Transcript Slide 1

CHAPTER 11
DEPRECIATION, IMPAIRMENTS,
AND DEPLETION
Sommers – Intermediate I
Is Accounting Helpful for Valuation?
• Conceptual Framework (FASB)
– Purpose of Accounting: “financial reporting should
provide information to help investors, creditors, and
others assess the amounts, timing, and uncertainty of
prospective net cash inflows to the related
enterprise.”
– Caveat: Accounting information “may help those who
desire to estimate the value of a business enterprise,
but financial accounting is not designed to
measure directly the value of an enterprise.”
Discussion Questions
Q11–1 Distinguish among depreciation, depletion, and
amortization.
Cost Allocation
Depreciation is the accounting process of allocating the cost
of tangible assets to expense in a systematic and rational
manner to those periods expected to benefit from the use of
the asset.
Allocating costs of long-term assets:

Fixed assets = Depreciation expense

Intangibles = Amortization expense

Natural resources = Depletion expense
Cost Allocation – An Overview
• The matching principle requires that part of the
acquisition cost of operational assets be expensed in
periods when the future revenues are earned.
• Depreciation, depletion, and amortization are cost
allocation processes used to help meet the matching
principle requirements.
Some of the cost is expensed each period.
Acquisition
Cost
(Balance Sheet)
Expense
(Income Statement)
Cost Allocation – An Overview
Operational
Asset
Debit
Property, Plant, &
Equipment
Depreciation
Natural Resource
Depletion
Intangible
Amortization
Account Credited
Accumulated
Depreciation
Natural Resource
Asset
Intangible Asset
Caution! Depreciation, depletion, and amortization
are processes of cost allocation, not valuation!
Depreciation
on the
Balance
Sheet
Discussion Questions
Q11–7 What basic questions must be answered before the
amount of the depreciation charge can be computed?
Measuring Cost Allocation
Cost allocation requires three pieces of
information for each asset:
Service
Life
Depreciable
Base
The estimated expected
use from an asset.
Allocation
Method
The systematic approach
used for allocation.
Total amount of cost to be allocated.
Cost - Residual Value (at end of useful life)
Estimation of Service Life

Service life often differs from physical life.

Companies retire assets for two reasons:
1. Physical factors (casualty or expiration of
physical life).
2. Economic factors (inadequacy,
supersession, and obsolescence).
Depreciable Base
• How much is value going to decrease while company
owns it?
• This amount has to be transferred to expense during the
period that the company is using the item.
Methods of Depreciation
The profession requires the method employed be “systematic
and rational.” Examples include:
(1)
Activity method (units of use or production).
(2)
Straight-line method.
(3)
Sum-of-the-years’-digits.
Accelerated methods
(4)
Declining-balance method.
(5)
Group and composite methods.
Special methods
(6)
Hybrid or combination methods.
Straight-Line
Time:
Activity:
Acquisition
Cost
Depreciation
rate per unit
of output
=
Depreciation
Depreciation
=
rate per unit
Residual
–
Value
Estimated Output in Units
×
Units of
output
Example 1a: Straight Line Depreciation
On January 1, 2011, the Excel Delivery Company purchased a
delivery van for $33,000. At the end of its five-year service life, it
is estimated that the van will be worth $3,000. During the fiveyear period, the company expects to drive the van 100,000
miles. Calculate annual depreciation for the five-year life of the
van using:
• Straight line
Example 1b: Activity Based Depreciation
On January 1, 2011, the Excel Delivery Company purchased a
delivery van for $33,000. At the end of its five-year service life, it
is estimated that the van will be worth $3,000. During the fiveyear period, the company expects to drive the van 100,000
miles. Calculate annual depreciation for the five-year life of the
van using:
• Units of production using miles driven as a measure of output,
and the following actual mileage:
($33,000 – $3,000) / 100,000 miles
= $0.30 / mile deprec rate
Year
2011
2012
2013
2014
2015
Miles
22,000
24,000
15,000
20,000
21,000
Example 1b: Continued
On January 1, 2011, the Excel Delivery Company purchased a
delivery van for $33,000. At the end of its five-year service life, it
is estimated that the van will be worth $3,000. During the fiveyear period, the company expects to drive the van 100,000
miles. Calculate annual depreciation for the five-year life of the
van using:
• Units of production using miles driven as a measure of output,
and the following actual mileage:
Year
2011
2012
2013
2014
2015
Miles
22,000
24,000
15,000
20,000
21,000
Depreciation
Declining-Balance Method
Sometimes called a Decreasing-Charge Method or an
Accelerated Method
Declining-Balance Method.

Utilizes a depreciation rate (percentage) that is some multiple
of the straight-line method.

