Chapter 11: Depreciation,
Impairment and Depletion
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Depreciation

Depreciation is a method of cost
allocation.
– it is used to allocate the capitalized
cost of PP&E over the years
benefited (matching)
– Note: depreciation will decrease the
carrying value of the asset, but it is
not a valuation technique (i.e., book
value is not market value)
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Depreciation
The journal entry to record depreciation credits a
contra asset rather than crediting the asset
directly. This maintains the original cost of the
asset, and supplies additional information
regarding the approximate remaining life of the
asset.
Depreciation Expense
xx
Accumulated Depreciation
xx
The presentation on the balance sheet shows the
cost of the assets net of the accumulated
depreciation. This is called book value.
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Depreciation Methods
Depreciation methods
(1) Activity (units-of-production)
(2) Straight-line
(3) Sum-of-the-years’-digits
(4) Declining balance
(5) MACRS (income tax depreciation)
(6) Group and composite methods
(7) Hybrid or combination methods
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Class Example
Given the following information regarding
an automobile purchased by the
company on January 2, 2012:
Cost to acquire = $10,000
Estimated life = 4 years
Estimated miles = 100,000 miles
Salvage value = $2,000
Calculate depreciation expense for the
first two years under each of the
following methods.
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(1) Units-of-production (Activity)
Assume that the car was driven 20,000 miles in
the year 2012, 30,000 miles in 2013,40,000 in
2014 and 20,000 in 2015
Annual depreciation =
Cost - Salvage Value
x Current Activity
Total expected activity
Rate = (10,000-2000)/100,000 = $0.08/mi.
For 2012= $0.08 x 20,000 = $1,600
For 2013 = $0.08 x 30,000 = $2,400
For 2014 = $0.08 x 40,000 = $3,200
For 2015 = $0.08 x 20,000 = $1,600 XXX
So just take bal. to $8,000 = $800 in 2015
(2) Straight-Line
Annual depreciation =
Cost - Salvage
Estimated Life
=
10,000 - 2,000 = $2,000 per year
4 years
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(3) Sum-of-the-years’-digits (SYD)
SYD is a systematic allocation that yields an
accelerated depreciation in early years and lower
depreciation in later years.
The basic calculation in SYD involves creating a
set of fractions based on the number of years.
The numerator starts with the highest year (4 in our
example), then declines each year. The
denominator is the sum of the years’ total
(4+3+2+1 = 10 in our example). Calculations:
2012: 4/10 x (10,000 – 2,000) = 3,200
2013: 3/10 x (10,000 – 2,000) = 2,400
2014: 2/10 x (10,000 – 2,000) = 1,600
2015: 1/10 x (10,000 - 2,000) = 800
Note that SYD does a clean allocation of the total
depreciable base of an asset, similar to SL
depreciation.
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(4) Double Declining Balance
DDB is an accelerated depreciation technique. It
generates more expense in the early years and
less in the later years.
Annual depreciation = % (Cost - A/D)
where A/D is the accumulated depreciation for all
prior years, and the percentage is double the
straight line rate, or 2 x 1/Estimate life. In the
example, the % = 2 x 1/4 = 2/4 = 50%.
Depreciation expense (D.E.)for:
2005 = 50% x (10,000 - 0) = $5,000
2006 = 50% x(10,000-5,000) = $2,500
2007 = 50% x (10,000-7,500) = $1,250 XXX
So just take bal. to 8,000 A/D = $ 500
2008 (carry fully depreciated) =$0
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(5) MACRS

MACRS (modified accelerated cost recovery
system) is a technique developed by the IRS for
tax reporting. It utilizes combinations of DDB,
150%DB, and SL to calculate a table of
percentages that can be applied to any
depreciable asset.
 Additionally, the IRS assumes no salvage
value, and a half year in the first and last year of
depreciation (some limitations on fourth quarter
purchases).
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(5) MACRS



The IRS supplies a full set of tables with
percentages to indicate exactly how much
depreciation may be taken each year (see
Appendix 11A).
Note: companies may use MACRS for tax
purposes and another technique, like straightline for financial statement purposes.
Many companies keep two separate
depreciation schedules - one for financial and
one for tax - two different calculations for the
same assets.
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(6) Group and Composite Methods

These methods combine assets and depreciate
the combined assets at a single average rate.
 The group method is used for similar assets,
where the composite method may include
assets of different types.
 No gain or loss is recognized on asset
retirement until the last asset in the group is
retired.
 These methods “smooth out” the estimation
error effects, but contain less information for the
investors.
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(7) Hybrid Methods

Hybrid methods combine different GAAP
methods to achieve a particular result.
 Some companies combine straight-line with the
units of production for depreciation on certain
productive assets.
 Straight-line may be combined with an
accelerated technique by switching to straight
line when the accelerated technique yields a
lower depreciation expense than straight-line.
 For example, MACRS switches from DDB to
straight-line in later years.
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Depreciation – Partial Years


Partial year depreciation may be applied if
companies choose to do so. Straight line and
DDB have simple calculations in the first, partial
year: just depreciate for the portion of the year
used. SYD is more complicated, and will not be
tested.
Companies may also use a “full year”
convention for depreciation. If the asset is
purchased any time during the year, the
company may choose to take a full year’s
depreciation that year, or choose to defer any
recognition until the next year.
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Depreciation - Change in Estimate
Because depreciation is an estimate, and
two of the three components are subject to
variability, sometimes we need to make a
change in estimate (either in the estimated
life or the estimated salvage).
 The change in estimate affects only the
current and future years (prospective); we do
not go back and change the previous years
that have already been posted.

