accounting year
2nd Yr.
3rd Yr.
4th Yr.
Depreciation expense for year ending 2012 is made up of 4
months of equipment year 1 and 8 months of equipment year 2
2010
2011
2012
2013
7
2014
Example: Consider a $6,000 three year equipment with no salvage value using the
sum-of-the-year (SYD) method.
Rate of depreciation: 1st year 3/6; 2nd year 2/6; and 3rd year 1/6
Equipment cost allocation: 1st yr. = $3,000;
Age of equipment
Accounting
Periods
End of
acctg. yr 1
2nd yr. $2,000;
Yr 1
End of
acctg. yr 2
3rd yr. $1,000
Yr 3
Yr 2
End of
acctg. yr 3
End of
acctg. yr 4
If equipment bought on 1st April, then depreciation expense recognize would be:
Accounting yr. 1 = 3,000*9/12 = $2,250
Accounting yr. 2 = 3,000*3/12 + 2,000*9/12 = $2,250
Accounting yr. 3 = 2,000*3/12 + 1,000*9/12 = $1,250
Accounting yr. 4 = 1,000*3/12 = $250
For straight line method, above manipulations not necessary because cost allocated
and depreciation expense will be the same over each 12 months.
8
p.638 E11-6 ( Depreciation Computations— Five Methods, Partial Periods) Agazzi Company purchased
equipment for $ 304,000 on October 1, 2012. It is estimated that the equipment will have a useful life of 8
years and a salvage value of $ 16,000. Estimated production is 40,000 units and estimated working hours
are 20,000. During 2012, Agazzi uses the equipment for 525 hours and the equipment produces 1,000 units.
Compute depreciation expense under each of the following methods. Agazzi is on a calendar- year basis
ending December 31.
a)
Straight- line method for 2012.
b)
Activity method ( units of output) for 2012.
c)
Activity method ( working hours) for 2012.
d)
Sum- of- the- years’- digits method for 2014.
e)
Double- declining- balance method for 2013.
a)
Rate: 1/8 = 12.5%; 3 mths dep
= (304,000 – 16,000)*12.5% * 3/12
= $9,000
b) Rate = (304,000-16,000)/40,000
= $7.2/unit;
for 1,000 units, dep. Exp = $7,200
c) Rate = (304,000-16,000)/20,000
= $14.4/hour;
for 525 hrs, dep. Exp. = $7,560
9
p.638 E11-6 ( Depreciation Computations— Five Methods, Partial Periods) Agazzi Company purchased
equipment for $ 304,000 on October 1, 2012. It is estimated that the equipment will have a useful life of 8
years and a salvage value of $ 16,000. Estimated production is 40,000 units and estimated working hours
are 20,000. During 2012, Agazzi uses the equipment for 525 hours and the equipment produces 1,000 units.
Compute depreciation expense under each of the following methods. Agazzi is on a calendar- year basis
ending December 31.
a)
Straight- line method for 2012.
b)
Activity method ( units of output) for 2012.
c)
Activity method ( working hours) for 2012.
2nd machine year
d)
Sum- of- the- years’- digits method for 2014.
3rd machine year
e)
Double- declining- balance method for 2013.
a/c
Oct 1, 2012 eqt
purchase
Depreciable amount
= 304,000 – 16,000
Year end 2012
= 288,000
year
2014
2013
2014
2015
*
SYD method
Year
Rate
Cost allocated Dep for year
Dep for year 2014 =
1
8/36 64,000
2012
9 mths of machine yr 2
2
7/36 56,000
2013
+ 3 mths of machine yr
3
6/36
48,000
2014
3
4
5/36
40,000
2015
= 9/12 * 56,000 + 3/12
* 48,000 = 54,000
10
p.638 E11-6 ( Depreciation Computations— Five Methods, Partial Periods) Agazzi Company purchased
equipment for $ 304,000 on October 1, 2012. It is estimated that the equipment will have a useful life of 8
years and a salvage value of $ 16,000. Estimated production is 40,000 units and estimated working hours
are 20,000. During 2012, Agazzi uses the equipment for 525 hours and the equipment produces 1,000 units.
Compute depreciation expense under each of the following methods. Agazzi is on a calendar- year basis
ending December 31.
a)
Straight- line method for 2012.
b)
Activity method ( units of output) for 2012.
c)
Activity method ( working hours) for 2012.
1nd machine year
d)
Sum- of- the- years’- digits method for 2014.