Does not deduct the salvage value in computing the
depreciation base.
Accelerated Methods
• Accelerated methods result in more depreciation in the early
years of an asset’s useful life and less depreciation in later
years of an asset’s useful life
• Note that total depreciation over the asset’s useful life is the
same as the Straight-line Method
Declining-Balance depreciation –
• Based on the straight-line rate multiplied by an acceleration
factor
• Computations initially ignore residual value
• Stop depreciating when BV = Residual Value
Acceleration Factor
DDB =
Book
Value
× ( 2 × Straight-line Rate )
• Note that the Book Value will get lower each year
Example 1c: Continued
On January 1, 2011, the Excel Delivery Company purchased a
delivery van for $33,000. At the end of its five-year service life, it
is estimated that the van will be worth $3,000. During the fiveyear period, the company expects to drive the van 100,000
miles. Calculate annual depreciation for the five-year life of the
van using:
• Double-declining balance
Year
2011
2012
2013
2014
2015
Total
Book Value
Beg of Year X
$33,000
19,800
11,880
7,128
4,277
Rate per
Book Value
Year = Depreciation End of Year
2/5
$13,200
$19,800
2/5
7,920
11,880
2/5
4,752
7,128
2/5
2,851
4,277
*
1,277 *
3,000
$30,000
Use of Various Depreciation Methods
Example 2: DDB to Straight Line
On January 2, 2011, the Jackson Company purchased equipment to be
used in its manufacturing process. The equipment has an estimated life
of eight years and an estimated residual value of $30,625. The
expenditures made to acquire the asset were as follows:
Purchase price
$154,000
Freight charges
2,000
Installation charges
4,000
Jackson’s policy is to use the double-declining-balance (DDB) method
of depreciation in the early years of the equipment’s life and then switch
to straight line halfway through the equipment’s life. Calculate
depreciation for each year of the asset’s eight-year life.
Year
2011
2012
2013
2014
Book Value
Depreciation
Book Value
Beg of Year X Rate per Year = Depreciation End of Year
Example 2: Continued
Year
2011
2012
2013
2014
2015
2016
2017
2018
Total
Book Value
Depreciation
Book Value
Beg of Year X Rate per Year = Depreciation End of Year
$160,000
120,000
90,000
67,500
50,625
45,625
40,625
35,625
2/8
2/8
2/8
2/8
*
*
*
*
$ 40,000
30,000
22,500
16,875
5,000
5,000
5,000
5,000
$129,375
$120,000
90,000
67,500
50,625
45,625
40,625
35,625
30,625
* Switch to straight-line in 2015:
($50,625 – $30,625) / 4 years = $5,000 per year
Partial-Period Depreciation
Pro-rating the depreciation based on the date of acquisition
is time-consuming and costly. A commonly used
alternative is the . . .
Half-Year Convention
• Take ½ of a year of depreciation in the year of
acquisition, and the other ½ in the year of disposal
That said, unless told otherwise for class you
calculate based on months!
Example 3: Partial-Period
On October 1, 2011, the Allegheny Corporation purchased
machinery for $115,000. The estimated service life of the
machinery is 10 years and the estimated residual value is
$5,000. The machine is expected to produce 220,000 units
during its life. Calculate depreciation for 2011 and 2012
using each of the following methods. Partial-year
depreciation is calculated based on the number of months
the asset is in service.
1. Straight line.
2. Double-declining balance.
3. One hundred fifty percent declining balance.
4. Units of production (units produced in 2011, 10,000;
units produced in 2012, 25,000).
Example 3: Continued
Straight-line:
$115,000 – 5,000 = $11,000 per year
10 years
2011 $11,000 x 3/12
2012 $11,000 x 12/12
=
=
$ 2,750
$11,000
Example 3: Continued
Double-declining balance:
2011 $115,000 x 2/10 x 3/12 =
$ 5,750
2012 ($115,000 - 5,750) x 2/10 =
$21,850
One hundred fifty percent declining balance:
2011 $115,000 x 1.5/10 x 3/12 =
$ 4,313
2012 ($115,000 - 4,313) x 1.5/10 =
$16,603
Example 3: Continued
Units-of-production:
$115,000 – 5,000 = $.50 per unit depreciation rate
220,000 units
2011 10,000 units x $.50 =
2012 25,000 units x $.50 =
$ 5,000
$12,500
Special Depreciation Methods
Choice of method depends on nature of the assets involved:

Group method used when the assets are similar in nature
and have approximately the same useful lives.

