Intermediate Accounting, 10th Edition

Kieso, Weygandt, and Warfield

Chapter 11:
Depreciation, Impairments, and Depletion

Prepared by
Krish Ranganathan, Angelo State University
San Angelo, Texas

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 Part 1:
Methods of Depreciation

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 Depreciation - Concept

* 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 assets

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 Factors in the Depreciation Process

* Questions to be answered:
 What is the depreciable base of the asset?
 What is the asset’s useful life?
 What method of cost apportionment is best for
the asset in question?

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 Depreciable Base
 Depreciable base is the amount subject to
depreciation.
 It is determined as:
 Original cost of the asset less
 Estimated salvage or disposal value

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 Estimated Service Lives
* An asset’s service life and physical life are not the
same.
* Assets are retired (from productive life) due to:
 physical factors (such as casualty), or
 economic factors (such as obsolescence)
* Economic factors in turn include
 Inadequacy (asset can not meet current demand)
 Supercession (by a better asset)
 Obsolescence (other factors)
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 Depreciation Methods
 Depreciation methods can be classified as
follows:
 Tax depreciation methods
 Financial accounting Depreciation methods
 Financial accounting methods are:
 straight-line
 accelerated methods, or
 special methods

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 Depreciation Methods: Overview
Depreciation
Methods

Financial Accounting Tax

Depreciation Methods Depreciation

Activity Straight-line Accelerated Special

method method methods methods
1. Declining Balance 1. Composite method
2. Sum-of-the-years’ digits 2. Hybrid methods
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 Depreciation Methods: Example
 Amber corporation buys a truck on January 1,
2000. Information relating to the truck is as
follows:
 Cost, $34,000
 Estimated service life, 5 years (or 60,000 miles)
 Salvage value end of five years or use, $4,000
 Actual miles driven:
 20,000 miles (in 2000); 15,000 miles (in 2001)

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 Straight-line method
1. Depreciable base = $34,000 less $4,000 = $30,000

2. Annual depreciation = $30,000 / 5 years = $6,000

3. Depreciation Schedule: (years 1 and 2)

Year Book Depreciation Accumulated Book value
(beg) Depreciation end of year
1 $34,000 $6,000 $6,000 $28,000
2 $28,000 $6,000 $12,000 $22,000

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 Activity method (unit = mile)
1. Depreciable base = $34,000 less $4,000 = $30,000

2. Depreciation per mile = $30,000 / 60,000 = $0.50

3. Depreciation (2000) = $0.50 * 20,000 miles = $10,000

4. Depreciation Schedule: (years 1 and 2)

Year Book Depreciation Accumulated Book value
(beg) Depreciation end of year
1 $34,000 $10,000 $10,000 $24,000
2 $24,000 $ 7,500 $17,500 $16,500

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 Sum-of-the-years’-digits (SYD) method

1. Depreciable base = $34,000 less $4,000 = $30,000

2. SYD fraction = (1+2+3+4+5) = 15

3. Depreciation (2000) = $30,000 * (5/15) = $10,000

Depreciation (2001) = $30,000 * (4/15) = $ 8,000
Depreciation (2002) = $30,000 * (3/15) = $ 6,000
Depreciation (2003) = $30,000 * (2/15) = $ 4,000
Depreciation (2004) = $30,000 * (1/15) = $ 2,000

Decreasing Fractions
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 Sum-of-the-years’-digits (SYD) method

4. Depreciation Schedule

Year Book Depreciation Accumulated Book value

(beg) Depreciation end of year

1 $34,000 $10,000 $10,000 $24,000

2 $24,000 $ 8,000 $18,000 $16,000
3 $16,000 $ 6,000 $ 24,000 $10,000
4 $10,000 $ 4,000 $ 28,000 $ 6,000
5 $ 6,000 $ 2,000 $ 30,000 $ 4,000

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 Double Declining balance method

1. Rate of depreciation = 2 * (1/5) = 0.40

2. Depreciation (2000) = $34,000 * 0.40 = $ 13,600

Depreciation (2001) = $20,400 * 0.40 = $ 8,160
Depreciation (2002) = $12,240 * 0.40 = $ 4,896
Depreciation (2003) = $ 7,344 * 0.40 = $ 3,344
Depreciation (2004) = none

Total depreciation taken = $ 30,000

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 Double declining balance method

