Chapter 11: Depreciation, Chapter 11: Depreciation, Impairments and Impairments and

DepletionDepletion

Intermediate Accounting, 11th ed.Kieso, Weygandt, and Warfield

1. Explain the concept of depreciation.2. Identify the factors involved in the

depreciation process.3. Compare activity, straight-line, and

decreasing-charge methods of depreciation.

4. Explain special depreciation methods.

After studying this chapter, you should be able to:

Chapter 11: Depreciation, Chapter 11: Depreciation, Impairments and Impairments and

DepletionDepletion

5. Explain the accounting issues related to asset impairment.

6. Explain the accounting procedures for depletion of natural resources.

7. Explain how property, plant, equipment, and natural resources are reported and analyzed.

Chapter 11: Depreciation, Chapter 11: Depreciation, Impairments and Impairments and

DepletionDepletion

• Depreciation is a means of cost allocation.

• It is not a method of valuation.• Depreciation involves:

allocating the cost of tangible assets to expense in a systematic and rational manner to periods expected to benefit from use of its depreciable assets.

Depreciation: ConceptDepreciation: Concept

Questions to be answered:

1. What is the depreciable base of the asset?

2. What is the asset’s useful life?3. What method of depreciation is best

for the asset in question?

Factors in the Factors in the Depreciation ProcessDepreciation Process

• Depreciable base is the dollar amount subject to depreciation.

• It is determined as:

Original cost of the asset lessEstimated salvage or disposal value

Depreciable BaseDepreciable Base

• An asset’s service life and physical life are not the same.

• Assets’ service life are affected by: physical factors, and economic factors • Economic factors include: Inadequacy (asset can not meet

current demand) Supercession (by a better asset) Obsolescence (other factors)

Estimated Service LivesEstimated Service Lives

DepreciationMethods

Financial AccountingDepreciation Methods

TaxDepreciation

Specialmethods

1. Declining Balance2. Sum-of-the-years’ digits

Straight-line

Activity DecreasingCharge

1. Composite method2. Hybrid methods

Depreciation Methods: Depreciation Methods: OverviewOverview

• Is a function of time rather than usage• Results in an equal amount of

depreciation expense for a given period

• Depreciation Expense is computed as:Cost – Salvage Value

Estimated Life

Depreciation Methods: Depreciation Methods: Straight-LineStraight-Line

• Is a function of usage rather than time.• Estimated life is in terms of total

input/output of asset.• Depreciation expense is computed as:

Cost – Salvage Value x Input/Output this period

Total Estimated Input/Output

Depreciation Methods: Depreciation Methods: ActivityActivity

These methods result in higher depreciation expense in the earlier years and lower charges in the later years.

Two decreasing charge methods are:1. Declining balance2. Sum-of-the-years’-digits

Depreciation Methods: Depreciation Methods: Decreasing Charge Decreasing Charge

(Accelerated)(Accelerated)

1. Salvage value is not deducted when computing depreciable base.

2. Utilizes a depreciation rate (%) that is some multiple of the SL rate.

3. The depreciation rate is multiplied by the asset’s book value at the beginning of the period to get the depreciation expense for the period.

4. Since the book value decreases over time this results in a decreasing amount of depreciation expense over time.

5. An asset’s book value can never be less than its estimated salvage value.

Depreciation Methods: Depreciation Methods: Declining BalanceDeclining Balance

• A fraction is multiplied by the depreciable base to arrive at the depreciation expense per period.

• The fraction is:1. Numerator: number of years remaining in the

asset’s life as of the beginning of the period.2. Denominator: sum of the years in the life3. For example, a 5 year life property would have

depreciation expense for the first year as:4. (Cost – Salvage value) X 5 (years remaining)

15 (computed as 5+4+3+2+1)

Depreciation Methods: Depreciation Methods: Sum-of-the-Years’ DigitsSum-of-the-Years’ Digits

• The group method is applied to a collection of assets similar in nature.

• The composite method is applied to a collection of assets dissimilar in nature.

• The composite depreciation rate is determined as follows:

total of annual depreciation for all assets

total cost of all assets

Group and Composite Group and Composite Depreciation MethodsDepreciation Methods

• When an asset is bought sometime during the year, a partial depreciation charge is required.

• The procedure is:determine depreciation for a full

year, and allocate the amount between the two periods affected

Partial Year DepreciationPartial Year Depreciation

• Determination of depreciation involves initial estimates (e.g., life, salvage value)

• When these estimates are revised, depreciation must be re-computed:

Remaining B.V. – Est. Salvage ValueRemaining Est. Life

• These revised depreciation expenses apply prospectively to the remaining life of asset.

• These changes do not affect prior periods.

Revision of Depreciation Revision of Depreciation EstimatesEstimates

An impairment of a depreciable asset occurs when:

• the carrying amount of the asset is not recoverable, and therefore a write-off is needed.The recoverability test determines if an impairment has occurred.

ImpairmentsImpairments

Impairment?

Sum of expected future net cash flows

from use and disposal of asset is less thanthe carrying amount

Sum of expected future net cash flows

from use and disposal of asset is

equal to or more than the carrying amount

Impairment has occurred No impairment

Impairments: The Impairments: The Recoverability TestRecoverability Test

Impairment has occurred Loss =Carrying amount

lessFair value of asset

Does an active marketexist for the asset?

Determine impairment loss

Yes

No

Loss =Carrying amount

lesspresent value of

expected net cashflowsUse company’s market

rate of interest

Impairments: Measuring Impairments: Measuring LossLoss

Impairment has occurred

1. Loss = Carrying value less Fair value2. Depreciate new cost basis3. Restoration of impairment loss is NOT permitted

1. Loss = Carrying value less Fair Value less cost of disposal 2. No depreciation is taken3. Restoration of impairment loss is permitted

Assets are held

for useAssets are held

for sale

Impairment: AccountingImpairment: Accounting

Graphic of Accounting for Graphic of Accounting for ImpairmentsImpairments

Depletion refers to the cost basis write-off of natural resources (e.g., coal, oil, timber)

Depletion expense per unit is calculated:

Cost – Estimated Salvage ValueTotal Estimated Units Available

This per unit cost is the multiplied by the units extracted during a period to derive the depletion for the period.

Depletion: TerminologyDepletion: Terminology

• Difficulty of estimating recoverable reserves

• Problems of discovery value• Accounting for liquidating

dividends

Depletion: Special Depletion: Special ProblemsProblems

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