2nd machine year
e)
Double- declining- balance method for 2013.
a/c
Date of purchase Oct 1, 2012
year
2013
e) DDB: rate = 2/n = 2/8 = Year 2011
2012
2013
2014
1/4
DDB method
Year Balance
Rate
Cost allocated Dep for year
1
304,000
1/4
76,000
2012
Dep for year 2013 =
2
228,000
1/4
57,000
2013
9 mths of machine yr 1
3
171,000
1/4 42,750
2014
+ 3 mths of machine yr
4
128,250
1/4 32,062
2015
2
= 9/12 * 76,000 + 3/12
* 57,000 = 71,250
11
11
Change in estimate or Revision of Depreciation rates – changes are handled
prospectively
p.636 BE11-7 Holt Company purchased a computer for $ 8,000 on
January 1, 2011. Straight- line depreciation is used, based on a 5- year
life and a $ 1,000 salvage value. In 2013, the estimates are revised. Holt
now feels the computer will be used until December 31, 2014, when it can
be sold for $ 500. Compute the 2013 depreciation.
Original depreciation per year = (8,000 – 1,000)/5 = 1,400
After 2 years, BV = 8,000 – 2,800 = 5,200
In 2013, computer has 2 years life, BV 5,200 and SV 500
Depreciation expense for 2013 = (5,200 – 500)/2 = $2,350
12
Impairment – recovery test
GAAP follows a two step process: 1) test for impairment or recovery test
and 2) calculate write-down
1)
2)
Is sum of expected future net cash flows (undiscounted) less than
carrying value? – Yes: impairment has occurred.
To write down the asset, determine the fair market value: its market value
or PV of expected future net cash flows (discounted). Amount written off
reported as losses in “others in the IS”. Accumulated depreciated is credited.
Impairment loss are not restored for an asset held for use.
If impaired asset held for disposal, treat it like inventory and use LCM with no
depreciation. Write up permitted so long as the carrying value never exceeds the
carrying amount of the asset before the impairment.
See IL 11-16 p.620
13
p.640 E11-16 ( Impairment) Presented below is information related to equipment owned by
Pujols Company at December 31, 2012.
Cost
$9,000,000
Accumulated depreciation to date
1,000,000
BV = 8,000,000
Expected future net cash flows
7,000,000
Fair value
4,400,000
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.
a)
Prepare the journal entry ( if any) to record the impairment of the asset at Dec 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.
a) Carrying value = 8,000,000 which is higher than the expected future cash flows
Equipment is impaired and must be written down to its Fair Value
Impairment loss
3,600,000
Depreciation 3,600,000
Acc.
= BV - fair value
after loss, BV = 4.4m
b) 4-year life, so annual depreciation = 4.4m / 4 = 1,100,000
Depreciation expense 1,100,000
Acc. Depreciation
1,100,000
c) Since equipment is for use, restoration of impairment is not permitted.
14
p.640 E11-17 ( Impairment) Assume the same information as E11- 16, except that Pujols
intends to dispose of the equipment in the coming year. It is expected that the cost of disposal
will be $ 20,000.
a)
Prepare the journal entry ( if any) to record the impairment of the asset at Dec 31, 2012.
b)
Prepare the journal entry ( if any) to record depreciation expense for 2013.
c)
The asset was not sold by December 31, 2013. The fair value of the equipment on that
date is $ 5,100,000. Prepare the journal entry ( if any) necessary to record this increase
in fair value. It is expected that the cost of disposal is still $ 20,000.
a) The cost of disposal is included in the loss on impairment
Impairment loss
3,620,000
Acc. Depreciation
3,620,000
b) Asset intend for disposal, so treated like inventory, thus no depreciation.
c)
BV of asset after recognizing the impairment loss in part (a)
= 8m – 3.62m = 4,380,000
Upward revision permitted.
FV = $5,100,000 less cost $20,000 of disposal = 5,080,000
so BV has to be adjusted upwards by 5.08m - 4.38m = 700,000
Acc. Depreciation
700,000
Recovery of loss on Impairment
700,000
15
Depletion – applied to natural resources (wasting assets)
Determination of depletion base:
1) Acquisition cost
2)
Exploration - controversy in oil & gas industry: full cost or successful
efforts (similar to R&D for software)
3) Development - tangible: equipment used, usually treated as separate asset
- intangible: drilling costs, tunneling, etc. - considered part of
depletion base
4)
Restoration - part of depletion base:
Cost necessary to return property to acceptable condition.
Example, re-leveling of land after mining.
5) Salvage value reduces depletion base
Write-off (recognition of depletion expense) similar to activity method: Inventory
debited and asset base credited. When inventory sold, cost recognized (COGS) is
often referred to as depletion expense.
Note: some company uses accumulated depletion. If so, credit acc. Depletion
instead.