3. Depreciation Schedule

Year Book Depreciation Accumulated Book value

(beg) Depreciation end of year

1 $34,000 $13,600 $13,600 $20,400

2 $20,400 $ 8,160 $21,760 $12,240
3 $12,240 $ 4,896 $ 26,656 $ 7,344
4 $ 7,344 $ 3,344 $ 30,000 $ 4,000
5 $ 4,000 $ none $ 30,000 $ 4,000

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 Group and Composite Depreciation
Methods
 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

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 Composite Depreciation Method: Example

Given the following information relating to fixed

assets, A and B:
Asset Cost Annual depreciation
A $20,000 $ 4,000
B $36,000 $10,000
$56,000 $14,000
Composite depreciation rate is: $14,000 / $56,000
= 25%

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 Partial year depreciation
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 (see example ==> )

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 Partial year depreciation: Example
 Amber corporation buys a truck on July 1, 2000.
Information relating to the truck is as follows:
 Cost, $10,000
 Estimated service life, 5 years
 Salvage value end of five years, none.

 Determine depreciation expense under the double

declining balance method.

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 Partial year depreciation: Example

 Before allocating depreciation, determine

full year depreciation as follows:
 First full year (2000) ==>
$10,000 * 40% = $4,000
 Second full year (2001) ==>
$ (10,000 - $4,000) * 40% = $2,400
 And so on for the remaining years

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 Partial year depreciation: Example

Double declining: date of purchase, July 1, 2000

Allocate first full year’s Allocate second full year’s
depreciation of $4,000 depreciation of $2,400
between 2000 and 2001 between 2001 and 2002

$2,000 $2,000 $1,200 $1,200

2000 2001 2002

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 Revision of Depreciation Estimates
 Determination of depreciation involves
initial estimates (life, salvage value.)
 When these estimates are revised, we re-
compute depreciation.
 These revised depreciation expenses apply
prospectively to the remaining life of
asset
 These changes do not affect prior periods.

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 Revision of Depreciation Estimates:
Example
Amber corporation buys a depreciable asset on
January 1, 2000 for $95,000.
 Estimated life was 20 years.
 Estimated salvage value was $5,000.
On January 1, 2006, estimates were revised as
follows:
 salvage value, $2,000
 estimated life : 24 years (years 2000 through 2023)
Determine depreciation for 2006 based on straight
line method of depreciation.
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 Revision of Depreciation Estimates:
Example
 Accumulated depreciation to date of
revision of estimates:
 ($95,000 - $5,000) / 20 years = $4,500 dep
 $4,500 * 6 years = $27,000 accumulated depr.
 Amount to be depreciated (years 2006 through
2023 = 18 years)
 ($95,000 - $27,000 - $2,000) / 18 years
 = $3,667 (rounded) annual depreciation
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 Part 2:
Impairments

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 Impairments
 An impairment occurs when:
 the carrying amount of an asset is not
recoverable, and
 a write-off of the impaired amount is needed
 To determine the amount of impairment, a
recoverability test is used (see next slide)

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 Impairments: The Recoverability Test
Impairment?

Sum of expected
Sum of expected
future net cash flows
future net cash flows
from use and disposal
from use and disposal
of asset is
of asset is less than
equal to or more than
the carrying amount
the carrying amount

Impairment has occurred No impairment

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 Impairments: The Recoverability Test
Impairment has occurred Loss =
Carrying amount
Determine Yes less
impairment loss Fair value of asset

Does an active market

Loss =
exist for the asset?
Carrying amount
less
No present value of
expected net cash
Use company’s market flows
rate of interest
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 Impairment: Accounting
Impairment has occurred

Assets are held Assets are held

for use for sale
1. Loss = Carrying value 1. Loss = Carrying value
less Fair value less Fair Value less
2. Depreciate new cost basis cost of disposal
3. Restoration of impairment 2. No depreciation is taken
loss is NOT permitted 3. Restoration of impairment
loss is permitted
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 Part 3:
Depletion

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 Depletion: Terminology

 Depletion refers to the cost basis write-off

of natural resources
 Natural resources are characterized by:
 complete removal of the asset, and
 replacement of the asset only by an act of nature

