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Administrative Quiz #4 due Wednesday 3/4 Ch. 10: wrap up
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  1. Agenda • Administrative • Quiz #4 due Wednesday 3/4 • Ch. 10: wrap up • Ch. 11: Depreciation, Impairments and Depletion

  2. Depreciation: Concept • Depreciation is a means of cost allocation • It is not a method of valuation • What does this mean? It means that we will see Book Value = Fair Value only by coincidence (except for at the time when the asset is purchased) • 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 •  Matching

  3. Factors in the Depreciation Process Questions to be answered: • What is the depreciable base of the asset? • Depreciable base is the dollar amount subject to depreciation. It is determined as: Original cost of the asset less Estimated salvage or disposal value • (however note that for declining balance methods, we use original cost (and ignore salvage value) in the calculation, and only check that our deprecation does not cause the carrying value of the asset to drop below salvage value) • What is the asset’s useful life? • What method of depreciation is best for the asset in question?

  4. Financial Accounting Depreciation Methods Tax Depreciation Straight- line Activity Decreasing Charge Special methods 1. Composite method 2. Hybrid methods 1. Declining Balance 2. Sum-of-the-years’ digits Depreciation Methods: Overview Depreciation Methods

  5. Depreciation Methods: Straight-Line • S/L is a function of time rather than usage • most commonly used method • Results in an equal amount of depreciation expense for a given period • Depreciation Expense is computed as: Cost – Salvage Value Estimated Life

  6. Example – Depreciation Methods Jose Inc. bought a new printing press for $1,000,000 on June 30, 2005. The press has an estimated useful life of 15 years, and a salvage value of $50,000. It is estimated that the machine will provide 200,000 hours of use. From its purchase to Jose’s year end of December 31, 2005, the press ran for 7,000 hours. Calculate depreciation expense for the machine for using the following methods: straight-line, Activity, and Double Declining Balance (2x SL rate).

  7. Straight Line Method Jose Inc.’s 2005 depreciation (S/L Method): • Depreciable Base: 1,000,000 – 50,000 = 950,000 • Rate per year: 950,000 / 15 = $63,333 • 6 months from July 1 to Dec 31: $31,666 • Note: unless told otherwise, assume that firms using SL depreciation; go by month for part-year problems

  8. Depreciation Methods: Activity Based • This method is a function of usage rather than time • requires more effort in recording asset use (e.g., must read + record odometer readings, or install hourly usage meters, etc.) • Estimated life for this method is in terms of total input/output of asset. • Depreciation expense is computed as: (Cost – Salvage Value) x Input or Output in period Total Estimated Input or Output

  9. Activity Based Method Jose Inc.’s 2005 depreciation (Activity-Based Method): • Part-year? Doesn’t impact calculation • $950,000 / 200,000 hrs = $4.75 / hr • 7,000 x $4.75 = $33,250 Dep’n for 2005

  10. Depreciation Methods: Decreasing Charge (Accelerated) These methods result in higher depreciation expense in the earlier years and lower charges in the later years. Two accelerated methods are: • Declining balance • Sum-of-the-years’-digits

  11. Depreciation Methods: Declining Balance • Salvage value is not deducted when computing depreciable base for declining balance • Often utilizes a depreciation rate (%) that is some multiple of the SL rate • 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. • Since the book value decreases over time this results in a decreasing amount of depreciation expense over time. • An asset’s book value can never be less than its estimated salvage value. • You must check this “manually” after calculating the depreciation expense for the year – and cut back on depreciation that would drop carrying value below salvage value

  12. Double Declining Balance Method Jose Inc.’s 2005 depreciation (DDB method): • Ignores Salvage Value • Calculate full- year depreciation: • 1,000,000 x [2/15] = $133,333 • Since only half-year: 133,333 x [6/12] = $66,667 • What about next year in 2006? • Take the NBV at the beginning of the period (1,000,000 – 66,667) = 933,333 X [2/15] = $124,444

  13. Depreciation Methods: Sum-of-the-Years’ Digits • A fraction is multiplied by the depreciable base to arrive at the depreciation expense per period. • The fraction is: • Numerator: number of years remaining in the asset’s life as of the beginning of the period. • Denominator: sum of the years in the life • For example, a 5 year life property would have depreciation expense for the first year as: • (Cost – Salvage value) X 5 (years remaining) 15 (computed as 5+4+3+2+1)