Composite approach used when the assets are dissimilar
and have different lives.
Companies are also free to develop tailor-made depreciation methods,
provided the method results in the allocation of an asset’s cost in a
systematic and rational manner (Hybrid or Combination Methods).
Discussion Questions
Q11–10 What are the major factors considered in determining
what depreciation method to use?
Impairments
When the carrying amount of an asset is not recoverable, a
company records a write-off referred to as an impairment.
Events leading to an impairment:
a. Significant decrease in the fair value of an asset.
b. Significant change in the manner in which an asset is used.
c.
Adverse change in legal factors or in the business climate.
d. An accumulation of costs in excess of the amount originally
expected to acquire or construct an asset.
e. A projection or forecast that demonstrates continuing losses
associated with an asset.
Measuring Impairments
1. Review events for possible impairment.
2. If the review indicates impairment, apply the recoverability
test. If the sum of the expected future net cash flows from
the long-lived asset is less than the carrying amount of the
asset, an impairment has occurred.
3. Assuming an impairment, the impairment loss is the
amount by which the carrying amount of the asset exceeds
the fair value of the asset. The fair value is the market
value or the present value of expected future net cash
flows.
Impairments
Finite-life Assets to be Held and Used
Step 1 – Recoverability
• An asset is impaired when the undiscounted sum of its estimated
future cash flows is less than its book value
Step 2 – Measurement
• Impairment loss is book value less fair value (Market value, price of
similar assets, or PV of future net cash inflows)
• Impairment loss is reported as part of income from continuing
operations
$0
Fair Value
$125
Case 1: $50 book value.
No loss recognized
Undiscounted future
cash flows
$250
Case 3: $275 book value.
Loss = $275 - $125
Case 2: $150 book value. No loss recognized
Example 5: Asset Impairment
Chadwick Enterprises, Inc., operates several restaurants
throughout the Midwest. Three of its restaurants located in the
center of a large urban area have experienced declining profits
due to declining population. The company’s management has
decided to test the operational assets of the restaurants for
possible impairment. The relevant information for these assets
is presented below.
Book value
$6.5 million
Estimated undiscounted sum of future cash flows 4.0 million
Fair value
3.5 million
Determine the amount of the impairment loss, if any.
Example 5: Continued
Step 1: Recoverability
Book Value > Undisc Future CFs
6.5 > 4.0
Step 2: Measurement
Book value
Fair value
Impairment loss
$6.5 million
3.5 million
$3.0 million
Example 5b: Asset Impairment
Chadwick Enterprises, Inc., operates several restaurants
throughout the Midwest. Three of its restaurants located in the
center of a large urban area have experienced declining profits
due to declining population. The company’s management has
decided to test the operational assets of the restaurants for
possible impairment. The relevant information for these assets
is presented below.
Book value
$6.5 million
Estimated undiscounted sum of future cash flows 6.8 million
Fair value
5.0 million
Determine the amount of the impairment loss, if any.
Example 5b: Continued
Step 1: Recoverability
Book Value < Undisc Future CFs
6.5 < 6.8
Because the undiscounted sum of future cash flows
of $6.8 million exceeds book value of $6.5 million,
there is no impairment loss.
Example 6: Asset Impairment
General Optic Corporation operates a manufacturing plant in Arizona.
Due to a significant decline in demand for the product manufactured at
the Arizona site, an impairment test is deemed appropriate.
Management has acquired the following information for the assets at
the plant:
Cost
$32,500,000
Accumulated depreciation
14,200,000
General’s estimate of the total cash flows to
be generated by selling the products manufactured at its Arizona plant, not discounted
to present value
15,000,000
The fair value of the Arizona plant is estimated to be $11,000,000.
1. Determine the amount of impairment loss, if any.
2. If a loss is indicated, where would it appear in General Optic’s
multiple-step income statement?
Example 6: Continued
1. An impairment loss is indicated because the estimated
undiscounted sum of future cash flows of $15 million is
less than the book value of $18.3 million. The amount of
the loss to be reported is calculated using the estimated
fair value rather than the undiscounted future cash
flows:
Book value
$18,300,000
Estimated fair value 11,000,000
Impairment loss
$ 7,300,000
2. The loss would appear in the income statement along
with other operating expenses.
Example 6: Asset Impairment
General Optic Corporation operates a manufacturing plant in Arizona.
Due to a significant decline in demand for the product manufactured at
the Arizona site, an impairment test is deemed appropriate.
Management has acquired the following information for the assets at
the plant:
Cost
$32,500,000
Accumulated depreciation
14,200,000
General’s estimate of the total cash flows to
be generated by selling the products manufactured at its Arizona plant, not discounted
to present value
15,000,000
The fair value of the Arizona plant is estimated to be $11,000,000.
1. Determine the amount of impairment loss, if any.