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Change in Estimate - continued
To calculate the new depreciation
expense, first find out how much
depreciation has been posted (the
Accumulated Depreciation to date).
 For straight-line, use the following
formula (to revise the depreciation rate
for current and future years):
Remaining Book Value - Revised Salvage
Revised Remaining Useful Life

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Asset Impairment

If events occur that might cause a reduction in
the value of PP&E below book value, then an
asset write-down might be necessary.
 The first step in the impairment process is a
recoverability test. This test estimates the future
net (undiscounted) cash flows expected from the
asset and its eventual disposition.
 If the undiscounted future cash flows are equal to
or greater than the carrying value of the asset, no
impairment is recognized.
 If the undiscounted future cash flows are less
than the carrying value of the asset, then an
impairment loss is recognized.
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Asset Impairment

The estimated loss to be recognized is calculated
based on the discounted present value of the
future cash flows.
 This is a “two step” process, in which some
impairments might not be recognized; however,
FASB does not allow a subsequent reversal of the
impairment.
 Note: for assets held for sale, “lower of cost or net
realizable value” is used to decide write-down. No
depreciation is taken on these assets, and writedown may be reversed if value increases.
 IFRS has a “one step” process, based on
discounted present value, but does allow
reversals in subsequent periods.
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Depletion

Depletion is the process of allocating part of the
cost of acquiring inventories of natural resources .
 Natural resources include assets like petroleum,
minerals and timber. They are “natural” resources
because they may only be replaced by nature.
 Once the depletion base has been established,
most companies use some form of units-ofproduction (activity method) to allocate the cost.
 The journal entry transfers the current period
allocation from the natural resource to Inventory,
as the depletion cost is part of the cost of
acquiring the inventory.
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Depletion Costs

The depletion base may include
– Acquisition costs: the cost to acquire the
right to the natural resource (property rights,
resource rights, or lease rights).
– Exploration costs: the cost to find the
resource; these costs may be significant with
some resources like oil and gas.
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Depletion Costs

The depletion base may include
– Development costs: the intangible costs relating to
the extraction of natural resources; these costs
may relate to labor, and many of the drilling costs
that do not result in a physical asset (tunnels,
shafts, wells). Note that tangible costs, such as
purchase of reusable rig components, trucks,
cranes, etc., are depreciated separately.
– Restoration costs: the development of many
natural resources leaves land that must be
restored (timber and mining, for example). These
costs are estimated, recorded as a future liability,
and included in the depletion base.
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Accounting for Oil Exploration Costs

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

Prior to 1977, there were two alternative techniques
used to record oil exploration costs: (1) full cost (FC)
and (2) successful efforts (SE).
FC capitalizes the costs of drilling all the dry holes
with the costs of drilling the successful wells, arguing
that the dry holes were necessary to find the
successful wells (accumulating and matching all costs
to future revenues). This technique created a very
large asset called “Oil Exploration Costs”.
SE capitalizes only the costs relating to the successful
wells, and expenses the exploration costs of dry holes
in the period incurred.
The general split has been that large oil companies
use SE, and small companies use FC.
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Accounting for Oil Exploration Costs




In 1977, the FASB required all oil companies to use SE.
Small oil companies lobbied Congress, stating that they
would be driven out of business, leaving only the large oil
companies to control the price of oil.
Congress went to the SEC and, in 1978, the SEC
proposed an alternative, fair value, technique called
Reserve Recognition Accounting (RRA). This technique
required estimation of fair value of all of the of the oil
companies’ activities, from discovery to production.
During the 1978 – 1981 reporting period, companies were
permitted to continue with FC and SE, with a disclosure of
certain required RRA estimations.
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Accounting for Oil Exploration Costs

In 1981, the SEC dropped the RRA requirements, but
maintained the requirement that a fair value estimate of
“proven oil reserves” be included.
 The FASB rescinded its SE requirement, and allowed
companies to use either method.
 The result is that small companies still use FC, and large
companies use SE, but all report their “proven reserves.”
 One benefit from this process is that the FASB now has a
more “inclusive” process in its standards development.
The Chief Accountant of the SEC now sits on the
Emerging Issues Task Force (EITF) and the FASB has
never had to rescind another standard because of
disagreement with the SEC.
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