  14. SYD Method Jose Inc.’s 2005 depreciation (SYD Method): • Calculate full- year depreciation: • (Cost – SV) X (# years remaining at beg of period/sum of years) • 950,000 x [15/120] = $118,750 • Since only half-year: 118,750 x [6/12] = $59,375 • What about next year in 2006? • The remaining $59,375 is attributable to the first 6 months of 2006 • Then calculate depreciation for the next 12 months: 950,000 x [14/120] = $110,833 • Then allocate 6 months of the $ 110,833 to the last six months of 2006: $ 110,833 X 6/12 = 55,417 • 2006 depreciation: 59,375 + 55,417 = 114,792

  15. Depreciation Methods: Summary • Straight-Line Cost – Salvage Value Estimated Life • Activity Method • Depreciation expense is computed as: (Cost – Salvage Value) x Input or Output in period Total Estimated Input or Output • DDB: • Salvage value is not deducted when computing depreciable base. • The rate is double the SL rate • 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. • SYD: (Cost – Salvage value) X 5 (years remaining) 15 (computed as 5+4+3+2+1)

  16. Partial Year Depreciation • When an asset is bought sometime during the year, follow the company’s policy for treatment • In some cases, a partial depreciation charge is required • In other cases, the firm may choose to take a full year’s depreciation in the year purchased, and none in the year of disposal (or even ½ year when purchased and ½ year when disposed) • If the firm allocates proportionately based on months owned, determine depreciation for a full year, and allocate the amount between the two periods affected

  17. Revision of Depreciation Estimates • 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 Value Remaining Est. Life • These revised depreciation expenses apply prospectively to the remaining life of asset. • No Adjustment to prior periods

  18. Revision Example Kennedy Floatation Devices Inc. (KFD) bought a plastic foam manufacturing machine on November 1, 2005. At that time, KFD assumed the machine would last for 10 years, and would have a salvage value of $1,000. The machine cost $50,000. On July 1, 2007, KFD installed a new part on the machine at a cost of $15,000. The new part extended the life of the machine for an additional 15 years, although at that date it would have a salvage value of only $500. Calculate the depreciation expense for the machine for the 2007 fiscal year (ended December 31).

  19. Solution Book value on July 1, 2007, before new part: 2005 depreciation = (50,000 – 1,000)/10 = 4,900 x 2/12 = 817 2006 depreciation = 4,900 2007 depreciation (up to July 1) = 4,900 x 6/12 = 2,450 Total Accum. Depn.: 817 + 4900 + 2450 = 8,167 Book Value before new part = 50,000 – 8,167 = 41,833 BV after new part: 41,833 + 15,000 = 56,833 Remaining Life: 15 years New Depreciation per year = (56,833 – 500) / 15 = 3,756 per year Total Depreciation for 2007: 2,450 + 3,756 X (6/12) = 4,328

  20. Impairments An impairment of a depreciable asset occurs when: • The carrying amount of the asset (or asset group) is not recoverable, and therefore a write-off is needed. • The recoverability test determines if an impairment has occurred.

  21. Impairments ARecoverability test should be performed when circumstances change indicating a carrying amount may not be recoverable: • Significant decrease in market price • Significant change in use or physical condition • Significant change in legal factors or in business climate that could affect asset’s value • Accumulation of cost significantly greater than amount originally expected to acquire or construct a long-lived asset • Expectation that entity will sell or otherwise dispose of long-lived asset significantly before the end of its previously estimated useful life

  22. Impairments

  23. Impairment has occurred No impairment Impairments: The Recoverability Test Impairment? Sum of expected future net cash flows (NO DISCOUNTING) from use and disposal of asset is less than the carrying amount Sum of expected future net cash flows from use and disposal of asset is equal to or more than the carrying amount

  24. Impairment has occurred Yes Determine impairment loss Loss = Carrying amount less present value of expected net cash flows No Use company’s market rate of interest Impairments: Measuring Loss Loss = Carrying amount less Fair value of asset Does an active market exist for the asset?