2. If a loss is indicated, where would it appear in General Optic’s
multiple-step income statement?
3. If a loss is indicated, prepare the entry to record the loss.
Example 6: Continued
1. An impairment loss is indicated because the estimated
undiscounted sum of future cash flows of $15 million is
less than the book value of $18.3 million. The amount of
the loss to be reported is calculated using the estimated
fair value rather than the undiscounted future cash
flows:
Book value
$18,300,000
Estimated fair value 11,000,000
Impairment loss
$ 7,300,000
2. The loss would appear in the income statement along
with other operating expenses.
3. Loss on impairment
7,300,000
Accumulated depreciation
14,200,000
Plant assets
21,500,000
Assets Held for Sale
• Assets held for sale include assets that management
has committed to sell immediately in their present
condition and for which sale is probable.
Impairment
loss
=
Book
value
Fair value less
– cost to sell
Depletion and Amortization
Depletion of Natural Resources
• As natural resources are “used up”, or depleted, the cost
of the natural resources must be allocated to the units
extracted.
• The approach is based on the units-of-production
method.
Establishing a Depletion Base
Computation of the depletion base involves four factors:
(1) Acquisition cost.
(2) Exploration costs.
(3) Development costs.
(4) Restoration costs.
Example 7: Depletion
At the beginning of 2011, Terra Lumber Company purchased a timber
tract from Boise Cantor for $3,200,000. After the timber is cleared, the
land will have a residual value of $600,000. Roads to enable logging
operations were constructed and completed on March 30, 2011. The
cost of the roads, which have no residual value and no alternative use
after the tract is cleared, was $240,000. During 2011, Terra logged
500,000 of the estimated five million board feet of timber. Calculate the
2011 depletion of the timber tract and depreciation of the logging roads
assuming the units-of-production method is used for both assets.
• Timber tract:
• Logging roads:
$240,000 / 5,000,000 board feet = $0.048 per board foot
500,000 x $0.048 = $24,000 depreciation
Continuing Controversy
Oil and Gas Industry has two acceptable accounting
alternatives
• Successful efforts method – Exploration costs resulting
in unsuccessful wells (dry holes) are expensed.
• Full-cost method – Exploration costs resulting in
unsuccessful wells may be capitalized.
Political pressure prevented the FASB from requiring all
companies to use the successful efforts method.
MACRS vs. GAAP
Modified Accelerated Cost Recovery System
MACRS differs from GAAP in three respects:
1. a mandated tax life, which is generally shorter than the
economic life;
2. cost recovery on an accelerated basis; and
3. an assigned salvage value of zero.
(Basically DDB with a half-year convention)
IFRS vs. GAAP
RELEVANT FACTS - Similarities
The
definition of property, plant, and equipment is essentially the
same under GAAP and IFRS.
Under
both GAAP and IFRS, changes in depreciation method and
changes in useful life are treated in the current and future periods.
Prior periods are not affected. GAAP recently conformed to IFRS in
this area.
The
accounting for plant asset disposals is the same under GAAP
and IFRS.
The
accounting for the initial costs to acquire natural resources is
similar under GAAP and IFRS.
Under
both GAAP and IFRS, interest costs incurred during
construction must be capitalized. Recently, IFRS converged to GAAP.
IFRS vs. GAAP
RELEVANT FACTS - Similarities
The
accounting for exchanges of nonmonetary assets has
recently converged between IFRS and GAAP. GAAP now requires
that gains on exchanges of nonmonetary assets be recognized if
the exchange has commercial substance. This is the same
framework used in IFRS.
GAAP
also views depreciation as allocation of cost over an
asset’s life. GAAP permits the same depreciation methods
(straight-line, diminishing-balance, units-of-production) as IFRS.
IFRS vs. GAAP
RELEVANT FACTS - Differences
IFRS
requires component depreciation. Under GAAP, component
depreciation is permitted but is rarely used.
Under
IFRS, companies can use either the historical cost model
or the revaluation model. GAAP does not permit revaluations of
property, plant, and equipment or mineral resources.
In
testing for impairments of long-lived assets, GAAP uses a twostep model to test for impairments. As long as future undiscounted
cash flows exceed the carrying amount of the asset, no impairment
is recorded. The IFRS impairment test is stricter. However, unlike
GAAP, reversals of impairment losses are permitted.
Example 8: GAAP vs. IFRS Depreciation
On June 30, 2011, Rosetta Granite purchased a machine
for $120,000. The estimated useful life of the machine is
eight years and no residual value is anticipated. An
important component of the machine is a specialized highspeed drill that will need to be replaced in four years. The
$20,000 cost of the drill is included in the $120,000 cost of
the machine. Rosetta uses the straight-line depreciation
method for all machinery.
Calculate depreciation for 2011 and 2012 applying the
typical U.S. GAAP treatment.
Repeat applying IFRS.
Example 8: Continued
• U.S. GAAP
2011: $120,000  8 = $15,000 x 6/12 =
2012: $120,000  8 =
$ 7,500
$15,000
• IFRS:
2011: Truck: $100,000  8 = $12,500 x 6/12 =
Drill: $ 20,000  4 = $ 5,000 x 6/12 =
Total
$ 6,250
2,500
$ 8,750
2012: Truck: $100,000  8 =
Drill: $ 20,000  4 =
Total
$12,500
5,000
$17,500