Chapter 11
Depreciation and
Depletion
Intermediate Accounting 11th edition
Nikolai Bazley Jones
An electronic presentation
By Norman Sunderman
and Kenneth Buchanan
Angelo State University
COPYRIGHT © 2010 South-Western/Cengage Learning
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Depreciation
Depreciation is the process of
allocating the cost of an asset in a
systematic and rational manner over
the periods benefited.
Land is not depreciated because it
generally does not have a limited life.
3
Factors Involved in Depreciation
Asset Cost
The cost of an asset includes all the
acquisition costs a company incurs to
obtain the benefits from the asset.
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Factors Involved in Depreciation
Service Life
The service life of an asset is the
measure of the service units 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
 Time-based methods
a. Straight-line
b. Accelerated (declining charge)
1) Sum-of-the-years’-digits
2) Declining balance
 Activity (or use) methods
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Depreciation
Problem Information
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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
=
$20,000 per year
10
Methods of Cost Allocation
Time-Based Method: Sum of the Years’ Digits
Year
Number
1
2
3
4
5
Sum of the Years’ Digits =
n(n + 1)
30
= 15
=
2
2
Years of service
remaining at
beginning of year
5
4
3
2
1
15
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Methods of Cost Allocation
Time-Based Method: Sum of the Years’ Digits
Year
2009
2010
2011
2012
2013
Depreciation
Book Value at
Base
Fraction Depreciation
Year-End
$100,000
5/15
$ 33,333
$86,667
100,000
4/15
26,667
60,000
100,000
3/15
20,000
40,000
100,000
2/15
13,333
26,667
100,000
1/15
6,667
20,000
$100,000
Residual
Value
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Methods of Cost Allocation
Time-Based
Method:
Double-Declining
Balance
Time-Based
Method:
Declining-Balance
Year
2009
2010
2011
2012
2013
Book Value at
Beginning of Year
$120,000
72,000
43,200
25,920
20,000
Rate Depreciation
40%
$ 48,000
40%
28,800
40%
17,280
—
5,920
—
—
$100,000
Book Value at
Year-End
$72,000
43,200
25,920
20,000
20,000
Residual
Value
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Methods of Cost Allocation
Time-Based
Method:
Declining-Balance
Time-Based
Method:
150%-Declining
Balance
Year
2009
2010
2011
2012
2013
Book Value at
Beginning of Year
$120,000
84,000
58,800
41,160
28,812
Rate Depreciation
30%
$ 36,000
30%
25,200
30%
17,640
30%
12,348
—
8,812
$100,000
Book Value at
Year-End
$84,000
58,800
41,160
28,812
20,000
Residual
Value
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Methods of Cost Allocation
Activity Method
Cost – Residual Value
Depreciation Rate =
Total Lifetime Activity Level
=
$120,000 – $20,000
10,000 hours
=
$10 per hour
Depreciation = $21,000 (2,100 hours × $10)
Assume the asset is used for 2,100 hours.
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Recording Depreciation
The credit entry to record
depreciation is to a contra-asset
account usually called
Accumulated Depreciation or
Allowance for Depreciation.
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Conceptual Evaluation of Depreciation Methods
$
Sum-of-the-Years’-Digits
Depreciation
Expense
Straight-Line
Double-Declining-Balance
2009
2010
2011
2012
During Year
2013
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Conceptual Evaluation of Depreciation Methods
$
Sum-of-the-Years’-Digits
Book
Value
Straight-Line
Double-Declining-Balance
2009
2010
2011
2012
At End of Year
2013
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Conceptual Evaluation of Depreciation Methods
If a company expects that repair and
maintenance costs and the total
economic benefits of the asset will
remain similar each period,…
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Conceptual Evaluation of Depreciation Methods
…a similar total cost each period can be
achieved through straight-line
depreciation and the similar repair and
maintenance costs.
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Conceptual Evaluation of Depreciation Methods
If the company expects that
benefits of having the asset will
decline each year for the life of
the asset,…
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Conceptual Evaluation of Depreciation Methods
…and repairs and maintenance costs are
constant each period, a declining total
cost will be achieved by using accelerated
depreciation.
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Effect of Depreciation on Rate of Return
Year
Net Income
Book Value of Asset
at Beginning of Year
2009
2010
2011
2012
2013
$12,000
12,000
12,000
12,000
12,000
$120,000
100,000
80,000
60,000
40,000
Rate of
Return
10%
12
15
20
30
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Disclosure of Depreciation
GAAP requires the following:
 Depreciation expense for the period
 Balance 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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IFRS vs. U.S. GAAP
 IFRS require that depreciation be
“systematic,” rather than “systematic and
rational.”
 IFRS also require that the estimated useful
lives and residual values, and the depreciation
method, be reviewed at least once a year. U.S.
GAAP only requires this review when events or
circumstances indicate that the estimate has
changed.
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IFRS vs. U.S. GAAP
 IFRS also require that companies disclose the
accumulated depreciation for each class of
asset, not just the total amount as allowed by
U.S. GAAP.
 IFRS require that when an operating asset is
made up of individual components that are
significant with respect to the total cost of the
item (e.g., an airplane and its engines) that the
initial cost be allocated to the significant
components and each component be
depreciated separately.