16
p.641 E11-20 ( Depletion Computations— Oil) Federer Drilling Company has leased property on which oil has
been discovered. Wells on this property produced 18,000 barrels of oil during the past year that sold at an
average sales price of $ 65 per barrel. Total oil resources of this property are estimated to be 250,000 barrels.
The lease provided for an outright payment of $ 600,000 to the lessor ( owner) before drilling could be
commenced and an annual rental of $ 31,500. A premium of 5% of the sales price of every barrel of oil removed
is to be paid annually to the lessor. In addition, Federer ( lessee) is to clean up all the waste and debris from
drilling and to bear the costs of reconditioning the land for farming when the wells are abandoned. The
estimated fair value, at the time of the lease, of this clean- up and reconditioning is $ 30,000.
From the provisions of the lease agreement, compute the cost per barrel for the past year, exclusive of operating
costs, to Federer Drilling Company.
Depletion Base:
Lease =
$600,000
Reconditioning of Land $30,000
Total to produce 250,000 barrels
$630,000
Cost per barrel = 630,000 / 250,000 = $2.52
Annual Cost:
Rental $31,500 for 18,000 barrels = $1.75 per barrel
Premium of 5% on sales @ $65 =
Total cost per barrel
=
3.25 per barrel
$7.52
17
p.640 E11-19 ( Depletion Computations— Timber) Hernandez Timber Company owns 9,000 acres of timber-land
purchased in 2001 at a cost of $ 1,400 per acre. At the time of purchase, the land without the timber was valued at
$ 400 per acre. In 2002, Hernandez built fire lanes and roads, with a life of 30 years, at a cost of $ 87,000. Every
year, Hernandez sprays to prevent disease at a cost of $ 3,000 per year and spends $ 7,000 to maintain the fire
lanes and roads. During 2003, Hernandez selectively logged and sold 700,000 board feet of timber, of the
estimated 3,000,000 board feet. In 2004, Hernandez planted new seedlings to replace the trees cut at a cost of $
100,000.
a) Determine the depreciation expense and the cost of timber sold related to depletion for 2003.
b) Hernandez has not logged since 2003. If Hernandez logged and sold 900,000 board feet of timber in 2014, when
the timber cruise ( appraiser) estimated 5,000,000 board feet, determine the cost of timber sold related to
depletion
2014.acres + timber = $1,400 /acre; land/acre = $400 ; so timber = $1,000/acre
2001: for
9,000
Fire lanes and roads (30 years life) = $87,000 depreciation each year = $2,900
a) Depreciation expense = $2,900 for roads and fire lanes
Value of timber = $1,000*9,000 = $9,000,000
Rate = $3/bf
Total estimated production = 3,000,000
In 2003 board feet logged and sold 700,000 bf, so, depletion = $2,100,000
b) 2014 logged and sold 900,000 bf when timber appraised at 5,000,000 bf
After the 2003 logging, BV = $9m - $2.1m = $6,900,000
Add 2002 seeding of $100,000; total = $7,000,000
New estimate in 2014 =5,000,000 bf,  New rate = $1.40
Depletion for 2014 = timber logged * rate = $1,260,000
18
p.641 E11-22 ( Depletion Computations— Mining) Henrik Mining Company purchased land on February 1,
2012, at a cost of $ 1,250,000. It estimated that a total of 60,000 tons of mineral was available for mining.
After it has removed all the natural resources, the company will be required to restore the property to its
previous state because of strict environmental protection laws. It estimates the fair value of this restoration
obligation at $ 90,000. It believes it will be able to sell the property afterwards for $ 100,000. It incurred
developmental costs of $ 200,000 before it was able to do any mining. In 2012, resources removed totaled
30,000 tons. The company sold 24,000 tons.
Compute the following information for 2012.
( a) Per unit mineral cost.
( b) Total material cost of December 31, 2012, inventory.
( c) Total materials cost in cost of goods sold at December 31, 2012.
Depletion base:
Purchase cost:
Development $200,000
Restoration
$90,000
Salvage
($100,000)
Total
$1,440,000
$1,250,000
Depletion rate
= Cost/Est total production
= $1,440,000 ÷ 60,000
= $24/ton
(a) Per unit mineral cost: $24/ton
(b)
12/31/12 inventory: Mined – Sales = 30,000 – 24,000 = 6,000 tons
at a cost of $24 * 6,000 tons = $144,000
(c) Cost of goods sold 2012: $24 * 24,000 tons = $576,000
19
End of Chapter 11
Suggested Homework:
E11-5, 6, 13, 17 and 19; P11-3, 6 and 10
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