chapter 11 depreciation impairments and depletion sommers intermediate i
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Chapter 11 DEPRECIATION, IMPAIRMENTS, AND DEPLETION Sommers – Intermediate I. Is Accounting Helpful for Valuation?. Conceptual Framework (FASB)

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is accounting helpful for valuation
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
Discussion Questions

Q11–1 Distinguish among depreciation, depletion, and amortization.

cost allocation
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

AcquisitionCost

Expense

(Balance Sheet)

(Income Statement)

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.

cost allocation an overview1
Cost Allocation – An Overview

Caution!Depreciation, depletion, and amortizationare processes of cost allocation, not valuation!

Depreciation on the Balance Sheet

discussion questions1
Discussion Questions

Q11–7 What basic questions must be answered before the amount of the depreciation charge can be computed?

measuring cost allocation

The systematic approach used for allocation.

The estimated expected use from an asset.

Total amount of cost to be allocated.

Cost - Residual Value (at end of useful life)

Measuring Cost Allocation

Cost allocation requires three pieces of information for each asset:

Service Life

Depreciable Base

Allocation Method

estimation of service life
Estimation of Service Life
  • Service life often differs from physical life.
  • Companies retire assets for two reasons:
    • Physical factors (casualty or expiration of physical life).
    • Economic factors (inadequacy, supersession, and obsolescence).
depreciable base
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
Methods of Depreciation

The profession requires the method employed be “systematic and rational.” Examples include:

  • Activity method (units of use or production).
  • Straight-line method.
  • Sum-of-the-years’-digits.
  • Declining-balance method.
  • Group and composite methods.
  • Hybrid or combination methods.

Accelerated methods

Special methods

straight line
Straight-Line

Time:

Activity:

example 1a straight line depreciation
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 five- year 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
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 five- year 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

example 1b continued
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 five- year 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:
declining balance method
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
  • 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
  • Note that the Book Value will get lower each year

Acceleration Factor

example 1c continued
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 five- year 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
example 2 ddb to straight line
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.

example 2 continued
Example 2: Continued

* Switch to straight-line in 2015:

($50,625 – $30,625) / 4 years = $5,000 per year

partial period depreciation
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
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.

  • Straight line.
  • Double-declining balance.
  • One hundred fifty percent declining balance.
  • Units of production (units produced in 2011, 10,000; units produced in 2012, 25,000).
example 3 continued
Example 3: Continued

Straight-line:

$115,000 – 5,000= $11,000 per year

10 years

2011 $11,000 x 3/12 = $ 2,750

2012 $11,000 x 12/12 = $11,000

example 3 continued1
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 continued2
Example 3: Continued

Units-of-production:

$115,000 – 5,000= $.50 per unit depreciation rate

220,000 units

2011 10,000 units x $.50 = $ 5,000

2012 25,000 units x $.50 = $12,500

special depreciation methods
Special Depreciation Methods

Choice of method depends on nature of the assets involved:

    • Group methodused when the assets are similar in nature and have approximately the same useful lives.
    • Composite approachused 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 questions2
Discussion Questions

Q11–10 What are the major factors considered in determining what depreciation method to use?

impairments
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:
    • Significant decrease in the fair value of an asset.
    • Significant change in the manner in which an asset is used.
    • Adverse change in legal factors or in the business climate.
    • An accumulation of costs in excess of the amount originally expected to acquire or construct an asset.
    • A projection or forecast that demonstrates continuing losses associated with an asset.
measuring impairments
Measuring Impairments
  • Review events for possible impairment.
  • 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.
finite life assets to be held and used
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

Undiscounted futurecash flows

Fair Value

$0

$125

$250

Case 3:$275 book value.

Loss = $275 - $125

Case 1: $50 book value.

No loss recognized

Case 2: $150 book value. No loss recognized

example 5 asset impairment
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
Example 5: Continued

Step 1: Recoverability

Book Value > Undisc Future CFs

6.5 > 4.0

Step 2: Measurement

Book value $6.5 million

Fair value 3.5 million

Impairment loss $3.0 million

example 5b asset impairment
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
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
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 manu-factured at its Arizona plant, not discountedto present value 15,000,000

The fair value of the Arizona plant is estimated to be $11,000,000.

  • Determine the amount of impairment loss, if any.
  • If a loss is indicated, where would it appear in General Optic’s multiple-step income statement?
example 6 continued
Example 6: Continued
  • 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
  • The loss would appear in the income statement along with other operating expenses.
example 6 asset impairment1
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 manu-factured at its Arizona plant, not discountedto present value 15,000,000

The fair value of the Arizona plant is estimated to be $11,000,000.

  • Determine the amount of impairment loss, if any.
  • If a loss is indicated, where would it appear in General Optic’s multiple-step income statement?
  • If a loss is indicated, prepare the entry to record the loss.
example 6 continued1
Example 6: Continued
  • 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
  • The loss would appear in the income statement along with other operating expenses.
  • Loss on impairment 7,300,000Accumulated depreciation 14,200,000 Plant assets 21,500,000
assets held for sale

Impairmentloss

Bookvalue

Fair value lesscost to sell

=

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.
depletion and amortization
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
Establishing a Depletion Base
  • Computation of the depletion base involves four factors:
    • Acquisition cost.
    • Exploration costs.
    • Development costs.
    • Restoration costs.
example 7 depletion
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
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
MACRS vs. GAAP

Modified Accelerated Cost Recovery System

  • MACRS differs from GAAP in three respects:
    • a mandated tax life, which is generally shorter than the economic life;
    • cost recovery on an accelerated basis; and
    • an assigned salvage value of zero.
    • (Basically DDB with a half-year convention)
ifrs vs gaap
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 gaap1
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 gaap2
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 two-step 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
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 high-speed 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
Example 8: Continued
  • U.S. GAAP

2011: $120,000  8 = $15,000 x 6/12 = $ 7,500

2012: $120,000  8 = $15,000

  • IFRS:

2011: Truck: $100,000  8 = $12,500 x 6/12 = $ 6,250

Drill: $ 20,000  4 = $ 5,000 x 6/12 = 2,500

Total $ 8,750

2012: Truck: $100,000  8 = $12,500

Drill: $ 20,000  4 = 5,000

Total $17,500

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