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IFRS vs. U.S. GAAP
 U.S. GAAP neither requires nor prohibits a
company from depreciating components.
 IFRS allow a company to write up the value of
its property, plant, and equipment assets to fair
value. Such a write-up would affect the amount
of depreciation that the company records each
period.
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Group Depreciation
A company
purchased 10
cars for $20,000
each, and the
average
expected service
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
$200,000 – $50,000
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 the end of the second year.
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Group Depreciation
To record the disposal of three cars at the end of
the second year for $8,000 each:
Cash
Accumulated Depreciation
Cars
24,000
36,000
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
To record the disposal of five cars at the end of the
third year for $6,000 each:
Cash
30,000
the $11,000 book
Accumulated Depreciation To reduce70,000
value to the estimated 100,000
residual
Cars
value.
To record the fourth year’s depreciation expense:
Depreciation Expense
Accumulated Depreciation
1,000
1,000
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Group Depreciation
ToThe
record
of sold
two for
cars$4,800
at the each.
end of
finalthe
twodisposal
cars were
the fourth year for $4,000 each, and the net gain
or loss of the entire group:
Cash
Accumulated Depreciation
Loss on Disposal
Cars
9,600
30,000
400
40,000
Cash received
Book value
Loss
$ 9,600
10,000
$ (400)
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Composite Depreciation
Asset
A
B
C
Cost
$25,000
13,000
12,000
$50,000
Residual
Value
$5,000
1,000
—
$6,000
Depreciation Rate =
Annual
Life
Depreciation
10 years
$2,000
6
2,000
4
3,000
$7,000
7,000
= 14%
$50,000
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Depreciation for Partial Periods
A company purchases a $6,000 asset with a threeyear life and no residual value on August 18. The
firm uses the double-declining-balance method.
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Depreciation for Partial Periods
Year
1
2
3
4
Computation
4/12 × $4,000
0.667 × ($6,000 – $1,333)
0.667 × ($4,667 – $3,113)
Remaining balance
Two times
straight-line
rate = 2 × 1/3
Annual Depreciation
$1,333
3,113
1,037
517
$6,000
Declining-Balance-Method
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Impairment of Property, Plant, and Equipment
GAAP requires a company to review
its property, plant, and equipment for
impairment.
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Impairment of Property, Plant, and Equipment
Impairment occurs whenever events
or changes in circumstances indicate
that the book value of the property,
plant, and equipment may not be
recoverable.
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Impairment of Property, Plant, and Equipment
Impairment Test
If the total expected cash flows
(undiscounted) are less than the book value of
the asset, an impairment loss is recognized.
Measurement of the Loss
The loss is measured as the difference
between the book value of the asset and the
present value of future cash flows.
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Conceptual Evaluation of Asset Impairment
The recognition of an impairment loss is intended
to enhance the usefulness of a company’s
financial statements.
All these issues could result in earnings
management. For example, management
might prefer to recognize as large a loss as
possible, thereby reducing the book value to
the lowest possible amount. This would
result in lower depreciation expense and
higher net income in the future.
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IFRS vs. U.S. GAAP
 IFRS use a “trigger” value, which is the (1) higher of
the asset’s fair value (less costs to sell), or (2) its usage
value to determine if an asset is impaired. U.S. GAAP
uses undiscounted cash flows.
 Typically, this should mean that international
companies will recognize impairment losses earlier
than U.S. companies. Under IFRS, the impairment loss
is the difference between the book value and the
“trigger” value defined above.
 IFRS allow an impairment loss to be reversed if the
value is recovered, which is not allowed under GAAP.
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Depreciation for Tax Purposes
For assets purchased in 1987 and later, the
Modified Accelerated Cost Recovery System
(MACRS) is required for tax purposes. A
company’s computations of depreciation for
income tax purposes and financial reporting
purposes differ in three major respects:
1. A mandated tax life, which is usually shorter
than the economic life
2. Acceleration of the cost recovery (except for
buildings)
3. Elimination of the residual value
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MACRS Principles
On January 1, 2009, 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 the next slide to determine
the annual depreciation rates for 2009
through 2014
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MACRS Percentages
Determine depreciation for 2009–2014.
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MACRS Principles
Year
2009
2010
2011
2012
2013
2014
Cost
$200,000
$200,000
$200,000
$200,000
$200,000
$200,000
×
×
×
×
×
×
MACRS %
20%
32%
19.20%
11.52%
11.52%
5.76%
=
=
=
=
=
=
Annual Tax
Depreciation
$ 40,000
$ 64,000
$ 38,400
$ 23,040
$ 23,040
$ 11,520
$200,000
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Changes and Corrections of Depreciation
1. A change in an estimate of the residual value
or the service life of a currently owned asset is
accounted for prospectively.
2. A change in the depreciation method for
currently owned assets is also accounted for
prospectively.
3. A correction of an error in depreciation is
accounted for as a prior period adjustment
(restatement).
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Depletion
 Depletion of natural
resources is calculated
using an activity method.
 Any environmental costs
at the end of the project
are added to the cost in
determining depletion per
unit.
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Chapter 11
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