  25. Assets are held for use Assets are held for disposal Impairment: Accounting Impairment has occurred • 1. Loss = Carrying value • less Fair value • 2. Depreciate new cost basis • i.e., this is a change in • estimate • 3. Restoration of impairment • loss is NOT permitted 1. Loss = Carrying value less Fair Value less cost of disposal 2. No depreciation is taken 3. Restoration of impairment loss is permitted

  26. Graphic of Accounting for Impairments Not Discounted

  27. Impairment Example Rocky Inc. manufactured a pet rock making machine. Raw materials and direct labor costs totaled $100,000, plus another $5,000 of allocated overhead and $3,000 of capitalized interest. On January 1, 2003, the machine was put into use. On that date, Rocky estimated that it would have a useful life of 10 years and no scrap value. In 2004, another $3,000 was spent on overhauling the machine. This did not extend the life or output of the machine, and was part of its regular maintenance. After sales declined in early 2006, Rocky’s controller assessed whether the machine’s value was impaired. He estimated that the machine would generate net cash flows of $14,000 per year for the next 4 years (including 2006), but would not generate any future cash flows after that. No market existed for the machine. Rocky’s discount rate is 10%. Rocky intends to continue to use the machine to make pet rocks. Show any journal entries that might be required for 2006 with respect to the machine.

  28. Solution We need the Book Value as of January 1, 2006: 108,000 / 10 = 10,800 x 3 years (2003 to 2005) = 32,400 BV: 108,000 – 32,400 = 75,600 (note: the $3000 expenditure in 2004 is regular maintenance, and was charged to expense in 2003) Total future net cash flows: 14,000 x 4 = 56,000 Because 56,000 < 75,600, there is an impairment (move to stage 2) No market exists for the machine, so use PV  i=10%, n=4, pmt=14,000  PV = $44,378 Dr. Impairment Loss (75,600 – 44,378) 31,222 Cr. AD – machine 31,222 Dr. Depreciation Expense (44,378 / 4) 11,095 Cr. AD – machine 11,095

  29. What if… • What if the market improved in 2007, and expected future cash flows increased? • We would do nothing, unless the expected useful life of the machine also increased. In that case, we would revise our depreciation rate from 3 years remaining to some new number • What if a market existed for the machine in 2006, and its fair value was $50,000? • We would have written the machine down to 50,000 instead of $44,378 • What if Rocky had decided to sell the machine instead of continue to use it? • We would write the machine down to its present value less any estimated disposal costs (e.g., fees paid to an auction) • No more depreciation! • If a market existed, and its market value increased in the future, we could recognize a recovery of the loss we recognized in 2006 (but we could not increase its book value above the original $75,600)

  30. IFRS vs. US GAAP Step 1: Recoverability test • US GAAP compares carrying value to future undiscounted cashflows • IFRS compares carrying value to the recoverable amount. • The recoverable amount is the greater of: • Net selling price (market value of the asset less disposal costs) • Value in use (Discounted future cashflows) Step 2: Measurement of loss • US GAAP: Carrying value less: • Fair value (if there is a market for assets) – or – if not market: • Future discounted cashflows • IFRS: Carrying value less the recoverable amount Write-ups for subsequent recoveries: • Under US GAAP, allowed only if asset is held for disposal, up to carrying value at time of original write-down • Under IFRS, allowed • If using cost model, up to carrying value at time of original write-down • If using the revaluation model, no ceiling

  31. Depletion: Terminology Depletionrefers to the cost basis write-off of natural resources (e.g., coal, oil, timber) • Note that cost here includes (future) restoration costs (e.g., replanting logged areas) Depletion expense per unit is calculated: Cost – Estimated Salvage Value Total Estimated Units Available The per unit cost is multiplied by the units extracted during a period to derive the depletion for the period.

  32. Oil and Gas – A Special Case • How to you treat “dry” well costs? • There are no future benefits from dry wells – so you could write off all related expenses (successful efforts method) • However, there will always be dry wells dug in the process of finding good wells • So perhaps the cost of dry wells could be capitalized and added to the depletion base of good wells (full cost method) • Currently, both methods are acceptable