Chapter 12: Depreciation, Impairments, and Depletion

Calculate depreciation using straight-line, declining-balance, and units-of-production methods

Depreciation:

• Allocation of acquisition cost of a fixed asset to expense over estimated useful life

• Allocated in a systematic and rational manner

Straight-Line Depreciation

Acquisition cost - Residual value / Estimated useful life in years = Depreciation expense

Depreciable cost = acquisition cost - residual value

Book value = original cost - accumulated depreciation

• Relates depreciation directly to the passage of time

• Assumes fixed asset declines in usefulness at a constant rate

Declining Balance Method

Book value at beginning of the year * Depreciation rate

• Accelerated depreciation method

• Allocates more expense early in useful life

• Residual value is not subtracted from cost when computing depreciation

• A constant depreciation rate is applied to declining-balance (book value)

• The depreciation rate is a multiple of the straight-line rate

Units-of-Production Method

• number of units of output or input are used to measure asset use

• Constant amount allocated to each unit of production

• depreciation is aligned with productivity

  Depreciation rate per unit of output (input) = Depreciable cost / Estimated productive output (input) in units

  Annual depreciation expense = Depreciation rate per unit of output (input) * Actual units of output (input)

Account for depreciation in partial periods

• Full-year convention-Beg. of period

  • Assets disposed of during a period are depreciated a full period, and assets purchased during a period are not depreciated that period

• Full-year convention-End of period

  • Assets purchased during a period are depreciated a full period, and assets disposed of during a period are not depreciated that period

• Half-year convention

  • ½ year’s depreciation in both year of purchase and year of retirement, regardless of the date of purchase or retirement

• Full-month convention

  • Full month of depreciation during month of purchase and no depreciation in month of disposal

Calculate depreciation using group and composite depreciation methods

• Group depreciation-used for homogeneous or similar assets, such as delivery trucks having similar costs, useful lives, and residual value

• Composite depreciation- used for heterogeneous or dissimilar assets, such as industrial equipment with different costs, useful lives, and residual value.

Composite Depreciation Calculation

Composite annual depreciation rate = Annual group straight-line depreciation / Total group acquisition cost

Composite group useful life = Group depreciable cost / Annual group straight-line depreciation

composite annual depreciation = Composite annual depreciation rate * Total group acquisition cost

Total Annual Straight-Line Depreciation = (Total Acquisition Cost - Total Residual Value)/Unit Useful Life

Group Depreciable cost = Sum of Total Acquisition Cost - Sum of Total Residual Value

• Gains and losses are not recorded on disposal

• The difference between cash received and the original cost of the item is recorded in accumulated depreciation

• Over time, unrecorded gains offset unrecorded losses within accumulated depreciation

• Record no gain or loss on disposal

  • Debit cash for proceeds

  • Credit fixed assets for original cost

  • Debit accumulated depreciation for the accumulated depreciation for the difference

Account for changes in estimate as they relate to depreciation

Change of residual value, useful life

• change of residual value, useful life

• prospective treatment

• no change to prior reporting

• disclose only if effect is material

Accounting for errors in reporting property, plant, and equipment

• Retrospective treatment

  • restate past financial statements

  • record an error to correct retained earnings and balance sheet accounts

  • disclose nature and amount of error

Account for impairment of property, plant, and equipment

Indicators of Asset Impairment

• Review for impairment whenever events or changes in circumstances imply that the carrying value might not be recoverable

• Examples of indicators

  • decline in market value of asset

  • change in manner asset is used

  • change in legal or business climate

  • cost overrun on assets acquires

1. Asset impaired if: Recoverable cost< Carrying value

2. Impairment loss = Asset carrying value - Asset fair value

• Recoverable cost: Total estimated future net cash inflows (undiscounted) expected to be generated by the asset through use and disposal

• Net cash inflows: Cash flows expected to be generated by the asset less the cash flows needed to obtain the inflows

• fair value is the amount at which the asset could be purchased or sold in an active market

• if quoted market prices are unavailable, take the present value of future net cash inflows using a rate reflecting the risk involved

• Update the carrying value by recording depreciation expense at the date of loss

Journal entries for Impairment

Dr. Loss on Impairment

Cr. Accumulated Depreciation

Account for assets held for sale

• Conditions for an asset held for sale

  • management committed to sell

  • asset available for immediate sale

  • management actively locating a buyer

  • sale is probable (generally within a year)

  • asset is actively marketed for sale at a price reasonable to its fair value

  • significant changes to plan are unlikely

If an asset qualifies as an asset held for sale, the carrying value reported is the lower of:

• Carrying value, or

• Fair value less estimated direct cost to sell the asset

When the fair value of the assets less costs to sell is the lower of the two amounts, a loss is recognized, and the asset is written down to that amount.

Recoverability of losses is limited to the cumulative amount of prior recorded losses. In other words, the asset’s value may not exceed the carrying value at the time the decision to dispose of the asset was made.

To record impairment of asset held for sale:

• Dr. Loss on Impairment

• Cr. Accumulated Depreciation

To record recovery of impairment on asset held for sale:

• Dr. Accumulated Depreciation

• Gain on Recovery of Impaired Asset

Describe property, plant, and equipment disclosures

• depreciation expense

• balances of major classes of depreciable assets, by nature or function

• accumulated depreciation by asset or in total

• general description of depreciation methods used with respect to major classes of assets

Record acquisition and depletion of natural resources

Depletion Base

• Acquisition costs

  • costs incurred to purchase or lease the rights to property for purposes of exploring for and producing a natural resource

• Explorations costs

  • costs incurred to identify areas or to test areas for the presence of natural resource

• Development costs

  • costs of extracting, treating, gathering, storing natural resource

• Restoration costs

  • costs to restore property to original condition after extraction of natural resource

Depletion

• Depletion

  • Transfer cost from Natural Resource account to Inventory account

  • Deplete the depletion base (less residual value) using the units-of-production method

depletion rate per unit = depletion base / estimated activity base in units

annual depletion = depletion rate * actual activity base in units

Exploration Costs in Oil and Gas

• Successful-efforts method

  • only exploration costs of successful wells are capitalized

  • exploration costs of unsuccessful wells are expense as incurred

  Dr. Cost of Oil Reserve

  Dr. Exploration Expense

  Cr. Cash, Payables, Accruals

• full-cost method

  • all exploration costs are capitalized if the estimated value of reserves discovered from the successful wells is >= the amount to be capitalized