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 Determining the Depletion Base: Factors
Types of Costs What they are
 Acquisition cost  Price paid to search for
and find deposit of the
natural resource
 Exploration costs  Costs incurred to find the
natural resource
 Development costs  Costs of heavy equipment
(Tangible costs): not part for extracting and
of depletion base shipping natural resource.
 Development costs  Drilling costs, tunnels, and
(Intangible costs) shafts
 Restoration costs  To restore after extraction
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Accounting for Exploration Costs
Exploration costs are usually expensed as incurred
These costs are capitalized when:
 they are substantial, and
 uncertainty exists regarding finding the natural
resource
Two competing approaches are employed in
practice to account for exploration costs (next
slide)

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 Accounting for Exploration Costs

 The two approaches are:

 Successful efforts approach, and
 Full cost approach
 Under the successful efforts concept, only
exploration costs of successful projects are
capitalized.
 Under the full cost concept, all costs are
capitalized.
 Either approach is currently acceptable.
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 Special Problems

 Difficulty of estimating recoverable

reserves
 Problems of discovery value
 Accounting for liquidating dividends

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 Part 4:
Tax Depreciation

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 Overview of Depreciation
Depreciation Methods

Financial Accounting Tax Depreciation

depreciation methods

1. Straight line
2. Double declining bal
3. Sum of the years
4. Units of production
Up to 1980-end, same as
financial methods.
Beginning with 1981,
tax methods changed.
 Tax Depreciation Methods

• The current tax depreciation rules are called Modified

Accelerated Cost Recovery System (MACRS)
• MACRS usually produces greater tax deductions
earlier in the asset’s life.
• Differences between tax and GAAP depreciation
deductions produce timing differences for deferred
tax purposes
• Differences between the MACRS and GAAP
depreciation amounts are reconciled in the M-1
and M-2 schedules (tax return)
 MACRS (1987 and later)

• MACRS incorporated recovery periods for assets

• Assets can be either personalty, or realty, or
intangible assets
• For personalty, the recovery periods are: 3 [years],
5, 7, 10, 15, and 20 years
• For residential and non-residential real estate,
recovery periods range from 27.5 to 39 years.
• For intangibles, the recovery period is fifteen
years.
 Taking section 179 expensing
option
Before we compute depreciation, we can take a
one-time deduction of $20,000 in 2000 in addition
to the annual tax depreciation.

The depreciable cost is then

reduced by the $20,000 one-time
write-off.
 Section 179 expensing option for personalty

• TP can expense up to a maximum of $20,000 per

year of cost of assets placed in use in 2000.
• The election applies to TANGIBLE personalty
used in trade or business ONLY.
• The election does NOT apply to either realty or to
property used for the production of income.
• The limit applies separately for each year.
 Section 179 expensing option for personalty

The initial write-off ($20,000) is reduced for

“excess” assets dollar for dollar.

If you place in service assets exceeding a

total cost of $200,000, you lose $1 in write-off
for every dollar of excess assets.

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 Section 179 expensing amounts
• Tax year Annual Limit

• 1998 $18,500
• 1999 $19,000
• 2000 $20,000
• 2001 or 2002 $24,000
• 2003 and thereafter $25,000
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 MACRS (1987 and later): Example

 Taxpayer buys a computer on July 23,

2000. The cost is $69,000.
 Determine the tax depreciation deduction
for the asset under MACRS.

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 Example
Taxpayer buys a computer on July 23, 2000. The cost is $69,000.

Is 5-year MACRS Entire

property applies cost is
recovered
 Taking the expensing option ….
Taxpayer buys a computer on July 23, 2000.
The cost is $69,000.

Original cost = $69,000

less: one-time expensing = ($20,000)
-------------
Adjusted basis: = $49,000
subject to tax depreciation -------------
 Computing MACRS depreciation
MACRS:
….
5-year personalty

Year 5-year Depreciation

1 [2000] 20.00% 49,000* 0.20

2 [2001] 32.00% 49,000* 0.32
3 [2002] 19.20% 49,000* 0.192
4 [2003] 11.52%* 49,000* 0.1152
5 [2004] 11.52% 49,000* 0.1152
6 [2005] 5.76% 49,000* 0.0576
= $49,000 total
100.00%
 Summing up the expensing option and
MACRS depreciation ….

Depreciation deduction in 2000: (first year)

One-time expensing = $ 20,000

MACRS depreciation [1999] = $ 9,800
Total cost recovery = $ 29,800 total
Summing up the expensing option and
MACRS depreciation ….

Depreciation deduction in 2001: (second year)

[no further expensing allowed]

(49,000 * 0.32)
MACRS depreciation [2001] = $ 15,680
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